ECONOMYNEXT – Sri Lanka is now emerging from a peacetime (Latin America style) external sovereign default triggered by extreme macro-economic policy to target potential output with the help of unsound money and high inflation.

Sri Lanka has had two years of rare stability as the central bank missed its inflation target, and growth has returned to around 4 to 5 percent.

As growth recovers in the stability provided, Sri Lanka again faces the threat of depreciation and external trouble as money supply is inflated with ad hoc changes in issuing rules (inflationary open market operations, buy-sell swaps, fx surrenders, selectively denying convertibility), to manipulate rates or debase money to push up prices.

Rising prices give short term profits to some economic agents at the expense of others, triggering an illusory growth, because the fallout of inflation is not simultaneous, as described by the Cantillon effect, especially when inflation expectations are low.

Now money is unstable and governments are unstable not just in Sri Lanka but in advanced nations that engaged in stimulus and use single policy rates (floor systems), and people are suffering and unhappy. Government finances are shattered from stimulus.

In this interview we discuss the history of money and how the current state of instability came to be, with Lawrence H. White, now Distinguished Senior Fellow of at the Mercatus Center at George Mason University.

We try to answer mysteries like why the worst type of monetary regime – soft-pegs or flexible exchange rates – are so popular in unstable countries, why the IMF tends to promote regimes without consistent rules where crises are almost inevitable, why inflation targets have failed to control central banks, and why central banks still try to push growth or employment, with high inflation targets, rejecting repeated lessons of history.

Professor White specializes in the theory and history of banking and money and is an authority on free banking systems. Under free banking or multiple issuers, macro-economists cannot escape accountability by blaming ‘economic fundamentals’ for depreciation as they do now, as the failing bank whose notes depreciate is clearly isolated from the rest that maintain convertibility.

Professor White is the author of The Clash of Economic Ideas (2012), The Theory of Monetary Institutions (1999), Free Banking in Britain and Competition and Currency (1989). He has been a visiting research fellow at the American Institute for Economic Research, a visiting lecturer at the Swiss National Bank, and a visiting scholar at the Federal Reserve Bank of Atlanta. Professor White is a co-editor of Econ Journal Watch and a member of the board of associate editors of the Review of Austrian Economics.

Q: Can you give us a brief overview of the monetary institutions of the past? There seems to have been a diverse array of institutions in the past, but we no longer have that.

A: Well, if we go back to prehistory, there are a variety of commodity standards.
People used shells, silver, barley in different parts of the world. With the growth of agriculture and trade, there’s a convergence on gold and silver, especially after coinage is developed, because that makes it easier to identify what how much and what quality of silver or gold you’re receiving.

And so, in ancient Rome and Greece and India, there is a silver standard and silver coins are used, sometimes produced by governments, sometimes produced by private moneyers.

Governments Take Over Mints

Governments take over the mints because it’s a source of revenue for them. They don’t improve the quality of the coins. In fact, they notoriously debase the coins. Because the coins are debased in Europe, you get the growth of banking. Banks provide claims to silver, which are more reliable than the actual physical pieces of silver that governments produce. And from there, banks begin to issue paper notes, first deposits, but then paper notes in the fifteen hundred, sixteen hundreds.

And so you have a system of a silver standard in most countries. The UK and the US switch to a gold standard. And then other countries eventually follow.

But the banks are issuing most of the common currency. The everyday currency is banknotes, which are these paper claims that say we’ll pay the bearer on demand so much gold or so much silver. And that’s the standard money, the common money in most places.

Emergence of Central Banks

And then governments begin developing central banks. The Bank of England was the premier central bank in the world, and it wasn’t deliberate that they created an institution which controlled the money supply in the country. But it grew into that role, having been given a monopoly on the issue of banknotes.

All the gold became concentrated in the Bank of England. And then the Bank of England’s responsibility was to lend money to the government.

But it had so much power in the financial markets that it could make money abundant or make money scarce just through its own policy, at least for long enough to cause major problems. Eventually, if they made money too abundant, gold would flow out and that would cure the problem. But, you know, it would be a boom and bust cycle.

In the First World War, all the major combatant countries went off the gold standard. And they never really restored it after the war. We got the Bretton Woods system after the Second World War, which pegged the U.S. dollar to gold and all other major currencies to the U.S. dollar.

And countries that had previously been pegged to British pound are now pegged to the U.S. dollar.

Unredeemable Fiat Money

The U.S. broke its obligation to redeem dollars for gold at $35 an ounce in 1971. And since 1971, all the major currencies in the world are not redeemable for gold or silver, not constrained by the scarcity of gold or silver. And they float against each other in exchange markets. So, we get fluctuating exchange rates.

Now, some countries have put themselves on a dollar standard by dollarizing. Some countries on the periphery of the eurozone have euroized. So they have fixed exchange rates. And their central banks really don’t have the power to control the quantity of money.

But otherwise, it’s up to central banks how much money they create and therefore what purchasing power the money has. And, so we have wildly different inflation rates across countries. Sri Lanka has been one of the most inflationary countries in the last 10 years.

Inflation targets fail to control Fed or ECB

So that’s where we are today. And the political systems have started to try to constrain central banks through inflation targets mostly. Traditionally, it was fixed exchange rates that constrained the central bank.

But there’s been a migration to trying to target inflation rates and continue to let exchange rates fluctuate. But inflation targeting provides an alternative method to constrain central banks from inflating too much. And it’s had mixed success.

The U.S. has a 2 percent inflation target. It didn’t stop us from having 9 percent inflation two years ago. Europe has a 2 percent inflation target.

They had more than 10 percent inflation. So it’s been a rather weak constraint.

Q: Can you give us an idea about countries that really did well under free banking? Even when Bank of England was there originally, until quite late until the Bank Charter Law, the country banks were creating their own money.The banks in Scotland were creating their own money, if I am correct. Can you give us a little idea about that?

A: Free banking is the label for a system where there’s competitive issue of currency by commercial banks. And there are still a few places in the world where you have commercial banks issuing paper currency.

Scotland still has three banks of issue [Bank of Scotland, Clydesdale Bank, The Royal Bank of Scotland].

Northern Ireland has four [Bank of Ireland (UK), Northern Bank Limited/Danske Bank, National Westminster Bank/Ulster Bank, First Trust Bank recently ceased].

Hong Kong has three. [HSBC, Standard Chartered, Bank of China]

Macau has one or two. So, it hasn’t been outlawed everywhere. But in the U.S. and in England and in other places, central banks took a monopoly of issuing currency.

The debate in the middle of the 19th century was should we have decentralized competitive note issue or should we concentrate it all on a government-controlled monopoly? And that’s central banking. So free banking systems worked really well where they were least restricted, where the banks were allowed to make themselves strong. And so Scotland was an example of that.

Community Based Constraints

The restrictions on the banks were very minimal. They could raise as much capital as they liked. They could branch as widely as they liked.

There weren’t any reserve requirements. There weren’t any capital requirements. But they had to compete for the favor of the public.

So, in a system where you have to do diligence when you’re choosing which bank to put your money in, people did that. And banks that were perceived as unsafe couldn’t attract customers. And each bank is issuing notes with its own name on them.

But they’re all interchangeable because they’re all redeemable for gold or silver coins. They are all on the same monetary standard. And it’s not much different from today.

Today, you have banks issuing checking accounts. And the check written on one bank is a $100 check written on Chase Manhattan is the same as a $100 check written on Citibank.

They’re interchangeable because the banks all get together and clear their obligations against each other. So, it wasn’t multiple standards in the same country. It was multiple brands of bank-issued money.

And the competition made the banks pay better rates on deposits and charge lower rates on loans in order to attract business. The spreads were very small between deposit and loan rates. The banks were well capitalized.

And they would advertise how much capital they had, capital being the cushion they have to absorb loan losses. Because if you want your bank to be safe, it needs to be well capitalized. So they were competitive and they were solid.

So, the best of both worlds for customers. There wasn’t any concentration of reserves. Banks kept their own reserves.

It’s a decentralized system that worked quite well. Adam Smith, in his famous Wealth of Nations, published in 1776, talked about how the Scottish system had been so successful that most people would carry bank notes instead of coins. And that had enabled the country to export coins, import raw materials and machines, and become wealthier.

READ MORE : Colombo to Haldummulla, Sri Lanka’s centres of free banking

Scotland pretty much caught up with England in per capita income, having started somewhat behind them. It helped promote growth in the Scottish economy, that they could substitute a less expensive payment system for a more expensive one, which was just using gold and silver coins.

Q : The Bank of England went off the gold standard a few times, what actually happened to the Scottish notes? Did they float against the Bank of England or what happened?

A: That’s an interesting episode. When Napoleon was threatening to invade England in 1797, there was a panic in England and the Bank of England had to suspend payments. They were running out of reserves. So they floated against gold.

The Scottish banks stayed pegged to the Bank of England note, not to gold. So they de-pegged from gold. They maintained a fixed exchange rate with the Bank of England.

And I think that’s because most of their trade was with England and England is now on a paper pound standard. So Scotland also went on a paper pound standard.

And it’s kind of surprising that nobody sued them because this was a kind of breach of their contract to pay gold or silver on demand. But nobody seems to have forced the issue. And when the Bank of England resumed convertibility, so did the Scottish banks.

Q : So they had no problem? They kept their gold, and they didn’t over-issue during the suspension?

A : Right. So their fear was if they kept paying gold when the Bank of England wasn’t, then they would be drained of their gold.

So they suspended against gold so that wouldn’t happen.

Q : Canada also had a free banking system until quite recently, isn’t that right? Can you give us an overview of that and why did it stop?

A : So Canada, unlike the US, had a much freer banking system. In the US, banks were not allowed to branch across state lines. And so banks in the US were small and they were poorly capitalized, but mostly they were not well diversified because if a bank is just in one town, it’s hard to diversify its investments, its loan portfolio.

Whereas the Canadian banks were governed by national law, not by provincial law. They were free to branch across provinces from coast to coast. The Canadian system was very well diversified.

And the banks were strong and didn’t fail frequently, not as frequently as the US banks. In particular, in the late 19th century, the US had, under federal regulations that restricted banks, had a series of financial panics. Canada didn’t have any financial panics.

Their system, like the Scottish system, was solid as well as competitive. And it was a kind of a model for US reformers who said in the late 19th century, we should adopt the Canadian system. And it didn’t get very far in the US Congress because the small banks in local communities didn’t want the large banks branching into their territory, which was part of the Canadian system.

When reformers said we should allow branch banking, that sort of killed it politically. But everybody understood at the time that Canada had a much more solid banking system than the US did. Instead, the US passed the Federal Reserve Act.

And you can think of that as a way of backstopping a weak banking system without fundamentally reforming what was making it weak.

Q: What led to the setting up of the Bank of Canada? That was somewhere in 1935, as I recall?

A: Yes. So the Federal Reserve Act in the US established a central bank in 1913. The law was passed in 1913 and the Fed was up and running in 1914.

The Bank of Canada Act came in the middle of the Depression. But the bankers didn’t want it. In the case of the Federal Reserve Act, we’d had the panic of 1907 and the bankers in New York finally said, OK, we need we want federal assistance in panics. So let’s set up this system.

And of course, they hoped that they would control it.

But in Canada, the bankers said, no, we’re fine. We don’t need a central bank. Thanks very much. But the government decided for political reasons that they should have a central bank.

Even though if you looked around the world, the countries with central banks were not doing better in the Depression than countries without central banks.

They established a Commission, actually, to determine that they needed it. It was stacked with three supporters of a central bank and only two opponents. So they decided in favor of a central bank.

But the one banker on the panel said, ‘We don’t need a central bank’. And a former finance minister who was on the Commission said, ‘No, we don’t need a central bank. We’re doing quite well.’

But they set up the central bank, the Bank of Canada anyway. And the Bank of Canada did less than the Federal Reserve System. It didn’t immediately nationalize the clearing system the way the Fed did.

So the interbank clearing system continued to be private in Canada up until the 1970s, I think it was, when it was finally nationalized.

But what were they hoping to get by creating the Bank of Canada? Well, there were some reformers, some inflationist reformers who wanted cheaper money. And they thought, forget a national bank of issue, we can pressure it to issue more money. And they thought that would help them get out of the depression.

But the Canadian banking system had no bank failures during the Great Depression. It’s quite remarkable. They were so solid. They did close some branches that were unprofitable, but none of the banks failed.

Q: Also, even after the establishment of the Bank of Canada, they haven’t done as badly as the Fed. Why was that?

A : Well, for a long time, that was true. Well, basically, because under the Bretton Woods system, they were pegged to the U.S. dollar. So, Canada had the U.S. dollar inflation rate. It was basically one Canadian dollar for one U.S. dollar for a long time.

After 1971, the Canadian dollar has depreciated against the U.S. dollar. Today, it’s about 75 cents. So, the performance of the Bank of Canada has been like the performance of the Fed, better sometimes, not as good other times.

Q : But in terms of bank failures and bubbles and stuff, they have done better ?

A : That’s right. So they didn’t have the Housing Bubble we had leading up to the crash of 2008.

Q : I was looking at some of the policy rates of the countries that had the bubble. The Fed ran an eight-year cycle. ECB ran an eight-year cycle. But the Bank of Canada and Bank of Australia actually ran a four-year cycle.

They had hiked rates in the middle and they did not have a long time for the bubble to form, so-called. So they seem to have done better.

A :. Yes, I’m not sure why that is. But they evidently saw that keeping interest rates too low for too long wasn’t a good idea, and they started raising rates more promptly.

Q :Could it have been the inflation index would have been a better index than the US one, and commodities showed up? Because even though the commodity prices were going up, Fed didn’t raise rates?

A : I don’t know how their price index differs. That’s a good thing to look at. It is a problem in the U.S. that asset prices and commodity prices are not in the price index.

So when excess credit creation by the Fed drives up housing prices or commodity prices, it doesn’t prompt any reaction by the Fed because they’re not looking at those prices. They’re only looking at the personal consumption expenditure deflator.

Q : What do you think is the primary kind of reason for this explosion of state-owned monopoly central banks? Because if the private banks did better earlier, even when they were monopolies, and if the free-banks were better and central banks were clearly bad, how did they proliferate so fast? What were the legislators doing and why did they do that?

A : I had a former student write a paper about enumerating all the free banking systems he could find in history, and there were more than 60, and then asking why did they end?

In some cases, it was because there was a banking crisis and a central bank was created in response to that, and that’s the case of the Federal Reserve System. In other cases, it was pretty clearly just a fiscal measure. It was to raise revenue. The Bank of France, the Bank of Italy, and the Bank of England are explicitly created to lend the government money at low interest rates.

That’s their duty. And to enable them to do that, they’re given a monopoly on banknote issues so that they can finance their lending to the government easily. It’s a slightly different story in each country.

There’s a book called The Rationale of Central Banking by an author named Vera Smith published in the 1930s, and she goes through the US, Canada, Germany, France, Great Britain. It’s interesting to see the details in each case, but I think the fiscal motive is probably the overriding thing.

Now, later on, in the early 1900s, under the auspices of the League of Nations, there was an economics professor named Edwin Kemmerer, who was sometimes called the money doctor, who was sent to developing countries in particular. He went all through Latin America, advising the national governments to set up central banks. And his idea was that having a central bank would help safeguard the gold standard better than having free banking, which ironically turns out to be the opposite of the truth.

If you have one point of failure, if you have a central bank who’s responsible for maintaining convertibility, and there’s some kind of fiscal problem where they need to print money or the government wants them to print money, they’re going to suspend the gold standard.

And so all the gold standards were suspended at some point or another. As I said, most of the countries that already had central banks did it in the First World War, but all the Latin American governments eventually suspended it too. Whereas if you have a multiplicity of – going back to free banking – if you have two dozen banks of issue, any one of them can suspend payments without the gold standard disappearing.

It just means there’s one bank that has to be closed, but the other 23 banks are still fine and the gold standard persists. So having a central bank is putting all your eggs in one basket. And there are fiscal incentives for them to not remain on the gold standard because it constrains the use of the printing press as a method of finance.

Q : Walter Kemmerer, I kind of went through some of the banks that he had created. They were actually not so bad if you really look at it. I think later on, Robert Triffin and Raoul Rrebisch went and tinkered with the law and then after that, they went completely crazy.
Is that what you also – the impression that you had?

A: Yeah, their intentions were good. And to the extent that the central banks they set up considered themselves bound to play by the rules or obeyed the rule of law, then it worked. I mean they maintained convertibility. It worked in that sense. But soon they were overwhelmed with political pressure for cheap money.

So the story in Sri Lanka is that you had John Exter came and on behalf of whom set up a central bank?

Q : Yes. They had a kind of a playbook or blueprint. So when we asked for help, the Fed this practice of sending these money doctors around. And he came here.

But, the paper he wrote – even though he abolished the currency board that was here – in the original paper that was made into a law [the Exter Report], he put in so many cautions. Don’t do this. Don’t do that. America may do this, but you are a trading nation. You can’t do that. He seems to have had a kind of a distrust towards the central bank, even though he made the law.

A : Yes. Many years ago I met John Exter. So I was probably 25 and he was 75. But, yes, he was very sceptical of central banks and, you know, very much wringing his hands over the mischief they had done.

Q : So what did he actually say? People here are very interested to know about John Exter because, even though he created the central bank, I think he probably did a better job than we would have if somebody else had done it. Things would have got bad earlier.

A : I guess when I met him, it was the early 1980s and there was double digit inflation in the US. And he was very concerned about inflation all around the world and the potential for central banks to try to inflate their way and the government’s way out of problems.

So he was looking for some way to re-fasten constraints on them.

Q : Now, it seems that like floating exchange rates if the inflation target is low enough, like maybe 2 percent and maybe the index is good enough, they seem to be doing ok. I don’t know how successful, but they seem to be doing ok. Australia and New Zealand seem to have done better than others. And even hard pegs seems to be doing ok.

But a lot of countries have intermediate regimes and they seem to be the ones that are doing the worst. But they are so popular. Why is that?

A : Wishful thinking, really (laughing). As you say, the durable systems are either a really hard peg, outright dollarization or a credible currency board. And at the other extreme, you don’t have exchange rate crises if you have a floating exchange rate and you don’t try to mess with it at all. You don’t try to dirty the float.

But in between, you’re trying to have your cake and eat it, too. You’re trying to maintain some exchange rate stability while still having discretion for the central bank.

But when the central bank is using its discretion to try to finance budget deficits or bring down unemployment or something like that, then they act in ways that are inconsistent with maintaining the exchange rate peg.

If you have more inflation than the currency you’re anchored to, there is a discrepancy and there is an arbitrage opportunity for people to attack your currency. So there’s been what people have referred to as a hollowing out. These kind of weak pegs or dirty floats, crawling pegs, those sort of things have not really lasted.

But the Southeast Asian crisis in 1997 was an example of many of those regimes being attacked by speculators because they became non-credible, not believable that they were going to maintain the peg.

To maintain a peg when your monetary policy is inconsistent with it, you need exchange controls. So they had all kinds of import controls, export controls, rationing of foreign exchange, that sort of thing.

Q : So coming to the countries like Sri Lanka and also these mixed regimes : Sri Lanka is now trying to do inflation targeting despite trying to collect reserves also at the same time. And they call it a flexible exchange rate.

And the IMF is also supporting this kind of another intermediate regime. Now they say they are trying to target inflation, but without actually having a clean floating exchange rate and intervening and trying to collect reserves at the same time. And IMF is supporting this instead of trying to get into a more consistent one like a clean float or dollarization or hard peg.

And why do you think that is happening? Why do they always support these intermediate regimes?

A : It’s a puzzle. I mean, the IMF was created under the Bretton Woods system to serve as a referee and backstop to the fixed exchange rates. So, if a country pursued a monetary policy inconsistent with the fixed exchange rate and needed to devalue, the IMF would rule on how much they were allowed to devalue.

And if they decided they shouldn’t devalue, then they would lend them enough reserves to make it through while they corrected course. That was the idea. Since the collapse of Bretton Woods, which is now what? More than 50 years ago.

IMF Re-invents as flexible exchange rates trigger bigger crises

The IMF has kind of been at a loss for what is our mission now. We’re not supporting the exchange rate regime. What do we do?

And they’ve kind of reinvented themselves as a kind of crisis resolution agency.

So they come in after a crisis and decide who gets paid in what order and how much they will lend to the country that’s having a problem repaying their debts. And then, of course, they add conditionality. They say we’ll lend you the money if you pursue the following policies, which makes the IMF, of course, very unpopular, as evidenced in the latest election in Sri Lanka, where the winning party ran against the IMF.

But I think the IMF thinks of themselves as crisis managers. And maybe that makes them not that interested in systems that don’t need management, systems that are automatically self-sustaining. And so if you have a clean floating exchange rate, you don’t need a crisis manager.

And if you have a credible peg, if you’re dollarized, especially, you don’t need the IMF’s help. So maybe they want to preserve regimes where they are needed.

Q : Has anybody done any research on the link between the monetary regime and the default, external defaults?

A : I’m not aware of it, but of course, most of the defaults are by countries that are borrowing in dollars. Because if you don’t have to default, if you’re borrowing your own currency, you can always print enough of it to pay back the creditors.

But countries with bad inflation track records can’t borrow in their own currency. Nobody trusts that currency. They have to borrow in US dollars and they can have real trouble getting enough dollars, earning enough through exports, either because of real shocks or because of bad monetary policy.

My suspicion would be that taking away constraints on central banks leads to more cases of unsustainable debt burdens because it makes the local currency unpredictable in terms of its dollar value.

Q : We are focusing on the central bank independence. But the collapse of the Bretton Woods, housing bubble: they all happened under an independent central bank. Why have independent central banks failed so miserably or spectacularly?

A : Well, I guess I wouldn’t blame it on the independence. I would blame it on the lack of a constraint or a rule governing the central bank. The Federal Reserve stopped respecting its constraint at the end of the Bretton Woods system to only issue as many dollars as could be redeemed at $35 an ounce. And the US started losing gold reserves because it was overprinting dollars and they were being redeemed. And finally, they just shut the gold window.

And after that, monetary policy had no compass. They had to learn how to control it. But before they learned, we went through a period of double-digit inflation and financial crises.

And I guess the housing bubble was another example of learning by doing. They thought they were following – the Fed thought that it was behaving responsibly, that it wasn’t holding interest rates too low. But we learned after the fact that they had been holding rates so low that it created a credit bubble.

So, they had to go back to the drawing board and re-calibrate. That’s the sort of the big theme, that the fiat money systems need to be managed in a way that requires some experience. And central banks in a changing environment have to keep learning how to avoid going off the rails.

Q : The Fed has this, whatever they call the employment mandate or the Humphrey Hawkins and the old Employment Act of 49. But I was looking at some transcripts and there was a conversation between Paul Volcker and Henry Wallich. And they were talking about how to avoid this and explain to the Congress that we are actually, you know, going to give you better outcomes or better employment by actually not doing that. They seem to have had some knowledge that other people didn’t have. And the lawmakers have themselves put this on the central bank to do the employment.

A: It’s impossible to pursue two targets with only one tool or one instrument. And the Fed has one, well, it used to before it changed its system in 2008, had only one tool, which was its Fed funds target. So you can’t simultaneously pursue low inflation and low unemployment when there’s in any state of inflation expectations, a trade-off between the two.

So, yeah, so Volcker’s philosophy was we’re only going to aim at the inflation target and we’re going to talk fancy to Congress to explain to them how this is consistent with, in the long run, having maximum employment.

Which is actually true. I mean, the central bank can’t do anything about unemployment fundamentally. That’s a labor market issue. You need to get wages correctly aligned with the demand for labor.

It doesn’t really make sense to have a real target like an employment target or a real output or growth target for the central bank. They can’t control that. All they can control is the purchasing power of the monetary unit. So it makes more sense for them to have a single target.

And I think Volcker understood that.

Q : Another thing that I noticed is even Greenspan, before maybe Bernanke became his deputy, he never talked about an explicit inflation target as such that we can see, like a 2 percent target or something. But he was doing a whack-a-mole kind of thing where, when you see the asset price coming up, he used to whack it down.

A : Greenspan seemed to think that he could, you know, juggle many balls and that he could simultaneously manage the inflation rate and the unemployment rate by not pre-committing to anything, but just responding to events as they happened. And it worked okay. Inflation was a little higher than 2 percent through most of Greenspan’s regime, but at least it wasn’t double digits.

It worked okay until the Housing Bubble. That was his big undoing, because he was in charge when following the dot-com recession, they kept interest rates too low for too long. He thought that we were in a new era with great productivity growth and therefore low interest rates are appropriate.

But that turned out to be a mistake. They couldn’t keep them that low.

Q : Professor Steve Hanke claims that he was misled by Bernanke, that there was a false deflation scare and he kind of kept rates down and then fired the bubble?

A : I think that’s true. Bernanke was on the Federal Reserve Board as one of the governors. And because he studied the Great Depression, I guess, he has always been very paranoid about the risk of deflation. He has this theory where you don’t want to go below zero because then you get sucked into a negative feedback loop. So you always want to keep inflation positive.

Ironically, the last time we had deflation was in Bernanke’s tenure in the middle of the financial crisis. But yes, Bernanke never understood that you could have a benign deflation if it’s driven by productivity growth. And so, he wanted to do everything to avoid any kind of deflation.

Q : The Austrians always said that the best thing that you can have, is to have productivity drive an index down. It’s nothing to do with actual credit conditions, but capitalism drives prices down?

A : Right. So if you have a gold standard, you would like output of goods and services to grow faster. And if it grows faster than the world supply of gold, then prices will fall. You’ll have output growing faster than the number of money units chasing them. And that’s fine. That’s very benign. That’s great.

In a fiat system, you can manage the growth of the quantity of money and keeping it at a rate that makes inflation slightly negative is what Milton Friedman called the optimum quantity of money. It imposes the least tax on money holding by consumers.

So that maybe is minus half a percent. It’s not very negative because, the real rate of interest is not very positive. The risk-free short-term rate of interest is pretty low and the prescription is you should deflate at the real rate of interest.

Q : I have a couple of philosophical questions. If some of these things seem to be quite evident to people – I think you did a paper on some of the regulatory aspects in the US also that pushed the bubble and forced banks to lend – I think I remember…

A : . I had a paper called, How did we get into this financial mess? I think that’s probably what you’re thinking.

READ MORE : How did we get into this financial mess?

Q : Yes. So if all these things are known, why don’t central bankers seem to learn? And especially if you see the example of people who have ignored the employment mandate, doing better and having a lot of migrants in the 80s. And with whatever the problems that even Greenspan was doing, that seems to have been a more successful regime. Why don’t people learn?

A : Well, several people have written histories of the Federal Reserve trying to explain the variations in monetary policy. The Fed had this bad theory in the Great Depression, for example. They had the real bills of doctrine, which led them to be passive in the face of a shrinking money supply. And then they learned that that was a bad idea.

And then the Fed thought that they could exploit the short run Phillips curve in the 60s. And then they learned that that was a bad idea when we got double digit inflation. And so the Fed is continually updating. And I think there’s some truth to that.

Some central banks have been sort of more consistently non-inflationary. The Swiss National Bank has a better track record than others. But there are other pressures on central banks besides, you know, following their own ideas, even when their own ideas are relatively good.

So if you look around the world at countries with double digit and higher inflation, there are political pressures on them to stimulate the economy through loose monetary policy.

Or in an extreme case like Argentina, the ministers call up the central bank and say, here’s my payroll. Please send over enough money to meet the payroll. And so central banks get roped into having to ignore everything they know about monetary policy and just print the money.

I was in Argentina in 1989 for a conference, and somebody set up an interview with the head of the central bank. I don’t know why he wanted to talk to me, but it was quite interesting. He was a well-trained economist.

He understood what was driving inflation. He said, look, I know we’re creating too much money to have low inflation, but what am I going to do? I’m not independent. I get messages from the government saying, please send over this many pesos, and I have to do it.

Q: In 2018, we also had a problem. We had a currency crisis because they were cutting rates and injecting money. And I was also, at the same time, Argentina was also having, starting another cycle. They had this sterilization security called Lelique, and those auctions were failing because the BCRA actually didn’t want to allow it to be rolled over at a higher rate.

And they themselves did that by trying to stop the interest rate from going up and then injecting the liquidity by redeeming the Leliques back to itself. So there seems to be some knowledge gap there as well.

A : I don’t know. Well, there is perpetually greater popularity for low interest rates. And so central banks that think that it’s part of their job to stimulate growth, they want to keep interest rates lower than they should be to actually coordinate savings and investment.

Q : So, for a country like Sri Lanka, if you have kind of two kind of regimes, like, for example, if you allow dollarization or even free banking, I think it’s like too radical for people to think of now.

A So before you have free banking, you need an external monetary standard, one that the domestic government doesn’t control. So you can have free banking on a dollar standard.

Q : Is it a good idea to have kind of dollarization in parallel and let the central bank people select which one they want to price it? Is that a possibility?

A : Well, if we want to promote the well-being of households, then yes, let people put their savings and even their transaction balances in whatever currency they would like to use and let them vote with their pocketbooks. So don’t put legal obstacles in the way of people holding dollars or euros or whatever, transacting in alternative currencies. Let the banks have accounts in other currencies or let parallel banks open accounts in other currencies.

Do you have an estimate of how dollarized the savings of Sri Lanka are?

Q : We have officially allowed savings to be kept in dollars and it’s part of the banking system. But at the moment, when you withdraw the money, they pay in rupees at the correct exchange rate. So people are allowed to save in dollars, but you can’t actually transact domestically. People don’t price mark in dollars, but after the crisis, I think some of the companies, especially IT companies, denominated salaries in dollars and they paid in rupees. So that kind of thing has happened, but it’s not something that is encouraged.

A : So in Argentina, under the convertibility plan in the 90s, they also allowed dollar-denominated bank accounts.

But when they decided to crash the system, they confiscated everybody’s dollar bank accounts and forced conversion into pesos at like a third of the previous exchange rate because when they floated, the peso fell by two-thirds. So everybody with a dollar-denominated account had two-thirds of it stolen from them. So you need to worry.

You need to worry about whether that could happen.

Q : Our central bank was better. I think they have done two things. One is that they have asked the banks to lend to export companies and people who have dollar revenues when they give the loan. But the previous government borrowed a lot of the dollar banking unit, offshore banking unit money. And the central bank, the government eventually repaid those things in rupees at the current exchange rate.

And they allowed the banks to build up dollars to match the deposits. So when the government defaulted on the dollar loan, they were paid in rupees. And banks were allowed to collect the dollars from the market and match the deposits.

I want to ask one last question, kind of a philosophical one. When you talk about the golden age of liberalism, that also seems to have been accompanied by fairly sound money for a long period. And also when you look at what happens in a stabilization crisis, like what happened in Germany, for example, there is a big government change. The people who say the weirdest thing can come into power. So is there a kind of a link? Is sound money essential for democracy and individual freedoms?

A : I think so. And I think many historians attribute the popularity of Hitler to the hyperinflation of the 1920s, that basically stripped all the savings from the German middle class and made them quite vulnerable to economic insecurity. And so they thought they were voting for a candidate who would restore order to a chaotic economy.

Yeah. So classical liberalism has always stood for free choice in money, competition in note issue, freedom to use foreign currencies, no exchange controls. And that sort of openness is important to put constraints on how much damage government can do to the economy, how much damage central banks can do to the economy.

If people can protect themselves by freely moving their assets away from investments that are vulnerable to changes in monetary policy. But when you have bad monetary policy, it can cause hyperinflation. It can cause big business cycles, big financial crises.

And it’s under that kind of uncertainty that people sometimes desperately vote for what they think is going to restore order. And you get populist leaders who are promising, you know, unrealistic or authoritarian approaches. So I think I think those two things are kind of self-reinforcing, having an open, free, liberal economy and having sound money.

That’s really kind of a side effect or a byproduct of having a liberal regime. And so the classical gold standard was a regime which limited the power of central banks very much because they couldn’t expand without gold leaving the country and them being forced to return to normal.

But in a system of fiat money, that constraint is gone. There’s no penalty, almost no embarrassment to the central bank to behaving irresponsibly or producing money that’s unsound.