Sri Lanka debt crisis trapped in spurious Keynesian ‘transfer problem’ and MMT: Bellwether
ECONOMYNEXT – In Sri Lanka politicians are blamed for the country’s economic ills and rising default risk, but it is only partly their fault, as the general public is systematically misled by economic advisors and bureaucrats who are trapped in Keynesian Mercantilism that dates back to the 1920s.
The Mercantilists have also lit a fuse under the monetary system with Modern Monetary Theory.
Why do policy makers think that imports are a ‘Problem’ with a capital P?
Why does Sri Lanka try to compress trade and imports through controls? And fail? Why does Sri Lanka try to ‘save’ foreign exchange instead of stopping the creation of excess rupees?
Why do people think exports are good (postponed consumption or austerity) and imports are bad (actual consumption of the proceeds of exports)?
Why is Sri Lanka now in danger of default? Why did the last administration raise so much foreign debt though ‘Active Liability Management’?
Why did the last administration stop gold imports and re-exports? Why did the last administration stop car imports?
Why did Sri Lanka sell rupee debt at higher yields than dollar debt?
Why are import substitution rackets promoted now so that a group of cronies can get unbelievably rich at the expense of an entire population?
Why are Mercantilists (who go by the label economists in Sri Lanka) so obsessed with the current account deficit?
While many people including the ordinary man on the street has a vague idea of what the trade deficit is, many surely do not know what the current account is made up of. That obsession is clearly with the ‘educated’ lot.
And here is the clincher that is the icing on the cake.
Why do people think that foreign debt cannot be repaid by raising domestic debt?
While it is true that money printing by Sri Lanka’s Latin America-style central bank and its single minded obsession to keep interest rates down is at the root of most of Sri Lanka’s monetary problems, driving illiberal anti-growth policies and controls, it does not answer all of the questions above.
The answer to the questions lie in a Keynesian mis-understanding of international trade and capital flows that is generally called the ‘transfer problem’, which does not exist in the real world.
The Transfer Problem
The mis-understanding that is currently prevalent about trade and current account deficits, comes from the origins of Keynesian Mercantilism and is widely taught in universities and schools not only in Sri Lanka but also in many Anglo-Saxon areas.
Because there is a centralized syllabus similar to a communist state in Sri Lanka, students are brainwashed with the spurious Keynesian idea which is generally referred to as the ‘transfer’ problem.
The non-existent problem dates back to German monetary instability in the 1920s involving war reparations – which is similar to repaying foreign debt.
In 1929, John Maynard Keynes published a piece in the UK based The Economic Journal called ‘The German Transfer Problem’ claiming in a nutshell that the Germany would not be able to make war reparations, because the country had a trade (or current account in modern parlance) deficit.
In order to be able pay reparations, Germany had to boost exports and it also had to reduce domestic wages and costs to be more competitive (price effect) it was argued. Proponents claimed that it was particularly because the payment was political in nature and not related to ordinary commerce.
Classical economists on the opposite side argued that it was certainly not so, and that Germany only had a ‘budgetary problem’ in that it had to impose a reparation taxes or borrow money in domestic debt markets.
The action would transfer domestic spending power to the government from the public and make available resources and foreign exchange (or gold) to make the payments by compressing spending and therefore imports.
The act of making outward payments the Classicals pointed out, would automatically and necessarily create a trade or ‘commercial’ surplus.
It was not a ‘price effect’ they pointed out, but it was simply an ‘income effect’ that was at play.
But it was a difficult concept to for people and politicians to grasp. The debate took place between the so-called Dawes Plan and the Young Plan both of which sought to make it easier for Germany to make reparations.
In the end the politicians and Keynes had their way, and the Socialist Weimar Republic collapsed in hyperinflation, hastened by the US Fed’s Great Depression.
In the debate, Keynes sort of accepted that the ‘budgetary problem’ (raising funds in German currency) could be solved but continued to insist that there was a ‘transfer problem’ based on an idea that exports could not be competitively priced enough to get a higher market share (price effect) and Germany had to deflate.
Keynes edited The Economic Journal between 1912 to 1944. That probably helped in the spread of Keynesian ideas in the UK, though to be fair he has published criticisms as well.
It is this ‘price effect’ belief that drove the last UNP-led administration to engage in monetary and capital destruction by targeting the real effective exchange rate.
One economist who pointed out the error of Keynes thinking was Bertil Ohlin. Ohlin was from Sweden. The Stockholm school of Economists (led by Knut Wicksell) had proposed Keynesian style remedies to downturns before Keynes himself.
Nobody however would accuse Stockholm economists of not knowing international trade or monetary policy. Gunnar Myrdal in 1974 shared a Nobel Prize with Hayek.
Ohlin pointed out in piece also published The Economic Journal (Transfer Difficulties, Real or Imagined) that the excess of imports over exports came from higher spending power that was given to the German economy through foreign borrowings.
Foreign borrowings not only increased the demand for imports, they may also increase the domestic demand for previously exported goods.
“A and B are two countries with normal employment for their factors of production,” Ohlin tried to explain in the June 1929 issue of ‘The Economic Journal’.
“A borrows a large sum of money from B this year and the same sum during each of the following years. This transfer of buying power directly increases the A’s demand for foreign goods while it reduces B’s. Thus A’s imports grow and its exports fall off.
“If the sum borrowed is 100 mill. Marks a year the excess of imports in A brought about in this direct manner may be 20 mill. Marks. For in large countries only a small part of demand turns directly to foreign goods or to export goods. The rest, 80 mill. Marks increases the demand in A for home market goods.”
This is the type thinking in Sri Lanka that goes to say tourism receipts or apparel exports have some imported inputs, therefore the actual difference will get piled up somewhere and help the trade deficit.
If Sri Lanka produces more domestic goods and block imports the country will therefore ‘save’ the foreign exchange – which gets piled up somewhere – and reduce the trade or current account deficit.
In 2021 authorities claimed that out of a large volume of foreign 2.5 billion dollars of foreign direct investments are expected, one billion dollars may be imports, and the rest will be domestic inputs, similar to the 20 million/80 million mark division in Ohlin’s illustration.
Here is the crux of the problem in this type of thinking. The cycle does not end at that point.
“Evidently Mr Keynes and the school of economists who share his view think that this is the end of the 80 mill. marks. As they do not directly increase the excess of imports they can have no effect whatever on the balance of trade. They can be left out of the reasoning altogether,” Ohlin wrote.
“I venture to suggest that, on the contrary, this amount of borrowed buying power deserves special attention. It sets in motion a mechanism which indirectly calls forth an excess of imports in A of about the same magnitude (as the borrowing).
“Just as the loss of this buying power indirectly creates an export surplus in B; or rather, these changes in buying power bring about at the same time as excess of imports A and of exports in B.
“A corresponding adjustment takes place in B. Home market industries grow less as a result of reduced demand for their products, and the labour and capital turns in greater proportion to export industries and industries which manufacturing goods which compete directly with import goods.
“The outcome is an excess of exports. B finds a widened market for its goods in A as a result of the adaptation of production which takes place in that country. Thus, the readjustment of production is the consequence of change in buying power in the two countries.”
“The monetary mechanism which brings about the change varies with the organization of the monetary system.”
Decades later when East Asian central banks mopped up large volumes of inflows through the sale of sterilization securities and built up forex reserves by purchasing US Treasury bills (transferring large volumes of capital below the line to the US) America ran a trade deficit.
Mercantilists then sort of got it (the reference ‘Asian savings glut’) but they are clueless about the actual operations of a successful East Asian central bank that gives a current account surplus, or the part that the elimination of exchange controls play in helping a current account surplus.
After World War II America ran a trade surplus when it financed Marshall Plan loans, and European demand for goods suddenly surged. The demand fell away as Marshall Plan loans were repaid.
Koheda Yannay Mallay Pol
However Keynes did not get it. He did not appear to know how banking systems worked and seemed to have been bogged down in semantics.
This was his rejoinder to Ohlin. He said a loan will not increase money incomes in the recipient country but will “enable German workmen to be employed in producing capital goods”.
The Allied leaders did not get it either.
Neither do the policymakers here get it in this century, hence the import controls and import substitution. Neither do Trump or any other economic nationalist who go on about trade and current account deficits.
The current account deficit is – roughly – the inverse of the financial account balance. This however eludes Keynesians or as Ohlin put it in 1929 “Mr Keynes and the school of economists who share his view.”
Keynes belief in a fatalistic structure
Another Economist who replied to Keynes was Jacques Reuff in the same publication tried to explain the phenomenon through what he termed the principle of conservation of purchasing power where in “all cases one’s loss is another man’s gain…”
Rueff, a French economist pointed out (Mr Keynes’ Views on the Transfer Problem) that Keynes seemed to believe that ‘the balance of trade at any moment is largely dependent upon the economic structures of the various countries, and that it cannot adjust itself rapidly to the requirements of an equilibrium balance of payments when the conditions of this equilibrium are abruptly modified. ”
This fatalistic belief is also true in Sri Lanka. The IMF was also largely built on the false fatalistic idea of loaning reserves from ‘surplus to deficit countries’.
The concept of self-correcting gold standard central banks and currency boards is impossible for Keynesians to grasp.
Many policy makers seem to believe that there is some inherent ‘structural flaw’ that makes Sri Lanka run a current account deficit and it is not the import of capital (and the exchange controls that prevent their export) are the reasons for the current account deficit.
Rueff (a Frenchman who was a Deputy Governor of the French central bank) wrote giving a real world example of how in 1919 British and American governments halted the payments of about ’20 milliards of francs’ to France. Note that this is a ‘political’ payment.
According to Keynes this should not have reduced the ‘commercial balance’ (trade deficit).
“The facts show, however that this was by no means he case,” Rueff explained. “In 1919, the deficit in Frances commercial balance was approximately the same. But in 1921 it had been reduced to approximately 2 milliards of francs, and remained more or less during 1922 and 1923.”
Rueff went on to explain that in 1923, France started to export capital and in 1924 it had a ‘commercial surplus’ of 1,450 million francs.
“Thus, during all this period France’s commercial balance has always adjusted itself very definitely to modifications in the financial factors of the BOP (first political credits and then investments abroad), although these modifications were extremely rapid and involved exceptionally large amounts, and although they had no relation to what Mr Keynes called the economic structure of the countries concerned.”
Reuff explained that between 1872 to and 1875 when France was repaying a war debt imposed by Germany, there was a trade surplus.
The Weimar Republic went further than borrowing money. It printed money. When money is printed not only does not trade deficit increase, there may also be a fall in the currency as more outflows than inflows hit the forex market.
Imports will rise over and above current receipts, and not just due to foreign borrowings or foreign investments.
Ohlin explained this succinctly in a note (words in brackets added for current context).
“In a country, which neither borrows from nor lends to other countries and which maintains equilibrium on its capital market, “buying power” is identical with “aggregate of money earnings.”
“Foreign borrowing, however, increases and loans (to foreigners) reduce buying power. Similarly, inflationary credit policy (central bank purchases of Treasury bills) and deflationary policy (CB securities sales) reduces it.
“In the former case new buying power is created by the banks; in the latter, money which is earned and save is not lent by the banks to others, – it vanishes (is sterilized) and buying power falls off.”
Monetary systems are credit systems. They are made up of banks. A pegged central bank is an agency which takes deposits in dollars and issues a ‘bank note’ as it a commercial bank issued fixed deposit certificate with zero interest. Unless the money is sterilized (mopped up) they are used by the recipients.
As the Reichsbank printed money, The Weimar Republic collapsed into hyperinflation. The allies then suspended reparation payments.
Ludwig von Mises an Austrian economist later wrote that the Western Allied politicians were roundly misled by the “spurious ” transfer problem.
“They were disposed to accept the German thesis that “political” payments have effects radically different from payments originating from commercial transactions.
“The truth is that the maintenance of monetary stability and of a sound currency system has sound currency system has nothing whatever to do with the balance of payments or of trade.
“If a country neither issues additional quantities of paper money nor expands credit, it will not have any monetary troubles.
“An excess of exports is not a prerequisite for the payment of reparations. The causation, rather, is the other way round. The fact that a nation makes such payments has the tendency to create such an excess of exports. There is no such thing as a “transfer” problem.”
UK went off the gold standard on 27 September 1931.
“There are few Englishmen who do not rejoice at the breaking of our gold fetters,” Keynes wrote in his persuasive way.
“We feel that we have at last a free hand to do what is sensible. The romantic phase is over, and we can begin to discuss realistically what policy is for the best.”
The Sterling gave up its position to the US dollar, which it never recovered.
With self-correcting gold-standard central banks no longer in existence the IMF was later built to loan reserves from ‘surplus to deficit’ countries.
By the time he died Keynes and his policies and spurious beliefs had left the UK in a mess.
UK had to beg loans from the US soon after World War II.
It is said that Harry Dexter White, an arch New Dealer/socialist with alleged Soviet sympathies who set up the International Monetary Fund, ignoring Keynes’ ‘Bancor’ plan for the Bretton Woods in favour of the ‘key currency’ plan, humiliated Keynes in the negotiations.
Though UK won the war against German nationalism, domestic socialism and Keynesianism held back the country which was wracked in exchange controls for decades.
When Sri Lanka got independence from Britain, UK had to beg Ceylon not to withdraw currency board reserves precipitately.
Germany on the other hand (with less than half the original territory) forged ahead under Ordoliberals after striking zeros off the old currency, with a new Deutschemark restoring monetary stability.
The Federal Republic – with a fraction of its pre-war territories – paid reparations, repaid Marshall Plan money (which Ordoliberals were not very keen on) and also paid the cost of occupation to the Allies.
Unlike Keynes whose policies reduced Britain to begging status, Rueff later advised Prime Minister Charles De Gaulle to overhaul the French central bank and created the New Franc (like the Deutsche Mark) after a series of devaluation at the rate of 100 to one, and helped save the country in 1960.
In Ohlin country, Sweden’s central bank Sveriges Riksbank is a global example for monetary probity and set the stage for Scandinavian region on a path to prosperity, free trade and peace.
In an interview in 1978, F A Hayek described Keynes as one of the “most intelligent original thinkers” with a fine brain, an ‘amazing memory’, who was widely read about a great many subjects’ but economics was “just a sideline to him”.
Keynes was a “man with a great many ideas who knew very little economics,” he said.
“He knew nothing but Marshallian economics, he was completely unaware of what was going on elsewhere. He even knew very little about the nineteenth century economic history. His interests were very largely guided by aesthetic appeal. And he hated the nineteenth century and therefore knew very little about it. He was an expert about the Elizabethan age.
“Even within the English tradition, he knew very little of the great monetary writers of the nineteenth century. He would know nothing about Henry Thornton (anti-bullionist), he knew a little about Ricardo of course – the famous things.
“But he could have found any number of antecedents of his inflationary ideas in the 1820’s and 1830’s. And when I told him about it, it was all new to him.
“He took it for granted that Marshall’s textbook contained everything one needs to know about the subject. There was a certain arrogance of Cambridge economics about it. And they thought they were the centre of the world. And if you have learned Cambridge economics there is nothing else worth learning.”
Cambridge economics did enormous damage not just to Britain but to any number of former colonies and to other countries in Latin America, Asia, Africa and Europe, triggering currency collapses, ending free trade, and through exchange controls laws expropriating and punishing minorities in particular.
In the economic devastation that followed nationalists and dictators came to power.
Britain continued to struggle until monetary policy was tightened and exchange controls were removed under Prime Minister Margaret Thatcher and her advisor Alan Walters allowing the country to finally dig itself out of Sterling crises and IMF bailouts.
Thatcher reportedly went about carrying Friederich Hayek’s Constitution of Liberty in her handbag.
Once when an ‘economist’ at a conservative think tank advised her to tread the ‘middle path’ or ‘mixed economy she had pulled the book out, laid it on the table and said ‘This is what we believe’.
The favoured road of fascists, violators of private property and robbers of individual freedom had always been the ‘middle path’
“Mrs Thatcher certainly knows as well as anybody that it would be -possible quickly to reduce unemployment for a time by increasing inflation (“reflation”). But for this, as we ought to have learnt by now, we would have to pay by even more severe unemployment later on,” Hayek wrote in reply to an article critical of the PMs economics, which Greenspan-Bernanke Fed forgot and triggered the Great Recesssion and MMT advocates are forgetting now.
“It is to Mrs Thatcher’s great merit that she has broken with the Keynesian immorality of “in the long run we are all dead” and to have concentrated on the long run future of the country irrespective of possible effects on the electors. Keynesian irresponsibility naturally appeals to the timid wets.
“Mrs Thatcher’s courage makes her put the long run future of the country first. After being much too long restrained by the believers in the Muddle of the Middle, her new stature ought to enable her to guide us by her true vision.
It is this Keynesian immorality of targeting the output gap with printed money and interest rate controls that brought down the economy in 2018 despite ‘revenue based fiscal consolidation’ and gave a swift kick in the pants to the last UNP led administration,
Razeen Sally, a former and London School of Economics professor where Hayek had taught, has pointed out Sri Lanka’s fatal conceit of moving away from self-correcting markets to state intervention was based on an entirely false Keynesian world view.
“Underlying all this is a misguided world view,” Sally said. “It is a world view Lord (John Maynard) Keynes and his Bloomsbury circle had shared. And (Friedrich) Hayek accused Keynes and his ilk of suffering from a fatal conceit, for that very reason,” Sally said delivering a lecture marking 69 years of Sri Lanka’s soft-pegged central bank in 2019.
“Why is the world view misguided?
“It is as if you could get a committee of really good super qualified, intelligent people, together. Who are platonic guardians as it were, who only have the public interest in mind. They are the best committee to sort out the complex problems of the world because they know best. They also assume they have the requisite knowledge to intervene here, there and everywhere as superior to the market, in particular situations.”
“Let me choose a generic example. And this happens around the world, sometimes also here in Sri Lanka.
“The generic example is, say, the monetary board of a central bank that actually tells market actors beginning with commercial banks what interest rates they should charge, to whom they should lend and under what conditions.
“And when these market actors don’t behave accordingly, they are ticked off like naughty school children and sometimes threatened with punitive action.”
Sri Lanka’s self-correcting currency board was dumped in 1950 and the country was doomed to forex shortages and ‘save’ foreign exchange ever since.
The Budgetary Problem
Like the Weimar Republic and Sri Lanka is now printing money again, creating forex shortages and there are worse import controls than the UNP led administration did and default is much closer.
The dollar inflows that come into the country do not belong to the government. Even when they are converted to rupees, the rupee proceeds belongs to private citizens.
To get hold of the rupees the government has to tax or borrow the money. Since taxes have been cut only borrowing is the alternative.
But Treasury auctions are failing, and money is being printed.
To solve Sri Lanka’s ‘budgetary problem’ in repaying debt, Treasuries auctions have to succeed. When that is done, the ‘transfer problem’ of foreign exchange will be automatically solved. But this is beyond the ken of Keynesians.
Instead with failed Treasury bill auctions filled with printed money under Modern Monetary Theory the country is slipping deeper into imbalances.
So far the dollar peg has been maintained to some degree at the cost of reserve losses. If the peg starts to slide, it will be an Argentina (the country printed more money in 2020) or a Weimar Republic.
A monetary meltdown is much worse than a default, though it is admirable that Sri Lanka’s rulers and policymakers genuinely do not want to default.
The foregoing shows that opening imports in Sri Lanka will not be a problem.
It will only impact the interest rates, as private credit will pick up, but not the exchange rate as long Treasury bill auctions are successful.
But opening imports will bring more tax revenues and reduce the rate of interest that is needed for successful bill auctions, while allowing economic activities to resume and prices to fall.
Moreover, ending import controls will save the people from being exploited by rent-seeking import substitution cronies.
There is no harm in the government’s attempt to boost inflows to 32 billion dollars a year in 2021 as announced.
Greater inflows are helpful as it will bring more resources and help repay debt at a lower general interest rate by boosting potential savings – in other words ‘the Weimar budgetary problem can be solved at a lower interest rate. Other than land sales, these moneys do not belong to the government.
Unless Treasuries auctions are successful, not only will these money s slip through the fingers of the Treasury, outflows will exceed inflows if money is printed and is used by the people.
The Transfer Problem in Surrender Requirement
The central bank has imposed surrender requirements on banks. That will create more liquidity.
Surrender requirements are also placed by soft-peggers around the world due to the belief that there is a ‘Transfer Problem’.
Ideally the dollars should be sold to the Treasury not the central bank, for existing rupees – rupee taken through Treasury auctions on which imports have already been curbed – without expanding reserve money.
There is nothing to stop the Treasury from buying dollars, with the rupees taken from bill auctions even if there is no surrender requirement.
The surrender requirement will create more pressure on the peg by generating excess liquidity and the central bank should be prepared to sell dollars to maintain the peg.
These actions, like the import controls, exchange controls and price controls, will be un-necessary as long as Treasury bill auctions are successful.
Ideally value added taxes should also be raised. But fiscal corrections will not save the country as 2018 showed and Argentina and oil producing Iran and Venezuela are living proof.
To make the monetary system work with a peg, there has to be a market clearing interest rates and no liquidity injections.
The International Monetary Fund is a useful tool since they have a ready-made debt repayment mechanism.
However IMF also generally subscribes to the spurious Keynesian theory of a ‘price effect. Hence they advocate depreciation and real effective exchange rate targeting and whole ‘overvalued’ or ‘undervalued’ currency misconception. That will be a disaster.
The IMF, having returned to its New Dealer roots, despite a brief foray into Washington consensus does not understand the problem, which is why it is now peddling ‘flexible’ Keynesian policy.
Successful East Asian nations have had either currency boards (unsterilized sales to defend the peg, and unsterilized purchases to match the growth in reserve money) which are neutral or monetary authorities that collect vast forex reserves by exporting more savings.
Countries such as Vietnam follow the rule of partially unsterilized sales (when US hikes rates for example) which drives call money rates up, and sterilized purchases to buy and build up reserves at other times.
The US Treasury and the IMF is mistaken when claiming that the State Bank of Vietnam is undervaluing its currency, when it sterilizes purchases (buys dollars and kills the dong with securities sales), and so is the IMF in advising it not to do so.
This is the whole question of being confused about the ‘price effect’ and ‘income effect’ all over again.
Floating and depreciation are not the same things. A floating currency is fundamentally different from a pegged one. S
It is not possible to control the exchange rate and print money to keep rates down. And it is not possible to print money and repay debt without losing reserves.
There is nothing wrong with Sri Lanka. There is nothing structurally flawed. Sri Lanka’s private savings are in excess of 20 percent a year.
At the market interest rate it will be quite easy to sterilize 1 percent of gross domestic product at build up reserves year after year. As soon at the capital account is opened there could even be a current account surplus.
When chronic depreciation stops with a floating call money rate, capital destruction and high nominal rates will end, creating an abundance of capital for investment and prosperity.
There is nothing inherently superior about current account surpluses or trade surpluses. Neither are they due to a ‘price’ effect. Price effects – driven by productivity not depreciation – can boost total exports, but not the balance.
They are just an outcome of income effects or a transfer of capital out, either above the line through outward foreign investment or below the line by the central bank or both.
Like Western Allied politicians in the 1920s, politicians in this century are being misled about imports and current account deficits. What Sri Lanka has to do is to shake off the spurious ideology, or ‘immoral inflationary policies’ and give a chance for hardworking people to get on with their lives.
It took 40 years for Thatcher to shake off the Keynesian exchange controls. Germany did it shortly after the World War II.
Singapore, Malaysia and Hong Kong which had currency boards, never (except during Japanese occupation) had no such problems.
Until Mercantilist policy makers see the light, or some politicians succeed in reforming the central bank or adhering to A S Jayewardene’s core mandate of economic and price stability, Sri Lanka will suffer same fate it has suffered since the Latin America style central bank was created.
In 2021 Sri Lanka is closer to Latin America than ever.
This column is based on ‘The Price Signal by Bellwether‘ published in the March 2021 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: [email protected]