Wednesday, May 27, 2015

Venezuela versus what Ecuador learned

Steve Hanke in GlobeAsia PDF re Venezuela

First, basics of rule of law including sound currency:
The rule of law subjects the State to a fixed set of rules that limits the scope of its coercive powers. Individuals and their property are protected from the arbitrary, ad hoc actions of the State and other individu- als. In consequence, individuals can plan their activities within the confines of known, fixed “rules of the game.” This allows people to pursue their personal ends, as long as their actions do not infringe on the broadly-defined property rights of their fellow citizens. 
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 great Austrian economist Ludwig von Mises dealt at length with this issue in The Theory of Money and Credit, which was published originally in 1912: 
“It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights. The demand for constitutional guarantees and for bills of rights was a reaction against arbitrary rule and the non- observance of old customs by kings. The postulate of sound money was first brought up as a response to the princely practice of debasing the coinage. It was later carefully elaborated and perfected in the age which—through the experience of the American Continental Currency, the paper money of the French Revolution and the British Restriction period—had learned what a government can do to a nation’s currency system.”
Then the mess of Venezuela.
Today, 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 the accompanying chart).
Relative to the mighty U.S. dollar, Venezuela’s currency, the bolivar, is also falling like a stone. Indeed, it has lost 47% against the greenback just since the start of the year (see the accompanying chart). [Written in May.] 
As night follows day, inflation has soared as the bolivar has plunged. I estimate Venezuela’s annual inflation rate at 335%. That’s the highest rate in the world. For those holding bolivars, it amounts to: “no rule of law, bad money.” 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, the average annual inflation rate was only 1.7% -- not much above Switzerland’s...
Meanwhile, in Ecuador most people suffered decades of impoverishment for the benefit of the elite. There were even laws to benefit the rich.
Ecuador represented a prime example of a country that was incapable of imposing the rule of law and safeguarding the value of its currency, the sucre. The Banco Central del Ecuador was established in 1927, with a sucre-U.S. dollar exchange rate of 5. Until the 1980s, the central bank periodically devalued the sucre against the dollar, violating the rule of law. In 1982, the central bank began to exercise its devaluation option with abandon. From 1982 until 2000, the sucre was devalued against the dollar each year. The sucre traded at 6,825 per dollar at the end of 1998, and by the end of 1999 the sucre-dollar rate was 20,243. During the first week of January 2000, the sucre rate soared to 28,000 per dollar. 
In the case of Ecuador, the inability of the 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 (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 was the order of the day. For example, during the rout of the sucre in 1999, laws were passed that allowed bankers to make loans to themselves. 
Then Ecuador implemented a policy of sound money and stuck with it. They got rid of their own currency and adopted the US dollar in 2000 and gained stability.
… the critics of dollarization condemned it as something akin to voodoo economics. Well, the critics have been predictably proven wrong. 
The misery index is an objective measure of just how well dollarization has worked. The index is equal to the sum of the inflation rate (end of year), bank’s lending interest rates and the unemployment rate, minus the actual percentage change in GDP per capita. Simply put, a high index means higher misery. 
In Ecuador, prior to the implementation of dollarization in 2000, the country sustained a misery index of over 120. The public suffered greatly from inflation, but after dollarization was implemented, high inflation was stifled and misery drastically fell. The accom- panying chart shows the direct link between dollarization and the immedi- ate and sustained decrease in misery. From 2003 through 2014, the misery index in Ecuador has been remarkably constant at around 20 – one of the lowest in Latin America. 
Ecuadorians know that dollarization has allowed them 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 dollarization is embraced by 85% of the population. It’s time for Venezuelans, as well as many others, to take note and dollarize.

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