ECONOMYNEXT – On August 23, 1950 Sri Lanka, then Ceylon, barely two years after independence, dumped the country’s single anchored money regime and replaced it with a pseudo currency peg that sealed newly independent country’s economic fate for the next 73 years.
In 2023, as the unfortunate country celebrates 75 years of independence the pseudo currency peg with a policy rate is to be replaced by pseudo inflation targeting without a floating exchange rate.
The new monetary law published is a mish-mash of policy contradictions, with output gap targeting – stimulus – legalized.
Under the existing monetary law there is no mandate for creating economic growth, only for creating a stable foundation to allow growth to happen.
It was violated especially from 2011 onwards and taken to new heights after the International Monetary Fund taught the central bank how to calculate an output gap.
Now output gap targeting (a growth mandate) has found its way to the monetary law itself.
The IMF is railroading the politicians into passing this law which allows monetary policy (policy rate targeting), exchange rate policy (exchange rate targeting) and output gap targeting (stimulus) by including it as a prior action/structural benchmark in the reform program.
Central bank constitutions should be instruments of restraints that subjects officials and politicians to strict rules of law, not discretion.
At the time the claim by made US Keynesians who promoted pseudo pegs was the economic bureaucrats could have monetary policy independence (print money to fix the interest rate) with an exchange rate peg, unlike the currency board era.
Sri Lanka’s unfortunate citizens lost its economic freedom due to the pseudo peg shortly after 1950 with ever tightening exchange controls following a law enacted in 1952.
The US soft-peg went down the drain with the collapse of the Bretton Woods in 1971 and the Fed, or to be precise the American academics and bureaucrats who designed it took the gold standard down with them.
The Bank of England which kept the gold standard through three centuries did not have a fixed policy rate for itself to manipulate interest rates for very long, though it had also briefly floated on several occasions after suspending gold convertibility.
In 1971-73 the US and major reserve currency central banks floated as the gold price (as well as other commodities) relentlessly kept rising, plunging the world into floating exchange rates.
But floating rates did not have a credible anchor to replace gold. As a result, the 1970s came to be known as the period of Great Moderation. In 1980 Paul Volker tightened interest rates in the US to 20 percent and brought inflation down.
There were various experiments with money supply targeting as an anchor in the period.
By and by, Sweden and New Zealand invented inflation targeting as a credible anchor for clean floating regimes, where rates were hiked when inflation was seen to rise, disregarding other considerations like growth or employment and reducing discretion or flexibility available to bureaucrats.
Pseudo Inflation Targeting
Now the International Monetary Fund and US academics are peddling a pseudo inflation targeting regime to Sri Lanka called flexible inflation targeting, with aggressive open market operations, which has failed and led to default in several countries.
Instead of a floating exchange rate – which is a very strong exchange rate where reserves are not used for imports – because there aren’t any – a pseudo exchange regime rate called a flexible inflation targeting is proposed with a reserve collecting central bank.
As the country celebrates its 75 years of independence, pseudo inflation targeting is coming in as flexible inflation targeting with a pseudo floating rate called the flexible exchange rate.
Sri Lanka has been messing with a flexible exchange rate– with money supply targets as an anchor – in the 1980s.
That unstable regime destroyed J R’s attempt to bring back an open economy and helped plunge the country in to strikes and social unrest.
Bad Money and Macro-Prudential Regulations
A central bank that provides sound money will not only reduce price inflation, but the other negative effects of inflating money.
If money is unsound, price inflation will one of the lagged effects. If there is an exchange rate peg, forex shortages are the first fallout.
Mal-investment and asset price bubbles are others.
A raft of bank regulations and the Securities and Exchange Commission was set up in the US after the Fed fired the roaring 20s bubble and triggered the Great Depression.
During the 1980s and 1990s as Fed Chiefs Volcker and then Alan Greenspan maintained monetary stability ignoring Fed’s employment objective and bank regulations were relaxed.
Enter Ben Bernanke.
In November 20, 2001 he made a speech, Deflation: Making Sure “It” Doesn’t Happen Here, to the National Economists Club in Washington, a setting the tone for rate cuts that followed and ended in the housing bubble.
“The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation,” Bernanke said.
“By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails.”
Bernanke persuaded Greenspan to loosen monetary policy fearing that deflation was about to happen.
Rate cuts followed. The deflation of the Great Depression was a result of a monetary shock and banks were collapsing with people withdrawing money. No such monetary shock existed in 2001.
The so-called Housing Bubble followed. In truth there were other bubbles as well. And then more monetary loosening followed in response to the banking crisis.
Many parts of Bernanke’s November 2001 speech became frighteningly true after 2000 as the effects of the rate cuts ended in a macro-prudential disaster.
Choice picks include:
*Of course, the U.S. government is not going to print money and distribute it willy-nilly
* Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it.
*To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.
And a strategy that Central Bank Governor W D Lakshman borrowed from Bernanke playbook in setting ‘explicit ceilings’ for Treasury securities in helping drive the country into default.
*A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years).
Ironically, Bernanke was given the Nobel Prize for Economics recently. In earlier ages he would have been beheaded or expelled from the country for his actions.
As a result of his actions and subsequent injections the threat of mal-investments and asset price bubbles are now greater.
In the classical period central bank banks targeted their anchor at zero not two percent and periods of inflation was followed by periods of deflation. That is why prices remained stable for centuries.
The inclusion of macro-prudential regulations in Sri Lanka’s new monetary law – a global trend – is an admission that money is bad.
Sri Lanka is going to target inflation at around 5 percent, not zero, not 2 percent. This is the rate that led to serial currency crises, heavy foreign borrowings as forex shortages and ultimate default.
But the flexible monetary juggernaut is rolling along, driven by the International Monetary Fund agreement which requires the bad money law to be enacted as the island celebrates its independence.
The unelected interventionists who devised the unsound money law with macro prudential will persuade politicians to enact this law as they did in 1950.
They then misled politicians to enact an exchange controls law as forex shortages emerged.
They then persuaded the politicians the enact an Import and Exchange Control Law as reserve fell to historic lows in 1969 due rates supressed with re-finance.
Sri Lanka will adopt this third rate monetary regime – not practiced by any stable country – but is operated in many of the country’s that defaulted – Ghana was targeting inflation at 8 percent, and Argentina 17 when it collapsed in 2018 for the n’th time.
All warnings against this unsound money law which requires macro-prudential regulations to cover its shortcomings will be ignored as warnings were ignored in 1950.
When the central bank was built on 1950 with a law promoted by Washington to Latin American nations that have since collapsed, there were warnings that it was a mistake – mostly from abroad – according to then Prime Minister D S Senanayake
“There are some I know who think that we should not have established the central bank,” he was quoted as saying.
“We made our decision to establish the central bank deliberately and with the full realization of its great possibilities for harm as well as its great possibilities for good.
“We need only to remind ourselves of how excessive use of central bank credit reduce the real value of the currency and resulted in the dissipation of foreign exchange reserve in countries like China and Greece after the war.”
Joining D S Senanayake in 1950, Kabir Hashim, former minister and economist has made some prophetic words.
“Before passing the new central bank law there should be a wider consultation in the country and the parliament,” Hashim told parliament in a debate for the budget 2023.
“European countries or stable East Asian countries and stable countries in the Middle East do not follow flexible exchange regimes,” Hashim said. “They can withstand shocks.”
“This time also we are not doing a complete structural change.
Hashim also pointed out that Sri Lanka’s economic policy makers had similarly ignored the advice of classical economists like B R Shenoy (who advocated a clean float).
Hashim along with former Central Bank Deputy Governor W A Wijewardene were the people who educated the current generation about the advice Singapore’s economic architect Goh Keng Swee who gave to JR Jayewardene in 1980 not to print money and not to depreciate the currency as there was no export advantage or prosperity in inflationist-devaluationism.
Sadly, both the pseudo external anchor set up in August 1950 and the pseudo domestic anchored regime are coming from the same source – US salt-water university style thinking that drove the IMF at its inception and is driving policy now in the wake of the Great Recession.
Ceylon joined the IMF the day after the central bank was set up in August 23, 1950.
The Central Bank of Ceylon was set up in the style of a model developed by Fed’s then Latin America division chief Robert Triffin in the style of Argentina’s BCRA.
Countries where the model was replicated collapsed repeatedly and also defaulted repeatedly if they had market access.
Sri Lanka got market access around 2005, but did not initially default due to the tight monetary policies of Governor A S Jayewardena and later Deputy Governor W A Wijewardena.
Many of the countries in Latin America which were unfortunate recipients of this US advice is paying the price to this day.
Some have dollarized and escaped the curse of the policy rate and open market operations.
But they are beset with the corruption and illiberal socialist or nationalist ideology that takes holds of the polity and urban intelligentsia in the aftermath of each economic crisis.
In Sri Lanka politicians have repeatedly paid the price for the privilege given to the Monetary Board to suppress interest rates. The people have paid a higher price.
But the economic bureaucrats who demand monetary policy independence to print money escape censure.
Unaccountable Economic Bureaucrats
The unaccountable economic bureaucrats have become adept at deflecting blame from themselves and transferring it to their victims.
They have blamed exporters, they have blamed importers, they have blamed expatriate workers.
And they have blamed deficits after printing money for rural credit and to manipulate bond yields when politicians raised taxes and market price fuel.
But politicians should take note.
In Latin America and in Sri Lanka unlaced bureaucrats who draw up laws to give themselves independence to print money to suppress rates to stimulate growth, employment, output gaps or other goals which cannot be achieved by liquidity injections and plunges countries into chaos are unaccountable.
The accountability provisions of the flexible inflation targeting law is laughable. Not only is there no jail sentence, there is no loss of jobs, demotions or pay cuts.
But politicians will lose their jobs. They will be subject to violence from an angry electorate.
Sri Lanka United National Party – which was responsible for the central bank – and was supportive of free markets – paid the biggest price.
Their plans and anyone else’s plans for free trade and economic prosperity will be lost as they were lost to Dudley Senanayake as Prime Minister, J R Jayewardene as President and Mangala Samaraweera as Finance Minister if this flexible law is enacted to continue.
Bad Money, Bad Results
Many of the actions that led to the current crises were illegal under the existing law.
In his wisdom, A S Jayewardene put the objective as economic and price stability.
Sound money stops not just price stability but also financial bubbles and mal-investment which are outcomes of inflating money.
Hyperinflation and external default at lower levels of inflation are also outcomes of inflating money.
Money is bad not only in Sri Lanka but also the West where thinking had been corrupted.
The rush for macro-prudential regulations in Sri Lanka and the West is an open admission and-knee jerk reaction that money is bad just like it was in the immediate post-depression years when a raft of bank regulations were enacted in the US.
Now Western central banks that injected money without any banking trouble to solve a real economy problem like Covid, are now forced to back-peddle, killing a recovery.
Both macro-prudential regulations and Bernanke winning the Nobel are signs of severe corruption of monetary theory around the world.
There can be no good economic outcome from bad money. Stability can only be brought by an inflation targeting law with genuine clean float.
Or stability can be brought by a hard peg with a genuine, floating short-term rates.
Any law, flexible inflation targeting or otherwise that cannot also lead to a repeal of the import control law and the exchange controls law – as Thatcher –Walters – Howe combination did ending 70 years of exchange controls in the UK in 1978- is not worth the paper it is written on.
The hopes and dreams of a newly independent nation that were dashed in August 23, 1950 fueling economic nationalism and illiberalism will be repeated in the future with in more nightmares and defaults after if this law is passed in its original form.
It is up to legislators to change the law, take away the key sections involving output gap targeting and contradictory policy and restrain the ability of the rate setting committee engage in discretionary and flexible policy and drive the country into forex shortages, currency crises and repeated default.
Politicians will be held accountable by the public for high inflation, currency crises and eventual default, coming from bad money, not officials or economists either in the government or those in the private sector who support inconsistent and contradictory policy. (Colombo/Mar01/2023)