November 01, 2014 (EconomyNext) – Sri Lanka’s bank credit is contracting in the wake of the latest burst credit bubble and balance of payments crisis and there is great temptation for the state and rulers to intervene with their powers of coercion and compulsion.

The greatest temptation is to tax or borrow and spend other people’s money. In Sri Lanka at least the Treasury is not trying to increase spending, rather, taxes as a share of gross domestic product and total state spending as a share of GDP has fallen, leaving more space for people to make their own spending decisions.

If a strong sustainable recovery is desired the temptation to intervene or deficit spend must be resisted as much as possible.

In general Sri Lanka’s budgets are a shocking morass of interventions and state support for well connected special interest groups, though not all of them cause major damage to the people.

One budget even decreed that airline crews should not be given discounted rooms at 5-star hotels.

But on the plus side total revenues have come down to 13.3 percent of GDP in 2013 from 17.2 percent in 2000 and state spending has come down to 19.2 percent of GDP in 2013 from 26.7 percent in 2000. That means more money is left in the hands of the citizens for productive spending, though there are questions over the GDP number itself.

In the same period budget deficits have narrowed and capital expenditure had gone up.

Credit Crunch

In the wake of the 2009 balance of payments crisis, credit contracted much more than this time. At the time inflation was lower and even negative and the rupee also appreciated, recovering most of its lost value quickly resulting in less need for working capital and credit to fund existing business volumes.

This time the rupee depreciated much more and the ensuing inflation probably required more credit to sustain the same volume of business, which prevented the credit from contracting in 2012 and early 2013.

But inflation has stabilized over the past 12 months with the exchange rate also being more stable.

The rupee depreciation in 2012 also seems to have hit the purchasing power of consumers much more than after the 2012/2013 crisis, dampening domestic demand. According to available data, domestic demand growth was the lowest since the 2001.

While credit bubbles have occurred in free banking systems, they burst much more spectacularly after central banks were established. Global depressions and very high inflation came after the Fed was created as a state agency in the 20th century.

Contradictory Interventions

The most recent balance of payments crisis and the rupee depreciation in Sri Lanka was itself was a result of contradictory state interventions.

First, the Treasury intervened in energy prices by preventing the power regulator from market pricing electricity every six months as required by its act. Then state bank credit was used to fund losses of selling electricity and fuel at a loss.

The Central Bank then printed money to keep interest rates down after intervening in forex markets by selling dollars, a combination that is impossible to sustain in practice for a significant length of time.

This contradiction between monetary and exchange rate policy is what economists call the impossible trinity of monetary policy goals. A fixed exchange rate cannot be pursued with independent monetary policy (have your own interest rate) and the free movement of capital.

In practice even without the free movement of capital it is almost impossible to control the exchange rate while printing money, as Sri Lanka has seen after the creation of a central bank with exchange controls after 1950.

If the exchange rate is to be controlled, interest rates have to be allowed to move up in step with credit demand. Knowing all this central banks continue to try to control both the interest rate and the exchange rate, in a doomed belief that both goals can be achieved.

In the 2009 crisis, the recovery was sharp and the Central Bank generally allowed the market to work, though the Treasury tried to bring interest rates down faster by putting pressure on state banks.

Of late Sri Lanka’s Central Bank has also tended to interfere in interest rates through administrative means, setting ceiling and floors to finance company loans and deposits more often than in the past.

It also recently issued directions on credit card interest rates. The credit card companies responded by raising fees.

The aftermath of the latest balance of payments crisis has been compounded by toxic gold loans. In the 2008/2009 crisis toxic loans were mostly in property in the finance company sector.

A whole series of interventions have been made on pawning or gold loans and taxes were slapped on gold imports.

These interventions can also have unintended consequences (see box story Toxic gold loans and Sri Lanka’s policy conundrum elsewhere in this section).

Any fresh interventions in the credit systems must be avoided.

Police Power

It is now politically fashionable to intervene. And elected rulers who do nothing can face criticism from their own kind in their own kind, interventionists and sections of the voting public who want state favours.

Interventionism became popular in Europe especially with the rise of the post-feudal state which had a standing army, police and an extensive system of prisons with which to impose its will on citizens.

Greater legitimacy was given to state control through an elected administration where the separation of the ruler and ruled were blurred in the minds of the people and not clearly evident like in feudal times.

The machinery of a modern state can be used to provide rule of law and justice, where the threat of force is wielded to protect the freedoms of the weak from the powerful. In a liberal state the citizens are also protected from the state itself – the most powerful player in society – through constitutional restraint and an independent civil service.

Or, state machinery can be used for socialism, intervention and the ultimate path to discrimination and dehumanization; nationalism and national-socialism.

“The state is, if properly administered, the foundation of society, of human coöperation and civilization,” wrote Austrian economist Ludwig von Mises in 1944.

“It is the most beneficial and most useful instrument in the endeavors of man to promote human happiness and welfare.

“But it is a tool and a means only, not the ultimate goal. It is not God. It is simply compulsion and coercion; it is the police power.”

A state essentially has the monopoly on the use of force and violence within a given geographical area under its control.

“Governments are never liberal from inclination,” writes Mises. “It is in the nature of the men handling the apparatus of compulsion and coercion to overrate its power to work, and to strive at subduing all spheres of human life to its immediate influence.

“Governments become liberal only when forced to by the citizens.”

“From time immemorial governments have been eager to interfere with the working of the market mechanism.

“Their endeavors have never attained the ends sought. People used to attribute these failures to the inefficacy of the measures applied and to the leniency of their enforcement,” says Mises.

He adds,

“Many American and British supporters of price control are fascinated by the alleged success of Nazi price control.

“They believe that the German experience has proved the practicability of price control within the framework of a system of market economy. You have only to be as energetic, impetuous, and brutal as the Nazis are, they think, and you will succeed.”

It is ironical that after the Nazis were defeated West Germany abandoned all economic controls and interventions and went through the German Economic Miracle (Wirtschaftswunder) under Economy Minister and later Prime Minister, Ludwig Erhard.

Economy-wide Interventions

But in the English speaking world and the British Empire the dogma of John Maynard Keynes legitimized interventions in the minds of a generation of economists with a Mercantilist and control mindset.

The German post-war experience was virtually unknown in the English speaking world.

Even before World War II, Friedrich von Hayek, another Austrian economist, who was with the London School of Economics, had tried to show the error or Keynesianism, but failed to sway the inexorable shift of ideology in Britain.

Economics per se supposedly systematized by Adams Smith – now called classical economics – went into hibernation. Mercantilism, the prevalent way to looking at economics before Smith, was flying high. The new religion of Keynesianism gave a new lease of life to interventionism taking it in new directions.

In a nutshell, Keynesian ideology advocated state spending, backed by central bank credit (printed money) to boost economic activity at an economy-wide level, adding to the armory of specific interventions available to the state.

These so called ‘macro’ interventions became fashionable after the Great Depression and the Second World War, creating high inflation, currency depreciation and mass-impoverishment in the process.

The practice of Keynesian economics created foreign exchange problems in Keynes’ homeland itself and led to repeated devaluations of the Sterling pound.

Throughout the former British Empire, including Sri Lanka central banks were set up giving the power to the elected ruling class to print money, control interest rates, deficit spend, generate high inflation, destroy currencies and impoverish entire populations.

Positive Non-Intervention

At one place in the British Empire interventionism was resisted. That was in Hong Kong.

The man responsible for freeing the territory from coercive interventions was an unelected member of the ruling class, a civil servant.

John James Cowperthwaite (later Sir) joined the Hong Kong Administrative Service in 1941 and after a stint in Sierra Leone, returned to Hong Kong in 1945.

He served as Finance Secretary from 1961 to 1971 after earlier holding other posts such as Assistant Finance Secretary.

Cowperthwaite was asked by London to find ways to ‘boost’ economic activity in the territory. After looking around he found that the economy was recovering by itself and decided not to meddle.

This policy later became known as ‘positive non-interventionism’. By not intervening, Hong Kong was saved from costly state mistakes.

According to Cowperthwaite: “In the long run, the aggregate of decisions of individual businessmen, exercising individual judgment in a free economy, even if often mistaken, is less likely to do harm than the centralised decisions of a government; and certainly the harm is likely to be counteracted faster.”

He preserved the trade freedoms of the people and refused to allow domestic businesses to exploit the poor with protectionist taxes.

No support from tax payer money was given to businesses and appeals for privileges from special interest groups were rejected.

“I should have thought that a desirable industry was, almost by definition, one which could establish itself and thrive without special assistance in ordinary market conditions,” he once told a group of businessmen who sought state support.

Private property rights were protected and just rule of law was maintained in the typical night watchman state style. In 1974 an anti-corruption agency was set up to combat widespread bribery.

Cowperthwaite refused to increase income tax above 15 percent when taxes were raised by in Singapore. Income tax destroys investible capital which can create employment and increase labour productivity when rulers use it for consumption spending.

The government made money from land sales.

Famously, he also refused to collect economic statistics like unemployment data because he feared that they may be used to pressure the government into interventions and proposed the abolition of the statistics office.

Once asked whether the secret of his success was ‘doing nothing’, he had replied saying much of his time was spent stopping attempts by politicians in London from interfering in Hong Kong.

Philip Haddon-Cave who succeeded Cowperthwaite has said: “positive non-interventionism involves taking the view that it is normally futile and damaging to the growth rate of an economy, particularly an open economy, for the Government to attempt to plan the allocation of resources available to the private sector and to frustrate the operation of market forces.”

Haddon-Cave had said that the government would look at a problem to see whether an intervention would create harm or not. Though usually the conclusion was that an intervention would be harmful, sometimes interventions were done.

Hong Kong was not a complete free market in that there were also some infrastructure monopolies.

Hong Kong became a global financial centre and an industrial export powerhouse, even as mainland China regressed under Mao Zedong.

A tale of two cities

Politicians in Sri Lanka and elsewhere like to showcase Singapore, an authoritarian interventionist state, which however had rule of law and the protection of private property.

Singapore’s interventions however were carefully researched in the British public policy making style, and like in Japan during the Meiji period, recreated or set up policies that happened in more liberal states.

They were not secretly hatched and sprung on an unsuspecting populace through a budget or through a midnight gazette while they are sleeping.

Even so, Hong Kong with no overt planning, outperformed Singapore by conventional measures for a long time.

In 1981 for example Hong Kong had a population of 5.1 million compared to Singapore’s 2.5. Its gross domestic product was 31.4 billion US dollars or more than double the 14.3 billion of Singapore’s. Hong Kong’s capita GDP was 6,063 dollars compared to 5,654.9 dollars for Singapore.

In 1983, a currency board was created in Hong Kong by Alan Walters, an advisor to Margaret Thatcher, effectively blocking any possibility of monetary stimulus.

Cowperthwaite had anyway balanced the budgets.

It is said that the Thatcher administration – which freed Britain’s economy from many controls, privatized previously expropriated firms and tightened monetary policy and made it a leading nation in the world again – was influenced by Hong Kong.

Hong Kong’s per capita GDP exceeded that of the UK in 1993.

Like the German economic miracle however, the achievements of Hong Kong are not usually taught in modern economic courses which are neo-Mercantilist. Countries like Singapore or Korea, which were more interventionist, are showcased, lionizing their rulers in the process.

Hong Kong began to lose steam ahead of the handover to China in 1997. Even during the Asian financial crisis it’s per capital GDP fell less than Singapore.

After the handover to China, Singapore began to gradually gain on Hong Kong. In 2004 Singapore recorded per capita GDP of 27,047 dollars, overtaking Hong Kong’s 24,876.

Hong Kong’s chief executive said in 2006 that positive non-intervention was no longer the official policy.

Graph headline: Employment Path Source: IMF (& left axis,population in millions right axis)

Unemployment has also been higher than Singapore in the last decade.

In 2010 Singapore’s nominal GDP at 233 billion US dollars overtook Hong Kong’s 228 billion, despite Singapore having a smaller population. If there was no handover would Hong Kong’s GDP have been over 500 billion US dollars by now?

Hong Kong is still ranked as one of the freest or perhaps the freest economy in the world in many rankings.

This column is based on The Price Signal by Bellwether published in the September 2014 issue of Echelon Magazine