Complexo do Alemão, a group of favelas north of Rio de Janeiro, Brazil. (Credit: João Lima/Flickr)
Complexo do Alemão, a group of favelas north of Rio de Janeiro, Brazil. (Credit: João Lima, 'Complexo do Alemão'/Flickr licensed under ) (via:

After developing remarkably over the course of the 20th Century, the Brazilian economy stagnated in the 1980s, as a consequence of high inflation and a substantial foreign debt crisis.

Since 1994, despite these two obstacles having been overcome, the country’s growth per capita has been limited to 1% per year, down from an average of 4.5% between 1950 and 1980.

In 2007, I wrote Macroeconomics of Stagnation in order to develop a new theory to understand and explain the Brazilian economy’s poor performance. This article is about the application of that theory to Brazil. The 2007 essay garnered little attention when it was published because a commodities boom caused the Brazilian economy to skyrocket, but the following years confirmed my diagnosis. Globalization and Competition (2010) and Developmental Macroeconomics (2016, co-authored with Nelson Marconi and José Luiz Oreiro), represent a more extensive articulation of the theory.

The theory gradually took shape and received a name: new developmentalism. Inclusive of development macroeconomics and a political economy of developmental capitalism, the theory contrasts with two extremes: liberal capitalism and statism.

New developmentalism’s macroeconomics is innovative in how it addresses the exchange rate and the current account balance and by virtue of its focus on the five macroeconomic prices: the interest rate; the exchange rate; the wage rate; the rate of profit; and the rate of inflation.

Education, institutions, investment in infrastructure, a financial system able to facilitate investment, and sustained demand are all essential to the economic development process. I argue that the exchange rate and the current account balance are just as essential, and, together with sustained demand, their outcomes are short-term.

Of all the macroeconomic prices, the exchange rate has received least interest from economics. In The General Theory of Employment (1936), John Maynard Keynes created a ‘closed’ economy model involving no foreign trade and posited a fixed exchange rate, thereby excluding exchange rate policy from his book.

Liberal or neo-classical economists believe the exchange rate is satisfactorily determined by the market and their only proposal in this regard is free currency exchange.

Classical development economists like Arthur Lewis, Albert Hirschman, Raúl Prebisch, and Celso Furtado understood the importance of the exchange rate, but instead of arguing for a competitive rate, they proposed a problematic substitute to foster industrialisation: high tariffs on imports of manufactured goods.

Many still believe the exchange rate is only important in its effect on imports and exports but it is crucial for inflation as well. According to new developmentalism, the exchange rate is a significant determinant of investment and savings, and therefore of economic development.

An exchange rate that is overvalued in the long run makes a country’s manufacturing firms uncompetitive, discourages investment, and thereby becomes an obstacle to growth. In addition, the corresponding current account deficit leads the country into a balance-of-payments crisis. Nevertheless, the overwhelming majority of economists fails to recognise the importance of current account deficits. They are rightly concerned with the fiscal indiscipline expressed by severely high public deficits but are deeply mistaken to not argue for exchange rate discipline as well, in order to guard against severe current account deficits.

1. Against current account deficits

A theory possesses value if in addition to being true to fact it is also counter-intuitive. The simple replication of common wisdom is not good science.

New developmentalism’s macroeconomics begins with a counter-intuitive principle: middle-income countries like Brazil do not need foreign capital. Current account deficits, which are necessarily financed by foreign funds, hamper economic development rather than fostering it. The notion that capital-poor countries must attract capital from rich ones seems true, but is misguided.

The argument for taking on foreign debt is that a current account deficit equates to ‘foreign savings’ and that foreign savings and domestic savings together make up total savings, which always spells investment. This, however, is an accountant’s reasoning, not an economist’s. An economist thinks in terms of cause and effect, not in terms of identities.

When a country has a current account deficit, its exchange rate rises in parallel; secondly, the revenues of labourers (wages) and rentiers (interest, rent, and dividends) increase in real terms; thirdly, profits fall, discouraging firms from investing, while workers and rentiers are encouraged to consume. The influx of foreign funds, therefore, leads to a high level of substitution of domestic savings for foreign savings.

The only situation in which the substitution of domestic for foreign savings will not be as significant is when a country is already experiencing very marked growth when investment opportunities are multiplying, and the propensity to invest is increasing. The last time this occurred in Brazil was during the 1968-1973 economic ‘miracle’.

As figure 1 shows, there is a direct link between the current account balance (horizontal axis) and the exchange rate (vertical axis). A current account deficit corresponds to a higher exchange rate than that required for a balanced current account.

This can be illustrated by a country like Brazil, which has already industrialised but exhibits a very slow growth rate, low investment and savings rates, and high public and current account deficits.

In a country like this, an exchange rate that would keep the current account at zero is R$3.30 to the US dollar, whereas an exchange rate that would enable manufacturing companies to be competitive is R$4.00 to the US dollar, corresponding to a current account surplus of 1% of GDP. In the same country, a current account deficit of 3% of GDP would correspond to a higher exchange rate of R$2.80 to the US dollar. Figure 1 displays this correlation.

When a government decides to pursue growth through foreign savings, it, therefore, decides to incur a current account deficit. The decision is self-defeating because the growing current account deficit denotes an exchange rate that in the long run, is so high as to make technologically competitive companies (i.e., those using the best technology available) uncompetitive in monetary terms.

By accommodating a current account deficit, the government engages in exchange rate populism: the country incurs a current account deficit that causes wages interests, real estate rents, and dividends to be artificially high, rather than encouraging investment and growth.

Figure 1: Current-account balance and exchange rate

New developmentalism: Macroeconomics for developing countries 1

In order for Brazilian firms (be they local or multinational) to remain internationally competitive, the government must ensure an exchange rate of around R$4.00 to the US dollar, corresponding to a current account surplus of just over 1% of GDP.

This idea is counter-intuitive because it means the country does not need foreign funds. In fact, by incurring a current account surplus the country will grow while reducing its foreign debt, increasing its international reserves, and/or financing local companies investing abroad.

2. Dutch disease

In the example above, the exchange rate that balances the current account, or holds it at zero (R$3.30 to the US dollar) is the ‘current equilibrium’ exchange rate. The competitive or ‘industrial equilibrium’ exchange rate is different – at around R$4.00 to the US dollar – because the country suffers from the Dutch disease. In this example, the Dutch disease represents the R$0.70-to-the-US-dollar difference between the industrial and current equilibriums.

The Dutch disease is a long-term over appreciation of a country’s currency caused by commodities exports which – whether due to a momentary boom in prices or differential or Ricardian rents – can be profitably exported at an exchange rate significantly higher than that enabling state-of-the-art manufacturing firms to remain internationally competitive.

Although the Dutch disease represents a R$0.70-to-the-US-dollar differential in this example, it may be far greater in other cases, especially in oil-exporting countries where the cost of extraction is very low. The severity of this competitive disadvantage will vary in accordance with international commodities prices.

Figure 2: Current and industrial equilibria and exchange rate

New developmentalism: Macroeconomics for developing countries 2

A country affected by the Dutch disease will experience a current account surplus. In figure 2, with the exchange rate on the vertical axis and time on the horizontal axis, the two equilibriums are shown by the near-parallel red and blue lines: the current equilibrium is the lower red line, and industrial equilibrium is the blue line above. In a commodities-exporting country, commodities will determine the current equilibrium because this equilibrium corresponds to a satisfactory rate of profit for local producers.

Neutralising the Dutch disease means raising the current equilibrium to the level of the industrial equilibrium. Because the latter is higher than the former, this means that neutralising the Dutch disease and thereby ensuring a competitive playing field for firms operating abroad necessarily involves a current account surplus.

The two equilibriums vary over time. For the purposes of this article, it suffices to say that the industrial equilibrium varies mainly with increased productivity and rising manufacturing wages, whereas the current equilibrium varies mainly with changes in commodity prices.

How can the Dutch disease be neutralised? Before it was properly acknowledged, the Dutch disease was neutralised intuitively through high customs tariffs. Governments justified this using the infant industry argument, while critics accused governments of protectionism. However, in many cases, high customs tariffs aimed to neutralise the Dutch disease for the sake of the foreign market.

The United States, for example, endured the Dutch disease due to oil exports, so maintained high tariffs until 1939. To speak of an infant industry at that point would have been absurd, and nor does it make sense to think in terms of protectionism. In fact, high tariffs were a necessary condition for US industrialisation. The US stopped neutralising the Dutch disease in 1939 because it was already very rich and – because of the war – it lacked competitors.

Ordinarily, countries neutralise the Dutch disease from a certain stage of development onwards, following an import substitution model of industrialisation. To this end, they subsidise exports of manufactured products in addition to implementing high import tariffs on foreign goods. Brazil did this successfully between 1967 and 1990. In 1965, manufactured goods exports represented just 6% of total exports; this had risen to 62% by 1990!

The WTO now forbids subsidies. The alternative is to tax commodities exports at variable rates based on commodity prices, whereby, in the Brazilian case, the exporter of a certain commodity would pay 0.70 per US dollar of exports earned. As a consequence of the reduced supply caused by the tax, the exchange rate would depreciate, thereby re-establishing supply, with the manufacturing industry becoming internationally competitive. The tax on commodities exports would lead the market to automatically equalise the current and industrial equilibriums.

This is a very interesting way to neutralise the Dutch disease because ultimately it doesn’t cost exporters anything. What they pay, they receive back in full by way of currency depreciation.

3. Exchange rate overvaluation

Figure 2 also shows a third curve, with cyclical behaviour expressed by two peaks; this is the real exchange rate curve. If the market operated as liberal economists assume, the curve would float around the current equilibrium. We know, however, that this is not the case.

According to new developmental macroeconomics, in developing countries afflicted by the Dutch disease, severe long-term exchange rate overvaluation is typical, leading the economy from one financial crisis to another. The peaks correspond to financial crises, after which the exchange rate falls sharply.

In Brazil’s case, this occurred in 2002 and 2014, when the exchange rate briefly rose above the industrial equilibrium. The exchange rate then crossed beneath the industrial equilibrium, then the level of the current equilibrium, to enter the area representing a current account deficit (between the real exchange rate and the current equilibrium), finally stabilising for a few years at a ‘bottom level’ that was not good for commodities, but enough to keep producers exporting.

Two things cause the exchange rate to rise after a crisis: the Dutch disease and very high interest rates. The Dutch disease ‘pulls’ the exchange rate only as far as the current equilibrium because, for a commodities exporting country, it is commodities that determine the current equilibrium. But the exchange rate continues to drop below the current equilibrium. This is because a commodities exporting country implements substantially higher interest rates than rich countries. Finally, the exchange rate reaches a bottom level, which, in the Brazilian case, was around R$2.80 to the US dollar (at today’s prices) from 2007 to 2017, accompanied by drastic deindustrialisation and quasi-stagnation.

While the exchange rate fluctuates around this bottom level, the current account deficits incurred year after year gradually increase firms’ foreign currency-denominated debt and therefore the debt of the country.

Because the exchange rate regime is free-floating, the deficits should cause the country’s currency to depreciate, but this is prevented by the forming of a credit bubble. Foreign creditors are happy to benefit from high interest rates, economists explain the deficits as ‘foreign savings’, beneficial for the country, and creditors continue to gladly extend credit. In consequence, local manufacturers become internationally uncompetitive and accumulate debt.

Usually, more than half of the foreign debt is financed through foreign investment, which only extends the period of overvaluation. But creditors eventually realise the risk of sovereign default and suspend refinancing of the foreign debt. Alternatively, multinational companies, fearful of being unable to repatriate profits, stop investing. Local firms (manufacturers especially) which have been forced to take on debt, having ceased to be competitive, may also conclude they have to stop accumulating debt. In any case, firms stop investing and a financial crisis is triggered, while the exchange rate rises sharply once again.

Interest rates in developing countries are usually justified by two ‘needs’: that of attracting foreign capital, and that of using the exchange rate as an anchor against inflation.

It should be clear that a policy designed to attract foreign capital is self-defeating.

Central banks have to use interest rates to fight inflation. The level of the real interest rate around which the central bank conducts policy is particularly important. It is fine for this level to be a little lower than that of rich countries, but nothing justifies a much higher level. A third cause for high interest rates can be their benefit to rentiers and financiers, which is perverse when one realises that healthy economies in democratic countries are characterised by low interest rates. Justifying high rates through foreign savings is a mistake: the resulting exchange rate rise leads to higher levels of consumption rather than higher levels of investment.

The use of the exchange rate as an anchor against inflation is absurd. Economists are outraged when governments hold back the prices of state-owned companies (like Petrobras, for example) to keep inflation under control; they should be similarly outraged when central banks hold back the ‘price of the country’: the exchange rate.

4. Financial crises

Every country is subject to financial crises, which mainly consist of banking crises in rich countries and balance-of-payment or foreign exchange crises in developing countries.

Conventional economics explains crises away in terms of fiscal irresponsibility. Indeed, financial crises may stem from this: excessive government spending can cause increases in demand, imports, and ultimately, fiscal and current account deficits. When these occur together, they are referred to as the ‘twin deficits’.

Still, crises may emerge in the absence of fiscal indiscipline, simply as a consequence of policies of growth through foreign savings.

These days, government fiscal accounts are increasingly scrutinised by rating agencies, financial economists, and the press, so that imbalances like those of the Rousseff Administration are more of an exception than a rule amongst middle-income countries.

On the other hand, current account deficits and the indebtedness of firms do not receive the same level of attention from conventional economists, be they liberal or developmental, because they mistakenly assume the market will provide appropriate controls. It is therefore understandable that these deficits are the main causes of developing countries’ financial crises.

5. The exchange rate and development

Investment is the key variable in the development process. The state’s economic role in contemporary societies is to provide equitable income distribution and ensure conditions for capital accumulation. In this latter role, firstly, it has to provide education; secondly, institutions that ensure market efficiency; thirdly, infrastructure investment; fourthly, long-term finance, and fifthly, a stable national currency.

Keynes diagnosed capitalism’s tendency for insufficient demand and added a sixth condition: demand for investment. New developmentalism adds a seventh general condition: an exchange rate capable of ensuring firms’ access to demand. The exchange rate is like a switch that will turn access to foreign and domestic markets on or off.

Economic development textbooks do not discuss exchange rates because they are seen to represent short-term problems and economic development is chiefly interested in long-run trends. Exchange rates are acknowledged to be volatile, but this volatility does not occur around the current equilibrium. If that were the case, its negative effect on investments would be relatively small because businessmen would not take a higher interest rate for reference when making their investment calculations.

New developmentalism views the problem differently because it is the only theory accounting for the fact developing countries have a tendency for cyclical and long-run exchange rate overvaluation in-between financial crises.

In Brazil, for example, the exchange rate remained overvalued for seven years from 2007 to 2014, during which it hovered around R$2.80 to the US dollar. Under these conditions, businesses find investment does not help them remain competitive, even if using state-of-the-art technology, and choose not to invest.

6. Economic policy

To ensure increases in savings and investment, macroeconomic policy must not only guarantee fiscal responsibility but exchange rate responsibility as well, with an even greater focus on the latter because current account deficits are less justifiable than public deficits.

Of paramount importance is that five key prices are effectively controlled: low interest rates; competitive exchange rate; wage rates compatible with rates of profit sufficient to provoke investment; and a low rate of inflation.

The exchange rate is the most important of these five prices. Exchange rates should be maintained close to the industrial, or competitive, equilibrium. In other words, cyclical exchange rate overvaluation must be neutralised to ensure firms can access both foreign and domestic demand. Industrial policy is also necessary, but as a supplement, never a substitute, for macroeconomic policy.

In order to maintain a competitive exchange rate, the Dutch disease should be neutralised through a variable tax on commodities exports, and should also reject the three policies habitually embraced by developing countries which cause additional currency appreciation: the policy of growth through foreign debt; the use of the exchange rate as an anchor against inflation; and – the policy used to enable the former two – high interest rates.

Central banks should certainly use interest rates to combat inflation, but it should be kept low – slightly above rich country rates. Because central banks are responsible for keeping inflation in check, they are constantly tempted to keep interest rates high and the exchange rate overvalued. That is why central banks should be responsible for growth in addition to inflation. As is already the case in certain countries, exchange rate policy committees should operate similarly to existing monetary policy committees. Naturally, the government should also be able to control capital flows.

7. Where the difficulty lies

The theory is simple and so is the exchange rate policy that derives from it. New developmentalism explains why so many developing countries face the competitive disadvantage of long-term exchange rate overvaluation and are therefore unable to industrialise, and why middle-income industrialised countries which dismantle their mechanisms for neutralising the Dutch disease then deindustrialise, as has been the case in Brazil.

The reason countries like Brazil have followed the course they have is the pressure received from the rich world since the 1980s, when developing countries surrendered to economic liberalism and opened up their economies, thereby dismantling mechanisms which had previously prevented exchange rate overvaluation: import tariffs and subsidies for the production of manufactured goods.

New developmentalism explains the fortunes of deindustrialising middle-income countries and offers policy responses. But now that the theory is available, why don’t developing countries, Brazil included, embrace the necessary policies?

Firstly, in spite of interest from younger scholars, trained economists have enormous trouble learning and internalising new things.

Secondly, there is a short-run cost involved in shifting from a current account deficit to a surplus. The necessary one-time devaluation reduces the income of both workers and rentier capitalists.

The fact neither workers nor rentiers like devaluation is why development economists who defend the short-term interests of wage-earners, and liberal economists who basically represent the interests of rentiers and financiers, are both opposed to devaluation.

Rentiers oppose devaluation with a better reason than workers. For the latter, a depreciation will cause wages to lose purchasing power in the short run, but they will soon be rewarded with additional jobs, and later, with increased productivity and higher wages. For rentiers, the picture is different. A devaluation will similarly reduce the purchasing power of their revenues (interests, dividends, and real estate rents), but also the worth of their wealth. Devaluation will also occur only via an interest rate cut, which definitely runs counter to rentier interests. That is why – besides the neo-liberal education they receive in American and British universities – liberal economists refuse to countenance a competitive exchange rate and inevitably ‘forget’ exchange rates when discussing developing countries’ economic problems.

Faced with the macroeconomic issues caused by large current account deficits and public deficits, liberal economists merely propose fiscal adjustment. By causing recessions and unemployment, sole reliance on fiscal measures reduces interest rates and makes the national currency more competitive without devaluing it. In this way, only waged and salaried workers pay for the adjustment by way of a drop in wages.

New developmentalism’s proposals include fiscal adjustment too but alongside a simultaneous cut in interest rates and a currency devaluation. This leads to a more complete adjustment of the country’s accounts and a more equitable distribution of the cost of the adjustment.

Under conditions of ‘liberal’ adjustment, costs are entirely borne by workers, who lose their jobs and see their wages and salaries reduced. In contrast, the bill for new developmentalism-style adjustment is distributed between wage earners and rentiers.


Luiz Carlos Bresser-Pereira

Emeritus professor of the Getulio Vargas Foundation



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