Everything You Need to Know About Sales Tax Nexus

By: David Behrens

The decision of Wayfair v. South Dakota seems to have opened the door for states to collect sales tax on internet purchases. But is it really that simple?

On June 21, 2018, a Wall Street Journal news alert flashed up on my phone: “Supreme Court Rules States Can Collect Sales Tax on Web Purchases.” This alert was the decision of Wayfair v. South Dakota, a case that was brought to court in 2016.

My initial reaction was one of dull exasperation: great, more taxes– and on e-commerce at that. Stock prices for Amazon and other online retailers dipped, reflecting pessimism about how consumers would respond to these changes.

The WSJ headline, though unintentionally so, was severely misleading, something I only realized after researching the case pretty intensively. It implies– falsely– that web purchases weren’t taxed before Wayfair. In reality, the Wayfair case drew a crucial line in settling hopelessly complex conflicts over various sales tax regimes in the U.S.

The central point of contention in Wayfair and the nationwide sales tax battle is the determination of nexus. Nexus is the relationship between a business and a state which constitutes the business’s responsibility to collect and remit the state’s sales tax.

Before Wayfair, businesses had nexus in a state if and only if they had a physical presence in the state. However, South Dakota made laws, called economic nexus laws, saying that out-of-state online retailers had nexus in South Dakota if they met certain conditions. For example, businesses only have nexus in South Dakota if they make $100,000 or 200 distinct sales to South Dakotan consumers in a year. The state also provides a compliance software to help businesses collect and remit the appropriate taxes; businesses who use the software are immune from accounting errors. South Dakota’s victory in the Wayfair case confirmed their ability to enforce their pre-existing laws. 

If you, like me, are generally not enthusiastic about taxes, then South Dakota probably sounds like the bad guy in this scenario. However, further research brings us back to a longstanding axiom of state fiscal policy: New York and Massachusetts were already doing something much worse.

In 2008, New York began enforcing a system of “click-through nexus laws,” which I’ll illustrate with the following example. A consumer visits NYReferrals.com (located in New York). They follow a referral link to buy something from NYReferrals.com’s affiliate, MEGoods.com (located in Maine). New York’s laws say that the New York website is a physical object which gives MEGoods.com nexus in New York; MEGoods has to collect and remit New York’s sales tax (Avalara 2016).

The “cookie nexus” system pioneered in Massachusetts is arguably even worse. Say a consumer in Massachusetts buys something from MEGoods.com, and the website leaves “cookies,” cached files, or other software on the consumer’s computer. Massachusetts considers those virtual entities physical items, meaning they can assign nexus to MEGoods.com (Blocker 2017).

A handful of other states have used click-through and cookie nexus laws for several years now. These laws use absurd definitions of physical presence to abuse the legal precedent overturned by Wayfair. The Supreme Court had this aspect in mind when they deemed the physical presence rule unsound.

Because this case involves state fiscal policy, there are a lot of moving parts, but there are some pathways to simplification. There is a coalition of 22 states in the Streamlined Sales and Use Tax Agreement (SSUTA). These states have worked together since 1999 to make their own economic nexus laws, which are similar to the ones in South Dakota. Some of these states automatically gained the ability to enforce those laws following the Wayfair decision; other states can do so as soon as they pass enabling legislation.

States such as New York and Massachusetts will hopefully abandon their subversive tax laws in favor of more transparent economic nexus regimes. Other states without any remote seller laws on the books have a clear guideline for which ones to make now that they can. The 5 states without any sales taxes don’t have to do anything, though some of them aren’t thrilled with the way that Wayfair may affect in-state businesses. For instance, New Hampshire Governor Chris Sununu has stated that he will pursue legislative action to prevent other states from forcing New Hampshire’s businesses to collect sales taxes.

Congress may also act on this issue; a week after the Wayfair decision, senators introduced an act to prevent states from forcing out-of-state businesses to collect and remit sales tax. This act also gives a specific definition of physical presence which cannot be subverted by click-through and cookie nexus laws.

The Wayfair decision’s aftermath should make us more cautious about how we instinctively process information. As someone who is passionate about fiscal policy and economics in general, even I fell for the Wall Street Journal’s misleading headline at first. Unfortunately, most consumers did too.

It’s very concerning that Amazon’s stock price fell as a result of Wayfair. Amazon has been collecting and remitting state sales taxes for years, largely because it has physical presence (warehouses, etc.) in virtually every state. Wayfair levels the playing field for small and medium-sized retailers who didn’t previously have nexus in other states. By all means, Amazon’s stock price should have gone up following the decision. Unfortunately, investors were tricked into believing simplistic mischaracterizations of the Wayfair case– or at the very least, they predicted that consumers would be tricked this way.

Personally, the Wayfair decision leaves me cautiously optimistic. No matter what happens, it’s likely that abusive physical presence claims from tax-happy states will no longer obscure the tax code. Economic nexus laws are a solid step toward transparency, and they won’t ruin online shopping as you may have been led to believe.

Works Cited:

Image Source: https://c.o0bg.com/rf/image_960w/Boston/2011-2020/2018/06/21/BostonGlobe.com/Business/Images/59a7b1d0d3e24257b005fd85b6d916f7-59a7b1d0d3e24257b005fd85b6d916f7-0.jpg

Bishop-Henchman, J. (2018, September 05). What Does Wayfair Really Mean for States, Businesses, and Consumers? Retrieved from https://taxfoundation.org/what-does-the-wayfair-decision-really-mean-for-states-businesses-and-consumers/

Blocker, R. (2017, August 10). Sales Tax Slice: ‘Cookie’ Nexus Returns. Retrieved from https://www.bna.com/sales-tax-slice-b73014462999/

A Guide to Click Through Nexus – Avalara. (n.d.). Retrieved from https://www.avalara.com/us/en/blog/2016/06/a-guide-to-click-through-sales-tax-nexus-for-small-businesses.html

J. (2018, June 28). S.3180 – 115th Congress (2017-2018): Stop Taxing Our Potential Act of 2018. Retrieved from https://www.congress.gov/bill/115th-congress/senate-bill/3180

News Release. (n.d.). Retrieved from https://www.governor.nh.gov/news-media/press-2018/20180628-sales-tax.htm

Nexus Chart – Remote Seller Nexus Chart. (n.d.). Retrieved from https://www.salestaxinstitute.com/resources/remote-seller-nexus-chart

Office, U. G. (2017, December 18). Sales Taxes: States Could Gain Revenue from Expanded Authority, but Businesses Are Likely to Experience Compliance Costs. Retrieved from https://www.gao.gov/products/GAO-18-114

How are Economists Portrayed by the Media? Let’s Ask Them.

By: David Behrens

Economists have received more attention from the media in the past decade than ever before. Finally, economics is accessible to the public. However, this newfound relevance has brought economists some negative attention; there is a litany of recent hit pieces targeting the profession as a whole. This article enlists economists Tyler Cowen, Scott Sumner and Alex Tabarrok, who give their thoughts on these new developments.

Modern political discourse is undoubtedly as polarized as it has ever been. The increased attachment of cultural attitudes to political positions has augmented people’s desires to definitively “shut down” their intellectual opponents. Citing experts is one very popular way of doing so, and economists have recently been thrust into the limelight because of the political implications of their work.

Despite this exposure, many people don’t know what economists actually do. For instance, when I tell people I’m an economics student, they unfailingly respond either by asking, “So you work in the stock market?” or “OK, so would you agree that [their political opinion]?”

I usually answer no to both questions. My job as a student of economics is simply to make sense of how people make decisions when faced with certain alternatives; that is the goal of economics in a nutshell, and there are countless different kinds of economists who apply this goal in more specific ways. Not all economists work with stocks, and not all economists agree with your political opinions (or anyone else’s). The purpose of this article is therefore to illustrate the caricature of economists created by the media, and to set the record straight with the help of three leading members of the field. Ultimately, I hope to show that economists are normal human beings, for better or for worse.

Economists as Cultural Entities

“Economists have completely failed us. They’re no better than Mystic Meg.” This is the title of a 2017 Guardian article by Simon Jenkins claiming that the entire study of economics “neglects human behavior” and is “plagued by the spurious exactness of mathematics.” These are tired stereotypes, and you’ve probably heard them before—they make good talking points and complement the idea that economists are cold-blooded financial-sector stooges who are irrelevant in the real world. Jenkins’s article is a response to a small group of Bank of England economists wrongly predicting an economic downturn following the Brexit referendum. However, the article’s title is strikingly broad, and most of it refers to the field as a whole.

Jenkins’s coworkers at the Guardian are similarly prone to using such sweeping generalizations, if for entirely different purposes. Recent Guardian headlines include “Bank economist calls for counselling for primary school pupils,” “More than 1,000 economists warn Trump his trade views echo 1930s errors,” and many more.

This phenomenon is not limited to The Guardian, of course; every major news source has done it and their audiences eat it up. During the 2016 election campaign, you most likely heard the phrase “170 top economists,” used to describe some economists’ support for Bernie Sanders’s financial reform plan, countless times. Perhaps your fiscally conservative friends have insisted that “minimum wages are bad, it’s basic economics.”

If anything, the conflict between articles slamming the economics profession and those glamorizing it should remind us to separate individuals from their employers and professions, but it won’t be easy. Countless buzzword-riddled phrases have bled into the public from all kinds of media outlets intent on hijacking the credibility of modern academics for the sake of strengthening a narrative. So, we must start with the all-important question: why are they wrong?

What are Economists Really Like?

There are many economists in the world, but they don’t all have the same opinions on any subject. Economics is a science which is conducted in many ways, within many subfields. However, the tendency of some economists to endorse certain political views is enough for journalists to represent their personal opinions as academic orthodoxy, no matter what those opinions are. If they find it difficult to do so, they may, like Simon Jenkins, attempt to discredit the profession entirely. Both approaches unfairly give the impression that economists form a singular ideological community, which undermines the variety of ideological and professional communities within the field. These communities (particularly schools of thought like Keynesians, Monetarists, and others) all contribute something to the field, but none define it.

Furthermore, the large communities that do exist within the economics profession are nothing like the rigid, dogmatic caricatures created by the media. For instance, the world’s most popular economics blog, MarginalRevolution.com, consists almost entirely of references to other economists’ work, which in turn often refutes or expands upon other work. Most popular economics writers do this, and the prevalence of blogging within the profession has created a large, interconnected network of intellectuals accessible to the public. This community has an air of curiosity and open-mindedness far beyond what most journalists give them credit for.

The Experts Weigh In

I spoke with Tyler Cowen and Alex Tabarrok, the GMU economists who write MarginalRevolution. I also contacted monetary economist Scott Sumner, who writes the popular blog TheMoneyIllusion.com. These are three of the world’s most well-known economists. I asked them several questions, starting with their general opinion of the recent negative press around economists. Cowen remarked that economists were “still relatively high-status, for better or worse.” Tabarrok was more vocal:

It is the best of times. It is the worst of times. It is not uncommon, for example, to see critiques of economics in the media which are about as sophisticated as saying “look at those silly physicists who think that a bowling ball and a feather fall at the same rate.” Even people who should know better like David Suzuki say ridiculously, obtuse things when it comes to economics–perhaps for ideological reasons.

At the same time, the quality of the coverage of economics in the media is often excellent and has never been better. Greg Ip, David Leonhardt, Catherine Rampell, Adam Davidson, Stacey Vanek Smith, Cardiff Garcia, Megan McCardle all do superb economic commentary and reporting not just about the economy about economics. And those are only the people off the top of my head, I could name many more.

The public also has access to top economists through the blogs and social media. I would count Paul Krugman, Tyler Cowen, John Cochrane, and Jeniffer Doleac in this category.

While some people claim that economics is out of touch or obsolete, economics passes the market test. Economists have never been more in demand. Designing new types of markets is a big part of the internet economy and computer scientists, followed by economists, are the leaders in this field. Google and Facebook run billions of dollars of auctions using what was once an obscure economic theory (Vickey-Clarke-Groves auctions). Google, Facebook, Uber and Airbnb all hire economists to better understand data and design new economic mechanisms. Even some online games like Eve Online are hiring economists to help to run virtual economies–one such economist, Yanis Varoufakis, went from a virtual economy to a real economy when he became Greece’s Minster of Finance.

If you want to understand the world and make it a better place there is no better degree than an economics degree because it is so versatile.

Scott Sumner added:

Reporters tend to see economists as being too narrow in their perspective, not understanding the complexity of human behavior, culture, politics, etc.  There is a bit of truth to this, although often not in the way assumed by reporters.  Thus the problem is not too much reliance on rational expectations and efficient markets models (which actually are useful), nor is the problem not enough focus on “behavioral economics”.

I asked the economists if any of their work was affected or even motivated by popular stereotypes about their profession. Though their writing often seems to contradict these stereotypes, they gave the impression that this was coincidental. “I would just say that I write and blog what appeals to me,” wrote Cowen. Sumner replied:

I’m not sure if my work is motivated by stereotypes, as I don’t set out to boost the prestige of economics.  But I often take contrarian views, where I think economists have too shallow an understanding of a particular issue, such as monetary policy.  Like Tyler Cowen, I believe that complex issues must be considered from many different perspectives, and that many economists focus too much on the implications of a single (unrealistic) model.  But my motivation is just to do good economics as I see it—if my methods are an implied rebuke to the dominant approach in the profession, then so be it.

Cowen, Tabarrok and Sumner seem optimistic about their field of study and even about the public’s perception of it, flawed as that perception may sometimes be. They’re enthusiastic about the development of economic methodology and its growing relevance. As writers and professors, they stoke that enthusiasm in upcoming generations of economic thinkers, myself included.

Economists are human beings, and human beings have opinions. Economists’ opinions may be informed by their professional study, but other economists will always have a good counterargument for them. As is the case with most fields outside the natural sciences, there is no objective—or even overwhelming—consensus among economists about anything. If there was, you can be sure that the media would reference this pseudo-community much more fervently than it already does. In the meantime, most economists’ research is publicly available, and many also write blogs. Judging the merits of their work on an individual basis is something we’re all capable of—that is, if we’re serious about what it means.

Bibliography

Easley, J. (2016, January 14). 170 Economists Endorse Bernie Sanders’ Plan To Reform Wall St. And Rein In Greed. Retrieved from Politics USA: https://www.politicususa.com/2016/01/14/170-economists-bernie-sanders-plan-reform-wall-st-rein-greed.html

Hunter, B. (2017, April 5). After Studying Basic Economics, Mayor Vetoes Minimum Wage Increase. Retrieved from Foundation for Economic Education: https://fee.org/articles/after-studying-basic-economics-mayor-vetoes-minimum-wage-increase/

Jenkins, S. (2017, January 6). Economists have completely failed us. They’re no better than Mystic Meg. Retrieved from The Guardian Online: https://www.theguardian.com/commentisfree/2017/jan/06/economists-economic-policy-brexit-crash-failure

Moran, C. (2018, April 18). Why the problem is economics, not economists. Retrieved from openDemocracy: https://www.opendemocracy.net/neweconomics/problem-economics-not-economists/

Rushe, D. (2018, May 3). More than 1,000 economists warn Trump his trade views echo 1930s errors. Retrieved from The Guardian Online: https://www.theguardian.com/us-news/2018/may/03/donald-trump-trade-economists-warning-great-depression

Sumner, S. (2018, May 8). A little bit of knowledge is a dangerous thing. EconLog. Retrieved from http://econlog.econlib.org/archives/2018/05/a_little_bit_of_1.html

The Economist. (2018, May 3). Economists focus too little on what people really care about. The Economist. Retrieved from The Economist: https://www.economist.com/news/finance-and-economics/21741563-fourth-our-series-professions-shortcomings-economists-focus-too

Weale, S. (2018, April 26). Bank economist calls for counselling for primary school pupils. Retrieved from The Guardian Online: https://www.theguardian.com/education/2018/apr/26/bank-economist-andy-haldane-counselling-primary-school-pupils-mental-health

Image source: https://financialtribune.com/sites/default/files/field/image/17january/04-zs-iranian_economists_875-ab.jpg

The Tabarrok Curve: A Call for Patent Reform in the US

By: David Behrens

Economic theory indicates that the modern US patent system is counterproductive. How can we change this?

Consider the following sketch:

Picture2.png

This is the Tabarrok Curve. Its appearance on a napkin is an homage to the Laffer Curve, Arthur Laffer’s massively influential idea that increasing tax rates could reduce tax revenues, which Laffer first illustrated on a bar napkin. Alex Tabarrok, a George Mason professor and co-author of the famous blog MarginalRevolution.com, chose the same medium to casually introduce his ideas on patent laws in America. The insight conveyed in this curve is that the US patent system in its current form discourages innovation by making it costlier, rendering patent laws largely counterintuitive.

Where do Patents Go Wrong?

Patent laws are put in place to create incentives to innovate, or rather to remove disincentives which may cause innovators to hesitate. The Austrian economist Joseph Schumpeter, famous for comprehensively introducing the concept of creative destruction, was one of the first to note that innovation is partially motivated by the potential to hold monopoly power; that is, if a firm discovers something new, they can temporarily enjoy substantial profits from selling it exclusively while other firms catch up. Patent laws are intended to augment this incentive by ensuring that firms cannot simply copy a product that has been patented. This provides a cushion which makes firms more comfortable with the idea of introducing new products.

Unfortunately, many firms operating within the current patent system are too comfortable. Patents create barriers to entry for firms (especially small ones) which may otherwise grow and generate more innovation. Moreover, patents intended to delay firms from entering new markets may stop them altogether, preventing them from building on the progress of similar producers who hold patents, and thus impeding innovation. For instance, when the iPhone and other smartphones were first introduced a decade ago, the market quickly became saturated in legal red tape, in what were known by some as the “smartphone patent wars.” This led to the smartphone market being dominated largely by well-established tech companies, which may or may not have been avoidable.

Meanwhile, firms enjoying monopoly power are able to keep prices above the equilibrium brought about by more competitive markets, so consumers lose out. The current laws also empower “patent trolls,” which are firms or their representatives who threaten legal action against potential competitors, even when they have a weak or dubious case. Patent trolls are notoriously persistent, and unfortunately, the modern legal structure of patents is both strong and complex enough to allow these trolls to intimidate small firms and prevent them from releasing their own inventions.

Tabarrok argues that at some point, it is more costly to produce copies of existing products than to create new ones. After all, only innovation has the potential to bring about coveted monopoly profits. It’s therefore likely that the patent system addresses problems that aren’t as severe as one would expect. In addition, it fails to provide a solution to patent disputes in which two firms make a new discovery at the same time, even though these disputes are among the most common.

In various works, Tabarrok has advocated for U.S. patent laws in most sectors to be significantly weakened, which he believes will have a net benefit on economic growth. However, he is not dogmatically committed to such reductions; in fact, he believes that patents in the U.S. pharmaceuticals industry should be strengthened, due to the unique nature of that industry. To be specific, FDA testing requirements and other regulations make innovation in pharma extremely expensive; in fact, a recent study estimates that the average costs of producing a single approved new compound add up to about 3 billion dollars. On the other hand, imitating publicly available drugs is cheap and easy. In this case, without strong patents, the period of monopoly profit experienced by an innovative firm could never last long enough to compensate for the high costs of testing and discarded compounds, so pharmaceutical firms wouldn’t even bother attempting to innovate.

This scenario makes one wonder if there are other cases in which patent laws act as a necessary evil. Such cases would most likely involve goods markets which, like pharma, carry high costs of innovation and relatively easy imitation of existing products. One of the first sectors that comes to mind is the automobile industry, which, like pharmaceuticals, is highly regulated, leading to high innovation costs. However, it is different in many crucial ways, the most important being that the automotive industry is much more production-based than pharmaceuticals, and less reliant on consistent innovation. In addition, many new innovations in the automotive industry are relatively small, and it’s very unlikely for a manufacturer to come up with anything game-changing enough to garner monopoly power in the Schumpeterian sense (though companies like Tesla are beginning to expose a growing potential for unique innovations). Also, automobile producers never imitate their competitors’ products completely; for example, Ford will never produce a Chevy Silverado.

Based on these and other factors, it seems that innovation in the automotive industry is lucrative enough not to merit stronger patents, as evidenced by the willingness of firms to introduce innovations like heated seats, hybrid technology, interactive navigation systems and more, which have all quickly become ubiquitous. It’s much more likely that this industry is, like most others, beyond the Tabarrok Curve’s maximum. However, it is probably not as far along the curve as some other sectors such as personal electronics. This leaves one wondering if there is an effective way of evaluating each sector’s position on the curve, and how doing so could allow for the pursuit of more effective patent laws.

Tabarrok in His Own Words: What Should be Done?

I contacted Alex Tabarrok asking for insight on this issue. He was gracious enough to respond within a day with the following comments:

Yes, I agree with you that where we are on the ‘Tabarrok Curve’ will vary by industry. The diagram is a judgment call but meant more to get people thinking than anything else. … [Patent] theory says we need patents when innovation costs are high relative to imitation costs. Yet, patent law ignores this entirely. Everyone with a novel, non-obvious idea gets a 20 year patent, for example, regardless of whether their innovation costs were a billion dollars or $20. Ideally, we would have different patent terms by R&D costs. We do have R&D tax credits so this doesn’t seem impossible but a simpler system would go by industry, say shorter terms for software patents than for pharmaceuticals. An even simpler system would offer say three classes of patents 2, 10, and 20. The nice thing about this system is that we could encourage people to self-identify by saying if you ask for a 2 year patent we are in all likelihood going to approve it quickly but if you ask for a 20 we are going to ask for more information about R&D costs. In this way, the system would require less top-down planning.

I encourage you to look further into Tabarrok’s writing (see References) for more information regarding the current patent system and its disregard for patent theory. Essentially, the takeaway from his work is that patents are too strong to be useful in most industries, and that there are many politically viable ways of reforming the patent law system, preferably so that it is based on R&D costs. In a developed country like the US, innovation is the most important source of long-run economic growth, making such reforms crucial.

References

DiMasi, J. A., Grabowski, H. G., & Hansen, R. W. (2016, May). Innovation in the pharmaceutical industry: New estimates of R&D costs. Retrieved from https://www.ncbi.nlm.nih.gov/pubmed/26928437

Optimist, R. (2015, September 23). The Tabarrok curve. Retrieved from http://www.rationaloptimist.com/blog/the-tabarrok-curve/

Segal, D. (2013, July 13). Has Patent, Will Sue: An Alert to Corporate America. Retrieved from http://www.nytimes.com/2013/07/14/business/has-patent-will-sue-an-alert-to-corporate-america.html

Tabarrok, A. (2002, 01). Patent Theory versus Patent Law. Contributions in Economic Analysis & Policy, 1(1). doi:10.2202/1538-0645.1039

Worstall, T. (2013, June 24). The Tabarrok Curve: Why The Patent System Is Not Fit For Purpose. Retrieved from https://www.forbes.com/sites/timworstall/2013/06/23/the-tabarrok-curve-why-the-patent-system-is-not-fit-for-purpose/#6b280a335d25

I. (2015, June 29). Sequenom case leaves pharma confused over patent law. Retrieved from https://www.in-pharmatechnologist.com/Article/2015/06/30/Sequenom-case-leaves-pharma-confused-over-patent-law

Inflation in Perspective

Yes, inflation is an increase in prices. But what does it mean in the larger scale of things?”

By David Behrens

        If you ask an average person what inflation means to them, you may expect them to say it’s an increase in prices. This isn’t that far off from the economically accepted definition, where inflation is the percentage increase in the price index over time. However, the definition of inflation is meaningless without understanding its implications, and most ordinary people don’t realize how complex these implications are. We hope to illustrate the differences between causes and effects of inflation in various cases, and shed light upon current and possible methods to deal with the phenomenon financially and politically.

What Inflation Isn’t

        Inflation, by definition, doesn’t necessarily decrease purchasing power, contribute to financial bubbles or harm the overall economy. In fact, contrary to popular belief, inflation isn’t even a bad thing sometimes. It is a natural byproduct of how a nation’s policymakers control the money supply in response to their analysis of the economy. However, this process of evaluation is crucially important, as are the corresponding actions. So, the question becomes: What does this entail?

Money Management in America

Since 1913, the United States Federal Reserve System has been responsible for monetary policy in the U.S. Technically, it is privately owned and operated, but its functions are indisputably connected with those of the government. Today, the Federal Reserve sets Required Reserve Ratios for banks, mandating that a certain proportion of a bank’s assets (currently 10%) be held as reserves to avoid liquidity issues. The Fed also sets capital requirements, acts as the lender of last resort, regulates lending, and insures banks in the U.S. via the Federal Deposit Insurance Corporation (FDIC).

Since 1978, the Fed has also been responsible for “stabilizing the macroeconomy” by attempting to keep interest rates steady at about 2%, in conjunction with keeping the economy at the estimated full unemployment rate of 4.5%. The Fed does this by manipulating the money supply and interest rates through a process called open market operations. For example, to increase the quantity of money, the Fed will buy bonds from some bank in the market, causing that bank to have more loanable funds available. That bank, in turn, will loan out as many of these funds as they can while maintaining the required amount of reserves. This process repeats in a cycle, resulting in a higher quantity of money and a lower interest rate. It should also be noted that the Fed does not print or coin physical money; two departments within the Treasury do this in accordance with the quantity of money controlled by the Fed’s open market operations. The Fed will engineer inflation with these operations in accordance with the stabilizing objectives mentioned above.

It’s All About Incentives

        Inflation is very politically useful, regardless of party lines, because it allows policymakers to affect the market without the noticeable consequences that come from fiscal policy. For instance, politicians have incentives to cut taxes for their constituents, but they also have an incentive to promise government funding for popular programs. They can resolve this conflict either by borrowing the money, or by allowing the Federal Reserve to engineer inflation. These methods still have their own considerable consequences. However, the general public’s reaction to them isn’t as harsh as their reaction to being taxed, which is convenient.

In fact, ordinary people often embrace inflation when it occurs, because they notice the higher price index for things they sell. Moreover, one of those things is labor, meaning inflation is welcomed in the form of higher wages, even if the purchasing power associated with those wages doesn’t actually increase. The problem is, monetary policymakers assume such a wage increase takes effect in the first place. Historically, it often has, particularly in fast-growing economies with a competitive labor market. But take the opposite case, in which jobs are not so plentiful, and there may be a different effect. In this case, workers at one job may not have any realistic opportunities to find another. Employers, understanding the labor market, have a diminished incentive to compete for their workers by offering them higher wages. If this happened, nominal wages would stay the same as the price index rose. In a certain (and not uncommon) set of circumstances, inflation will simply cause a relative pay cut for that set of workers with fewer prospects (Cowen 2016). It will also cause the relative value of savings to decrease, which will presumably affect older citizens more substantially.

Losing Control

We know a bit about how people realistically respond to inflation. But how does money management go off the rails? What causes the hyperinflation that has occurred in nations like Zimbabwe, where at one point it took an average of just over one day for all prices to double (Hanke 2009)? How are the causes connected to the incentives of both consumers and policymakers, and what can ordinary people do to help?

The great American economist Milton Friedman is famous for noting that inflation is “always and everywhere a monetary phenomenon,” meaning it isn’t directly created by fiscal policy. However, fiscal policy affects the economy in a way that monetary policymakers must attempt to account for. In the U.S., as we’ve noted, the pseudo-independence of the Federal Reserve prevents some degree of direct political motivation in engineering monetary policy. Notably, the U.S. hasn’t experienced major cases of hyperinflation or banking collapses, with the exception of the early stages of the Great Depression. For a thorough exploration of the Fed’s role in this crisis, I recommend A Monetary History of the United States, 1867-1960 (1963) by Milton Friedman and Anna Schwartz.

In nations with central banks, which are directly tied to the federal government, political incentives may influence objective decision-making when it comes to monetary policy. It seems, in this case, that the concept of populism may cause monetary policymakers to overlook the long-term effects of their management of the money supply, possibly allowing inflation to slip out of control before anyone notices, and leading to a crisis. The presence of a powerful central banking system is a conspicuously common thread in the major historical cases of hyperinflation, including those in Hungary (1946), Germany (post-WWI) and Zimbabwe approximately a decade ago. This is because inflationism is like binge drinking; the good effects come first, and the bad effects come later. Similarly, curing inflation is like curing alcoholism; the period of withdrawal is painful, but necessary. The pain is not the cure, but a necessary byproduct of it.

Centralizing power, however, is not the only explanation for the faults of monetary management. The reality is that keeping track of goods, services, transactions and wealth is extremely complicated in the first place. No one has developed a perfect index for prices — it is even widely acknowledged that the U.S. Consumer Price Index is always overestimated– and there will always be incentives and patterns of action that we don’t fully understand, as we mentioned above with inelastic employment. There is very little that individuals can do to prevent problems sometimes caused by inflation; we can only hope the money supply is managed adequately, and wait for natural experiments and crisis situations to allow us to make that process more simple and less volatile.

References

Image: Payne, David. Drop in Prices Not Likely to Delay Fed Rate Hike. Kiplinger. http://www.kiplinger.com/article/business/T019-C000-S010-inflation-rate-forecast.html

The Perils of ‘Strategic Protectionism’

“Can we really use tariffs to make other countries play fair?”

By David Behrens

“I believe in free trade, but…”

     This sentence almost never ends well. It leads to several misguided arguments for forms of protectionism that end up being harmful. Retaliatory tariffs have become a centerpiece of such arguments, in the modern United States and throughout recent history. People from all political persuasions have supported such tariffs in the guise of keeping trade “fair,” but many are misguided in their endeavors. Ironically, it is often the case that those who are most passionate about helping American workers and industries will inadvertently support policies that  harm them.

What is Trade?

     At the most fundamental level, trade of any kind is the act of exchanging goods and/or services between two or more parties. Each party trades because they believe they will gain some value from the exchange. Thus, every voluntary exchange results in mutual benefit: a win-win situation. Each exchange is a set of choices made by individuals, representing themselves, a business, or a government. For the most part, trade occurs between ordinary people seeking to gain value of some kind. We can benefit from trade because of the principle of comparative advantage: certain individuals are more efficient than others at producing certain goods and services, so when more people produce things based on specialty, more goods and services are produced in general and at a more efficient rate. The economy grows faster, and the differences between what people produce and consume are resolved through trade.

     Barriers to international trade, broadly categorized, are collectively known as Protectionism. Such barriers include tariffs (taxes on imports or exports), embargoes (complete bans on importing and/or exporting certain goods), quotas (fixed limits on the amount of goods imported and/or exported), and subsidies (government funds and/or benefits granted to certain firms in certain domestic industries). A strategy used in ‘trade wars’ is the imposition of a retaliatory tariff, a tariff with the specific intention of pressuring another country to alter its own trade policy or other public policies.

What Makes Things Complicated?

     Because economists from just about every school of thought are, for the most part, in favor of freer trade, it seems that problems- and bad policy- arise from strictly political motivations. Even John Maynard Keynes, the godfather of modern macroeconomics, serves as an example; he advocated for Britain to impose tariffs in 1931 (Eichengreen 1984), despite clearly opposing them throughout his career. He believed Britain should abandon the gold standard and adopt a floating exchange rate, but was confident that political complications would prevent this from happening (Friedman 1978), and thus decided to publicly champion tariffs. Incidentally, Britain abandoned the gold standard 3 weeks later and Keynes re-adopted his free-trade positions. Political complication is the lifeblood of Protectionism, and makes it difficult to understand the nuances of trade. Retaliatory tariffs serve as a clear and very relevant example.

     This is particularly relevant in today’s United States, and not just because President Trump has vocally supported retaliatory tariffs (along with other trade barriers). Public figures like Bernie Sanders have echoed Trump’s sentiments on trade almost to the word (OnTheIssues 2016), and workers in several countries have decried the trade liberalization allowed by the TPP and NAFTA. The past two years have proven that with certain rhetoric, many people can be convinced to passionately support many forms of Protectionism for the supposed sake of patriotic interest. However, once we begin to unveil the unintended consequences of certain policies, the rest will follow.

The Most Common Misleading Claims

     Claim: Under NAFTA, U.S. companies, such as car manufacturers, move to Mexico, with net losses in jobs and revenues for American workers. Mexico steals our business.

     Prescription: Rewrite NAFTA, impose tariffs on imports (up to 35%) to level the playing field.

     NAFTA went into effect in 1994 following 7 years of drafting. It eliminated tariffs on goods made entirely in North America, with the exception of goods made with capital from non-NAFTA countries, which were still subject to tariffs. You can find plenty of reasons to oppose this 35% tariff in general, but is it a strategic way of negotiating with the Mexican government? Consider every option.

     Mexican economy minister Ildefonso Guajardo has stated that Mexico would take immediate fiscal action to counteract the tariff. This tariff would likely spark some sort of trade war, though actual war with Mexico is highly unlikely. Tariffs hurt producers and consumers, foreign and domestic, without anything to show for it in the long run. A grueling trade war, therefore, isn’t worth the economic harm, especially considering that the resulting agreement, if one is reached, almost certainly wouldn’t improve on the present-day scenario. The Mexican government and citizens are under attack for crimes they did not commit; businesses face much more hardship in the form of domestic taxes and regulations than can be attributed to trade with Mexico. Taxing their exports has no political or economic upsides.

 

     Claim: The U.S. debt to China can be made up by engineering trade policy.

     Prescription: Impose a large tariff on imports from China.

 

     This claim comes from an interview of Donald Trump conducted by Wolf Blitzer in 2015. Blitzer objected to Trump’s tariff proposal, saying it would start a trade war, and claiming America’s large debt to China made this scenario undesirable (incidentally, economists have dismissed Blitzer’s fear of China holding U.S. debt reserves). Trump responded, “One year of this tax and we don’t owe them anything.” The President’s conclusion displays a fundamental misunderstanding of the concept of trade deficits. He is certainly not alone, even among policymakers, in perpetuating these misconceptions.  However, they are dangerous, and should quickly be refuted.

     The trade deficit is not like a budget deficit. Budget deficits describe shortages in goods and services themselves, which are supposed to be accounted for in the form of money but are not. Trade deficits describe the differences between how much one country imports from another country and how much they export to that country. For instance, in 2015 the U.S. had a trade deficit for merchandise of over $365 billion with China (Jeffrey 2016). This should simply indicate that the Chinese, at least for now, are better-suited to produce and sell merchandise, and so we benefit from the low resulting prices. In the same way, almost all of us have trade deficits with our grocery stores, which sell us more groceries than we sell them. But they also relieve our need to produce our own groceries; as a man named Andy George found out, it takes $1500 and 6 months to make a sandwich from scratch by yourself (Singleton 2015).

     As it turns out, increasing tariffs on China does not raise the kind of revenue required to pay America’s debt. The national debt increases with the budget deficit, not the trade deficit. Tariffs may reduce the trade deficit, but this is highly undesirable; it forbids the exchanges that let people spend less, get more, and use their leftover capital to improve their lives and grow the global economy. This strategy can hurt U.S. businesses and their employees, and stifle economic growth, which in turn can lead to increases in transfer payments from the government, and decreases in tax revenues. Thus, the roundabout effect of tariffs may actually increase the national debt to China.

     Claim: China uses currency manipulation to gain an unfair advantage, and profits from unfair tariffs on U.S. companies trying to sell products there.

     Prescription: Impose tariffs to pressure the Chinese government to lower tariffs and reform fiscal and monetary policies.

 

This one is the most complicated, because it is based on the most truthful assumptions. Even economists have acknowledged the apparent irregularities in the way that the People’s Bank of China (a central bank) has managed the value of their currency (the yuan). In particular, there was controversy over the devaluation of the yuan by 1.9% and then 1% in two consecutive days in July 2015. Such manipulations are intended to give the Chinese a competitive edge by making all other currencies stronger than the yuan by comparison, meaning global consumers have stronger incentives to buy Chinese goods and services. Some economists see the move as a sign of weakness, and other countries may devaluate their currencies in response.

However, it is important to note that the power and role of each currency, even in a fixed system, is not solely decided by the central bank behind it. The price of yuan can cause market-based adjustments of floating currencies, like the dollar, and all currencies are subject to the pressures of inflation as the real-world correspondence between money and goods becomes clear. In short, engineering monetary policy is extremely complicated, because the foreign exchange market consists of many countries with fixed exchange rates reacting to one another alongside the market forces of floating rate systems.

How, then, will the imposition of tariffs from the United States result in a “better” structure of fiscal and monetary policy? Only by convincing Chinese policymakers that they can reach an optimal outcome by adapting to standards proposed by the current U.S. policymakers. Considering the turbulent political climate in both countries, and the other set of circumstances by which the Chinese government operates, this seems highly unlikely. In addition, we’ve already shown that retaliatory tariffs don’t improve the relative standing of the country imposing them, and it seems similarly true that the U.S. has nothing to gain by raising tariffs on Chinese imports.

In general, the sentiment behind “strategic” tariffs is based on the ideals of fairness, competition, and patriotism. However, the real effects of retaliatory tariffs and other forms of Protectionism make them counterintuitive means of promoting these initiatives. When trade is liberalized, we will reap the benefits of comparative advantage, which include economic prosperity and improved international relations. It is now our responsibility to make these opportunities clear.

 

Sources

Eichengreen, B. (1984). Keynes and Protection. The Journal of Economic History, 44(2), 363-373. Retrieved February 2017, from http://www.jstor.org/stable/2120714

Friedman, M. (1978). Free Trade: Producer vs. Consumer. Manhattan, Kansas, U.S.A. Retrieved from https://www.k-state.edu/landon/speakers/milton-friedman/audio.html

Gillespie, P. (2017, January 17). Mexico warns Trump on tariffs: We’ll respond ‘immediately’. Retrieved February 2017, from CNN Money: http://money.cnn.com/2017/01/14/news/economy/donald-trump-mexico-tariffs-response/

Jeffrey, T. P. (2016, February 9). U.S. Merchandise Trade Deficit with China Hit Record in 2015. Retrieved from CNS News: http://www.cnsnews.com/news/article/terence-p-jeffrey/365694500000-merchandise-trade-deficit-china-hit-record-2015

McDonald, B. (2012). International Trade: Commerce among Nations. Retrieved February 2017, from International Monetary Fund Web site: http://www.imf.org/external/pubs/ft/fandd/basics/trade.htm

OnTheIssues. (2016). Bernie Sanders on the Issues. Retrieved from OnTheIssues: http://www.ontheissues.org/2016/Bernie_Sanders_Free_Trade.htm

Ryan, F., & Farrer, M. (2015, August 11). China devalues yuan by 2% to boost flagging economy. Retrieved from The Guardian Business: https://www.theguardian.com/business/2015/aug/11/china-devalues-yuan-by-2-to-boost-flagging-economy?CMP=share_btn_tw

Shira, D. (2016, December 6). Import-Export Taxes and Duties in China. Retrieved from China Briefing: http://www.china-briefing.com/news/2016/12/06/import-export-taxes-and-duties-in-china.html

Singleton, M. (2015, September 17). A man spent 6 months and $1500 making a sandwich from scratch. Retrieved from The Verge: http://www.theverge.com/2015/9/17/9344597/man-spent-six-months-1500-making-sandwich-from-scratch

U.S. Department of Commerce. (1994). NAFTA Key Provisions. Retrieved from IATP.org: http://www.iatp.org/files/NAFTA_Key_Provisions.htm

United States Government. (2017, January). Trade Deals That Work For All Americans. Retrieved February 2017, from The White House: Issues: https://www.whitehouse.gov/trade-deals-working-all-americans

Automation and Employment: A Complicated Relationship

“Machines today can prepare your food, clean your house, and build a whole lot more machines. They’re out of control, coming to take our jobs and impoverish people—or are they?”

By David Behrens

     A bad habit of many of today’s commentators and even economists is to pay stringent attention to one economic variable and disregard how others behave in the long run. There is no better example of such a variable than employment; the idea of every member of society having a job is so appealing to people that even some economists prescribe solutions which prioritize this facet of national economies too heavily. It’s a useful political crutch; talking heads have gotten away for centuries with false rhetoric about government creating jobs, or more recently, the notion that jobs can be ‘stolen’ from people.

The Source of Confusion

     Likewise, the concept of automation has taken center stage in rhetorical debates about employment. Of course, we take it as a given that machines are used to consistently and efficiently perform tasks, many of which people could do themselves. It is stylishly philanthropic for the modern layman to cry out against the implications of permanently replacing human labor with machines. In fact, it must alarm all of us to imagine that one sudden mechanical innovation could permanently render obsolete the skills of thousands of good working people, stealing away their livelihood.

      However, taking the opposite view to its logical extreme is yet more frightening. The great French economist Frederic Bastiat once poignantly illustrated this point with his satirical essay “A Petition,” (1845) in which his narrator advocates for the government to extinguish the sun, because it takes away business from candlemakers. Now, no machine is the sun, but members of the global workforce aren’t mere candlemakers, either. Economists often fall prey to fortune-telling and dogma, but invisible mechanisms of human action have unpredictable, long-reaching effects on our societies. We can at best, consider the direct effects of automation and remain conscious of those which are not so obvious.

What is Employment?

     Employment, like many other concepts, is somewhat meaningless on its own (Bastiat 1850). This seems a daunting assertion to many people, as the concepts of hard work and career life have long dominated human culture. But it’s true; if resources were not scarce, and no effort was required to distribute them, labor would be entirely unnecessary. Humans work so that they can produce goods and services for everyone to enjoy. They are compensated based on the impact that they as a unique individual can generate for everyone else.

The Tradition of Human Progress

     At this point in time, there is one thing that humans produce that can never be produced by machines alone: innovation. To this end, automation has proven very beneficial in an interesting way. Innovation is considered the primary driver of growth in highly developed nations like the United States, whereas developing nations grow because of increases in capital stock and productivity (Friedman 1980). Automation in developed nations saves time and effort that humans in turn can use to invent new things to make life more easy and enjoyable. Eventually, new technologies make their way into developing nations, helping growth accelerate with increases in productivity.

Crucial Effects in the Short Run

     Classical economics demonstrates that in the long run, industries adjust, and workers will shift to jobs in other fields (Say 1803). However, large shocks to the labor market may have more severe consequences; the more workers lose their jobs simultaneously, the larger the ripple effect could be. The negative effects include decreases in consumption from those workers, as well as a possible surge in payouts from unemployment insurance. Positive effects follow as well; companies that can automate will cut costs, possibly allowing them to decrease prices and encourage consumption of their products. As I mentioned, consumers’ newfound disposable income may encourage some investment in innovative technologies and lead to economic growth.

     The main problem with all of this is that the negative effects come first, are more noticeable and can be politicized. The long-run benefits, however, manifest themselves more subtly over a long period. The initial panic can grow like a virus; if consumption suddenly decreases, production will as well, so there will be a little bit more unemployment, and so on. That is why the severity of short-run changes is important; this is a textbook example of Keynes’s theory of the trade cycle.

     Luckily, there are some safeguards against such a drastic level of structural unemployment and its implications in the short run. For one, it’s generally easier to automate production in sectors that use primarily unskilled labor (Robinson 2014). In these cases, unemployed workers aren’t liable to have wasted years of vocational training or specialized experience. This makes it easier for them to assimilate into different sectors. Additionally, the automation process is often gradual, and many large companies have positions for employees to move to instead of being laid off entirely.

     Still, the invisible effects of unemployment and those of automation cannot be taken for granted. They aren’t quantifiable, and have far-reaching effects of their own. If we are to see even temporary unemployment as too high a cost to offset the benefits of automation, it becomes another matter to properly regulate the advancement and use of innovative technologies. In the end, there is nobody who can predict all the consequences of any economic phenomenon. Our responsibility as economists and ordinary people alike is to look for hidden information whenever possible, recognizing that we cannot hope to completely understand it.

 

References

Bastiat, C. F. (1845). The Candlemakers’ Petition. In C. F. Bastiat, Economic Sophisms.

Bastiat, C. F. (1850). Ce Qu’on Voit et Ce ne Qu’on Voit Pas. Paris, France.

Friedman, M. (1980). Free to Choose. Chicago: Harcourt.

Robinson, A. (2014, October 22). Manufacturing Technology. Retrieved from Cerasis: http://cerasis.com/2014/10/22/industrial-automation/

Say, J.-B. (1803). A Treatise on Political Economy (6th ed.). (C. C. Biddle, Ed., & C. R. Prinsep, Trans.) Philadelphia: Lippincott, Grambo and Co. Retrieved 2017

 

All About the Business Cycle

“For over a century, different opinions have formed about the causes of economic “booms and busts,” an apparent cycle of financial activity. The Austrian and Keynesian schools of thought completely disagree on this matter, and the pertinent solutions. Who is right—and why?”

By David Behrens

     Financial crises have rocked the foundations of international monetary policy for over a century, and with instability looming large in today’s markets, economic decisions will have to be made. In times like this, it’s important for the public to understand the anatomy of the business cycle. Two major schools of thought have dominated Business Cycle Theory since the early 20th century: The Keynesian school, which asserts that stimulus can spark economic growth, and the Austrian school, which describes how artificially low interest rates create the illusion of a boom, followed by an inevitable bust.

     John Maynard Keynes, particularly in his most famous work, The General Theory of Employment, Interest and Money, established many fiscal and monetary precedents which contributed to the development of modern macroeconomics. Keynes believed that the fluctuations of employment caused by those of investment, in a cyclical manner, had a roundabout effect of diminishing the marginal propensity to consume. Furthermore, he believed that this would decrease aggregate demand and that decreases in aggregate demand would limit productive capacities. To put these ideas in context, Keynes thought that the inherent instability of an economy would cause uncertainties, leading consumers to consume less and producers to produce less. When this happens, Keynes’ solution was to boost aggregate demand in order to spark activity in sectors that created capital, thus relieving the glut in production by simulating a jolt in consumption. It is consequently crucial to recognize the composition of aggregate demand, which is made up of consumption, investment, government spending and net exports. Keynes’s prescription to boost aggregate demand by increasing government spending was based off the level of control that the government could wield over government spending versus a more complex variable like consumption. This plan was eventually welcomed by many politicians in the later years of the Great Depression.

     The Austrian School of economic thought is stylistically very different from the London, or Keynesian school. Championed by economists such as Friedrich Hayek and Ludwig von Mises, it relies on a rationalist methodology known as Praxeology. The Austrian Business Cycle theory correlates the “booms” experienced by an economy with a “bust” that follows. Their theory is that the problems caused by ordinary fluctuations of capital are exacerbated by the policies of central banks. Typically, the Austrian School lays out the following scenario:

     Central banks, in the hopes of encouraging consumption, mandate that interest rates be kept below a certain point. For this to have any effect, that point must be lower than the uninhibited market would have roughly placed it. Therefore, banks across the country, endowed with currency from the central bank, issue cheap credit—people are able to get loans more easily than they otherwise would. The problem with this is that the market, made up of countless independently-acting individuals, always determines a rate of interest that will come closest to satisfying everyone’s needs. The central bank, made up of a small handful of elites, does not intend to have this same effect and fundamentally can’t reproduce the same market result. The consequence of cheap credit is that it incentivizes people to take out loans to the point where the loaned funds are not all eventually accounted for. People will use their new capital to undertake projects that they ordinarily wouldn’t (a recent example of this is the housing boom around the turn of the 21st century). The return on all of this investment is not as high as it needs to be for banks to account for all of their loans, so the banks need to claim they have more money, as interest rates rise. This aforementioned sequence of events comprises the process of inflation. Depreciated currency ends up taking up the slack caused by the interest rates being too low. In addition, people are incentivized by low interest rates to spend when they may ordinarily save, thus distorting the natural signals of supply and demand for money in an economy. Those who decide to save their money are harmed by the inflation caused by the business cycle because their savings become less valuable.

     The distinction between these two theories is important because it has continued to challenge policymakers in all parts of the world. Today, the United States Federal Reserve faces consistent uncertainty over whether or not to raise interest rates, as investors such as George Soros have begun to predict a financial crash. Central banks such as that of Venezuela have had a difficult time determining the value of their currencies, resulting in uncertainty for consumers and producers responding to price signals. No matter which side is more adhered to today, there is comfort in the magnanimous volume of empirical evidence that the future will provide, particularly with the aftereffects of both Brexit and the next U.S. election. Analysis awaits us as today and tomorrow’s economic points of interest arise.

References
Keynes, J. (1936). The General Theory of Employment, Interest and Money.
Mises, L. v. (1949). Human Action. Yale University Press.
Rothbard, M. (1962). Man, Economy and State.

Chile vs. Venezuela: A Tale of Two Economies

By Gobierno de Chile – Jefa de Estado sostuvo una reunión bilateral con el Presidente de Venezuela, Nicolás Maduro, CC BY 2.0, https://commons.wikimedia.org/w/index.php?curid=38124158 .”

by David Behrens

June 21st, 2016

    Latin America has seen a divergence in terms of political and economic policy over the late 20th Century. In particular, Chile and Venezuela are interesting cases, having employed varied policies since the 1970s to striking effect.

    Today in Venezuela, prices practically write themselves. The nation faces shortages of food and staples, electricity and basic supplies with price inflation expected to approach 500% by the end of the year. A large McDonald’s Fries is said to cost $126 at a sticker price of 800 bolivars.With Venezuelan President Nicolas Maduro’s declaration of a state of emergency last month, many claim that he did so in a ploy to stem the momentum of his opposition and to keep his government in power.

    Venezuela is an extreme example of South America’s perpetual political, economic and fiscal struggles, also often seen in Brazil and Argentina, among others. However, Chile, a striking exception, is notably well-off at the present moment. According to the IMF, Chile and Peru are the only countries with positive growth outlooks for 2015 and 2016. Chile’s GDP grew faster than that of any South American nation in 2015, and has a high level of human resource development, a skilled workforce and a HDI of 0.832. It is also perceived to have a very low level of corruption in comparison with its Latin American peers.

    Venezuela and Chile have similar geography and are closely located to each other. As one of the most northerly South American countries, Venezuela is closer to Central and North America and Europe. With a temperate climate, a year-round growing season, incredible biodiversity and the largest proven oil reserves on the planet, Venezuela has a lot to offer to investors and to its own citizens. But then why does this divergence in the trajectories of the two countries exist?

    While both Chile and Venezuela are democratic republics with mixed economies, Chile has a far greater level of market integration. HumanProgress.org’s ranking of economic freedom (based on the level of government intervention) lists Chile as the 10th freest economy in the world, leading South America. Venezuela, however, ranks last in the world. (Author’s note: this title should probably belong to North Korea, however the nation does not publish economic statistics and hence could not be ranked.)

    Furthermore, Chile sees a far greater freedom in terms of its exchange rates. Venezuela’s currency, the Bolivar has been placed at a fixed peg to the USD, and was revised in 2003 and 2008 and 2015 to reflect market conditions. With heavy currency controls in place to prevent capital flight, a thriving black market developed for the currency which more readily reflected the market rate. This means that the Central Bank of Venezuela valued the currency, and in turn the economy of Venezuela to be far more than the markets did. This led not only to the promulgation of an “official” and “real” exchange rate, but also to the use of alternative currencies to the Bolivar. This currency mismanagement led to massive overconsumption resulting in hyperinflation of prices, shortages and political chaos once it was revealed that the Venezuelan economy did not have the capacity to absorb the excess currency that the central bank had created.

    This series of events was particularly disastrous for Venezuela for numerous reasons primarily deriving from the excessive involvement of the Venezuelan government in the establishment of prices for goods and services. In the case of an accurately placed currency exchange rate, this might not have been as problematic. However given the issues Venezuela was facing with its currency, the consequences affected every consumer in the country. Furthering the problems it was facing was nature of the Venezuelan economy, structured as it was to be heavily dependent on international trade for revenues and the maintenance of currency reserves. With the 2015-16 plunge in the prices of oil, several oil-exporting nations felt the pinch and likewise tightened government budgets to reflect dropping revenues. However with rampant price inflation, the Venezuelan government was in no position to do so, and thus did not reflect the value of its trade.  

    In contrast, Chile’s financial stability derives from its more diversified economy, a plethora of trade agreements, carefully implemented market reforms and a managed-floating exchange rate. In addition, several expensive government welfare measures like the social security system were privatized. After years of Allende, Pinochet and the like, Chile rid itself of the regimes which had constrained growth and limited personal and economic freedoms and strove forward, leaving Venezuela and many other Latin American nations behind.

    Today’s Venezuela is a consequence of tough choices that should have been made in yesterday’s Venezuela, and the leftover brunt of those lost opportunities. The forces of the markets are being suppressed by government controls, stifling innovation and the free exchange which generates growth with positive incentives. Forced currency controls have wreaked havoc in conjunction with a government drunk on the perceived power of controlling the economy – or killing it trying. Riding the revolutionary sentiment of Hugo Chavez, Nicolas Maduro leads a governmental regime that is losing the trust of its citizens – a trust necessary in the maintenance of a government-controlled economy. There are abundant opportunities for Venezuela to mould itself into the kind of nation that Chile has become and to enjoy the same kind of growth and prosperity. Until then, we can only sit back, watch, and learn how extreme the consequences of interventionism can be.

References

Rosati, A. (2016|, April 27). Venezuela Doesn’t Have Enough Money to Pay for Its Money. Retrieved fromhttp://www.bloomberg.com/news/articles/2016-04-27/venezuela-faces-its-strangest-shortage-yet-as-inflation-explodes
Venezuelan bolívar. (n.d.). Retrieved fromhttps://en.wikipedia.org/wiki/Venezuelan_bol%C3%ADvar|
Chew, J. (2015, November 05). A Large McDonald’s Fries Will Cost You This Much in Venezuela|. Retrieved fromhttp://fortune.com/2015/11/06/mcdonalds-venezuela-fries/
IMF. (2015|, April 29). IMF Survey : Growth in Latin America Weakens for Fifth Year in a Row. Retrieved fromhttp://www.imf.org/external/pubs/ft/survey/so/2015/CAR042915A.htm
Country Ranking Based on Economic Freedom. (2015|). Retrieved from http://humanprogress.org/story/2145