Lessons for America From Hugo Chavez, Economist

Robert Murphy
Tuesday, February 09, 2010

Venezuelan President Hugo Chavez has decided to devalue his country's currency and impose price controls. These actions will provide U.S. politicians, economics professors and the public with a textbook demonstration of how bad government policies hurt consumers.

In early January, the Chavez government announced that it was devaluing the Venezuelan currency against the U.S. dollar. The bolivar is on a fixed exchange rate, meaning that the government determines how many U.S. dollars it officially trades for. The official exchange rate had been 2.15 bolivars per dollar, but now the Chavez government will allow international trades at a rate of 4.3 bolivars per dollar.

In and of itself, this devaluation is arguably a good move that will promote economic efficiency. The previous official exchange rate was completely divorced from reality, because the bolivar was trading at a much lower value against the U.S. dollar in the black market.

For various reasons (including national prestige) the Venezuelan government had been overpricing its currency. Before the announcement, it had insisted that one U.S. dollar would only fetch 2.15 bolivars, whereas in reality one U.S. dollar should have been able to purchase double that amount. In this respect, the "devaluation" was an acknowledgement of economic reality. If this were the only change in policy, it would have eased imbalances in the foreign exchange market, and more transactions could have been conducted at the official rates rather than being driven underground by the absurdly overvalued bolivar.

Unfortunately, the Chavez government didn't make this announcement out of devotion to economic efficiency. Rather, by increasing the number of bolivars that trade for one U.S. dollar, the decision effectively will double the amount of foreign revenue the state-controlled oil company PdVSA will earn.

When Venezuela exports oil to the world market, it receives the world market price -- denominated in U.S. dollars -- for every barrel. These dollar earnings are not affected by the decrees of the Venezuelan government. However, when the dollars are converted back into bolivars to be spent domestically, they are now allowed to fetch twice as many units of the local currency. This consideration seems to be the motivation for Chavez's decision, and indeed PdVSA officials (quoted anonymously) are wondering how much of the windfall they will be allowed to reinvest in the state oil company, and how much the government will spend on other budget priorities.

Of course there will be other ramifications from the currency devaluation. The actual currency arrangement in Venezuela is complicated, with different official exchange rates for different goods, but the general principle still holds: The previously overvalued bolivar made imports into Venezuela artificially cheap, and the prices of these imported goods will instantly double at the new exchange rate. Predictably, Chavez warned businesses not to gouge their customers through price hikes and threatened to seize any businesses that did.

"The bourgeois are already talking about how all prices are going to double and they're closing their businesses to raise price," Chavez said on state-controlled television. "People, don't let them rob you, denounce it, and I'm capable of taking over that business."

True to his word, Chavez sent troops into retail shops to inspect prices. Economists know the effect this will have. Chavez will find that no amount of populist rhetoric or military might can overturn the laws of economics.

By definition, the market-clearing or equilibrium price is the one that equates supply and demand. By using soldiers to intimidate businesses into keeping their prices below the (new) market-clearing level, Chavez will cause demand to exceed supply, creating a shortage. Venezuelans will find that the items in question will simply disappear from the shelves, and will be available only in the black market.

Americans would do well to follow the situation in Venezuela and learn the lesson. If and when price inflation picks up steam in the United States, politicians may be tempted to "protect" American consumers with similar policies here. Attentive Americans will have learned from Hugo Chavez, economist, that price controls don't work.