Sri Lanka’s destabilizing central bank has for many years set its own inflation target at around 4 to 6 percent, printed money to meet the loose anchor, triggered forex shortages, currency crises and excessive foreign borrowings in their wake, which ended in default in 2022.
This was not the case before 1920 when inflation was not permanent, there were no balance of payments troubles and sovereign default was almost unheard of, and the concept of gilt-edge was the fiscal standard.
Central banks were tightly controlled by parliaments through law and the market through the gold standard as rules triumphed discretion up to around the 1920s, when monetary systems started to deteriorate.
The gold standard kept inflation down (therefore budgets, debt and banking troubles under control) and balance of payments in balance through free market interest rates.
Banks did not generally print money and was forced to float (break the gold targeting rule) only during war when inflationary financing took place.
There was no deliberate money printing to boost growth, jobs or meet a high positive inflation target as now, triggering instability in peacetime.
Before open market operations banks did not print money as a general rule
The aggressive open market operations though which Sri Lanka’s central bank and those in Latin America now create high levels of inflation was absent, when inflation was temporary and the balance of payments balanced before the First World War.
In this period when the UK because a great imperial power, the Bank of England – as a private agency – was accountable to both the public and the parliament.
There were no macro-economists to say that central banks were extra-judicial independent agencies with wide discretionary powers to inflate at will. Money was definitely a legitimate matter for law, and therefore parliaments.
A classical central bank subject to market rules and the parliaments law with specie targeted at zero, could not depreciate at will or impose exchange and imports controls to hide its policy errors as third world SOE central bank do now after turning their countries into basket cases.
The so-called Lombard and discount rates of banks moved frequently as banks targeted a specie anchor at zero.
Now inflation is targeted at 2 percent by Western central banks including the Fed which created the Great Recession and the recent inflation bout, which has still not run its course.
Open market operations were accidentally discovered by the New York Federal Reserve in the course of firing the roaring 20s bubble leading to unaccountable central banking.
The Fed was set up as an SOE central bank.
“The real significance of the purchase and sale of Government securities was an almost accidental discovery,” writes Randolph Burgess in Reflections on the Early Development of Open Market Policy.
Burgess joined the New York Fed in 1920 as a statistician and saw with his own eyes what happened,
“During World War I member banks borrowed heavily from the Federal Reserve Banks, and the interest from these loans brought the Reserve Banks substantial earnings,” he says.
“But, due to the deflation of credit in 1921, a substantial return flow of currency, and heavy receipts of gold from abroad, the banks were then able to pay off a large part of their borrowings.
“Hence the Reserve Banks found their income cut to a point where they had difficulty in meeting their current expenses. So, a number of the Reserve Banks went into the market in 1922 and bought Government securities to eke out their earnings.
“Then they made two important discoveries. First, as fast as the Reserve Banks bought Government securities in the market, the member banks paid off more of their borrowings; and, as a result, earning assets and earnings of the Reserve Bank remained unchanged.
“Second, they discovered that the country’s pool of credit is all one pool and money flows like water throughout the country.”
Unaccountable Central Banking
That liquidity injections flows like water and concurrent loss of gold reserves was well known to classical economists in Europe. The price specie flow mechanism described by David Hume and other classicals was the bedrock of low inflation and external stability.
Today foreign reserves flow in exactly the same way, in reserve collecting monetary authorities like Sri Lanka or Hong Kong or the UAE.
The UK first went off the gold standard (floated) with the First World War and there was a Currency and Bank Notes Act of 1914 after the First World War.
The prior knowledge that money printing causes forex (reserve asset) shortages, that led to such legislation, is no longer a matter of wide knowledge among bankers, legislators or present-day economists particularly in countries with balance of payments trouble.
August 1914 also saw the longest banking holiday in UK history as attempts were made to calm financial markets as war was declared.
In the next decade the Fed fired the roaring 20s bubble which created the Great Depression.
The UK finally went off the gold standard in 1931 in a complex set of circumstances without prior approval, setting the stage for monetary instability that is now widespread, with some parliaments outsourcing their responsibilities and claiming monetary policy is not under its purview.
Other central banks in countries which recovered from the Great Depression also went off the gold standard like dominoes.
J M Keynes cheered the float (suspension of convertibility). This was in sharp contrast in the 19th century when classicals led by David Ricardo and later the currency school fought back against the private Bank of England for a tight anchor.
The Bank of England was made into an SOE in 1946 and exchange controls came in 1947. They were not removed until Margaret Thatcher, who was advised by Hayek, Friedman and Alan Walters came to power, rejecting these ideas.
Ironically, it was the classicals of the Currency School – through good intentions – who gave the Bank of England the monopoly in UK money through the Bank Charter Act (Peel Act), ending free banking, which in the context what is happening now, had provided a more stable system.
Through the Bretton Woods an attempt was made by the US and UK to stop devaluations and preserve free trade. But with open market operations fixed policy rates becoming normalized, it was doomed to failure.
Central banks money printing now became a cyclical affair, determined by flawed operational frameworks, and not limited to war, as macro-economic policy (rate cuts to boost growth) drove countries into chaos and people into poverty and hunger.
Open market operations allowed central banks to monetize past deficits – in effect assets held by the public and commercial banks – destabilizing countries and nations with no fear of reprisals or public outrage.
The Bretton Woods almost collapsed in 1950/51 and was saved by Fed Governor Marinner Eccles. But within 20 years it was dead.
Second class anchors
By and by a 2 percent positive inflation target came to be a fairly successful rule or anchor to control floating fiat money central banks, but it was far worse than gold at zero. The 2 percent rule failed to prevent big banking crises and asset price bubbles.
By targeting core inflation, these central banks bought more room to print money and suppress rates, in the false hope that they can boost the economy or create inflation.
If low, positive inflation targeting, created the Great Recession and other asset price bubbles and bank failures seen in the 1980s and 1990s, 4 to 6 percent was enough to bankrupt entire governments. Countries like Ghana had inflation targets of around 8 percent.
Sri Lanka’s repeated currency crises in 2012, 2015/16, 2018 and 2020/22 came from trying to target inflation at 4-6 percent, almost three times the positive inflation target of more stable central banks.
Eventually, the country borrowed large volumes of foreign debt from ISB holders as well as China – both of whom were lending liberally as the Fed and ECB engaged in quantity easing – as a series of currency crises triggered forex shortages and defaulted.
Central banks in Sri Lanka and Pakistan also borrowed through central banks swaps, another deadly invention of the Fed in the desperate dying days of the Bretton Woods to cover up its own money printing.
Before swaps, central banks could only run down their reserves and float (suspend convertibility). After the Fed invented swaps, they could print money until reserves were negative as happened to Sri Lanka.
Sri Lanka’s lawmakers should ban the central bank from borrowing through swaps in addition to denying goal independence to macro-economists at 4-6 percent.
All borrowings should be made only with parliamentary approval like any other loan, not through an unaccountable central bank, whose balance sheet is linked to the stability of peoples’ lives, which is printing money and losing its reserves.
Law of nature vs statistical econometrics
In this century SOE central bankers are also supported by statistics – which started to infect economics in the last century – to try and defy laws of nature discovered by classicals.
That a reserve collecting central bank loses reserves, when other domestic assets are bought for circulating money, is a law of nature, long ago discovered and described by classicals ranging from Ricardo to Hume to Adam Smith.
Adam Smith allowed for limited short term credit expansion. Scotland had a well-functioning gold restrained free banking system at one time, which had worked very well.
Therefore, the real bills doctrine could operate as long as there was no fixed policy rate for extended periods of time.
That reserve collecting central banks which operated fixed policy rates for extended periods will trigger forex shortages is not a statistical hit or miss based or some econometric real effective exchange rate index, as academic mercantilists make out now, but a law of nature discovered and described by classicals centuries before and which works every time.
The impossible trinity of monetary policy objectives is also a law of nature, which, in a roundabout way, is another way of describing a reserve flow mechanism.
When exchange and monetary policy (reserve collecting and inflation targeting) conflict with each other, forex shortages are inevitable.
Goal Independence through High Positive Inflation Targeting
But now, even in stable countries, a much weaker standard than gold – a consumer price index with services, or worse a core inflation index with commodities removed – is targeted not at zero but two percent.
Basket case countries like Sri Lanka targets 4 to 6 percent under the benign Mercantilist stamp of approval of the IMF.
Other recently defaulted countries have targeted inflation indices as high as 7 percent. India until around 2011 successfully targeted a 5 percent wholesale price index which had a lot of traded commodities and was the antithesis of the core inflation index.
After RBI shifted its anchor to a consumer inflation index, the rupee had collapsed.
Sri Lanka’s legislators should therefore deny central bank and the country’s macro-economists the right to continue to set their preferred de-stabilizing 4-6 percent inflation target and get not only “instrument” but also “goal independence”.
Central bank independence is a flawed concept. Central banks should be subject to a tight rule.
Even in the flawed concept of giving independence to a money producing SOE, it is accepted that it should not be given ‘goal independence’ but only instrument independence, a reference of operational frameworks.
The tighter rule, lower the inflation, and lower the room to create banking crises though mal-investments and sovereign default.
That operational frameworks of countries with forex shortages and exchange controls fundamentally also flawed is another matter.
That a 2 percent inflation target is found wanting is openly admitted through the emphasis now placed on macro-prudential regulation.
In a reasonably tight or prudent monetary standard, micro-prudential regulations are enough to stop banking crises, as they were before 1971 and they were in the days of Lombard Street and Bagehot.
Sri Lanka’s proposed new central bank law, apparently drawn up by the central bank itself under IMF tutelage, has given macro-economists wide discretion to engage in naked Keynesian stimulus through output targeting.
It is more than foolhardy to give independence to a central bank that believes in Keynesian stimulus.
Output gap targeting is a surefire way to depreciate the currency (the way to create more inflation than the barely successful US Fed) and drive Sri Lanka to a second default.
A reasonably low inflation target of zero to 2 percent could tame the central bank even under the current law and go a long way to stop a second sovereign default.
A low inflation target would also go some way to prevent a currency crisis and panic and loss of confidence that is guaranteed in a flexible exchange rate regime.
A 2 percent inflation target is inferior to an exchange rate target, but it is way better than the 4-6 target with output gap targeting which had driven Sri Lanka into default with serial currency crisis, without a war.
Both flexible inflation targeting and flexible exchange rates defy laws of nature and are based on flawed econometrics with a record of instability and default in Latin America, Africa and now South Asia.
Going Bankrupt by Defying Laws of Nature
Flexible inflation targeting is an impossible trinity regime where foreign reserves are depleted by a domestic inflation target due to the lack of a floating exchange rate.
The 1980s defaults and currency crises were created by a similar conflicts where foreign reserves were depleted by money supply targeting due to the lack of a floating exchange rate.
At the time floating rate central banks were targeting money supply as an anchor just as they are targeting inflation as an anchor now.
In the 1980s East Asian countries rejected these ideas wholesale. The most politically stable East Asian nations and stable GCC countries in the Middle East still reject these ideas, though they come under pressure from IMF economists to do.
It is not that the central bankers and economists in a country with forex shortages and exchange controls like Sri Lanka are especially bad or ill-intentioned people.
It is just that these are the current in vogue monetary fads peddled by Western Mercantilists and uncritically embraced due the lack of a doctrinal foundation in sound money.
Flexible inflation targeting is rejected in the home countries of Western macro-economics who come up with these concepts, but are peddled to the third world where there is less understanding of monetary history or workings of note-issue banks.
J M Keynes was the most influential economist/Mercantilist in the last century and naturally his ideas and those of post-Keynesians dominate the agenda.
He destroyed the Sterling, one of the greatest currencies the world has known until 1931, and made England a beggar nation through the Anglo-American agreement as well as through 11 IMF programs.
Macro-economic policy fine-tuned by post-Keynesians also destroyed the US dollar in 1971.
Policies and operational frameworks that destroyed the Sterling and US dollar can and did destroy the Sri Lanka rupee as they had from 1950 after market interest rates was abolished and centrally planned interest rates came with, money printing.
It is no accident that Sri Lanka’s social and civil unrest worsened from the 1970s and Western nations are seeing a spate of strikes and unrest now after Covid money printing, as they did in the late 1960s and 1970s.
A 2 percent inflation target with conflicting money and exchange policies (dual anchors) is inferior to a single anchor regime (a floating rate with a 2 percent inflation targeting or fixed exchange rate target at zero).
But it is better than a 4-6 percent target, which will drive the country into a second default.
The entire idea of central bank independence is to supposedly protect the people’s money from stimulus happy politicians who want to employ macro-economic policy to boost output.
If the monetary authority is run by stimulus happy macro-economists who want to target an output gap, central bank independence will not protect the people’s money or the economy.