ECONOMYNEXT – Sri Lanka’s Central Bank Act 2023 which has legalized fully discretionary macro-economic policy in a reserve collecting central bank is an unfortunate re-emergence of original ideas put forward by classical Mercantilists.
The idea of output gap targeting with easy money dates back to Scottish Mercantilist John Law and fully discretionary flexible policy to James Steuart.
The ideas have been revived down the ages through different labels driving countries into instability and people to misery.
Sri Lanka’s central bank was originally set up in 1950 in a fit of Mercantilism ideology that took hold of the US economists who created the post-Worl War II monetary order. However the basic ideology has been festering from the 1920s.
Sri Lanka started its descent towards Mercantilism, started less than 10 years after the central bank was set up, with exchange and trade following in its wake giving rise to Nazi-autarkist self-sufficiency with protectionist (domestic production) rent seeking.
The country descended into IMF programs from the mid-1960s, as US inflationism worsened under econometrics, triggering big shocks in unwary Bretton Woods members.
The recent revival of targeting potential output by rate cuts that eventually drove Sri Lanka to default, seems to be knee-jerk reaction following the interventionism that became ‘normalised’, just as Keynesianism was a reaction to the Great Depression.
The new law did not outlaw provisional advances as promised, but amusingly the can be printed for interest. But in any case the central bank will transfer profits as domestic currency and there is full discretion for open market operations to print any amount of money, so provisional advances may be irrelevant.
More dangerous is the underlying interventionist ideology behind the law, which tends to persist in countries without a foundation in sound money.
A central bank law is expected to be a ‘constitution’ which restraints the agency, not a tool for discretion or flexibility.
The John Law Clause
The Central Bank of Sri Lanka Act 2023 legalizes both exchange rate policy (intervening in forex markets) and monetary policy (printing money to mis-target rates), which was the fundamental flaw that failed the Bretton Woods system and is found in all unstable countries in Latin America, Africa and South Asia.
But the monetary law goes beyond the Bretton Woods by taking away the last vestiges of legal restraint on the central bank by allowing flexible exchange rates instead of restraint by an external anchor.
That a central bank by inflating money (cutting rates and inflating money supply through open market operations to maintain excess liquidity in the interbank bank market), can grow an economy is a classical Mercantilist belief articulated several centuries earlier.
In 1705 Scottish Mercantilist John Law wrote as follows in Money and Trade Considered With a Proposal for Supplying the Nation with Money.
“Domestick Trade [meaning economic activity] depends on the Money. A greater Quantity employes more People than a lesser Quantity. A limited Sum can only set a number of People to Work proportion’d to it.”
The 2023 Sri Lanka Monetary Law enshrines John Law’s concept by writing it into the law with fancy econometric terms with the idea of a ‘potential output’ replacing the John Law’s ‘Domestick Trade’ in Section 6 (4).
“In pursuing the primary object referred to in subsection (1), the Central Bank shall take into account, inter alia, the stabilization of output towards its potential level,” the law says.
In the US, this idea is expressed as the Fed having some ability to create full employment by a peripheral legislation, though high inflation, commodity bubbles and banking crises are often the result.
BOP troubles (gold losses of the Fed) and the collapse of the Bretton Woods and the US dollar was the result before 1971.
The Fed’s interventionims worsens because the effects of commodity bubbles are not initially captured due to the use of a ‘core inflation’.
The Battle Between Classical Economists and Mercantilists
Mercantilism has a frightening ability to resurface in cycles, with slightly different terminology, though the basic ideas have been the same across centuries.
John Law’s ideas were defeated in the UK and Scotland and he went to France to peddle his ideas and drove that country into a crisis with the use of Banque Royale, in the lines of the one Sri Lanka is undergoing now and Latin American countries do repeatedly.
However, the ideas re-appeared in the bullionist and anti-bullionists debates in the early 1800s (after Bank of England suspended gold convertibility or floated) with David Ricardo among those opposing the Mercantilists.
Ricardo and his followers were able to defeat the Mercantilists. However, the ideas keep re-appearing like a bad penny.
Mercantilism re-appeared in the UK in the 1840s with the debates of Currency School vs Banking School. Again, the Mercantilist Banking School was defeated resulting in long term free trade and monetary stability at least up to World War I.
The Fed was set up as a state bank in 1916. The US did not have a long history in central banking (The Second Bank of United States was closed in 1836 after only 20 years of operations) and the Fed accidentally invented the fixed policy rate, triggering the Great Depression in its wake.
The Bank of England which resumed gold convertibility in 1925 with the Sterling under upward pressure, and was able to sterilize gold (like the central bank builds reserves) but fell victim to the fixed policy rate, with which it was also infected soon.
Mercantilism Revived by Keynes
In the 1930s Mercantilism came roaring back with Keynes writing his Treatise on Money (1930) and General Theory (1936), regurgitating the ideas of John Law and others leading to inflationist macro-economics.
The Fed’s Latin America unit – driven by arch Keynesian Robert Triffin – was also instrumental in setting up a series of interventionist central banks in the region, which later became top customers of the IMF and serial defaulters that ended up in hyperinflation. Only dollarization stopped the monetary massacre of several of these countries but they remain steeped in socialist ideology to this day.
With universities teaching Keynesianism and interventionism, later backed up econometrics which gave these once discredited ideas a ‘scientific’ aura, the problem never went away unlike in the 19 century.
The Great Moderation ended in 2001 with Ben Bernanke persuading Alan Greenspan to cut rates and run an 8-year cycle triggering the Great Recession, leading to another revival of inflationism, which was festering in any case except for few German speaking countries in Europe and some East Asian countries.
In addition to the problem of universities teaching inflationism, Mercantilism from the World War II onwards was also perpetuated due to nationalized central banks, like Bank Royale.
As state agencies, they were not accountable and subject to the same criticism as private central banks were before World War II and managed to dupe the people and legislators with false doctrine more effectively than private banks ever did.
After World War II the Bretton Woods was set up along with the IMF backed by the mistaken idea that money can be printed with a fixed policy rate to engage in discretionary macro-economic policy while also maintaining a stable exchange rate, defying laws of nature.
In the last century universities led by Cambridge and Harvard had fully jumped into the fray except for a minority like LSE and University of Chicago where Friedrich Hayek had taught.
“..[E]ven some of the colleagues I most respected supported the wholly Keynesian Bretton Woods agreement, I largely withdrew from the debate, since to proclaim my dissent from the near-unanimous views of the orthodox phalanx would merely have deprived me of a hearing on other matters about which I was more concerned at the time,” Hayek wrote later.
“I believe, however, that, so far as some of the best British economists were concerned, their support of Bretton Woods was determined more by a misguided patriotism – the hope that it would benefit Britain in her post-war difficulties – than by a belief that it would provide a satisfactory international monetary order.”
A large number of central banks were set up in newly independent countries, based on Bretton Woods/IMF lines, bringing misery to millions, as forex shortages came with development economics and re-financing credit programs by central banks.
Targeting potential output is however much more indiscriminate.
Singapore, Dubai, Oman got independence about a decade later and escaped the carnage of development banking and open market operations kept stable exchange rates.
Stable exchange rates necessarily require prudent monetary policy with little room for flexibility.
Exports and Keynesianism
Sri Lanka’s central bank was set up by John Exter, who was increasingly skeptical of Keynesianism even then, and who put a number of caveats into the law even in 1949.
Though the central bank he set up had dual anchor conflicts (both monetary and exchange rate policy) like in the 2023 law, he insisted that exchange rate policy must be the final restraint on monetary policy as Ceylon was as a free trading nation which wanted to export.
Keynesianism worked in self-sufficient economies, not in external trade oriented open economies like Ceylon where half the productive resources (at the time Ceylon had an East Asia style currency board) were geared to exports, he said.
“…[H]igher domestic incomes would stimulate the consumption of imported goods and precipitate serious balance of payments difficulties,” he wrote in background notes on the draft monetary law in 1949.
“This should serve as a warning to those who might hope that some of the policies growing out of Keynesian economics can be uncritically adapted to Ceylon,” he added.
In targeting potential output Sri Lanka is now “uncritically” adopting the policy of Keynesian inflationism along with a high inflation target to make it possible.
The IMF is at fault for teaching the central bank how to calculate this so-called potential output, leading to repeated currency crises and default under a 5 percent inflation target in recent years.
Potential output is also a milder version of Modern Monetary Theory which was peddled in the wake of the Great Recession and quantitative easing, along Mercantilist lines.
Despite giving the ability to the central bank to engage in monetary policy by abolishing the non-discretionary rule based currency board, Exter warned that if there are monetary policy errors, the exchange rate should be the final brake (Section 64) if the country wanted to be an exporter.
“This clause recognizes the importance to Ceylon of a stable currency and of making the Ceylon rupee feely convertible for current and international transactions,” Exter wrote.
“In a country where almost half the national income is produced for export the significance of these objectives is self-evident”
Exter had said this long before East Asian nations became export powerhouses riding on the discipline imposed by fixed exchange rates.
Singapore’s Goh Keng Swee famously rejected central bank GDP targeting with this phrase speaking in favour of floating interest rates: The way to a better life was through hard work, first in schools, then in universities or polytechnics and then on the job in the work place. Diligence, education and skills will create wealth, not Central Bank credit.
This is in sharp contrast to the idea of permanently depreciating currencies in IMF countries in Latin America, Africa and South Asia.
How, a despite being a Harvard economist, Exter ended up doubting Keynesian or bureaucratic targeting of GDP was explained later in a 1991 interview.
Keynes published his famous book, The General Theory of Employment, Interest, and Money, in 1936. I went to Harvard graduate school in the fall of 1939, 3 years later, Exter explained.
By that time the principal professors of economics at Harvard had just grabbed Keynesianism and run away with it. It was like a new religion.
The leading Keynesian at Harvard was Alvin Hansen. His sidekick was John Williams. Williams was much more circumspect, much more doubtful about Keynesianism.
I should not say that I rejected Keynesianism right away. I had it pumped into me in those early years and actually taught it in the entry level economics course at Harvard. As the years wore on I became more and more sceptical.”
Flexibility and Discretion
Sri Lanka’s 2023 monetary law touts the idea of a “flexible” exchange rate as well as “flexible” inflation targeting.
In practice this flexibility allows unchecked money printing and for monetary policy to triumph over exchange rate policy.
Under the IMF’s flexible exchange rate, instead of ending easy money to stabilize the external sector, the currency is busted, usually repeatedly, driving social unrest and poverty,
The overwhelming desire to maintain easy money over temporary tightening of credit is explained by the exchange rate as the first line of defence ideology despite having a reserve collecting central bank.
This is a policy that seemed to have emerged from the 1980s, as the original idea of the IMF and Bretton Woods of stable exchange rates were hurriedly jettisoned in the chaos of the Bretton Woods collapse, US tightening in 1980.
It seems to have been subsequently backed up by mistaken ideas about the East Asian crisis where currencies other than Hong Kong, which did not have a fixed policy rate, collapsed.
Depreciation is encouraged due to another econometric idea that currencies are either “overvalued” or “undervalued” through a real effective exchange rate index.
But Sri Lanka’s currency collapsed repeatedly in recent crises, with the REER below 100, due to inflationary open market operations.
The overall idea of a flexible inflation targeting regime with a high inflation of 5 percent or more is also to give discretion: discretion for bureaucrats to print money and cut rates, discretion to depreciate the currency, and discretion to target output.
There is a wide time gap between price inflation showing up in indices and the start of inflationary policy.
A 5 percent inflation target is not a rule. It is to give oneself enough room to print money (inflate reserve money) until the currency collapses. Reserve losses or depreciation tends to take place long before price inflation shows up in indices.
The Benevolent Discretionary Bureaucrat
The entire idea of giving discretionary independence to the central bank bureaucrats through a high inflation target to engage in both money and exchange policies and target potential GDP with printed money also, dates back to another fundamental classical Mercantilist idea.
It hangs on the idea of discretionary and benevolent and all-knowing bureaucrats who have perfect knowledge to intervene for the good of one’s own country unchecked by rules.
James Stueart, a leading classical Mercantilist explained the ideology as follows.
“The more perfect and the more extended stateman’s knowledge is of the circumstances and situation of every individual in the state which he governs, the more he has it in his power to do them good or harm,” Steuart wrote in an inquiry into the principles of political economy.
“I always suppose his inclinations to be virtuous and benevolent.”
Steuart is also a pioneer proponent of the idea that inflation is not monetary but cost-push. False doctrines like wage spiral inflation, and speculation (hoarding), that re-emerged in the 1960 and 1979s were articulated more than 200 years ago by Steuart.
Money and inflation works in opposite directions where the money supply adjusts to higher prices, including through velocity (a reverse causality), he also argued.
Central banks that trigger high inflation and depreciation like in Sri Lanka and Fed, in the run up to and after the Bretton Woods collapse, also believed that inflation is at least partly, cost-push.
However not even classical Mercantilists had put forward such a mixed-up theory.
The recent inflation and commodity bubble were fired by the Fed and ECB who claimed that ‘supply chain bottlenecks’ and not monetary policy was the cause. These ideas have an amazing knack of persisting.
It is an idea that emerged in the run up and during the Great Inflation period put forward by dysfunctional central banks and their allies in academia.
When central banks believe that inflation is not monetary, either fully or partially, the country ends up like Sri Lanka or the US and UK in the 1960s and 1970s.
In the ashes of the new monetary law, there lies a way out. That is to target the exchange rate, which is permitted, so that mistakes in targeting interest rates in an open economy are checked automatically.
Targeting the exchange rate at 323.50 rupees or any other rate is no big deal as long money is not printed to mis-target rates down.
It is one of the simplest monetary regimes to implement and was used by East Asia to provide stability, promote domestic capital formation, encourage foreign investment with long term stability, grow fast and avoid a second default.
But to do that, open market operations have to be deflationary and short-term interest rates have to move within a wide policy corridor. (Colombo/Oct16/2023)