ECONOMYNEXT – Targeting an output gap with printed money is not in line with the original intentions of Sri Lanka’s Monetary Law Act and ‘flexible’ inflation targeting is a corrupted version of the original, a top economist and former central banker has said.

Contradictory money and exchange policies (trying to maintain an exchange rate after printing large volumes of money to keep rates down and boost growth or target an output gap) has led to the collapse of the rupee from 131 to 202 so far in three currency crises since 2015.

However Sri Lanka’s Monetary Law Act, the constitution of the central bank does not have a growth mandate, to target the output or growth.

Violating MLA intentions

“Output gap targeting does not comply with the original intention of the economic and price stability objective that has been incorporated in the Act,” former Deputy Governor of the Central Bank W A Wijewardena told EconomyNext.

The MLA says “the Central Bank is hereby charged with the duty of securing, so far as possible by action authorised by this Act, the following objectives, namely –

(a) economic and price stability; and
(b) financial system stability,

with a view to encouraging and promoting the development of the productive resources of Sri Lanka.”

Wijewardena says the Central Bank is trying to push the aggregate demand curve to the right by injecting liquidity.

However the MLA does not give any authority for the central bank to print money to try shift demand higher and de-stabilize the balance of payments and the overall economy.

Wijewardena has explained why the then-Central Bank Govenor Jayewardene put the ‘economic and price’ stability as an objective because only focusing on an inflation index may lead the central bank astray.

Wijewardena in his previous writings recalls Jayewardene telling him: “…if you have only price stability, then you would fall into the trap of attempting to stabilize a price index which is not what is meant by price stability, in the context of a central bank. The attainment of price stability for a central bank means elimination of both excess demand and excess supply in the market so that the market is free of potential inflationary or deflationary pressures”

Analysts say when classical economists originally coined the word ‘inflation’ it did not refer to just an index compiled by a state agency.

Inflation referred to the expansion of reserve money (inflation of fiat injections) beyond the specie stock (gold reserves) of a central bank which led to assets price inflation, balance of payments trouble (export of gold like modern forex shortages) and mal-investments by an over-expansion of credit.

The problem was graphically shown when the US Fed, targeting a core-inflation index which excluded commodities, triggered a massive housing and commodity bubble, which collapsed in what is now called the Great Financial Crisis.

In 1971 the Fed had already ended a gold standard by trying to target an ‘output gap’.

Eliminating Conflicts

The danger of focusing only on an inflation index also was that it could be manipulated.

Then Governor A S Jayewardene had transferred responsibility of calculating both the output and inflation to the Census Department to avoid any conflict of interest, Wijewardena said.

Jayewardene revised the Monetary Law Act as part of a drive to shift to inflation targeting which however requires a fully floating exchange rate.

An earlier requirement to maintain the external value of the rupee was dropped.

When a US Federal Reserve official built the central bank in 1950, to join the Bretton Woods system of failed soft-pegs, the rupee was defined as 2.88 grains of gold, .

The peg would have put the brakes on credit expansion and maintained the exchange rate, if rates were allowed to rise in time and credit curtailed.

Under the Bretton Woods both Germany under Austrian economic influence (4.2 to the US dollar) and Japan (360 yen to the dollar) showed that it could be done .

However in Sri Lanka the central bank placed import and exchange controls to maintain the exchange rate, while financing the deficit, instead of allowing the credit system to adjust to the balance of payments.

Before the setting up of the soft-peg in 1950 which brought forex shortages and currency crises, Ceylon had a hard peg (currency board) from 1885, where the exchange rate was fixed by allowing short term rates to float in line with the balance of payments.

Given the experience of trade and exchange controls up to 1977 and the currency collapses and high inflation after that, the Monetary Law Act was revised to clearly maintain stability so that economic agents could carry out real growth generating activities.

Jayawardene also stopped central bank re-finance of rural credit which had directly contributed to the currency collapses, high inflation and the inevitable high interest rates, that are required to stabilize the economy the 1980s.

Corrupted Inflation Targeting

Sri Lanka has triggered three currency crises in 2015/2016, 2018 and is now in the middle of the third as rule based monetary policy was jettisoned in favour of highly discretionary ‘flexible’ inflation targeting and ‘flexible exchange rate’.

Under ‘flexible’ inflation targeting, the real effective exchange rate, the yield curve and also lending and deposit rates were controlled to target an output gap targeting (growth).

The International Monetary Fund has been advocating ‘flexible inflation targeting’ to many countries which is a more discretionary form of monetary policy than that is followed by successful inflation targeting like Sweden, New Zealand and Australia.

“Inflation targeting has now been corrupted by a new concept called flexible inflation targeting,” Wijewardena said.

The IMF as part of technical assistance taught the central bank to calculate and output gap and may have been complicit in the economic instability that followed from the ‘flexible’ policy.

Whether the IMF broke the MLA by teaching the central bank to target an output gap which led to the money printing bout in 2018 and the subsequent currency crises and growth collapses has not been tested in court.

Supreme court justices in many countries including the US has not upheld monetary laws, due to the general lack of understanding monetary policy, though counterfeiting is generally understood by most.

However public awareness of central bank policy errors are growing in Sri Lanka.

Earlier in 2021, Chandra Jayaratne, a public interest activist made a public appeal for the central bank to engage in a public debate about its monetary policy as the balance of payments continued to deteriorate.

“I request that the Central Bank (CBSL) arranges a public participative intellectual debate, on a virtual platform, between the CBSL Team and invited economists, bankers and business managers with practical experience in business, consultancy and banking/finance, with the subject of the debate to be on the present external sector monetary management policies and practices,” Jayaratne wrote in February 2021.

“I make this appeal as I fear that the public image of the CBSL and the independence, professionalism and intellectual integrity of yourself and the CBSL Team, may come in to question, if not now, in the near future or even in the long term.”

The central bank declined to take up the offer.

In 2019 after the 2018 output targeting exercise triggered a currency crisis, despite taxes being raised and oil being market priced and import controls being placed, the central bank sent out a long statement about its monetary policy actions.

However in 2020 Sri Lanka is in another crisis.

Related: Sri Lanka’s central bank defends discretionary monetary policy

Not the People’s Fault

Sri Lanka is now mired in some of the worst import controls since 1970s when the central bank was injecting money by purchasing Treasury bills in a large scale.

In 2020, unprecedented volumes of Treasury bills had been purchased by the central bank under so-called Modern Monetary Theory.

The central bank’s Treasury bill stock has topped 900 billion rupees, central bank credit to government has exceeded reserve money – it is not clear whether there is any historical precedent for it in Sri Lanka, and forward exchange rate premiums are negative despite a run on foreign reserves due to low rates.

There is greater public understanding of the policy errors of the central bank, and the import controls that come in their wake.

Import controls imply that the public is doing something wrong to depreciate the exchange rate and not the central bank which is failing to manage reserve money.

Despite the worst import controls since 1970s, the rupee is continuing to fall. The rupee also continued to fall despite last administration ending gold imports and vehicle imports, blaming the people for a failure of the state.

Ross McLeod an Australian economist says, who studies East Asia currencies say the people cannot be faulted for currency depreciation, which is always the case of the central bank mis-managing, reserve money, a monetary variable that only it can created and control.

When central banks try to control both the exchange rate and interest rates (by expanding reserve money) the currency falls.

“Well, it’s not the people at all. It’s the policies of the central bank in all cases,” McLeod said in an interview with Advocata Institute in Colombo.

“There’s a demand for money from the people but the supply is determined by the central bank,”

“If then supply is made too large relative to the demand for it, or if the growth rate of supply is too rapid relative to the growth of demand for it, then just like everything else, the value falls.

“The value of money is its purchasing power. That’s kind of the inverse of the inflation rate. If you have the value of the currency falling, it is equivalent of saying prices are rising.

“So it’s never the fault of the people. It’s always attributable to the policies of the central bank.”

Countries that severely mis-manage reserve money could end up in dollarization. (Colombo/Apr12/2021)