Burning the bridges in Europe

In just a few weeks, on the 1st of January 1999, eleven European countries will forsake the right to issue their own currency and accept the circulation within their boundaries of a common currency, the Euro. 

Monetary policy related to the Euro will be set by a European Central Bank. One fact that struck me as curious is that in all the abundant legislation that regulates this process, there is no mention whatsoever of how to manage the withdrawal or future regret of any of the union’s members.

The absence of alternatives in this case evidently represents a burning of the bridges, but this may be necessary to achieve credibility. There is no turning back and there is no doubt that this is a truly historical moment. As participants in a globalized world in which Europe has an important role, we must naturally wish all members luck, no matter what worries we might secretly harbor.

Until 1971, all money used throughout the history of humanity was backed in one way or another by something physical to which a real value was attributed. Sometimes the backing was direct, pearls for example, while in other cases it was indirect such as the right to exchange bills for a certain quantity of gold.

This physical backing in itself did not necessarily mean it consisted of something of fixed value. The value of a pearl, for example, is in itself subjective. 

The promise to exchange bills for gold did not guarantee anything either, since this promise could easily be voided by fraud. Whatever the backing was, however, it did at least offer the holder of the money the illusion that it was supported by something concrete.

In 1971, the United States formally abandoned the gold standard and the direct backing, however imaginary, disappeared. Since the Dollar is a legal currency, it could always be used to repay Dollar denominated debt. 

Today, however, in spite of the fact that the Dollars may have lost some of their purchasing power, a holder of excess Dollars can only hope that the Government of the United States will exchange his old bills for new ones of the same tenor.

This apparently precarious situation must be the raison d’etre of the motto printed clearly on the bills which states “In God We Trust”.

Since 1971, the real value of the Dollar as an element of exchange, has lost some of its value due to inflation. 

Today, we would need many more Dollars to buy the same houses, cars, movie tickets and gold than we would have needed in 1971. In spite of the above, with few exceptions such as the end of the ‘70s during which inflation increased dramatically, few would dare qualify the United States’ elimination of the gold standard as a failure.

The world’s economies have managed to increase international commerce drastically and with it, sustain a healthy growth rate. Many analysts would explain this phenomenon by saying that the discipline exacted by the gold standard represented a brake on international commerce. The growth rate registered in commerce after 1971 was the result of the release of this brake. 

Other more critical analysts sustain the thesis that, due to the fact that we have abandoned the discipline required by the gold standard, the world has accumulated gigantic accounts payable, which we may be coming due very soon.

I personally swing back and forth between amazement of the fact that the world has accepted such a fragile system and satisfaction that it actually has done so.

The Euro has one characteristic that differentiates it from the Dollar. This characteristic makes me feel less optimistic as to its chances of success. 

The Dollar is backed by a solidly unified political entity, i.e. the United States of America. The Euro, on the other hand, seems to be aimed at creating unity and cohesion. It is not the result of these.

The possibility that the European countries will subordinate their political desires to the whims of a common Central Bank that may be theirs but really isn’t, is not a certainty. 

Exchange rates, while not perfect, are escape valves. By eliminating this valve, European [Eurozone] nations must make their economic adjustments in real terms. 

This makes these adjustments much more explosive. High unemployment will not be confronted with a devaluation of the currency which reduces the real value of salaries in an indirect manner, but rather with a direct and open reduction of salaries or with an increase of emigration to areas offering better possibilities.

What worries me most is the timing. The world is facing the possibility of a global recession. This will require very flexible economic and monetary policies. 

The fact that the search for initial credibility for the Euro is based on trying to assure markets around the world that the new currency will be guided by a philosophy closer to that of Bonn (soon to be Berlin) than that of Rome, probably goes against the best interests of the world.

Published in Daily Journal, Caracas, November 19, 1998

20 years later: Let’s face it. Americans dream they are American. Few if no Europeans, dream they are Europeans.

PS. A new English Language Empire?

PS. What I did not know when I wrote this article was that EU authorities (EC), for the purpose of their (crazy) risk weighted capital requirements for banks decided, in a “good-will” gesture, to assign a sovereign debt privilege of a 0% risk weight to all European sovereigns like Greece. That of course, by removing market credit constraints, would make the Euro challenges so much more explosive especially considering that the Euro is de facto not a domestic (printable) currency of any Eurozone nation. Shamefully EU authorities responsible for that have not acknowledge their mistake, and made Greece have to walk the plank for it.

IT IS NOW A TICKING BOMB!

Of bolivars and time-sharing

The oft-mentioned Law for the Safeguarding of Public Patrimony (Ley de Salvaguarda del Patrimonio Público) imposes controls over the sale or liquidation of public assets. 

It is interesting to note that this law is completely and utterly ignored when it comes to the sale, day after day, hour after hour, of what should be classified as the country’s main public assets, i.e. its reserve of dollars.

At this point in time, I doubt there is one economist that, upon having analyzed the evolution of relative prices and the forecasts for the country’s income levels (basically oil), doesn’t consider that the Bolívar is overvalued to the tune of at least 20%. That means the Dollar should be worth at least Bs. 670.

Why, then, don’t we devalue? I don’t know the proper answer for this question, but if you asked me to speculate, I would probably infer that it was due to factors such as ignorance or stubbornness. 

I still remember back in 1982, when I called for a modest devaluation of the Bolivar so as to correctly reflect circumstances that resemble the ones we have present today. The absurd argument against this devaluation I received from professionals of fame and reputation was that this was impossible since we were due to celebrate the bicentennial of our Liberator Simon Bolivar in 1983, and that a devaluation was tantamount to denigrating the latter.

These references to the dishonor of Bolivar’s memory, were totally confusing for someone like myself. I was educated under the influence of a system of competitive economies for whom the real heroes were those authorities that managed to devalue the currencies of their countries just a tad more that their neighbors, furthering economic development even if this came at the expense of others. I consider it is patriotic to generate opportunities of internal employment by way of increasing exports and minimizing imports. 

It is possible that we still have public servants that equate a downwards readjustment of the exchange rate with national weakness and an upwards readjustment with strength. If these people have invested a high amount of ego in this argument, God save us if they find that they could theoretically return to the days of Bs. 4.30/US$ by increasing bank reserve requirements and increasing interest rates.

One of the more ridiculous arguments arising from this debate is that the government is not promoting a fiscally motivated devaluation thereby showing that there is great seriousness in the managing of the country’s finances. Devaluations are the consequence of irresponsible fiscal management, not the cause of it.

The only truly fiscally motivated devaluation that occurs is when, due to a lack of confidence in the future of the country, the market decides to pay an exaggerated premium for foreign currency. We could call this a tax on nervousness. 

When we analyze recent Venezuelan history, there is no doubt that our governments have been very efficient in their collection of this tax. “The budget doesn’t balance. Let’s spook the markets and get more Bolivars for every Dollar”.

The least we should expect out of a government in its dying days is that they don’t leave a wide gap in the valuation of our currency based exclusively on artifices such as disproportionately high interest rates or the simple burning of international reserves.

The next government’s job, whoever it is, will be sufficiently complicated without having to tackle this type of problem.

The use of mini-devaluations fixed within a band is a reasonable policy when one is trying to manage market expectations on inflation and devaluation into the future. The use of the band system and mini-devaluations to hide facts that already exist (inflation and falling oil prices) is an insult to our country and our intelligence.

If, in the face of all of its mistakes, the Government really wishes to make an act of penitence, I suggest they go about seriously and effectively reducing the unproductive public payroll. I say seriously and effectively since our governors have in the past demonstrated their dexterity in applying the techniques used by the sales persons hawking time-sharing units.

These sales persons normally increase the sales price by US$ 15,000 in order to then generously award potential purchasers a discount of US$ 12,000. The same goes for our politicians, who first increase the public payroll in order to then propose a reduction.

By the way, it is being said that, although the government has not been able to reduce the payroll, it has at least designed the restructuring plans that will allow the next government to achieve this goal “with ease”. 

I believe that, as far as shamelessness is concerned, our politicians are head and shoulders above sellers of time-sharing units.

The shameful lack of housing

A young Venezuelan recently spoke with satisfaction and pride about how he had managed, after only eight months in the United States, to purchase his own home. He could finally enjoy his privacy and consolidate his married life. Unfortunately, he had to work in New York City cleaning bathrooms, but what else could he do? For the previous five years in Venezuela, after graduating as an engineer together with his wife, he had not even managed to scrape together the minimal down payment required to purchase an apartment.

It is difficult to fathom the accumulation of errors required to create a scenario in which young educated people from an oil rich nation with all the advantages of a tropical climate must immigrate to a country with a hostile winter in order to solve their housing problems. A country’s reserves are not those sitting in the Central Bank, but rather its people, especially after they have invested in a decent education. Today, our Central Bank is raising interest rates in order to keep its dollar reserves. Today, our young human reserves are leaving in droves.

A home is a long-term investment. It is not a vehicle, a trip to some Caribbean isle or a new double-breasted suit. A home for the normal citizen, who lives from his work and savings, is an investment that he hopes to amortize in 20 or 30 years if all goes well. In order to allow a young couple to acquire a home it is necessary to provide them with a real and sustainable source of long-term financing. The key words here are “real” and “sustainable”.

In Venezuela, the conditions for local currency loans are non-existent. To begin with, there is absolutely no possibility to establish fixed interest rates for a long-term Bolívar loan. Either interest rates are so high in real terms that it becomes virtually impossible to service the loan. Or they are too low, which effectively results in undeserved subsidies, which in turn threaten the very existence of the financial system as a whole.

In the case of loans with variable interest rates, the erosion of value due to inflation is usually covered with an increase in the interest rates. This makes the term of a 20- or 30-year loan, whether documented as such or not, a tasteless joke.

Let us take a closer look at this. If inflation rises to 40%, interest rates more than likely will be pegged at around 50%. Should a young couple manage to qualify for a Bs. 10 million loan for a 20-year term, they would need to raise Bs. 5 million to cover interest payments and Bs. 500,000 to cover amortization of principal on an annual basis. After one-year elapses (if they survive) they still owe Bs. 9.5 million. This amount, adjusted for 40% inflation is only worth Bs. 6.8 million in real terms (Bs. 9.5 million divided by 1 plus the inflation rate). Our young couple in essence has amortized the sum of Bs. 500,000 plus the amount corresponding to this adjustment, that is, Bs. 2.7 million. This has absolutely no relation with a 20-year term.

Other countries plagued by inflation have looked for solutions to this problem by denominating loans in indexed units. In this case, the debtor would owe Bs. 13.3 million instead of Bs. 9.5 million after the first year (Bs. 9.5 million plus inflation of 40%). However, instead of having to pay Bs. 5.5 million to service the loan as in our first example, service would have been limited to Bs. 1.5 million corresponding to a 10% real interest rate and the payment of a real amortization of Bs. 500,000.

Evidently, another alternative to indexed units is the denomination of loans in a stable currency, US dollars for example. Even when devaluation could possibly wreak havoc with debt service in the short term, a working person could most likely weather this and adequately service his dollar loan if and when it is contracted under prudent terms. When contracting a dollar denominated loan, a company or bank must immediately reflect exchange losses on their balance sheets. In the case of our young couple, the impact is limited to higher monthly payments which he could eventually expect to offset with inflation adjusted increases in his salary.

It is a shame that a full 15 years after the initial devaluation in 1983, we have not managed to reestablish sources of long-term financing for acquisition of housing. The fact that the Agenda Venezuela does not include a real and concerted effort directed at solving the problem of housing only serves to reinforce my belief that my daughters’ respective agendas have much more meaning.

I hope to stay in Venezuela. Somehow, I feel I would definitely prefer to remain here accompanied by many young, eager and educated people dedicated to the country’s future and without one single dollar in the Central Bank, rather than the other way around.

Roping in the herd

We have frequently seen examples of how economies that permit total liberty for foreign investment flows, especially those that are in essence short-term investments, often must confront more difficulties than those that impose certain restrictions.

As so many things in life do, problems often have their roots in exaggeration. It is possible that on the one hand confidence and the magnitudes of the resulting flows become so great that they can actually hide problems or diminish the pressure brought to bear on local authorities to take corrective measures. On the other hand, absolute mass panic may set in, creating the medium for the type of accidents normally attributed to such a response (for example, the Mexican debacle and resulting “Tequila Effect”).

Since it is very difficult in most cases to identify a special event such as war, earthquakes, or the sudden death of an important leader as the trigger for a change in sentiment, and as we supposedly live in a world of virtual and perfect information, what could be the possible origin of the overly exaggerated reactions of fund managers?

Above all, I suspect that the financial roller-coaster rides we are subjected to have their origins in the traditional search for the type of security usually found in herds. This instinct predominates in most decision making. I refer specifically to the attitude “it doesn’t matter if things go well or not, as long as I’m in good company.”

As an example, I can go back to the period just after Venezuela abandoned exchange stability (February 1983). I watched with surprise as the treasurers of large multinational companies blithely signed contracts that insured future exchange rates at such incredible costs that they seemed outright irrational. The premium paid easily surpassed the possible exchange losses that would be caused by reasonably predictable devaluations.

When I tried to get to the bottom of this madness (frequently assisted in my investigation by offering a shot of whisky), I invariably would receive the following explanation: “We actually have two accounting registries. In the first we register the exchange earnings or losses per se. In the second we register the cost of the insurance premiums to cover exchange risks. Our head office has become so sensitive to exchange risk that it doesn’t combine both accounts to analyze the total net results. On the contrary, even if I save the company a fortune by not contracting this coverage, but incur in so much as one cent in exchange losses, I would be handed my pink slip in a flash.”

What, then, does this observation aim at? Simply that even when an individual or company is perfectly amicable, capable and basically worthy of an invitation to invest in our country, if his inclination as manager of funds is to follow the herd in stampede, the nation can simply not afford to allow him and his company to enter.

In this sense, we must ask why our monetary authorities have not managed to develop a coherent set of regulations to limit the inflow of international investment when this is obviously intended to be for irrationally short periods of time, in grossly large amounts, or both, instead of wasting time and money exchanging bonds and restructuring debt that matures in 20 years.

Countries like Chile, which have earned the confidence of international markets, limit the inflow of short-term investments. This limitation has definitely not resulted in damage. On the contrary, it has helped increase the confidence of exactly those foreign investors whom the country actually wishes to attract. They are not those that come on a 30-day visa, but rather those that come to invest for the long term.

It is important to remember that when a foreign investor risks his funds in a country in the long run, installing factories, developing projects, creating employment, and in general acquiring a real presence in the country, his interest in the future of the country becomes much more sincere and similar to that of the nation’s own population. Much more so than the interest of some fund manager sitting in New York or London.

When we speak of gaining the confidence of foreign investors, we must learn to discriminate among them.

PS. As you would want to know if those courting your daughters have serious intentions.

PS. 1998. Speaking about trust and distrust.

Published in Daily Journal, Caracas, December 4, 1997 and in "Voice and Noise" 2006.