A few lessons from the last time an oil economy crashed catastrophically.
Venezuela is not the first developed country to put itself on track to fall into a catastrophic economic crisis. But it is in the relatively unusual situation of having done so while in possession of enormous oil assets. There aren’t many precedents to help understand how this could have happened and what is likely to happen next.
There is, however, at least one — the Soviet Union’s similar devastation in the late 1980s. Its fate may be instructive for Venezuela — which is not to suggest Venezuelans, least of all the regime of Nicolás Maduro, will like what it portends.
Venezuela has been ailing ever since the decline in oil prices that started in June 2014, and there is no reason to think this trend will shift anytime soon
Venezuela has been ailing ever since the decline in oil prices that started in June 2014, and there is no reason to think this trend will shift anytime soon. Energy prices move in long quarter-century circles of one decade of high prices and one decade of low prices, so another decade of low prices is likely. Similarly, the biggest economic blow to the Soviet Union was the fall in oil prices that started in 1981 and got worse from there.
But the deeper problem for the Soviet Union wasn’t the oil price collapse; it’s what came before. In his book Collapse of an Empire, Russia’s great post-Soviet reformer Yegor Gaidar pointed out that during the long preceding oil boom, Soviet policymakers thought that they could walk on water and that the usual laws of economic gravity did not apply to them. Soviet policymakers didn’t bother developing a theory to make sense of their spending. They didn’t even bother paying attention to their results. The math seemed to work out, so they just assumed there was a good reason.
This is as true of the current Venezuelan leaders as it was of the Soviet leaders. The Venezuelan government, though it doesn’t claim to be full-fledged in its devotion to Marxism-Leninism, has been pursuing as absurd an economic policy mix as its Soviet predecessor. It has insisted for years on maintaining drastic price controls on a wide range of basic goods, including food staples such as meat and bread, for which it pays enormous subsidies. Nonetheless the Venezuelan government, like the Soviet Union’s, has always felt it could afford these subsidies because of its oil revenues.
But as the oil price has fallen by slightly more than half since mid-2014, oil incomes have fallen accordingly. And rather than increase oil production, the Venezuelan government has been forced to watch it decline because of its mismanagement of the dominant state-owned oil company, PDVSA.
And now Venezuela seems intent on repeating the Soviet folly of the late 1980s by refusing to change course. This is allowing the budget deficit to swell and putting the country on track toward ultimate devastation.
The Soviet Union in its latter years had a skyrocketing budget deficit, too. In 1986 it exceeded 6 percent of GDP, and by 1991 it reached an extraordinary one-third of GDP. Venezuela is now following suit. The Soviet Union used its currency reserves to pay for imports, but when those reserves shrank, the government financed the budget deficit by printing money. The inevitable result was skyrocketing inflation.
It seems as if President Nicolás Maduro has adopted this tried-and-failed combination of fiscal and monetary policy. Venezuela already is dealing with massive shortages as a result of its controlled prices, because the government can no longer afford its own subsidies. But it will get worse from here.
Maduro seems intent on printing money like crazy, so the next step will be hyperinflation.
Maduro seems intent on printing money like crazy, so the next step will be hyperinflation. Inflation is already believed to have reached 700 percent a year, and it is heading toward official hyperinflation, that is, an inflation rate of at least 50 percent a month.
Hyperinflation is as frightful as it is rare. According to Johns Hopkins University professor Steve Hanke, the world has experienced only 56 hyperinflations, and half of them occurred when communism collapsed. (All of the Soviet Union’s 15 union republics suffered it during the country’s disintegration.) Hyperinflation is profoundly demoralizing. Suddenly, it makes no sense to work any longer. Instead of standing in queues to buy food with the money they’ve earned, people stop working entirely, because they cannot spend the money they would have earned. Smart profiteers indulge in speculation, buying safe assets such as commodities or real estate.
As a result, output plummets and enters a downward spiral until financial stability is restored. In 1991, Soviet production probably fell by 10 percent, and oil production plunged by half from 1988 to 1995. Something similar seems to be going on in Venezuela.
The Soviet Union had insisted on an unrealistically high official exchange rate of the ruble, usually five times higher than the black market exchange rate. The government did so to make people feel richer than they really were, but this meant that the government subsidized purchases of foreign currency just as it subsidized purchases of food. As the Soviet government spent more money, allowing the budget deficit to balloon, the black market exchange rate plummeted, humiliating its citizens. Gradually, people accepted the black market exchange rate as the real rate. When the Soviet Union fell apart in December 1991, the average Russian monthly salary was a miserable $6. This is where Venezuela is heading.
In parallel with these miseries, Soviet foreign debt surged. The Soviet government, just like Maduro’s government, borrowed as much as it could for as long as it could. Foreign governments provided much of the financing, just as Venezuela has received half of its foreign credits from China. The Soviet government refused to acknowledge its poverty while continuing to service its debt for far too long. Venezuela seems to have been caught in the same hamster wheel.
Naturally, there are differences. The Soviet Union was a multinational state with union republics unlike Venezuela. However absurd Venezuela’s economic policy may be, the country does not have a Marxist-Leninist system, and it remains far more open than the Soviet Union was, with a lively political opposition and a highly educated elite.
But the economic demise of the Soviet Union offers a likely scenario for Venezuela’s future evolution. The financial crisis is likely to worsen because any significant change in policy would imply an admission by Maduro that his policies had been wrong, which would probably lead to his ouster. Thus, the budget deficit, shortages, inflation, exchange rate fall, and public debt are likely to grow much worse.
One alternative could be a preemptive political overthrow of the Maduro regime fueled by public discontent or that the rulers just flee the country. Another possible endgame would be that the country runs out of international currency reserves and defaults on its foreign debt. That would deprive Venezuela of all foreign credit, and the natural consequence would be a complete collapse of imports and the exchange rate of the bolivar, the country’s currency.
Either way, the Maduro regime is not likely to survive for long because it won’t be capable of making the necessary adjustments that avoid abject economic misery for most of the population, and the pressure on it will eventually become intolerable. A successor government will have to make the adjustments instead. But regardless of the nature of the new government, the choices it has available to it won’t be large: In extreme economic crises, the actual policy choices are few.
The budget needs to be brought close to balance. That can only be done by cutting expenditures, because more taxes cannot be collected in the short term. The key cut will have to be to the elimination of price subsidies. Venezuela’s foreign aid projects must be cut as well. That might suffice to balance the budget.
At the same time, the exchange rate needs to be unified around the market equilibrium, regardless of whether the exchange will be floating or pegged. Venezuela’s depleted international reserves will have to be restored. The only international agency that can do so fast and effectively is the International Monetary Fund. The IMF can quickly restore a country’s reserves and creditworthiness, but Venezuela has to make peace with the macroeconomic reforms the fund will call for. In parallel, other international organizations and friendly countries will have to engage to salvage the country from the ravages of the Maduro regime. The country’s foreign debt burden will need to be restructured.
The situation of the former Soviet Union was much more difficult, because 15 new countries had to be formed and the common currency, divided. The negative lesson from Russia is that the country took far too long — seven years — to get the budget deficit under control. The warning for the West is that it failed to help Russia at its moment of greatest need, eventually pushing its politics in an anti-Western direction. When reform finally arrives in Venezuela, it needs to be radical and fast, and the West should offer wholehearted financial support.
The collapse of the Maduro regime will not be pretty, but it is difficult to see how it can be avoided. While the politics might be difficult to predict, the main features of a severe economic crisis are quite predictable. The key question is how fast a new government will manage to do the right things.
Photo credit: JUAN BARRETO/AFP/Getty Images
– Anders Aslund – 2-5-2017 (en inglés)