The Output Gap in Brazil

What about the economic debate on the so-called output gap? This is a macroeconomic concept invented in the sixties by the economist Arthur Okun, economic advisor of President Kennedy. To the extent that the measurement of unemployment had failures, Okun demonstrated a very strong correlation between the output or GNP gap and the unemployment rate. The bigger the gap, the bigger the unemployment.

Furthermore, practically everybody believed at that time in the so-called Phillips Curve: a negative correlation between inflation and unemployment and consequently a negative correlation between inflation and the output gap.

The dilemma inflation-unemployment was duly reviewed along the years with the discovery of rational expectations by Robert Lucas and the accelerationist theory of Edmund Phelps and Milton Friedman. Even so, the output gap is maintained nowadays as an important component which influences the “acceleration of inflation” in these Central Bank models related to inflationary targets. In other words: when the Monetary Authorities find out that the gap is diminishing, they fear inflation and then raise interest rates.

But there are dozens of methods to measure the gap. After all, the gap is the percentage differential between the potential output of a country in a certain year (full employment GNP) and the output effectively and actually verified. It is estimated that in Brazil in 1966 the output gap reached up to 20% which certainly helped and facilitated the “Brazilian economic miracle” of 1968-1973: GNP grew at 10% per year on the average without any inflationary acceleration – on the contrary, inflation fell from 1968 to 1973.

What about today in Brazil? What is the output gap number? It depends entirely on the rate of growth which is attributed to potential output. During the sixties and seventies in Brazil, we worked with 7% per year as the potential growth rate, but nowadays Monetary Authorities in Brazil seem to be so conservative that they prefer to consider 3% or 4%. With that, the Brazilian output gap – measured by this conservative method – would be very small and consequently the country would be facing inflationary pressures.

But why would the potential rate of economic growth of Brazil fall from 7% in 1975 down to 3% in 2005 or 2008? What went wrong during these 30 or 33 years in Brazil?

This is the fundamental question: why Brazil lost dynamism in the last 30 years, passing through the presidents Figueiredo, Sarney, Collor, Itamar, FHC and Lula? This is the mystery. At the same time, we watch China, India, South Korea and Russia amazing the world with two-digit growth rates.

This hypothesis of a potential growth rate of only 3 or 4% in Brazil in the face of an effective actual growth that might reach 6% in 2008 raises great risks: the inflation target model of the Central Bank of Brazil requires interest rates increases. Because the output gap would be diminishing dramatically. In other words: inflation is coming back.

However, it seems to be quite reasonable to defend an opposite or contrarian view. We might be back at the sixties in Brazil. The output gap in 2008 might be enormous because one cannot imagine a potential growth rate much below 5% in Brazil in the last three decades, with the decline from 7 to 5% being explained simply by the decline in population growth.

From 1981 up to 2007, Brazil grew on the average 2% per year. This means that the output gap kept growing and growing. We might be back to 1966. Or more. A lost production of 100% of GNP in 26 years. This means that Brazilian GNP could be twice what it is in fact. It is almost as if we would be coming from a long war, having lost on an accumulated basis the equivalent to a full Brazilian GNP.

In this “contrarian”case, Brazil might have therefore full conditions to grow at 7% per year (or more) in the next few years without any acceleration of inflation – with or without a world economic crisis. This is what happened in 1968-1973.

We might have an accumulated output gap inherited from past years much greater than the measurement of the Brazilian Central Bank. An enormous idle capacity, ready to go back to production through credit and low interest rates. Vehicles and real estate. In this case, the Brazilian Central Bank is only hurting economic growth by raising interest rates unnecessarily.