Currency and the Venezuelan Crisis

Mon 21 August 2017

Before getting stuck into the main point let me say that what's happening to the people of Venezuela is nothing short of a tragedy. If you, like me, live in a stable and affluent society then I doubt we can really imagine what Venezuelans feel as their society descends into turmoil. The situation and its historical causes are not simple, and people far more knowledgeable than myself have written about it, such as here or here.

With that said, I'll focus on one aspect where I do have some understanding which I'd like to share.

You may have come across a statement like this recently. If not, let me introduce you to it:

A country with its own currency and central bank cannot go bankrupt because of large debts (held in its own currency).

This is true, but less profound than it sounds, mainly because the bit in brackets is often left out.

Now consider this:

An explorer leaving the North Pole must go south.

This is similar in that it's true and sounds profound.

Both sound interesting because they take a familiar notion but put it in a special context. The North Pole is a unique place on the globe because it's the source (or destination) of lines of longitude and so notions of north, south, east and west lose their usual meaning. Likewise, a central bank is a special place in an economy because it's a source of money. Well, base money which includes notes and coins and private bank reserves but not what you might see on your bank statement, that's broad money, but I digress.

With that in mind let's pull the first statement apart and see what it means.

For starters, what does a country going bankrupt mean? More usually it is called a 'default' and, apart from some technical differences in law, it boils down to the same thing as for a person or a company: a declaration that debts cannot be repaid on time.

But, unlike a person or a company, if a country's debts are in its own currency then it can repay them at any time by creating money at the central bank. It can do this literally by minting coins or printing paper notes, but more usually it just makes the money appear in one of the accounts it manages. In the past this was done by writing an entry in an old-fashioned ledger book but these days it'd be in a database managed by some specialised software.

Whatever the mechanics of it, the key point is that a central bank can just create base money in its own currency and then spend or distribute it via private banks as it pleases1.

But doesn't creating money cause inflation to get out of control? In other words, if several billion pounds are created out of nothing, won't the pound be worth less in dollars or euros, and won't this cause prices to shoot up in the shops?

Not necessarily. It depends on how it is spent and the circumstances of the economy. For example, quantitative easing (QE) in the UK's central bank — the Bank of England — created £435 billion that was used to buy back chunks of government debt called bonds. This is a huge amount of money — about a quarter of the UK's public debt, and a fifth of annual GDP — but it didn't cause problematic inflation. Of course, this is an extreme and unusual example but central banks routinely do something similar on a smaller scale with what they call open market operations. Also, if you stop to think about it, a result of QE is that the UK public sector, which includes the Bank of England, owes itself a quarter of its total debt2!

If you're confused at this point, it's likely because everyday ideas of debt, and even money itself, take on counter-intuitive meanings when talking about public finances in a country with its own central bank and currency. Common sense is likely to mislead you, so it's important to think it through carefully. I've only offered a partial explanation of why in this post as I don't want to deviate too far from its main point, but if you're curious see the links in the footnotes for more detail.

Let's turn our attention to Venezuela. It has its own currency and central bank, so how come it's in trouble3? The explanation involves the bit in brackets in the statement at the start. It ran up debts priced in dollars, not in its own currency, the bolivar fuerte — the strong bolivar which replaced the previous bolivar which also fell foul of inflation. Having your own currency and central bank won't help with debts held in another country's currency. If your debt is in dollars, you must pay in dollars.

Dollars, and indeed other currencies, are also needed for trade. Venezuela relies on imports of many essential goods, including basic staples of food. To buy these things from the USA requires US dollars and so importers supplying shops go to the central bank to exchange bolivars for dollars4. But reserves of dollars are running low for two reasons: they're needed to pay interest on dollar denominated debt, but also the supply of dollars from oil exports dried up after the oil price crash in 2014-15. The net result of all this is that there is a shortage of goods in the shops and inflation is rampant, that is, more and more bolivars are required to buy one dollar.

So while it's undeniable that having a central bank with its own currency gives a country considerable domestic flexibility in its public finances, this advantage is limited in a world increasingly interconnected through trade. In fact, if a country has a dominant trade partner, or relies on trade in something priced in a foreign currency — oil is priced in dollars, for example — then its currency is not really its own. Such a country will be constrained by actions of the trade partner, or perhaps an international cartel such as OPEC. This blog post by France Coppola goes into much more detail on this point.

The statement at the start is worthy of serious thought, and if properly understood it can and should be used as a basis for countries to take sensible approaches to public finances especially during an economic downturn. There are actually only a few countries that can be deemed to have a currency that is really their own: most obviously, the US, the UK, Japan and China. But even for them there's an international tangle. Japan and China vie with each other for holding most of the US's debt, and the US dollar floats on waves made by decisions in oil-exporting countries, mostly in the middle east. And of course, none of the countries using the euro have their own currency except, perhaps, Germany because of its dominance in exports.

So beware of the statement made at the beginning being deployed in a glib and over-simplistic way, especially if the bracketed qualification is omitted. In such cases it becomes about as profound as

A car with its own controls and engine can't crash into other cars (if there are no other cars on the road).

1. Private banks can create broad money and do so whenever they lend. If you dispute that please go and read this paper published by the Bank of England and argue with them.

2. The debt still exists technically to avoid violating the Lisbon Treaty that is the constitutional basis of the EU. Article 123 forbids repaying debt using money created at a central bank. To work around this, the Bank of England simply says it owns the bonds with the intention of selling them back to the private sector at some point in the future. If you think further on this counter-intuitive situation you'll realise that public debt is not debt at all and is actually more like a form of savings used by the private sector.

3. A quick web search will yield many articles explaining the situation in Venezuela. This one is over a year old, but it gives one of the clearest explanations I've read of the economics of the crisis.

4. The other option is to exchange bolivars for dollars on the black market and it is this plus bolivar-creation at the central bank that is fueling inflation.