Venezuela's future

In "Macroeconomic Populism in Latin America," NBER Working Paper No. 2986, May 1989 (later published in Journal of Development Economics I believe), Rudiger Dornbusch and Sebastian Edwards describe the stages of macroeconomic populism in Latin America:

Initial Conditions. The country has experienced slow growth, stagnation or outright depression as a result of previous stabilization attempts. The experience, typically under an IMF program, has reduced growth and living standards. Serious economic inequality provides economic and political appeal for a radically different economic program. The receding stabilization will have improved the budget and the external balance sufficiently to provide the room for, though perhaps not the wisdom of, a highly expansionary program.

No Constraints: Policy makers explicitly reject the conservative paradigm. Idle capacity is seen as providing the leeway for expansion. Existing reserves and the ability to ration foreign exchange provide room for expansion without the risk of running into external constraints. The risks of deficit finance emphasized in traditional thinking are portrayed as exaggerated or altogether unfounded. Expansion is not inflationary (if there is no devaluation), because spare capacity and decreasing long run Costs contain cost pressures and; there is room to squeeze profit margins by price controls.

The Policy Prescription. Populist programs emphasize three elements: reactivation, redistribution of income and restructuring of the economy. The common thread here is "reactivation with redistribution". The recommended policy is a redistribution of income, typically by large real wage increases. Inflation notwithstanding, devaluation is rejected because of the inflationary impact and because it reduces living standards. The economy is to be restructured to save on foreign exchange and support higher levels of real wages and higher growth.

Phase I: In the first phase, the policy makers are fully vindicated in their diagnosis and prescription: growth of output, real wages and employment are high, and the macroeconomic policies are nothing short of successful. Controls assure that inflation is not a problem, and shortages are alleviated by imports. The run-down of inventories and the availability of imports (financed by reserve decumulation or suspension of external payments) accommodates the demand expansion with little impact on inflation.

Phase II: The economy runs into bottlenecks, partly as a result of a strong expansion in demand for domestic goods, and partly because of a growing lack of foreign exchange. Whereas inventory
decumulation was an essential feature of the first phase, the low levels of inventories and inventory building are now a source of problems. Price realignments and devaluation, exchange control, or protection become necessary. Inflation increases significantly, but wages keep up. The budget deficit worsens tremendously as a result of pervasive subsidies on wage goods and foreign exchange.

Phase III: Pervasive shortages, extreme acceleration of inflation, and an obvious foreign exchange gap lead to capital flight and demonetization of the economy. The budget deficit deteriorates violently because of a steep decline in tax collection and increasing subsidy costs. The government attempts to stabilize by cutting subsidies and by a real depreciation. Real wages fall massively, and politics become unstable. It becomes clear that the government has lost.

Phase IV: Orthodox stabilization takes over under a new government. An IMF program will be enacted; and, when everything is said and done, the real wage will have declined massively, to a level significantly lower than when the whole episode began! Moreover, that decline will be very persistent, because the politics and economics of the experience will have depressed investment and promoted capital flight. The extremity of real wage declines is due to a simple fact: capital is mobile across borders, but labor is not.

They seem to view Phase IV with rose-colored glasses - when you read "new government," think Pinochet. Twenty five years ago my intermediate macroeconomics professor put it more cynically: "first come the Yanks, then the banks, then the tanks." Nevertheless, this is a pretty good description of the rise and fall of left-populist governments in Latin America. I think Venezuela is now at the beginning of Phase II - expansionist, redistributionist policies have caused inflation to rear its ugly head, but rather than dealing with the root causes of the problem the Chavez government has decided to adopt a dramatic currency reform to "restore confidence" in Venezuela's economy. This will not have much effect, though continued high oil prices could keep Venezuela from reaching Phase III for some time. But eventually we can expect Phase III to come, followed inevitably by Phase IV. The Bush Administration had hoped the time was ripe for Phase IV when they supported the coup attempt back in 2002, but they jumped the gun.