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Rupee, Sri Lanka, in trouble after Keynesian stimulus

Mar 29, 2016 22:49 PM GMT+0530 | 6 Comment(s)

ECONOMYNEXT - Sri Lanka has increased government spending to boost 'aggregate demand' after coming to power in 2015, Prime Minister Ranil Wickremesinghe admitted in parliament, as a policies are now being devised to rescue the country from a 'stimulus' fallout.

"In 2015, when we built the government, there was a collapse in aggregate demand," Prime Minister Wickremesinghe told parliament.

"In that situation in April we raised (state worker) pensioners' payments by 1000 rupees, we raised state workers' salaries, private sector salaries were raised.

"Gas prices were reduced by 300, milk powder 68, wheat prices by 12.50 rupees sugar 10 rupee, green gram 40 rupee, sprats 15. Sustagen 100 rupees. Tinned fish 60 rupees. Maldive Fish 200, Chillies 25, kerosene 06 rupees."

"In this way we put more money in the hands of consumers to increase aggregate demand."

"When we go from day to day, from time to time some prices go up, and do down. Incomes go up," Wickremesinghe said.

"But I would like to say that we would not go to a situation where aggregate demand will collapse again."

Among the increased spending, the salary hike to the state workers cost about 10 billion rupees a month, with the monthly wage bill rising from 41.1 billion rupees in January 2015 to 49.9 billion rupees by December and is climbing.

The budget deficit rose from 489 billion rupees in 2014 to 690 billion rupees by November 2015.

Central Bank Credit

Total domestic financing rocketed from 380 billion rupees to a revised estimate of 519 billion rupees by December 2015.

By October 2015, 200 billion rupees of domestic spending was financed by central bank credit or printed money.

If money is not printed (or excess liquidity is not used) government spending will not generate an increase in aggregate demand, as money is raised either through borrowing or taxes from the society at large (reducing their ability to spend) and is given to state workers and deficit spending.

Politically directed state spending - most of which can be unproductive - can even bring down growth levels, as happened in many countries after independence from British rule.

Keynesian aggregate demand effects are usually expressed by the Hicks and Hanson or IS-LM model, which claims to show a relationship between savings and investments and money supply.

However such utopian equations only work in an autarky, or a self-sufficient nation with no international trade.

"The Keynesian system is a closed one, that is, it takes no account of foreign trade," explained Goh Keng Swee, Singapore's first independent finance Minister who refused to build a central bank, but retained its currency board without money printing powers.

"This is admissible in theory, but in practice, since all modern states engage in foreign trade, a Keynesian stimulus will lead eventually to balance of payments deficits if government do not exercise restraint in time.

"A part of the increased incomes people receive will be spent on imports and when exports do not increase in proportion a trade deficit will occur."

Sri Lanka's rupee has fallen from 131 to the US dollar to 147 to the US dollar so far. The rupee is expected to fall further before an International Monetary Fund backed stabilization program comes.

Taxes are expected to be raised this year. Interest rates are already up, allowing the central bank to reduce money printing (central bank credit) if it wants to.

"Our economy was and is both small and open. Financing budget deficits through Central Bank credit creation appeared to us as an invitation to disaster," Goh said.

"There was no effective way of exchange control in an open trading economy like ours to deal with the inevitable balance of payments troubles.

"The way to a better life was through hard work, first in schools, then in universities or polytechnics and then on the job in the work place. Diligence, education and skills will create wealth, not Central Bank credit."

Aggregate Demand

What Finance Minister Goh said was also expressed by Robert Mundell and Marcus Fleming in what is now known as the ISLM-BoP model or 'open economy model', which can used to explain balance of payments crises.

But standated aggregate demand or the IS-LM model is still taught to students in what goes as 'economics' after World War II.

Finance Minister Goh said John Maynard Keynes came up with his The General Theory of Employment, Interest and Money after the governments and central banks in the US and Europe (mainly the Bank of England) generated the Great Depression.

"If one has to fault Keynes on any point, it would be the title of his book. This should have been — The Special Theory of Employment, Interest and Money," he said.

Deficit spending without damage can be undertaken (with excess liquidity or central bank credit) only when domestic credit has already collapsed, like during the Great Depression.

By the fourth quarter of 2014, Sri Lanka domestic private credit had already recovered from the 2011/2012 balance of payments crisis fired by energy subsidies and the January 2015 revised 'Keynesian stimulus' budget - a result of election promises - generated fresh BOP trouble.

Ironically ex-President Mahinda Rajapaksa, who generated two BOP crises with credit financed fuel subsidies in 2009 and 2011, called the salary hike 'irresponsible' in a recent hard hitting statement.

Miserable developing country

"Democratically elected governments the world over are exposed to the temptation of winning votes though promising better and cheaper services and at the same time lower taxes," Goh said.

"In Singapore, an irresponsible government does not need a Central Bank to finance lavish spending as a means to win popularity.

"But if the electorate misled by soft-headed opinion makers, persists in wanting the good life without working for it, constitutional safeguards cannot stop foolish behaviour for all times.

"What will happen if the electorate chooses this option is that after a brief period of high living, Singapore will spiral downwards and eventually become another miserable developing country."

Stimulus advocates generally ask governments to start infrastructure projects, which finish in a few years or give tax cuts which can be reversed.

Sri Lanka however hiked salaries, pensions and subsidies permanently, which cannot be reversed and are a permanent burden on society.

Instead, these increases are now being 'reversed' by currency depreciation or destroying the real value of salaries and pensions, as well as lifetime savings.

Prime Minister Wickremesinghe is planning new taxes to fix the problems in the budget.

Taxes do not destroy lifetime savings unlike currency depreciation, and is the best and most compassionate way to finance state salaries and subsidy increases.

To save their real capital, foreign investors are pulling out their money out of Sri Lanka.

But Sri Lanka's 'miserable' population is meanwhile trapped in rupee bank deposits and pension funds.

Keynes himself had said that most people would not be able to see the "secret confiscation of wealth" from inflationism.

"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency," he said once.

"The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." (Colombo/Mar29/2016 - Update II - corrected General Theory)


 

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6 Comments

  1. MetteyyaBrahmana April 10, 10:12 AM

    Sri Lanka needs to stop floating the rupee and go back to a pegged system. Pegging to the dollar or basket of currencies of top five export destinations for Sri Lankan products would stabilize the currency without having to raise interest rates.A lower rupee will only stimulate exports once Sri Lanka increases its export capacity. This will take time, and in the interim it is best to keep the currency stable.

  2. Colombo7 Type March 30, 08:22 AM

    I feel that you are unfairly condemning Kurundu Watte. Which politicians come from Colombo 7? Last I heard, the rogues who set the stage for this mess were from the south of the country.

  3. Rainmaker March 30, 03:59 AM

    This website and many other commentators on it go on and on about a currency boardThe problem with a currency board is the money supply is linked to foreign exchange levels. In the mid 1960s Malaysia suffered a crisis due to commoditiy prices affecting forex flows and at one point the monetary base shrunk by a half. Unlike HK or Singapore, Sri Lanka doesn't have anywhere near the forex flows to set up a currency board. If it did the fluctuations in the price of tea and workers remittances would wreck havoc on the economy.

  4. Mr D March 30, 02:21 AM

    We now move to Round 2. Whilst the PM is technically correct that he placed more money into people's hands, it was still an extremely amateurish comment to make.


    Prof Milton Friedman argues that an increase in permanent income would lead to an increase in current consumption. This is because there is a larger effect on lifetime wealth with a permanent income increase. One would then tend to smooth consumption by consuming more in the current period. This wage hike would qualify as permanent and the result was exactly what Prof Friedman stated in his permanent income theory.


    The only issue was that current consumption occurred mainly for imports, thus exacerbating the issue. Also the vast majority of individuals in SL are either credit or liquidity constrained, which simply means that they would like to consume more than what they are capable of. Therefore the increase in wages would not primarily be saved but rather be used for consumption, thus pressuring the economy into overheating. What everyone needs to understand is the fact that they should not be fooled by whatever the statistics may say about inflation being low. When the money supply increases, inflation increases alongside it, a one to one relationship in theory but rarely in practice.


    Regardless of the talk that the yahapalanaya regime has done with respect to food prices, anyone that has been to a market place knows the true story. Real wages have fallen in reality. The reason being that the wage hike benefit is less than proportional to the increase in money supply, whereas prices have kept in line with the increase in money supply for the most part. This has eroded the relative purchasing power of indivduals at or below middle class status in real terms, which is the majority of the country.


    Remember that inflation is steadily on the rise due to the excess money supply and the CB have consistently manipulated interest rates below the optimal level, even choosing to keep it steady at 6.5 per cent today. This means that our real interest rates are getting dangerously close to 1 per cent or even lower. The importance of real interest rates is that it reveals the direction of the CB's monetary policy. Low real interest rates favours more consumption, hence pushes aggregate demand upwards.


    However our economic genius, the PM, was then quoted saying that he would not go into a situation where AD will collapse again. You might want to convey the message to the CB in that case Mr PM because it does not seem like they got the memo.Another thing I heard PM say was that if the UK had revised their budget this year due to adverse economic conditions, then everyone should not get riled up for the November failure that was the 2016 budget.


    Well Mr PM, which revision are you referring to? The only one that was of note was CoE Osborne's disability welfare benefit cut, which he admitted was a mistake but surely that cannot be the revision you meant? Maybe you meant the fact that he downgraded growth forecast figures from 2.4 to 2 per cent?


    However, that forecast is perfectly logical given the Brexit debate and the pound taking a massive hit. The big difference is that they have the current grandmaster of central banking, Dr Mark Carney, heading the Bank of England with complete independence whilst we have Mr Oxford providing an ugly and distorted lifeline for your fiscal mistakes, destroying the currency in the process.

  5. Mr D March 30, 02:20 AM

    Seems like Mr RW has decided to join the yahapalanaya economic comedy show. As if CB Governor and Fin Min weren't bad enough, the so called economic genius has decided to speak up. So the PM begins by saying that he wanted to boost aggregate demand in 2015 amidst an ongoing global economic slowdown. Meanwhile our main impetus, export earnings,was taking an unfortunate hit due to buyer countries facing economic difficulties, like the Middle East, or due to sanctions imposed on us, like the EU.


    On top of that, foreign worker remittances were steadily declining, mainly due to the OPEC dilemma, further pressuring the trade deficit. In the PM's mind, he had to improve consumption, investment and government spending in order to offset the trade deficit and achieve an increase in aggregate demand. This leads us to the mini budget in February.


    As the PM proudly mentioned, he and the finance minister had increased public sector salaries by 10000 rupees amongst other things and also reduced the prices of essential goods, whilst failing to mention that the global commodity rout gave him the space to implement the latter. As we all know about the wage increase, it was for cheap political advantage but with dire economic consequences.


    It is shocking that Dr Harsha de Silva could use the above quoted phrase so arrogantly in his most recent article on Ft.lk, when he blatantly allowed this crisis to begin by staying quiet about the causality in the first place. Does he not have a Phd in Economics?
    Maybe he did not understand the consequences because it was above his level of economic understanding. With regards to government spending, the yahapalanaya administration went overboard with the wage increases and realised that they could not sustain it. They then forced the CB to print more money to finance the budget proposal and increased the money supply as well putting depreciative pressure on the rupee.

    As evidence of this, the one week forwards for the rupee as of today hit Rs 149. Note that this new low was achieved due to the CB's mismanagement of monetary policy over the course of the last year. The real issue was that the dollar strengthened due to the Fed increasing policy rates whereas our CB kept rates relatively low, fueling inflation and a loss of real value of SL assets. The consumption direction that the PM hoped for did not come to pass.


    As expected, import consumption increased and this led to further pressure on the trade deficit, mainly due to the increase in car purchases, which brings with it a host of public sector issues which I will discuss in another relevant article in the future. Although official figures indicate that the trade deficit has been falling, please be aware that this was due to the decrease in oil prices. Once oil prices stabilise and return to their upward trajectory, the real picture will be revealed. Please do rejoin me for round 2 found above.

  6. Lasantha March 29, 05:17 AM

    This is what happens when Colombo 7 politicians are running lower income country. All these politicians are only worried about business people, not the ordinary folks.

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