ECONOMYNEXT – Sri Lanka is treading on the path of John Law, an 18 century French Mercantilist who drove France to a monetary meltdown with an early central bank, in implementing so-called Modern Monetary Theory debauching the currency, an opposition legislator has charged.

Sri Lanka cut taxes sharply in December 2019 in a fiscal ‘stimulus’ and started printing in large quantities following several rate cuts in early 2020 in a monetary ‘stimulus’.

John Law Returns

“Look at the problems in fiscal policy. What was the benefit of cutting taxes?” opposition legislator Kabir Hashim questioned in parliament.

“Government revenues fell and prices of goods went up. Look at monetary policy. In 1700s in Britain there was a man called John Law. It is his policies we are following now, printing money and calling it MMT.”

Law fled his native Scotland to France over an incident in a duel, but had tried interest Scottish leaders in setting up a central bank and a national paper money.

Scotland had a series of free banks where a type of short term advances of printed money similar to ‘provisional advances’ found in Sri Lanka’s central bank law, called the ‘real bills doctrine’ which was in use to various degrees.

However he failed to persuade Scottish leaders including the Duke of Argyle of his scheme. Following his flight to France, Law cultivated a friendship with the Duke of Orleans, who was regent to King Louis of France.

In 1720 Law was appointed Controller General of Finance. A private bank set up by Law (Banque Générale Privée) was nationalized as Banque Royale and it bought government debt.

“He (Law) bankrupted France,” Hashim said. “The same thing is happening in Sri Lanka.”

Mississipi Stocks

Placing restrictions on free trade, Law created several companies with crony-Mercantilist monopoly powers including the Mississippi Company, driving up stock market prices with excess profits.

In Sri Lanka import restrictions are also driving up stock market profits of some so-called crony import-substitution companies, which exploit people with high prices benefiting from import duties and import controls.

However inflation soon followed and stock markets collapsed as people demanded gold in return for the paper money, in a similar way people demand dollars in return for printed money in a pegged exchange rate central bank.

Hashim said hundreds of billions of rupees had been printed in 2020.

“Where had his money gone?” he questioned. “There should be lots of money. Why is the government saying there is no money now?”

The money left country as a balance of payments deficit as the new money was redeemed for foreign reserves for trade transactions and for dollar debt repayment through the ‘convertibility undertaking’ of the peg.

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The BOP deficit started in late 2019 as the Yahapalana central bank bought bonds to target an output gap and lower interest rates artificially again ending a policy of mopping up inflows.

Excess Money Redeemed for Reserves

The BOP deficit in 2020 was 2.3 billion US dollars. In 2021 up to April the BOP deficit was over 900 million dollars.

“The rupee had been severely debauched (mus-ther barl-doo),” Hashim said. “Mahinda Rajapaksa hit the rupee over 100 to the US dollar in 2005. Gotabaya Rajapaksa hit it over 200 to the US dollar in 2020/2021.”

However the central bank in the administration in which Hashim was a cabinet minister also followed a milder version of MMT called ‘output gap targeting’, triggering currency crises.

Ironically the International Monetary Fund gave technical support to calculate a supposedly existing ‘output gap’.

Hashim’s administration also followed a more non-credible peg called the ‘flexible exchange rate’ involving vicious dual anchor conflitcs, which switched between floating and fixed rapidly, sometimes within the same day, due to refusal to convert to dollars very much smaller volumes of printed money and went sliding down.

The administration also made an attempt to institutionalize dual anchor conflicts by writing the ‘flexible exchange rate’ into the monetary law.

Printing money to target an output gap created a currency crisis in 2018 driving the rupee down from 153 to 182 to the US dollar forcing corrective policies to be implemented as the balance of payments was blown apart, in a so-called ‘stop-go’ policy. (Stop-Go policies of the political business cycle)

The central bank also jettisoned a ‘bills only policy’ trying to control long term yield curve, going beyond a short term ‘real bills doctrine’ to longer term permanent injections of money in the style of Banque Royale.

It was claimed that ‘inflation targeting’ was followed, despite operating the highly unstable pegged exchange rate called ‘flexible exchange rate’ with a foreign reserve target, which analysts warned would end in disaster.

The 2018 debacle was also significant since money was printed despite tax hikes and market pricing of oil, showing there was no fiscal dominance of monetary policy.

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However the country does not have a floating rate to avoid a currency collapse when money is printed through open market operations.

Deteriorating Policy

After busting the rupee the central bank also controlled deposit rates, in an unprecedented double expropriation of the small man in favor of leveraged businesses and the state in another Mercantilist intervention.

The central bank also engaged in real effective exchange rate targeting resisting an appreciation of the currency in 2017 while buying up over a billion US dollars in reserves and also undoing dangerous swap deals.

Instead of letting the currency appreciate like in 2010 and 2011, the rupee was further depreciated by 3 rupees in 2017.

The then administration gave ‘central bank independence’ and allowed REER targeting, a blatantly Mercantilist strategy aimed at getting a short term trade advantage by destroying real wages of export workers.

The then-cabinet also did not objects to ‘output gap targeting’ to be implemented though no cabinet sanction had been given for such an action which went against the stability objective of the central bank.

A policy rate corridor was also narrowed from 150 to 100 basis points, and no action was taken.

MLA mandate for stability

Call money rate targeting was then started where large volumes of money was printed to target a rate below the ceiling of the corridor making nonsense of the idea of having a policy corridor in the first place which is to allow rates to go up automatically when a peg is defended.

Critics have pointed that the central bank only has a stability mandate and no growth mandate for any John Law type activity other than provisional advances for six months, and both output gap targeting and MMT violates Section 05 of the constitution of the central bank.

However even in 1950, an economist writing in The Banker magazine warned that the six-month limit was no protection as long at the CB could buy Treasuries and had many tools used in Latin America.

Sri Lanka’s central bank was one of several set up by the Fed in Latin America and Asia in the style of Argentina’s central bank.

In 2015 large volumes of money was injected initially to keep call money rates at the bottom of the corridor eventually driving the rupee from 131 to 151 to the US dollar by early 2017 in the first currency crisis in the last administration.

Analysts warned that the call money rate targeting would be a death-knell for the rupee and REER targeting would, trigger monetary instability and political unrest.

However MMT is much more dangerous.

Analysts have warned that MMT combined with swap deals could make the central bank insolvent, in addition to possible sovereign default and could trigger a monetary meltdown unless corrective action was taken to stop printing money.

History Repeats
The 2020 MMT exercise was done despite the experience of 2015 and 2018, where growth collapsed after the liquidity injections triggered currency crises.

In France, despite the experience of the John Law’s paper money, a currency called Assignat was printed after the French revolution. The assignat was printed not against Treasury bills but land seized mostly from the Church and ‘assigned’ against paper livres.

The currency soon lost value and trading restrictions and exchange controls were brought to maintain its value.

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In August, 1793, a law was passed punishing any person who sold assignats at less than their nominal value with imprisonment for twenty years in chains, and later a law making investments in foreign countries by Frenchmen punishable with death.

“On whom did this vast depreciation mainly fall at last?”,” questioned Andrew Dickson White in his work Fiat Money Inflation in France.

“When this currency had sunk to about one three-hundredth part of its nominal value and, after that, to nothing, in whose hands was the bulk of it?

“The answer is simple.

I shall give it in the exact words of that thoughtful historian from whom I have already quoted: “Before the end of the year 1795 the paper money was almost exclusively in the hands of the working classes, employees and men of small means, whose property was not large enough to invest in stores of goods or national lands.

“Financiers and men of large means were shrewd enough to put as much of their property as possible into objects of permanent value.

“The working classes had no such foresight or skill or means. On them finally came the great crushing weight of the loss. After the first collapse came up the cries of the starving.” (Colombo/July02/2021)