Why Exchange Rates and Interest Rates are the Al and Peg Bundy of Economic Policy

But Peg…I debauched you last month.

Did you hear? The government is going to liberalize the dollar-bolivar market! It’s huge news!

On paper, the Convenio Cambiario #27 setting up what’s known locally as SICAD2 – a legal, market-driven alternative to exchange controls – looks like the most significant economic reform in 15 years. What’s more, it looks like the first pro-market reform we’ve seen from chavismo…ever.

Still, color me skeptical.

The whole concept of allowing buyers and sellers to interact freely to determine an important price looks impossibly radical in a chavista policy-setting context. More importantly, there are powerful economic reasons to doubt this thing can work.

It’s easy to get lost in the details, so it’s best first to establish the principle: there’s a reason economic reforms usually come as a package. Various bits of the economy are deeply interconnected in complicated ways, and if you mess with one part of the system without adjusting the other bits at the same time, the whole thing is liable to break down.

If those dreaded paquetes are usually implemented at once, it’s not out of some intrinsic neoliberal perversion, but because the alternative is like dropping a much more powerful engine in a car without upgrading the brakes and the suspension at the same time: you end up with a dangerously unbalanced beast liable to crash and burn in short order.

The easiest of these interconnections to grasp is the one Miguel Angel Santos has been droning on about at some length: the link between lifting foreign exchange controls and interest rate controls. These two are very much the love-and-marriage of the economic reform world:

This I tell you brother

You can’t have one without the other. 

It’s easy to see why. Right now a good many Venezuelan people and companies keep savings in bolivar bank accounts (and in government bonds) that pay less than 20% interest, even though inflation is running at over 50% per year. Real interest rates are crazy negative: put Bs.100 in a bank account today and the Bs.120 you end up with a year from now buys much less than Bs.100 buys today.

So saving in bolivars is sort of like keeping dollars under your mattress, taking them out once a year and putting about a third of them through a paper shredder.

Why do people put up with this? Because they don’t have a legal way to turn Bs.100 into assets that can be relied on to hold their purchasing power over time, like dollars. But if you give people that option, nobody sane is going to hang on to those fast self-destructing bolivars.

The one way to persuade them to hang on to those bolivars is to pay much higher rates on deposits. Either interest rates go up sharply or we’re going to see an almighty stampede out of the bolivar zone, with potentially dire consequences for the banks, the public treasury and everyone else, too.

So we’re calling for interest rates rise sharply, right?

If only it was so easy. When rates rise fast, a bunch of people who borrowed from the banks face much more onerous payments than they had foreseen. You borrowed at 15%, now suddenly you have to pay 50%. Lots of creditors are going to default. Enough to compromise the solvency of the big banks?

I have no idea, but I don’t want to find out.

Perhaps the bigger question is what the shock would do to the biggest borrower of them all in the bolivar zone: the government. It’s piled up huge mountains of bolivar denominated debt over the years. If the cost of that debt triples overnight, what happens to the budget deficit? And how do they cover that hole?

The temptation will be to just print more money, but the inflationary impact of that would be grave…and little by little you start to grasp why “fiscal reform” (i.e., bringing government spending broadly into line with what it can sustainably raise in tax) is usually thrown into the paquete too.

What’s worrying is that even though these three policy areas – exchange rate, interest rate, fiscal – are so intimately tied, we’re basically only hearing about one leg of that stool. Rafael Ramírez has spoken hazily about how the system will be “complemented by other measures”, but that makes it sound like they need a tweak here and a tweak there to make SICAD2 work, rather than the wholesale rethinking of chavismo’s political economy model.

It’s taken 12 years to convince chavismo of the need to overhaul exchange controls. I suspect it’ll take 12 more to get them to understand that you need interest rate liberalization at the same time. And another 12 years after that before they’ll grasp that those two together force a fiscal reorganization.

As it stands, we’re about to undergo an economic adjustment process of a brutality undreamed of in 1989: a neoliberal ajuste run by economic stalinists.

How to make sense of it all? To me – and this is obviously a bit of a conspiracy theory, but bear with me – SICAD2 is designed to fail.

Even an economic troglodyte can see that as people beat down the SICAD2 doors desperate to turn their fast-depreciating bolivars into dollars, the exchange rate is likely to overshoot, going way higher than anyone in the economic cabinet would consider acceptable.

Let that process run for more than an auction or two and bank balance sheets are going to start to look distinctly shaky, spooking the hell out of everybody.

At that point, the radicals inside the economic cabinet (paging Dr. Giordani) can step in gallantly and say, “see, I told you this stuff about liberal adjustment was a dangerous fantasy.”

And that’ll be the last you’ll ever hear of SICAD2.