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How to Help Venezuela

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USA - February 25, 2019

First, this is not about saving the Venezuela ruling regime and how it would be possible quickly and efficiently to solve the economic problems of Venezuela. After all, these problems affect ordinary people. The sad Venezuelan history is also interesting because it is very close in its economic plot to the Russian history of the early 1990s.

It has become commonplace to believe that the main economic problem of current Venezuela is hyperinflation. According to the IMF, in 2018 it was measured by millions of percent. But if we look at the situation more closely, we'll see that inflation is only part of a larger problem: the problem of reducing the amount of money in the Venezuelan economy. It sounds paradoxical if we consider that the number of zeros on banknotes, and the number of bills itself are growing rapidly there. The network is full of photos with signs such as "14m bolivars for a chicken." However, as will be shown below, Venezuela's main problem is the rapid decline in the amount of real money in the economy. And this is what the Venezuelan authorities urgently need to address.

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What's wrong with inflation fighting

Traditionally proposed and often imposed by external creditors (for example, the same IMF) attempts to "overcome" hyperinflation by "cornering" the money supply will only lead to a deterioration of the economic situation for Venezuelans and the complete collapse of its economy. After all, the fight against inflation often leads to deterioration in the people’s socio-economic situation, but, alas, not to the desired economic growth. There are numerous examples that confirm that inflation is not a problem for economic growth.

High price of inflation-fighting

The first minus is a high social price. The classic ways (in particular, recommended in such cases by the International Monetary Fund) of combating inflation involve extremely serious consequences for the economy and population. They include clamping down on the money supply, reducing the budget deficit, and, accordingly, social programs, which dramatically worsens the situation for citizens. Enterprises also suffer, which leads to an increase in overt or covert unemployment.

Fighting inflation doesn't lead to economic growth

The second minus means that the result is not guaranteed. The Russian example of 1992-1996 is a clear indication that measures to combat inflation don’t lead to economic growth. In order to combat inflation in these years, strict rationing (quantitative restriction) of credit, delays in payments from the budget, reduction of the budget deficit and other measures were used. As a result, over these years, Russia's GDP decreased by 37%, in some years, and by more than 10% overall (from 14% in 1992 to 12% in 1994).

This is not the only example. Economic literature notes that the fight against inflation is almost always accompanied by crisis phenomena in the economy.

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Hyperinflation doesn't hinder economic growth

However, the economic history of many countries has episodes when high (hundreds or even thousands of percent per year) inflation not only doesn't lead to economic recession but even allows the economy to grow. Here are some examples:

Weimar Germany. Hyperinflation in 1920-1924. In 1922, with an increase in prices by more than 42 times, production increased by 11.7%. The decline (relatively little, by 11%) occurred in 1923 when France occupied the Ruhr and prices per year increased by 860 million times. But already in 1924, production began to grow again, despite that from June 1923 to June 1924 prices increased by 60 million times.

Argentina. In 1983, the inflation rate was 344%, GDP growth was 2.8%, in 1984 — 627% and 2.6% accordingly.

Peru. GDP growth of 2.6% in 1991 with inflation of 410%.

Brazil. In the late 1980s and early 1990s, prices rose 20-30 times in some years. From 1985 to 1994, the most sparing in terms of inflation was 1986, when prices rose only 2.5 times (by 147%). But Brazil's GDP fell markedly in 1985-1994 only once: in 1990, but even that year it was relatively little (-3.1%). Moreover, with such rampant inflation in some years, GDP growth exceeded 8% (1985, 1986).

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Vietnam. Against the background of high inflation (in 1988 it was more than 400%), in 1989, instead of the traditional "shock therapy" fall in Vietnam, a GDP growth of 7.4% was observed.

Russia. After the default and the devaluation of 1998, inflation rose sharply. As of January 1, 1999, the annual price increase was 86% and by April of the same year it exceeded 120%. Regardless, GDP growth in 1999 was 6.4% (an unprecedented rate since the late 1980s). And then GDP growth followed by 10% in 2000 (higher than in China).

Bottom line: fighting inflation is a false goal

In other words, the price (social and economic) of anti-inflationary measures is very high, and the economic growth as a result of these measures is not guaranteed. Conversely, numerous examples confirm that economic growth is possible with high and even ultra-high inflation. Therefore, to recognize hyperinflation as the main problem of the Venezuelan economy and to throw all effort at its suppression is a false diagnosis and a faulty course of action.

The main harm of such a diagnosis is that one of the tools used to fight inflation is the reduction of the money supply. The chain of reasoning is logical at first glance, but in fact, remains false.

  • the main problem – hyperinflation, the fall in the value of money, 
  • the value of money falls because there is too much, 
  • so it is necessary to reduce the amount of money.

To think like that is to fall into a trap leading to the economic collapse. And this trap, alas, caught a huge number of countries.

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The right recipe: to defeat hyperinflation to increase the amount of real money in economic turnover.

Why, then, do the economies of some countries still grow when inflation is rampant, and other countries, struggling with inflation, suffer from an economic downturn? The answer is among the basic economy truths: The number of goods that can be bought for a certain amount of money depends on the size of this amount and the price of the goods.

Let us write this in the form of a formula (1) Q=M/P, where Q is the number of units of goods that the buyer can buy (or what the seller can sell to this buyer); M is the amount of money from the buyer; and P is the price per unit of goods. Experts probably saw this formula as the known equation of Fisher's exchange in the simplified form, for one transaction. Simplification doesn't affect further conclusions.

Imagine that a student has $40 to buy notebooks. At a price of $2 per notebook, he will be able to buy 20 notebooks. But, if prices rise, say, up to $4, he will be able to buy only 10 notebooks for the same amount.

Now imagine the formula describes the economy of the whole country. Q is the number of all goods that can be purchased by the residents of this country for the M money they have, and P is the level of prices for these goods. What happens with the P growth, that is, prices? If the amount of M money doesn't change, the inhabitants of the country buy fewer goods. Accordingly, manufacturers produce less of these goods (or are stuck with excessive inventories). And this means a drop in production or, in other words, a drop in the GDP.

How to Help Venezuela

Let's look at the formula again. What should happen if the sale of goods (and hence their production) continuously grew and didn't decline? The answer is obvious: The amount of money should grow faster than prices. That's it! It is this "magic" formula used by Brazil, Vietnam and other countries in the above examples, managing to grow with high inflation.

And the countries in which they tried to fight inflation by reducing the amount of money, went the wrong way, willingly or unwittingly reducing the demand for goods (and hence their production), thereby plunging their own economies into crisis.

Increasing the amount of money

Increasing the amount of money is the first of two correct steps in hyperinflation. And it can be effective even if prices continue to rise. The secret of economic growth with high inflation in Weimar Germany after the First World War, Brazil in the 1980s, and Vietnam after price liberalization is simple. In all these cases, despite the rise in prices (P), the amount of money (M) grew even faster. Simply put, the money supply in these examples grew in real terms.

For example, in Vietnam in 1989, the money supply M2 increased by 213% in real terms (in nominal – more than 5 times). It is this super-soft monetary policy that allowed the country to grow by 7% per year in conditions of high inflation and "shock therapy."

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The same method of accelerated growth of the money supply after inflation or devaluation shocks has been successfully and repeatedly used in Belarus. That is why in the previous two decades the economy of this country has grown faster than other CIS countries, despite the high inflation and periodic devaluation of the Belarusian currency.

What is happening in Venezuela now? Judging by the publicly available information, the authorities increase the money supply instinctively realizing that if they try to stop this process the collapse is inevitable. When the number of zeros on the bills began to go off the scale, Venezuelan President Nicolas Maduro announced a resolute denomination, getting rid of five zeros on the bills in August 2018. Are the Venezuelan authorities doing the right thing by increasing the money supply? Yes. Do they have time to increase the amount of money faster than prices grow? But here there are doubts. According to tradingeconomics, prices in Venezuela increased by 1.7 million percent or 17,000 times in 2018. Were the authorities able to print money at the same or faster pace? No, it's doubtful. In any case, to get out of the spiral of hyperinflation, the Venezuelan authorities need to stabilize prices.

Price stabilization

Stabilizing prices is not only important for maintaining aggregate domestic demand. High inflation leads to such a paradoxical effect as a real strengthening of the local currency with its nominal weakening. This makes it extremely uncompetitive and therefore production within the country unprofitable.

But stabilizing prices by reducing the amount of money (or even by slowing the rate of increase in their number) is a sure way to collapse. What can the Venezuelan authorities do to stabilize the rise in prices?

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What they can really do quickly is to return the local currency’s attractiveness in the eyes of the population. After all, the main vice of the Venezuelan currency (like any currency during hyperinflation) is the inability to use it for savings. Just imagine a man who kept his savings in bolivars for a year. These savings, according to available data on inflation, would have depreciated in 2018 by 17,000 times (!). It is not surprising that Venezuelans sweep away any goods from the shelves.

To solve this problem, the Venezuelan authorities need to meet two preconditions:

  • To ensure the free exchange rate of the bolivar against the United States dollar or any other stable currency (e.g. the euro).
  • To provide official and accurate data on inflation. 

 

In other words, anyone should be able to find out the dollar rate daily and weekly and/or monthly and precise official inflation data from the internet or newspapers. If these two conditions are met, then the authorities will be able to resort to the issue of special savings instruments – government bonds – protected from depreciation. At the first stage, you can do only two types of bonds.

The first bond should be an analog of the dollar, interest-free, with several different repayments (six months, a year, two, three years). Anyone should be able to buy such a bond for bolivars. And it should also be repaid by bolivars, but at the rate of the dollar at the time of repayment. If the dollar rises, the bondholder will not lose anything – it will get as many bolivars as at the time of repayment the dollar will cost.

Vividly speaking, the value of the bond will be indexed in accordance with the change in the dollar exchange rate. A second bond is also a protective tool but against inflation (a close analog of the American inflation-protected securities tips). The value of this, also interest-free-bond should be indexed to rising prices. For example, if the prices for the year increased 27,000 times, the person who bought such a bond at the beginning of the year with a maturity date in a year will receive at the end of the year 27,000 times more than was spent on the purchase. In fact, the sale of such a bond would be tantamount to the promise of such interest on the deposit, which would fully compensate for the rise in prices.

An important point: Both types of bonds should be freely traded, that is, their owners should be able to sell them at market prices. And the Venezuelan authorities, in order to avoid devaluation of their government bonds, should be able to carry out a kind of monetary intervention to buy these bonds.

The Central Bank's rate

With very high inflation, one of the problems of stabilization is negative real interest rates, as in Russia in 1992-1995. Despite that the nominal rates were very high, more than 200% per annum, in reality, they were negative (sometimes below -80%) due to high inflation (graph 1).

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The Central Bank of Venezuela should raise the refinancing rate, gradually bringing it into the area of positive real rates.

There are still some nuances that the Venezuelan authorities need to take into account for financial stabilization. For example, if the financial system is stabilized according to the scheme proposed above, the tendency of the bolivar’s strengthening against foreign currencies, the same dollar and the euro, will appear quite soon and sharply. And it would be a gross mistake to allow this strengthening. But the very tendency to strengthen the local currency of the Venezuelan Central Bank can and should be used for a sharp increase in the real money supply in the country and, accordingly, to stimulate economic growth. As for the timing, the implementation of the above measures will stabilize prices in a matter of two to three months.

Author: USA Really