ECONOMYNEXT – Sri Lanka has recorded primary surpluses above International Monetary Fund targets, after steep rises in tax rates, despite large state salary hikes and welfare payments, with low inflation amid (largely) deflationary policy that kept inflation below the central bank’s target.
(This column was originally published in the Echelon Magazine in November 2025)
The primary expenditure is all expenses before interest costs. A country that runs a primary surplus has interest costs bigger than the budget deficit.
The high interest bill is not only due to the size of the debt but also the nominal interest rate which is a function of monetary instability and destruction of domestic capital from depreciation and inflation – which is basically the same thing.
By September 2025, Sri Lanka had run a primary surplus of 1,465 billion rupees, over 4 times the 300 billion rupee target in the IMF program.
By September a 6 billion rupee surplus was run in the current account of the budget, which includes interest. That means a part of the capex was financed by taxes.
Sri Lanka lost this ability after 1987.
The current account surplus seems like a revolution but before high levels of inflation created by macro-economists, it was pretty normal and in fact overall budget deficits were also possible. Before macro-economic policy and inflation, the budget went to deficit in war.
Deflationary Policy
Sri Lanka’s large primary surplus and the ever so small current account surplus by September could not have been possible if the central bank had not kept the exchange rate stable and run deflationary policy to miss its 5 percent inflation target.
A 5 percent inflation target means that non-interest current spending which is about half the current spending will go up by 5 percent a year.
Of course, the US Fed also helped, keeping coal and fuel prices down.
Before floating rate and positive inflation targeting it was not difficult to run budget surpluses and bring deficit and debt down absolutely.
In the age of inflation – after the collapse of the gold standard – the debts are not reduced absolutely as there is no possibility of running budget surpluses.
Instead, the debt to GDP ratio is brought down even as deficits – hopefully trimmed from earlier levels, continue.
However that was not the case before the collapse of the gold standard.
World Wars
After the deficit budgeting during the First World War, the Treasury Secretary Andrew Mellon was able to return to budget surpluses even as the Federal Reserve invented inflationary open market operations.
He was able to run budget surpluses until the Great Depression hit. Then stimulus and all kinds of state interventions began, worsening and extending the Great Depression leading to the birth of Keynesian stimulus.
GRAPH : US BUDGET SURPLUS AFTER WORLD WAR I
Similarly, Treasury Secretary John Snyder also ran budget surpluses, during the Korean War, after World War II to reduce the public debt.
Budget surpluses were also operated in the middle of what is falsely called the Korean war bubble.
Inflation rose due to the purchase of Federal Reserve of old Liberty Bond-style war debt with the yield capped at 2.5 percent (to maintain the secondary market value at 100 percent), amid a private credit recovery after World War II.
It was wrongly blamed on the Korean war, a tiny conflict compared to World War II, which was already financed by tax hikes amid fears that deficits were causing the inflation.
Congress in fact refused a second tax hike because the budget was in surplus, showing that macro-economists spread false narratives that budgets were responsible for monetary stability even then, only now.
It was in fact Governor Marriner Eccles, a former banker who insisted on raising rates, which then led to the Fed Treasury Accord and so-called independence of the Fed.
It was using this independence of the Fed that macro-economists busted the Bretton Woods, created Great Inflation, the Housing bubble and the post 2008 stimulus and the destruction of public finances that the West is left with.
The same ideology drives the potential output and the high inflation target in Sri Lanka.
Long Term Debt, Low Interest Rates
The insistence by John Snyder that the Fed continue to the wartime agreement to keep government debt yields down shows another stark fact.
The 40-year Liberty Bonds were issued to finance World War I. Snyder insisted on the Fed keeping rates down to protect the secondary market value of the bonds, because war widows held the bonds.
Before the creation of the Fed and its ‘tightening and easing cycle’ (like the printing of money in 1950) generated high interest rates ordinary people had been buying very long-term bonds, not just pension funds.
In Sri Lanka people were buying 20 year government loans below 3 percent when the central bank was created and it started to manipulate rates, triggering balance of payments pressure.
The problem also started during the same Liberty Bonds Bubble as the central bank did not allow rates to go up and printed money, triggering the first balance of payments problems in 1952 even as the US tightened policy.
The Central bank never looked back.
<b>Post-Gold Standard</b>
The US government also lost the ability to run budget surpluses after the collapse of the Bretton Woods led to Great inflation and floating rate.
In the early 1980s, Paul Volcker brought inflation under control, potentially allowing the deficits to be narrowed.
Though the Margarat Thatcher was keen on reducing the deficit, the Reagan Administration, advised by monetarists, decided to run deficits.
As a result Volcker had to raise interest rates close to 20 percent to balance credit.
The UK managed with very much lower interest rates under Alan Walters and Thatcher.
The UK managed to run good budgets until the eve of the ERM crisis in 1991 which led to collapse of the Pound.
The UK also managed to run good budgets up to 2000 when macro-economists in the US, led by Ben Bernnake in particular, claimed that there was ‘deflation’ and misled Alan Greenspan to print money.
The Reflated Housing Bubble
In the so-called ‘deflation’ of the late 1990s, the US was also able to operate budget surpluses, for the first time since the collapse of the gold standards.
In fact some East Asian central banks bought Fannie Mae and Freddie Mac paper due to the scarcity of Federal paper, amid a global rise in savings and low rates triggered by the lowered inflation.
By 1999/2000 gold was 284 dollars an ounce and gold 16 dollars compared to around 800 dollars for gold and 35 dollars for oil when Volker started to tighten money.
After the collapse of the housing bubble, fired in the course of reflation from 2000 to 2007, a great crisis was created by macro-economist without war, just like the roaring 20s bubble fired by the invention of the open market operations led to the Great Depression.
Stimulus
After the housing bubble, without tightening policy like Sri Lanka did after the 2022 crisis triggered by the earlier rate cuts, which led to a quick recovery in economic activities after inflation was squeezed out, the US engaged in stimulus.
Now the budgets and national debt of all Western governments have been destroyed by macro-economists who misled politicians into deficit spending.
Persistent inflation is making the public unhappy and nationalism is on the rise like in interwar Germany, which was also hit by the spread of open market operations and the onset of the Great Depression.
Sri Lanka’s budgets deteriorated in the 1980s as the rupee collapsed from IMF and other technical advice for competitive exchange rates, even as the US and UK tightened policy.
In fact in the UK, energy utilities also made large profits as inflation was brought down in the 1980s and newly privatized electricity firms made windfall profits.
The UK government taxed them, earning revenues to reduce the deficit.
There is no benefit for the people or the government in the insistence of high inflation. Five percent a year inflation is around or more than the Great Inflation the world and Sri Lanka suffered in the 1970s.
In the 1980s, unfortunately Sri Lanka’s budgets deteriorated due to Greater than Great inflation from currency depreciation even as East Asia with their fixed exchange rates benefited from the tighter policies of the UK and US.
The tighter policies also made free trade possible and great prosperity came to East Asian countries that ran deflationary policies and invested their savings in the US, also benefiting the Western nations.
If the central bank insists on creating 5 percent inflation and depreciating the currency, all the gains made over the past two years will disappear. (Ends)