January 31, 2009

Stagflation's just another word for Catch-22

Quico says: One vital question that's getting virtually no attention is what the correct policy response would be to the economic crisis likely to hit Venezuela later this year.

By all accounts, we're looking at a recession, with economic activity falling and unemployment rising. The normal, orthodox response to a recession is to spend, even if you have to borrow the money to do it. That's what the US, Britain, Germany and pretty much everyone else is doing these days...and what Mark Weisbrot wants Venezuela to do as well.

There's just one problem with that plan: the US, Britain, and the rest of them don't have 31% inflation rates to deal with. In those countries, it's the prospect of deflation that keeps policy-makers up at night . But in Venezuela, what we're staring at is something different: not a mere recession, but a recession-alongside-runaway-inflation. Stagflation, they used to call that.

And that changes things, because when inflationary expectations are already built into an economy, the net effect of higher public spending is not to boost aggregate demand, it's just to boost the price level. In other words, the ability to spend your way out of a recession is a privilege that serious countries earn by virtue of having kept a clean sheet, inflation-wise, for a number of years.

That's not where Venezuela is, and suggests that any attempt to borrow our way out of Hurricane Feces will only boost inflation.

The correct policy response to stagflation is actually the opposite: as Paul Volcker showed the world in the late 70s, the only way out of a stagflationary funk is a wrenchingly awful period of tight money where unemployment rises sharply as people are clobbered out of expecting prices to rise any further.

Which suggests that, very very painful though the coming months and years are likely to be, it's a good thing that the government is close to out of money. The way out of the inflation trap Chávez has built necessarily goes through a period of high unemployment.

But, again, there's a catch. Because as Chávez has already showed, once you compromise the Central Bank's autonomy, you can always get it to print more local currency for any given level of foreign currency reserves. As the hard budget constraints of the oil crash start to bite, we'll find ourselves in the hand of an autocratic leader who simply doesn't understand enough about macroeconomics to grasp the down side of just asking the central bank to print more cash. And as the government's bills pile up, in one way or another, that's exactly what he's going to do. Not out of any great ideological commitment, but just out of the sheer political imperative to pay off angry constituents.

Countries that back themselves into a stagflationary corner always end up faced with this same awful choice: they can try to fight inflation, or they can go after unemployment, but not both. Going after inflation sucks, but if you have the stomach for it, it eventually pays off, bringing down both inflation and unemployment in the medium term. But trying to go after unemployment only makes inflation worse, with the hoped-for employment gains of printing new money evaporating into the inflationary ether almost as soon as the money is spent.

Now, knowing his instincts...which way do you figure Chávez is going to go?