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?

Like this: Like Loading…