How could we curb Venezuela’s hyperinflation?

Think of a note worth 10,000 bolívars. That seems like a lot, right? I’m a nice guy; I’ll give it to you. Go buy yourself a nice TV or something.

What’s that? They said you don’t have enough money?

Precisely.

As of July 27, 2016, this seemingly valuable note is worth just over ten dollars (it’s almost definitely worth less by the time you’ll read this). In the UK, it wouldn’t be enough to buy you a takeaway dinner. This is because of the rapid hyperinflation that’s occurring in the South American country, leaving it in a tumultuous spiral of poverty, with some not even having enough to pay for essentials such as food or heating. A recent Bloomberg report even suggested that the Venezuelan government is running out of money to print money, such is the state of the country. An analyst at Nomura even predicts that a $200 oil price is needed before the Venezuelans can balance their budgets. Estimates for the rate of decrease of prices range from 400% to 720%, meaning that Venezuelans are eager to spend their money before its worth dramatically decreases just a few weeks later. It seems that policymakers are unable to come up with a solution to the problems that Hugo Chávez’s government largely created. Is the country doomed?

Not quite.

The Venezuelan government needs to learn from the lessons of German, Zimbabwean and Brazilian hyperinflation in order to put a stop to the inflationary pressure that has roiled its economy. Fundamentally, the problem is that, due to the pegging of the bolívar against the dollar, there is an “official” exchange rate of bolívars to dollars, and then there is a black market rate, which is a cause of the hyperinflation. Officially, the bolivar trades competitively against the US currency, however on the black market, it is estimated that 10,000 bolívars are worth just over one dollar. The solution? Officially unpeg the Venezuelan currency from the dollar, and allow it to float freely, so that both the government and the people of Venezuela are on the same side: there is now only one exchange rate, and this makes the problem much easier to solve – we need only one bullet, rather than two, so to speak. In addition, this allows Nicolas Máduro and his government to significantly reduce their fiscal deficit, that came about through them getting significantly less bolívars from overseas for every unit currency than the people got through black market transactions using the unofficial exchange rate.

Now that we have a reduced fiscal deficit, the Venezuelans need to stop printing money in order to finance deficit spending. This would stabilise the aggregate money supply in the economy, reducing the potential for a further reduction in the value of money. Logic dictates that the reduced inflation will disincentivise Venezuelans from spending their money in anticipation of a coming decrease in value, which would in turn lead to an increase in savings. Aggregate demand for goods and services would therefore reduce, causing a corresponding decrease in demand-pull inflation (inflation as a result of aggregate demand outmatching aggregate supply). This leads to a continuous cycle whereby more and more people save more and more money rather than investing it, and combined with the stable money supply, inflation will continue to decrease. Years of hyperinflation have battered the Venezuelan people’s expectations, however, so it may take a long time for them to be convinced that their currency will hold its purpose as a store of value, enabling inflation to decrease substantially. While this may allow the national debt of the country to increase, it is a price worth paying for the country to return to a period of long term economic sustainability, during which tight fiscal policy (increasing taxes and cutting government spending) can help bring this debt down.

The final prong of this three-pronged attack on inflation is that when inflation decreases substantially, the likelihood is that it will still be relatively high; inflation ranging from 400% to 720% can’t simply be swatted away. Therefore, the government needs to maintain interest rates at a level such that the nominal interest rate is far higher than inflation, causing the real interest rate to be high and positive. Intuitively, this means people will see it as beneficial to further save their money rather than invest it immediately, curbing the cycle that increases demand-pull inflation. As the rate of inflation continues to decrease, the central bank should gradually decrease nominal interest rates, while keeping them high above inflation, until they have reached a level of inflation that they see as sustainable, at which point real interest rates could potentially come down.

The sad state of Venezuela is a reminder of the dangers that letting inflation go out of control can provide; Hugo Chávez has failed his country immensely. Despite this, the policies outlined above should go a long way to cut out the plague of hyperinflation, and restore peace and prosperity to the Venezuelan people.

What do you think?

Shrey Srivastava, 16

36 Comments Add yours

  1. So having just read this blog post on hyperinflation in Venezuela I wanted to add my thoughts.
    So all the points here are important but I’m not convinced they go far enough- hyperinflation is a strange phenomenon that goes beyond normal policy solutions because it goes beyond normal inflation.
    It’s worth starting out by talking about inflation and central bank interest rates and what they usually mean.
    So inflation is just where prices gradually go up year on year which effectively means the currency is worth a little less each year because it can buy a little less. Most central banks aim for low inflation because if it’s very high then the currency isn’t worth having. That means a little inflation is a nuisance but money is still money- it’s good to have, but in hyperinflation it’s different, then the currency literally isn’t worth having so people just try to get rid of it as fast as possible which pushes up prices even more. That’s a nightmare.
    (Brief side note, you might think you’d ideally want deflation- where prices go down year on year and your money gets more valuable. The problem is that then debts effectively get bigger over time which can be backbreaking for both businesses and people.)
    Ok so what about central bank interest rates?
    Well when inflation is too high the central bank raises interest rates- that means you earn more from investments which encourages people to save rather than spend. When inflation is too low the central bank lowers interest rates which means you earn less from investments encouraging you to spend instead.
    So if inflation is really high and central bank interest rates are really high what does that mean?
    It means the central bank is begging people to save money and they’re overwhelmingly spending it instead. So fighting hyperinflation isn’t just a matter of correcting an imbalance by encouraging more people to save, you have to convince people that the currency is worth owning at all!
    So yes high interest rates are vital in combating high inflation but more is needed, often countries end up simply switching to a new currency entirely. Sometimes it’s a foreign currency (usually the US dollar) sometimes a new currency of their own. That can help stabilize the currency but there also need to be fundamental reforms.
    It might sound odd coming from someone who describes themselves as on the centre-left but this really is a situation where some pro-business reforms are needed. So what can a government do in this situation?
    Well if interest rates are high and investment is low businesses are going to struggle to gain investment. You need to persuade citizens to stop spending and start investing. So, as much as it hurts me to say this, this is a classic situation where you would want to shift taxes from businesses to the middle classes.You need to keep the costs of business down so that they can compete with each other more on price and you need consumers to spend less.
    So here’s a couple of suggestions, both drive up government debt but really when the country is falling apart I hardly think that’s the highest concern.
    Firstly the government should move business debts over from the businesses onto it’s own balance sheet. Then in return have those businesses owe the money to the government at an interest rate far below the market rate.
    Second increase taxes on the middle class and a little on the rich. This is going to be deeply unpopular though so give a large section of the taxes back to taxpayers as government bonds. They should have no maturity date but the government can choose to repay them at any time. The interest rate paid out should be far below the market rate but they should still pay some interest. This softens the blow for the middle classes (they can hold onto the bonds or sell them to recoup some of the taxes paid) Also have a section of taxes that you are allowed to keep in your bank account as long as you agree to have the funds frozen for a short time (say three years) at whatever interest rate your bank pays out or, alternatively, you can lend the money to Venezuelan businesses, you just can’t spend it.
    Now between those things you clearly move money from spending to investment. That’s pretty vital. It should help. Especially when paired with the central bank keeping interest rates high. The central bank should consider keeping the rate it lends out at high (or even raising it) but also lowering the interest it pays out to banks that keep money in their accounts at the central bank. That encourages them to lend it out to businesses instead.
    I would add though, all of this must include a commitment to help the poor. They suffer horrifically from hyperinflation and I really can not stress enough that helping them is important.
    There’s one more vital point to make though- the hyperinflation in Venezuela isn’t just about bad government policies, it’s also absolutely about the collapse in the oil price and it’s effect on a country where a HUGE percentage of their exports are oil. All the clever realignment of spending and investment you can think of won’t solve that problem. The only thing you can hope to do is eventually grow enough new businesses that they can export other things.
    There’s no way of doing that overnight.

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    1. Thank you so much for the comment! I’d just like to preface this comment by saying that this article was only meant to offer solutions to the problem of hyperinflation in Venezuela. I agree that just interest rates cannot solve the problem, which is why I’ve also proposed making the two exchange rates one and for the Venezuelan government to stop printing money in order to finance deficit spending. I don’t think pro-business reform encouraging investment will help solve the problem of inflation; in fact, I think it’ll increase the amount of demand-pull inflation due to short run aggregate supply remaining the same. It’d be lovely to hear your response, however, and thanks again for the comment 🙂

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      1. Hia so firstly thanks for replying!

        Second it’s true that investment in business can not solve the short term problem Venezuela faces. That’s a fair point. I talked about it so much for two reasons:

        1. You need to stop prices rising so lowering the amount of money consumers have/are spending and lowering costs for business ought to help with this. (It’s not going to solve the price of oil problem though! And you’re right that by itself it won’t do the trick.)

        2. It’s also about fixing the long term problem- so much of their exports being oil and so much of their economy being reliant on those exports.

        The only way to fix that is to have a buisness boom that switches to creating new products and services. That’s why I’d go so overboard in helping businesses.

        I’d also add that I’d effectively do the same as you as well- raising the rate the central bank lends out at will de facto mean it stops printing money. Money should only be issued when a bank accepts a loan at that rate from the central bank. Raising it to the point where no bank takes out a loan is absolutely a sensible thing to do.

        I also agree about letting the exchange rate float, there’s just no point fighting the tide on that one!

        But doing those things while also pulling money out of middle class pockets so they have less to spend should help slow inflation.

        Venezuela is a hard one to solve because getting around that oil price crash is near impossible.

        Long term they need growth in businesses, short term it’s just going to be bad.

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      2. Thanks for the response 🙂 However, don’t you think that investing in goods and services is just going to ramp their prices up due to demand outmatching supply, and will only serve to do more to put money in the pockets of lower and middle class employees of shops etc etc.? As horrible as it may sound, actively discouraging people from spending through a hike in nominal interest rates will reduce the revenue of the shops, hence them having to impose wage cuts or make some people redundant altogether, thereby meaning that the upper middle class, so to speak, will save rather than invest, and the lower middle class won’t have the option in the first place due to less money being in their pockets, creating less demand-pull inflation. Your second point is perfectly valid, though, I’d definitely start introducing business-friendly reform as soon as we got that pesky inflation rate under control. Eagerly awaiting your response, and thanks for the comment 🙂

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  2. George Reese says:

    What makes economic sense is often very difficult for a politician to do.

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  3. Ian K says:

    As unfortunate as their situation is, I think simply floating the Bolivar and not printing more notes for the time being is a band-aid when you need a tourniquet. It’ll help somewhat, but it’s not going to dig them out of the hole they’re in. They’ll probably have to make wholesale changes to their entire monetary system if not just using something like the Colombian peso for the time being. Germany and Zimbabwe both had to abandon their currency (Germany temporarily switched to the gold-tied Rentenmark as a stopgap before introducing the Reichsmark and Zimbabwe phased out their own currency in favor of the US dollar) while Brazil introduced five new currencies in an eight year period until their government stabilized again and the Real stuck.

    Honestly, the fact they didn’t see a near complete collapse coming when they effectively had a command economy based on exploiting one highly volatile commodity without any sort of infrastructural investment or diversification whatsoever is pretty embarrassing.

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    1. Thanks for the lengthy comment! I really appreciate it. I’d be interested to know why you think these solutions aren’t effective enough, and I’d like to say that in the Brazilian case, the currency changes more often than not did not help at all. I agree with you regarding how embarrassing the Venezuelan government has been; it’s strange to think that such high profile figures are capable of things like this.

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  4. Diggaman says:

    They are wrapping street food in paper money because it is cheaper than buying napkins…!!!…Great article.

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    1. It’s a sad story, yes; thank you so much for the appreciative comment! 🙂

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  5. GS says:

    Yes it is a sad story, and agree that things can be improved with steps cited in your article. World economy is immensely complicated… more so recently, and the same state is being faced by many other economies as well. Well written article!

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  6. Hi Shrey, can’t actually find a way to follow your blog (I’m new to this) mind helping me out? lol

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    1. Thanks 🙂 So go to your homepage and in the bottom right there should be a “Follow” button, which you click to follow me.. Please tell me if it’s not there! 🙂

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      1. found it, thanks.

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  7. chr1 says:

    The economic and policy prescriptions would go far if implemented. However, when Bonapartist Bolivarian revolutionaries control a country’s government, and the strongman’s successor is losing ever more control of power, the political situation is such that any economic/financial stabilization is tough to actually implement.

    People are desperate, many hungry, and running out of food. It’s a mess…but great piece. I believe there are enough Venezuelans to start building anew, with ideas that can work.

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    1. Thanks for the comment and the appreciation! I agree completely 🙂

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    1. Thank you so much 🙂

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  8. ryangoh says:

    Hi Shrey,

    Linked to this post. Great take and while the policy implications are a little more complicated that what you’ve suggested, it is nonetheless encouraging to see a young man interested in topics that many people decades older struggle to comprehend. Keep up the good work!

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    1. Thanks for the comment! 🙂 Please could you expound on the further policy implications; I’d be really interested to know what you think they are. Thanks again! 🙂

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  9. I think that a major issue with your suggestion is that you haven’t considered the effects of expected inflation. Even if you cut the money supply, the people will still continue to expect inflation to be high (perhaps slightly lower than before but high nonetheless) and spend whatever they receive, fearing that their currency will be worth less the longer they hold on to it. The result of cutting down the money supply is that the interest rates will automatically go up. Now, you have a situation of high inflation and high interest rates. The government cannot borrow from abroad since no one will trust the credit worthiness of the government and the government cannot monetize its budget deficit since the central bank has decided to cut money supply. The effect of this is that aggregate demand will fall dramatically (due to low investment spending and low government spending), causing businesses to shut down or lay off their employees. Now you have a situation of high inflation, high interest rates and high unemployment. The only way out for the government would be to focus on its exports since their goods would be highly competitive in the international markets. This would keep the aggregate demand high and would bring in much needed foreign exchange which the government can use as it desires to fight its most pressing problem, food.

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    1. Thanks for the comment! 🙂 Firstly, that’s why I’ve assigned a long timeframe to this process; it’ll take a great deal of time for people’s inflation expectations to align with what inflation actually is. Secondly, this method doesn’t cut the money supply, it merely stabilises it, hence not having too much of an effect on interest rates. Thanks again for the comment though, I learnt a lot from it and I’d be really interested to hear your response 🙂

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      1. In the long run, you could argue that producers will, looking at the excess demand, build up their capacities and the economy will arrive at an equilibrium at a higher income level. But in the short run, they’re all going to hell. I must say that you’re pretty knowledgeable on economics for a 16 year old. I thoroughly enjoyed myself in reading your post.

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      2. Thank you so much for your comment; I really appreciate it 🙂 I would agree that the short term future for producers would be rocky, but I would think that in the long term, as you said, “the economy will arrive at an equilibrium at a higher income level”. Thanks again for the comment 🙂

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  10. Steg says:

    Hi Shrey- came here from Dan Mitchell’s blog. This was a good read and I’ll probably be back regularly. MY ONLY suggestion would be to not advertise you are 16. I would think there are a lot of people who would take you less seriously(if not outright dismiss you because they don’t know your life story but can’t possibly imagine that someone could have wisdom at that age)- but I also see the comments you have now and you’re doing great. Age is just a number- you’ve got a great mind, just keep at it.

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    1. Thank you so much 🙂 I thought that adding my age would give me more of a USP and therefore more views, but I understand your point; I’ll definitely think about it. Thanks so much again for your comment!

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  11. Much appreciated! 🙂

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  12. 1776campaign says:

    Great post! I believe that it will be very difficult for them to keep the Bolívar as their currency. In the 3 most noted cases of hyperinflation (Germany, Zimbabwe, and Brazil), they ended up changing to a brand new currency or switching to an established one. I believe allowing currency competition, for the time being, would be beneficial, although Maduro would never let it happen. If he did, it would allow currencies to compete against one another at a floating exchange rate, and, obviously, the people would the use one that kept it’s purchasing power best.

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  13. very interesting. can’t believe you’re just 16!

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    1. Thank you so much 🙂

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  14. Justice4USA says:

    You asked that I review your blog. Here I am… finally. (Been super busy.!)

    My response to this article is that economics isn’t the problem. The key issue is leadership and government. They have an idiot (latest) for a leader and a communist government — even worse. If you’d like to see another view on why they are in trouble and why the U.S. is headed the same way, read my article: ‘America’s Future — If Not Careful’. Hopefully the arguments listed there will make sense. If not, post your question under my article.

    Keep it up. You’re way ahead of the ‘crowd’. Watch your spelling, punctuation, etc. People look for the ‘simple things’ to pick on and miss your main idea.

    Phil

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