## 13. Public Consumption and Cost of Capital

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### Introduction and long-term context
- Brazil’s real GDP grew at an average close to 7⅓ percent during the 1960s and 1970s, but growth fell sharply after the 1982 debt crisis.
- Average per capita growth for Brazil during 1960–2000 was 2.8 percent; cross‑country models based on conditions in 1960 explain only 25−50 percent of that performance.
- Real per capita GDP growth recovered to about 2¼ percent over 2001–04, above rates in the 1980s and 1990s.
- Cross-sectional (Sala‑i‑Martin style) models identify 18 robust “deep” determinants measured near 1960, but they do not capture major within‑country dynamics (e.g., large pre‑1980 vs post‑1980 performance differences).

### Cross‑country analysis: model performance and key statistics
- Initial conditions (income, education, tropical area fraction, coastal population density, share of mining in GDP, years open) explain around 55 percent of average cross‑country growth over 1960–2000.
- When applied to Brazil, the Brazil dummy is positive and statistically significant across specifications, implying Brazil performed significantly better on average than predicted by 1960 initial conditions.
- Extending the regressions to include financial development, terms of trade growth, and income distribution:
  - Initial level of financial development emerges as an important cross‑country determinant.
  - External trade and financing volatility matter more than fiscal policy volatility across countries once terms‑of‑trade volatility is allowed for.
  - Shocks to the proxy for international liquidity conditions appear positively correlated with growth in cross‑country regressions.

### Dynamic panel estimation and explanatory variables
- A dynamic panel specification (based on Loayza, Fajnzylber, and Calderón) for 79 countries over 1961–99 (five‑year averages) was estimated with OLS and GMM to address endogeneity.
- Incorporating the relative price of investment and proxies for international financial conditions (liquidity ratio; balance‑of‑payments pressure) improves model fit and helps explain Brazil’s per capita growth deceleration since the 1970s.
- Key empirical findings from the panel analysis:
  - Increased macroeconomic instability, higher government consumption, higher relative price of investment, and adverse external conditions account for a significant part of the deceleration in growth during the 1980s, though they do not fully explain five‑year changes in per‑capita growth.
  - The extended models predict Brazil’s per capita growth to have accelerated by around 1½–1¾ percent during 2000–04 compared with 1996–99, with much of the acceleration attributed to macroeconomic stabilization and improved structural conditions.
  - The liquidity proxy and the BOP‑pressure proxy yield somewhat different magnitudes but both indicate that external conditions materially affected Brazil’s growth path.
- Adjusted R‑squared of basic dynamic panel model: 0.5461 (selected specification reported).

### Dissection of specific growth determinants
- Government consumption:
  - Brazil’s ratio of government consumption to GDP increased sharply since 1980; the steady rise since the mid‑1980s has had a persistently negative impact on per‑capita growth in the panel estimates.
- Cost of capital and relative price of investment:
  - A sharp increase in the relative price of investment since 1980 is identified as a major constraint on capital formation and growth.
  - The relative price of investment is a component of the user cost of capital (along with real interest rate and depreciation); the proxy used likely understates the full impact because it does not fully capture high real interest rates over the past two decades.
- External financial conditions and liquidity:
  - Low ratios of international reserves to external debt (liquidity ratio) and episodes of balance‑of‑payments pressure are associated with negative growth contributions (e.g., oil shock of late 1970s, 1982 debt crisis).
  - Improvements in international liquidity conditions in the early 1990s contributed positively to growth after the Brady restructuring, while crises in the late 1990s and early 2000s (1999, 2002) again constrained growth.
- Macroeconomic stability and structural reforms:
  - The Real Plan (1994), adoption of inflation targeting, and a flexible exchange‑rate regime (1999) helped restore price stability and reduce exchange‑rate misalignment, contributing positively to growth since the late 1990s.
  - Trade liberalization in the early 1990s and subsequent increases in openness contributed materially to per‑capita growth, particularly since 2000.
  - Improvements in prudential and supervisory frameworks and reforms in public banks since the mid‑1990s reduced systemic banking risk and supported financial intermediation (even though private credit to GDP remains low relative to East Asia and the OECD).
- Infrastructure:
  - Public infrastructure (proxied by main telephone lines per capita) contributed positively to per‑capita growth; however, persistent declines in public investment (e.g., energy crisis in 2001, transport constraints) may be an increasing constraint on growth.

### Quantitative and illustrative figures highlighted in the analysis
- Brazil average per capita growth: 2.8 percent (1960–2000).
- Model‑predicted acceleration of per‑capita growth in 2000–04 versus 1996–99: around 1½–1¾ percent.
- Subperiod contrast (cross‑sectional regression footnote): dummy falls from 3.1 to 0.7 between 1960–80 and 1980–2000; average per capita growth 3.8 percent (1960–80) and −0.5 percent (1980–2000).
- Private sector credit to GDP (annual averages):
  - Brazil: 27.3 (1961–2000); subperiods include 25.7 (1971–80), 23.3 (1981–90), 31.5 (1991–2000).
  - East Asia (excl. Japan) 64.5 (1961–2000) and 98.7 (1991–2000) — illustrating the credit gap.

### Policy implications and recommendations
- Reduce the high level of government consumption:
  - Lowering public consumption would reduce the economy’s overall consumption level and its intertemporal price (the real interest rate), thereby fostering private investment and growth.
- Sustain and deepen macroeconomic stability:
  - Maintain price stability, a flexible exchange rate, and prudent fiscal policy to reduce volatility of real interest rates and exchange rates and to lower external vulnerabilities.
- Address cost of capital and investment pricing:
  - Policies to reduce the relative price of investment (including dealing with distortions in capital goods markets and exchange‑rate effects) could help revive capital formation.
- Strengthen external liquidity buffers and manage external vulnerabilities:
  - Policies aimed at improving international liquidity ratios and reducing balance‑of‑payments pressures can dampen financing‑cost volatility and support investment.
- Rebuild and prioritize public investment in infrastructure:
  - Reverse declines in public investment where binding (energy, transport, ports) to remove infrastructure constraints on growth.

### Conclusions and directions for further research
- Macroeconomic stabilization, financial‑sector reforms, trade liberalization, and improved infrastructure contributed to stronger per‑capita growth in Brazil since the mid‑1990s.
- Long‑standing structural weaknesses—especially elevated government consumption and a high relative price of investment—continue to weigh on growth.
- Cross‑country panel models provide useful insights but have limitations; further research should explore the dynamics of the debt overhang, institutional development, education, labor‑market informality, and income inequality to better understand Brazil’s mid‑20th‑century growth surge and the post‑1980 slowdown.

*Source: IMF staff estimates and analysis in “Public Consumption and Cost of Capital,” from the provided IMF chapter content.*

### References..............................................................................................................

### _wp06282 - References

### Tables
- 1. Sources of Growth, 1960–2003 .....................................................................................3
- 2. Cross-Country Growth Equations, 1960–2000..............................................................6
- 3. Private Sector Credit to GDP .......................................................................................11
- 4. Per Capita Economic Growth Regressions: A Dynamic Panel  
  Estimation, 1960–99 .................................................................................................12
- 5. Accounting for Brazil’s Growth Performance out of Sample Forecast .......................13

### Figures
- 1. Per Capita GDP, 1960–2000..........................................................................................3
- 2. Government Burden, 1960–2000...................................................................................7
- 3. Relative Price of Investment and Other Indicators of Cost of  
  Capital Goods..............................................................................................................8
- 4. Liquidity Ratio, 1963–2004 ...........................................................................................9
- 5. Proxy for Balance of Payments Pressure in Brazil ........................................................9
- 6. Discretionary Fiscal Policy and Output Growth, 1960–2000 ......................................10
- 7.         Openness,         1960–2000 ..................................................................................................10
- 8. Actual and Predicted Per Capita Growth Rate.............................................................13
- 9. Contribution to Higher Growth. 2000–04....................................................................13
- 10. Macroeconomic Factors and Growth...........................................................................14
- 11.       Structural       Factor and Growth.......................................................................................15
- 12. External Conditions and Growth .................................................................................16

*_wp06282 - References_*

### 13. Public Consumption and Cost of Capital.....................................................................16

### 13. Public Consumption and Cost of Capital

### Introduction and long-term context
- Brazil’s real GDP grew at an average close to 7⅓ percent during the 1960s and 1970s, but growth fell sharply after the 1982 debt crisis.
- Average per capita growth for Brazil during 1960–2000 was 2.8 percent; cross‑country models based on conditions in 1960 explain only 25−50 percent of that performance.
- Real per capita GDP growth recovered to about 2¼ percent over 2001–04, above rates in the 1980s and 1990s.
- Cross-sectional (Sala‑i‑Martin style) models identify 18 robust “deep” determinants measured near 1960, but they do not capture major within‑country dynamics (e.g., large pre‑1980 vs post‑1980 performance differences).

### Cross‑country analysis: model performance and key statistics
- Initial conditions (income, education, tropical area fraction, coastal population density, share of mining in GDP, years open) explain around 55 percent of average cross‑country growth over 1960–2000.
- When applied to Brazil, the Brazil dummy is positive and statistically significant across specifications, implying Brazil performed significantly better on average than predicted by 1960 initial conditions.
- Extending the regressions to include financial development, terms of trade growth, and income distribution:
  - Initial level of financial development emerges as an important cross‑country determinant.
  - External trade and financing volatility matter more than fiscal policy volatility across countries once terms‑of‑trade volatility is allowed for.
  - Shocks to the proxy for international liquidity conditions appear positively correlated with growth in cross‑country regressions.

### Dynamic panel estimation and explanatory variables
- A dynamic panel specification (based on Loayza, Fajnzylber, and Calderón) for 79 countries over 1961–99 (five‑year averages) was estimated with OLS and GMM to address endogeneity.
- Incorporating the relative price of investment and proxies for international financial conditions (liquidity ratio; balance‑of‑payments pressure) improves model fit and helps explain Brazil’s per capita growth deceleration since the 1970s.
- Key empirical findings from the panel analysis:
  - Increased macroeconomic instability, higher government consumption, higher relative price of investment, and adverse external conditions account for a significant part of the deceleration in growth during the 1980s, though they do not fully explain five‑year changes in per‑capita growth.
  - The extended models predict Brazil’s per capita growth to have accelerated by around 1½–1¾ percent during 2000–04 compared with 1996–99, with much of the acceleration attributed to macroeconomic stabilization and improved structural conditions.
  - The liquidity proxy and the BOP‑pressure proxy yield somewhat different magnitudes but both indicate that external conditions materially affected Brazil’s growth path.

### Dissection of specific growth determinants
- Government consumption:
  - Brazil’s ratio of government consumption to GDP increased sharply since 1980; the steady rise since the mid‑1980s has had a persistently negative impact on per‑capita growth in the panel estimates.
- Cost of capital and relative price of investment:
  - A sharp increase in the relative price of investment since 1980 is identified as a major constraint on capital formation and growth.
  - The relative price of investment is a component of the user cost of capital (along with real interest rate and depreciation); the proxy used likely understates the full impact because it does not fully capture high real interest rates over the past two decades.
- External financial conditions and liquidity:
  - Low ratios of international reserves to external debt (liquidity ratio) and episodes of balance‑of‑payments pressure are associated with negative growth contributions (e.g., oil shock of late 1970s, 1982 debt crisis).
  - Improvements in international liquidity conditions in the early 1990s contributed positively to growth after the Brady restructuring, while crises in the late 1990s and early 2000s (1999, 2002) again constrained growth.
- Macroeconomic stability and structural reforms:
  - The Real Plan (1994), adoption of inflation targeting, and a flexible exchange‑rate regime (1999) helped restore price stability and reduce exchange‑rate misalignment, contributing positively to growth since the late 1990s.
  - Trade liberalization in the early 1990s and subsequent increases in openness contributed materially to per‑capita growth, particularly since 2000.
  - Improvements in prudential and supervisory frameworks and reforms in public banks since the mid‑1990s reduced systemic banking risk and supported financial intermediation (even though private credit to GDP remains low relative to East Asia and the OECD).
- Infrastructure:
  - Public infrastructure (proxied by main telephone lines per capita) contributed positively to per‑capita growth; however, persistent declines in public investment (e.g., energy crisis in 2001, transport constraints) may be an increasing constraint on growth.

### Quantitative and illustrative figures highlighted in the analysis
- Brazil average per capita growth: 2.8 percent (1960–2000).
- Model‑predicted acceleration of per‑capita growth in 2000–04 versus 1996–99: around 1½–1¾ percent.
- Subperiod contrast (cross‑sectional regression footnote): dummy falls from 3.1 to 0.7 between 1960–80 and 1980–2000; average per capita growth 3.8 percent (1960–80) and −0.5 percent (1980–2000).
- Adjusted R‑squared of basic dynamic panel model: 0.5461 (selected specification reported).
- Private sector credit to GDP (annual averages):
  - Brazil: 27.3 (1961–2000); subperiods include 25.7 (1971–80), 23.3 (1981–90), 31.5 (1991–2000).
  - East Asia (excl. Japan) 64.5 (1961–2000) and 98.7 (1991–2000) — illustrating the credit gap.

### Policy implications and recommendations
- Reduce the high level of government consumption:
  - Lowering public consumption would reduce the economy’s overall consumption level and its intertemporal price (the real interest rate), thereby fostering private investment and growth.
- Sustain and deepen macroeconomic stability:
  - Maintain price stability, a flexible exchange rate, and prudent fiscal policy to reduce volatility of real interest rates and exchange rates and to lower external vulnerabilities.
- Address cost of capital and investment pricing:
  - Policies to reduce the relative price of investment (including dealing with distortions in capital goods markets and exchange‑rate effects) could help revive capital formation.
- Strengthen external liquidity buffers and manage external vulnerabilities:
  - Policies aimed at improving international liquidity ratios and reducing balance‑of‑payments pressures can dampen financing‑cost volatility and support investment.
- Rebuild and prioritize public investment in infrastructure:
  - Reverse declines in public investment where binding (energy, transport, ports) to remove infrastructure constraints on growth.

### Conclusions and directions for further research
- Macroeconomic stabilization, financial‑sector reforms, trade liberalization, and improved infrastructure contributed to stronger per‑capita growth in Brazil since the mid‑1990s.
- Long‑standing structural weaknesses—especially elevated government consumption and a high relative price of investment—continue to weigh on growth.
- Cross‑country panel models provide useful insights but have limitations; further research should explore the dynamics of the debt overhang, institutional development, education, labor‑market informality, and income inequality to better understand Brazil’s mid‑20th‑century growth surge and the post‑1980 slowdown.

*Source: IMF staff estimates and analysis in “Public Consumption and Cost of Capital,” from the provided IMF chapter content.*

### 1.          East Asian dummy

### 1.          East Asian dummy

### Variable list
- 1.          East Asian dummy
- 2.          Primary schooling 1960
- 3.          Investment price
- 4.          GDP 1960 (log)
- 5.          Fraction of tropical area
- 6.          Population density coastal 1960’s
- 7.          Malaria prevalence in 1960’s
- 8.          Life expectancy in 1960
- 9.          Fraction Confucian
- 10.        African dummy
- 11.        Latin American dummy
- 12.        Fraction GDP in mining
- 13.        Spanish Colony
- 14.        Years open
- 15.        Fraction Muslim
- 16.        Fraction Buddhist
- 17.        Ethnolinguistic fractionalization
- 18.        Government consumption share 1960’s
- 19.        Population density 1960
- 20.        Real exchange rate distortions
- 21.        Fraction speaking foreign language

### Data definitions and variables — Stabilization Policies
- Lack of price stability, from Loayza. Measured as the natural logarithm of the average inflation rate for the 5-year period, expressed in percent.
- Real exchange rate misalignment, from Loayza, following the Dollar(1992) methodology. Calculated as the difference between the bilateral real exchange rate against the U.S. dollar and a fitted line resulting from regressing the bilateral real exchange rate on per capita GDP, and regional and annual dummies.

### Data definitions and variables — Structural Policies and Institutions
- Initial GDP per-capita, from Loayza. Measured as log of the GDP per capita of the year immediately preceding the 5-year period.
- Population growth, from World Development Indicators.
- Government burden, from Loayza. Measured as the natural logarithm of the ratio of government consumption to GDP.
- Public infrastructure, from Loayza. Measured as the natural logarithm of the number of main telephone lines per capita.
- Cost of capital, from Penn World Tables. Measured as the ratio of the deflator of investment goods over the GDP deflator, in natural logs.
- Systemic banking crises, from Loayza. Measured by the fraction of years that a country undergoes as systemic banking crisis as identified in Caprio and Klingebiel (1999).

### Data definitions and variables — External Conditions
- Terms of trade growth, from Loayza. Measured as percent change of the corresponding variable.
- International liquidity. Measured as the ratio (in percent) of gross international reserves to total external debt.
- BOP pressure. Weighted average of the 5-year standard deviations of changes in real exchange rates, real interest rates, and international reserves, using the standard deviation of the full sample of each one of these variables as respective weights. Methodology follows closely that of Kaminsky and Reinhart (1999).

### References (as listed in the source)
- Arellano, Manuel and Stephen Bond, 1991, “Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations,” Review of Economic Studies 58 (2), pp. 277-97.
- Arellano, Manuel and Olymbia Bover, 1996, “Another Look at the Instrumental Variable Estimation of Error-Components Models, “ Journal of Econometrics 68 (1), pp. 29-51.
- Bacha, Edmar, and Regis Bonelli, 2004, “Accounting for Brazil’s Growth Experience: 1940–2002,” Instituto de Pesquisa Econômica Aplicada.
- Barbosa Filho, Nelson, 2001, “International Liquidity and Growth in Brazil,” Center for Economic Policy Analysis, CEPA, New School University.
- Caballero, R., 1994, “Small Sample bias and adjustment costs,” Review of Economics and Statistics.
- Campos, Nauro, Armando Castellar Pinheiro, Fabio Giambiagi and Mauricio Moreira, 2003, “Does it Take a Lula to go to Davos? A Brief Overview of Brazilian Reforms, 1980–2000. Working paper, The William Davidson Institute, University of Michigan.
- Caprio, Gerard, and Daniel Klingebiel, 1996, “Bank Insolvencies: Cross-country Experience,” World Bank Policy Research Working Paper 1620, (Washington: The World Bank).
- Cole, H., Lee E. Ohanian, A. Riascos, and James Schmitz, Jr., 2004, “Latin America in the Rearview Mirror,” NBER Working Paper No. 11008 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Dollar, David, 1992, “Outward-Oriented Developing Economies Really Do Grow More Rapidly: Evidence from 95 LDCs, 1976–1985,” Economic Development and Cultural Change, Vol. 40, No.3, pp. 523–44.
- Eichengreen, Barry, Andrew Kose, and Charles Wyplosz, 1995, “Exchange Rate Mayhem: The Antecedents and Aftermath of Speculative Attacks.” Economic Policy, Vol. 10, No. 21, pp. 249–312.
- Fatás, Antonio, and Ilian Mihov, 2003. “The Case for Restricting Fiscal Policy Discretion.” Quarterly Journal of Economics.
- Giambiagi, Fabio, and Marcio Ronci, “Fiscal Policy and Debt Sustainability: Cardoso’s Brazil, 1995–2002, IMF Working Paper 04/156 (Washington: International Monetary Fund).
- Glomm, Gerhard, Juergen Jung, Changmin Lee, and Ching Tran, 2005, “Public Pensions and Capital Accumulation: The Case of Brazil,” unpublished working paper, Indiana University.
- Heston, Alan, R. Summers, and B. Aten, 2002, Penn World Table Version 6.1, Center for International Comparisons at the University of Pennsylvania (CICUP).
- Kaminsky, Graciela L., and Carmen M. Reinhart, 1999, “The Twin Crises: The Causes of Banking and Balance-of-Payments Problems,” The American Economic Review, Vol. 89, No.3, pp. 473–500.
- Lindauer, David, and Land Pritchett, 2002, “What’s the Big Idea? The Third Generation of Policies for Economic Growth.” Economia, Vol. 3, pp. 1–39.
- Lisboa, Marco, and others, 2002, “ A Agenda Perdida: Diagnosticos e Propostas Para Retomada do Crescimento com Maior Justiça Social.” Rio de Janeiro.
- Lisboa Bacha, E. and Regis Bonelli, 2004, “Accounting for Brazil’s Growth Experience— 1940–2002,” Texto para Discussão No. 108, Instituto de Pesquisa Económica Aplicada, Rio de Janeiro.
- Loayza, Norman, Pablo Fajnzylber, and Cesar Calderon, 2005, “Economic Growth in Latin America and the Caribbean. Stylized Facts, Explanations, and Forecasts,” (Washington: The World Bank).
- Mody, Ashoka, and Martin Schindler, 2004, “Argentina’s growth; A Puzzle?” (Washington: International Monetary Fund) unpublished manuscript.
- ______________, 2004, “Economic Growth in Turkey, 1960–2000”, International Monetary Fund, unpublished manuscript.
- Pelgrin, F., Sebastian Schich, and Alain de Serres, 2002, “Increases in Business Investment Rates in OECD Countries in the 1990s: How Much Can Be Explained by Fundamentals?” ECO/WPK(2002)13.
- Pinheiro, Armando C., 2004. “Por que o Brasil Cresce Pouco?” in Reformas no Brasil: Balanço e Agenda, edited by F. Giambiagi, J.G. Reis, and A. Urani (Editora Nova Fronteira: Rio de Janeiro, Brasil).
- Rodrik, Dani and Andres Velazco, 1999, “Short-Term Capital Flows,” paper presented at the ABCDE Conference at the World Bank.
- Sala-i-Martin, Xavier, Gernot Doppelhofer, and Ronald Miller, 2004, “Determinants of Long-Term Growth: A Bayesian Averaging of Classical Estimates (BACE) Approach,” American Economic Review, September, Vol. 94, No. 4, pp. 813–35.

*Source: _wp06282 - 1.          East Asian dummy*

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