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Sunday June 23rd, 2024

Sri Lanka, world’s poor suffers from Fed’s accidental discovery: Bellwether

LOGICAL REASON: The lessons of Marriner Eccles, like Sri Lanka’s A S Jayewardena have been discarded today and Sri Lanka suffers.

ECONOMYNEXT – In Washington DC along Constitution Avenue and 20th Street sits the Marriner S Eccles building, named after one of the greatest central bankers of all time, who went against the prevailing economic religion that would have destroyed the US like Sri Lanka in 1951.

Marriner Eccles was instrumental in freeing the Fed from the US Treasury and the President, and later led to ideas about central bank independence.

It is not just deficit financing that leads to collapse of exchange rate pegs, but also open market operations which was invented by the Fed, and also ‘stimulus’ promoted by interventionist economists.

It through open market operations that money is printed to mis-target interest rates in Sri Lanka or in any other country with currency troubles and high inflation.

The Fed is also to blame for creating the Great Depression with open market operations with no deficit financing whatsoever and then giving a chance for Keynesian stimulus to take over the world like a ‘new religion’.

The Bretton Woods system of soft pegs collapsed in 1971 as the Fed printed initially to target an output gap, but later to sterilize interventions through open market operations as central banks in Europe and Japan demanded gold in exchange for the money it was printing.

Like the US dollar in Sri Lanka today, the price of gold – the then reserve asset – was soaring at the time, and the Fed was running out of gold to give, like Sri Lanka’s forex reserves.

The Fed then suddenly floated, reneging on the Bretton Woods commitments and floating rates were born shattering a 300 year old gold standard.

Fed was on track to suspend convertibility in 1951 not 1971

The Bretton Woods could have collapsed in 1951, almost before it was fully operational had it not been for Marriner Eccles.

At the time the Fed was monetizing World War I debt, by purchasing them from the secondary market under pressure from the US Treasury, to keep a yield ceiling and maintain their prices.

The US was not running deficits at the time but also surpluses from time to time.

Government securities acquired through open market operations to sterilize interventions do not finance the current year deficit but injects reserves into the commercial banks using bonds issues to finance deficits in past years, though it is later classified as debt monetization, misleading people into thinking the deficit was involved.

Central bank purchases of bonds from rejected auctions or open market operations lead to re-finance private sector activity (reserves for imports) not the government, but due to the use of government securities it appears as if the deficit was monetized to later observers.

This activity is done due the obsession of the central bankers themselves to control the interest rate.

The problem cannot be solved by giving the Central Bank independence but by changing its governing law to restrain domestic operations and rate-obsessed and central bankers with stimulus ideology from engaging in the practice after private credit picks up. (Sri Lanka facing 2021 with reckless MMT, stimulus mania: Bellwether)

Related

Sri Lanka’s central bank needs accountability and restraint, not independence to print money: Bellwether

This is what stable pegs, orthodox currency boards (Hong Kong, Brunei) and currency board like systems (UAE, Oman, Saudi, and Kuwait) have done and Germany and Japan did during the Bretton Woods to keep the peg and in the case of the Federal Republic also appreciate the currency.

The two countries eliminated labour unrest with low inflation and strong currencies and became export power houses.

A banker runs a state central bank

Unlike the academically qualified ‘economists’ who ultimately broke the gold standard with output gap targeting and created monetary mayhem in the US and elsewhere, Eccles was not a professional economist corrupted by a Mercantilist university and still had his powers of reasoning intact.

He was a banker with a high school education.

He was more in the style bankers who ran privately owned central banks like the Bank of England which kept inflation down for two centuries or more – sometimes under severe public pressure – before they were nationalized and stuffed with academic Mercantilists steeped in interventionist dogma.

When the Fed created the Great Depression by printing money in the 1920s, Eccles saved his banks in 1931.

Following a Congressional testimony on the crisis, President F D Roosevelt appointed him Chairman of the Fed. Or Governor as the position was then known. He restructured the Fed and eliminated the ex-officio membership of the Treasury Secretary as India did after the 1991 currency collapse and there are calls to do it in Sri Lanka as soon as possible.

He also represented the Fed at the Bretton Woods conference.

Eccles also advocated policies which could be called Keynesian, but with the full knowledge of their limitations as a banker. In a depression (negative private credit) they can be used, but in in an economic recovery, such policies lead to disaster.

In 1948 he stepped down as Chairman and was replaced by Thomas McCabe. But he continued to serve on the Board.

During World War II the Fed kept interest rates on government securities. In 1951 US inflation hit 7.9 percent up from 1.1 percent a year earlier and private credit was soaring.

Fed Independence

At the Fed was creating global inflation much like it is today through the Powell Bubble.

It was printing money through price controls on Liberty Bond yields; much like Sri Lanka did with yield controls on Treasuries auctions in 2020 and 2021 and the outright purchases of Treasury bonds from the market until 2019.

There are many parallels to today’s Sri Lanka. Price controls were slapped on items like cars, selective credit controls had been put in place, but with liquidity injections continuing nothing was working. More price and wage controls were planned.

Fed minutes at a now historic meeting on February 08, 1951 show that it was Eccles who gave the intellectual backing to allow interest rates to rise as the economy recovered and defied the Treasury and President Truman to raise rates and protect the poor from inflation and the collapse of the dollar.

He made it clear that what the Fed did in the past in 1941 during the war for example could not be done in 1951. The budget was not the source of the trouble. New taxes were also planned.

It is important to know when the stop the press. He was a banker and knew the problem of banks and bank reserves.

The way he acted shows a deep understanding of banks and not just based on ideology as followed by Keynesians today.

He pointed out that the inflation was not due to the Korean crisis and the situation was opposite of what happened during World War II.

Eccles said the Fed was already too late. And the inflation was rising and action was overdue.

“We cannot wait to act,” he said. “I say action is long overdue.”

The Fed sent a letter to the President, saying among other things that what he had told the press was not correct and the Open Market Committee was not in favour of purchasing government bonds and it undermined confidence in the securities.

That this is true was seen in Sri Lanka when yield controls drove investors of bond markets.

Sri Lanka’s bond markets are now working, though there are concerns about future rates with rising inflation. It is difficult to sell 12 month bills. Most are buying three month bills expecting inflation and interest rates to go up. (This column was published in the March 2022 issue of Echelon Magazine before rates were hiked in April)

People also bought stocks expecting as an inflation hedge expecting the currency to fall.

Similar expectations were also seen in the US in 1951.

That a central bank needs independence from the Treasury is true only if political or Treasury authorities want to print money and the central bank does not, like in the case of Fed with Eccles.

Around this time Sri Lanka’s newly set up Central Bank, by John Exter, a Fed official, was also losing reserves as it tried to resist rate increases. Sri Lanka also got into further trouble after rates were hiked by the Fed.

It is a myth that countries with pegs (flexible exchange rates) have monetary policy independence. Any attempt to exercise that ‘independence’ leads to a currency crisis.

The Fed eventually won the battle and the Fed Treasury Accord was signed, partly because of the intervention of Deputy Treasury Secretary William McChesney Martin.

By this time the Fed was already under a ‘dual mandate’ due to the Employment Act of 1946, which compromised its independence and was mostly recently used by Jerome Powell to create the current inflation crisis in the world.

The open market committee in 1951 however had not paid any attention to that. Alan Greenspan also ignored the law in keeping inflation down. So did Paul Volcker.

Eccles landmark comments show that, rather than knuckling down to such ideas, he was ready to seek a stronger mandate from Congress to maintain monetary stability.

Had he done that, the gold standard may not have broken in 1971. Latin America would not be in the trouble it is today and the widespread misery seen from currency collapses would not have happened and the legitimacy given to ‘pump priming’ may no longer exist.

Both Eccles and Chairman McCabe resigned shortly after.

McChesney Martin took over. If President Truman expected him to print money he did not.

Unusually his first degree was in English and Latin from Yale. Whether it saved his reasoning power and was able to escape the interventionist ideology is not known. He later went to work in a stock broking firm, and New York Stock Exchange, gaining stature in the immediate depression years.

Martin had later studied economics at Columbia but had not earned a degree. He turned out to be the longest serving Fed Chief who also kept the Bretton Woods peg system going despite some hiccups.

He was sacked by President Nixon in monetary conditions similar to 1951 when he was poised to hike rates and replaced by Arthur Burns. The dollar collapsed in 1971 ending a 300 year monetary system after output gap targeting and open market operations.

In fact the Gold Standard which allowed free trade and kept domestic stability may have also helped reduce wars in the 19th century under the so-called Pax Britannica, which ended with German nationalism triggering the First World War in 1914.

The Fed had got involved in interest rate fixing in the years before it created the Great Depression.

Sri Lanka’s problems and many other crises in Latin America come from open market operations.

Open market operations were invented the by the Federal Reserve and led to the creation of the Great Depression without any real deficit spending.

How it all started

The Bank of England influenced interest rates directly by purchasing private bills – banker’s acceptances.

It was not intended to influence economic growth as Keynesians now want to do and create economic mayhem but a very temporary – almost intra-day one may say – liquidity tool which moved according to market trends.

The Fed also copied the practice.

Accidental Discovery

Then came Benjamin Strong, Governor of the New York Fed, who made extensive use of liquidity injections via government debt.

The move to extensive use of government securities as open market operations had come around 1923, about 8 years after the creation of the Fed system.

“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. When Government securities were bought in Dallas, the money
so disbursed did not stay in Dallas, but flowed through the whole banking system and reappeared in New York or Chicago or Kansas City, and vice versa. These funds coming into the hands of the banks enabled them to pay off their borrowings and feel able to lend more freely.”

“Two obvious conclusions followed from these results: first, the effect of open market operations had to be carefully studied as it was not what it appeared on the surface and, second, operations had to be treated as System policy, rather than as separate policies for each Reserve Bank.

The US in the 1920s was able to print money without creating forex or gold reserve for itself as the Bank of England was also keeping rates down while trying to resume the gold convertibility and was losing gold.

Alan Greenspan later claimed that the Strong had printed money to help out the Bank of England ultimately triggering the Great Depression. (Read Gold and Economic FreedomCapitalism the Unknown Ideal)

Whatever the cause, it seems to have led to a belief in the US that liquidity could be injected into the system without blowing the balance of payments apart.

“There were no substantial historical precedents for this new venture in central banking,” Burgess explained.

“The Bank of England had seldom used the term “open market operations” as applying to Government securities, and when they did so they meant purchases or sales in small amounts for short periods for the purpose of market stabilization.

“Their funds reached the market mostly through the bill market; and the principal policy instrument was the discount rate at which bills were bought, and that was used mostly in response to changes in their gold reserves.”

Reserve Restraint

Gold standard central banks had to hit the brakes as soon as they started to lose reserves and raise the discount rate. That is how the peg was kept.

That knowledge was lacking in the US. It may have led to the later conclusion that ‘independent monetary policy’ was possible while keeping a peg which led to the creation of the failed Bretton Woods.

Certainly the lack of external trouble in the early years may have led to conclusions by John H Williams and others that similar to the Sterling Area, it would be possible to have the gold backed US dollars as key currency while engaging in sterilization.

From the 1960s however as the US became increasing integrated with the world like UK in the past, it turned out differently and led to severe gold losses and the float of the US dollar.

The countries that have low inflation, stability, free trade, internal peace and prosperity are those that realize that the ideology of stimulus and the obsession with low rate are eventually going to result in very high inflation and interest rates.

Mere central bank independence does not solve problems, if the central bank mis-uses that independence to maintain artificially fixed low interest rates thorough open market operations and to sterilize interventions as is done in Sri Lanka.

This column is based on ‘The Price Signal by Bellwether‘ published in the March 2022 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link.

To reach the columnist: BellwetherECN@gmail.com

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  1. sacre blieu says:

    All that and the organised thieving of the economy over the years, by those in power and position, brings us very desperately, ARE WE SCREWED?

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  1. sacre blieu says:

    All that and the organised thieving of the economy over the years, by those in power and position, brings us very desperately, ARE WE SCREWED?

India supports Sri Lanka Coast Guard to boost maritime security

ECONOMYNEXT – India has given 1.2 million US dollars’ worth spare parts to Sri Lanka’s Coast Guard to be used in a vessel also gifted to the Indian Ocean Island on an earlier occasion, the Indian High Commission in Colombo said.

“Handing over of the large consignment of spares symbolizes India’s commitment to support capability building towards addressing the shared challenges of Maritime Security in the region,” the Indian High Commission said

The spare parts were brought to Sri Lanka on the Indian Coast Guard Ship Sachet, an offshore patrol vessel that was on a two-day visit to the island.

The spares were formally handed over to the Sri Lanka Coast Guard Ship Suraksha which was gifted to Sri Lanka in October 2017 by India.

India has gifted spare parts for the ship in June 2021 and April 2022 and also provided assistance in refilling of Halon cylinders in January 2024. (Colombo/June23/2024)

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Sri Lanka Water Board makes profits, tax-payers inject Rs28bn

ECONOMYNEXT – Sri Lanka’s state-run National Water Supply and Drainage Board has made a profit of 5.2 billion rupees in the year to December 2023, after a tariff increase despite not getting money for 25 percent of its water it pumps out.

Total revenues went up to 61.8 billion rupees in 2023 from 35.4 billion rupees, a Finance Ministry report said.

Water revenue surged to 58.5 billion rupees from 33.1 billion rupees, cost of sales also went up to 32.8 billion rupees from 23.14 billion rupees, helping boost gross profits from 12.3 billion rupees to 29.0 billion rupees.

Finance costs surged to 14.9 billion rupees from 3.9 billion rupees,

NSWD reported net profits of 5.2 billion rupees for the year, against a loss of 2.7 billion rupees a year earlier.

The Treasury had given 28 billion rupees from tax payer money to settle loans.

During the Rajapaksa administration, macroeconomists who ran the Finance Ministry made state enterprises borrow money from banks through Treasury guarantees listing them as ‘contingent liabilities’, claiming they were ‘off balance sheet’.

The Road Development Authority, which had no revenues to speak of borrowed large amounts of money from banks which were listed as ‘contingent liabilities’ though they were a responsibility of the state from day one, allowing macroeconomists to understate both the budget deficit and national debt, critics say.

The water tariffs were raised by 81 percent after macroeconomists printed money to supress interest rates for flexible inflation targeting/potential output targeting. The currency collapsed after macroeconomists tried to float the rupee with a surrender rule in place.

Non-revenue water for which no money is collected was 25.2 percent. The agency was supposed to reduce non-revenue water. In some districts religious establishments are responsible for non-revenue water, according to an official who said it on condition of anonymity.

The water board is also unable to collect money from some services like common toilets for underserved communities. (Colombo/June23/2024 – Update II)

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Sri Lanka will expedite Indian projects: President

ECONOMYNEXT – Sri Lanka will expedite Indian-backed projects in the island, President Ranil Wickremesinghe told Indian business people after a visit by Indian External Affairs Minister S Jaishankar this week.

“I discussed with Prime Minister Modi the need to accelerate the joint program that we have decided, agreed on. So the major ones are identified, and Foreign Minister Jaishankar came down today [20] to have a discussion. Now this will show the new path we are taking,” president Ranil Wickremesinghe said.

“It won’t be individual projects. We’ve discussed a fair number of them. First is the grid interconnection between Sri Lanka and India, so that sustainable energy can be transmitted to India.

“We have the Sampur solar power project, which is a Government to Government (G2G) project, and a three island project, which is where we hope the ground breaking can take place in July,” he told Indian business people at the 31st All India Partner’s Meet 2024 (AIPM 2024), held at ICT Ratnadipa in Colombo.

The AIPM 2024 which was organised by KPGM Sri Lanka and India provided a platform for both countries to reaffirm their commitment to collaborative projects that promise to redefine bilateral relations and propel socio-economic growth.

“It’s a great pleasure and a privilege to have you in Sri Lanka, in Colombo, holding this meeting. It shows on one hand the close friendship that our two countries have, and on the other hand, the confidence that you have in Sri Lanka.

“Having now survived two difficult years, I must acknowledge that this was possible because India gave us a loan of $3.5 billion. All that will be repaid.”

Cooperation between the two nations needed to be enhanced, particularly in the energy sector, aiming to foster new development for the Northern region, Wickremesinghe said.

“We are looking at developing Palk Straight for wind energy and solar energy, both countries to get together and have a large farm for solar energy, for renewable energy. It also means that we will have a new economy for the northern province, which was worst affected by the war.”

Several Indian-backed projects in Sri Lanka have stalled due to protests from some parties, with some going to courts.

India is helping expand the Kankesanturai port, and is discussing development of the Palali and Colombo airports.

The National Livestock Development Board of Sri Lanka, in collaboration with India’s Amul Dairy Company, is involved in a project to enhance liquid milk production in the country.

The two nations are also considering establishing land connectivity.

Discussions have also taken place regarding expediting the Trincomalee Development Project, which encompasses industrial investment zones and tourist areas.

“Plans are underway to construct a multi-product oil pipeline from Nagapatnam to Trincomalee, pending the final observation report. Trincomalee is poised to become a hub for oil refining, with the development of ports and investment zones, transforming Trincomalee Port into a significant hub on the Bay of Bengal.

“Today, the entire East Coast is being opened up for tourism, with additional land earmarked for hotels in Galle and southern areas. Moreover, there are plans to establish more investment zones across the country, alongside expanding our professional training programs. In these endeavours, we are collaborating closely with India.” (Colombo/Jun22/2024)

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