September 24, 2002

Reinventing the hyperinflation wheel

Probably the hardest part of my job is writing about monetary and fiscal policy, impossibly technical topics that tend to make readers’ eyes glaze over. Inspired by the great and mighty Paul Krugman, I go to any lengths necessary to try to make these topics easily digestible. Not sure if I always succeed. In any case, today’s post is an attempt to write an interesting (or, at the very least, understandable) critique of the Venezuelan Central Bank’s monetary policy. Let me start with a bit of a story:

In 1941, a British officer by the name of R.A. Radford was captured by the Nazis and confined to a POW camp. At the camp, Radford and 2400 other inmates were forced to live on meager rations delivered by the Red Cross. The rations issued to each prisoner contained a bit of bread, some sugar, biscuits, jam, margarine, tea and chocolate bars, with small rations of canned meat sporadically made available. They also included 25 cigarrettes per prisoner per week. Radford, who had been trained in economics before the war, noticed how even in the extreme conditions of a Nazi prison camp, a rudimentary market system developed as prisoners traded with one another to maximize their satisfaction. The British army's Gurkahs, for instance were eager to trade their meat for other foods, since as Hindus they were strict vegetarians. Prisoners who didn’t smoke were eager to trade their cigarettes for food. At first, each of these trades was a simple barter. But soon enough, the inmates realized the need for a more sophisticated system of exchange. Lacking money, they started using cigarettes as prison currency. A ration of margarine might be bought for seven cigarrettes, which could then be used to buy one and a half chocolate bars, and so on.

Soon after his release, Radford described the system that developed in a classic paper entitled “The Economic Organization of a POW Camp,” a write-up that's much appreciated by undergraduates everywhere for its skill at explaining the mysteries of monetary systems. What interested Radford the most was the way that cigarrettes, as a means of exchange, were subject to all of the fluctuations of normal currency. So long as there was a roughly steady relationship between the number of cigarettes in circulation and the goods those cigarettes could be traded for, “prices” in terms of cigarettes remained more or less stable. But when a shipment of cigarrettes unexpectedly arrived, an inflationary spiral was set in motion. With the camp suddenly awash in “unbacked cigarettes” (additional cigarettes that circulated without a corresponding increase in the amount of other goods they could buy) prisoners would demand more and more of them in exchange for other goods. Alternatively, when cigarettes failed to arrive for one reason or another (an allied bombing raid, for instance,) a liquidity crunch took hold of the camp. These currency shortfalls would actually lead to recessions at the camp: with inmates eager to hang on to their scarce cigarettes, it became more and more difficult to find people to trade with.

If you want to understand why so many Venezuelan economists are alarmed by the Central Bank’s decision to monetize Bs.6.2 trillion worth of “exchange profits”, go read Radford’s piece. As Venezuelan analysts keep saying, but few people seem to quite grasp, exchange market profits are just unbacked money. The effect of financing a government deficit with unbacked money is just the same as the effect of sending a huge new shipment of cigarettes into Radford’s prison camp. The balance between the money supply and the goods available for purchase goes all out of whack, and prices begin to rise out of control.

“Exchange market profits” is one of those expressions that tends to baffle people. My boss likes to explain it with an example. Imagine you run a company whose only asset is an apartment. The company bought that apartment for $100,000 a few years back. But now, due to inflation, that apartment is worth $120,000. Would you say you’ve made a $20,000 profit? Well, not really. Not unless you’ve actually sold the thing, right? But what if, before selling the apartment, the company declares a $20,000 dividend and distributes it among its shareholders? Does that seem kosher to you? It's Enron-accounting, isn’t it?

Well, that’s precisely what the Venezuelan Central Bank is doing. Over the years, the Central Bank receives a certain stream of dollars, mostly from oil sales. It books each of those dollars at their bolivar cost at the time they’re bought. A year ago, for instance, they could get a dollar for about Bs.750. Now, that same dollar is worth Bs.1450…so what they’re doing is saying that they’ve made a Bs.700 profit on that dollar, booking it, and sending the profits to its only shareholder: the government. The government takes those bolivars and uses them to cover its budget spending commitments, paying wages, state contractors, past-due bills, etc. In short, they pump the resulting bolivars into the economy. Crucially, they do all of this before they’ve actually sold that dollar.

And how can they get away with it? Because they’re the central bank, and they get to print the money! Because our hypothetical private company can certainly book that fictitious $20,000 profit, but they can't make that profit materialize out of thin air. But the Central Bank can. It doesn’t matter to them that the profits are purely an accounting fiction because they can just order up a fresh batch of crisp new bolivar bills from the printers to cover their declared “profit.” Devious, huh?

Of course, the Chávez administration has been pumping such funny money into the Venezuelan economy for several years now. What sets this latest initiative apart is the scale of this year’s injection. In the past, the exchange gains injected never exceeded Bs.1.5 trillion. This year, following the Bolívar’s sharp devaluation, the Central Bank’s unrealized exchange profits amount to a whopping Bs.6.2 trillion. Printing that many new bolivars would boost the currency base by an eye-popping 38%. Put another way, for ever 100 cigarettes now circulating in the POW camp, the government wants to pump in another 38. The results can only be a very strong spike in inflation.

It’s difficult to overstate how wrong-headed this policy is. For years, academic economists have been investigating the effects of inflation on economic performance and social well-being and, for once, they agree: not only is economic growth impossible to sustain when inflation is out of control but, crucially, runaway inflation hurts the poor the most, impoverishing them farther and faster than almost any other economic phenomenon.

In fact, the inflationary effects of printing money and the effects of inflation on economic performance and on the poor are so well understood it’s just plain embarrassing that Venezuela is having to rehash this discussion well into the 21st century. The outcome of the policy the Chávez government is hawking was fully clear by the 1920s, when the German economy imploded in a flood unbacked marks, paving the way for the rise of the Nazis who eventually took R.A. Radford prisoner. They’ve been confirmed again and again by generations of Latin American populists, from Juan Perón to Alan García. The rest of Latin America has been clear on the disastrous effects of monetizing deficits for at least 20 years now, consigning these policies to the dustbin of history. Only Venezuela, it seems, continues to be determined to reinvent the hyperinflationary wheel.