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Venezuela’s Bizarre System of Exchange Rates – Article by Emiliana Disilvestro & David Howden

Venezuela’s Bizarre System of Exchange Rates – Article by Emiliana Disilvestro & David Howden

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The New Renaissance HatEmiliana Disilvestro & David Howden
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Venezuela is currently going through its worst crisis in history, replete with an endless list of interesting problems. Foremost among these are severe shortages in even the most basic of necessities. Economists have used these shortages as textbook examples to illustrate the pernicious effects of price controls.

Few people, however, are aware that many of the country’s problems are caused by a complex monetary arrangement that makes use of four different exchange rates simultaneously. The result is that Venezuela can either be extremely cheap, or unbearably expensive, depending on the rate used.

Monetary chaos began in 2003 when the late President Hugo Chavez imposed currency controls to stem capital flight after an oil strike. At the time, one US dollar could fetch 1.6 Venezuelan bolivars. Today, barely ten years later, that same dollar can buy 172 bolivars, a devaluation of over 99 percent! Of course, that is in the official (i.e., government regulated) market. On the black market, the exchange rate is currently nearly 900 bolivars to the US dollar. That is, if you can find anyone selling dollars, or more importantly, looking to buy the badly tarnished Venezuelan currency.

This devaluation is in and of itself a large problem, both for consumers who must deal with high degrees of price inflation and for businesses that must undergo long-term capital planning decisions with a constantly moving monetary unit. However, it is the volatility of the exchange rate caused by the government’s continuous changes to currency restrictions and official rates that is proving the most cumbersome problem.

A Very Complex System of Exchange Rates

Currently there are four exchange rates: First is the official one, called CENCOEX, and which charges 6.30 bolivars to the dollar. It is only intended for the importation of food and medicine.

The next two exchange rates are SICAD I (12 bolivars per dollar) and SICAD 2 (50 bolivars per dollar); they assign dollars to enterprises that import all other types of goods. Because of the fact that US dollars are limited, coupons are auctioned only sporadically; usually weekly in the case of SICAD 1 and daily for SICAD 2. However, due to the economic crisis, no dollars have been allocated for these foreign exchange transactions and there hasn’t been an auction since August 18, 2015. As of November 2015, the Venezuelan government held only $16 billion in foreign exchange reserves, the lowest level in over ten years, and an amount that will dry up completely in four years time at the current rate of depletion.

The last and newest exchange rate is the SIMADI, currently at 200 bolivars per dollar. This rate is reserved for the purchase and sale of foreign currency to individuals and businesses.

There are many problems in Venezuela as a result of this complex system. The most obvious is the near impossibility to actually get assigned to these rates due to the complex bureaucratic process one must navigate to apply for them. In response to these difficulties, Venezuelans must rely on the black market to meet their demands for foreign currency. Therefore, people naturally rely on the black market rate, which although it is much less advantageous (at 900 vs. anywhere from 6.3 to 200 bolivars per dollar on the “official” market), at least offers the possibility to procure the much needed foreign exchange.

Corruption, which is a main characteristic of Venezuela’s political regime, is another problem derived from this complex monetary system. Officials within the government and those connected to it have taken advantage of their positions of power and influence to mismanage the money assigned for other, productive and necessary, institutions. Thus, well-connected individuals obtain US dollars through the legal channels and then sell them on the black market at a higher price. (This activity is one of the only ways to consistently earn high levels of profits in the beleaguered Venezuelan economy, and is only available to those privileged few who are connected to the proper government officials.)

This point is especially important when studying the vast array of shortages. The embezzlement of foreign currency intended for importing basic goods, e.g., foreign exchange reserved for the CENCOEX and SICAD exchange rates, leave legitimate businessmen with no options to obtain legally the necessary currencies to import goods. Owing to the rapidly depreciating bolivar, US dollars are hoarded as a means of savings, thus further exacerbating the foreign exchange shortage for importers. As a consequence, imports are unable to be paid for, leading to shortages on top of those already caused by extensive and damaging price controls.

The Poor Suffer the Most

These problems affect directly all citizens, but are especially pernicious to lower-income individuals. Many suppliers will only sell what few goods they have for US dollars, eschewing accepting bolivars in the payment of their wares. Black market currency sellers set up shop outside supermarkets to accommodate this phenomenon, but it must be noted that only the upper-middle and higher income earners are able to afford to pay the black market rate. The result is that the lower-income segment of Venezuelan society, those who price and currency controls are supposedly helping, are not able to obtain the currency necessary to buy simple goods and services (and the wealthy can only do so at a high price).

Although the business community demands to be paid in US dollars this harms lower-income individuals unduly and is a completely rational response. If businesses kept selling their scarce supply of goods at the official rate their shelves would deplete faster than they already do. Venezuelans earn income at the official rate of 6.30 bolivars to the US dollar while businesses must pay a much higher rate in order to import goods. This difference must be accounted for by stores asking for prices commensurate with what they must pay to stock their shelves.

The complex exchange rate system in Venezuela is not only a good example of unnecessary government meddling in the economy, but also explains why a corrupt political regime has been able to retain power for so long despite more than a decade of hardship imposed on the country. The use of several exchange rates has made it easy for the Chávez and Maduro governments and their followers to make enormous profits by embezzling the money assigned to the business community and individuals. By doing so, they have completely devalued the bolivar and impoverished what was once one of the richest countries in the world.

Emiliana Disilvestro studies international business at Saint Louis University at its Madrid campus.

David Howden is Chair of the Department of Business and Economics and professor of economics at St. Louis University’s Madrid Campus, and Academic Vice President of the Ludwig von Mises Institute of Canada.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

How Time and Uncertainty Can Make Us “Antifragile” – Article by David Howden

How Time and Uncertainty Can Make Us “Antifragile” – Article by David Howden

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The New Renaissance Hat
David Howden
January 26, 2014
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Antifragile: Things that Gain from Disorder, Nassim Nicholas Taleb (New York: Random House, 2012).

No two buzzwords define the present crisis more than “contagion” and “robustness” in the world of economists and policy wonks. The current interrelated nature of the financial system has bred a fragile situation where the success of the greater economy supposedly hinges on its individual components, such as banks that are too big to fail. To combat this fragility, economists have increasingly sought to build robust institutions. Such institutions will remain strong in the face of adverse effects if an individual component of the economy fails — be it subprime mortgages, sovereign debt, deposit-taking institutions or investment banks. This approach to the crisis stresses that if we cannot battle contagion, we had better construct strong institutions to weather future storms.

Nassim Taleb takes great issue with this approach in his new book Antifragile. His view is that constructing such so-called robust institutions is not sufficient as they continually fight yesterday’s battles. Instead the focus should be in building “antifragile” insti­tutions. Although often confused with robustness or resilience, an antifragile institution is not only unharmed by adverse events, but is actually strengthened by them. Building antifragile institutions will not only strengthen the global economic arena, but also have wide-ranging social applications.

Taleb’s latest work builds on two of his previous books, Fooled by Randomness (2001) and The Black Swan (2007). The common theme underlying all three is that there are events which are fundamentally unknowable — true uncertainties — in distinction to merely risky outcomes. Since we cannot know in advance what these events are, or what their effects will be, we should not exert too much effort in constructing contingency plans.

It is at this point that my first quibble with the book arises, and one I had with its predecessor The Black Swan. Taleb bifurcates between two definitions of uncertain events. On the one hand he invokes random or fundamentally unknowable events. Readers of this journal will be sympathetic to this definition of uncertainty, bearing close resemblance to Mises’s own use of “case probabilities”[1] (1949, pp. 110–113), or Shackle’s (1949) use of “non-seriable, non-divisible” events.[2] On the other hand, it is also clear that Taleb also thinks of uncertain events as merely rare events. These are events located on the fat or long tails on a probability distribution. Even though he thinks that these represent true uncertainty, there is no doubt that he is referring to funda­mentally probabilistic events.

This quibble aside, one can apply much of the remaining work cognizant that Taleb’s terminology differs from that of the Austrian economists, and also that the domain of his theory is slightly different than he thinks.

Something is “antifragile” if it gets stronger from a negative event. What are some examples? Taleb applies the prefix of his book liberally to outline what choices we should be pursuing. Indeed, the body of the book gives a long list of antifragile actions that, at least on one level, boil down to doing the exact opposite of what you think you should be doing.

Authors should be shocked to learn that there is almost no news that can harm a writer’s credibility, and that any publicity is good publicity (pp. 51–52). Corporations and governments that try to “reinstill confidence” should not be trusted because they would do so only if they were ultimately doomed (p. 53). Children shouldn’t be on antidepressants as this removes a source of learning from the life experience and thus make individuals less capable of dealing with unwanted events later in life (p. 61). The sinking of the Titanic was a positive disaster as it put shipbuilders on their toes, and possibly avoided an even larger accident later (p. 72). The general theme is that those who make errors are stronger than those who don’t — reliability, or antifragility — only comes when something is regularly tested by an unwanted event.

The theory has merit. Consider this lesson applied to central bank policies. In the wake of the dot-com bust a concerted effort by the world’s central banks flooded the global financial system with liquidity. The liquidation of assets that should have happened never did, and as a result lenders and borrowers didn’t learn their lesson on prudential money management. The seeds were sown for the larger crisis starting in 2007–2008 because a simple lesson was not learned when the financial system’s problems were still in relative infancy.

There is much to learn from this book and much to be wary of. At the end of the day, Taleb reckons the best test of an anti-fragile institution is Mother Nature mixed with a healthy dose of time. In chapter 21 he criticizes the prevailing orthodoxy of “neomania,” the mistaken belief that newer is better. Those institutions that have existed the longest are, in all likelihood, those that will continue to exist into the future. As an example, imagine that the year is 1988 and answer the following: which structure will last the longest, the Berlin Wall or the Great Pyramid of Giza.

In this test, as in much of the book, Taleb asks too much and too little. He asks too much because those institutions with the most longevity were once upon a time also the ones with the least. There must be a better test than longevity, as it only pushes the problem back in time to identify the source of antifragility. It cannot be turtles all the way down.

An applied example relevant to the present financial crisis would involve looking for those institutions that have been strengthened by current affairs. The crisis has taken its toll on many aspects of the financial services industry, but some general types of products have proven surprising resilient, or antifragile. Governments with prudent fiscal policies — e.g., Germany, Switzerland and Singapore — have fared well and indeed been strengthened as finances deteriorate in more profligate countries. Investment funds capitalizing on what were once unorthodox strategies, such as gold and other precious metal holdings, have out-performed more traditional investments as the financial crisis worsens. Readers of this journal will also notice that their stock in Austrian economics has increased in value over the past decade. Question begging and failed policies developed through more mainstream theories have led many former outsiders to the ranks of Austrian economists. An unwanted event caused an offsetting positive outcome in all these scenarios. That is what being antifragile is about.

Taleb asks too little by not exploring the true sources of antifragility. He comes close, alluding in many places that market-based institutions better combat the false security that planned institutions create. Explaining and elaborating on this link would do much to take the fundamental merits of antifragility to the next level. It would be, however, fodder for another book.

References

[1] Mises, Ludwig von. 1949. Human Action: A Treatise on Economics. Auburn, Ala.: Mises Institute, 1998.

[2] Shackle, G. L. S. 1949. Expectations in Economics. Westport, Conn.: Gibson.

David Howden is Chair of the Department of Business and Economics and professor of economics at St. Louis University’s Madrid Campus, Academic Vice President of the Ludwig von Mises Institute of Canada, and winner of the Mises Institute’s Douglas E. French Prize. Send him mail. See David Howden’s article archives.

This article first appeared in the Fall 2013 edition of The Quarterly Journal of Austrian Economics.

Inflation Has Not Cured Iceland’s Economic Woes – Article by David Howden

Inflation Has Not Cured Iceland’s Economic Woes – Article by David Howden

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The New Renaissance Hat
David Howden
November 6, 2013
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No two countries’ responses have polarized commentators over the past five years more than the contrasting post-crisis policies in Iceland and Ireland.

In a paper published in Economic Affairs (available here as a PDF) I contrast the policies enacted by Iceland and Ireland, perhaps the two countries most affected by the liquidity freeze of 2008. A common conclusion has been that one country did everything right and the other did everything wrong, however, I take a more pragmatic approach. There are some positive aspects in each case, and other aspects we can do without.

At the risk of over-simplifying their situations, the key policy differences are:

  1. Iceland allowed substantial swaths of its financial sector to collapse (mostly foreign-domiciled subsidiaries) while Ireland enacted blanket guarantees to keep its financial sector afloat.
  2. Iceland quickly inflated its krona in a bid to regain international competitiveness through depreciation. By being locked in the euro, Ireland was unable to pursue a similar path and instead had to become more attractive to foreigners by lowering its domestic prices (i.e., disinflation or outright deflation).
  3. Iceland stymied a capital flight by enacting monetary controls aimed at keeping investment within the country. By being part of the European Union, Ireland maintained its commitment to free capital markets, and investors were able to enter or exit as they pleased.

The evidence is mixed as to which solution was more effective. Iceland seems to have softened the immediate blow of its recession, but present growth in Ireland is stronger. In a similar way, unemployment in Iceland was less and still remains lower today.

For our purposes here, I want to focus just on the effects of their respective monetary policies, and how the short-term gains from Iceland’s inflationary response now pale in comparison to Ireland’s more subdued response.

Figure 1: Nominal GDP (2008 = 100) Source: Federal Reserve Bank of St. Louis

Figure 1 shows the common story. Iceland’s inflationary policy stimulated exports, papered over some bad debts, and in general allowed it to exit the storm relatively unscathed. In contrast, Ireland is languishing in slow growth and five years later the country’s income is still 10 percent below its pre-bust peak.

Such an analysis neglects the pernicious effects of inflation on the Icelandic economy. This policy increased the money supply by almost 20 percent in 2008 alone, and lead to an immediate increase in prices.

Figure 2: Real GDP (2008 = 100) Source: Federal Reserve Bank of St. Louis

In figure 2 we get a better feel for how the situation felt to the average Icelander or Irishman. As the Central Bank of Iceland inflated the money supply, price inflation raged. Icelanders continually felt their financial security worsen as their purchasing power collapsed. This was not apparent to the rest of the world, fixated as it was on the nominal prices the Icelandic economy posted. By its nadir in late 2010, inflation-adjusted income in Iceland was down over 35 percent.

In Ireland this decline was muted because of price deflation. As domestic prices fell it became easier for Irish citizens to make their declining nominal incomes go further. At its worst, the Irish economy collapsed less than 10 percent in real terms.

This seems to suggest that Ireland had the better solution by not pursuing an inflationary monetary policy. Some will note, however, that Iceland’s recovery since 2010 has been quite strong.

Indeed, if we look at the drop in the employment rate for both countries most probably feel more sympathy for the masses of unemployed Irishmen.

Figure 3: Employment rate (2008 = 1) Source: Federal Reserve Bank of St. Louis

Digging deeper, however, we find that not all is as it seems. Many Icelanders work two jobs to make ends meet. This effect was increasingly pronounced through the recession as inflation made it more difficult to get by with one salary. As a consequence, many Icelanders lost one job during the recession but the unemployment statistics did not reflect this as they were still employed elsewhere. This is notably not the case in Ireland, where not only is one job per worker the norm, but falling prices made it easier for an employed person to make ends meet as the recession continued.

A better way to gauge the employment situation is to look at changes in the hours worked.

Figure 4: Annual hours worked (2008 = 100) Source: Federal Reserve Bank of St. Louis

Here we can see the situation is reversed. By the recession’s trough in 2010 the number of hours worked by the average Icelander had fallen 6 percent while in Ireland the corresponding drop was only 3.5 percent — almost half as much.

Both countries still have problems. Iceland’s monetary controls are notably stifling needed investment, while Ireland is left with a large debt from bailing out its banks, and this is stalling growth. One thing is clear though — the effects of monetary policy are stark and the proclaimed benefits of Iceland’s inflationary policy were counteracted by the price inflation that ensued.

Don’t let a good crisis go to waste; learn something from it. As the tale of these two countries demonstrates, inflating one’s currency may give the appearance of recovery, but the truth is somewhat less rosy.

David Howden is Chair of the Department of Business and Economics and professor of economics at St. Louis University’s Madrid Campus, Academic Vice President of the Ludwig von Mises Institute of Canada, and winner of the Mises Institute’s Douglas E. French Prize. Send him mail. See David Howden’s article archives.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.