Sophie’s Choice

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• The performance of industrial output in Brazil remains puzzling: retail sales have been doing fine (except in May), while the economy operates close to full employment. Yet, industrial output has been either stagnant or in decline since early 2011, despite the apparent strength of consumer demand;

•  Adding to the puzzle, the labor market remains strong, thanks chiefly to the services sector, where employment continues to rise at a solid pace, where while industrial employment, like output, fares substantially worse;

• Based on the work of Afonso Pastore, Marcelo Gazano and Maria Cristina Pinotti, I proposed a relatively simple model that formalizes the issue and puts forth an explanation. Whereas the expansion of domestic demand tends to distribute itself across sectors when there is slack in the labor market (a high unemployment rate), the dynamics change considerably as the economy approaches full employment;

• Indeed, when labor is available, both sectors can grow; yet, as scarcity materializes, the sectors must compete for resources. That said, given that services must be produced locally, the expansion of domestic demand requires the expansion of domestic services output. In contrast, the expansion of the demand for manufactures can be met by higher net imports, so manufacturing output can go down while demand and supply for both manufactures and services clear;

• More concretely, competition for labor pushes wages, and hence unit labor costs, up. The industrial sector, however, is constrained from passing higher costs to prices due to international competition; the services sector, however, does not face the same constraint, so it can pass costs through to prices, limited only be domestic demand;

• Thus, when the economy is close to full employment, domestic demand growth leads to an asymmetric supply response: non-tradable sector thrive thrives, while tradable sectors whither, if international prices remain constant;

• We claim that this dynamics provide an explanation for the industrial puzzle that is both simple and consistent with the empirical evidence;

• That said, there is not much to be done in terms of policy to tackle this problem, aside a significant fiscal effort in terms of reducing government spending, chiefly for non-tradable goods. This policy would reduce the pressure on the labor market, hence on unit labor costs and industrial margins. Yet, I would not hold my breath waiting for it. 

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