[1106] Of fighting inflation by shooting down the zeros

What would one do to fight runaway inflation?

In Venezuela, chop the zeros off:

CARACAS (Reuters) – President Hugo Chavez said he will chop three zeros off new bolivar currency bills to bolster Venezuelans’ perception of a strong currency in a bid to curb inflation, which is now highest in Latin America. [Reuters, Feb 16 2007]

If I remember my history correctly, the German Empire took similar route to combat inflation right after the First World War. Though similar, there is one major difference.

In the aftermath of War to End All Wars that did not only fail to end all wars but instead made way for a larger war, the Allied was victorious and the Central Powers was devastated: the Ottoman Empire ceased to exist, Astro-Hungary disintegrated while the German Empire was humiliated through and through. As if such victory was not enough, the Allied at the Treaty of Versailles imposed heavy war reparation against the German state. Given heavy debt burden as well as the power to print money, the German government indulged in seigniorage.

The ability to print money might be cool but be careful, if you printed too much money, you might end up poorer, as the German learned in the 1920s. The German not only learned a lesson or two about inflation — they learned it the hard way.

In 1923, one US dollar was equivalent to 4.2 trillion mark. No. I am not kidding. That is 4,200,000,000,000 mark; 4.2 x 10¹² mark. Imagine, if you lived in Berlin in 1923, you would have to use scientific notation to buy a sack of flour. And converse in German to boot!

And oh shit, imagine the (nominal) cost of roses on Valentine! Inflation on top of inflation cannot be good news.

Further, the nominal interest rate stood at around 900%. For comparison purpose, as of February 2007, the Malaysian nominal interest rate is 3.5%.

The funniest thing is, since prices across the board were raising so fast on daily basis if not on hourly basis, the central bank could not print out enough money to make life a little bit simpler for the Germans. In fact, there is one famous picture that depicts how bad inflation was back in 1923:

On Wikipedia: “A German woman feeding a stove with currency notes, which burn longer than the amount of firewood they can buy.”

Suffice to say, I do not think a person could buy dirt with the mark in 1923.

Some time in the same year, the German government which got tired of probably raising the interest rate almost daily — while the people got tired of running from the banks to the stores just to make sure 4.2 x 10¹² mark would still be 4.2 x 10¹² mark an hour later — replaced the heavily inflated mark with a new mark. Those outrageous zeros were slashed. While the Venezuela is cutting three zeros, the German cut 12. The new regime brought sanity back to an insane monetary roller coaster ride.

Apart from that, the new mark was anchored to real assets, which, I do not think is true for the Venezuelan bolivar. Because of this — this is the only policy tailored to fight inflation — and the reputation of Venezuelan central banking, I believe that the problem Venezuela is facing would not end anything soon. Reputation is important in the fight against inflation. Given how populist the Venezuelan government is right now, I doubt the central bank — which I assume has no independence on monetary policies — would have the stomach to fight inflation.

Apart from that slashing of zeros, there are other efforts aimed to fight inflation. For instance, Venezuela is cutting down taxes to fight inflation:

Chavez said VAT will first be reduced on March 1 by 3 percentage points and then by a further 2 points on July 1. [Reuters, Feb 15 2007]

And to promise to introduce new taxes to replace the old taxes:

To compensate for the income loss, Chavez, a proud socialist, said the government will create new taxes, including one that could involve the private property of the rich. [Reuters, Feb 15 2007]

With the removal of VAT, prices could fall but it remains unclear what the net effect would be as, as stated in the first Reuters’ article, price could increase with the slashing of zeros. The price increase is similar to the effect of abolishing the pennies.

Moreover, the abolition of VAT encourages consumption, which could lead to demand-push inflation. I am unsure what the net tax shift would be though.

Right or wrong nevertheless, Venezuela will be an exciting economy to watch from far.