Latin Sinkholes

This article appeared in Forbes magazine on November 26, 2007.
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During the last five years Latin America has reaped the benefits of surging commodity pricesand low interest rates. Unlike past commoditydrivenbooms, this one has not been accompaniedby fiscal profligacy. Indeed, net public debt issuancehas declined sharply, with many countries buying back some oftheir outstanding debt. Some have also continued down the freemarketreform road toward flexibility and modernization,notably Colombia, El Salvador, Guatemala and Peru.

But not all of the politicians in this region believe in free markets.They have turned back the clock. Venezuela's PresidentHugo Chávez is the leader of the negative reformers. Followinghis bad example are Ecuador, Argentina and Bolivia. Chávezcame to power in February 1999; he hails Cuba, the largest openairprison in the Americas, as his model. His revolution's enemyis the marketplace.

According to the World Bank's recently released "Doing Business2008" report, Venezuela is tied with Zimbabwe as this year'schampion in smothering economic freedom. In terms of objectivemeasures concerning the ease of doing business, Venezuelasank from 163rd to 172nd out of 178 countries covered. Atpresent high oil prices are masking Venezuela's economic sins.What happens when oil's price comes back to earth? Don't expectany surge of entrepreneurship to take up the slack in Caracas.

Oil prices have increased almost eightfold since Chávez tookoffice and now account for 90% of Venezuela's exports. Despitethat, Venezuela's economic performance under Chávez has beenanemic; its gross domestic product per capita has grown at anaverage rate of only 2% per year. Inflation has averaged 34% ayear, the highest in Latin America.

When Chávez assumed power the bolivar, Venezuela'scurrency, was trading at 577 per dollar. In February 2003 thebolivar was pegged to the U.S.dollar at 1,600; in a desperatebid to stop the flight of hardcurrency, Chávez also put exchange controls in place.

These didn't stem Venezuelans' desire to dispose of bolivarsas rapidly as possible. The official rate now: 2,150 to the greenback.But on the black market the bolivar is worth 64% less, 6,000per dollar.

Chávez plans to ring in the New Year by lopping three zerosoff the currency and issuing a "strong bolivar" at the exchangerate of 2.15 per dollar. This cosmetic change won't alter anything.

Ecuador has been the most recent country to be caught up inChávez's Bolivarian Revolution. Rafael Correa, a trained economist,was sworn in as Ecuador's new president on Jan. 15. LikeChávez, he is very popular, and clever like a fox.

Since assuming office Correa has been ruthlessly efficient. Hehas completely sidelined the Ecuadoran Congress and pushedthrough a popular referendum that approved the establishmentof a Constituent Assembly to rewrite Ecuador's constitution. Thenew constitution will be the twentieth since Ecuador gainedindependence in 1830.

That's a neat ten times as many as we've had, if you countthe Articles of Confederation(1777–89) as a constitution.Correa's objective is to amassexecutive power, as Chávez hasin Venezuela, so he can do abetter job of stomping out free marketeconomics.

But Correa isn't waiting forthe Constituent Assembly tochange the rules. He has alreadyinstituted a de facto nationalizationof oil production by raisingthe state's share of oil companies'profits from 50% to 99%.

One big thing differentiatesEcuador from Venezuela, however. After a long history of badmoney, Ecuador abandoned the sucre in 2000 and replaced itwith the U.S. dollar. Since then the average GDP per capita growthrate has been 4.4%, and inflation is estimated at 2.1% for 2007.No wonder dollarization has an 82% approval rating.

To pull off a Bolivarian Revolution in Ecuador, Correa musteither dump dollarization or undermine it. Given its popularsupport, Correa won't attack dollarization directly. Yet he hasstarted to undermine it by proposing a 1% tax on capital flowsinto and out of the country. This form of exchange control isstrictly verboten under orthodox dollarization. It is also a veryworrying sign; it indicates that Correa will attempt to impairdollarization, which is the linchpin for the Ecuadoraneconomy.

When the commodity-driven boom abates, Latin America'seconomic sinkholes will take hard hits. The next round of revolutionsand constitutions will not be pretty.

Steve H. Hanke

Steve H. Hanke is a professor of applied economics at the Johns Hopkins University and a senior fellow at the Cato Institute in Washington, D.C.