Venezuela must adopt the dollar

Such a move is not as radical as it seems with Ecuador having done it successfully

of the government to abide by the rule of law is, in part, a consequence of traditions and moral beliefs.

Ecuadorean politics have traditionally been dominated by elites (interest groups) that are uninhibited in their predatory and parochial demands on the state. With the lack of virtually any moral inhibitions, special interest legislation has been the order of the day.

For example, during the rout of the sucre in 1999, laws were passed allowing 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.

This, as well as the collapsing sucre, enraged most Ecuadorians. With the rule of law (and the sucre) in shambles, President Jamil Mahuad announced on January 9, 2000 that Ecuador would abandon the sucre and officially dollarise the economy. The positive confidence shock was immediate.

Dollarisation provisions

On January 11th — even before a dollarisation law had been enacted — the central bank lowered the rediscount rate from 200 per cent a year to 20 per cent. On February 29, the Congress passed the so-called Ley Trolebus, which contained dollarisation provisions. It became law on March 13, and after a transition period in which the dollar replaced the sucre, Ecuador became the world’s most populous dollarised country.

I had a front-row seat in Ecuador’s dollarisation drama — both as a participant in the dollarisation debates that preceded the sucre’s collapse and also during the replacement of the sucre and the greenback’s implementation phase, when I was an adviser to Carlos Julio Emanuel, the Minister of Finance and Economy.

As for Venezuela, I had another front row seat, as President Rafael Caldera’s adviser in 1995-96, prior the arrival of Chávez. To put discipline into Venezuela’s monetary and fiscal spheres, I recommended an orthodox currency board — one that would have made the bolívar a clone of the US dollar.

Caldera came close to adopting my recommendations. But, in the end, he failed to do so. The elites and special interest groups, as well as a variety of leftists, were opposed to any reform that would introduce the rule of law and impose monetary and fiscal discipline.

The failure to adopt the rule of law has been catastrophic.

Let’s look at oil production. Venezuela has the largest proven oil reserves in the world — even greater than Saudi Arabia. But, the oil output of Venezuela’s state-owned oil company, PDVSA, is only 80 per cent of what it was in 1999 (see the accompanying chart).

In contrast, Ecuador’s oil output has jumped in the post-dollarisation period and is now over 40 per cent higher than in 1999.

Venezuela’s inflation record under Chavez was dismal, and under Maduro it has been catastrophic. For the past three years, Venezuela’s inflation rate has held the world’s top spot. It reached an annual rate (yearover-year) of almost 800 per cent in the summer of 2015 and is 145 per cent at present, still the world’s highest rate (see the chart below).

In contrast, Ecuador’s annual inflation during the last 10 years — dollarized years — has averaged 5.2 per cent. The most telling contrast between Venezuela’s Chavismo and Ecuador’s Chavismo Dollarized can be seen in the accompanying chart of real GDP in US dollars. We begin in 1999, the year Chávez came to power in Venezuela.

The comparative exercise requires us to calculate the real GDP (absent inflation) and do so in US dollar terms for both Venezuela and Ecuador. Since Ecuador is dollarised, there is no exchange-rate conversion to worry about. GDP is measured in terms of dollars. Ecuadorians are paid in dollars. Since 1999, Ecuador’s real GDP in dollar terms has almost doubled.

To obtain a comparable real GDP for Venezuela is somewhat more complicated. We begin with Venezuela’s real GDP, which is measured in terms of bolívars. This bolivar metric must be converted into US dollars at the black market (read: free market) exchange rate.

This calculation shows that, since the arrival of Chavez in 1999, Venezuela’s real GDP in dollar terms has vanished. The country has been destroyed by Chavismo.

So, where is Venezuela going? According to the International Monetary Fund’s (IMF) forecast, inflation will be 720 per cent by the end of the year. We can reverse engineer the IMF’s inflation forecast to determine the bolívar-greenback exchange rate implied by the inflation forecast. When we conduct that exercise, we calculate that the VEF/USD rate moves from today’s black market (read: free market) rate of 1,079 to 6,218 by year’s end. So, the IMF is forecasting that the bolívar will shed 83 per cent of its current value against the greenback by New Year’s Day, 2017.

The following chart shows the dramatic plunge anticipated by the IMF.

Venezuela is clearly in a death spiral. The only way out is to officially dump the bolívar and replace it with the greenback.

The writer is Professor of Applied Economics at the Johns Hopkins University in Baltimore, MD. He is also a Senior Fellow and Director of the Troubled Currencies Project at the Cato Institute in Washington, D.C. You can follow him on Twitter: @ Steve_Hanke