When Inflation Stops Working

Normal people tend to think of Inflation as a byproduct: the unwanted consequence of shop-owners’ greed (if you’re a chavista) or of government cluelessness (if you’re in the opposition.)

Economists, by contrast, tend to think of it as a tax: just one of many ways the government puts its hand in your pocket, takes some of your purchasing power and transfers it to itself.

After all, each time the government prints money, it can afford more things – the things it can buy with the money it just printed – and you can afford fewer things, since each of the bolivars you hold is now worth that little bit less.

But if inflation is a tax then, like all taxes, it faces a Laffer Curve: a tendency for the revenue it raises to peak at a certain rate and start declining thereafter.

(A needed clarification: the Laffer Curve is highly controversial, but only politically. A furious controversy has indeed raged for decades on whether U.S. income tax rates were, or are, anywhere near the Revenue Maximizing point at the top of the Laffer Curve. Conceptually, though, nobody questions the idea that such a Revenue Maximizing point exists: it’s clear that if you try to tax income at, say, 99% you’re not going to raise very much tax revenue!)

Now, research by the economist everybody loves to hate – Bank of America’s Francisco Rodríguez – suggests Venezuela might be on the right side of the Inflation Tax Laffer Curve. And the right side of a Laffer Curve is emphatically the wrong side to be on.

Rodríguez shows real government spending has been falling over the last few months even as the government cranks up its inflation tax. In effect, Venezuelans are now spending their money faster than the government can print it.

To see how this works, you have to grasp what inflation is a tax on.

Inflation taxes real money holdings: cash you’re sitting on rather than spending. When the government creates money, prices go up, and when prices go up, the value of the money you hold goes down. How’s that value transferred to the state? Easy: the government just plain hands over the new money to itself, in the form of a BCV “loan” to PDVSA. (And, secondarily, via financial repression.)

As people catch on to this dynamic, their willingness to hold bolivars collapses.

You see this in all kinds of ways: when you see people standing in line waiting to buy something without knowing what it is they’re standing in line to buy, that’s a collapsing willingness to hold real money balances right there. People would literally prefer to hold anything of value rather than bolivars. When you see people struggling to get their money out of the country in any way they can, whether via sobrefacturación or paying whatever crazy black market rate DolarToday is quoting, that’s a collapsing willingness to hold real money balances right there.

In outright hyperinflation, of the kind Bolivia and Argentina went through in the 1980s, this dynamic reaches bizarre extremes, with people quite literally running to turn their paychecks into goods the second they got them. When hyperinflationary dynamics take hold, minutes count.

But you don’t have to reach that extreme for the effectiveness of inflation as a revenue raising mechanism to wobble. Already, the Venezuelan government finds itself chasing a mirage, printing money faster and faster, pushing people to work harder to hold less money, creating faster and faster inflation which, in turn, “forces” the government to try to create money even faster to try to keep up.

It’s a losing game.

The bottom line is that when you tax anything at a very high rate, you tend to erode it. Tax tobacco at a very high rate and people smoke fewer cigarettes. Tax income at a very high rate and workers work fewer hours. And tax holding money at a very high rate and people stop wanting to hold money.

At some point, the government runs up against its seignorage-maximizing rate of money creation and from then on out it’s on the wrong side of the inflation Laffer Curve, where more and more inflation brings in less and less revenue.

Why does the government crank out more and more bolivars? Because the public sector is deep, deep in the red, running a ginormous, unmanageable deficit worth almost a fifth of what the economy produces.

I’ve said it before and I’ll say it again: a broke state is a hyperinflationary state. As the state deals with its out-of-control deficit by printing money, it teaches people it’s better not to hold bolivars. The resulting “collapse in demand for real money balances” does double duty as economists’ definition of “hyperinflation.”

Of all the ways the Maduro administration is up a creek without a paddle, this might actually be the worst. The last trick in their arsenal, the final bit of revenue raising magic they thought they could count on, has gone barren for them. You know you’re shit-out-of-luck when even the damn printing presses at BCV won’t get you out of the pickle you’ve gotten yourself into.

If Madurismo was even vaguely sophisticated it would realize that the gig really is up now and that it has to adjust exchange controls and end energy subsidies at this point. When even inflation stops working for you, you genuinely have exhausted every other alternative and you’re left forced to do the right thing virtually by process of elimination.

But these guys have proven themselves so insanely self-destructive it’s hard to imagine even this will dissuade them.