Category Archives: Latin America

Demonetization on Five Continents

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Several countries are undergoing “demonetization” or currency reforms in which the government recalls bills of particular denomination that are circulation and replaces them with new notes. Some of these initiatives are going better than others.

India is still reeling from the consequences of Prime Minister Modi’s announcement on November 8 that 500- and 1000-rupee denomination bills, which constitute 86 % of the cash in circulation, could no longer be used and that residents have until the end of December to turn them in. They have been waiting in long lines, only to find in many cases that the banks have not received enough of the new currency to make the exchange. Some businesses are unable to operate. India’s experiment is unique in that it combines mostly benign motives – a crackdown on illegal activities – with an abrupt implementation that has inflicted unnecessarily high costs on the economy.

Demonetizations fall into several widely different categories. The most dramatic and disruptive episodes are usually signposts on the highway to hyperinflation. Venezuela’s President Maduro on December 11 announced a recall of the 100-bolivar note, creating chaos by giving residents only 10 days to make the exchange into new higher-denomination-notes (500-bolivar notes and higher, up to 20,000 bolivars).

Venezuela will almost certainly be in hyperinflation in 2017. Economists generally define hyperinflation as a pattern of price rises that exceed 50% per month. The inflation rate may cross over the line into technical hyperinflation within the next few months. Hyperinflation had become much rarer in the 21st century, compared to the 20th century. Venezuela’s would be the first since Zimbabwe’s hyperinflation in 2008-09 — which exceeded 79,600,000,000 % per month, rendering the Zim dollar worthless long before it was officially demonetized.

The current Venezuelan episode continues in a long tradition of gross mismanagement of their currencies by some governments, especially in Latin America and the former Soviet bloc. They have demonetized as a means of confiscating wealth from the public, in effect, and transferring it to themselves. The fundamental problem is that the government spends way beyond its means, unable to finance the spending by taxation or borrowing, and so relies on debasing the currency. The “currency reform” may be announced in the name of a program to end high inflation. But true macroeconomic reform requires fundamental measures to end the excessive printing of money and its origin in excessive primary budget deficits. Without such a true reform, the exchange of new bills for old is just one more symptom of mismanagement (along with price controls and the rationing of goods).

A very different category of demonetization entails the orderly decommissioning and replacement of bills for technical reasons. The technical reasons can range from the lack of popularity of a particular note, to the desire to honor a national hero, to a re-design of features to block counterfeiting, to more consequential – but still orderly – reforms such as a European country’s switch-over to the euro as the national currency. An example was the announcement in April by US Treasury Secretary Jack Lew that the $5, $10 and $20 bills are to be replaced with new designs that include women and civil rights leaders.

What differentiates this second category is that citizens are given enough time to trade in their old currency for the new unit. The monetary authorities plan ahead, so that they have plenty of new bills available. Nobody needs to lose out or even to wait in long lines at the bank. Lithuania is the most recent country to have joined the euro, having given up their lita in 2015. The currency transition went smoothly, as it had when the Germans traded in their marks for euros in 2002, the French their francs, and so on with the rest of the 19 countries that have joined the eurozone.

The main motive for India‘s demonetization apparently puts it into a third category, which includes what the US did in 1969, when it announced the phasing out of $500 bills and higher denominations, and what the European Central Bank commendably decided to do in May of this year with its decision to phase out the 500-euro note. In each of these cases, most of the high-denomination notes are used in illegal activities, ranging from tax evasion to corruption to drug trafficking and even terrorism. So the government stops issuing the big bills to avoid facilitating these illegal activities. Such prominent observers as Ken Rogoff, Larry Summers and Peter Sands think the US should do the same with its $100 bill.

In these cases, the phase-out period is typically long — in some cases indefinitely long, until all the existing paper notes wear out on their own. If the leaders are brave, they could set a relatively short time period, of less than a year, after which the note in question is no longer valid, and could ask tough questions of anyone trying to cash in a large quantity of the high-denomination notes. The goal would be to go beyond merely phasing out the facilitation of illegal activities in the future and to strike a strong blow against those who acquired stockpiles by engaging in such activities in the past. The need for bravery arises because some citizens would object strongly, probably ranging from survivalists to grandparents who want to give a crisp new $100 bill to a grandchild for a special occasion.

Although the discouragement of illegal activities is a motive to be applauded, the implementation in the case of India has obviously fallen short. The reform did not need be so very sudden and so very secret. Especially because the notes were relatively small (worth approximately $7 and $15, respectively) and widely used by all Indians, not just in illegal activities, the authorities should have allowed enough time to print plenty of the new notes and even to allow businesses to accomplish some of the desired switch-over to non-cash means of payment (checking accounts and electronic funds transfer).

Even with the advance warning time, those who had accumulated large wealth stashes in the form of the bills would still have lost some value – in effect a tax – if they had been unable to demonstrate to a bank that they had valid reasons for having the bills. Yes, they would still have been able to take recourse to an unofficial market in the phased-out bills, but they would have had to sell the bills at a discount. Most importantly, allowing more time would have avoided the serious inconveniencing of ordinary people and disruption to the economy that India has experienced since November.

Given the problems that it has created for ordinary Indians, why did the Modi government feel the need to launch the reform so suddenly, without time to print enough new notes? One theory is that a goal was to disrupt rival parties that use cash heavily in their campaigns, ahead of important elections in early 2017 (in the state of Uttar Pradesh). If the theory is valid, it is hardly an uplifting justification for what is supposed to be a good-government reform.

Western leaders probably do not act with sufficient boldness and bravery when they choose to phase out big bills as gradually as they do. But Prime Minister Modi acted too boldly in ending the use of medium-sized bills so abruptly.

[A shorter version of this column appeared at Project Syndicate. Comments can be posted there or at the Econbrowser site.]

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The Threat to US Global Leadership

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President Barack Obama has had a remarkable series of foreign policy triumphs over the last 12 months.  One of the lesser-known was the passage of legislation for reform of the IMF on December 18, 2015, after five years of obstruction by the US Congress.   As the IMF convenes in Washington DC for its annual spring meetings April 15-17, we should pause to savor the importance of this achievement.  One could almost say that if Americans had let yet another year go by without ratifying the IMF quota reform, they might as well have handed over the keys of global economic leadership to someone else.  That would be China.

The IMF reform was an important step in updating the allocations of quotas among member countries. (Quota allocations in the IMF determine both monetary contributions of the member states and their voting power.  They are supposed to be determined by economic weight.)   The agreement among the IMF members was to allocate greater shares to China, India, Brazil and other emerging market countries, coming primarily at the expense of European and Persian Gulf countries.  The change in IMF quotas is a partial and overdue adjustment in response to the rise of the newcomers.  President Obama managed to get the leaders of the other G20 countries to agree to this reform at a 2010 summit in Seoul.

Approving the agreement should have been a “no-brainer” from the viewpoint of the United States:   it was neither to pay a higher budget share nor to lose the voting weight that has always given it a unique veto power in the institution.  The reform was an opportunity to exercise US global leadership.  But one might have thought it was a threat to US leadership if one judged from congressional opponents who blocked passage of the legislation until last December.

If the game is a competition between China and the US for international power and influence, then some damage has already been done.  China feels that its economic success merits a greater role on the world stage.  If the status quo powers “move the goal posts” by denying China the place at the table of global governance that it has earned, it will look to establish its own institutions.   Meanwhile, Asia has been wondering if the US is committed to the region (as its “pivot” claimed).  Indeed, the rest of the world has often in recent years wondered if internal politics prevents the US from functioning at all.  Asians tend to prefer to have the US engaged. China’s territorial assertions in the South China Sea confirm its neighbors worst fears. But they will look elsewhere if need be.

Thus Asian countries (and others) were happy to join a new China-led institution, the Asian Infrastructure Investment Bank. The AIIB, widely viewed as a serious diplomatic setback for the US, went into operation December 25.

The good news is that the AIIB is off to a good start, with no sign so far of the feared lowering of standards relative to other multilateral development banks (such as the World Bank).  But it is even better news that the US can now get back into the game, after a string of international successes.

It has been a busy 12 months for President Obama in the international arena.   Consider  global achievements in four areas (in addition to the IMF reform):

  • On April 2, 2015, the United States (and five other major powers) reached a long-shot breakthrough with Iran over its nuclear program, which was then consummated in a July 14 agreement diverting Tehran from what had seemed an inexorable march to nuclear weapons.   On January 16, 2016, the International Atomic Energy Agency verified that Iran had in fact completed the necessary steps under the agreement to ensure that its program remains exclusively peaceful.
  • On June 24, 2015, Congress was persuaded to give the White House Trade Promotion Authority.  It allowed the administration to complete the Trans-Pacific Partnership (TPP) in October.
  • On July 20, 2015, the US and Cuba re-opened embassies in each other’s countries.  Last month, on March 20, Obama because the first president to visit Cuba in 90 years. The historic event marked the end of 55 years of an attempted isolation policy that had only succeeded in giving the Castro brothers an excuse for economic failure and in handicapping American relations throughout Latin America.
  • On December 12, against all expectations, representatives of 195 parties to the UN Framework Convention on Climate Change successfully reached an agreement on global action in Paris, spurred in no small part by an earlier breakthrough between President Obama and Chinese President Xi Jin Ping.  This month, on April 22, the two leaders are scheduled to sign the Paris Agreement on behalf of their respective countries, the world’s two largest emitters of greenhouse gases.  The signing will encourage others to ratify.

These accomplishments are not the kind that come automatically with possession of the Oval Office.  A year ago, not one of them was expected.  Not only did the international political obstacles appear nearly insurmountable; the domestic obstacles looked even worse.  The overwhelming conventional wisdom was that Obama would not be able to accomplish much in his remaining time in office.  After all, the Republicans had succeeded in blocking almost all Obama’s proposals since they took the House of Representatives in November 2010.  Why should he have any better luck after they took the Senate (in November 2014) and especially now that he was a “lame duck” as well?

The Trade Promotion Authority legislation was declared virtually dead last May.  The IMF quota reform legislation was considered so moribund, the press did even consider it worth reporting on.

A lot of the opposition came from Republicans who from the start have been eager to line up on the opposite side of whatever position President Obama takes.   But opposition to such internationalism comes from the far left of the political spectrum as well as the far right, and not just in the area of trade.  To take the salient example of Bernie Sanders, historically he has joined with congressional Republicans in trying to block efforts to rescue emerging market countries in Latin America and Asia at times of financial crisis.  (These rescues are invariably called “bailouts,” even while they cost the US nothing – the Treasury made a profit on the 1995 loan to Mexico that Sanders fought – and even while they sustain economic growth.)  To take another example, New York Senator Chuck Schumer joined the Republicans in trying to block the Iran nuclear agreement, an effort that failed on September 8.

The IMF deal is done.  Managing Director Christine Lagarde is doing a good job (especially compared to her three predecessors, none of whom was even able to serve out his term).   She is right, for example, to tell the Germans that a solution to the Greek problem requires further debt-reduction as one of its components.

But each of the other four initiatives could still be de-railed by US politics, especially if the far left and the far right join together.  Congress has yet to repeal the Cuba embargo.   It could reject the TPP, in effect telling Asia it is on its own.  On June 2, a federal Appeals Court will hear a challenge to the Clean Power Plan whereby the Obama Administration hopes to begin implementing its commitment under the Paris Agreement.  Donald Trump and Ted Cruz both say that if elected president they would tear up the Iran nuclear deal.   (What would happen then?  Probably the same thing that happened when George W. Bush took office in 2001 and tore up Bill Clinton’s “framework agreement” with the North Koreans:  they predictably and promptly got a bomb.)

The struggle over whether the US will lead the world continues.  It is not a struggle between the US and rivals, but a struggle within American politics.

 

[This is an extended version of a column that appeared at Project Syndicate.  Comments can be posted there or at Econbrowser.]

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Devaluations are Often Associated with Changes in Government

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The possibility of devaluation is apparently an issue in the upcoming Argentine elections.  (The forward rate for next year is about 13 pesos per dollar, which is close to the informal rate and suggests a big  devaluation relative to the current official exchange rate of 8.)   In this connection, an Argentine newspaper has asked me about “Contractionary Currency Crashes,” a paper that I presented as the 5th Mundell-Fleming Lecture of the  IMF’s Annual Research Conference. 

1) Do you think the conclusions about the connections between devaluation and elections are still valid in 2015 even though your article was published in 2005?

My most relevant finding was that political leaders had historically been twice as likely to lose office in the six months following a big devaluation as otherwise.  It is true that some things have changed over the last ten years.  Medium-sized emerging market countries used to have pegs or targets as their exchange rate policies, with occasional forced devaluation.   Since the turn of the century, the typical medium-sized emerging market country has switched to a managed float.   Thus changes in the exchange rate are more commonplace.   Nevertheless, I think most of the conclusions are still relevant in 2015.

2) What would you suggest to the presidents that are in campaign? That he/she should never promises that is not going to devalue? That this promise can be very costly?

Any politician in campaign mode is familiar with the general problem that declarations which are likely to help his or her chances of being elected may create constraints that he or she regrets later when facing the realities of governing.  I am glad that I am not a politician.   But in my study we found that presidents seldom make an explicit promise not to devalue; rather, when necessary, they delegate this dangerous task to their finance minister or central bank governor.  Then the minister is the one who has to resign if the devaluation happens anyway.

3) What are the arguments to support the possibility that the “costs of a devaluation may be more political than economic”?

It is worth considering political aspects of devaluation that may hold even when devaluation has a beneficial effect on the economy.  One political aspect is the finding that ministers are more likely to lose their jobs as a result of a devaluation if they had promised not to devalue.   Another is the point that incumbent politicians often postpone a needed devaluation until after an election, so that they don’t have to take the blame.  A third is the observation that sometimes new leaders decide it is smart to get the delayed devaluation out of the way soon after taking office.

My study found that, aside from these political phenomena, the big costs arose in those cases when a devaluation contributed to an economic recession.  The most important reason why a devaluation sometimes causes an economic recession has to do with dollar debt:  If the country has previously incurred a lot of dollar-denominated debt, the devaluation confronts a currency-mismatch and so devastates the balance sheets of banks and other companies who find that they can no longer service dollar debts because dollars are now so expensive.   Fortunately during the years 2004-2008, many emerging market countries managed to switch the composition of their capital inflows away from dollar-denominated debt.  Unfortunately corporations in many Emerging Market countries have recently gone back to borrowing in dollars, which means that they are once again vulnerable to a devaluation.

 

 

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