Topic: International Economics and Development

Understanding the Protests in Ukraine and Venezuela

“All happy families are alike; each unhappy family is unhappy in its own way.” If one believes Tolstoy’s famous dictum, then the protest movements in Ukraine and Venezuela should not have much in common. However, there are several striking parallels between the events unfolding in the two countries—as well as some important differences:

1. It’s the economy, stupid!

Although the popular unrest in Ukraine was triggered by the government’s decision to cancel the agreed free trade agreement with the European Union, the popular discontent has deeper roots. After years of kleptocratic governance, which derailed the country’s transition toward a market economy, ordinary Ukrainians are desperate for change. In 1990, Ukraine’s GDP per capita was $8,200, which was roughly identical to Poland’s. Today, Poland’s GDP is $18,300 and Ukraine’s has gone down to $6,400. Unlike its post-communist neighbors to the West, Ukraine did not pursue deep institutional reforms and its economy was seized by a narrow group of oligarchs, with close connections to political power and to the Kremlin. The son of the President Viktor Yanukovych, Oleksandr, has become one of the richest men in the country during his father’s time in the office, while incomes of most Ukrainians stagnated.

In Venezuela the economic situation has deteriorated sharply since the death of Hugo Chávez last year. The country has the highest inflation rate in the world (officially 56 percent in 2013, although according to Steve Hanke’s Trouble Currency Project, the implied annual inflation rate is actually 305 percent). After years of nationalizations, expropriations, and currency and price controls—all under the name of “21st Century Socialism”—the private sector has been decimated. Hour-long lines in supermarkets are a daily occurrence and shortages of basic food staples and medicines are widespread. And just like in Ukraine, corruption is rampant as the ruling elite rake in the profits from oil revenues. This has resulted in the rise of a new privileged class called the “Boligarchs.” so-named because they’ve prospered tremendously under the so-called Bolivarian revolution. Moreover, Venezuela is now one of the most dangerous nations in the world, with almost 25,000 murders committed last year. A large segment of the population, mostly middle class, is simply fed up as the country quickly becomes unlivable.

Nightmare Scenario Underway in Ukraine

As the Ukrainian security forces are moving to clear Kiev’s ‘Maidan’ protest camp again, after an unsuccessful attempt last night, the events are unfolding quickly and with the characteristically scary dynamics of an autocratic regime acting under pressure:

Ukraine’s state security service said it was launching an “anti-terrorist operation” across the country after the seizure of administrative buildings and arms and ammunition depots by “extremist groups.”

Labeling the opposition as ‘terrorists’ is a common rhetorical device used by authoritarian governments under duress. But we should make no mistake – the current situation is not just an outcome of the divisions existing within Ukrainian society but also a result of Vladimir Putin’s long standing and sinister meddling in Ukraine.

For Mr. Putin, the current situation is both a source of fear and an opportunity. The fear stems from the possibility of Ukraine setting a precedent of a bottom-up, civil society-driven initiative displacing a Moscow-sponsored leadership in a country with strong cultural and historical ties to Russia. The opportunity lies in leveraging the current unrest and the ethnic divisions it has uncovered to strengthen Russia’s influence over the country’s politics. The Russian government already provided Mr. Yanukovych with cash in December 2013; this week, another bond purchase worth $2 billion was announced, conditional on the government successfully tackling the opposition.

The international response is too timid given the magnitude of the problem and its proximity to the European Union’s borders. Targeted EU sanctions, such as the asset freezes and travel bans directed at Ukrainian officials, which are likely to be adopted tomorrow, seem fully justified–although they come very late. Still, care needs to be exercised so that they hurt the regime and not ordinary citizens.

More importantly, European leaders need to clearly articulate the long-term alternative that they are offering to Ukraine lest it remain the Kremlin’s client state. The roadmap to full EU membership ought to have an accelerated timeline, incentivizing Ukrainian policymakers to adopt open political and economic institutions.

The EU’s engagement with the country needs to come with tangible benefits for Ukrainians. Those would include most fundamentally a removal of trade and regulatory barriers, as well as immigration restrictions, making Ukrainians a de facto part of the common European market now rather than at an uncertain point in the future.

Venezuela’s Plunging Petroleum Production

A hallmark of socialism and interventionism is failure. Venezuela is compelling proof of this, having spent the past half century going down the tubes. Indeed, in the 1950’s, it was one of Latin America’s most well off countries. No more. Now it is a basket case – a failed state that’s descending into chaos.

How could this be? After all, Venezuela’s combined reserves of oil and gas are second only to Iran’s. Well, it might have reserves, but thanks to the wrongheaded policies of President Hugo Chavez, Venezuela is the only major energy producer that has seen its production fall over the past quarter of a century. The following chart tells that dismal tale:

ABBA and the Story of the Most-Inane-Ever Tax Controversy

The tax code is a complicated nightmare, particularly for businesses.

Some people may think this is because of multiple tax rates, which definitely is an issue for all the non-corporate businesses that file “Schedule C” forms using the personal income tax.

A discriminatory rate structure adds to complexity, to be sure, but the main reason for a convoluted business tax system (for large and small companies) is that politicians don’t allow firms to use the simple and logical (and theoretically sound) approach of cash-flow taxation.

Here’s how a sensible business tax would work.

Total Revenue - Total Cost = Profit

And it would be wonderful if our tax system was this simple, and that’s basically how the business portion of the flat tax operates, but that’s not how the current tax code works.

We have about 76,000 pages of tax rules in large part because politicians and bureaucrats have decided that the “cash flow” approach doesn’t give them enough money.

So they’ve created all sorts of rules that in many cases prevent businesses from properly subtracting (or deducting) their costs when calculating their profits.

One of the worst examples is depreciation, which deals with the tax treatment of business investment expenses. You might think lawmakers would like investment since that boosts productivity, wage, and competitiveness, but you would be wrong. The tax code rarely allows companies to fully deduct investment expenses (factories, machines, etc) in the year they occur. Instead, they have to deduct (or depreciate) those costs over many years. In some cases, even decades.

But rather than write about the boring topic of depreciation to make my point about legitimate tax deductions, I’m going to venture into the world of popular culture.

Though since I’m a middle-aged curmudgeon, my example of popular culture is a band that was big about 30 years ago.

Are We Nearing a Breaking Point in Venezuela?

Today could be a very tragic day in Venezuelan history. Two large marches, one from the opposition and the other organized by the government, are already taking the streets of the capital and might converge in the same district. The regime of Nicolas Maduro outlawed the opposition march and threatened violence if they try to enter the municipality of Libertador, in downtown Caracas. Things could get very ugly.

Tensions have built up since last week when tens of thousands of people, mostly students, took to the streets to protest against the government. The heavy-handedness with which the regime has dealt with the protests is almost unprecedented. At least 3 people died, scores have been detained and many are still missing. The students that were released have denounced that they were tortured and raped while in custody. Moreover, the government issued an arrest warrant against Leopoldo López, former mayor of the district of Chacao and one of the most emblematic leaders of the opposition. As leader of the march today, he turned himself in to the National Guard.

We need to keep a few things in mind as events unfold:

A large segment of the population is fed up: This is not the first time that tens of thousands of Venezuelans take the streets to protest against the government. However, as the acute economic crisis worsens, the level of desperation among the population, especially the middle class, is reaching a boiling point. The scarcity index shows that more than one out of four basic products is out of stock. Hour-long lines are an every-day occurrence in super markets. And when you can actually find a product, your income is rapidly dwindling to purchase it. The official inflation rate reached 56 percent last year, but according to my colleague Steve Hanke’s Troubled Currency Project, the implied annual inflation rate is actually 305 percent. Crime has significantly worsened living conditions: Venezuela is now one of the most dangerous places in the world with almost 25,000 homicides in 2013 –a murder rate of 79 killings for 100,000 inhabitants. The country is quickly becoming unlivable and many Venezuelans think that they have nothing to lose.

Venezuela Verifies Hayek on Exchange Controls

Foreign airlines have begun to restrict ticket sales in Venezuela. As the bolivars’ value evaporates, and with exchange controls in force, the airlines fear that the funds they have in Caracas will evaporate, too. By restricting ticket sales, the airlines will limit the amount of new money that is trapped behind the government’s wall of exchange controls.

Of course, President Nicolas Maduro isn’t the first autocrat to impose exchange controls, and he won’t be the last to impose these confiscatory policies. Indeed, the pedigree of exchange controls can be traced back to Plato, the father of statism. Inspired by Lycurgus of Sparta, Plato embraced the idea of an inconvertible currency as a means to preserve the autonomy of the state from outside interference.

So, the temptation to turn to exchange controls in the face of disruptions caused by hot money flows is hardly new.  Tsar Nicholas II first pioneered limitations on convertibility in modern times, ordering the State Bank of Russia to introduce, in 1905–06, a limited form of exchange control to discourage speculative purchases of foreign exchange.  The bank did so by refusing to sell foreign exchange, except where it could be shown that it was required to buy imported goods.  Otherwise, foreign exchange was limited to 50,000 German marks per person.  The Tsar’s rationale for exchange controls was that of limiting hot money flows, so that foreign reserves and the exchange rate could be maintained.  The more things change, the more they remain the same.

This brings me to Nobel laureate Friedrich Hayek’s 1944 classic, The Road to Serfdom. Many thought Prof. Hayek hurt his case because he was extreme. What nonsense. Just consider the Wall Street Journal’s reportage from Caracas about the real concerns of foreign airlines that have funds locked up in Venezuela. And then reflect on the following insightful analysis from the Road to Serfdom:

The extent of the control over all life that economic control confers is nowhere better illustrated than in the field of foreign exchanges. Nothing would at first seem to affect private life less than a state control of the dealings in foreign exchange, and most people will regard its introduction with complete indifference.  Yet the experience of most Continental countries has taught thoughtful people to regard this step as the decisive advance on the path to totalitarianism and the suppression of individual liberty.  It is, in fact, the complete delivery of the individual to the tyranny of the state, the final suppression of all means of escape—not merely for the rich but for everybody.

Hayek’s message about convertibility has regrettably either been overlooked, or thought to be too extreme. Exchange controls are nothing more than a ring fence within which governments can expropriate their subjects’ property. Open exchange and capital markets, in fact, protect the individual from exactions, because governments must reckon with the possibility of capital flight.

Offer Free Trade, Not Foreign Aid to Egypt

Egypt is racing toward dictatorship.  But Washington always has been more interested in maintaining influence than encouraging democracy or promoting development in Egypt.  That’s why the U.S. provided more than $75 billion in “aid” over the years. 

In fact, the cash bought little leverage.  Hosni Mubarak spent decades oppressing Egyptian citizens and persecuting Coptic Christians despite Washington’s contrary advice.  Israel’s military superiority, not America’s money, bought peace. 

Unfortunately, as elsewhere in the Third World, foreign “assistance” hindered economic development by effectively subsidizing Cairo’s inefficient dirigiste policies.  A decade ago the government finally decided to open the economy. 

Reforms including lower tariffs, enterprise privatizations, and regulation reductions.  Meredith Broadbent of the Center for Strategic and International Studies also cited corporate tax reductions and insurance regulation modernization. 

However, Egypt soon began to fall behind other reformers.  For instance, Broadbent pointed to the survival of “significant elements of a heavy-handed statist bureaucracy.”  The banking system was opaque, monopolistic, and inaccessible.  A joint report by the Carnegie Endowment and Legatum Institute cited the need to give poor Egyptians clear title to their property, reform the bankruptcy law, and reduce costs of opening, operating, and closing businesses.

Corruption was pervasive, with commerce dominated by cronyism and privilege.  The military controlled anywhere between 15 percent and 40 percent of the economy. 

The most serious economic hindrance was expensive consumer subsidies, particularly for food and fuel.  Most of the benefits did not go to those in most need.  Moreover, the cost today accounts for roughly a third of the government’s budget and 14 percent of Egypt’s GDP. 

Thus, even after the Mubarak reforms unemployment and inflation remained high while Cairo ran large deficits.  The situation worsened after the 2011 revolution.  Uncertainty and insecurity discouraged investment and the public deficit increased to 11 percent of GDP. 

The coup was another step backwards.  The government is focused on suppressing the Muslim Brotherhood and reconstituting old political and economic relationships.  Reported the Washington Post:  “now some businessmen and officials implicated in post-uprising corruption probes are again in positions of power and influence, including in the cabinet appointed last summer by the military.” 

The prime minister said the government plans to “rationalize” the subsidy, but economic reform appears to be a low priority.  In September the regime launched a “$4.2 billion program for “economic development and social justice,” the sort of big spending initiative which has not worked elsewhere.   

As I point out in my new National Interest article:

Military rule could offer a form of stability.  However, Gen. al-Sisi’s brutality, including the slaughter of Brotherhood protesters in Cairo in August, has encouraged increasingly violent opposition.  Policemen are regularly being killed, and both auto and suicide bombings are on the rise.

Such violence could frighten off investors and tourists. 

In this environment American financial assistance would be even more harmful than before.  The massive aid coming from Saudi Arabia and other Gulf states—given purely for the political purpose of combating the Brotherhood—reduces any financial pressure on the regime to streamline economic policy. 

In contrast, freer trade would be a positive good.  Meredith Broadbent proposed negotiating a free trade agreement—previous talks left off in 2005—and updating the bilateral investment treaty.  The Institute for International Economics once projected that an FTA would increase Egypt’s GDP by three percent annually.

A new accord also would benefit U.S. firms which have been left at a disadvantage by the EU-Egyptian FTA.  Such agreements, Broadbent argued, “can serve as systemic tools to help pry open closed government regulatory processes.”

Absent an inclusive political process, Egypt likely faces an unstable and violent future.  However, economic reform also is necessary.  That is unlikely to come from lectures and money from foreign governments.  But the prospect of increased participation in international commerce would offer a far more powerful and direct incentive for action.  Washington should propose that the two governments free up investment and trade.