ECONOMYNEXT – Sri Lanka’s monetary instability, the rising cost of living, falling living standards and the resultant strikes, revolutions as well as the enactment of authoritarian constitutions are a common thread in almost all countries where Latin America style central banks were set up by the Federal Reserve.

In many of the countries, central banks were set up in a post-Depression philosophy peddled by Raul Prebisch – a key force behind Argentina’s central bank and so-called ‘development economics’ and Latin American Structuralism- and Robert Triffin who came to head the Latin America unit of the Fed.

These flawed unstable soft-pegs became top customers of the International Monetary Fund: with very ‘flexible’ exchange rates, involving never-ending energy subsidies followed by price hikes and in many cases sovereign default.

Some exchange rates were so ‘flexible’ that, three zeros at the time were taken off (re-denominated) and new currencies issued amid massive depreciation and inflation.

In many of these countries, which were originally friendly to the US and had turned to the country for help, widespread inflation and currency depreciation laid the ideal foundation for anti-American sentiments to be stoked by leftists and the Soviet Union.

With high inflation and economic decline, many of the countries became ungovernable, leading to strongmen or military dictators coming to power and remain in power with severe repression.

The Kemmerer Wave and the Deadlier Triffin Wave

The first wave of central banks in Latin America after World War I was set up by missions involving the so-called ‘money doctor’ of the US, Edwin Walter Kemmerer, who was at one time at Princeton, where decades later another professor from the same university, helped triggered the Great Recession.

The first wave of Latin American central banks including Colombia, Chile, Ecuador, Bolivia, and Guatemala and Peru at least paid lip service to the gold standard, like the Federal Reserve and were not intended to have collapsing exchange rate.

But like the Federal Reserve did with open markets operations, they had enough tools to inject money and bust the gold standard. During the Great Depression as commodity prices fell and tax revenues fell, it is exactly what happened and many of these countries went off the gold standard.

Unlike the Bank of England which kept the gold standard – more or less – with a near market discount rate that moved, the Open Market Committee which evolved gradually in the US, tried to fix economic conditions after World War I, eventually created the Great Depression and ended the gold standard.

A second wave of central banks created by Robert Triffin and his followers’ was much worse. They involved the Depression-era philosophy.

Triffin who had come to head what was effectively the Latin American unit of the Fed peddled a philosophy involving more intervention and so-called counter cyclical policy involving Keynesianism.

The problem with depression-era economics was that at normal times, such philosophies create monetary havoc.

When credit was negative it was easier to print money and get away with it. In fact, liquidity and foreign reserves tend to go up automatically (as gold did in the past) when credit collapses and interest rates fall. There is no requirement to print money to cut rates during a Depression.

But if currencies are unstable, there could be capital flight even when credit was weak.

The reason many Latin American countries got into trouble even before the Triffin-Prebisch wave was because unstable currencies triggered capital flight.

In 1935 Raul Prebisch led the effort to set up the Banco Central de Argentina, which had multiple tools to print money and also for exchange controls.

The idea was to sterilize the balance of payments on one side and promote credit on the other.

This was much worse, since the idea was to use the central bank for state-led development, which proved to be disastrous.

State led development called for central bank credit at all times, even when credit demand was strong, which was a disaster.

But with Roosevelt’s New Deal, the deadly Second Wave of exporting interventionism under Robert Triffin was right on cue.

Ironically it was supposed to have been done under a ‘good neighbour’ policy to help the Latin Americans.

Raul Prebisch Influence

In 1941 Robert Triffin helped set up a central bank for Paraguay, which was interventionist unlike the earlier ones.

“You have developed monetary principles in your projects which are most suitable to countries like ours,” Prebisch later wrote to Triffin.

‘I deliberately include Argentina….. Paraguay now has an efficient instrument for the stabilization of its economy. If managed with good judgment and prudence, the reform will be the beginning of a new monetary orthodoxy in our countries, under the auspices of the big shots of the Federal Reserve.

“We shall be freed, my dear friend, of the exorcisms by which foreign advisors would have wished to purify the exchange policy of these countries in not too remote periods.”

Triffin replied that he was actually inspired by Prebisch.

“If the reform is successful I think the credit should always go to you. Yours was really the hard work while mine remained perforce confined to more or less academic theorizing.”

The Depression was basically the result of a bubble fired by open market operations of the Federal Reserve system in general and the New York Fed in particular, during the 1920s.

Commodity prices fell as the credit bubble collapsed and banks also collapsed much like the Great Recession run.

American New Dealers then devalued the US dollar to 35 dollars an ounce from 22 despite there being no credit and banned the public from holding gold.

Prebisch thought that less industrialized countries that exported commodities were hit worse and that those with industrial goods which managed to maintain price. In actual fact farms were suffering and were foreclosed in the US as well.

So he went on an ‘import-substitution’ and state led industrialization drive which was much worse than any the infant industry strategies of Adolf Wagner and the German nationalists.

When credit recovered these depression-mindset central banks destroyed and destroyed utterly .

Entire economies were laid waste, entire populations were left destitute or starving or in revolution.

Though the central bank operation was successful, the patient died, with a cancer eating away at the monetary foundation of every individual, every family, every business, and finally the government.

In the lucky few countries which dollarized, the central bank and the worthless paper money consumed itself as people shifted to dollars.

Ceylon Central Bank

The Fed mission to Sri Lanka (Ceylon) occurred after World War II. At the time the US was recovering rapidly.

The State Department at the time had been trying to get dollar pegged central banks to sign up to Harry Dexter White’s Bretton Woods soft-peg system. Harry White was an arch New Dealer.

Interestingly the Bretton Woods was passed partly with the votes of the so-called ‘Latin American bloc’ of countries (not Argentina) which had links with the Fed and they asked for certain concessions, later researchers showed. (see The Latin American Origins of Bretton Woods/Eric Helleiner).

”It is essential to the success of the foreign missions or assignments that the System staff members participating be individuals of the highest competence and ability…,” Ralph Young, a Fed official who later headed its Research and International Divisions wrote in 1950.

Accordingly John Exter was selected to go to Sri Lanka. Exter had previously set up the central bank of the Philippines.

“In connection with any foreign mission or assignment involving Federal Reserve participation, it should be made explicit to the party requesting assistance that the work and recommendations of Federal Reserve representatives will be on a basis of intellectual independence in the light of their technical experience and training, and that their studies and recommendations do not carry the endorsement of the Board of Governors or of a Federal Reserve Bank,” Young, who was later secretary to the Open Market Committee explained in the memo to the Board.

“It should also be understood that the Federal Reserve representatives will give practical effect to the history, development, and current needs of the country or area concerned, and that their recommendations do not necessarily establish a pattern or model for any other country or area.”

In practice however most or all of these central bank constitutions had a cookie cutter Monetary Board, and in line with Triffin-Prebisch and New Dealer thinking, Finance Ministry involvement and interventionist tools.

This was in spite of Exter later turning out to have been an independent thinker and a Keynesian skeptic as Fed money printing intensified in the 1960s under an interventionist policy.

If there are no active open market operations and there is a wide policy corridor it is possible to hold pegs for long periods.

Strongmen and Dictators

Many of the countries in which the unstable central banks were created went into the hands of dictators after economic contractions driven by currency collapses.

Philippines, where Exter set up a central bank came under a strongman Ferdinand Marcos and is now under another strongman.

When Korea came under US authority after the defeat of Japan, the Bank of Chosun (Japanese had prohibited the use of the word Korea) which was carrying out monetary activities triggering inflation and steep depreciation, was transformed into a new central bank.

Having seen the effects of military financing under Japanese rule on the currency and consumer prices, Bank of Chosen officials were keen to run a stable monetary system.

However politicians wanted development economics. Korea was unlucky.

The US Economic Co-operation Agency (basically the Marshall Plan unit which it goes without saying was New Dealer style) helped Korea set up the first central bank and it was a disaster.

Arthur Bloomfield, a Fed official, was sent to set up the new Bank of Korea with greater stability in mind. But with Keynesianism riding high, it was doomed to failure. The law was also revised by the finance ministry.

Korea’s 1945 Won fell from 15 to 6000 to the US dollar.

The new Bank of Korea started with a new currency called Hwan, at 60 to the US dollar.

It collapsed to below 1200 by 1961 and General Park Chung-hee set up a military dictatorship.

Korean Debacle

The central bank along with the constitution was changed.

All dictators like to change constitutions to get more powers. That is their stock in trade.

General Park’s later Yushin Constitution introduced six year Presidential terms with no term limits. J R Jayewardene did the same.

In 1962, a new Won was started at 1 for 10 hwan or about 125 to the dollar.

In subsequent decades it was devalued periodically, but it held for fairly long periods, like the Bangladesh Taka over the last decade, allowing for periods of stability and growth.

In the early 1980s after very high inflation and currency collapses in the wake of US tightening under Paul Volcker, the central bank reformed its operations and the currency started to finally appreciate.

But it was too little too late and the dictatorship was toppled after a massive strike coming from the previous years’ inflation and wage suppression (a type of REER targeting).

South Korea is now a free country and OECD member which imports labour.

Chile – whose central bank was created in Fed waves also fell to a dictator, Augusto Pinochet who was friendly to the US, after a socialist elected leader was deposed. The legitimacy of his constitution – which has been amended multiple times – is questioned even now.

The Chilean peso fell from 600 to 800 to the US dollar over the past two years, triggering an economic meltdown. Chile was a poster child for reform at one time. But the central bank was not reformed.

Nothing works for long with bad central banks.

Argentina also fell to a military dictatorship. It is still a poster child to the meltdowns coming from Prebisch-style central banks.

Japan was extremely lucky that that the US military administration got Joseph Dodge an American banker, from West Germany, who had worked with hard money Austrian-style German economists after World War II.

Read more about how New Dealer Keynesians were defeated and Joseph Dodge was helicopter dropped to save Japan under military rule

He promptly fixed the Bank of Japan, fixed the currency, eliminated dual exchange rates, and closed the development bank (Reconstruction Bank), which was fueling inflation by selling securities (Fukkin Bonds) to the Bank of Japan.

Dodge worked with the military administration of Douglas McArthur and managed to edge out the New Dealers.

After the so-called ‘Dodge Line stabilization’ Japan remained a free country and became an export powerhouse, second only to Germany. Its currency remained fixed till 1971 at 360 yen to the dollar and has since appreciated.

Foreign Policy Disaster

One of the biggest ironies is that the Fed believed that it was helping American foreign policy in setting up money printing central banks in developing countries.

When the Prebisch-Triffin central banks were set up, the US hoped it would lead to friendly ties.

US President Franklin Roosevelt apparently ‘helped’ Latin America on a ‘good neighbour’ policy.

“Foreign missions or assignments have always been recognized as ancillary to the foreign policy of the United States,” Fed’s Ralph Young wrote.

“The furnishing of technical assistance of kinds that the Federal Reserve might properly provide, when requested by a foreign monetary authority or government (or by an agency of the US Government) affords a means whereby relations with foreign central banks and whereby the United States may increase its influence abroad in ways which are free of imperialistic or other undesirable implications.

In practice however many of the central banks were disastrous to US foreign policy.

The economic hardships brought leftists to power who were aligned to the Soviet Union and they went on a confrontation course with the US.

Or right wing dictators or strongmen who abused human rights came to power.

When the IMF went to rescue the countries, without reforming the interventionist powers of the central bank to stop the depreciation and instability but simply raising taxes and raising fuel prices to fit the depreciating currency, entire populations turned against the IMF and Washington in general.

Cuba went to the communists outright.

So did China. The Kuomintang who lost to Mao seemed to have learnt its lesson in Taiwan.

Latin American Backlash

In Latin America there was a massive backlash against the US as leftists came to power in countries with monetary instability.

Exchange controls and expropriation killed investment.

The IMF was blamed for its never ending programs – perhaps rightly – as it did not address the root cause – the flexible or depreciating exchange rate coming from a bad Triffin-Prebisch central bank.

All reforms failed with a rotten monetary foundation. The supreme irony was that the problems and corrective actions blamed on the IMF and markets in fact stemmed from an interventionist and anti-market central bank and related policies.

The fascination with neo-liberalism spoken about by Wimal Weerawansa and Governor W D Lakshman in Sri Lanka also has its roots in the Latin America backlash.

Import substitution (which also fascinates Sri Lankan policy makers) and state led industrialization were also hot themes in Latin America.

“Years ago I had become impressed with the Argentinean economist Raul Prebisch, both in his innovative approach to central banking and in his analysis of cyclical dynamics…” wrote Henry Wallich, who was later appointed a Fed Governor by President Nixon.

“His thoughts helped me to sort out my own ideas about how export economies worked.”

“I was less enthralled by the developmental policy principles, not necessarily derived from Prebisch, which had taken over in Latin America under the motto of ‘import substitution”.

Wallich set up a central bank for Cuba – which he called an export economy. The country went to Fidel Castro. He also set up the central bank of the Dominican Republic, which even now is having similar problems to Sri Lanka.

Its credit was downgraded earlier in 2020, the IMF gave it a Rapid Finance Instrument injection and currency depreciation is triggering losses in energy utilities – again like in Sri Lanka.

The economy is partially dollarized which has reduced somewhat the ability of the central bank to impoverish the public.

In addition to Prebisch, they were influenced by Triffin, Wallich had said.

“With respect to a number of other countries including, Paraguay (11 IMF deals). Dominican Republic (9 IMF deals), Guatemala (15 IMF programs), Ecuador (19 IMF deals – dollarized sovereign default), The Philippines (23 IMF programs, recapitalized), Korea (17 IMF programs, central bank self-reformed – now developed country) and Ceylon (16 and counting), Federal Reserve technicians, especially Robert Triffin, David Grove, Arthur Bloomfield, John Exter and myself provided advice embodying many of the ideas pioneered by Triffin,” he wrote (Some uses of Economics).

Triffin is now known not for the disastrous soft-pegs he created or inspired, but for his criticism of the Bretton Woods system of soft-pegs and the eponymous Triffin’s Dilemma’, which takes the cake, since all the central banks he built had the same or worse problems that he did not warn about.

”…[T]he reforms which I proposed were truly revolutionary at the time,” Triffin himself wrote.

“They sought to put monetary and banking policy at the service of the overwhelming development objectives previously ignored in central bank legislation copied one from the other and trying merely to imitate a distant and largely inappropriate Bank of England…”

Rising socialism and state intervention in the monetarily unstable Latin American countries also led to expropriation and driving out of foreign investors.

Sri Lanka also expropriated as well as having exchange controls.

East Asia Central Banks

Successful East Asian nations and Gulf Co-operation Council nations on the other hand embraced classical economist ideas of the British classical liberals and in the case of Singapore, the London School of Economics where Hayek, who challenged Keynes, taught.

Currency boards were invented by the British.

Singapore (modified currency board- No IMF programs), Brunei (currency board) and Hong Kong (re- created currency board, no IMF programs), were either colonial currency boards or very hard pegs that operated on currency board or pre-1917 Bank of England style peg principles which were similar to a currency board (gold peg).

Malaysia set up a central bank but operated a strong peg (no IMF program even during the East Asian crisis). Thailand went to the IMF five times including once during the East Asian crisis.

Indonesia, another East Asian laggard like the Philippines, which exports labour to GCC countries and to stable East Asian nations, had gone to the IMF 11 times.

Its central bank was set up under different conditions partly inspired by the Netherlands, also in 1953 like that of South Korea.

“In Indonesia, the decision to establish a new bank appears to have arisen more from the desire to sweep away the traces of the colonial past than from any strong conviction that the Java Bank was inadequate to meet the central banking needs of the new nation,” wrote Irvine Reed, a rare classical economist who had worked at the Fed.

“The Java Bank had served for 125 years as the sole bank of issue, in the area now constituting the Republic of Indonesia.”

The private bank was nationalized after independence. A new law was passed.

“Bank policy will be determined by a three-man Monetary Board, composed of the Ministers of Finance and of Economic Affairs and the Governor of the Bank,” Irvine observed in 1953.

“This is a compromise between the views of the officials of the Java Bank, who sought greater independence for the new central bank, and those of government officials who desired to follow the Dutch pattern and to make the Bank subject to the direct orders of the Ministry of Finance in policy matters.

“The device of setting up a policy-making board on which the Minister of Finance, or his representative, and the Governor of the Bank serve as co-equals had already been introduced in the Philippines and Ceylon, and the experience of these countries may have suggested this solution in Indonesia.”

The rest is history.

In the East Asian crisis the rupiah collapsed from around 2000 to 10,000 which was the worst fall among the countries affected.

Bank Negara Indonesia had generally been operated as a crawling peg in a type of REER targeting unlike the better performing East Asian nations, leading to ever rising prices and energy price reform protests.

There is currently a bill to strike three zeros off the rupiah, which however has not been taken up.

Prebisch Proved Repeatedly Wrong

The less than stellar experience of Indonesia and Philippines, the absolute collapses seen in Vietnam, Laos and Cambodia (Cambodia is now dollarized and booming) and the examples of Singapore, Malaysia, Hong Kong and Taiwan have destroyed the key themes of Prebisch’s theory.

China fixed her currency in the early 1990s after the Tiananmen Square massacre which came in the wake of high inflation and currency depreciation.

After the 1986 re-opening of Vietnam, the economy imploded due to central bank re-financed credit.

East Asia proved conclusively that countries with monetary stability performed exceptionally well.

Both Germany and Japan, which were influenced by German/Austrian sound money principles (Japan after the Dodge reforms) had also outperformed most other Western war-torn nations after World War II.

Japan after the Meiji restoration in the mid 19th century went on a state industrialization drive and then had the first large scale privatization drive as monetary instability hit finances. Taiwan and Korea, which were colonies of Japan, were driven largely by domestic industries.

But East Asia also busted another of Prebisch’s pet (Depression-era) theories known as the Prebisch-Springer hypothesis, which claimed that industrial products had higher prices while commodities (produced by developing countries) fell.

East Asian countries including China and Vietnam which were run by the communist party, industrialized with foreign direct investment (as opposed to the socialist expropriation in Latin America) and their output led to falling real prices of industrial goods, which even led to factory closures in Western nations.

Long periods of monetary stability in the West in the 1980s and 1990s also led to productivity improvements as companies competed and innovated and developed technology, rather than battling the effects of high inflation, currency collapses and never ending strikes.

When the Fed fired the mother of all (or Bernanke doctrine) liquidity bubble (firing booms in commodity/food/metals/precious metals) which triggered the Great Recession as well as the 1970s oil shocks) it was clearly shown that commodity prices could rise independently of industrial products when reserve currency central banks printed money.

Mini-commodity booms also followed each quantity easing exercise during the Great Recession. Commodities could rise again due to the current Covid related cash injections.

This was the complete reverse of what was seen during the Great Depression.

Bernanke was also a depression-era scholar which is believed to be why he influenced Alan Greenspan to fire the post-2000 liquidity bubble as inflation fell in the wake of the collapse of the earlier tech bubble.

Time Warp

Keynesian remedies in general are depression-era tactics which cause havoc in normal times (when the credit system recovers from the broken bubble).

China and Vietnam industrialized (Prebisch style) during communist rule. Many of the SOEs made losses, and central bank financing busted the currency.

When the People’s Bank of China was reformed to fix the Renminbi, a key rule was to stop financing SOEs. The two countries grew fast only after foreign companies with exportable products set up shop.

In countries with monetary stability in East Asia, growth was also driven by strong non-tradable domestic activity in housing and services including entertainment.

Unlike Latin America which was plagued by capital flight (as well as destruction of domestic capital through depreciation), East Asian countries which rejected Prebisch-Triffin-Keynes wholesale, ended up exporting capital to the West making them run trade deficits.

Mercantilists called this phenomenon – which came from monetary stability and central banks which operated policies consistently tighter than policy-neutral currency boards – the Asian savings glut.

GCC countries with currency-board-like systems also re-exported petroleum receipts (Mercantilists call them petro dollars), while oil producing countries like Iran, Nigeria and Venezuela collapsed.

Monetary stability is not a cure all. Expropriation, regime uncertainty and nationalism can still hold back countries.

Nationalism hit both Germany and Japan which also triggered two World Wars.

But when there is monetary instability, hardly anything works.

Though Prebisch was proved wrong by East Asia on both central banking and state led industrialization and import substitution, and Latin America remains backward to this day largely due to Prebisch-Triffin central banks, his ideas are worshipped in Sri Lanka.

Sri Lanka is caught in a time warp due to the ideology of people who learnt these ideas in their young days.