It is often difficult to understand how countries that are dealt a pretty good economic hand can end up making a major mess of things. It is as if they were trying to commit suicide by jumping from the basement.
Two of the most extreme cases (but not the only ones) are Argentina and Venezuela, countries that have benefited from high prices for their exports, but have managed to miss the highway to prosperity by turning onto a dead-end street. They will eventually have to make a U-turn and backtrack over the terrain of fictitious progress.
The puzzling thing is that this is not the first time either country has veered into an economic cul-de-sac. It has been said that only barbers learn on other people’s heads, but some countries seem unable to learn even from their own experience. The ultimate reason for such self-destructiveness may be impossible to identify. However, it is certainly possible to describe how the road to hell is paved, whatever the intentions.
It all starts when some imbalance causes overall inflation or some key price — typically the exchange rate, but also power, water and gasoline — to come under upward pressure. The government then uses its coercive power to keep a lid on price growth.
For example, Brazil has wreaked havoc on the financial health of its national oil company, Petrobras, to keep gasoline prices low. Argentina destroyed its natural-gas sector with price controls. Many countries have kept power and water prices too low and have ended up with shortages.
However, things become really nasty when the government opts for foreign-exchange controls. The usual story, nicely summarized by the late Rudiger Dornbusch and Sebastian Edwards, is that lax fiscal and monetary policies cause a flood of freshly printed currency to chase more US dollars than the central bank can provide at the going exchange rate. Rather than let the currency depreciate, or tighten its policies, the government opts for foreign-exchange controls, limiting access to dollars to those who “really” need it and thus preventing “speculators” from hurting “the people.”
Foreign-exchange controls, typically accompanied by price controls, give the government the sense that it can have its cake (lax policies) and eat low inflation. However, controls lead to a parallel exchange rate, which can be either legal, as in Argentina, or illegal and even unpublishable, as in Venezuela.
However, having two prices for an identical dollar creates enormous arbitrage opportunities. A dollar purchased at the official rate can be sold for almost twice as much in the “blue” market in Argentina and a whopping 10 times more in Venezuela. Repeat that game a few times and you will be able to afford a corporate jet. Nothing becomes more profitable than over-invoicing imports and under-invoicing exports. In Venezuela, importing spoiled food and letting it rot is more profitable than any investment anywhere else in the world (disregarding, of course, the bribes needed to make it happen).
The dual-exchange-rate system ends up distorting production incentives and causing the effective supply of imported goods to decline, leading to a combination of inflation and shortages. Here, things turn interesting. Public spending tends to rise with inflation more than government revenues do, because revenues depend on the tax on exports, which is calculated at the pegged official exchange rate.