A geography lesson

Fascinating economic analysis of Brazil by John Mauldin (accessible by email subscription only). We live in an age of air travel, technology and the Internet so it's somewhat sobering to be told that much of what passes for economic activity in the world still centres on geography. For this reason, despite it's vast natural resources, Brazil has always been hampered by major geographic limitations. These are unlikely to disappear anytime soon, so the country has some difficult decisions ahead. Here are some extracts from this long but brilliant analysis:

"To this day, Brazil has very few major highways and railways because even where the topography does allow for the possibility, the costs still are much higher than in flatter lands farther south. The country lacks a major coastal road system, as the escarpment is simply too steep and too close to the coast. Following the Brazilian coastline makes clear how Brazil's coastal roads are almost exclusively two-lane, and the coastal cities — while dramatic — are tiny and crammed into whatever pockets of land they can find. And most of the country is still without a rail network; much of that soy, corn and rice that the country has become famous for exporting reaches the country's ports by truck, the most expensive way to transport bulk goods."

"Only Sao Paulo has sufficient flat lands to follow a more standard development pattern and thus achieve any economies of scale. It is also the only portion of Brazil that possesses anything resembling the modern, integrated infrastructure that follows more traditional development patterns. Unsurprisingly, this single state accounts for more than one-third of Brazil's gross domestic product (GDP) despite only serving as home to one-fifth of the country's population. As recently as 1950, Sao Paulo state produced more than one-half Brazil's economic output."

"[Sao Paulo's high elevation] helps mitigate the climatic impact of the region's near-tropical conditions that predominate on the coast, but comes at the dauntingly high capital and engineering costs required to link the city and state to the coast. So while Sao Paulo is indeed a major economic center, it is not one deeply hardwired into Brazil's coastal cities or to the world at large."

"Brazil is correctly thought of as a major exporter of any number of raw commodities, but the hostility of its geography to shipping and the inability of its cities to integrate have curtailed port development drastically. The top seven Brazilian ports combined have less loading capacity than the top U.S. port, New Orleans, and all Brazilian ports combined have considerably less loading capacity than the top two U.S. ports, New Orleans and Houston."

"All of the [Rio de la Plata river's] navigable lengths were now shared between Argentina, Paraguay and Uruguay, leaving capital-poor Brazil sequestered in its highland semi-tropical territories. Argentina and Paraguay rose rapidly in economic and military might, while Brazil languished with little more than plantation agriculture for more than a century."

"Nor was Brazil united. Between the economic pull of Argentina and its rivers and the disconnected nature of the enclavic coast, regionalism became a major feature of Brazilian politics. Contact between the various pieces of Brazil was difficult, while contact with the outside world was relatively easy, making integration of all kinds — political, economic, and cultural —often elusive."

"Brazil's biggest problem — which began with the colonial settlement process and continues to the current day — is that it is simply not capable of growth that is both sustained and stable. Economic growth anywhere in the world is inflationary: Demand for arable land, labor, transport, capital and resources pushes the prices of all of these inputs up. Growth in most places can continue until those inflationary pressures build and eventually overtake any potential benefit of that growth. At that point, growth collapses due to higher costs and a recession sets in. Brazil's burden to bear is that land, labor, transport infrastructure and capital exist in such extreme scarcity in Brazil that any economic growth almost instantly turns inflationary."

"First, the capital required for these plantations was so great that smallholders of the American model were largely shut out. No smallholders meant no small towns that could form kernels of education and industrialization. Instead, plantations meant company towns where economic oligarchies gave birth to political oligarchies. In time, the political and economic power imbalance would provide the foundation for the Brazilian military governments of the 20th century. Even in modern times, Brazil's geography continues to favor oligarchic plantation farming to family farming. At present, 85 percent of farms in the United States— a country with a reputation for factory farming — are 500 acres or fewer, whereas 70 percent of Brazilian farms are 500 acres or more."

"Plantation agriculture calls for unskilled labor, a pattern that continues into the modern day. Unlike the more advanced New World colonies — which enjoyed access to easier transport and thus more capital, yielding the kernels of urbanization, an educational system and labor differentiation — Brazil relied on slave labor. It was the last country in the Western Hemisphere to outlaw slavery, a step it took in 1888.

"A lack of skilled labor means, among other things, a smaller middle class and lower internal consumption than other states at a similar level of development. Consequently, Brazil has a small number of landed elite and a large majority of poor. As of 2011, fully one in four Brazilians eke out a living in Brazil's infamous slums, the favelas. According to the Gini coefficient, a sociological measure of income inequality, Brazil has been the most unequal of the world's major states for decades.

"Taken together, Brazil faces inflationary barriers at every stage of the growth cycle. Starting a business requires capital, which is in short supply and held by a privileged class. Shipping goods requires scarce infrastructure, which is insufficient to needs, expensive and often owned by a privileged class. Any increase in demand for either of these inputs puts upward pressure on the associated costs. Expanding a business requires skilled labor, but there is not a deep skilled labor pool, so any hiring quickly results in wage spirals. And holding everything back is the still-disconnected nature of the Brazilian cities, so there are few economies of scale. More than anywhere else in the world, growth triggers inflation — which kills growth"

"[Despite Argentina's squandering of it's geographic advantage] Argentina is still the power in South America with the clearest, most likely growth path. It still holds the Rio de la Plata's river network and it still holds the Pampas, the best farmland in the Southern Hemisphere. What it cannot seem to figure out is how to make use of its favorable position. So long as that remains the case — so long as the natural dominant power of the Southern Cone remains in decline — other powers have at least a chance to emerge. Which brings us back to Brazil."

"Surprisingly, the clear-cutting of the interior provided the basis of Brazilian political liberalization. One of the many downsides of an oligarchic economic system is that politics tend to become as concentrated as wealth. Yet in clearing the land Brazil created artificial trade ways — roads — that allowed some Brazilians to strike out on their own (though they were not as efficient as rivers). Currently there are some 2.6 million landholders with farms of between 5 and 100 acres (anything less is a subsistence farm, while anything more verges into the category of high-capital factory farms). That is 2.6 million families who have a somewhat independent economic — and political— existence. Elsewhere in the world, that is known as a middle class. The environmental price was steep, but without this very new class of landholder, Brazilian democracy would be on fairly shaky ground"

"The rising importance of the interior — best symbolized by the relocation of the political capital to the interior city of Brasilia in 1960 — diluted the regional leanings of the coastal cities. The lands of the interior saw themselves first and foremost as Brazilian, and as that identity slowly gained credence, the government finally achieved sufficient gravitas and respect to begin addressing the country's other major challenge [inflation]."

"The macroeconomic strategy of the current regime, along with that of a string of governments going back to the early 1990s, is known colloquially as the "real plan" (after Brazil's currency, the real). In essence, the strategy turned Brazil's traditional strategy of growth at any cost on its head, seeking instead low inflation at any cost. Subsidies were eliminated wholesale across the economy, working from the understanding that consumption triggered inflation. Credit —whether government or private, domestic or foreign — was greatly restricted, working from the assumption that the Brazilian system could not handle the subsequent growth without stoking inflation. Government spending was greatly reduced and deficit spending largely phased out on the understanding that all forms of stimulus should be minimized to avoid inflation"

"These strict inflation control policies have achieved a high degree of economic stability. Inflation plunged from more than 2,000 percent a year to the single digits. But those gains came at a cost: Between 1980 and 2005, Brazil has shifted from one of the world's fastest growing economies with one of the highest inflation rates to one of the lowest inflation economies with one of the lowest (if somewhat irregular) growth rates."

"As with the interior expansion plan, the success of the real plan has changed how Brazilians feel about their country. When inflation burned through poor citizens' savings, when it destroyed livelihoods and condemned tens of millions to lives of poverty, faith in central institutions was lacking. The real plan may not promise great growth or even great wealth, but it has delivered price stability — and with price stability people can lay at least a limited groundwork for their own futures. Savings holds value from year to year. Purchasing power is constant. These are basic economic factors that most of the developed world takes for granted but which are relatively new to the current generation of Brazilians— and Brazilians rightly credit their central government with achieving them"

"Brazil cannot be truly secure until at the very least it controls the northern shore of the Rio de la Plata. That requires significant penetration into Paraguay and de facto control of Uruguay and of select pieces of northern Argentina. Were that to happen, Brazil's interior would have direct access to one of the world's most capital-rich regions. The marriage of such capital generation capacity to Brazil's pre-existing bulk will instantly transform Brazil into a power with global potential.

"But not before. Without these territories, the Southern Cone balance of power remains in place no matter how weak Argentina becomes. So long as Argentina can exercise functional independence, it persists as a possible direct threat to Brazil, constrains Brazil's ability to generate its own capital and exists as a potential ally of extraregional powers that might seek to limit Brazil's rise."

"Obviously, this imperative will be well beyond Brazil's reach for many decades. Not only is Brazil's navy far smaller than that of states with one-third its population, it is nowhere close to commanding the Rio de la Plata region. Until that happens, Brazil has no choice but to align with whatever the Atlantic's dominant power happens to be. To do otherwise would risk the country's exports and its overall economic and political coherence."

"A normal trade deal removes barriers to trade and exposes companies in all the affected countries to competition from each other. In Mercosur's case, the various Brazilian industrialists were able to block off entire swaths of the economy for themselves, largely eliminating foreign competition"

"Throughout the past decade, Brazilian governments have sought Chinese investment largely to help alleviate some of the country's transport bottlenecks. The Chinese, hungry for Brazilian resources, have happily complied. But that infrastructure development has come at the cost of granting Chinese firms Brazilian market access, and that access— and even the investment — is damaging the Brazilian system.

At its core it is a difference in development models. The Chinese system is based on ultraloose capital access aimed at maximizing employment and throughput, regardless of the impact on profitability and inflation — about as far as possible from the real plan. This has had a number of negative side effects on the Chinese system, but as regards Brazil, it has resulted in a flood of subsidized Chinese imports.

"Scrapping Mercosur and adopting free market policies would throw the Brazilian market open to global competition. That would decimate Brazil's inefficient industrial base in the short run with the expected knock-on impact on employment, making it a policy the oligarchic and powerful labor unions alike would oppose. But it is difficult to imagine Brazilian industry progressing past its current stunted level if it is not forced to play on a larger field, and weakening the hold of the oligarchs is now at least a century overdue. Two more years of a rising currency and an enervating Chinese relationship will surely destroy much of the progress the Brazilians have painstakingly made in recent decades."

"Success in any free market-oriented reforms would require brutal and rapid changes in Brazil's standard operating procedures — changes that would undoubtedly come with serious political risks. The alternative is to continue to pursue protectionist, defensive policies while allowing international forces to shape Brazil rather than Brazil developing the means to shape international forces. This could well be the path Brazil follows. After all, the damage being inflicted by Mercosur and the China relationship are direct outcomes of policies Brazil chose to follow, rather than anything produced by Brazil's geography."

"We do not mean to belittle Brazilians' achievements to date. Taming their lands, taming inflation and crafting a series of economic sectors fully deserving of international acclaim are no small feats. But insufficient infrastructure, an ossified oligarchy, a shallow skilled labor pool and the looming question of Argentina continue to define the Brazilian position. The maintenance of that position remains largely beyond the control of the Brazilian government. The economy remains hooked on commodities whose prices are set far beyond the continent. Their ability to supply those commodities is largely dependent upon infrastructure in turn dependent upon foreign financing. Even Brazilian dominance of their southern tier is as much a result of what Argentina has done wrong as opposed to what Brazil has done right.

"For Brazil to emerge as a significant extraregional power, Brazilians must first address a lengthy list of internal and regional issues. These include — but are hardly limited to — moving beyond their oligarchic economic system, ensuring that Argentina will never again threaten it and formalizing their dominant position in the border states of Bolivia, Paraguay, and Uruguay. These cannot be accomplished easily, but doing so is the price Brazilians must pay if they are to be the masters of their own destiny rather than simply accepting an environment crafted by others."