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The Fine Print of Central Banking

Mises Daily: Thursday, May 27, 2010 by

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Since the rise of Hugo Chavez, Venezuela has become a superstar of sorts. It frequently makes headline news, whether due to some type of utility shortage, some political scandal, or a corruption case. The most common perception of Venezuela is one of economic peril. Indeed, analysts have been predicting the government's collapse since at least 2007. While Chavez's Venezuela has survived so far, most agree that its economy limps on one leg and that default is only a matter of time.

Mark Weisbrot, codirector of the Center for Economic and Policy Research, disagrees. In a recent article for The Huffington Post ("Venezuela is not Greece"), he argues that Venezuela's saving grace is Chavez's efforts to maintain the national debt as low as possible. Given a low public debt, high government expenditure, "low inflation," and the ability to manipulate exchange rates, Mark Weisbrot holds that Venezuela is poised to "pursue a robust economic expansion."

In reality, Mark Weisbrot's analysis could not be further from the truth.

Venezuela's economy is heavily burdened by the state. Not only have Venezuelans been deprived of their right of free speech, but Hugo Chavez has also burdened the markets through his incessant quest for power. Most of the country's utility industries have been outright nationalized, and the nationalizations have spread to other sectors as well. Fear of expropriation has paralyzed investment. Without a healthy private sector, Venezuela does not boast of the necessary foundations for a true economic expansion. Not even Hugo Chavez believes otherwise!

Weisbrot is right about one thing: Venezuela's government enjoys a relatively small public-debt burden. This is but one of the many advantages of having your own central bank. Indeed, why care about debt at all? One can simply print it out of existence! While surely Chavez has benefited from the printing press, other Venezuelans have not been so fortunate. Contrary to Weisbrot's claims, inflation has skyrocketed. Venezuelans have become progressively poorer, as Chavez funds his social programs through monetary expansion.

Venezuela's inflation can be considered a type of fraud. Economies are not built on cash. Automobiles are not fabricated out of money. Families do not eat paper. By printing money, Venezuela's central bank and government are not creating capital, they are only funding their ability to bid it away from the private sector and squander it on uneconomical public programs. Imagine the average Venezuelan who receives nothing but a currency that is consistently falling in value in exchange for his resources. Simultaneously, his savings are confiscated, because they are progressively worth less in the face of rising prices. How can anybody consider this a basis for a rise in wealth?

Anatomy of an Economic Disaster

In Venezuela, entrepreneurship is condoned when it doesn't interfere with the plans of Hugo Chavez. Unsurprisingly, entrepreneurs in the utility industries are not part of Chavez's plans, and as such the Venezuelan utility market has been almost completely nationalized. While prior to the recent global depression Chavez stuck to nationalizing certain sectors at a relatively slow (yet steady) pace, the onset of global crisis accelerated the socialization of Venezuela's economy. Indeed, few foreign-owned oil companies were left untouched after Chavez decided to solve his debt problem by simply taking over those businesses he owed money to.

Other key industries nationalized include the telecommunication and electrical markets. Admittedly, Chavez's nationalizations did not consist solely of expropriating the property of others for the benefit of the "people of Venezuela." Like any good politician, Chavez pandered to big business, offering two Spanish electrical companies, Iberdrola and Elecnor, a total of nearly two billion dollars to build a 1000Mw electrical plant in the city of Cumaná, in eastern Venezuela. The average construction cost for the specific type of plant being built was $0.75 a watt. Chavez paid Iberdrola and Elecnor $2 a watt.

"Economies are not built on cash. Automobiles are not fabricated out of money. Families do not eat paper."

The nationalization of the utility industry has been a disaster. Venezuela continues to suffer from severe power and water shortages. This all seems surreal for a country with the largest reserve of crude oil outside of the Middle East, as well as one of the largest hydroelectric systems in the world. The resource shortages are largely a result of years' worth of price controls, as Chavez sold his socialist revolution by providing Venezuelans with cheap energy. Unfortunately, the market has adjusted at the expense of the average Venezuelan, as artificially low prices have led to severe shortages in available resources.

The government's response to the shortages has been even greater regulation of the use and distribution of these utilities. Venezuelans who use more than the prescribed amount of energy and water are subject to taxation, while even heavier fines are imposed upon businesses. The result has been widespread damage to Venezuela's economy. Stores open later and close sooner, limiting the amount of business they receive, while large industrial plants find it difficult to run efficiently under the government's energy quotas.

While this is disastrous from the point of view of an economist, it is even more so from the perspective of the average Venezuelan. Indeed, standards of living have decreased, as the lack of electricity has caused issues with refrigerating food, and citizens can no longer enjoy some of the luxuries they did prior to the economic crisis.

The utility industry is hardly the only sector to see continued nationalization and regulation. The automobile industry, hardly able to afford the necessary parts and materials due to a very weak bolívar, found its production quotas regulated and dictated by the Chavez dictatorship. The alternative was expropriation. The unsurprising result of Chavez's regulation of the automobile industry has been a shortage of cars! So, while new cars are purchased many months before production, the price of used cars has soared in the face of increasing demand.

Chavez also nationalized the cement industry as a means of solving the "housing shortage." Continued shortages and difficult economic conditions have prompted the nationalization of even more industries, including steel producers and food suppliers.

The banking industry has not been left alone. In the face of possible bank failures, Hugo Chavez decided not to risk a bailout. Instead, he outright nationalized banks most likely to default, while threatening those "failing to comply with the law." Of course, "not complying with the law" roughly translates into "failing to remain a source of income for the government." It is no surprise that the financial sector is mostly led by Chavez military lackeys, and Chavez's favorite form of regulation has been actively replacing the leadership of certain banks by purging his own appointees. The result of all of this has been capital flight, as investors look to secure whatever wealth they can by moving their investments offshore.

Regulation, outright nationalization, political corruption, and price controls have led to one of the worst economic crises in the history of Venezuela. The cause is simply the loss of private investment, which has come as a result of the burden of the growing socialist government. Instead of allowing entrepreneurs to invest and produce wealth, Chavez has preferred to centrally coordinate the markets. Unsurprisingly, this has caused irreparable damage. Venezuela has become the perfect case study for Ludwig von Mises's socialist calculation problem — without a price mechanism, the government has been unable to coordinate the distribution of resources in the most economically efficient way, leading to widespread shortages and the destruction of wealth.

With all of this in mind, it is difficult to see how Mark Weisbrot justifies his opinion that Venezuela is ready to "pursue a robust economic expansion." With domestic investors fleeing and Chavez effectively blocking foreign investment, one is left wondering where exactly Chavez will find the capital necessary to catalyze economic growth. Even assuming such capital was readily available, given the poor performance of nationalization so far, what gives Weisbrot confidence in the Venezuelan government? Weisbrot can only point to Venezuela's low national debt. It's clear Mark Weisbrot is leaning on the printing press as the solution to Venezuela's economic woes.

Prosperity through the Printing Press

The Central Bank of Venezuela and Hugo Chavez have beaten Mark Weisbrot to the punch line. Since Chavez's ascendency to the presidency, the bolívar's monetary base has been growing at an accelerating pace. Increasingly expensive social programs have been paid for by money created ex nihilo, allowing the government to maintain a low debt level.

For example, as a method of paying debt and "stimulating economic growth," Chavez devalued the bolívar fuerte by half in January 2010. Ironically, in 2008 the Venezuelan government introduced the bolívar fuerte, pegged to 1/1000th the value of the original bolívar, as a way of combating the rampant inflation that had taken a toll on the value of the latter. Cutting zeroes was meaningless while the Venezuelan central bank continued accelerating money expansion.

Figure 1

The result has been a progressive increase in the general price level. In 2008, Venezuelans suffered from a 30.9% increase in the general price level, and while price inflation fell to 25.1% in 2009, the general price level increased by 30.4% between January and April 2010. The result has been a decreasing level of confidence in the bolívar, as Venezuelans rush to spend their savings before the government confiscates them through inflation. Some expect up to a 60% increase in general prices by the end of 2010!

The worst is yet to come. While Hugo Chavez and Venezuela's central bank continue to inflate the money supply in an effort to forestall disaster, prices will continue to rise. The inevitable conclusion is hyperinflation, as consumers and businessmen begin to fear that inflation will continue indefinitely.

By this time, it should be clear that monetary inflation is not a method by which to increase production. By printing money, the government does not simultaneously produce capital goods. The belief that further inflation in Venezuela will spur investment is completely detached from reality. The pitfalls of the printing press were already well illustrated by the recent collapse of Zimbabwe.

But, surely printing more money will allow investors to buy more capital goods? Knowing that the supply of capital, during a specific moment in time, is fixed, by giving certain entrepreneurs more money it will only allow them to bid capital away from other entrepreneurs. Furthermore, over the long run an increase in money will, at best, cause the price of capital to adapt to the increase in the supply of money. There is no physical increase in the volume of capital available to entrepreneurs.

At first, an increase in the supply of money will cause entrepreneurs to invest into capital goods and lengthen the structure of production. This leads to the intertemporal discoordination predicted by the Austrian business-cycle theory, and an inevitable bust. A central bank can avoid the bust by continuing to inflate the money supply at an accelerating pace, but this can only end in a crisis of confidence and hyperinflation.

In Venezuela's case, further monetary expansion is unlikely to lead to increased investment — even malinvestment. Venezuela's private sector has been crushed by nationalization, regulation, and price fixing. The majority of newly created money goes towards a development fund known as FONDEN. Money transferred to FONDEN is used to finance a myriad of infrastructure projects. For example, of the 98.9 billion bolívars comprising the money supply in December 2009, over 57 billion were allotted to FONDEN. Around 36.4 billion bolívars were represented by coins and bank notes in circulation.

Most new bolívars go directly towards the consumption of capital, rather than towards investing capital and lengthening the structure of production. In other words, inflation is helping to directly deplete the existing stock of capital in Venezuela by subsidizing its consumption. So, instead of at least offering the illusion of prosperity, the Venezuelan government is directly contributing to the visible impoverishment of society.

Venezuelan End Game

Mark Weisbrot correctly suggests that the Venezuelan economy is not in the same position as the Greek economy. While the Greek government's ability to fund its spending is constricted by its lack of a sovereign central bank, Hugo Chavez's Venezuelan junta has the luxury of printing as much money as it needs. But this slight difference is not enough to justify the belief that Venezuela is somehow poised to begin an economic recovery.

Venezuela's market has been absolutely flattened by an overburdening government. Nationalization turned vibrant industries into dead factories, while regulations and price fixing crushed what remained of the private sector. With no true recovery possible, the regime has turned to the printing press as the solution to its economic problems. But, as events clearly show, this has not led to prosperity. It has only led to further suffering, as inflation quickly erodes Venezuelan savings and further damages Venezuelan industry.

Far from the recovery claimed by Mark Weisbrot, the continuation of current fiscal and monetary policies will bring immeasurable pain upon the people of Venezuela. Unless Hugo Chavez's government suddenly ends spending and returns to a free market, the most likely conclusion to current events in Venezuela is a crisis of interventionism, as the bolívar collapses and the government finds it more and more difficult to fund itself.