Dollarisation is Venezuela’s best hope
by Steve Hanke
Venezuela has at best a tenuous grip on the rule of law. This is nowhere more visible than in the monetary sphere. The country’s foreign exchange reserves are falling like a stone (see Chart 1). The bolivar has plunged 47% against the dollar since the start of the year (see Chart 2).
Venezuela’s worsening financial situation can be glimpsed in the government’s approaches to Wall Street. On 24 April, it secured a $1bn loan from Citibank, with 3,500 gold bars (worth $1.7bn) as collateral.
In line with the bolivar’s decline, inflation has soared to an estimated annual 335% (see Chart 3), the highest in the world. For those holding bolivars, it amounts to: ‘no rule of law, bad money.’ Facing this inflationary theft, Venezuelans have voted with their wallets. Indeed, they have begun to unofficially dollarise the economy. The only way to reestablish the rule of law in the monetary sphere is to take this development further and officially dollarise the economy by dumping the bolivar and replacing it with the dollar, following the pattern of Ecuador which swapped its sucres in 2000.
In general terms, the rule of law subjects the state to a fixed set of rules that limits the scope of its coercive powers. When properly applied, the rule of law guarantees freedoms in the economic, political, intellectual and moral spheres. In the economic sphere, money constitutes an important element.
The Austrian economist Ludwig von Mises dealt at length with this issue in The Theory of Money and Credit published in 1912: ‘It is impossible to grasp the meaning of the idea of sound money if one does not realise that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments.’
It is worth noting that currency debasement and inflation robbery were not always the order of the day in Caracas. During the decade of the 1950s, Venezuela’s average annual inflation rate was only 1.7%, not much above Switzerland’s. In the 1960s, inflation fell to a 1.2% average annual rate. It wasn’t until the 1980s that Venezuela experienced a decade of double-digit annual inflation. Today, inflation, contrary to the official numbers and amateur estimates, has soared well into triple-digit territory.
When inflation rates are elevated, standard economic theory and reliable empirical techniques allow us to produce accurate inflation estimates, using free market exchange rate data (usually from the black market) and the principle of purchasing power parity (PPP), which links changes in exchange rates and changes in prices. My estimate of a 335% inflation rate stems from black market exchange rates that The Johns Hopkins-Cato Institute Troubled Currencies Project has collected over the past year.
Ecuador, where I served as the chief adviser to the finance minister during the dollarisation episode, offers some lessons. Ecuador represented a prime example of a country that was incapable of imposing the rule of law and safeguarding the value of the sucre. The Banco Central del Ecuador was established in 1927, with a sucre-dollar exchange rate of 5.
Until the 1980s, the central bank periodically devalued the currency. Then, devaluations became more frequent. By the end of 1998, the sucre traded at 6,825 per dollar. A year later, the rate was 20,243. During the first week of January 2000, it soared to 28,000.
The inability of the Ecuadorian government to abide by the rule of law was, in part, a consequence of traditions and moral beliefs. Ecuadorian politics have traditionally been dominated by elites who are uninhibited in their predatory and parochial demands on the state. Special interest legislation was the order of the day. For example, in 1999, laws were passed that allowed bankers to make loans to themselves. In addition, state guarantees for bank deposits were introduced. These proved to be a deadly cocktail, one that allowed for massive looting of the banking system’s deposit base.
With the rule of law (and the sucre) in shambles, President Jamil Mahuad announced on 9 January 2000 that Ecuador would abandon the sucre and officially dollarise the economy. The positive confidence shock was immediate. On January 11 – even before a dollarisation law had been enacted—the central bank lowered the rediscount rate from 200% a year to 20%.
But this newfound ray of hope was threatening to some, and on 21-22 January, a coup d’état ensued. While the Mahuad government was toppled, the coup was bungled. Gustavo Noboa, a former vice president, assumed the presidency and honoured Mahuad’s dollarisation pledge. Congress passed the so-called Ley Trolebus, containing the dollarisation provisions, which became law on 13 March. Ecuador became the world’s most populous dollarised country on 13 September.
The critics of dollarisation condemned it as something akin to voodoo economics, but have been proven wrong. The so-called misery index shows how well dollarisation has worked. The index is equal to the sum of the inflation rate (end of year), banks’ lending interest rates and unemployment rate, minus the actual percentage change in GDP per capita. A high index means higher misery.
In pre-2000 Ecuador the country sustained a misery index of over 120. After dollarisation, high inflation was stifled and misery drastically fell (see Chart 4). From 2003 to 2014, the misery index in Ecuador has been remarkably constant at around 20 – one of the lowest in Latin America. Dollarisation has allowed Ecuadorians to import a vital element of the rule of law – one that protects them from the grabbing hand of the state. That’s why recent polling results show that 85% of the population embrace dollarisation. It’s time for Venezuelans to take note and follow suit.
Steve Hanke is professor of Applied Economics at Johns Hopkins University.