The ins and outs of zero zapping

Quico says: A few of you have written in with questions about monetary reform. Here’s my attempt to clear things up:

First off, the practice of striking zeros from a devalued currency is nothing new. France, Laos, Bolivia, Argentina and Brazil have all done it. Just a couple of years ago, Turkey zapped 6 (count ‘em, six!) zeros off of the lira, ending the era of the 20,000,000 lira banknote. Certainly, zero-zapping makes day-to-day transactions easier to deal with. There’s nothing wrong with that, as far as it goes.

Thing is, Chávez is selling his bolívar fuerte scheme not just as a way to simplify calculations, but as an inflation fighting scheme. And this is where the wheels come off: there’s just no logical connection between zero-zapping and the rate at which the new currency loses purchasing power.

Obviously, Chávez has no clue what it is that causes inflation. What’s sad is that, outside the chavista anti-rationalist bubble, the underlying cause of inflation is well understood. Inflation is what happens when you have too much money chasing after too few goods. When the amount of money sloshing around an economy grows faster than the stock of goods available for purchase, prices have to go up.

The trick is to think in terms of the ratio of money in circulation to goods in the economy. If there are 100 ounces of gold circulating in an economy and the only thing for sale is 10 horses, you can guess that a horse will sell for 10 ounces of gold. If, suddenly, miners dig up 100 extra ounces of gold but there are still just 10 horses available for purchase, over time, the price of a horse will rise to 20.

It’s not some big mystery: when new money gets injected into an economy faster than its output is growing, prices rise. Since 2005, liquidity in Venezuela has more than doubled, while GDP has grown by about a fifth. Which suggests that, if anything, inflation has been too low in the last two years…so you can expect more to come.

The point is that you can strike however many zeros you want off of the bolivar; that does exactly nothing to change the rate of liquidity growth. And if you want to control inflation, you’ll have to come to grips with that.

Nothing Chávez has said suggests that he’s willing to make the kinds of choices that it would take to slow down liquidity growth. And the main reason liquidity has been growing so fast in Venezuela is that the government spends too much money, and the central bank no longer has the power to say “no” when the government asks it to print up some more. So long as that’s the case, prices will keep rising.

Which is a crying shame, because when coupled with sensible reforms, zero-zapping can be a useful ingredient in a broader stew of inflation-fighting measures. Psychologically, it can mark a clean break, a before-and-after marker, a symbol of a government’s newfound commitment to sensible inflation-busting policies. But expecting zero-zapping to bring down inflation by itself is like expecting a frying pan to cook you dinner.