Nova workboard

a blog from young economists at Nova SBE

The impact of education on time consistent behavior

In times in which saving seems pointless and spending often impossible, the importance of intertemporal choices might not be evident. However, in economic decision-making it is crucial to behave time consistent in order to elaborate in right saving and investment behavior.

In an experimental research project, the Chair for Behavioral and Experimental Economics of the Ludwig-Maximilians University in Munich examine if and how education can change time preferences over time to identify significant effects on intertemporal decision-making. Assisting the research team in the field allows me to give an insight about the procedure. In order to forecast possible outcomes, the results of the evaluation from the previous year are also stated in the following report.

The objective of the study was to analyze if financial education initiatives can influence time preferences of adolescents. Following a random assignment of the initiative, intertemporal choices have been measured using a controlled and incentivized experiment. Results of the previous year show that there is a positive influence of financial education intervention on time consistency.

The experiment took place in 32 classes (7th or 8th grade) in schools of the lower track of the German high school system in Munich and surrounding. Participants in the treatment group completed a financial training, My Finance Coach, before the experiment took place. The training is offered by a non-profit organization since 2010. It coaches students in financial decision-making due to three standardized modules, including shopping, planning and saving. However, the training does not include any decisions that directly resemble the tradeoffs made in the experimental task.

One month after the training, the experiment took place. The experiment was  constructed by a detailed instruction on the upcoming procedure, followed by four control questions that proofed if the task has been understood. Then the participants conducted the time-preferences elicitation task and a survey. The session was completed by a drawn, deciding which of the decisions will be paid to the pupils. They received their payment in cash, based on the individuals’ decision, in two points in time.

Intertemporal choice was measured with a controlled and incentivized task, the Convex Time Budget (Andreoni and Sprenger, 2012). This method asks individuals to allocate amounts of money to an earlier point in time or a later point in time. Choices are elicited by using three different combinations of payments (today and two weeks; today and four weeks; in two weeks and in four weeks). On each decision sheet seven different interest rates were presented. Going from top to bottom, the price for the earlier payment increases i.e. preferring an earlier payment would decrease the overall payment received. Students could chose between four combinations of money at the earlier and later points in time for each of the 21 (3×7) choices.

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Example of the CTB Task, 2014

Comparing decisions with different payoff periods but same interests provides identification of the degree of present bias. Allocations in situations when the earlier payment is made immediately are compared to allocations when the earlier payment is delayed. Further, comparing decisions with a delay of 2 and 4 weeks allows identification of the degree of impatience.

After the experimental task, the pupils answered the survey. The questions survey the socio-economic status of the individuals’ family, the financial knowledge and the financial and savings behavior. In addition, questions capturing heterogeneity in cognitive skills were included.

One of the strongest concerns, which arose during the experiment, was if choices are in coherence with the law of demand i.e. if adolescents choose smaller earlier payments if the price of choosing earlier payments increases. In order to cope with inconsistency, the instructor explicitly recommended to the students only to chose payments on the right side to the previous decision. However, during the sessions the students behaved differently. Their behavior questions if the task has been conceived. In the evaluation of the data last year, choices has been evaluated using an econometric model which allow for stochastic choices, coping for possible bias of the preference parameters and thus for inconsistency.

The results of the study conducted in the previous year suggest that financial education has a significant impact on intertemporal choices. Students in the control group allocated 6.73% more of their budget to the earlier point when the earlier point is today compared to in two weeks, stating more present- biased choices. In addition, choices made by students who participated in the financial training are more time-consistent. The financial training also induces an increase in the share of choices that is consistent with the law of demand. However, there was no significant evidence for an increase in the average allocation to earlier payments, when the delay between the earlier and later payments is increased. This result suggests that the treatment had no significant effect on patience. Taking the individual’s characteristics into account, the study found that the effects of the financial coaching varies strongly among pupils with regard to the pupil’s socio-economic background, age and cognitive ability.

The results of the study from this year are expected around spring 2015.



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The role of parents on education

The equality of opportunities is a dominant matter of societies. It is believed that one way to decrease inequality is through education. Thus, for this purpose, the education system has become an important foundation for the future of the citizens and economic opportunities. Therefore, because children are the key to a brighter future, it is society’s duty to provide them with complete education and teach them how to be productive.

The education that a child receives in their first years is crucial and has a huge impact in the rest of their lives. However, this kind of investment in children’s education requires two fundamental resources from parents, which are basically time and money. Besides these relevant factors, home background is also essential because parents have the capacity to induce their children to care about education and, thus, make them be interested in learning through so they can be more qualified and prepared for the different challenges they can face.

On the other hand, the education received by the parents can also influence the education of their children. In other words, parents with a high educational level know how to help their children to surpass the different obstacles that may appear because they are qualified to do so. Hence, this process of transferring knowledge may be essential to make children even more qualified than their parents.

Although it’s important for parents to have a high literacy level, one must verify that most of these qualified parents spend most of their time working and don’t really have the time needed to support their children as they should. Moreover, even if the parents aren’t qualified enough, the time spent with their children in activities such as checking homework, attending school events and letting kids know school is important, is considered the basis of successful performances by children. According to a study published by researchers at North Carolina State University, Brigham Young University and the University of California-Irvine family involvement has a strong positive effect on student’s education progress. Additionally, other study was conducted by researchers at the University of Leicester and University of Leeds, which concludes that parents’ efforts towards their child’s educational performance are fundamental since the role they play is more powerful and significant than that of the school or child. As a result, children of parents who put effort and dedicate time to children education have better achievements and a better performance on education.

So one can conclude that improving parents’ commitment on child education might be a competent policy in strengthening educational attainment, since it is more effective than changing parents social background and it will eventually lead to better economic results in the future. For example schools can volunteer to help develop parents information on student learning and make it better.

Maria Silva, 702

Money Creation in the Modern Economy

In the Bank of England’s Quarterly Bulletin “Money creation in the modern economy”, signed by three economists from the Bank’s Monetary Analysis Directorate, the endogenous nature of money creation, monetary circulation dynamics, and the way banks manage risk in the modern economies are thoroughly analyzed. The conclusions are controversial.

The orthodox analysis of the functioning of money creation tells us that banks act as intermediaries, as the deposits generated by families’ savings, are subsequently used by the banks to create new credit. What is more, the Central Bank determines the money supply in the economy by controlling the money base (banks reserves plus currency in circulation), and letting the money multiplier do its part.

The Bank of England argues that these conceptions may, after all, not be correct.

In reality, instead of commercial banks acting as intermediaries, receiving families’ savings and lending them afterwards, it is the loan itself that generates the deposits: the phenomenon is the inverse of the today’s consensual sequence of money creation. The choice of saving made by families, thereby increasing their deposits, instead of using such wealth in the consumption of goods and services, is made at the expenses of companies’ deposits which otherwise would have received by the payment of those same goods and services. There are no new deposits in the economy, and there is no money creation.

On the other hand, and as it is explained in the article, when someone mortgages a house, s/he does not receive hundreds of thousands of euros in bills that come from deposits of other clients of the bank. Instead, s/he sees his/her account credited with the amount of the mortgage. In that moment a new deposit is created in the economy: new money is created.
This process is depicted in the following figure, with the balance sheets of the Central Bank, commercial banks, and of the consumer, during the provision of a loan. In the consumer’s balance sheet, passives and actives are increased by the new deposit and the new loan, respectively: there is money creation in its broader sense. Despite that, this money creation is not necessarily followed by an increase in the Central Bank monetary base. While it is true that the increase in deposits might demand from banks a demand for reserves to cover their liquidity needs, that have just increased as well, the supply of reserves is unlimited on a collateralized basis and therefore is not what constraints the amount of loans.

balance sheet

The authors conclusion is simple, “Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out”. The conception of banks as intermediaries in the allocation of one’s savings to another’s consumption or investment is not necessarily accurate.

Regarding the money multiplier, the Bank of England also disputes its current conception. It can be read in the bulletin that the theory would only be correct if the amount of reserves was a relevant restriction in the concession of credit, and if Central Banks directly determined the amount of reserves. However, neither the first nor the second conditions holds. Instead of controlling the amount of reserves, Central Banks dictate monetary policy by fixing the price of reserves, the interest rate. It is in the price of money and not in its quantity that monetary policies focuses on. In fact, banks face indebtedness restrictions, but these are not due to the imposition of legal reserves. Banks are instead constricted by the capital ratio requirements, and by the interbank competition that makes them develop risk management strategies, gauging the relation risk-return in each loan, to avoid unprofitable loans.

It’s the decision of how much to lend, which is fundamentally constrained by the available opportunities of creating profitable loans, that determine the amount of deposits generated. And it is the amount of deposits that creates the banks’ demand for reserves. As it can be read in the bulletin, as in the relationship between deposits and loans, the relationship between reserves and loans operates in the inverse way of the commonly thought.

The article is worth a full read, to understand the limitations of money creation, being it due to monetary policy or due to families and companies behavior. And also to study what happens to the newly-formed money, the ‘reflux theory’, and the ‘hot potato’ effect. But above all, it is worth to ponder that the monetary system is not as clear and simple as one may think.

Gonçalo Pessa – 750
José Ricardo Sequeira – 729



After the Savings Glut

Addressing to the Virginia Economics Association at the Sandridge Lecture in 2005, the FED ex-Governor gave a conference, in which he justified the huge deficit on the U.S. trade balance with the existence of a world savings glut, opposing to the traditional justification of the twin-deficits.

Ben Bernanke excluded easily the twin-deficits hypothesis, with the simple argument that, in the previous years, the U.S. indeed suffered a tremendous deficit in the trade balance, but it wasn’t accomplished by a deficit in the Government budget. Then he pointed out that in the last years (1995-2005) there was a huge increase in savings in South American Countries (mainly because of the massive pressures generated for these countries to create a credible monetary and currency policies, after the Mexican and the Argentinean bail-outs), so as in oil producer countries and in China. Then this countries started to augment their dollar’s reserves, this created pressures in the U.S. for the interest rate to fall and consequently to increase the trade budget deficit.

The ex-governor pointed this out: “The development and adoption of new technologies and rising productivity in the United States–together with the country’s long-standing advantages such as low political risk, strong property rights, and a good regulatory environment–made the U.S. economy exceptionally attractive to international investors during that period. Consequently, capital flowed rapidly into the United States, helping to fuel large appreciations in stock prices and in the value of the dollar.”

            The scenario was closely the same until 2008 (having the lower record low at the -67823 USD Million in August of 2006), but from this year forward the government deficit started to increase, doubling the public debt from 40 to 80% of GDP. And at the same time the trade balance remained in the negative side. For the generality of the European countries the same happened, but in some of them the government debt crisis was even sharper (however it is important to refer that Portugal, which faced huge government deficits, was able to turn the trade balance from negative to positive).

In the majority of the western countries (considering European countries and the U.S.) there was a change and aggravation in the government deficit, but the trade balance, which was negative, remained in the negative side. This is a paradox, because the poorer countries are lending money to the richer ones. We should expect the opposite. And this will have some perverse effects on the future.

There is also other fact which stresses more this scenario – demography. Both the U.S. and Europe (also China, although it is still not a developed country, but because of its anti-birth policies, has the same demographic problem) are suffering a strong aging of their population, their future is not bright, there will be less adults to sustain more elders. This fact would also lead us to expect that this would be the time for developed countries to save, in order to be prepared for demographic problems in the future. (In this sense China is much more prepared for the future demographic unbalance than Europe and the U.S., because they are saving now.)                        There is in the international Economy a double paradox: the younger and poor countries are lending to the elder and richer ones, when we expected elder lending to younger, and richer to poorer… This gives rise for inequality today, but for unpredictable and dangerous problems for Europe and U.S. tomorrow. (However we have to recognize, that the surplus in the Trade Balance is helping to develop poorer economies, in the sense that it promotes their exports and production, and by consequence the development in their production process, which is an essential part for the development of every economy.)

However the problem stands in the huge difference in the consumption patterns – the Western world is now dominated by a wild consumerism, from which it doesn’t want to abdicate.         But is it sustainable? The current crisis, so as the aggravation in demographic patterns, makes us believe that these patterns are not sustainable at all. There must be a reduction in the consumption levels in the western countries, in order to contradict and to compensate the deficit on the trade balance. There must be an increase in savings, not only to compensate the negativity of the last years, but also to prepare for a darker future, that will appear, mainly because of demographic factors.

Are we prepared for it now? Do we want to do it? No, of course not, we would prefer to increase our consumption levels to infinite, we prefer to think that our sons will pay the debt, and then think that our sons will think that their sons will pay the debt, and so on… But after the savings glut, the scenario is tremendous for the entire western world, which will be in huge and durable problems, when the countries in development stop to lend, and start ask payment for their loans.

Then the young generations of today will have to sustain the retired elders (which will constitute the majority of the population) and, at the same time, they will have to pay all the debt, which was created during all the last years! Impossible…

António Capela nº739

Bernardo Branco Gonçalves nº771

Income Distribution in Germany and Sovereign Debt Crises

During the (economic) unification after 1990, Germany faced several challenges. A central problem was the high unemployment rate which forced the government to implement fiscal and monetary policies to reduce unemployment. Irrespective of the economic developments those measures led to stable wages, resulting in low production costs in times of economic growth in comparison to other European countries. Thus, Germany had a competitive advantage of tradable goods, leading to continuous growth of its current account surplus. A surplus generated partly on the expense of other European countries causing the European internal imbalance to enlarge, amplifying debts growth and the European crises. The foundation of income distribution for Germany’s workers and its consequences for the Sovereign debt crises will be discussed in detail.

After the German unification the country had a severe problem of unemployment with a constant rose in unemployment rate up to 10% in 1997. Facing the problem of increasing unemployment, a reverse in monetary policies led to a return to economic growth and low unemployment in the following years. Thereby, some important structural characteristics in the labor market were enforced to uncouple economic fluctuation with the unemployment rate and the wage rate. Mainly a general philosophy prevailed that makes long-term job security a priority over short- term profit making, keeping the labor market unaffected by boom-bust cycles of the world economy.

Based on this philosophy, German firms effectively kept unemployment numbers relatively lower than their production costs would normally allow by increasing working hours without additionally salary, or decreasing the number of full-time workers while increasing the number of part-time workers during times of instability.

In times of booms, instead of hiring new workers, firms motivated their workers that had already worked part-time to work longer hours, enabling firms to not encounter further training costs for new staff. Firms also rather reinvested their profits to increase their productivity to remain competitive in the world market.

German policymakers have traditionally realized to make structural adjustments that affect worker’s work-leisure patterns and their wage rate. The labor market ministry undertook a series of labor market reforms, including more experience for unemployment benefits, sanctions for refusing job offers and the development of labor agencies which allow more flexible temporary work. These measures allowed Germany to alter the work-leisure patterns of its workforce, motivating more workers to enter into temporary work and to stay in their firms to secure benefits in cases of unemployment during a crisis.

Those labor market policies undertaken by Germany’s government and the structural nature of Germany’s labor market operations, allow a stabilization of the unemployment rate, independent of macroeconomic cycles, thus keeping wages constant over time. Germany’s wage rate stayed constant despite growth-boom cycles induced by the world economy because those structural characteristics allowed German skilled workers long-term job security on a slowly increasing salary.

With the change in macroeconomic environment and the increase in GDP growth from 2000 onwards, these characteristics of the German labor market caused German firms not to hire many more workers or to increase wages excessively. This distinguished German’s income distribution from other European countries, comparing its very small increase in wages of 7.5% between 1990- 2010 with a rise of wages in e.g. Spain of 55% in the same time period. Since 2001, average hourly wages have even stagnated in real terms in Germany. Before the European debt crises, in the economic boom of 2005-2007 unemployment rates were also constant at about 9%, keeping wages rate also constant. Clearly, the comparable lower wage rates improved Germany’s competitive advantages in tradable goods keeping production costs low which result in an ever growing surplus in its current account from 2000 onwards. In addition, the repercussions of the hesitant wage rate policy in Germany is that Germany’s domestic consumer sector has always remained fairly weak with regard to its GDP, leaving spending/imports low despite economic growths. The surplus in Germany’s trade balance has been mostly based on expense of other European countries, which suffer from Germany’s advantage in production of tradable goods and it’s reserved spending pattern. With the European Monetary Union an adjustment due to nominal exchange rates in those countries were also impossible. The following statistic summarizes that Germany’s current accounts surplus mirrors the current account deficits in Southern European countries:

CA Europa

Facing the growing deficit in current accounts, Southern European countries were forced to increase their debts. A strong borrower was thereby Germany, able to invest in e.g. governments bonds in Greece and Italy with its newly generated profits. Starting from this point, as the bond market stagnated and fiscal imbalance increased, the situation for Southern European countries worsened, making it impossible to repay the high debts.

The income distribution in Germany can thus be applied to explain how the internal imbalance in Europe increased before the Sovereign Debt Crises, leading to growing debts in e.g. Southern Europe countries. The explained structures in income distribution and the low domestic spending in mind, also explains among other things why Germany has not been hidden by the recession as much as other countries and why its spending pattern has contributed to the crisis.

#712 #724

Negative feedback implosions

In the last twenty years there has been a dramatic increase in the frequency of financial crises leading to significant contraction in economic activity. The Global Financial Crisis, considered by many economists the most catastrophic financial crisis since the Great Depression of the 1930s, originated in the United States when it was observed a sharp drop (in absolute terms) in the value of financial assets.

The financial accelerator is the mechanism that theoretical macroeconomics has used to characterize how financial factors may amplify and propagate business cycles. Its heart is centred on the existence of an “external finance premium” (EFP), calculated by the difference between the cost of third-party funds raised by firms to finance their investments and the opportunity cost of internal resources.

The reason for the presence of an external finance premium is simply that there is agency problems introducing a conflict of interest between the borrower and his respective lenders. Even though creditors should be compensated for their costs, the financial contract is designed to minimize agency costs.

Furthermore, the lower the net worth of firms the greater the proportion of external resources in financing the investments and consequently, higher agency costs and EFP. So, shocks that affect the level of aggregate activity, generating changes in revenues and profits of firms and therefore in net assets, cause changes in EFP, which strengthens the initial impact of shocks by the worsening or improvement the access conditions to financing in the credit markets.

Since negative shocks in the economy reduce the net worth of borrowers (or positive shocks increase net worth), the spending and production effects of initial shocks tends to be amplified. In the Bernanke-Gertler model, economic shocks are amplified and propagate by their effects on borrower’s cash flows. For example, productivity shocks decreases current cash flows, reducing the firm capacity to finance investment projects. This net worth decrease leads to an increase in average external finance premium and new investments costs. The reduction in investment leads to a decrease in economic activity and cash flows in the following periods, amplifying and propagating the effect of the initial shock.

The main argument of the financial accelerator is the inverse relationship between the premium that borrowers have to pay when they ask for external credit in the banking system and the financial condition of the borrower.

Economists are not in agreement on whether and how responses of macroeconomic variables to monetary policy shocks differ in times of high financial stress and normal times. On one hand, it has been argued that monetary policy has not been effective during financial crises. During the recent financial crisis of 2008/09, credit standards tightened and the cost of credit increased even further, despite the Federal Reserve reducing interest rates substantially. In the other, the monetary policy has been effective and more powerful during financial crises. It reduced interest rates on default-free securities, and helped to lower credit spreads. When financial stress is low (normal times), firms and households are less sensitive to changes in their cost of credit, while during crises, firms and households are more sensitive to any change in their cost of credit.

Bernanke et al. (1999), making use of a two-sector model with the financial accelerator, showed  that firms with very limited access to external credit markets respond more strongly to an expansionary monetary policy shock than do firms with broad access to credit. So, we can conclude that a monetary expansion during financial crisis increases loans and asset prices by more than in times of low financial stress, leading to a higher decrease of the EFP which, in turn, causes stronger effects in macroeconomic variables as output, consumption, and investment. This happens because the financial accelerator is used assuming different values of the elasticity of the EFP with respect to the net worth of firms.

Is the financial accelerator able to explain the causes of the Global Financial Crisis? According to literature, it is able to offer a plausible theory.

In late 2007, the collapse of the subprime mortgage market in the United States subjected the financial intermediaries to the amortization of bad loans, which in turn led to the erosion of its capitalization. The deterioration of their balance sheets damaged the credit capacity and, consequently, the borrowers saw the supply of loans to be contracted. This credit crisis caused a reduction of real economic activity, including investment, consumption and houses prices (those sensitive to credit market behaviour). The decline in houses prices eroded the net worth of economic agents, and thus also decreased its borrowing capacity. Therefore, there was an increase in the external financing premium and amplification of existing lower investment, consumption and production.

Along with the resulting rise in unemployment, the contraction of aggregate economic activity and the reduction of houses prices increased the amount of bad loans. The profitability of financial intermediaries was then reduced and its net assets deteriorated even further. As a fish that bites its own tail, the initial shock in the financial sector seems to have caused and/or enhanced the net assets problem of economic agents and have generated a crisis through the effect of the financial accelerator.



The Affluence Test

A recent study by the National Center for Fair & Open Testing (USA) shows a clear correlation between students “aptitudes” – measured by the score in the SAT test – and their family’s income level. Indeed, the research denotes a clear increase in the test scores, for every topic being tested, as we move along the income distribution. Hence, a wealthier student, on average, does better than a poorer student and, therefore, that A on SAT not only stands for Aptitude but it may also stand for Affluence. (i)
Initially, the SAT test was called Scholastic Aptitude Test, but the name created a lot of controversy – scholastic means academic and aptitude stands for natural skills, and hence, some argued that the test “aimed” to check how prepared you were to succeed in the school environment, given your inherent skills only. This point of view completely neglects other variables as determinants of academic success and, after several changes throughout the years, the test is nowadays called SAT Reasoning Test (2004), where SAT stands for nothing at all (to avoid controversies), and the subjects tested are reading, mathematics, and writing. (ii) The test score is of particular relevance in the US, not only because college institutions widely use them in its admissions, but also because some employers still ask for the test results when one applies for a job.
Is there really a causal relation between the scores and parent’s income? To answer this question we would need the counterfactual event: what would the wealthier (poorer) kids grades be if they were less (more) wealthy?
On one hand, it is a fact that home environment is of great importance when we talk about academic success: children born into wealthier families (which are expected to be also more educated) are more likely to be exposed to a wider variety of realities and to receive moral support from their parents during their childhood. Thus, these students can focus right from infanthood on their studies and future, without distractions. Students from a poor background, on the other hand, have several distractions in the form of financial and social problems, and often do not have parents who can actively guide them and, as a consequence, may be less motivated to study. In fact, a very recent study shows that family is of particular importance when predicting education performance and future income. (iii) Furthermore, there are some studies which show that natural ability are correlated across generations, i.e., children whose parents are wealthier (and supposedly more educated and capable) are smarter than poorer background children. (iv)
Secondly, wealthier parents are able to pay for better schools, i.e., schools that provide better quality education to its students, and/or for additional tutoring after the school period. In fact, one of the reasons pointed out by the researchers to justify the gap is the ease by wealthier parents to pay for SAT preparation courses, although some research suggests that test preparation only rises math scores by 14-15 points and reading scores by 6-8 points, while the score gap is much bigger than this. Thus, although this is not the only reason behind the disparity, liquidity constraints are indeed a factor that may lead low educated parents (which are also expected to be more resource constrained) to underinvest in education.
Indeed, given these 2 reasons above, it is very likely that parent’s income has a causal impact on the children attainment in the SAT test. Bearing in mind the importance of the test results in the US, if there is indeed causality between income and SAT score, one concerning consequence of this asymmetric performance is that children from wealthier families are more likely to be admitted in college institutions, get a job and have higher income. All in all, there is a low opportunity cycle for those who are born into less wealthy families. In fact, some academic intellectuals, like Nicholas Lemann, argue that if the system continues to use the SAT score as an admission condition, low score students (which are, on average, more likely to come from poorer families) will perpetually be kept away from prominent careers and thus, incapable of leaving the poverty cycle. (v) Furthermore, creativity is not tested by the SAT and “numerical measurement isn’t the answer to everything in life,” Lemann says. By using the SAT score, the system is in a certain manner, supressing the creative/artistic thinking and, in fact, several art schools have already dropped the exam from its admissions. (vi)
All in all, family’s income is indeed a factor that seems to pre-determine student’s attainment in the SAT tests, leading to a concerning problem of a poverty cycle. Although the weight given to the results in these tests seems to be decreasing over time and despite the evidence that these tests don’t measure the whole range of a person’s ability, they are still very widely used. Is it prudent to use an Aptitude Test score as a determinant to a person’s whole future career (and generations)?

What Predicts a Successful Life? A Life-Course Model of Well-Being
(iv) See: Genetics of brain function and cognition – Eco J. C. de Geus, Margaret J.Wright, Nicholas G. Martin, Dorret I. Boomsma

David Dias Pissarra. 728

Housing bubble effects in the US economy

In beginnings 2004, the United States faced a great inflation housing bubble, an increase in housing princes powered an increase in demand in the event of limited supply which takes a long time to adjust, the speculators enter the market convinced that they can make short run profits through quick buying and selling. With the purpose of reducing the impact of this event, the Federal Reserve desired to increase mortgage rates. But instead of the increasing the federal funds rate, i.e., an increase in short-term rates, it did not raise the long-term rates, as expected.

The yield on long-term bonds can be explained by three different variables: expected inflation, average short-term rates and a term premium.  The relation between them can lead to different results. According to Ben Bernanke chairman of United States Federal Reserve, the biggest contributor for the lower long-term rates is the decline in the term premium, which is nearly zero and sometimes even negative.

The central bank purchases of government debt are one of the motives that generate a very low term premium. Since the government debt is commonly used in transactions between financial banks as collateral, its demand continues firm regardless the low or below zero real return.

Bernanke, also stated that the inflows from the Global savings glut countries, that is when the desired savings by these countries exceed the desired investment, are an important explanation for a small long-term interest rates In the United States last years. Bernanke expressed concern about the significant rise in global supply of savings, whose implications in monetary policy can be adverse.  This occurrence also has an effect in rising global imbalances with respect to international current account balances.

Foreign governments and central banks with positive current accounts hold approximately half of the total amount of the treasury debt outstanding as international reserves. The recently financial crisis has increased the demand of treasury securities lowering treasury yields, which consequently implies a low or negative term premium.

The problem behind foreign governments wanting to purchase American government debt is related to the fact that it decreases the competitiveness of America by diminishing its exports due to the increase in relative price of the dollar.

United States Federal Reserve could through its available tools implement different fiscal policy in order to stop the reckless lending. For example, moderate inflation may be a useful device to increase long-term rates.

The American monetary policy may boost the exposure of foreign countries if they continue to accumulate reserves which become a weakening force to the American economy. A greater accumulation of reserves by the foreign governments will lead to higher dependency on domestic demand to the US economy. If the American government creates more treasuries that is highly demanded by the rest of the world, it would be able to borrow massively and consequently be able to invest in several areas such as infrastructure, education, research and development, health, defense, etc… If the Federal Reserve boosts interest rates by a small percentage it would make investments in treasuries more appealing besides that investors also consider the fact that dollars could appreciate in a few years.

If we consider the hypothesis of an increase in the interest rate the United States would sell more treasuries at the same time investing on debt from other countries. It would increase the number of Treasuries available on the market therefore it would demand the markets to deal with these new supply and would increase the long term rates which would help the economy to recover. Buying foreign debts would be good for these foreign economies which would decrease the value of the dollar and boost American exports helping to stabilize the financial system at a global level.




Burgers Talk

In the real world, there is always something between you and what you want. It is called price. Whether we do it rationally, consciously or simply without knowing, we always make our decisions taking prices into account.

Economists came up with the notion of the Law of One Price. Based on a set of unrealistic assumptions (for example, a riskless world), it suggests that identical goods should be priced the same everywhere. If not, there would be arbitrage opportunities which would be exhausted until prices reach equilibrium.

Well, but our world is not exactly as Economists wished for it to be. In reality, prices vary across countries and currencies. If in Portugal you may do something with 1€, you should not expect to do the same, for example, in Norway. The Purchasing-Power Parity Theory (PPP) states that global exchange rates should eventually through a time-consuming adjustment process make the price of identical baskets of tradable goods the same in each country. In reality, it is possible to move tradable goods from one place to the other, influencing prices and implicitly influencing the exchange rate.

When it comes to exchange rates, for simplicity, we can consider two types: the nominal exchange rate (determined by supply and demand) and the real exchange rate. The latter is a real variable, meaning it must be determined by real factors such as productivity and preferences. Real exchange gaps may persist for long periods of time, as long as corresponding gaps are financed by capital flows, but the threat of capital flow reversals may call for fast corrections.

In 1986, “The Economist” constructed the Big Mac Index – aimed to assess whether currencies are correctly priced by comparing the implicit exchange rate given by the prices of the burgers in any two countries and the exchange rate of the market. Surprisingly, the reasons behind choosing the Big Mac have nothing to do with hunger. You can basically walk into any McDonald’s in any country and get essentially the same good (characteristics-wise). The problem with this approach is that the price of a Big Mac also reflects labor and rent costs and taxation that differ greatly across countries and influence the final price. In this sense, the raw Big Mac index can only be considered an approximation and has to be used with caution, in order not to extrapolate wrong conclusions.

Using actual data from ‘The Economist’, we put our hands to work in order to assess the potential of such an exquisite economic index. We selected 7 relevant currencies (used the most important currency – USDollar – as our base), studied a 14y time-span and got something close to this:

For instance, regarding volatility, the raw Big Mac index clearly points to Argentinian Pesos. In this country, the great volatility can be explained by factors such as a low stagnant level of reserves and inflationary expectations that lead to a high degree of uncertainty among individuals. Consequently, foreign investors will perceive the country as less attractive, further depressing the economy into a recessive spiral.

Considering now our Euro experience, the index shows evidence of increasing appreciation against the USDollar until 2008 – after, the movement has precisely been the opposite. With the tremendous negative shock in 2008, European countries became less attractive to foreign investors who reduced their demand for their assets. Consequently, the price of these assets decreased, depreciating the exchange rate.

Moreover, it was fun to see what the raw Big Mac index tells us about the Chinese RMB. Before 2006, the Yuan did not change relative to the US Dollar as it was pegged to it, on a fixed exchange rate regime. However, after 2006, a floating regime was announced and the currency remained highly undervalued, a debate that is still ongoing. It naturally is a source of friction in the US by undercutting US goods that lose out to a cheap Chinese currency. As China’s economic growth is highly dependent on exports, the government wishes to keep the currency undervalued, boosting the trade balance. To keep the currency undervalued, the Chinese Central Bank demands large quantities of dollar assets driving its price up when compared to the Chinese currency. Also, the biggest average appreciation against the USDollar was exactly in 2008. After that dark year, the USDollar started regaining its value continuously.

In the graph below, it is possible to visualize what the raw Big Mac index suggests about: the unstable currency of Argentina; the deliberately undervalued Chinese Yuan; the new experiment of the Euro Area; and the always-been-strong Swiss currency.


690 and 697

The impact of the European Union sanctions on Russian economy.

“About 40 billion dollars a year are lost due to geopolitical sanctions imposed by EU” – said recently Minister of Finance of the Russian Federation Anton Siłuanow appearing on the International Economic Forum.

In relation to the involvement of Russia in the conflict in eastern Ukraine, the European Union have imposed sanctions on Russia, including economic ones that cover restrictions on access to capital market by russian banks and state companies from the oil and defence sector.

One of the entities sanctioned is Rosnieft, one of the biggest oil companies in Russia. The restrictions include a ban on the purchase, sale, provision of interest services or assistance in the issuance of securities and other financial instruments with maturities greater than 30 days. Those movements will strongly inhibit further investments and the growth of  the whole oil sector in Russia.

Since 2006 Russia started a controlled opening-up of energy sector to foreign investors in order to attract modern technologies and capital inflows into Russia and to gain access to foreign assets that can help corporations like Rosnieft to reinforce their positions in international markets. It was the turning point in foreign investors’ policy towards Russia and significant capital inflows began.

In 2012 Rosnieft signed a co-operation agreement with three leading foreign corporations. In exchange for access to Russian oil fields on the continental shelf as minority shareholders, those investors started financing and carrying out explorations there. Estimated costs of joint projects are about 500 billion dollars.

Intensive capital inflows, especially from direct foreign investments, might be a great chance for a developing country like Russia to increase industry’s efficiency, transfer new technologies from abroad and better allocate capital. On the other hand, if capital inflows are not managed correctly they can lead to overheat of the economy, increase of exchange rate volatility and eventually to huge unexpected outflows that harm the economy. Former change in Russian policy towards foreign investors encouraged them to invest and transfer capital to Russia. New macroeconomic policy, recently introduced, resulted in lack of confidence in domestic markets and external effects that are global sanctions led to large outflows from Russia that are estimated at over 100  billion dollars this year.

Current situation in Russia is exacerbated by the global decline in oil prices. Now, it hovers around 70 dollars (04-12-2014) per barrel. Price below 90 dollars forces the government to increase the debt or cut spendings because tax revenues are based on oil export. Low price of oil influences the rouble huge depreciation as well as sanctions imposed by the West and associated outflows of foreign investors from Russia.

In response to sanctions, Russia restricted imports of food from abroad which now will be an additional challenge. Imports will be even more expensive, and food prices will affect less affluent Russians. Problems are also indebted Russian banks in foreign currencies. According to analysts, the Russian banks should pay off in the last quarter of 2014 55 million dollars from interest and loan installments.

Because of western sanctions now virtually the only source in the Russian currency market is the Bank of Russia. Exporters reduced the sale of foreign currencies to a minimum, because we need the dollars and euros to settle their obligations. Russia has a foreign debt of around 130 billion dollars, which will have to be paid back by the end of 2015. However, due to the sanctions imposed by the EU, Russian companies have no access to international markets.

These sanctions led to a sudden slowdown of foreign capital inflows into Russia, phenomenon known as a sudden stop. This was then followed by a severe fall in GDP, private spendings and credit to the private sector, as well as an appreciation of the real exchange rate. The Central Bank says it expects no economic growth for Russia in the next two years, and an increase in the inflation rate. A large slowdown in capital inflows can be met either by a loss of international reserves or a lower current account deficit.

A lower current account deficit can be achieved through a decrease in the internal demand for tradable goods, translating into a reduction of imports. Since tradable and non-tradable goods are complements, the demand for non-tradable goods also fell, leading to lower output and a real depreciation of the currency, meaning that the relative price of non-tradable to tradable goods decreased. The value of the Russian rouble, which closely tracks the oil price, has already decreased 30% in respect to the dollar since the beginning of the year and a weak rouble makes the foreign debt even more expensive than what it already is.

Bez tytułu

Similarly to South Korea during its crisis in 1997, Russia is also now facing a slowdown in capital inflows, even though the reasons for this slowdown are different in the two cases.

In the case of Korea, the government opened up their capital markets to capital flows from abroad, which resulted in a lending boom. But because of weak bank regulator supervision, losses on loans started to mount. Big companies and banks became highly leveraged, because they were not effective in allocating money to best investments.

Just like South Korea, Russia also has a liquidity problem to pay back its huge external debt. The rouble also depreciated a lot compared to the US dollar. Russia should learn from the Korean case and allocate the money they have available in the best possible way, without influences from interest groups. Due to the uncertainty in bank lending, banks should be more careful to whom they lend money.

Today Russia is nowhere close to the sovereign default of 1998, since it is still running a current account surplus of about 50 million  dollars because it is importing less. The drop in oil prices should be met with an increase in government spending, and the low available reserves should be made available for bail-outs. Otherwise, some big companies and banks risk going into bankruptcy.

The Russian government should increase interest rates in order to attract foreign investment, and for this to be possible the EU should, of course, remove the sanctions imposed. Russia should also reform its financial system, but what the country needs the most is more competition, and so far nothing has been done by the actual government to achieve these goals.

Afonso Queiroz Aguiar 722
Maciej Kimel 763

Poland – Challenges of Fiscal Policy

The 2008 crisis depressed EU economies still Poland was able to avoid a contraction in GDP growth, partially due to a fiscal stimulus. Following Keynes’ theory, during a financial crisis a fiscal stimulus allows an increase in aggregate demand, thus avoiding strong economic crisis and smoothing business cycles.

Although Poland is one of Europe’s relative success stories, this economy has run consecutive budget deficits in recent years financed through Government Debt.

Despite the effort made by Poland after 2009 to decrease its deficit, its debt is increasing substantially. Nevertheless, indebtedness can be sustained for a long time if Poland’s fiscal adjustment is credible to investors. If financial markets believe Poland is able to repay its debt, i.e. there is a small risk perception. A relatively low return on government bonds is asked allowing Poland’s financing costs to not increase dramatically. This seems to be the case given that government bonds’ yields are relatively low, with real GDP growth ranging from 2 to 5 percent, along with stable inflation, as shown in the graph below.

1Data source: IMF

However, one should bear in mind whether this credibility can be sustained when faced with an increasing government debt. Until recently, even highly indebted, Poland have been paying an interest rate lower than its nominal GDP growth, allowing for the change in debt-to-GDP to be relatively low.

Nonetheless, a serious problem might arise if this scenario reverts. Poland has been showing a decreasing trend in nominal GDP growth which means that it might be the case that it ends up as several European countries, paying an interest rate higher than nominal GDP growth, leading to a snowball effect for the public debt (initial debt builds upon itself, becoming larger and larger).

Moreover, market expectations play an important role setting interest rates and might deepen this problem. Even though Poland’s debt-to-GDP is lower than some countries in the EU, creditors largely compare it to other Eastern European countries; in that matter Poland has one of the highest debt-to-GDP ratio. In addition, markets might feel that Poland’s ability to repay is decreasing. All these factors might drive investors to ask for a higher rate of return on debt, exacerbating the snowball effect. This may lead to the so called Self-fulfilling prophecy – the higher risk perception the higher the interest rate, and the higher the interest rate the higher the risk of non-repayment.

Despite the fact that Polish government has made an effort to reduce the deficit, it eventually has to repay its debt. And keeping postponing that commitment will necessarily imply larger future primary surpluses.

It is understandable that given the economic conjuncture of the 90s, structural reforms were needed and with that the necessity of higher deficits. However, due to the fact that Poland is now much more indebted, it has to take into consideration excessive deficits while trying to implement structural reforms, taking advantage of a future boom (applying again the same reasoning of smoothing Keynesian fiscal multiplier).

In the medium term, fiscal consolidation can be attained with other avenues rather than higher taxation. Enhancing cost efficiency in public administration is one of the objectives of Polish government, which is has one of the lowest cost efficiency in the OECD (OECD, 2010b). Nonetheless, implementing some of these key measures may be social and politically difficult constituting one of the major challenges in fiscal policy. Due to the large number of public employees in Poland, this measure has to be made carefully in order to avoid a promptly contraction of the internal demand (which has been one of the main boosters of the economy).

To sum up, Poland is seen as an example for the transition economies in Eastern Europe due to impressive results in catching-up other EU15 members. Still, it will have to manage the increasing debt and avoid following the path of other periphery countries. Markets seem very confident in Poland’s performance but as history has showed “animal spirit” is hard to predict and control for. It may be the case that the deficits will be inverted when the economy cycle starts to boom. Nevertheless, the later the fiscal adjustment the hardest it is for the economy.

#705 and #693


FT 1 2 3


A World without Cash – The limits of Monetary Policy

Money was created thousands of years ago and has ever since maintained its three primary functions as a medium of exchange, a standardised unit of value and a means of storage. Over time the format changed from commodity money to fiat money but it always stayed hard cash. Only with the transition into the information age, has electronic cash been introduced and with it the time has come to question whether hard cash is still useful.

Since the economic crash in 2008, economies around the world are trying to get back on their feet. America most of all suffers from a lack of demand and desperately tries Keynesian monetary policy to force an economic upswing. In an attempt to create investment incentives the key interest rates were pushed downward. This has led to the first time in history that the Federal Funds Rate has reached the zero percent mark on the 16th of December 2008. Ever since, the target rate has stayed at the 0-0,25% level which strongly limits the Federal Reserve’s room of manoeuvre.

This phenomenon known as the Zero Lower Bond can be overcome in a world without cash. Macroeconomic models suggest further decrease of the key interest rate beyond 0% but the opportunity costs of storing money at the bank will lead people to store in cash instead. In consequence the key interest rate cannot be pushed beyond zero as it would have no effect but rather lead to a bank-run. Only when cash is removed from this equation will people no longer have the possibility to store money under their mattresses, thereby eliminating the constraint of the Zero Lower Bond.

Now if Central Banks decide to set key interest rates lower than zero, commercial banks can pass those on to their customers, who can no longer avoid the policy. In consequence they will lose purchasing power by the minute, promoting their willingness to spend and thereby propelling the economy. Keynesian monetary policy regains impact.

The level of desperation to regain impact through monetary policy is illustrated through the latest actions of the European Currency Union. On 11th June the ECB, which commonly errs on the side of conservatism, set the deposit facility (effective for overnight deposits) to -0.1%. The goal is to penalise private banks that park money at the ECB. As a reaction Commerzbank, Germany’s second largest bank, announced to preserve its right to introduce a fee on large deposits. Or in other words, to introduce negative interest rates on deposits that are too big to fit under the mattress. Deutsche Bank is also said to consider similar actions.

European Central Bank Policy Rates

Featured image

The theoretical possibility of lowering key interest rates below zero in times of crises has been studied by the Federal Reserve of Cleveland. In a recent paper they pretend that unconventional monetary policy instruments such as Quantitative Easing or even forward guidance were not exploited during the heights of the crises (2009/2010). With this assumption they estimate that the efficient interest rate would have been around -5%. Holding such a negative interest rate would strongly encourage customers to shift their consumption pattern towards today rather than saving for tomorrow, finally diminishing economic downward spirals.

Apart from the positive effects on the potential of ECB interventions, a cash-free economy can also benefit the fight against criminality. Shadow economies including the black market can be observed significantly easier. A bank note does not tell where and how an illegal transaction takes place. An electronically registered cash flow, however, can be traced back to seller and buyer, eradicating the seller’s ability to stay unidentified. Forgery is made impossible and in the same breath tax evasion gets increasingly complicated, both due to registered cash flows.

Hence, cash-free economies hold significant advantages. They widen the possibilities of conventional monetary instruments and help to confine criminal activities.

Yet, for the timing being, cash remains to be an important way of performing monetary transactions. Especially nowadays, people are sceptical of being monitored in every step they take. Therefore a preference for being able to buy things without leaving traces, even if purchases are of a legal nature, stands in the way of eliminating cash. If a single currency regime tried to force the change into electronic cash, citizens could simply substitute it with foreign currencies or even digital currencies such as Bitcoin.

Still, the time being is a transition phase. Sweden is a pioneer in this regard, slowly pushing towards a cash-free society, in which even the homeless carry a credit-card reader. In the long-run, hard currency will be replaced by electronic cash and with it new possibilities in multiple areas of economics will open up.

Amery Gülker 761 and Lars Uden 744

Fisher’s Comeback

In 1929, just before things went south in Wall Street, Irving Fisher made a public claim that stained his spotless academic reputation. Days after claiming that stock prices had reached a permanently high plateau, the stock market crashed, followed by the Great Recession. Although he developed pioneer work in areas such as quantity theory of money and theory of interest, both widely applied and developed throughout the last century, his unfortunate statement drove the spotlight away from him and towards economists like Keynes. While barely noticed by the public at the time, it has been in the light of the current recession that some of Fisher’s work has received a renewed wave of attention, particularly his Debt-Deflation Theory of Great Depressions that attempted to explain recessions.

This work by Fisher puts debt and deflation at the heart of recessions. For Fisher, debt is the problem, or more specifically, debt-fueled investments made during the booms. Why? Because the loans taken up by firms and households during booms – periods where access to credit is widespread – are usually stated in rigid debt contracts whose terms and nominal value don’t change in the face of fluctuations in prices. Then, when this debt-fueled bubble bursts, agents are over-indebted and will rush to sell their assets in the open market, in what’s called a fire sale. Since so many people are trying to sell a bunch of assets at the same time, these assets will be transitioned at much lower prices (relative to their underlying quality value) and inevitably end up in less productive hands – what Fisher called supply side changes. So after selling assets for, let’s say, half their price, there will be less money circulating in the economy, meaning, the money supply will contract. In this situation of mass bankruptcy, these supply side disruptions can last for a long time: in a world with animal spirits where people are reluctant to trust each other, companies and entrepreneurial agents can’t go out there and borrow readily, which constitutes a real barrier to restart the economy.

The question that follows is of course: how then can future recessions be avoided? For a man who favored very limited government intervention, Fisher’s answer for this question is, curiously enough, a monetarist one: in the wake of Benjamin Strong – the chairman of the Federal Reserve Bank of New York who first supported a leaning against the wind monetary policy – Fisher argued for the importance of controlling prices as the most relevant tool for avoiding debt-deflation crisis. Namely, he believed the monetary authorities should aim to produce reflation (getting the price level back to its pre-deflation level), leading one to speculate that Fisher would have been sympathetic to the idea of boosting money supply in the context of the recent financial crisis to try to keep the economy on track (what we call discretionary monetary policy).

This is not to say that Fisher’s theory is a perfect fit for the current situation. Skeptics might claim that the financial crisis that started at the end of 2007 did not result in a major deflation in consumer prices, which would be inconsistent with Fisher’s model. Yet, while the size of the fall in prices might be debatable, even if we consider it was not significant, we could always hypothesize that the Federal Reserve’s monetary and fiscal measures prevented hyper deflation. The fact is, Steve Keen, acclaimed for soundly predicting the financial crisis, drew many notions from Fisher’s Debt-Deflation theory. Like Fisher might have suggested, Keen claims that the current global economic crisis is the result of too much debt.

Decades after his death, debt-deflation theory has become one of the main works associated with Fisher’s name. Time and context have washed away some of the skepticism that Fisher’s unfortunate approach in 1929 generate and it is now fascinating to see a century-old theory from one of the most notable classicists managing to make its way into current economic discussions.

Filipa Canas & Margarida Anselmo

The Norwegian Medicine for Dutch Disease

Winter is coming: and with it, flues! Indeed, we are actually writing this article with a box of tissues by our side. In order to bring a bit of this spirit into the world of macroeconomics, we decided to talk about another common yet not so known disease, named after the Dutch.  Put in simple terms, the Dutch disease refers to the negative consequences of large increases in a country’s income, generated by unilateral transfers or, as we’ll see in this post, by other phenomenon such as an increase in availability of a natural resource driving an export boom. This export boom will divide the economy in three – the booming tradable sector, the lagging tradable sector and the non-tradable sector[1]. With the Dutch Disease, the lagging tradable sector will be crowded out by the other two. This happens because with an increase in availability of natural resources, exports increase, domestic demand expands and there is a real exchange rate appreciation. If there is an increase on expenditure on domestic non-tradable goods and their price rises, the lagging tradable sector will be harmed losing capital and labor that will move away to the non-tradable sector.

Although the export boom may seem beneficial for the economy, there are plenty of examples that illustrate that natural resource abundance need not imply economic prosperity. Congo, rich in diamonds and gold, yet having the lowest GDP per capita in the world and nearly 49 million living under the poverty line[2]. Mozambique has a natural yearly capacity of over 100 million m3 of natural gas, a number putting it on the top 10 of countries with the largest extraction worldwide, but it’s placed 178th out of 187 on the United Nations Human Development Index. Russia, Venezuela, Saudi Arabia… none of these countries escaped this dreadful illness. So what made Norway so special?

That little kingdom is surprisingly one of the few countries in which an unexpected and large natural resource discovery actually catalyzed growth. The massive oil discovery in Norway took place in the late 60’s, and although it was firstly explored and fully financed by private companies such as Philips Petroleum Company, it was soon taken over by the Norwegian government. Contrary to what we would expect, that poor, austere economy prospered: GDP is growing at a relatively fast pace since the 1970s. In 2012, the oil sector represented 23% of GDP, 30% of government revenue, 29% of total investment and 52% of exports[3].

Moreover, the Viking’s land managed to stay with a real exchange rate that did not deviate considerably from the equilibrium value[4]. Fluctuations occurred around an apparently stable equilibrium level.

Back to our question, then. What’s the Nordic recipe for dodging a disaster?

Besides being privileged by an unique background featuring a highly educated workforce and a corruption-free environment, the government had a very important role with the creation of a sovereign wealth fund known as The Oil Fund. There, 96% of Norway’s oil earnings are placed for savings which are non-withdrawable until oil runs out and, most importantly, are non-investable inside Norway. The creation of this fund acts as sterilization, and the oil revenue flowing out of the country prevents inflation.

In addition, the government also applied a specific tax system to the oil sector that made possible to recollect, in addition to a 28% tax rate over the profit of all oil companies, an extra tax of 50% over the sector. The government collects 78% of the revenues from the oil companies, and despite the high taxes that harm firms and households, Norway’s institutional wonders compensate for that loss.

So as you can see, the answer doesn’t lay in the barbarian Nordic DNA. Credibility of governors and institutions, along with planning, long-term vision and self-discipline may lead the way!

#701 and #743

[1] Corden, Neary, 1982

[2] Banque Central du Congo

[3] Norwegian Petroleum Directorate

[4] Real equilibrium Exchange rates for Norway, Q.Farooq Akram

Would you exchange your US dollars with Venezuelan bolívares?

When traveling to Venezuela with your euros or US dollars you might wonder how much your money is actually worth when converting it into Venezuelan bolívares (VEF), the local currency since 2008. Well, the answer is: it depends. Venezuela is well known to have one of the most complicated foreign exchange regimes in the world. At the moment, the South American nation handles four different exchange rates, among which just three are functioning within the legal framework. Besides the country’s official exchange rate, the Venezuelan government set up two alternative exchange rates, called Sicad and Sicad 2. The fourth exchange rate, the illegal one, has been created by the black market.

But how did Venezuela ended up having such a complicated exchange regime? Having the largest proven oil reserves in the world, Venezuela’s oil revenues represent about 95 per cent of the country’s export earnings. Since the industrialisation of the oil sector about 100 years ago, today, this sector accounts for about 25 per cent of Venezuela’s gross domestic product. In consequence, the important role of oil exports is the explanation why a change in world oil prices has significant influence on Venezuela’s economic structure and exchange rate system. The figure below demonstrates the high correlation between world oil prices and the equilibrium real exchange rate in Venezuela.


Source: International Financial Statistics, World Economic Outlook

Higher world oil prices result in higher prices in the domestic oil sector and to an increase of capital inflow and government expense, which in turn leads to an increase in prices of non-tradable goods. As a consequence, the local currency becomes stronger in comparison to other foreign currencies and the real exchange rate appreciates. This phenomenon is known as the Dutch disease, a mechanism that can be observed in countries that experience a high increase in natural resources. As seen in the figure above, the high fluctuation of the real oil price has been leading to an unstable equilibrium exchange rate for VEF. Besides a production decline and an increasing appreciation pressure due to recent macro-policies, the high fluctuation of oil prices and the government’s policy responses have been the determinants for the troubled exchange rate system Venezuela experiences today. (IMF, 2006)

In order to overcome the high fluctuation of its real exchange rate, the Venezuelan government has had numerous exchange rate regimes and foreign exchange controls over the past several decades. A notable fixed exchange rate regime, which was maintained from 1930 to 1983[1], led the Venezuelan currency to be perceived as one of the most stable in the region during that period. In 2003, after national oil strikes brought the country into a severe recession, Venezuela’s president at that time, Hugo Chavez, opted again for a fixed exchange regime by pegging the local currency to the US Dollar (USD) and applying additional currency controls.

Besides the positive aspects of having fixed exchange rates, countries dealing with peg regime often face its disadvantages. In the case of Venezuela, one of the most pressing economic problems resulting from the fixed exchange rate has been the overvaluation of its domestic currency. When Chavez pegged the exchange rate in 2003, the Venezuelan currency was already overvalued by about 32.4% relatively to the USD. Additionally, Venezuela’s inflation has been much higher in comparison to its major trading partners in the last decade. Holding the nominal exchange rate fixed, led to a currency appreciation in real terms and to an increasing overvaluation of the VEF. As a consequence, Venezuela’s imported goods became by far cheaper than domestic production and this has been harming the development of non-oil sectors, especially manufacturing. The overvaluation of the domestic currency, combined with currency controls imposed by Chavez, led to the existence of an illegal parallel exchange rate for US dollars in Venezuela. Meanwhile, in order to tackle the rapid overvaluation, the Venezuelan government began to devaluate the domestic currency on an irregular basis. The high number of devaluations, (the last official devaluation took place in 2013 and was the fifth one in nine years), led people to lose confidence in the domestic currency. This scenario where people were loosing trust in their domestic currency was further aggravated by the restrictions imposed by the government on the amount of US dollars they could own and demand from the government.

All this led to an increasingly larger gap between the official and the black market exchange rates to the extent that on 2 October the non-official exchange rate traded at 96.6 VEF per USD, while the fixed exchange rate trades at 6.3 VEF per USD. The government, in order to reduce the gap and ease the shortage of dollars, firstly introduced Sicad in 2013, which is a currency exchange operating at a floating rate, and later in 2014 the Sicad 2, promoted as a free-market platform where people would be able to buy and sell dollars without restriction on a daily basis. How the government should proceed at this point is hard to say, it is clear that from any new policy there is both to gain and to lose for a country with a troubled economy such as Venezuela.

Giulia Casagrande, 745

Karoline Hormann, 756