“The Future of Manufacturing in Brazil: Deindustrialization in Debate” [REVIEW]

A Review Essay

“The Future of Manufacturing in Brazil: Deindustrialization in Debate”

By Edmar Bacha and Monica Baumgarten de Bolle

Review co-authored by John Williamson and Roberto Zagha[1]

As indicated by the subtitle, this book is spurred by the revival of the debate on deindustrialization in Brazil. The fundamental question is whether one needs to worry that the failure of industrial growth is going to lead to a more general slowdown of the Brazilian economy and, conversely, whether faster industrial growth is key to accelerated overall growth. It may be useful to precede the discussion of the contents of the book by a brief outline of our attitude to development, which is pretty orthodox.

We take it for granted that developing countries can grow faster in per capita terms than the advanced ones, hence the possibility of catch-up.  The fundamental reason is that it is easier to learn what is already known—in terms of technologies, policies and institutions—than to create them from scratch.  The absorption of this knowledge takes multiple forms: imports of capital goods, FDI, investments in education, learning by doing, studies abroad, participation in international conferences, and so on.  This is not to say that no innovation occurs in developing countries: Brazil’s aviation or agro-industry, India’s pharmaceuticals, and China’s electronics provide examples.  However, the bulk of expansion relies on technologies invented elsewhere.

Catching up is not just a theoretical possibility.  It has happened and it has changed the lives of hundreds of millions of people.  Japan, Korea, Taiwan and Singapore are instances of countries whose per-capita incomes caught up with those of advanced economies in two generations (60 years).  China has grown at annual rates in excess of 10 percent for three decades, an achievement unprecedented in human history: Whereas in 1980 China’s per capita income accounted for less than 3 per cent of the US per capita income (in purchasing power parity terms), it reached 19 percent in 2010 (the last year for which per-capita data in PPP terms are available).  In the same period Korea’s per capita income grew from 21 percent of that in the US to 64 percent.  Within 20 years, China’s per capita income is expected to reach today’s average in the OECD countries. East Asian countries’ high rates of growth have been facilitated by export-oriented industrialization, massive investments in infrastructure and education, stable and highly competitive exchange rates, and high savings. Whether the extensive state intervention to promote some industries helped very much is still subject to dispute: there is also the example of Hong Kong, which developed similarly under the closest the world had ever seen to pure laissez-faire (at least until the Baltic countries achieved independence).  In contrast, at recent rates of growth Brazil will need several centuries to catch up with living standards in the West.

Brazil has experienced periods of high growth as well, which started well before East Asia’s take off.  Between the end of WWI in 1918 and 1980, GDP grew at a compound rate of 6.3 per cent, a rate comparable to East Asia’s more recent performance.  It was not a smooth process.  Over these 60 years there were periods of growth exceeding 10 percent per year, as well as periods when growth was negative or marginal.  Inflation was a recurrent problem.  There were balance of payments crises.  There were military dictatorships and returns to democracy. Over 1932-39, while the rest of the world was mired in the Great Depression, manufacturing in Brazil grew at a rate of 9 percent per year.  This was an incidental result of price support for coffee, which had the effect of bringing about expansionary fiscal and monetary policies—Keynesian policies driven by the political need to protect the incomes of the politically powerful coffee farmers.  During the 1940s and 1950s there was extensive state-driven industrialization when some of Brazil’s largest public enterprises were created, such as Companhia do Vale do Rio Doce in 1941, Companhia Siderurgica Nacional in 1942, and Petrobras in 1952.  There was an opening up of the economy in the 1960s and a return to protectionism in the 1970s  This is not the place to review the economic policies over these 60 years; it suffices to remember that the process was not linear; there were abrupt changes, corrections, but, perhaps crucially, a political will to grow.  The net result was highly positive.

Brazil’s growth came to a stop in 1980.  Had the growth continued at the rates of the previous 60 years, Brazil’s per capita income would be twice what it is today.  As it happened, GDP growth was close to zero in the 1980s, barely above the population growth rate in the 1990s, and just above 2 percent per-capita during 2000-12 (2.2 per cent per year to be exact)—still barely enough to catch up with advanced economies, where the long term per-capita growth rate is close to 2 percent.   As a result, Brazil’s per capita income as a share of the US per capita GDP has declined from 32 percent in 1980 to 20 percent at present.

Since 1980, total factor productivity growth (TFPG) was for a long time negative, as documented by several studies[2].  It picked up in the early 2000s, when growth accelerated.  One reason for the long period of low or negative TFPG is that employment grew more rapidly in lower productivity activities, mostly in the informal service sector.  One of the central insights of development economics is that economic development entails moving resources from low productivity activities to higher productivity ones.  As labor moves from agriculture into modern activities the overall productivity of the economy rises.  Even within the same sector, productivity increases when labor moves from informal to formal employment.  What happened in the post debt crisis years in Brazil is that employment grew mostly in the less productive parts of the service sector, and that the share of employment in manufacturing declined.  In 1981 agriculture accounted for 29 percent of employment, industry for 25 percent, and services for 46 percent.  In 2009 (the last year for which data are available from the WB), the corresponding figures are 17, 22 and 61 percent.  And while in recent years there has been a shift from informal to formal employment, the share of the labor force in informal employment continues to be very high.  Various estimates suggest between 33 and 50 percent[3].

The shift out of industry that prevailed in recent years differs from what we see in China, and may help explain the evolution of TFPG over the last two decades.  While the share of manufacturing in any economy declines when per-capita incomes reach higher levels, Brazil  may have  started this evolution too early—“de-industrialization”  may be premature or excessive in a country whose per-capita GDP is just 20  percent that of the US (in 2010) and far behind that of the advanced economies of East Asia.

Bacha’s and Baumgarten’s book is a timely contribution to the understanding and debate of Brazil’s surprising growth deceleration and the loss of momentum of its industrial development.  It contains pearls of analysis as well as surprising errors of omission and errors of commission.  These errors are as important as the insights because they reflect the state of mind of Brazil’s economists and policy makers In particular, one is surprised by the lack of interest on Brazil’s loss of growth momentum over 30 years, of curiosity on the reasons behind Asia’s high growth achievers, and of interest in the limited integration in the global economy in contrast with the fast growing Asian economies.   Is the premise that Brazil is so unique that there are no lessons to draw from the success of others?  Is it, as Fishlow suggests, that “God is Brazilian”?  Are the relevant comparators, as indicated in several of the papers, Australia, Canada, and Norway?  Or are they instead China, India, Vietnam, Korea, Japan?  Whatever the reason, exceptionalism is inimical to intellectual curiosity and to sound policy making.

Part I contains three chapters. The first is a revised and updated version of Albert Fishlow’s classic article describing Brazil’s import-substitution policy in the postwar years. Rich as this article is, it hardly fits with the title of the book, which one begins to think should have been called “The Past of Industrialization in Brazil”.  As in his other publications[4]  Fishlow is a constant optimist about Brazil, but one should be concerned that his optimism has been unscathed by three decades squandered in terms of economic growth.  It would have been useful to have a justification of his optimism.

The second chapter is by Regis Bonelli, Samuel Pessoâ, and Silvia Mattos. They distinguish three possible reasons why industry is decreasing: a cyclical weakness of industry on a global basis; the integration of China, India, and other Asian countries with low labor costs into the global market; and the secular tendency for the weight of manufacturing to decline, as a counterpart to the increase of services. (As brought out in one of the subsequent papers, there is a fourth possible reason, which is capable of explaining differential national tendencies: abnormally high unit labor costs—or, for that matter, other national weaknesses in the industrial sector). The main part of the paper shows just how general the decline of manufacturing as a share of GDP has been. Brazil achieved its maximum of 27% in the middle of the 1970s, since when the share has declined about 1 percentage point of GDP every 5 years. They go on to calculate a regression equation (R2 adjusted = 0.42) that explains the share of manufacturing in GDP, as a function of per capita income and its square, population, the savings rate, population density, and the real exchange rate (not significant); one wishes the output of the commodity-producing sectors as a fraction of GDP had been included too. They conclude from this that Brazil (currently 0.14 to 0.15) lies only 1% of GDP below the lower confidence interval.  The implication is that Brazil’s deindustrialization is to be expected and is consistent with fundamentals. The corollary is that Brazil is condemned to continue to be a laggard in the world economy.

The third chapter is by Luiz Schymura and Mauricio Canêdo Pinheiro, and is the first where Industrial policy is discussed. The authors give the impression of being conflicted; they want to support industrial policy, but the reasons they give for this support are highly unconvincing. They end up by supporting “light” industrial policy, in the sense of either being restricted to the general provision of public goods or involving market interventions that benefit particular firms, but opposing “heavy” industrial policy, which according to their diagram involves both general provision of public goods and is designed to favor particular firms. The logic of their position escapes us.

Part II contains 4 chapters that explore the (very) short-term decline of manufacturing in Brazil and link it to external and internal macro-economic developments and policies.  The four papers complement each other and suggest that good luck for the country was actually bad for the industrial sector. Government policies did not have industrial growth as a priority and the decline in Brazil’s industrial growth was the passive and (except for one paper) inevitable result of the vagaries of the weather, international commodity prices, and other external shocks. The four papers are possibly the best in the book—analytical and well-researched—even though they recognize Brazil’s “de-industrialization” has been going on for more years than the few analyzed in their papers.

The first chapter, by Edmar Bacha, aims to explain the decline in industrial production from 18 percent of GDP in 2005 to 16 percent of GDP in 2011.  Starting in 2005 Brazil has experienced an episode of Dutch disease: a significant increase in the price of its commodity exports and capital inflows, both leading to a real appreciation of the currency.  The paper develops an accounting framework to estimate the windfall followed by a simple macro-economic model showing that this windfall, by allowing higher levels of domestic absorption, increased the demand for non-tradables and hence a shift of labor from tradables to non-tradables.  While the model explains the decline in the share of the manufacturing sector, it does not allow “what if” questions.  What if the government had introduced export taxes to capture a part of the windfall and hence partially offset expansionary public spending?  What if it had abandoned, or toned down, its expansionary public spending? What if it had taxed or introduced controls on inflows of capital more severely than it has?  What if it had accumulated reserves at a higher rate?  Or adopted a combination of all these policies?  The paper concludes on the need to develop a more complex dynamic model to answer these questions, and one can only applaud this plan. But it will be unfortunate if the absence of the ability to pose such questions is interpreted as an endorsement of the policies that produced them.

The paper by Affonso Celso Pastore, Marcelo Gazzano and Maria Cristina Pinnoti is another solid piece of analysis which seeks to explain the stagnation of the industrial sector since 2010.  It provides a counter-intuitive finding: the decline in the share of industry in the economy has been worsened by the fiscal and monetary counter-cyclical policies pursued in response to the 2008 crisis.  The expansion in domestic demand resulted (as estimated in the previous paper) in an increase in the demand for services and hence of wages in that sector. Like the Scandinavian model of inflation, they argue that both sectors must have equal wage increases, though they assert that it is the dominant sector numerically—the service sector, which employs 60 million versus the 20 million in manufacturing—that determines wage inflation. The resulting increase in unit costs in manufacturing did not offset the positive impact of interest rate reductions. The consequence was the reduction of capacity utilization in manufacturing and an increase in imports of industrial goods.  This explains the decline in capacity utilization in the industrial sector, despite the economy being close to full employment.

The third paper in this part is the interesting and clear paper by Beny Parnes and Gabriel Hartung, which examines the rise (2004-08) and decline (2008-12) of Brazilian industrial growth.  In fact, industrial production in 2012 was 2 percent below the level of 2008.  The authors raise the question:  was the industrial deceleration the result of a global shock, or the result of Brazilian domestic policies?    The industrial deceleration in Brazil was much faster, and lasted longer, than in other parts of the world, and industrial growth lagged behind such growth elsewhere.  The authors conclude that industrial deceleration in Brazil was the result of domestic policies; these increased domestic demand in response to the 2008 shock, reduced the fiscal surplus, and helped increase real wages.   Together with the appreciation of the nominal exchange rate, this led to an increase in the dollar unit cost of labor.  In fact, this increase already started in the early 2000s (see Table 1 of the paper) when the dollar unit cost of labor started to rise faster than in any of the competitive countries of East Asia, or Europe, or the US, both as a result of the appreciation of the exchange rate, and rises in real wages at rates higher than productivity growth.   As in the preceding paper, the rise in real wages—at rates above productivity growth–is the result of expanded demand for services.

The paper by Ilan Goldfajn and Aurelio Bicalio concludes Part II of the book. They use a VAR model to study the responses of industry and services to demand shocks. They confirm that one of the reasons behind the deceleration of industrial growth since 2008 was the expansionary fiscal and monetary policies adopted in the wake of the Lehman crisis, that generated strong demand for services rather than goods, with the resulting effects on wages noted in the paper of Pastore et al.

While the four papers contain interesting and insightful perspectives, the deceleration of Brazil’s industrial sector has had a much longer history than that examined in this part of the book, and one would have expected some questions to be explored, or at least posed, such as: why was Brazil able to grow its industry in the past and is failing now?  What were the motivations of governments that pushed growth? Has it been accepted that Brazil will not be able to catch up with the current level of industrialization?  At the time of writing growth is declining as the commodity price boom fades away. What are the policy actions that could help restore industrial dynamism?

Part III of the book contains three chapters.  That by Sergio G. Lazzarini, Marcos Sawaka Jank and Carlos F. Kiyoshi V. Inoue focuses on the effects of the commodity boom on Brazil’s industrial performance, and discusses whether this boom has been a blessing or a curse.  Ignoring six decades of theory and practice of development experience, the authors’ unambiguous answer is that it has been a blessing.  They debunk five “myths”: (1) value added in commodities is low; (2) the technological content of commodities is low; (3) the rents are captured by the political system; (4) there is a secular decline in the price of commodities; and (5) commodities are a cause of Brazil’s Dutch disease.   The power of their convictions finds no parallel in the paper’s reasoning or data, however.  The two concerns with a commodity economy are not that the value added is low: on the contrary, it is well known that a commodity economy is typically based on advanced technologies and capital intensive production methods, and hence labor productivity is very high (as the chapter illustrates). The concerns are, rather, that commodities have few linkages with the rest of the economy, and that they appreciate the exchange rate and reduce the competitiveness of labor-intensive and less technologically advanced sectors. Showing commodities add value and that labor is more productive than in the rest of the economy hardly addresses these two problems.  Regarding capture, the authors may be right that income inequality is more important than production of commodities per se.  They may also be right that through creative institutional design and state ownership Norway has been able to avoid the worst consequences of a resource curse.  But can Brazil import Norway’s (5 million people) income distribution? And is it realistic to base improvements in income distribution on the distribution of commodity rents as they suggest? Turning to the secular decline of commodity prices, the authors are right on the lack of evidence—that was settled a long time ago.  The authors are also right that volatility is and remains a problem.  Last but not least, the authors’ view that the Brazilian economy is sufficiently large and diversified to withstand Dutch disease relies is belied by the facts.   At $2.2 trillion (at market exchange rates) the economy of Brazil accounts for one fourth that of China, one-sixth that of the US, and 3 percent of the global economy.  The economic opportunities afforded by an economy more integrated in the rest of the world, in terms of export opportunities and economies of scale, vastly surpass those that can be achieved in an economy 3 percent the world size.

The second chapter, by Sandra Polonia Rios and Jose Tavares de Araujo Jr, starts on an optimistic note: it points out that Brazil’s manufacturing exports in 2011 were close to the 2008 historical record; industrial production in 2011 was 33 percent above its 1996 level; and that the share of exported manufacturing output increased from 9 percent in 1996 to 19 percent in 2005.  It then shows that sectors which grew the fastest are those where imports as a share of domestic production are the highest.  Fierce competition forced firms to respond through improved competitiveness: they adopted innovations generated abroad and expanded investments in R&D.  However, a 33 percent increase in manufacturing output from 1996 to 2011 amounts only to a 2 percent annual growth rate. Most sectors have lost export competitiveness. The performance of labor-intensive sectors has been particularly dismal, because of the emergence of low-wage China and other Asian economies.  The conclusion, rather exhortation, is that Brazilian manufacturing needs to increase its productivity—but the mechanism and dynamics of the process are left unspecified.

The last chapter in this part is a valuable contribution to the main theme of the book.  It shows that Brazil has been unable to participate in the growth of international trade, including the part based on value chains, mainly because of the country’s high tariffs.  Whereas in 2011 Brazil ranked 6th in terms of the size of its economy, it ranked 22nd by volume of exports.  Among some of the largest developing countries, Brazil has the highest tariffs on imports of capital goods, twice as high as China or Korea, and 60 percent higher than India’s.  In the case of intermediate goods, while the differential is less pronounced, Brazil has the highest rates among relevant comparators.  This is perhaps the best documented paper of this part of the book and the most useful in terms of its implications and conclusions.

The fourth part of the book consists of three chapters dealing with different aspects of industrial policy.  The first, by Mansueto de Almeida, reviews the recent literature on industrial policy, and makes the useful point that a large share of official (subsidized) lending by the National Development Bank (BNDES) has been dedicated to sectors which were already well established—thus not contributing to a more diversified industry.  The second paper, by Vinicios Carrasco and Joao Manuel Pinho de Mello, demonstrates the (well-known) fact that protection of an industrial sector is an implicit tax on consumers, but then goes on to the very useful and insightful exercise of documenting the effects of protection on one industrial product widely used in the construction industry: the steel reinforced bar (“rebars”).  It shows that a regulation (presumably) prevents imports of rebars below a certain grade, which is higher than that commonly used in European countries, the US, or China.  The result is that the price of rebars in Brazil is between 2 and 4 times that in other countries.  How seemingly benign (presumably safety) regulations end up providing what turns up to be huge protection to the domestic industry is a very important insight.  One would have liked to know more detail, and if it extends to other manufactured goods.  One suspects that high tariffs, and regulations of the type that apply to steel rebars, explain why imports in Brazil are so low in relation to its GDP.  The third paper of this part of the book, by Tiago Berriel, Marco Bonomo, and Carlos Viana de Carvalho, is an unusual exercise seeking to estimate the optimal composition (agriculture, industry and services) of the Brazilian economy, recognizing that an economy highly concentrated in the sectors in which it has the greatest comparative advantage runs the risk of low diversification and high variability of incomes.  It applies an analytical framework that establishes a trade-off between diversification and economic growth that concludes that the share of industry in Brazilian GDP is above optimal.  This is an interesting mental exercise, but it would be a mistake to take its result to heart.

The fifth and last part of the book consists of four chapters that explore different aspects of the Brazilian policies implemented in recent years.  The paper by Eduardo Augusto Guimaraes examines the effects of minimum local content requirements in industries supplying equipment and materials to Petrobras for oil and gas exploration.  It concludes that the local content requirements are excessive and lacking in a sense of priorities.  In particular, the policy should clearly identify the parts of the industry that have a long term potential and focus on those.

The well-researched paper by Leonardo Rezende analyzes the current system of government support to industrial innovation.  It contains two interesting conclusions.  The current system does not support industries that innovate and, in fact, supports mostly incumbents in the highly concentrated parts of the industrial sector (reinforcing the conclusion of Carrasco and Pinho de Mello).  The author recommends a reorientation of government support towards innovation in areas that would benefit a large number of firms—on the example of EMBRAPA (a large and highly successful agricultural research outfit responsible for much Brazilian progress in agriculture in the last three decades).

The last two papers of the book contain two different perspectives on the government’s recent decision to change the basis of social security taxes from wages to revenue of the firm.  The paper by Rogerio Werneck considers this change a mistake: social security benefits should be financed by those who benefit from them.  In addition, the change introduces cascading into the tax system.  The paper by Fernanda Guardado and Monica Baumgarten recognizes these shortcomings, but also highlights the fact that the change introduces a welcome counter cyclical component to the tax system.  They also make the point that this change has a long run effect, because it encourages the substitution of labor for capital  – and since they consider Brazil to be close to full employment, it is the use of capital that they argue should be encouraged in the long run.   Given the large share of informality in Brazil, the conclusion that one should encourage the substitution of capital for labor seems hasty.

So much for detailed review of the individual chapters which, in many cases, give the impression of complacency: Brazil had the great good fortune to enjoy improved terms of trade and abundant capital inflows that enabled it to run down its manufacturing industry without encountering a balance of payments problem. Presumably the impending reversal of this good fortune, if it occurs, will be regarded as a problem, but a separate problem. Commodities are a blessing rather than a curse. Industry is only one percentage point of GDP below the lower confidence interval in the analysis of Bonelli et al, while the paper of Terriel et al even concludes that it is too large. China, India, and other Asian countries are low wage economies against which Brazil cannot compete.  The size of Brazil’s economy can provide markets sufficiently large to support industrial development. And while one can only agree that Brazil’s industry needs to be internationally competitive, a theme in several of the chapters, the dynamics of this process are left unclear.  Why would firms invest to expand and modernize when some of the fundamentals of the economy are so unsupportive and uncertain?  The drama of growth lost for an entire generation does not seem to find a sufficiently large voice in the book; one would have liked a little more stridency on this issue.  For the millions of people in Brazil who are not fortunate enough to belong to the distinguished groups analyzing the economy and formulating policies, the decline of per capita income as a share of US per capita GDP from 32 percent in 1980 to 20 percent at present is nothing less than a silent tragedy of missed opportunities and squandered lives.

One can therefore understand that, in August 2013, as reported in the newspaper Valor[5], Edmar Bacha had a nightmare the night preceding a trip to Sāo Paulo to present and discuss the book with a group of prominent industrialists.  In the nightmare, the building hosting the Federation of Sāo Paulo Industrialists (FIESP) had become an industrial museum.  In a sudden reversal of fortunes, however, the building was restored as the Federation of Manufacturing Exporters of Sāo Paulo, the message being that to grow faster Brazil needs to orient its industry towards exports.

A few weeks later, Bacha published a paper[6] which, reinforcing the conclusions of the paper in this book, recognizes that the euphoria of 2004-12 was unsustainable and due to a bout of good luck, a windfall which is now over, and that “the Brazilian economy is sick”.   According to the paper, the closedness of the economy is responsible for this state of affairs.  Both in terms of exports and imports relative to the size of the economy, Brazil lags well behind other economies.  The solution is to adopt policies that would integrate the country more closely in the global economy and be a larger participant in world trade (Brazil’s share of world exports declined from 2 percent in the 1950s to half that at present).    A clear message is that—as was the case during the years of the “miracle” — Brazil needs to expand the role of exports in its economy and growth strategy.  Higher exports would tend to result in a larger industrial sector, though how much larger is not something on which we would be dogmatic. (The one thing that is clear on the latter is that it was a mistake to allow the industrial sector to be squeezed by temporary booms in commodities and capital imports.)

To implement a growth-oriented strategy, Bacha suggests three types of reforms, to be introduced gradually: fiscal, reduction of import protection, and preferential trade agreements.  The fiscal proposal is to emulate a policy introduced in Israel that constrains expenditure growth to one-half of the GDP growth of the previous ten years.  The second pillar would consist of a reduction of import tariffs over several years, together with elimination of all the preferences granted domestic industry (in the form of local content requirements, preferences in government procurement, and technical specifications different from those accepted internationally), compensated by devaluation.   In an Annex to the paper, the author provides more details on how to maintain the competitiveness of the real exchange rate, including through restrictions on capital inflows.  This is a refreshingly novel recognition of the role of the exchange rate in an export-oriented growth strategy and of the costs of an open capital account.  There has been ample recognition[7] on the need to manage financial flows in a manner that does not damage the real economy and does not appreciate the exchange rate unduly.  These lessons from recent decades of the development experience have been well assimilated in East Asia.  In Brazil, however, there has been a Churchillian aspiration to a strong currency with little awareness or even discussion of its costs.  The greatest contribution of “The Future of Industrialization in Brazil” may have been to prepare the ground for a paper that recognizes that Brazil needs an export-oriented growth strategy and that this strategy is closely related to a more open import regime and a more competitive exchange rate.

[1] John Williamson was a senior fellow associated with the Petersen Institute from 1981 to 2012; Roberto Zagha has recently retired from the World Bank and wrote this paper while a visiting fellow at the Hoover Institute, Stanford University, which he thanks for the support afforded to complete this work.  The Portuguese version of this paper has been submitted to the Journal “Estudos Economicos”

[2] Bacha, Edmar and Regis Bonelli, “Crescimento Brasileiro Revisitado” in “Desenvolvimento Economico: Uma Perspectiva Brasileira”, volume edited by Veloso, Fernando; and Ferreira, Pedro Cavalcanti; Pessoâ–Elsevier, 2013; Bosworth, Barry and Susan M. Collins (2003). “The Empirics of Growth: An Update.”  Brookings Papers on Economic Activity (2).  McMillan, Margaret S. and Dani Rodrik, “Globalization, Structural Change and Productivity Growth” NBER Working Paper 17143 June 2011

[3] Holanda Barbosa Filho, Fernando, e Veloso, Fernando: “A Contribuição da Formalização para a Elevação Recente da Produtividade do Trabalho no Brasil”  IBRE/FGV, 2013

[4] Fishlow, Albert “Starting Over: Brazil Since 1985” Brookings Institution Press, Washington DC 2011;  “O novo Brasil: as conquistas políticas, econômicas, sociais e nas relações internacionais”,  Saint Paul Editora, Sao Paulo; “Down But Not Out.” Foreign Policy May 18, 2012.

[5] Valor Economico of August 27, 2013, “O sonho de Bacha”

[6] Bacha, Edmar (2013): Integrar Para Crescer: O Brasil na Economia mundial.  Paper presented at the National Forum Brasil,  Estratégia de Desenvolvimento Industrial com Maior Inserção Internacional e Fortalecimento da Competitividade. Rio de Janeiro: BNDES.

[7]  Jeanne, Olivier, Subramanian, Arvind, and Williamson, John (2012), Who Needs to Open the Capital Account? Petersen Institute for International Economics; Rodrik, Dani (1998) Who Needs Capital Account Convertibility?” in Essays in International Finance, Princeton University, May 1998;   Rogoff, Ken (1999), International Institutions for Reducing Global Financial Instability,” Journal of Economic Perspectives, Vol. 13 (Fall), pp. 21-42and “Rethinking capital controls: When should we keep an open mind?”, Finance and Development, December 2002, Volume 39, Number 4; Williamson, John (1995), The Management of Capital Inflows, in Pensamiento Iberoamericacon, January-June 1995.

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Review of Joe Studwell, How Asia Works: Success and Failure in the World’s Most Dynamic Region

In this book, the author lays out what he takes to be the conditions for catch-up growth à la Gerschenkron. These are essentially three. The first is land reform: letting the peasants own their own land and supporting this by the necessary ancillary services will result in maximizing output per hectare (and the labor input), with consequences that include a burst of output, increased savings, the creation of rural markets for urban-produced goods, without jeopardizing a ready-made supply of labor for the new urban industries. The second is the development of an industrial sector under heavy infant-industry protection, disciplined by the requirement of export success, and its progressive expansion into ever more advanced fields. The third is the use of a repressed financial system under government control in order to promote the first two conditions. He argues that this was the formula first pioneered by Meiji Japan and subsequently copied elsewhere in N.E. Asia (postwar Japan followed by Korea and Taiwan, and he hopes now China).

He also considers Indonesia, Malaysia, the Philippines, and Thailand (S.E. Asia), and dismisses claims that they have enjoyed comparable success. They failed to implement a serous land reform, nor did any of them institute an industrial policy aimed at growing industry and pushing it into ever more advanced fields. Entrepreneurs were not required to assist in “developmental” causes when privileges were extended to them, nor were the privileges dependent on revealed success, e.g. in exporting. Accordingly they have no chance of becoming developed.

Of course, countries are required to lie through their teeth in order to implement his strategy. His hero is Park Cheung-hee, who was prepared to assure the Americans that he was aiming to enhance free markets at the same time that he actually did the opposite. But Studwell admits that there is a problem with his prescriptions, which are aimed at development. For an advanced economy, it is quite appropriate to pursue efficiency. The problem is in knowing when to switch from caring for development to pursuing efficiency. Korea accidentally made the switch right, at the time of the Korean crisis in 1997, when its policies were fortuitously controlled by the IMF. Japan failed to make the switch, as a result of which it has suffered 2 lost decades.

One suspects that there may be other problems with his prescriptions besides the self-diagnosed one. Before elaborating on these, let me say what a pleasure it was to read a literate defense of land reform again, emphasizing the importance of accompanying land reform by the provision of extension services, credit, marketing, etc. This is a reform that we have almost forgotten about in recent years, yet it is surely of vital importance. The problem is that it involves destroying some people’s property rights, unless full compensation is paid, which tends to be expensive. That is why historically major land reforms have occurred only in the wake of major wars, when the rulers had no qualms about raiding people’s property rights, since these were widely regarded as having been illegitimately acquired. My guess is that under current conditions it would be worth compensating fully, even though this would add to government debt. (A compromise is available to countries that have previously imposed a land tax: pay compensation at the declared value of land, which is usually a gross under-estimate of its actual value.)

It is also a pleasure to have the logic of the industrial policies pursued in NE Asia laid out so clearly, though I am not filled with the same zeal for them as for the agricultural policies. Buying them essentially requires a similar act of faith to that involved in signing on to the neoclassical economics he so fervently despises, and accepting that there is no other way to develop except by the dirigiste strategy that he so well outlines. But is that really true? When I was young the developed countries comprised Western Europe and what Angus Maddison has called the “European offshoots”. To those we must now add not only Japan, Korea, and Taiwan, but also Southern Europe, Israel, Hong Kong, and Singapore.

It is difficult to know what Studwell would make of Southern Europe (at least outside Italy, which he considers to have developed properly) and Israel. But Studwell tells us quite explicitly that he is not going to consider Hong Kong and Singapore, because they are merely “anomalous port financial havens” (p. 63). The implication is that it is wrong to compare city-states to “real” countries. This would make sense if the cities normally sacrificed for the benefit of their hinterland, but surely they have, on the contrary, generally exploited their hinterlands, so that it is more and not less difficult for a city-state to develop. Of course, addition of Hong Kong and Singapore to the comparators is devastating to his thesis. Hong Kong developed under the purest laissez-faire that I know of; its addition to the list of comparators suggests that we look to what the countries of NE Asia have in common—competitive exchange rates, reputable educational systems, demographic transitions, and high savings—rather than to what is different between them—industrial policy—in explaining their success. And the inclusion of Singapore in the reference set would force him to admit that part of SE Asia has already made it.

His attitude to SE Asia is in fact something of a mystery. He says on p.160 that it is difficult for him to see how any of the Asian stock markets contributed to development. Let me tell him: by letting firms raise money, and without the danger of strangling themselves by excessive leverage. On p. 166 he tells us that Thailand had been going completely the wrong way prior to 1997, but two pages before that he told us that Thailand was the world’s fastest developing country over the decade 1987-96. He added that this did not signify real development. In the sense in which he defines real development, as implying mastery of more advanced techniques, this may be right, but it makes one wonder about his definition. If there are alternative paths to advanced-country living standards that maybe involve less sacrifice of the current generation, why not take them?

Let us suppose for the sake of the argument that Studwell is correct in his description of how NE Asia developed. (I have a feeling that he is closer to the truth than all those who tried to make out that they succeeded because they were really paragons of liberal virtue.) At the same time, he does not convince me that this is the only route to development. What stands out from his description is the price that was paid for developmental success: he records how Korean businessmen were at one stage locked up (p. 89); foreign holidays by Koreans were banned as late as the 1980s (p. 149); the high rates of inflation that were endured by Koreans right up to the 1980s; the negative real rates of interest paid on Korean deposits and even in the kerb market when there was a crisis (p. 149); and so on. (Not to mention the deprivations experienced by Chinese consumers as the counterpart to the massive accumulation of reserves—reserves that will have a negative yield—by the People’s Bank of China.) Surely development à la NE Asia works, but it works at a terrible cost to the first (and maybe second) generations. If (as I argue above) there are alternative routes to high-income status and these alternatives demand fewer sacrifices en route, then one has to judge the demand that countries master ever more advanced techniques as quixotic.

Another paper that I read (in Portuguese) simultaneously with this book calculates the expected proportion of GDP contributed by industry over the period 2001-07, the expected proportion being determined by a regression equation containing per capita income, its square, population, and population density (Bonelli, Pessoa, and Matos 2013). An extract of their results shows:

Observed value         Lower limit     Expected value      Upper limit

Brazil                          0.15                      0.16                      0.18                      0.20

China                          0.32                      0.22                     0.28                      0.33

Germany                    0.21                      0.16                      0.19                      0.21

India                           0.15                      0.18                      0.22                      0.26

Japan                          0.21                      0.19                      0.21                      0.24

Korea                          0.24                      0.20                     0.22                     0.24

Thailand                     0.34                      0.17                      0.20                     0.23

UK                               0.13                      0.13                      0.16                      0.19

US                               0.14                      0.10                      0.14                      0.17

None of the NE Asian countries, nor Germany for that matter, are shown as falling significantly above the expected proportion of income. Ironically, the one country exhibiting clear signs of what they dub the “Soviet disease” (the opposite to the famous Dutch disease) is Thailand. Ah, but doubtless Studwell would fault them for having the wrong type of industry!

Let me note in closing that Studwell uses the term “Washington Consensus” with great frequency and always in what I think of as the populist sense. In n.3 he asserts, quite wrongly, that in introducing the term I favored floating exchange rates and unrestricted capital mobility: in fact I was quite explicit in condemning both. It is this that distinguishes the populist sense of the term (“populist” because it is used to signify policies that would discredit it in the minds of the audiences addressed) from my initial usage.

To return to the main theme, I welcome, though without much hope of his making an impact, the emphasis on land reform. But to assert that real development consists only of the process of mastering ever more advanced industrial techniques condemns most countries to remaining undeveloped. It has still to be proved that most countries cannot aspire to developed-country living standards without mastering the most advanced techniques. Unless this happens to be true, the notion of having a separate economics of development and then changing over to a concern with efficiency at some point in time, makes no sense.


Bonelli, Regis, Samuel Pessoa, and Silvia Matos. 2013. “Desindustrialzação no Brasil: fatos e interpretação”, in E. Bacha and M. Baugareten, eds., O Futuro da Indústria no Brasil (Rio de Janeiro: Editora José Olympio Ltda).

Studwell, Joe. 2013. How Asia Works: Success and Failure in the World’s Most Dynamic Region. (New York: Grove Press.)

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Corporate Taxation

The OECD has just announced a program of “detailed work on about a dozen of the most contentious issues, including the treatment of digital businesses and the rules on transfer pricing” in furtherance of its proposed Action Plan on tackling base erosion and profit shifting caused by globalization. There is a much simpler way of achieving the objective of tackling base erosion and profit shifting by corporations seeking “tax efficiency” than that being pursued by the OECD, which appears to have signed on to the idea of country-by-country reporting as the main modification of the current system. This is the idea usually described as unitary taxation, meaning common worldwide taxation of corporate profits.

Unitary taxation is usually criticized as diminishing national sovereignty. This is of course correct; the rate of unitary taxation would be set on a worldwide basis rather than by individual nation states. The question is how much this costs nations when the forces of tax competition oblige them to impose much the same levy for fear of losing revenue. There are those who believe that their particular nations gain by tax competition and would therefore oppose anything that would curtail it, but their attitude can be criticized as myopic; any short-run gain comes at the expense of other countries and lasts only as long as those other countries do not reduce their tax rates. The only logical basis for opposing unitary taxation is that it would help maintain the rate of corporate taxation, which will be judged undesirable by those who wish to see the abolition of all corporate taxation (for which there is some economic logic, though the likely cost would be further concentration of income).

Unitary taxation would demand a formula for sharing out the profits of a multinational company between the countries where it operates. There is no ambiguity about the distribution of sales, apart from those introduced by the variability of exchange rates, which could easily be resolved by adoption of a convention (e.g. to use the rates officially announced monthly by the IMF). There is a further important addition to ambiguity in the case of costs, since these include the costs of capital, and of research and development. These may, or may not, be amortized over several years. My inclination would be to leave this decision up to the individual firm, providing only that it sticks with the same rule each year. In addition, there would need to be a value-judgment regarding the rule for combining costs and sales. I cannot see that one needs to vary this by industry, although doubtless this case will be argued by some. A simple rule of 50:50 would seem as good as any.

Under these conventions, country A would be entitled to receive from firm X a payment equal to

t[½α(A) + ½β(A)]π

where t is the rate of corporate taxation, α(A) is the share of firm X’s revenues derived from A, β(A) is the share of firm X’s costs in A, and π is the firm’s worldwide profit (= ΣiRi – ΣiCi = R – C, where R is the firm’s total revenue and C is its total costs).

The great advantage of this approach is that it would dispense with the need for rules on transfer pricing, at the cost of a sacrifice of national sovereignty that is largely mythical. It seems a modest price to pay.

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The UK Fiscal Debate

When the present government was first formed, I expressed support for the fiscal strategy outlined by George Osborne, the new Chancellor, subject to the understanding that the pace of fiscal tightening would be scaled back in the event of outcomes for the real economy markedly worse than forecast. I continue to feel unease at the prospect of a new burst of fiscal expansion designed to reignite the economy, as is being widely advocated in professional circles. Why?

It is not that I doubt the truths of Keynesian economics, let alone the proposition that it is better to have big deficits when there is excess aggregate supply and to make up the lost revenue by raising taxes and/or reducing expenditure when the economy is in boom. Of course, the reluctance of many of the present Keynesians to support large fiscal surpluses during the last boom (in 2005-08) hardly gives them great credibility. (Similarly, most British economists refuse to acknowledge that fixing the sterling rate by joining the euro when it was first formed would have had the great virtue of ruling out as immediately inflationary the irresponsible fiscal policies of the pre-2007 years.) But all that is water under the bridge. The basic reason for concern at the prospect of renewed fiscal expansion is because this involves adding to debt. And high debt is a bad thing: because it involves transferring income to the present generation (which has already done quite nicely, thanks Jack) from future generations; because it involves lowering the potential growth rate (this has not been denied in the Rogoff-Reinhardt controversy); because it increases the chance of a currency collapse. And there can be no doubt that fiscal expansion would increase the level of debt, and the ratio of debt to potential GDP (the conceptually relevant measure), even though it is true enough that it is not certain that it would increase the ratio of debt to actual GDP, as many of the proponents of fiscal expansion have argued with great vehemence. No one sensible (i.e. someone who has absorbed Keynesian economics and not subsequently engaged in an intellectual abnegation called “rejecting Keynes”) denies that a reduction in fiscal expansion is likely to reduce the level of GDP in the short term. But the essence of economics is weighing off one good against another, and the question is whether this means that the lower debt is bought at too high a price. There seem to me to be two arguments as to why a lower debt may be worth sacrificing some current income. The first argument is that one cannot be sure that there will be the possibility of reversing the increase in debt while there is still time. It is all very well to proclaim, the principle that fiscal policy should be tightened when times are good, but this takes it for granted that times will improve. A danger in delaying action is that if recovery does not follow promptly even with fiscal expansion then it may become necessary to tighten policy at an even more inopportune time. Indeed, the present government has argued that it found itself in this situation: that if only there had been tighter policies in the past, there would be less need to tighten policy now. Admittedly the argument that there is no alternative but to tighten policy now is highly speculative: It is only true if a continuation of existing spending policies without a tax increase to pay for them (or a new stimulus, where that is what is being urged) threatens to tip the economy into crisis. But the counter-argument that because the government is currently able to borrow at low interest rates this danger can be ignored is unpersuasive: a few weeks before the Greek crisis started the Greek sovereign was able to borrow at only a few basis points more than Germany. In other words, one cannot predict how or when a crisis will emerge. All one can say with any confidence is that actions which violate the transversality conditions1 will sooner or later generate a crisis. Hence it is safer to avoid violating the transversality conditions, knowing that one cannot predict the next crisis. The other danger with delay is that the tightening may never happen, for political reasons. No politician will welcome the prospect of having his time in office remembered for the fiscal contraction undertaken, and there are countervailing arguments. They look phony enough to anyone with an economics education, but that does not mean that they do not have political appeal. Can’t you already hear it: You want to cut expenditure when we have the resources to afford it? Already the reduction in the budget deficit in the United States in recent weeks (written on May 18, 2013) is being cited as reducing the need to cut public expenditure. It is asking a lot to expect politicians to take actions that are contrary to common sense just because they are theoretically correct. So if one does not reduce spending (or raise taxes) when times are difficult, it may never get cut at all. So where does this lead me? To the same place as the IMF: Advocacy of less fiscal contraction in the short run than is currently planned, within a framework of regarding fiscal contraction as generally a good thing.

1 The transversality conditions are those that guarantee solvency in the long run.
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Currency Wars and Currency Order1

In a recent Comment article in the Financial Times (“The world wisely edges away from talk of a currency war”, April 29), Barry Eichengreen argued that the world should welcome the fact that the Japanese monetary expansion is no longer being equated with a desire to depreciate the yen. This begs the question: how does one expect the monetary expansion to boost growth? If the answer is exclusively through currency depreciation, then the world’s re-evaluation amounts to dishonesty. The monetary expansion would simply reallocate a given level of demand so that more was satisfied by Japanese production and less by production in the rest of the world.

Now in practice no one assumes that monetary expansion only affects demand by depreciating the yen. Equally, no one doubts that it has this effect. The question is what proportion of the total effect operates through the exchange rate. Judging by the limited effect of QE on demand in the United States, or Europe or the UK, one has to believe that it will have very different effects in Japan to avoid the conclusion that the vast bulk of the effect will operate through the exchange rate. It follows that the Japanese surplus is likely to re-emerge as a policy problem.

This conclusion is consistent with a model of my former colleague, Bill Cline. He concludes that Japan’s sharp depreciation in recent months will lead to an increase in its current account surplus from 1 percent of GDP in 2012 to more than 4 percent in 2018, and that the yen nw needs to appreciate by about 9 percent to keep its medium-term surplus from exceeding 3 percent of GDP (the benchmark of the Fundamental Equilibrium Exchange Rate, or FEER). Of course, there are many models, and doubtless one could find a model that would give a different answer. I happen to hold this model in high esteem because it was the basis for the series of papers we did on the estimation of FEERs (e.g., Cline and Williamson 2012). Let us see models that give a different answer, and let us judge their relative plausibility.

I recently attended a seminar in which Liaquat Ahamed, the author of Lords of Finance, drew a parallel between the 1934 increase in the gold price by the United States and the program of large-scale monetary expansion (“QE”) by the central banks of the main developed countries. He also argued that the increase in the gold price was the critical event in reversing the Great Depression. I would not contest either proposition. The way I reconcile them with the skepticism previously expressed for the effect of QE on demand is by arguing that QE will in due course re-liquify the Western economies and in that way permit renewed monetary expansion. The effect was quicker with the increased gold price because the world was at that time suffering from a liquidity shortage, but in the long run it is entirely possible that the domestic effect of QE will prove much greater than its short-run impact. At that stage one may well reach a different answer on the channels through which Japanese monetary expansion is likely to work. But for the moment, it is virtually certain that the primary effect will work through the exchange rate.

Is there no way of avoiding the Japanese monetary expansion igniting the fear of a currency war other than by giving Japan carte blanche to depreciate and pretend that this will have no adverse effect on demand elsewhere in the world? Of course there is, though it will require abandoning the G7’s, and now the G20’s, boilerplate about not targeting exchange rates. (This is no great loss anyway: intervention to weaken the dollar, or to strengthen the euro, in late 2001, when the euro stood at about 80 U.S. cents due to a failure of the private market to think beyond its nose, would have been thoroughly appropriate.)

Suppose instead that the monetary authorities got together, presumably via the IMF, in order to agree a target set of exchange rates, and then agreed not to undertake any external act which would have the effect of pushing rates away from those agreed. This would still allow Japan to pursue an expansive monetary policy (provided, as Mr Kuroda has affirmed, that it does this exclusively by buying JGBs rather than foreign currencies), but it would leave in place an agreed (more appreciated) target for the yen that would discourage excessive depreciation. It would do this by serving notice on the private market that, if and when the authorities believed that Japan had recovered, the BoJ might intervene, but it could do this only to strengthen the yen. Contrast this with the present situation, in which the knowledge that the BoJ is seeking monetary expansion encourages the market to push the yen down with no restraint.

The big question is clearly that of determining the set of exchange rates to be targeted in this way. I doubt if there is scope for deviating very far from the approach that Bill Cline and I have developed in the series of publications already cited (e.g. Cline and Williamson 2012). This requires agreement (a) that target exchange rates should be set so as to limit the size of current account imbalances; (b) on the size of the allowable imbalances; (c) on the appropriate internal objective of economic policy (even if “internal balance” is agreed to be desirable, there are differences of view on how much slack countries have); (d) on a model that translates demand and exchange rates into current account imbalances. It is important that countries’ leaders be asked to do this in the abstract, rather than viewing its implications for actual exchange rates directly. Given that the only undertaking they are subscribing to is not to actively try to push exchange rates away from these targets, one can hope that they would see the wisdom of agreeing.


Cline, William R., and John Williamson. 2012. “Updated Estimates of Fundamental Equilibrium Exchange Rates”, PB 12-23, Peterson Institute for International Economics, Washington.

Eichengreen, Barry. 2013. “The world wisely edges away from talk of a currency war”, Financial Times, 29 April, p.9.

1 The author is indebted to William Cline for information on the results of his modeling.

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Critique of Bruegel’s Evaluation of Financial Assistance in Euro Area

One of the most useful and timely documents to have been produced by any economic think-tank in the recent past is Bruegel’s “Financial Assistance in the Euro Area: An Early Assessment”. This gives a blow-by-blow account of the assistance programs of Greece, Ireland, and Portugal. (Spain is omitted because, while its banks received assistance, the sovereign did not; the document would have been even more useful had the terms of reference been less restrictive so that it had included Spain.) The detailed account of country programs is followed by a pioneering analysis of the role played by the various institutions that were involved.

It is natural that an evaluation (even if “early”) should offer judgments on the decisions reached. In listening to an oral presentation of the results, I concluded that they presented three main criticisms: that (with the benefit of hindsight) it is apparent that the austerity was overdone; that Ireland erred in bailing out the senior bondholders; and that Greece should have restructured sooner. On reading the report, I discovered that, while these criticisms are indeed discussed, the reasons for the actions are also presented and at the end of the day the report does not offer firm conclusions on these issues. Granted that they are reached with the benefit of hindsight, it seems natural to offer judgments, and their absence would seem excessively cautious. Others have suggested additional criticisms: notably that the “walk on the beach” in Deauville and the temporary appearance of acquiescence in the prospect of Greece being forced out of the Eurozone led to an unnecessary intensification of the worries of bondholders. It is a pity that the report remains silent on those topics.

But on the future role of the three institutions charged jointly with negotiating the adjustment programs—the IMF, the EC, and the ECB, which jointly form the Troika—the Report makes some very thoughtful suggestions. It recognizes that being a third of the Troika threatens IMF independence: too big to withdraw, too small to be sure of getting its way. The solution proposed is to retain an IMF role, because of its expertise, but to reduce its role to that of a “catalytic lender” responsible for perhaps 10% of the cash. It likewise recognizes the anomalous position of the EC as agent for the Eurogroup (i.e. the governments) rather than its normal role as guardian of the Community’s common interest. The solution proposed is to convert the ESM into a European Monetary Fund that would integrate design, negotiation, monitoring, and lending, and give it the responsibility. So far as the third element of the Troika, the ECB, is concerned, the Report notes that while it is a key player because of its powers the negotiations cover subjects that extend “far beyond the remit of a central bank”. It therefore proposes that the ECB should remain part of the Troika but be silent about programs. The solution proposed is not very elegant, but seems to be necessary.

On the country programs, the Report concludes that in every country growth and unemployment have fared worse than originally expected but the current account has fared better (primarily because of the depth of the recession). It is pessimistic about the future of Greece but moderately optimistic in that it expects Ireland and Portugal to be able to resume market access in the near future. This much is uncontroversial.

The Report is typical of economic reasoning during the crisis in ignoring the potential relevance of incomes policy. That incomes policy could have helped is evident from Fig. 1, which shows how unit labor costs rose everywhere in the European periphery relative to Germany. (The figure plots Italy and Spain as well as the three countries in the Bruegel analysis.) Anyone who believes that price competitiveness matters is bound to take the staggering loss of price competitiveness shown by the Figure as more or less ruling out the resumption of growth (other than by a new burst of credit expansion) until the restoration of competitiveness. The strategy pursued by the EU, which is not challenged by the Report, involves achieving internal devaluation by high unemployment.

The Figure is based on 1999 because the euro was founded in that year, and there is therefore some presumption that the guardians of the euro (or at least the
Bundesbank) took some care to make sure that real exchange rates were more or less in equilibrium at that time. Since then one can argue that Ireland, as a rapidly-growing country, would have experienced a trend appreciation in its equilibrium real exchange rate. There seems no strong reason to posit that any of the other countries would have experienced a change. Accordingly a return to an index of 100 seems a reasonable objective.

The latest figures from the EC give reason to hope. With the exception of Italy, all the “peripheral” countries—not just Ireland—have made good progress in restoring competitiveness. Indeed, if the rate of progress witnessed last year could be relied on for another year or two, it would be redundant to preach the virtues of achieving a once-over gain in competitiveness of 25% odd, which is what incomes policy ideally offers. Unfortunately it seems likely that the gains in competitiveness seen last year were one-off events that were achieved at enormous social cost rather than replicable results of high unemployment. There is still a long way to go in restoring competitiveness (except in Ireland) at the rate of progress achieved in previous years. And the problem of Italy remains even on the most optimistic interpretation.

The major weakness of the Bruegel Report (like most analyses of the European crisis) lies in the minimal emphasis given to the loss of competitiveness in the European periphery in the years that led up to the crisis, and the complete absence of any discussion of the potential relevance of incomes policy. Conversely, the striking restoration of competitiveness (outside Italy) revealed in Fig. 1 suggests that the German insistence on prompt adjustment has paid off. Austerity may be relaxed, not as a sop to expansionists, but as the reward for achieving a large measure of adjustment.


Source: Table 7.7 (nominal unit labor costs for total economy) for each peripheral country and Germany from ECFIN AMECO database at  http://ec.europa.eu/economy_finance/ameco/user/serie/SelectSerie.cfm

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Whether to vote for EU membership

Pro-European British citizens will face a major dilemma when the eventual referendum on EU membership takes place. On the one hand, they will wish to enhance British prosperity. But on the other, they will also be concerned to advance the future of the European ideal. The last time we were consulted, in 1975, the British people voted 67% for membership. At that time there was no perception of conflict between what was good for Britain and what was good for European integration; we took it for granted that British leaders would act in the interest of Europe, and that this would also advance British interests.

In the intervening years those of us who favored joining the EU have been sadly disappointed – not because of the failure of membership, but because of the anti-European attitudes of British Prime Ministers (let alone the Tory right-wing) ever since joining the EU. Suffice to recall the embarrassments of handbag diplomacy, the refusal to join the euro in favor of continuing to let the pound float (a disastrous policy that has to be blamed for the large twin deficits incurred in the years prior to the present crisis), or the current Prime Minister’s attempt to secure “repatriation” of powers from Brussels. It would be better to let the continental Europeans get on with constructing Europe free of the threat of continual sabotage by Britain.

It is overwhelmingly likely that Britain will be more prosperous inside the EU than as the Greater Switzerland that anti-Europeans seem to dream of. Judging by the experience of other non-members, we could not even count on saving the comparatively trivial sum of £9 billion per year  (about 0.06 percent of GDP) that presently represents the net British payment to the EU budget. Other non-members who have negotiated free trade with the EU and can afford to also make payments to the EU budget, in the Norwegian case of almost as much per capita as the UK. But offsetting any gain on this account would be the loss of much of the stimulus that membership of the wider European market can, and has, provided.

The anti-European lobby responds by arguing that Switzerland has negotiated free trade with the EU and therefore gets the best of both worlds. Apart from doubts as to whether a similar deal would be available to the UK, the fact is that such a deal would require the UK to accept many of the features that so antagonize the anti-Europeans, and without London having any say in designing those features.

Other than membership of Europe, how else does one account for the reversal of fortunes in post-EU Britain compared to Switzerland? The relative growth rates of the two countries are shown below (for which I am grateful to Edwin Truman and Allie Bagnall):

Average GDP Change, in percent

                          UK                               Switzerland















Source: IMF, International Financial Statistics

The result has been an increase over 1980-2011 of British per capita GDP (measured at PPP) as a share of Swiss per capita GDP from 56% to 82%. Over the same period, the Swiss share of global GDP has declined by 43% as compared to a British decline of only 27% (on a similar basis).

A  comparison of the development of the Swiss versus the British share of foreign exchange transactions is also instructive:



Swiss Share


UK Share


























Source: triennial surveys of foreign exchange activity by the Bank for International Settlements

Switzerland has always been a rival to London in terms of foreign exchange activity, but since the UK decided to join the EU, Switzerland has been out-competed by London. When Britain declined to join the euro, there were fears that this would produce an immediate decline in the earnings of the City. These fears proved misplaced: London has remained the financial capital of Europe. Whether that will survive indefinitely with the UK outside the euro is anyone’s guess. That it would survive a British decision to embrace the role of offshore island outside the EU seems quite improbable.

For that is the fate that will follow UK withdrawal from the EU. Britain will not find an alternative role: an offshore island will be no use to the United States, so the hyped “special relationship” will truly be at en end. The idea of making the old “white Commonwealth” into a major force in the world runs into the difficulty that most of its members find themselves more at home in the Commonwealth as it exists today, which is a body that is dominated by its newer (and non-white) members. Even if British membership of the G20 survives (which cannot be taken for granted), it may well become like Swiss membership of the G10 is today—a reflection of a more influential past. But at least Europe will be able to get on with the business of forging an ever-closer union without the albatross of continual British threats of vetoes.

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