Brazil’s Giant Problem - John Lyons and David Luhnow (WSJ)

• The Saturday Essay  

Crowds formed in Three Powers Plaza to await inauguration of new capital in Brasilia in 1960. Photo: ASSOCIATED PRESS

Brazil’s Giant Problem

John Lyons and David Luhnow

The Wall Street Journal, April 23, 2016 

Corruption is just a symptom of Brazil’s deeper issue: a vast state apparatus that has tried to be the country’s engine of economic growth.

But the sparkling new capital was a monument to Brazil’s past. For all its modernist appeal, it was one more expression of the country’s long and troubled attachment to the concept of a giant paternalistic state, responsible for managing the affairs of the entire society, from its biggest companies to its poorest citizens.
Founded by Portuguese monarchs who moved their court to Rio de Janeiro in 1808, Brazil has experienced almost every conceivable sort of rule over the past two centuries. Its leaders have run the gamut from emperors and dictators to democrats and former Marxists. Regardless of their politics, however, almost all of them have shared a commitment to the Leviathan state as the engine of progress.
“The problem is, from time immemorial, Brazil’s political leaders only see one way forward, the growth of the state,” said Fernando Henrique Cardoso, a former leftist intellectual who sought to reduce the size of Brazil’s government while president from 1995 to 2002. “But you need another springboard for progress, that doesn’t exclude the state but that accepts markets. This just doesn’t sink in in Brazil.”
Today, the Leviathan is sick. Brasília is embroiled in a sprawling embezzlement scandal at the state oil company, Petróleo Brasileiro SA . Investigators say that politicians, oil executives and businessmen conspired for a decade to siphon billions of dollars from the firm, channeling money to Swiss accounts and the slush funds of major political parties.
In Brazil’s Congress, where six in 10 members now face some kind of criminal investigation, lawmakers in the lower house have voted to impeach President Dilma Rousseff, a leftist economist whom many blame for fostering corruption and ruining Brazil’s economy. One vote against her came from Congressman Tiririca, a professional clown who won office campaigning that “it can’t get any worse.”
But it might. Brazil is deep in its worst recession since the 1930s, and it may not yet have hit bottom. The country’s debt tripled to $1 trillion in nine years, and some of its states are already going bust. Government insolvency is a possibility. If Ms. Rousseff is impeached, her vice president, Michel Temer, will need to rely on lawmakers implicated in the Petrobras scandal to make unpopular decisions like spending cuts to prevent Brazil’s crisis from turning into a full-blown calamity.
While many observers of Brazil’s predicament have focused on the country’s corruption, that may miss the point. Brazil’s deeper problem lies in the failures of its Leviathan state, which has perennially reached for the utopian visions embodied in Brasília but instead has produced recurring cycles of boom and dramatic bust.
A sensation of déjà vu hangs over Brasília right now. The current downturn follows one of Brazil’s greatest booms. Just a few years ago, the country appeared to be climbing into the global club of developed nations. The economy surged 7.6% in 2010, capping a decade in which millions of the poor climbed into the middle class. Diplomats opened new embassies and lobbied for a seat on the U.N. Security Council. Brazil was selected to host the 2014 World Cup and this year’s Olympic Games.
But the country has been here before. With 10% annual growth in the 1970s, some declared a “Brazilian Miracle,” only to see the 1980s become the “Lost Decade”: Inflation surged to four digits, and workers rushed out on payday to spend their wages, knowing that their money would be worthless by morning.

But it might. Brazil is deep in its worst recession since the 1930s, and it may not yet have hit bottom. The country’s debt tripled to $1 trillion in nine years, and some of its states are already going bust. Government insolvency is a possibility. If Ms. Rousseff is impeached, her vice president, Michel Temer, will need to rely on lawmakers implicated in the Petrobras scandal to make unpopular decisions like spending cuts to prevent Brazil’s crisis from turning into a full-blown calamity.
While many observers of Brazil’s predicament have focused on the country’s corruption, that may miss the point. Brazil’s deeper problem lies in the failures of its Leviathan state, which has perennially reached for the utopian visions embodied in Brasília but instead has produced recurring cycles of boom and dramatic bust.
A sensation of déjà vu hangs over Brasília right now. The current downturn follows one of Brazil’s greatest booms. Just a few years ago, the country appeared to be climbing into the global club of developed nations. The economy surged 7.6% in 2010, capping a decade in which millions of the poor climbed into the middle class. Diplomats opened new embassies and lobbied for a seat on the U.N. Security Council. Brazil was selected to host the 2014 World Cup and this year’s Olympic Games.
But the country has been here before. With 10% annual growth in the 1970s, some declared a “Brazilian Miracle,” only to see the 1980s become the “Lost Decade”: Inflation surged to four digits, and workers rushed out on payday to spend their wages, knowing that their money would be worthless by morning.
“It really begs the question: Is all this cyclical, is our economy and politics like a chicken trying to take flight, rising a few feet and then settling back down again?” said Marcos Troyjo, a former Brazilian diplomat who now teaches at Columbia University. “We seem to have returned to a spot in the past where inflation is a real threat, where debt is rising exponentially, where the president must act or the scenario deteriorates further.”
Brazil inspires optimism because it has a lot going for it. The South American nation has qualities that Americans would find familiar. It is a continent-sized nation with fertile land, abundant natural resources and a deeply ingrained sense of national destiny. Its population of 200 million is mixed, including descendants from a dark past of slavery (Brazil imported more slaves than the U.S.) and waves of European and Japanese immigration. But Brazil remained underdeveloped as the U.S. became a superpower.
“Brazil has yet to find a way to combine an enormous economic potential with the political leadership needed to sustain the needed enabling reforms,” said Mohamed El-Erian, chief economic adviser at Allianz. “As such, the economy ends up behaving like a thoroughbred horse that can run really fast on smooth ground but stumbles and falls when it gets bumpy.”
One explanation for Brazil’s stop-and-start development path is reliance on commodities. The country is even named for one: Brazilwood, used to make red dye in the 16th century. Brazil’s history can be told through commodities cycles, from sugar in the mid-1500s to coffee and rubber in the 1800s. In the early 2000s, iron, oil and soy positioned Brazil to soar as Chinese demand for the goods surged.
While commodities exports represent a small part of Brazil’s largely closed economy, they are a direct driver of growth. No other country in Latin America has a tighter correlation between commodity prices and growth, according to a survey by Morgan Stanley.
Brazil’s leaders spent much of the 20th century attempting to diversify away from natural resources, but their approach almost always relied on state banks and state companies—and it failed time and again. Juscelino Kubitschek, who built Brasília, promised “50 years of progress in five.” He created a state company to build the capital, called Novacap, and put a rival political party in charge to ensure stability. The cost of the city is still a matter of debate in Brazil, but the central bank printed so much paper money that inflation surged.
As a leftist militant in the 1960s, Ms. Rousseff was tortured by the military dictatorship, which itself tried to drive growth by creating state factories and Pharaonic projects such as giant dams. As an energy minister and later president of a left-leaning democracy, Ms. Rousseff helped to implement the same sort of industrial strategies.
Why does Brazil’s Leviathan state endure? One reason is a strong current of nationalism running through Brazilian life. Another is that it has delivered just enough on its grand promises to win the loyalty of key segments of the population.
Brazil has modernized significantly since World War II, when half the population was illiterate and much of it hungry. The government also created national health and educational systems that, though of poor quality, reach even into the country’s remote Amazon jungles.
Research by the government-backed Embrapa agricultural institute helped Brazil to expand soy and cattle ranching to the harsh soils of its West, and the country became a farming power. State initiative turned Brazil into a leader in ethanol, and the oil firm Petrobras was known as a pioneer in deep-water drilling before the corruption scandal overwhelmed it.
When Luiz Inácio Lula da Silva was elected in 2002, he set the Leviathan in motion to lift the poor. A massive expansion of a welfare program called Bolsa Familia fed families while encouraging children to attend school. Birth-weights in the poor northeast rose. Other programs expanded the electricity grid to regions without light and provided water where there was little. State-subsidized mortgages turned swaths of the working class into homeowners.
“There are vast parts of our country that are poor and without security or education. The state needs to reach these people. Brazil’s history has shown that the free market simply won’t do it,” said Luiz Torelly, a bureaucrat at the state-run Institute for National and Artistic Patrimony in Brasília who defends the size of Brazil’s state.
At the same time, there are few voices in Brazilian public life to challenge the ideas of people like Mr. Torelly. There is no major political party advocating limited government. Politicians who do are likely to be derided by nationalists as sellouts to the free-market U.S.
Unlike other nations in the New World, Brazil never had a revolution that set it in opposition to an intrusive state. The Portuguese monarchy brought an entire ship filled with royal files and documents when it relocated to Rio. Successive governments have added new layers of regulation to a state that began as a royal court. In 1979, military rulers tried to pare back the bureaucracy by creating a cabinet post, the Minister of De-bureaucratization.
The result today is a bureaucracy that spends 41% of the country’s gross domestic product—about double the rate of the U.S. The return for all that tax money is questionable: poorly built roads, ports and bridges, and second-rate education and health services. As one travelers’ cliché goes, Brazil taxes like Scandinavia but has Africa-level infrastructure. In 2013, huge and sometimes violent protests erupted across the country, with protesters upset that the country was spending billions on World Cup stadiums while patients died waiting on the floors of hospital hallways.
Brazil’s government employs millions of workers, most of whom are nearly impossible to fire because of protections written into the constitution. The sheer extent of the bureaucracy and red tape stifles job creation. Brazil ranks 174th in the world for ease of starting a business, behind Uganda and Djibouti, according to the World Bank.
During the “Lost Decade” of hyperinflation in the 1980s, the Leviathan went haywire. State banks that had made bad loans to state enterprises posted enormous losses, forcing Brazil to print money to support them, which in turn created hyperinflation. The currency changed value and even names so often that old bills started circulating with rubber stamps on them showing their new denominations.
Perhaps the most insidious legacy of Brazilian’s Leviathan state is the country’s endemic corruption. Bureaucrats with broad controls become tempted to seek bribes to issue permits, licenses and contracts. Businessmen become tempted to pay them.
Brazil’s Leviathan grew so great that it gave rise to a popular theory that corruption could be a good thing because it “greased the wheels” of otherwise paralyzed bureaucracies. The idea was outlined in a 1964 paper by the American economist Nathaniel Leff, who worked extensively in Brazil.
That view was challenged in the 1990s by economists such as Paulo Mauro, who saw that corruption directly inhibits development: Officials make investments based not on the country’s best interests but on the size of the bribes they get. Matters get worse during commodity booms, when corruption expands in a tide of easy money. “Corruption becomes a system, and the bigger the system, the harder it is to break it,” Mr. Mauro said.
Exhibit A is the Petrobras scandal. After Brazil discovered massive oil fields off Rio de Janeiro, planners sought to make Petrobras a driver of development. They required the company, for example, to source oil platforms locally, with hopes of creating a ship-building industry. Investigators now say that oil executives, businessmen and politicians conspired to skim contracts from Petrobras, channeling money back to Ms. Rousseff’s Workers’ Party and its allies, including the party of Mr. Temer, the vice president who will take over if she is impeached. Ms. Rousseff and Mr. Temer are not charged and deny involvement in the scheme.
The Petrobras scandal is also a case study in opportunities squandered by Brazil’s Leviathan state. Huge investments in refineries and other projects at the center of the scandal were largely wasted—just as Mr. Mauro had predicted. In 2006, Petrobras bought an aging refinery in Texas for $1.2 billion, 30 times what it sold for just the year before. Petrobras’s new $18.5 billion Abreu e Lima refinery is eight times over budget and still incomplete. Both deals are under investigation, and neither may ever be profitable, analysts say.
The Petrobras scandal also allegedly shows how politicians used corruption to retain control. Brazil has 35 registered political parties, some 27 of which are represented in the lower house. The variety is almost comical. Aside from the Workers’ Party, there is the Democratic Labor Party, the Brazilian Labor Party, the Christian Labor Party, the Labor Party of Brazil, the National Labor Party and the Brazilian Labor Renewal Party—and those are just the parties that mention labor or workers.
Many of these parties have no ideology: They exist to capture federal funds budgeted to political parties in the constitution. Their allegiance is for sale, political scientists say. Mostly that means swapping congressional votes for control of cabinet ministries and political appointments. Some 20,000 high-ranking posts in Brazil’s bureaucracy are political appointments, including posts at Petrobras, where investigators say that officials embezzled money for their parties and themselves.
The Workers’ Party came to power vowing to wipe out corruption but was pulled into it, some longtime members say. In 2005, the party and its founder, Mr. da Silva, were rocked by the “Mensalão” vote-buying scandal. Mr. da Silva’s chief of staff resigned and was later jailed. But the economy was booming, and Mr. da Silva was re-elected.
The 84 arrests in the Petrobras scandal—among them a senator and high-profile chief executives of big construction firms—show that Brazil’s big state has at least built a judiciary with strength and independence to go after elites. Part of the credit goes to the 1988 Constitution, which ensured lifetime jobs for judges and prosecutors and shielded their budgets from politicians.
In recent years, prosecutors also won the ability to use plea bargains to offer cooperating witnesses reduced sentences. And suspects could no longer avoid jail by endlessly appealing a guilty verdict in the country’s slow courts, as they had in the past.
“The culture of compliance is sinking in fast. Companies are all persuaded they need to change their ways,” said Rubens Ricupero, a former Brazilian finance minister.
What’s unclear yet is whether the Petrobras investigations represent a watershed for Brazil or an isolated crusade driven by a few willing to exert their power. “A big reason for the independence of the judiciary was not some high-minded separation of powers, but a happy byproduct of the lobbying of judges and prosecutors who wanted job security,” says Ivar Hartmann, a law professor at the Getulio Vargas Foundation law school in Rio.
Trimming back Brazil’s Leviathan state won't be easy. As much as 85% of Brazil’s federal budget goes to spending that is guaranteed by law, from increases in retirement plans to spending on housing. Changes will require constitutional amendments.
“The trouble is, the only way to fix the politics is through the politicians,” says Mr. Ricupero. “Are they really going to vote against their own self interest?”

Write to John Lyons at john.lyons@wsj.com and David Luhnow at david.luhnow@wsj.com