ECONOMYNEXT – Sri Lanka’s Central Bank, which has printed tens of billions of rupees in 2018 to boost economic activity artificially just as the economy recovered, generating another bust and currency collapse, bringing to fruition a remarkable prediction made in 1975.
False Promise on False Premise
Sri Lanka abolished a hard peg (currency board) with a floating interest rates and moved to money printing in 1950 on the false promise that the exchange rate and interest rate can be controlled at the same time and join the failed Bretton Woods system of soft-pegs.
The controlling of interest rates is called ‘monetary policy independence’. It was all the rage in post-colonial countries.
Monetary policy independence was simply a euphemism to say that the Central Bank officials could print money at any time they wished and no questions asked. It was the fad of the times after World War II, and Keynesianism was all the rage.
But countries like Malaysia, Singapore (later also Mauritius, Maldives and Dubai), stayed out of the craze and kept their pegs hard, while being part of the Bretton Woods. Japan, which had suffered from hyper-inflation, was also not tempted.
Maldives now has a per capita GDP of 11,000 dollars compared to 4,000 for Sri Lanka. But the law of the Maldives Monetary Authority has been ‘modernised’ leading to more instability of late. More ‘modernisation’ is planned.
Germany which lost the war, also stayed out of the Keynesian dogma, and created the German Economic Miracle through its Social Market Economy.
The basis for the social market economy was sound money not soft-pegging or a depreciating real effective exchange rate.
The UK suffered from Keynesian economics which generated unsound money, just as badly as any former colony that followed such policies, such as Sri Lanka, India, or Pakistan.
The Bank of England (UK had a soft-peg with the US dollar under the Bretton Woods system) was hit with sterling crises, inflation and depreciation and became a weak nation, while countries like Singapore forged ahead.
"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 workplace," Goh Keng Swee, architect of Singapore’s monetary stability and economic reforms said.
"Diligence, education and skills will create wealth, not Central Bank credit. Hence, we were not impressed by claims — excessive as they turned out to be — that government could bring about prosperity through spending. It did not surprise us that the Anglo-Saxon countries which adopted such policies got into trouble.
"We also noted that the Germans and Japanese did not believe they could ‘spend their way to prosperity’, as the phrase went. Like Singaporeans, they set store on diligence, education and skills.
Goh went to London School of Economics, where in the 1930s Friedrich von Hayek, an Austrian (German) economist lectured and pointed out the flaws of Keynes theories.
Under Margaret Thatcher, UK finally dug itself out of its post World War II economic morass. Thatcher incidentally was a fan of Hayek and reportedly flashed a copy of his ‘Constitution of Liberty’ when a Conservative think tank tried to make her a follow the ‘middle way’, the usual path of fascists.
Sri Lanka’s A S Jayewardene, who also went to LSE, was the first Central Bank Governor to resist money printing. Jayawardene also changed the underlying law of the central bank which earlier gave it the responsibility to maintain the internal and external value of the rupee, as both the exchange rate and interest rate cannot be controlled at the same time.
Age of Keynes
Under the Bretton Woods system, countries like the UK and Sri Lanka pegged to the US dollar. The US was expected to peg to gold at 35 dollars an ounce.
Under the interventionist New Deal, during the Great Depression (which was a result of the ‘Roaring 20s Bubble’ fired by the Fed in the first decade of its operation), the US dollar was depreciated from 22 to 35 dollars an ounce. This was a currency that has been stable since the late 1700s without a Central Bank.
If the Fed was supposed to peg at 35 dollars an ounce, obviously it could not operate independent monetary policy (print money as it wished). Fixed interest rate targeting is incompatible with maintaining a gold peg, just like Sri Lanka cannot maintain the exchange rate peg by printing money.
"In the end, gold convertibility of the US dollar was suspended in August 1971 and, shortly thereafter, the regime of floating currencies came into being. World currencies continue to float till this day," Singapore’s Goh observed.
"My Cabinet colleagues took careful note of these dramatic events as they unfolded on the world’s financial scene. None of us believed that Keynesian economic policies could serve as Singapore’s guide to economic well-being."
"There is a further difficulty to contend with. The Keynesian system is a closed one, that is, it takes no account of foreign trade. 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 the government does not exercise restraint in time.
The US also slapped import controls as the dollar’s gold peg collapsed.
Sri Lanka closed its entire economy after 1971, while countries like Singapore floated initially and then went back to a currency board. It has since been modified to appreciate if the US Fed is pursuing inflationary policy.
The sad thing is in 2018, Sri Lanka also slapped import controls. Sri Lanka has learnt nothing other than Mercantilism since 1950.
Taxes and Currency Depreciation
The current administration came to power to promising a Social Market Economy and good governance.
This column pointed out that central bank reform should be the first step in a social market economy soon after this administration came to power. (Sri Lanka needs Central Bank reforms for a Social Market Economy: Bellwether).
Germany brought down inflation and currency stability after World War II with its central bank and policymakers stuffed with newly resurgent liberals (mostly from the so-called Frieberg School like Ludwig Erhard) but also Austrian classical economists such as William Ropke who served on the currency reform panel.
Singapore’s Goh has said "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."
But Finance Minister Mangala Samaraweera, who took over later had an extremely difficult job to save the country from the 2015 budget, did not do that. He has imposed several unpopular taxes in sharp contrast to the danger Goh Keng Swee warned against.
Neither Samaraweera nor State Minister Eran Wickremeratne has put pressure on the central bank to loosen policy and print money.
The central bank printed money and generate monetary instability and capital flight entirely on its own doctrine, which then slowed economic activity and tax collections. Key monetary policy errors in February – April and after August 2018, were all done by central bank on its own volition exercising its independence.
In addition to paying new and higher taxes, people are now being forced to suffer exchange rate depreciation as well because of REER targeting. Meanwhile, the national debt is expanding and forex losses at state enterprises are also going up.
The International Monetary Fund also gave the soft-pegged central bank tools to engage in fancy monetary policy.
The central bank was taught to calculate the ‘potential output’ so that it would be induced to print money when output was below the threshold, like in April 2018.
Trying to close the potential output through printing money is what got the Fed and the US dollar in trouble in the 1960s and led to the collapse of the entire Bretton Woods system in the first place.
In sharp contrast to conventional wisdom regarding politicians, Harsha de Silva, the State Minister in charge of ministry that the central bank was placed under at the time urged the agency to allow rates to go up so as to reduce money printing.
It is not clear whether any elected politician in any other democratic country had ever asked a central bank to raise rates and follow prudent policy, since like Trump they are not aware or do not care whether a collapse comes later.
Other than Singapore, where the politician who is usually a classical economist is the central bank governor, it is perhaps the first time an Asian politician had asked a central bank to follow prudent policy.
How come he was ignored? Why did this happen? And how come IMF (apparently) sanctioned all this?
Keynes’ Ghost and the Big Lie
That countries will continue to suffer from Keynes’ doctrine despite the fall of Bretton Woods was predicted by non-other than Hayek over 40 years ago. Keynes died shortly after the first negotiations for Bretton Wood was done. He did not live to see the massive inflation and currency problems that his own country and the US suffered.
To be fair, Keynes’ first preference was to have a different system – the ‘bancor’ – and not the structure that eventually came. The special drawing rights, is perhaps a relic of this idea.
Bretton Woods Soft-pegs and the IMF were primarily a US idea driven by New Dealers (who were also Keynesians) who wanted to break the Sterling area and get central banks in countries like Sri Lanka to invest in US dollar debt instead of Sterling debt.
New Dealers were probably worse than Keynes and they had greater political power as the US was the biggest creditor nation remaining at the time, with gold reserves of the Bank of England and other European banks depleted. US also loaned officials to set up soft-pegged central banks including to Sri Lanka and the state department gave the diplomatic push.
Hayek pointed out the flaws and the dangers of the ideas contained in Keynes ‘Treatise in Money’ through a series of lectures in the 1930s. A central idea of the Treatise was that a recession would occur if savings exceeded investment. (In fact this is what happens after a bubble bursts and a modern-day central bank in Sri Lanka re-builds forex reserves).
The opposite happens when money is printed and balance of payment deficits occurs. It may may not cause harm to print money just after a bubble has burst, because the credit system is not giving enough loans (i.e savings exceed investment), but not so when the economy and credit starts to recover.
This is why Singapore’s Goh said restraint must be exercised ‘in time’. It is also why the Fed tightened as credit picked up in recent months.
Sri Lanka’s central bank on the other hand opens the monetary taps just as the economy is recovering. It did so in 2011, 2015 and in 2018.
The central bank also keeps un-necessarily high interest rates after the end of a BOP crisis, delaying a recovery, egged on by the IMF. After a currency collapse, and liquidity shortages end, inflation usually spikes, as the price structure of the country re-adjusts regardless of whether interest rates are high or low, unless the exchange rate bounces back like in a floating system.
Austrian economists (one of the last remaining classical economics schools who helped drive Germany’s social market economy after World War II) on the other hand said that stimulus would lead to a bubble, which will then collapse and generate transient unemployment.
Sri Lanka’s central bank has been in the habit of blaming the government budget for ‘excess demand’. This is not true. A budget cannot generate excess demand because spending power is transferred from one set of people (bond holders) to the government.
Excess demand can only be fired if the central bank prints money. It matters little whether the money is printed for deficit financing or it is injected through open market operations into the banking system for private credit.
The government which can pay higher rates are supposed to ‘crowd out’ other borrowers. If there is perfect crowding out there cannot be excess demand. The excess demand will only come if the central bank prints money to buy the bonds or gives money to banks through open market operations to finance the government.
To say that a budget fires excess demand is a lie, through whether it is intentionally done by the central bank to absolve itself from blame it whether or a ‘lost generation’ side effect is open to debate.
Even in the case of a credit collapse, deficit spending can only take the excess savings and expand consumption (or investment) to equal spending to savings.
Hayek was awarded a Nobel prize in 1974, shortly after the Bretton Woods system collapsed and the world went into floating rates and inflation picked up.
During this time Hayek made a presentation at a conference in Switzerland, urging countries to end legal tender laws and allow currency competition, so that better currencies would get wider use. He pointed out that money printing will only give a short term stimulus, the price is a bust and lower employment. It had been the case when tried out earlier by the likes of John Law in France.
"It was John Maynard Keynes, a man of great intellect but limited knowledge of economy theory, who ultimately succeeded in rehabilitating a view long the preserve of cranks with whom he openly sympathized," Hayek said in a speech that was published by the Institute of Economic Affairs as an occasional paper .
"The claim of an eminent public figure and brilliant polemicist to provide a cheap and easy means of permanently preventing serious unemployment conquered public opinion, and after his death, professional opinion too.”
John Hicks, (an economist who came up with an IS/LM model but later said it was a classroom gadget) had proposed that 1950 to 1975 be called the ‘Age of Keynes’ because the earlier quarter century was the ‘Age of Hitler’.
"I do not feel that the harm Keynes did is really so much as to justify that description," Hayek said. "But it is true that, so long as his prescriptions seemed to work, they operated as an orthodoxy which it appeared useless to oppose."
So why is there no learning curve at depreciating central banks either in Sri Lanka or in Latin America?
How come the central bank is still following John Law to generate excess liquidity when there is no currency pressure and continues to sterilize outflows through open market operations when the peg is defended after pressure is generated?
How come Sri Lanka is targeting an exchange rate with multiple convertibility undertakings without a floating policy rate?
"The whole theory underlying the full employment policies has by now of course been thoroughly discredited by the experience of the last few years," Hayek said.
"In consequence the economists are also trying to discover its fatal intellectual defects which they ought to have seen all along. Yet I fear the theory will still give us a lot of trouble: it has left us with a lost generation of economists who have learnt nothing else.
"One of our chief problems will be to protect our money against those economists who will continue to offer their quack remedies, the short-term effectiveness of which will continue to ensure them popularity."
In 2001 to 2004, when Prime Minister Ranil Wickremesinghe was in power, Sri Lanka operated exceptional economic policy and a liberalization drive.
With A S Jayewardene as Governor, sound money was preserved, budget were tight and the economy recovered with no inflation. Keynes was nowhere in sight.
But in 2015, Wickremesinghe was quoted in news reports saying a Keynesian stimulus was being done. There was a massive spike in the deficit under Finance Minister Ravi Karunanayake and released liquidity by terminating term repo deals like the central bank of Argentina was buying back its own sterilization securities and the BOP crisis came soon after.
It is also a puzzle why the IMF is giving a forex reserve target with an inflation target instead of a domestic assets ceiling for the central bank. An inflation target which allows the central bank to cut rates (print money) is incompatible with a forex reserve target which requires the operation of a peg tighter than a currency board.
The soft-peg is a creature of the Bretton Woods. And the Bretton Woods was a creature of US New Dealers, who were arch interventionists that made the Great Depression worse. US Treasury’s Harry Dexter White in particular, who was the prime mover behind the Bretton Woods, was a New Dealer with Soviet sympathies.
Unlike the Gold Standard which made free trade possible for about two centuries with no inflation, the Bretton Woods was failing by the 1960s and collapsed in 1971.
A key reason for building dollar pegged exchange regime by America was to get other central banks to buy US debt with their forex reserves, lowering deficit financing costs instead of Sterling debt. But people like then US Secretary of State Cordell Hull genuinely wanted free trade and a monetary order that would help achieve it after the devaluations and tariff wars during depression.
IMF also does not favour currency boards, which may be a throwback to the past since its original mandate revolved around breaking currency boards. (Amusingly, IMF teams that reviewed Hong Kong used to say that the linked exchange rate has served the country well.).
Since 1950 Sri Lanka’s central bank’s soft-peg has done enormous damage to the country, destroying stability, destroying people’s real salaries, destroying free trade. Forex shortages also helped economic nationalism with import substitution triggered by policy errors. Countless hapless Sri Lankans were prosecuted for breaking foreing exchange controls. This is, not counting the political instability that came from inflation and depreciation.
The latest cost of the soft-peg is to kill the Social Market Economy before it was born, taking away the basic stability destroy real wages and leave the people with both higher taxes and currency depreciation.
The REER targeting and the resulting unsound money also shattered the trade liberalization drive of Mangala Samaraweera by forcing him to roll back trade liberalization slam restrictions in monetary dominance of fiscal policy.
Currency depreciation also denied any benefit of lower tariffs to the people. A similar phenomenon was seen in the 1980s, where the benefits of an open market was denied to the people by monetary instability of the central bank as currency depreciation destroyed real wages triggering widespread strikes and unrest.
The question is when will unsound money end? It surely will not end as long as true believers keep faith in lost generation economics.
This column is based on ‘The Price Signal by Bellwether‘ published in the April 2019 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here. To reach the columnist write to: bellwetherECN@gmail.com.