Rupee, Sri Lanka, in trouble after Keynesian stimulus

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

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

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

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

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

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

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

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

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

Central Bank Credit

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Aggregate Demand

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

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

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

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

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

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

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

Miserable developing country

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

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

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

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

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

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

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

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

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

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

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

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

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

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