Hyperinflation Venezuela’s potential next crash: The Perils of Monetary Policy

As Venezuela approaches hyperinflation, they need to establish a monetary policy independent of political influences. Otherwise, the economy faces ruin.

As Venezuela approaches hyperinflation, they need to establish a monetary policy independent of political influences.  Otherwise, the economy faces ruin.

Hyperinflation Venezuela’s potential next crash: The Perils of Monetary Policy

by Alejandro Martinez, MBA ‘13

Monetary policy is an incredible tool for a country to battle unemployment and inflation. When done right, a country can obtain a boost to its economy in times of need. If left unchecked, monetary policy can destroy a country’s currency and markets. When central banks and other monetary institutions are dependent on current administrations, severe problems can arise quickly. We have seen this case in many countries, especially developing nations where central bankers do not enjoy the freedom to proceed according to economic principles or where politics trump economics and governments play loosely with the money supply. Venezuela is currently in the later of these two cases. A dramatic change needs to happen for markets to trust Venezuela and its currency again. The government needs to signal to the world that they will stop manipulating the money supply. In order to better understand the perils of monetary policy and Venezuela’s current situation we will make a speedy review of several economic concepts and how they evolved to current standards.

Throughout the ages different civilizations have used two methods to exchange goods and services between themselves 1) barter, and 2) currency. Early human societies relied on a barter trade system; for example, a farmer could exchange tomatoes with the local fisherman for fish. This trade system did not allow civilizations to grow very rapidly, and it was the first step to one of humanity’s most important inventions: widely accepted currency. May it be beads, shells, or precious metals, these items could be traded for anything. Gold and silver became the popular source of currency. However, heavy metals were cumbersome. Paper Currency backed by precious metals would replace this antiquated system.

Originally people deposited their gold in a bank and the bank issued a paper certificate or claim on that gold. These paper notes quickly substituted metals as people understood how they were directly linked to them. The banking system grew and the economy developed at a galloping pace and so central banks were created to be the sole entity responsible for the issuance of paper currency within any specified region. In order to continue growing the global economy, central banks stopped pegging their currency to gold reserves. Today’s money is nothing more than a social contract where all members of society agree to give a specified value to those pieces of paper or computer balances. The different governments stand behind their currency and claim that it is valuable because it is accepted as form of payment to all debts, public and private.

There are several ways in which we can deteriorate and weaken the social contract of money. Inflation, which is a persistent increase in the general levels of prices, erodes the value of money, by lowering the amounts of goods and services that you can buy with a specified amount. Inflation occurs when governments in their need for resources issue more currency than what is required to maintain pace with the economy. Government is responsible for this erosion of value, not businesses – which merely react to the new economic reality. Weakening currency over time makes financial planning extremely hard and drives people to place their savings in riskier investments that are able to cover the loss of value of the currency.

When inflation rates exceed 50% per month, economists call it Hyperinflation. It is the ultimate repudiation by a government of its currency, an item that costs $10 today, will cost $1,290 a year from now. Hyperinflation makes all citizens poorer at a very fast pace, so why would a government ever allow inflation to reach such destructive levels? The answer is fairly simple, if inflation is high enough, the real cost to the government of redeeming money in terms of goods and services is nothing. A country with high levels of public debt has an incentive to create and tolerate high levels of inflation. As it becomes clear to citizens that the government is printing money to finance a deficit, people become reluctant to holding paper money, they quickly exchange it for goods that they feel will not lose value as fast as the currency does (cars, apartments, TVs, etc.).

Several countries have experienced hyperinflation. Argentina in 1990 had a monthly inflation rate of 129%, Germany in 1923 experienced 29,500%. These examples clearly show that the threat of hyperinflation is very real and can be very destructive. When elected officials manipulate the money supply to finance excessive spending, we can achieve horrendous inflation rates. Zimbabwe reached 7 Billion percent inflation rate in 2008, making it the highest ever achieved in recorded history. Almost every country in Latin America has experienced hyperinflation at some point in history.

The only way to stop Hyperinflation is through fiscal reform and convincing the public that the government will not continue spending excessively. Venezuela currently faces the possibility of hyperinflation. It is a vicious cycle in which the local currency loses value and citizens despair, investing in riskier assets or purchasing US currency in the black market (Formal purchases are regulated to small monthly amounts and are audited by the government who may deny the sale to any individual or corporation). Citizens must urge their elected representatives to revise current fiscal policy and to reduce the amount of borrowing that the country does in local currency. The government should also focus on boosting local production and allowing companies to freely export their goods to other countries.

Germany managed to slip out of their inflation crisis when a new government stopped manipulating the money supply and the general population trusted them. Zimbabwe decided to eliminate the local currency and adopt the US Dollar. Venezuela must understand that production is the responsibility of the private sector. Government’s role is to legislate, create peace, stability, enforce laws and level the playing field for all citizens. President Maduro should know by now that excessive borrowing will only bring further destruction to Venezuela, which is currently experiencing the highest inflation in the world (70% in 2014. No 2015 numbers have been published). If Venezuela manages to get its act together, it could be a leading powerhouse in the LATAM region. It would attract billions in foreign direct investment in oil and other natural resources. Given the current situation, it appears that the only viable solution is to adopt the US dollar as Venezuela’s local currency. The Bolivar has suffered drastically since its last devaluation and would require an extreme makeover for citizens to trust the central bank again. Adopting the dollar would guarantee that the current administration could never again manipulate money supply to finance over spending and help bring back the trust and investments needed to restart growth and prosperity for all Venezuelans.

Sources: http://www.bcv.org.ve; The teaching Company Money & Banking course byProf Michael Salemi; http://www.cato.org/publications/working-paper/world-hyperinflations