Imagine walking into your usual Starbucks to pick up your daily double espresso, and as you’re taking out your wallet the cashier tells you that the coffee will cost you 1 million US dollars.
This is exactly the situation hyperinflation has created in Venezuela.
Hyperinflation refers to the situation of average price levels growing at more than 50% a month. According to the IMF, hyperinflation in Venezuela has exceeded 13,000 percent. It has caused the Bolivar, exchanged at 4.2944 bolivars per dollar in 2012, to lose nearly 99% of its value and reach an exchange rate in 2018 of 248,567.7500 bolivars per dollar. Hyperinflation has led to a number of negative consequences; foreign direct investment (FDI) has decreased, imports have become much more costly, and basic necessities have become unaffordable to Venezuelan citizens. This has led to mass protests against president Maduro, resulting in daily violence on the streets.
How did Venezuela, a country with one of the largest proven oil reserves in the world, end up in such a situation?
The answer lies at the heart of the Venezuelan government’s socialist welfare policies.
Ex-president Hugo Chavez had implemented multiple social welfare policies, spending huge amounts of money on fuel subsidies, wealth redistribution, and public services. The only thing keeping the government from running on a budget deficit was the immense oil revenue generated by the state-run company Petróleos de Venezuela, S.A (PDVSA) that was funding all the social spending. During Chávez’s term from 1999 to 2013, oil prices were soaring, enabling PDVSA to generate mass revenue through oil exportation. PDVSA was the primary source of government revenue apart from income taxes at the time, accounting for 95% of export earnings in the country.
During this time period, unemployment rates were at their lowest, poverty had decreased, and Venezuela was a fast-growing economy. However, in 2013 oil prices plummeted. 2013 was also the year that Chavez died of a heart attack and his successor, Nicolás Maduro, came into power.
This was a turning point in Venezuelan history. The nation’s dependence on oil revenues, which had been central to the country’s rise to success, became the reason for its downfall. With oil prices plummeting, government revenue decreased drastically. Instead of cutting government spending, president Maduro maintained the previous social welfare schemes, resulting in a huge budget deficit.
To fund the deficit, Maduro decided to print more money. This is when hyperinflation started to occur. Maduro was printing money much faster than real output was increasing; when money supply increases faster than real output, more money is chasing the same amount of goods and prices skyrocket. This turned into a downward spiral: tax revenues evaporated, leaving a hole in public finances, and the government filled it by printing money. What accelerated this cycle, leading to hyperinflation, is that high inflation also led to a fall in the real value of taxable income. Apart from the revenue earned from oil exports, income tax was a major source of revenue for the government. A decline in the real value of taxable income meant a decline in government revenue. Falling real incomes also made basic staples such as flour and wheat unaffordable to many Venezuelan citizens. This is when the government made its second wrong move in deciding to introduce price ceilings on flour and other basic necessities. Instead of making them more affordable, this policy only accelerated hyperinflation. The price ceilings were set below domestic firms’ costs of production, causing them to stop producing as much and created massive shortages with prices escalating even higher. Alongside this destructive cycle was another cycle driven by expectations; everyone who had a Bolivar wanted to get rid of it due to the expectation that it would lose value the next day. This resulted in a black market where people exchanged bolivars for dollars, depreciating the value of the currency even more.
Is there any way out of this hellish cycle for Venezuela?
Generally, hyperinflation makes a currency so worthless that it is supplanted by a hard currency such as the US dollar. This has been the case in previous situations; both Zimbabwe in 2008 and Ecuador in 2000 dollarized which quickly extinguished hyperinflation in their countries. Although adapting another currency could solve the problem of hyperinflation, it would not allow Venezuela’s economy to fully recover, as economic diversification is also needed to reduce Venezuela’s dependence on oil exports. Adapting the dollar also implicates that Venezuela would have to surrender control over their monetary policy and exchange rate.
Alternatively, Venezuela could get a loan from the IMF and start a reform program to stabilize the economy, but Venezuela broke off relations with IMF in 2007 and president Maduro continues to reject foreign aid.
Venezuelan hyperinflation was born out of the government’s attempt to fund Maduro’s high spending socialist policies that did not account for falling oil prices. Until a change in leadership occurs that puts a cap on social spending, there is no sign of recovery in Venezuela anytime soon.