Stabilization programs, despite halting greater inflation and more hardships from hyperinflation, provide fertile ground for fringe elements to come to power even as economies start to recover.

No liberal government, with free trading aspirations, can now survive in a country where forex shortages are created by spurious economic doctrines founded on statistics, backed by the International Monetary Fund more often than not.

Sri Lanka’s post-independence currency troubles emerged soon after the central bank was set up in 1950.

At the time Fed was firing a commodity bubble, by purchasing Liberty bonds (in what would now be called yield curve targeting) pushing up Sri Lanka’s export prices until 1951.

At the time the Sri Lanka’s currency board had just been abolished and 3-month T-bills were 0.4 percent according to central bank data.

The Fed tightened in 1951, some export commodity prices fell, but rice prices rose requiring more subsidies from the budget.

Stabilization Programs and Illiberalism

Sri Lanka ran BOP deficits in 1952 and 1953 as the central bank printed money. Reserves fell from 216 million US dollars to 114.3 million by year end 1953.

Then 3-month bills were pushed up to 2.48 percent. Attempts were made to cut food rations. Food rations had started during the Second World War as the Bank of England lifted convertibility (floated in today’s terminology) and ran un-anchored policy printing money.

Sterling monetary instability also worsened after World War II, with Keynes driving British economic policy and Sri Lanka also had some exchange controls dating back from British policy, though a currency board regime does not really need them.

There was a leftist hartal in 1953.

In 1954, Sri Lanka’s politicians acted decisively and pushed the budget into surplus in what would be the country’s first stabilization program without IMF help with fx reserves down to 114.3 million dollars.

Growth fell, inflation also fell, but in the slowdown the nationalists started to peddle their wares.

The Sinhala Only Act was an election issue. The Sinhala only by nationalists upset the Tamil community.

When nationalists come, or leftists come, policies reverse, as liberal economic policies of free trade and private enterprise as well as small government and fiscal prudence are discredited.

German Nazism after Reichsbank/Fed Excesses

Rewind to 1931.

Much the same happened in Germany, during the administration of Chancellor Heinrich Bruning, where a stabilization program helped bring Hitler to power.

The Fed had as the time already triggered the Great Depression by inventing the policy rate (about 1920) and open market operations (in 1923) in the previous decade.

The usual socialist messing up of the economy, expropriation, coupled with the global depression leads to a belief that a ‘strong man’ can also solve the problem, economist Friedrich Hayek later explained.

In Germany the Social democrats (Marxists essentially) were ruling at the time, and with their policies discredited, nationalists under Hitler peddled their ideology easily and came to power, targeting the Jewish minority.

West Germany Stands Out as Central Bankers Win Elsewhere

By the end of World War II, with Germany in shambles, nationalists were defeated by outside forces and liberals came back with a hard money and stability doctrine not policy rate (money printing) driven growth.

They closed the Reichsbank, set up the Deutsche Mark under full control of the politicians, in the Austrian-Ordoliberal tradition, established free trade and full free market competition under a full liberal democracy. There was not an inflationist macro-economist in sight.

The Deutsche Bank as a formal institution was established much later.

West Germany’s Ordoliberals were so successful that the Social Democrats were relegated to the political backwoods until shortly before the break-up of the Bretton woods, unlike in Sri Lanka where Socialists went from strength to strength.

In 1959, The SPD officially abandoned its Marxism of expropriation and anti-capitalism under its Godesberg Program as the economy boomed and support for a strong currency and private sector grew gaining strong public support.

READ MORE: Godesberg Program of the SPD (November 1959)

But the UK, the country that defeated Germany, remained mired in Cambridge economics, Sterling crises and IMF programs till Thatcher came.

The US was only slightly better.

Economics was under siege from the so-called Saltwater universities with a virulent form of Post-Keynesianism, coupled with toxic statistics, displacing classical economic principles.

Paul Samuelson, of MIT was a key driver of mindless econometrics in what could now be called data driven monetary policy.

Monetary policy deteriorated in the Fed with macroeconomics coming to the fore with lean-against-the-wind policy, with the ‘wind’ also being originally fanned by the Fed with rate cuts.

In Sri Lanka in 1961, the Bank of Ceylon was expropriated and the People’s Bank was set up.

In 1961 the Federal Republic of Germany appreciated its currency around the same time as the Fed invented central bank swaps to borrow from other central banks without going to the IMF after printing money and losing gold.

Sri Lanka where Anglophone qualified ‘development’ economists who were by now pushing import substitution after severely depleting reserves, started going to the IMF from 1965.

J R Fails to Defeat Macro-economists

J R Jayawardene, the Finance Minister who originally created a central bank in 1950 and made the country a member of the IMF the day after, brought B R Shenoy – probably the greatest classical economist produced in South Asia – to help in 1966.

Shenoy advises the country not to print money and float the currency, and avoid periodic devaluations, saying the calculations about equilibrium exchange rates which had by then emerged – with the expansion of econometrics – are suspect.

This is advanced thinking as the Fed has not floated yet.

Macro-economists in Ceylon predictably ignore his advice and instead print money for rural credit and start multiple exchange rates, Latin-America-style, amid rising central bank activism.

In 1969, with reserves severely down, an import control law was brought in, discrediting Dudley Senanayake’s free trade plans as central bankers won the day yet again.

In 1969, as the Fed fired global inflation, Germany’s Social Democrats were able to form a coalition government in Germany for the first time since they lost, helping bring Hitler to power so many decades ago.

In 1971, as oil, food commodities and gold prices soared, President Nixon closed the gold window, floated the dollar and imposed import tax surcharges (Nixon shock).

Nixon is impeached later.

As the Bretton Woods and the US dollar collapsed, Sri Lanka closed the economy completely in the 1970s going much further than Nixon.

Econometric Corruption Spreads

The collapse of the US dollar led to the Great Inflation of the 1970s as reserve currency countries struggled to find an anchor for floating exchange rates.

Statistical corruption of economic principles reaches a new high.

Academic inflationists, apparently with no knowledge of central bank operational frameworks, clutch at the latest statistical formula.

Blaming statistical formulae, imports and trade deficits are regurgitated from classical mercantilism as excuses for monetary instability allowing macro-economists to escape accountability for inflationary suppression of rates.

Wage-spiral inflation, oil shock, gives a new life to ‘cost-push’ inflation.

Nominal effective exchange rates are made popular by Fred Hirsch and Use Higgins.

Leftist uprisings proliferate worldwide.

Econometricians then came up with real effective exchange rates as currencies collapsed and inflation diverged widely in the 1970s and worsened in the 1980s.

Germany rejects the ideas and starts to target money supply and shifts to inflation later in the 1970s.

The deep knowledge operational frameworks (OFs) of note issue banks that classical economists from Ricardo to Hume to Torrens had developed in the 19th century seems to have disappeared by then in the unusually effective brainwashing at Anglo-American universities.

In 1978, the IMF effectively ended external anchoring without a credible replacement domestic anchor, plunging many countries like Sri Lanka into a blackhole of monetary instability.

The exchange rate goes haywire, and inflation rockets.

As inflation goes up budgets go haywire as the state is unable to manage rising expenses.

The macro-economists artfully blame budget deficits for monetary instability (which is dumb in the first instance, since credit is credit whether it’s private or state), not inflationary central banking.

Related Sri Lanka’s rupee depreciation and economic crises; the deficit lie

In the 1980s East Asia latches on to the dollar with currency boards (or currency+board+plus regimes where foreign reserves exceed reserve money), and imports the stability the US Fed achieves under Volcker and Greenspan which was called the Great Moderation.

These countries grew with both monetary and political stability and used the renewed free trade agenda of Western nations in the Great Moderation to grow their economies.

J R Jayewardena came to power on the back of trade and economic controls of the 1970s, driven by money printing as well as bad Fed policy involving the so-called ‘Great Inflation’.

In the belief that the ‘strong man’ can take the economy forward, an authoritarian constitution is enacted, in a repeat of what happened in Germany after Weimar socialism.

Open Economic Reforms Discredited by Unanchored Money, REER

But the depreciation of the rupee led to a period of ‘Greater’ Inflation within Sri Lanka until 1995, even as the US, Europe and East Asia grew in the Great Moderation of low inflation, directly as a result of the IMF depriving the country of a credible monetary anchor.

Sri Lanka tries money supply targeting without a floating rate and fails. As the Fed tightened in 1980, Sri Lanka went into the worst BOP deficit up to then of 191 million dollars.

In Latin America, external defaults begin.

J R ends up with severe social unrest and a second leftist uprising on top of the northern rebellion which turned into an intensified civil war after the 1983 nationalist riots. There was high inflation and a stabilization program around the time as well.

JR brings the greatest classical economist East Asia has produced, Singapore’s former finance minister Goh Keng Swee, as Sri Lanka is shunted into an IMF bailout within two years of the most radical economic reforms the country had ever seen.

Goh tells J R not to print money and not to depreciate the currency, as Sri Lanka is similar to Singapore and is a trade dependent country.

Related How Sri Lanka rejected Singapore monetary advice and politicians, people paid the price

Macro-economists ignore the advice. Instead, in 1985, macro-economists set up Regional Rural Development Bank linked to the central bank to give refinance (printed money) credit.

Jayewardene held on to power with electoral gimmicks and authoritarianism as the currency collapsed and inflation soared.

Import substitution again came to the fore, spreading to onions and potatoes.

Stabilization and Jan Bala Meheyuma

Fast forward to 2001.

Ranil Wickremesinghe came to power as Prime Minister on the back of the 1999/2000 currency crisis and IMF stand by arrangement, the ‘pariwasa government’, and the Jana Bala Meheyuma.

He completes the stand-by and starts a new IMF program – not to restore stability, but a pure reform program, labelled ‘Regain Sri Lanka’ with monetary stability already restored. The economy recovers strongly with a ceasefire also in place.

The JVP attacks him on fuel pricing as oil and fertilizer prices soar with Ben Bernanke misleading Greenspan into printing money to target positive inflation in what was later called the ‘mother of all liquidity bubbles’.

The just-ended 2000 currency crisis has also seen Sri Lanka’s CPC borrowing from Iran to import oil amid forex shortages in a precursor to supplier credits in the post-war flexible inflation targeting driven currency crises.

Though inflation is low, and the economy is in full recovery mode, Wickremesinghe is attacked by his political foes on a peace deal with the Tamil Tigers. When then-President Chandrika Kumaratunga takes over ministries while he is in the US, people flock to the road to support him as he lands in Katunayake.

Wickremesinghe sends them home empty handed and later he ends up without a government.

Because the Fed is targeting positive inflation using core inflation, ignoring the commodities, using hedonics and other tools that understates inflation amid a private sector productivity boom, a massive asset price cum commodity bubble is formed by 2008.

Amid a civil war and the Fed’s housing cum commodity bubble, Sri Lanka has another currency crisis with capital flights from rupee bonds, and goes to the IMF in 2008.

In the next election Mahinda Rajapaksa wins, despite the IMF stabilization program, with a war victory, in an unusual first for Sri Lanka on nationalist considerations.

The rupee is allowed to re-appreciate from 120 to 113.

But in 2012. rate cuts with printed money triggered a currency crisis within the IMF program giving rise to another stabilization program. The rupee fell to 130 to the US dollar.

Ranil Defeated by Potential Output Targeting

Fast forward a little to 2015.

Wickremesinghe came back to power in 2015, just as the economy is recovering very strongly from a currency crisis triggered by central bank rate cuts in 2011/2012.

The IMF then teaches Sri Lanka to calculate potential output. The central bank prints money to cut rates in 2015, amid a spending bout for the 100-day program, and triggers another crisis.

In this IMF program, there is no cost cutting. Instead, ‘revenue based fiscal consolidation’, a type of IMF backed state expansion, which rejects cutting government spending, is in operation.

Spending is ok, but deficits are supposed to be cut by tax hikes only, not cutting expenses (spending-based consolidation), putting the entire burden of adjustments on private citizens.

Sri Lanka then starts to print large volumes of money to narrowly target the call money rate in another deterioration of the central bank’s operating framework. The rupee falls from 130 to 152.

There is a stabilization program which discredits Wickremesinghe’s administration and taxes are hiked.

Hot on the heels of the 2016 crisis, another currency crisis is triggered in 2018 despite tax hikes on revenue based fiscal consolidation, due to targeting potential output with printed money, as inflation falls.

Yield curve targeting, Liberty-Bonds-style, also emerged in the period.

Instead of borrowing from Iran, the petroleum utility gets suppliers’ credit after potential output targeting driven fore shortages, and then converts them into state bank loans.

Related Shock revelation on how Sri Lanka’s CPC ended up with billions of dollar debt

CPC runs losses despite market pricing oil. The borrowings later add to national debt after a default.

The rupee falls to 182 and another stabilization program is put in motion.

Wickremesinghe’s goose is cooked and his economic policies are discredited.

Nationalists Rise on Stabilization Program

Nationalists have a field day on the stabilization program and revenue-based-fiscal-consolidation in 2018. This time Muslims are targeted.

Hitler blamed the jews for a ‘stab in the back’.

Muslims are blamed for sterilization pills. A prominent Buddhist monk calls for a Hitler to come to power.

Gotabaya Rajapaksa comes to power and takes oaths in front of Ruwanwelisaya, a Buddhist dagoba, built by King Dutugemunu.

Macro-economists and think tanks, who are advising, descends on him like vultures and taxes are cut on top of rate cuts saying there was a ‘persistent output gap’ in the most extreme macro-economic policy seen in the island up to then.

Covid comes. As the economy recovers from Covid, the printed money triggers forex shortages despite the worst import controls since the 1970s. All kinds of shortages appear.

People come to the streets, dwarfing the 1953 hartal and the Jana Bala Meheyuma.

Gotabaya Rajapaksa’s goose is cooked.

Poor people starve. Poverty rockets, Latin-America-style, as the rupee collapses. Outmigration picks up, Latin-America-style.

Another Stabilization Program

After the Rajapaksa’s ouster, Wickremesinghe comes to power again and goes about fixing the country, helped by newly appointed central bank Governor Nandalal Weerasinghe who markets prices interest rates. Longer term yields go far above the policy rate.

Unusually, going against the usual IMF advice to destroy the currency, to destroy savings, to destroy salaries and trigger more social unrest, he allows the currency to appreciate amid deflationary policy.

Because many nationalist elements are supporting President Wickremesinghe, nationalism is muted in the current stabilization program.

Instead of Muslims, nationalist elements tried to use archaeology against Wickremesinghe.

However, the strategy is less successful than in the past since it was a nationalist-backed administration that created the crisis in the first place. It seems also that Wickremesinghe knows more history than the nationalists.

Sri Lanka has destroyed the currency as well as domestic capital since 1977, but has not become an export powerhouse like East Asian nations with monetary stability did, or services hubs like the Middle Eastern currency-board-style nations.

The rupee is now probably allowed to appreciate on some econometric formula, not with any belief in sound money.

Wickremesinghe has been duped into legalizing potential output targeting through a deadly monetary law and giving ‘independence’ to macro-economists who believe in 7 percent inflation and central bank swaps.

The Reform Lie

Mercantilists and macro-economists who earlier spread the narrative of imports, trade deficits, current account deficits, lack domestic production and real effective exchange rates to escape accountability for external instability and IMF programs, come up with yet another excuse.

They now blame the lack of reforms for monetary instability and repeated trips to the IMF, conveniently forgetting that the 1980s repeated IMF programs came with the most radical reforms ever.

Each time, rate cuts trigger external instability and downturns, leftists and nationalists are elected by a desperate public who are looking here and there for saviour.

Liberal policies are rolled back and post-independent policies that gripped the nation from 1956 to 1977 are brought back.

Monetary instability involving dual anchor conflicts (a reserve collecting central bank trying floating rate OFs) is unchanging, and continues under different labels.

Corruption is also blamed for the crisis. Dollar earning exporters are themselves blamed for forex shortages and the currency crisis by some in another strange twist, which however is rejected by the central bank.

Who will IMF and the Central Bank Elect in the Upcoming Elections?

In summary, history shows that a stabilization program, which comes after rate cuts for growth, is when fringe elements are mostly likely to be elected.

The JVP, a leftist party which believes in expanding the state (in line IMF’s progressive Saltwaterist revenue based fiscal consolidation) is now doing well on social media.

Some of the younger demographics that supported Gotabaya Rajapaksa after the 2016 and 2018 stabilization programs are active in social media hoping to find salvation within the JVP.

In the confusion, a widespread belief that the currency crises and default was caused by corruption, and not aggressive macro-economic policy, is being strengthened.

The belief also helps the JVP, which has not been in power, and is projecting a clean image, regardless of its economic credentials and violent past.

That the 1970s problems came from Harold Laski’s Marxist ideas on top of monetary instability from the central bank is not known.

In any case it was before the time of the current generation of young voters.

On rare occasions, stabilization programs have helped build liberal democracies in the past, when nationalists and socialists were responsible for the crises.

Germany after WWII when the Social Democrats were confined to the backwoods for three decades and Korea in 1987 are key examples.

Korea’s Great Peoples’ Struggle or June Uprising which made the country a liberal democracy, better than Japan, came on the back of stabilization and the first currency appreciation in the history of its central bank under its previous authoritative administration.

Springtime of the Peoples after Railway Bubble and Puran Appu

The 1847-1848 Commercial Crisis or the Panic of 1847 in Britain also did not lead to nationalism but to the enhancement of liberal ideas sweeping the region, with most countries then under monarchs.

The 1847 banking panic also marked the end of the British Railway bubble

The 1847-1848 crisis saw widespread political crises in the gold area, not just the UK and Ceylon.

It was also called the ‘Revolutions of 1848‘ or the ‘Springtime of the People’.

The ensuing crises was mostly a liberal democratic struggle that led to the end of monarchies, freedom of the press in several dozen European nations.

As commodity prices deflated and coffee prices collapsed, many plantations in Ceylon went bust and Governor Torrington had to put new direct taxes on the people, IMF style.

The 1848 ‘Matale Rebellion’ was seen in Sri Lanka. This involved Gongale Godabanda, Puran Appu and others where it started with a tax protest in front of the Matale kachcheri.

This is why the IMF’s progressive taxation that has caused so many problems for the people and made a reformist government unpopular, should be a warning to the ruling class.

Wealth taxes are also on the horizon, in further depletion of wealth and savings for investment for the future.

Politicians on both sides of the isle, who have socialist tendencies, like direct taxes and only criticize VAT, which is a superior tax.

But people feel income tax, where money is taken in big chunks, before a voluntary transaction is made.

The IMF’s planned wealth tax is a type of expropriation where people who have invested their savings and built houses are punished even when there is no cash flow and are also likely to turn people away from reformist leaders.

The wealth tax, like the progressive taxation and revenue based fiscal consolation, is in line with old communist ideas, which is coming to Sri Lanka as the result of progressive Saltwaterism of the West.

There is no wealth tax in socialist Vietnam. European style wealth taxes have been resisted by Republicans in the US, a country which already has inheritance taxes when people die. Wealth taxes, especially on homes, are slammed as people, including elders on pension, are still alive.

Progressive Saltwaterism and Unsound Money

Under IMF influence Sri Lanka now has US-style inheritance taxes and personal income taxes, European style-VAT and and Argentina-style monetary policy under flexible inflation targeting with up to a 7 percent target.

A country can still survive socialist style big-government taxes with higher levels of unemployment, like in Europe, if monetary stability is provided.

Before the policy rate for economic intervention (macro-policy), was devised in the 1920s by the Fed, monetary crises were relatively rare, that is why the British were able to rule with only a few rebellions in Ceylon and elsewhere.

Sri Lanka’s central bank which has given coercive powers to a few bureaucrats to cut rates with printed money and create forex shortages, is a key reason for this country’s monetary as well as political instability.

Unlike in West Germany or UK under Thatcher (UK was IMF’s top client until Thatcher-Hayek-Walters), the current reforms will not bring any long term benefits.

As a result, all the reforms that are being done now will be so much water under the drain, as they have been for the last 72 years, since monetary stability will be denied to the people by the use of inflationary rate cuts.

Sri Lanka was a fully free trading, stable country in better shape than Singapore, when it gained independence with a currency board. There were hardly any economic controls to reform.

Singapore on the other hand was devastated under Japanese occupation and Banana Money (Military Yen) by the end of World War II, just like the rupee was with potential output targeting now.

In the final analysis, whoever comes to power may be academic, as the IMF has already denied a single anchor monetary regime to the country with the new central bank law and legitimized printing money for growth which devastated the country after the civil war ended.

In Latin America, nations default repeatedly with 23 percent plus revenue to GDP and 5 percent budget deficits, due to rate cuts enforced with printed money under operational frameworks similar to that of Sri Lanka’s central bank.

After the Second Amendment to its Articles Argentina is now IMF’s biggest client, not Keynes’ birthplace.

The undermining of Milei’s monetary plan, which would have stabilized the country, shows macro-economists and the IMF really rules Argentina policy.

Sri Lanka’s current central bank has allowed the rupee to appreciate, giving immediate benefits to the people, in sharp contrast to earlier programs.

History Set to Repeat

It is however not stable or consistent sound money, but only a temporary gain from external anchoring as the domestic anchor (5 to 7 percent inflation target to be achieved with money printing or depreciation or both) is not yet operative.

The operating framework involving flexible inflation targeting, and the flexible exchange rate is fundamentally flawed.

The benefits are coming now because external anchoring has supplanted the domestic 5 to 7 percent anchor. Inflation is now only 0.9 percent with currency appreciation from deflationary policy.

Unlike in East Asia, deflationary policy is not assured.

On the other hand, external instability is almost guaranteed under flexible inflation targeting, with a 5 or 7 percent inflation target, the latest spurious monetary doctrine peddled to hapless countries which then end up in default, where a reserve collecting central bank is urged to cut rates claiming historical inflation is low.

Not just future, but current domestic credit is disregarded in flexible inflation targeting despite a reserve collecting central bank being operated.

With Sri Lanka having market access, a second default is likely as the money exchange conflicts re-emerge as the economy recovers.

Supposedly, since 1978 (after the IMF’s second Amendment when external defaults proliferated) 58 percent of defaulters have defaulted again.

Meanwhile, after a decade of quantitative easing, US government finances are shot, and the chickens are coming home to roost. Economic nationalism is on the rise in the US.

With Trump in the wings, fully fledged nationalism is also on the cards. The same is happening in Europe.

Sri Lanka will also have to cope with that.

Whether it is Governor Torrington in 1848 with the British Commercial Crisis or Ranil Wickemesinghe in 2019 or 2024 after the potential output targeting cum/flexible inflation targeting crises, destroying money and credit has powerful political consequences to those who later try to fix the problem.

Even if 90 percent of the things are done right – as now – even this column will pick holes in some leftist aspects of IMF programs and warn about the inevitable consequence of deeply flawed monetary policy, confusing the public.

It is not about reforms or leaders. Sri Lanka’s politicians have been willing to take very hard decisions always to take the country out of crises.

It is about bad unstable money that prevents the fruits of those decisions from coming to the people in subsequent years.

The US was running bad to atrocious monetary policy since 2001, when Ben Bernanke misled Alan Greenspan into printing money to run an 8-year cycle, firing a commodity and housing bubble which collapsed after rates were kept at around 5 percent for about a year.

That was the end of the Great Moderation started by Paul Volcker and continued with some skill under Greenspan, until the Fed was infected by Bernanke, the depression scholar. Keynes was also a ‘depression scholar’, in essence.

Gold prices fell from 800 to 284 dollars an ounce under Volcker-Bernanke, until Bernanke cooked up a false deflation scare with a healthy banking system and started to reverse it, firing the housing bubble and the Great Recession in its wake.

READ MORE: Deflation: Making Sure “It” Doesn’t Happen Here : Remarks before the National Economists Club, Washington, D.C.

Then came quantity easing after the banking collapse and Frank-Dodd to control banks.

From around Covid and until March 2022, quantity easing resumed no holds-barred with fiscal policy also deteriorating as the government used the money.

It is now almost a year since interest rates have been at 5 percent in the US after Powell started to raise rates.

But this is not the US of 1980 or 2000. And it not just some companies but the government that is choked to the gills in debt after the MMT-style stimulus, Covid handouts and perhaps the most aggressive ‘full employment’ policies seen in the history of the Fed.

Warning Signs

F A Hayek said this of Keynesianism and the policy rate to boost growth through full employment policies (now called targeting potential output in Sri Lanka).

“It was John Maynard Keynes, a man of great intellect but limited knowledge of economic theory, who ultimately succeeded in rehabilitating a view long the preserve of cranks with whom he openly sympathized.”

In continuing with quantitative easing with a healthy banking system, the Fed and the ECB is putting Keynes and John Law to shame.

It was perhaps no accident that the IMF taught Sri Lanka to calculate potential output a few years ago, with this ideology running high in Washington, eventually taking both the Yahapalana and Gotabaya Administration down and driving Sri Lanka to default.

There was an unprecedented overall deterioration of policy around the world that spread from the Fed and US universities, just like in did in the 1920s when the policy rate and deliberate open market operations were invented and the 1960s when its own anchor was busted .

From last year the US broad money supply has been shrinking in absolute terms, something that has rarely happened.

The Fed no longer looks at money supply, under their current framework.

Economist Steve Hanke, who was ad advisor to the Reagan Administration when the landmark action was taken to bring monetary stability back in the early 1980s, and kick-start non-inflationary growth, has pointed out that absolute falls in the money supply is very rare in the US.

Hanke also accurately predicted the 2022 inflation spike from Fed’s inflationism.

Bad Money, Bad Budgets

US budgets are shot.

After years of bad Fed monetary policy (which also helped Sri Lanka borrow in dollars from sovereign bond holders and China), US rates are going up and interest costs are rocketing like in Sri Lanka.

Is it possible for a US Treasuries auction to fail?

In theory no, since the Fed can buy it up as Sri Lanka’s central bank does to cut rates and trigger external crises.

But any such event can send bad vibes which can be the proverbial straw that broke the camel’s back.

The US Treasury had almost a perfect system going until around 2000, with the China and East Asia buying up US debt and importing the stability of the Great Moderation to become investment and export powerhouses.

But US Mercantilists who believe that exchange rate pegs made East Asia export powerhouses, at the expense of the US trade deficit, put pressure on China and other countries to break the peg, losing a big buyer of their debt.

IMF backed Self Destruction

The IMF fully supported these efforts.

China then broke the peg from around 2005 and diverted savings to the Belt and Road project.

When the housing bubble broke, China was in pretty good shape with tighter than US policy until then.

After quantity easing started US rates were low in any case. Sri Lanka was one of the countries that the money was diverted to.

Bond holders, also awash in liquidity started to buy crappy bonds from low rated countries which are now defaulting like dominoes.

The Fed, by triggering commodity bubbles and oil prices that tends to incentivize leaders of illiberal mineral rich countries into war, Arab Israeli wars or Russian aggression.

US dealt itself another blow during the Ukraine crisis.

The lack of knowledge in US policy circles was clearly shown by the freezing Bank of Russia reserves invested in the US.

It prevented Russia’s central bank from using reserves to mis-target rates and sterilizing the interventions with printed money, and helped Russia avoid a monetary meltdown.

Instead of printing money to mis-target rates after intervening to trigger a currency crises like repeated IMF backed countries and Latin America does, Bank of Russia hiked rates to 20 percent virtually the day after reserves were frozen and clean floated.

As a result, the US budget has lost another customer for its bonds. More to the point it has discouraged others from buying US bonds as well. If reserves are frozen, then countries which have bad relations with the US will no longer buy US bonds.

Clean floating countries will not collect reserves in any case.

The steeply rising gold prices now, are partly driven by central bank purchases, who would perhaps have bought more US bonds in the past. If more countries are driven to external crises though flexible inflation targeting, they will also sell US bonds.

The IMF has has started peddling flexible inflation targeting to Vietnam.

In the last Article IV consultation, the IMF also promoted expansionary fiscal policy dealing a death blow the central bank efforts to stabilize the external sector by replacing private credit with government credit.

Curiouser and Curiouser

There is another curious phenomenon seen in Fed statistics that should make people sit up and take notice.

The reserve balances component of the US monetary base (there is no longer a required reserve rule in the US amid the latest deterioration of its monetary framework) is climbing even as the Fed is engaged in quantity tightening.

This is clear liquidity preference behaviour, where the smart banks are getting ready for the worst instead of – say – buying government treasuries.

Sri Lanka saw a similar situation among the best managed foreign banks in Sri Lanka during the country’s ‘mother of all currency crises’.

Fed wants to quantity tighten, but banks are building up liquidity. Essentially the effect on the economy is the same – some banks are not lending. The difference is these banks may be smarter.

There seems to be two types of banks, which are acting in completely different ways in the US.

While some banks seem to be loading up on liquidity others are lending – at 5 percent plus.

Commercial bank credit which stopped growing and fell from the time the Fed started to tighten policy in March 2022 has started to edge up over the past few months.

It is not clear who is taking the loans, at 5 percent plus which is a very high rate for a highly leveraged economy like the US. At least some of it must be going for commodity speculation.

Meanwhile gold has hit 2,400 dollars an ounce. Gold was only 284 dollars an ounce when Bernanke induced Greenspan to print money for positive inflation targeting by falsely firing a deflation scare in 2000.

There was some expectations by various technical analysts that gold will hit 2,400 an ounce. So, it can be a self-full filling prophecy.

Whatever it is, a commodity bubble at the tail end of a rate hiking cycle is not a good omen. A similar trend was seen just before the collapse of the housing bubble. It is like the dead cat bounce of the commodity world.

Soft-Landing or Disorderly Unravelling of the Powell Bubble?

In the Greenspan-Bernanke bubble it was HSBC’s housing unit in the US that showed that the system was rotten.

The jitters over the Iranian attacks show that US markets are skating on very thin ice.

It is not clear to what extent US companies are over-leveraged.  It was mostly a housing bubble that broke in 2008. But this time credit has shifted to other sector.

Government debt is one. The recent bank failures related to marked-to-market long-term government bonds confounding those who promote full reserve banking.

But there are signs that some other companies, including those in infrastructure which tended to be pretty safe, have borrowed and engaged in activities like leveraged dividend recapitalizations.

Over recent years there had been a spate of leveraged dividend recaps.

Jerome Powell said last two weeks ago that the Fed will continue to tighten with inflation still high.

“The recent data do not, however, materially change the overall picture, which continues to be one of solid growth, a strong but rebalancing labor market, and inflation moving down toward 2 percent on a sometimes bumpy path,” he said at forum at Stanford.

“Labor market rebalancing is evident in data on quits, job openings, surveys of employers and workers, and the continued gradual decline in wage growth. On inflation, it is too soon to say whether the recent readings represent more than just a bump.

“We do not expect that it will be appropriate to lower our policy rate until we have greater confidence that inflation is moving sustainably down toward 2 percent. Given the strength of the economy and progress on inflation so far, we have time to let the incoming data guide our decisions on policy.”

Under the Fed’s (historical) data driven monetary policy and its dual mandate (which by the way was generally ignored by both Volcker and Greenspan in favour of stability) there is no chance to cut rates, so he is justified in the stance.

But it does not necessarily mean that the historical data he is looking at will lead to a soft-landing or another deflationary collapse.

This time, the US government will have less room than in the past to engage in various macro-economic policies to manipulate the economy given its debt and the political crisis in Washington.

The banking system may also not respond to Fed actions as it had done in the past.

In earlier collapses, gold, dollar notes and US government debt were investments of choice for economic agents, as shown in Exter’s pyramid.

The US so-called ‘weaponizing’ of the dollar has reduced its attractiveness overseas, but not necessarily at home as shown by the recent liquidity preference behaviour.

Sri Lanka hit by bad US policy in the past

In past US monetary crises, whether the Great Depression, the 1960s inflationism (Sri Lanka first started its journeys to the IMF in the middle of that decade and passed the import control act), the 1971 collapse of the Bretton Woods (Sri Lanka closed the economy), the country has been hit.

In 1980s when US improved policy Sri Lanka failed to capitalize on it unlike dollar pegged East Asia.

From 1978, at the tail end of the Great Inflation period, Sri Lanka lost a credible anchor leading to high inflation and social unrest and missed stability that East Asia got by maintaining external anchors with the Fed improving its policy.

The US and the US dollar survived in 1951 and 1980 as hard money people got back into the driving seat and inflationist macro-economists lost favour.

However it did not happen in 2008. Things essentially got worse as it did in the 1930s with quantity easing infecting even once prudent reserve currency central banks, as Keynesianism and the policy rate did after the Great Depression, leading to mass devaluations in the 1930s.

It may be time to look for countermeasures. Sri Lanka at the moment is fixing its budgets and has reasonable monetary policy though the operational framework is deeply flawed.

Companies and individuals may also need to hedge their bets.

To reach the columnist: BellwetherECN@gmail.com

To read more recent columns

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Sri Lanka central bank salary hikes show lack of accountability for its actions

Standing facilities should be the last among lender of last resort facilities.

The more liberal the LOLR facilities are, the more unchanging the rate, the more external instability there will be in the future, and more bank bad loans will pile up as stabilization policies are applied.

Essentially, standing facilities, term or permanent injections allow banks to lend without deposits, and trigger forex shortages in a soft-peg or flexible exchange rate.

The UK has a standing facility that prints money at 0.25 percent above the policy rate.

“The operational standing lending facility consists of an overnight lending transaction collateralised against high-quality, highly-liquid (Level A) assets. We apply a 25 basis point premium (0.25%) above Bank Rate for this facility.

“The operational standing deposit facility consists of an overnight deposit transaction. This currently returns 25 basis points below Bank Rate.”

Safer, More Prudent Times

In earlier times, before monetary policy deteriorated and when the BoE gave more stability to the country and lower inflation, and less social interest, these premiums including for longer term money, have been higher.

“We moderate upward spikes in overnight rates by being ready to supply overnight funds to our counterparties at 3.30 pm (against collateral) if the shortage of funds has not been fully relieved in our main 9.45 am or 2.30 pm rounds,” according to a paper by William A Allen, one time Bank of England who retired before policy was corrupted by quantity easing and easy money, leading to current troubles.

“At the end-of-day stage, our operations are concerned not so much with implementing the MPC’s repo rate as with the more routine task of squaring off any residual market imbalance in as orderly a manner as possible. The rate charged on 3.30 pm lending is penal – the official repo rate plus 100 basis points (though we can vary this margin) – in order to encourage banks to borrow in the market wherever possible.

“If, after the market has closed, the system is still out of balance, we will lend off-market to the settlement banks to enable them to square off their end-of-day settlement with each other, at an even more penal rate of the official repo rate plus 150 basis points (again, this margin can be varied).

“These facilities are designed to eliminate excessive spikes in overnight interest rates at the end of the day, and have been successful in doing so. They are akin to the ceiling in a corridor system of rates, but not exactly so for two reasons.

“First, they are not standing facilities available at all times to all market participants. Second, funds are normally limited to the amount of the remaining daily shortage (though we reserve the right to supply more).

The rationale for prudence and discouraging moral hazard was explained as follows.

“Both these limitations are motivated by our desire to ensure that banks are subjected to the discipline of having to finance themselves in the market to the maximum extent possible.”

All of these principles have now gone out of the window and the world is a less safe place for all, particularly the poor in unstable countries like Sri Lanka.

How do Liquidity Shortages Emerge?

In reserve collecting central banks with pegged or managed floats, liquidity shortages come from dollar sales.

In a floating exchange rate regime, liquidity shortages do not arise unless many market participants refuse to deal with each other in times of crises and deposit money in the central bank (private sector sterilization).

This also happened in Sri Lanka in the last crisis, with foreign banks depositing money in the central bank instead of buying government securities or lending in the interbank market.

In the absence of a policy rate, such deposits become foreign reserves in a reserve collecting central bank.

If there is ‘quantity tightening’ in progress, liquidity can fall in a floating rate environment.

The Bank of England is giving unlimited facilities in quantity tightening to help ease any liquidity shortages at the moment.

In many countries the quantity tightening is aimed at reducing excess liquidity created from quantity easing.

 Sri Lanka’s central bank is also engaged in ‘quantity tightening’ in effect, by selling down its Treasury bill stock, with no excess liquidity present.

As a result, there is no money in the market to buy large volumes of CB held Treasury bills unless there is liquidity generated from central bank dollar purchases.

Overselling Treasury bills in large volumes and giving liquidity overnight through overnight windows or term, encourages banks and primary dealers to depend on the central bank’s printed money for their operations.

The central bank should internally roll over most of the maturing securities and only offer to the market a volume that will keep the aggregate balance in the market plus or minus 20 to 30 billion rupees.

Now T-bills are sold and money is injected term and overnight to allow market participants to buy them.

Market participants should buy CB held Treasury bill stock from real deposits, not central bank credit. To do so is a type of self-deception.

Liquidity Junkies

More to the point it is a bad practice that will get banks used to borrowing from the window – de-stigmatizing the practice – so to speak.

When banks become liquidity junkies, eventually the country will suffer forex shortages when credit recovers.

In Sri Lanka several well managed foreign banks, (and one or two local ones also before the crisis) always deposit some cash in the central banks window.

These banks are usually net sellers in the interbank forex markets.

In fact, all banks, whether local or foreign should be encouraged to have a little excess liquidity above the reserve ratio.

If the central bank has painted itself into a corner on a belief that it cannot roll-over maturing bills internally under the monetary law, it has only itself to blame for coming up with an illogical law.

If that is a problem, the central bank can submit a non-competitive bid and allocate itself the volume at the weighted average bid for the auction.

The current system of selling bills and giving new money short term, can also lead to sterilization losses in addition to making liquidity junkies out of banks.

In the name of transparency all bills rolled over should be disclosed to the market. The bill holding, inclusive of those taken for term or overnight operations, should also be disclosed daily.

A small liquidity shortage filled at penal rate will encourage better banking.

However if the central bank wants, it can also allow some liquidity to build up from dollar purchases and allow short term rates to fall further in the near term, now that confidence in the currency has been restored fully.

Long-term rates will fall as real savings go up (the exchange rate appreciation helps but care should be taken not to overdo it) and budgets become better, as long as monetary stability is maintained for a few years.

If liqudity is allowed to be plus, from outright dollar purchases and not swaps, a wide policy corridor and a penal standing facility is absolutely required to prevent forex shortages from developing and the whole house of cards collapsing when private credit recovers.

East Asia

Most East Asian nations which collect reserves (with deflationary policy) have tighter liquidity facilities in their operational frameworks, unlike unstable countries like Sri Lanka and those in Africa. Some have penalty rates for intra-day liquidity.

Rates move quickly in case there is a credit spike and exchange rate is defended when there is a wide policy corridor.

A wide corridor or a high ceiling rate helps reduce the negative effects of the obstinate policy rate and allow the market to finance credit instead of central bank facilities.

When standing facilities – including intra-day facilities – are given at penal rates the ceiling rate goes up and widens the corridor, helping protect against currency crises.

In several East Asian central banks domestic assets are negative.

Thailand, which fell victim to hedge funds in the East Asian crises first due to its policy rate and swap operations, was an exceptional central bank even when the Bretton Woods collapsed, but whose policy framework was not up to dealing with a swap attack in 1997 due to ‘monetary policy modernization’.

The Bank of Thailand swiftly descended into inflationary policy under attack, which then shattered confidence.

Running deflationary policy, and building reserves (exports of capital) has not hurt East Asia because the stability the practice provided through a tight monetary standard led to even larger inflows of capital in the form of FDI or other flows than the reserves that were built.

Domestic capital was preserved with no depreciation to inflate away capital.

Countries with completely free capital flows, including Singapore and Hong Kong which have the best monetary frameworks in East Asia, have very low interest rates and do not have policy rates at all.

Sri Lanka also had developed country level inflation and interest rates, before the monetary framework was corrupted progressively under IMF tutelage and also the inflationist beliefs that swept the academic community of the US in particular, from the 1960s.

Monetary instability and currency depreciation that led to high interest rates in Sri Lanka which is unrelated to credit risk.

No Logic

There is no point in imposing statutory reserve ratios if liquidity is provided liberally through standing term and overnight facilities after banks short the SRR.

Given the lack of foreign reserves, and negative net reserves of the central bank, banks should be encouraged to raise deposits, reduce credit and buy central bank held securities from liquidity generated from central bank dollar purchases.

Any cash deposited by banks in the standing facilities over and above the SRR actually results in foreign reserves for the central bank, unless system liquidity is liberally filled with standing facilities.

Dollar net open position units of banks in fact should be tied to the net balance of their standing facilities and other borrowings.

Outright purchases of securities and the engaging central bank or market swaps to borrow dollars should be discontinued.

Central Bank Swaps are also Illogical

A central bank swap with a domestic market participant is the same as the Lebanon Central Bank dollar deposits, which proved its undoing.

In addition to Lebanon Central bank swaps is also the path of Argentina central bank’s dollar Leliqs.

Sri Lanka’s central bank also made large losses on swaps, ACU borrowings and IMF borrowing in this crisis, by using swaps to meet external payments and printing money to maintain an untenable policy rate.

Goh Keng Swee did not allow swaps and Singapore banks gave credit to foreigners to reduce the room for speculative attacks which make rates rise, though other currency board regimes like Hong Kong which have a fixed exchange rate had no such restrictions.

Speculators who tried to hit HKMA with swaps lost out as the interbank rates went up during the East Asian crisis, while they made hundreds of millions in profits from policy-rate central banks.

Soft-pegs which were hit in the East Asian crises including Malaysia and Thailand, also stopped attacks by closing the offshore swap market.

Sri Lanka’s and the problems in other countries with forex shortages and the depreciation and social unrest comes from the deterioration of monetary doctrine in the ‘age of inflation’ started from the Fed’s open market operations in 1920 to trigger the Great Depression.

The deterioration accelerated very sharply in the 1970s with the collapse of the Bretton Woods and IMF’s second amendment to its articles.

That is why budgets became unmanageable in Sri Lanka from the 1980s, despite J R Jayewardene cutting subsidies, ending price controls and administered prices as they were known then.

 John Law and the Policy Rate

There was no bureaucratic policy rate before the Fed was created as such action has been fiercely resisted in Europe and Great Britain which had a longer monetary history.

It was John Law who originally proposed to suppress rates with liquidity injections for ‘macro-economic policy’ rather than imposing price controls. Britain in fact had usury laws, which imposed ceilings on interest rates at the time.

“Some think if Interest were lower’d by Law, Trade would increase, Merchants being able to Employ more Money and Trade Cheaper. Such a Law would have many Inconveniencies, and it is much to be doubted, whether it would have any good Effect,” John Law wrote.

“Indeed, if lowness of Interest were the Consequence of a greater Quantity of Money, the Stock applyed to Trade would be greater, and Merchants would Trade Cheaper, from the easiness of borrowing and the lower Interest of Money, without any Inconveniencies attending it.”

That new money was not to have been backed cross border exchangeable assets like gold or silver, but a non-tradable domestic asset, land.

Though John Law’s ideas were not accepted in Britain, he was able to persuade the French to do so, leading to the Mississippi bubble. The Mississippi bubble proved that Law was wrong.

In this age of inflation, asset price bubbles, external default, rising national debt, exchange and trade controls, the policy rate and liquidity tools are taken for granted amid heavy propaganda by academic inflationists and other Mercantilists.

But before the ‘age of inflation’, and before 1920 it was not so.

It is also not in central banks with wide policy corridors and those that give tiered facilities.

No less than William Patterson, a key promoter of the Bank of England (which did not have a bureaucratic policy rate to manipulate interest rates in the beginning though it also got into trouble by giving excess credit from domestic assets in times of crisis) opposed John Law and the deliberate attempt to suppress rates with printed money.

Reserve Currency Inflationism

When the Bank of England was able to maintain the gold standard and the Sterling was the pre-eminent currency in the world, it had no policy rate.

The peacetime economic crises seen after World War II was a direct result of the bureaucratic policy rate and aggressive liquidity facilities of central banks, as was Sri Lanka’s currency crises and default since the end of the civil war.

Ironically, when the Fed started open market operations in April 1923, (New York Fed Governor Benjamin Strong who later triggered the Great Depression with rate cuts was on leave), it was to mop up liquidity and do ‘quantity tightening’.

John Law was proved wrong by the Mississippi bubble, and people understood the problem.

But the Great Depression did not prove Strong wrong and instead gave rise to Keynesianism and the age of inflation.

The Housing bubble did not prove Ben Bernanke wrong but gave rise to quantitative easing which is much worse than the Keynesianism that brought down the UK after World War II.

After more than a decade of repeated trigger-happy quantitative easing US budgets and US debt have been shot to bits. There are no good budgets with bad money.

Some legislators are upset that the Parliament’s control of public finances has been usurped by the ‘independent’ central bank.

But Sri Lanka’s central bank has a history of topping up pensions also to cover for inflation  – whether low or high  – while giving low interest loans for staff.

This is questionable because unlike other SOEs, the central bank itself is responsible for cutting rates, blowing a hole in the balance of payments, driving up inflation and later interest rates to stabilize the currency.

The practice of transferring billions to defined-benefit pension staff funds when inflation and interest rates are down, can perhaps be excused as a reward for not triggering monetary instability.

But when steep salary hikes are given when inflation rises, the act insulates the staff of the agency from its own policy errors and makes the very people who de-stabilized the nation, to be rewarded for their actions.

This runs counter to the principle of accountability.

If a ceiling on the annual salary hikes is placed on the central bank along the lines of the inflation target – not its achievement – may be the agency would be incentivized to give low inflation.

That is why in price regulation, other SOEs with monopoly powers are given price increases based on a benchmark.

However, that is a second-class solution and distracts from solving the underlying problem of not having a single anchor monetary regime that can be practically operated and excessive discretion that comes from a high inflation target.

Lawyers and Activists

Sri Lanka’s lawyers and public interest activists took several macro-economists who injected money to cut rates to court as well as their politicians who endorsed the action (or were misled depending on how it is viewed) and got a historic judgement against them.

This should serve as a warning to macroeconomists who cut rates or otherwise inject liquidity and trigger forex shortages and currency crises.

The actions of the lawyers and activists and the historic judgement show that this country is no longer what it was in the 1970s or the 1980s.

Macro-economists cannot get away with the same actions they did in the 1970s, though they have managed to mislead the legislature into passing a new monetary law of the inflationists, for the inflationists and by the inflationists.

Inflationist macro-economists all over the world are adept at blaming all and sundry for the consequence of their obsession with rate cuts and the belief that easy credit forms a path to prosperity instead of providing a stable monetary foundation for people to live.

It is no accident that Lee Kwan Yew was a lawyer and he understood monetary systems as well as classical economists did.

Both lawyers and classical economists use deductive reasoning.

‘Data driven’ macro-economists today depend on mindless statistics and dismiss anything that does not fit their world view as ‘outliers’.

Even data driven macro-economists should reflect on why currency crises were created with a 5 percent inflation target after the end of the war, eventually driving the country into default, and whether they should continue to take cover under such a high target.

Accountability

The so-called ‘accountability’ provisions of Sri Lanka’s new law, can only be described as a joke and goes to show that it was a self-serving piece of legislation that allowed the agency to de-stabilize the nation and get away with it.

If the central bank misses the inflation target the governor or the monetary policy board does not get sacked.

A central bank’s monetary law has to be a constitution that restrains its actions and forces the agency which has been given a monopoly in money not to de-stabilize the nation.

It should not be a tool to give absolute discretion as the current law has done through ‘independence’, and a high inflation target.

Australia’s Central Bank Governor Philip Lowe last year lost his job – his term was not renewed – following high inflation and rate hikes after money was printed for ‘stimulus’.

He was under pressure for giving what was called forward guidance – promising not to raise rates till around 2024 and getting people to borrow – and suddenly doing so when inflation went up.

Ordinary people understand that kind of thing better than the fact that monetary stimulus or potential output targeting or indeed the policy rate itself which is mis-used for goals other than stability, is the fundamental problem.

A low inflation target is essentially a legal restraint on the mis-use of central bank’s liquidity tools.

How does a central bank get money for salaries?

The central bank earns money to pay salaries essentially from seigniorage, that is profits from the note issue.

If there is high inflation, the central bank makes more money from its Treasury bills portfolio, which it usually acquires in the process of cutting rates and de-stabilizing the nation.

This column has advocated a currency board, rather than dollarization, so that profits from the note issue remain in this country.

But the profits from the note issue are small compared to the losses to generations and the social unrest the agency creates in the process of issuing rupees.

By engaging in third world central banking and borrowing through swaps and the Asian Clearing Union to intervene in forex markets and print money to maintain its policy rate, the central bank made large losses on its forex operations in the current rate crises.

Dollarization is just as good a fix as a currency board, that will bring stability and block the ability of inflationists and the IMF to engage in macro-economic policy.

The benefits from dollarization, which will put a permanent brake on macro-economist’s powers to de-stabilize the nation and drive away part of the population, will be far greater than the lost profits from the note issue.

The macro-economists’ claim that a currency board cannot be set up without full reserve backing is false as a currency board is simply a means of eliminating the bureaucratically decided policy rate.

As in a floating exchange rate, currency boards do not actually use reserves (because money printing is outlawed) for imports or any other purpose. That is why reserves do not fall steeply in currency board regimes and the exchange rate remains fixed.

However, it is less easy to convince the public that a country cannot be dollarized or currency competition cannot be introduced.

In Argentina macro-economists and other inflationists successfully scared off that unfortunate man Javier Milei from dollarizing the country though several other countries in the region itself from Panama to Ecuador to El Salvador have done it.

He is now trying to relax economic controls without restraining the central bank first and the fate of JR Jayewardene or worse, awaits him.

The problems in Argentina show how difficult it is to defeat the inflationist macro-economists and the current ideology of interventionism that dogs a discipline that continues to be called ‘economics’.

Economic Freedom

Instead of just arguing about salaries of central bankers – even though it may well be a valid point from the view of parliamentary control of public finances – a better strategy will be to end the money monopoly of the agency and reduce its ability to destabilize the country in the future.

The current money monopoly was created by the British in 1884 when the Ceylon Currency Board was set up.

Before the currency board two Chartered Banks issued money.

The Madras Bank’s rupees did not depreciate, unlike that of the Oriental Bank Corporation (corrected), which depreciated steeply when it closed its doors in is now called ‘floating’.

Before the Bank Charter Act Sri Lanka had free banking as well as currency competition.

The false claims made by central bankers and other macro-economists today that the exchange rate has something to do with the real economy could not be made so easily in the earlier ages in countries without a money monopoly.

When one currency is stable and another currency depreciates in within the same country, one cannot get away with blaming budget deficits or current account deficits. The problem with excess credit in the note-issuing bank is clearly spotted.

Exchange controls can be eliminated after the powers to create monetary instability are taken away, and economic freedoms restored.

That is why countries like Estonia, Lithuania, Latvia, UAE, Singapore and Hong Kong where macro-economists were defeated in a crisis, figure on the top of the list of countries with economic freedom rankings.

By calling monetary instability ‘macro-economic instability’ Western post-1920s inflationists have managed to deflect the blame away from themselves, and prevented the problem from being ever solved.

If the legal tender monopoly is taken away from macro-economists, the people will have freedom to use other types of currencies.  

The central bank’s ability to depreciate the currency and blame its victims will diminish as foreign currencies progressively push out rupees as the circulating medium.

Salaries are low in Sri Lanka and people leave for jobs in currency-board-style regimes in the Middle East in Saudi Arabia, UAE or Qatar, due to the central bank destroying the rupee and denying monetary stability for this country to grow and create jobs, with unworkable operating frameworks and high inflation targets.

It must be noted that under current central bank Governor Nandalal Weerasinghe, the rupee has appreciated and not depreciated.

It is not an accident but purely due to the monetary policy followed by the agency under him.

The currency appreciation has prevented further burdens falling on the people, including through energy prices, but that is not widely understood.

Upending Economics

Ironically, it was the British Currency School in the classical tradition, that created the money monopoly of the Bank of England, though with very good intentions.

The Bank Charter Act was an attempt to impose restraint on note-issue banking from outside.

However, with the fixed policy rate, the opposite happened after the First World War and the US Fed invented open market operations.

Sri Lanka’s monetary law in particular and the operational frameworks of IMF-dependent reserve-collecting central banks with outright purchases of domestic assets in general, have been developed as if Ricardo, Hume, Cantillon and Adam Smith never existed.

It is a testament to the success of the ideology of Anglophone universities and perhaps the IMF, that such note-issuing banks continue to exist and spurious claims like exchange rates are ‘market determined’ are widely believed.

That the exchange rate is the outcome of the success or otherwise of the monetary anchor pursued by the central bank through its operational framework is no longer widely known.

If Robert Torrens, or Ricardo or Hume were alive today and heard what was being peddled as ‘economics’ in their name, or through Sri Lanka’s IMF backed monetary law, they would be shocked to the core.

They would be surprised to know that people who claim to be ‘economists’ are in fact following the doctrine of John Law, who was among the most well-known persons who proposed the bureaucratic interest rates enforced by printed money or what is now called the policy rate.

Sri Lanka’s macro-economists had inveigled President Ranil Wickremesinghe to handed them the power to conduct monetary policy (read print money) and generate inflation of 5 percent a year with room to push up price rises to 7 percent.

Related Sri Lanka central bank gets political nod to create up to 7-pct inflation

Legislators had already been misled by inflationists into passing the new IMF backed monetary law to target potential output (print money for growth) in the style of John Law, so positive inflation targeting was a piece of cake.

If the IMF knew how to actually draw up a monetary law to provide stability, with a proper operational framework, it would go out of business in two Fed cycles with no customers to bailout.

The Macro-inflationists

Positive inflation targeting denies private sector (capitalist) productivity growth to the people, making them mis-trust private sector led activity, liberal democracy and bring nationalists and other fringe elements to power in the high inflation period or the stabilization that follows.

And whenever there is high productivity growth after a period of stability, central banks fire an asset asset price bubble in trying to reverse it, as happened in the 2008 financial crisis/housing bubble.

If the power of ‘monetary policy’ (injecting liquidity to inflate bank reserves) was taken away from macro-economists this country will have a stable currency and inflation between 1 and 3 percent.

If Sri Lankans have been misled by macro-economist into an inferiority complex and;

a) cannot imagine that they deserve an inflation rate better than Americans, the Swiss or the British,

b) or they do not know that before 1977 Sri Lanka also had the same inflation as Western nations,

c) or cannot relate to Dubai or Saudi Arabia (an even better fully orthodox fixed exchange rate regime existed during British rule),

d) at least they would be able to relate to the Maldives or Cambodia.

The monarchies in GCC countries have remained due to the stability coming from the fairly hardened peg, unlike Iran’s Shah (and indeed Prince Norodom Sihanouk) who was driven out with the help of inflation around the same time.

In the late 1960s when Sri Lanka first started to go to the IMF was when the likes of Paul Samuelson started to corrupt US policy in the heyday of the Phillips Curve, even Malaysia which had a good monetary authority which worked almost like a currency board, saw a second communist uprising.

To give stability to the poor and prevent their flight to countries with monetary stability to seek jobs, the inflationist and interventionist ideology spread by macro-economists and the International Monetary Fund since 1978 in particular has to be defeated.

Sri Lanka’s new monetary law the agreement with Ranil Wickremesinghe shows that the Phillip’s Curve is alive and well, albeit under another label.

Third Rate Discriminatory Monetary Anchors

Before 1978, the IMF did not discriminate between rich countries and less rich countries allowing nations like Sri Lanka to have worse monetary anchors than Western nations.

The big challenge is to defeat the ideology of Progressive Saltwaterism and the relentless drive by the IMF to give central bank powers more and more powers to conduct ‘monetary policy’, essentially tools to print money to mis-target rates for interventionist purposes.

There are several ways to absolutely block the macro-economists from triggering external instability. The easiest is currency competition or dollarization, the other is a currency board.

Friedrich Hayek called currency competition the denationalization of money, but it is actually the emasculation of the Harvard – Cambridge macro-economics and to take away their powers to push up inflation, depreciate the currency and otherwise create monetary instability.

The advantage of monetary stability to politicians would be that they can remain in power for multiple terms and do reforms to boost growth, continuously.

The advantage to the people would be that interest rates would fall to around 5 percent and they can also be free of exchange controls.

The stability will also bring in foreign investors and real incomes would rise over time.

No good budgets with bad money

Bad money, in addition to destroying the finances of individuals, also destroys governments budgets. There can be no good budgets with bad money.

Under dollarization or a currency board, budget deficits would fall and the debt to GDP ratio would be low, at 50 percent or below as is seen elswhere, from GCC countries to Bulgaria to Cambodia to Hong Kong to Pananam.

Without central banks, it is difficult to borrow heavily and the need to give subsidies also goes away. Without a depreciating currency, domestic savings are good enough for investment and the need to borrow abroad is less.

Cambodia had very high debt as the currency collapsed in 1989 amid a coup and the country market-dollarized without any outside help.

The coup leader Hun Sen, was a former associate of Polpot (who abolished money after high inflation).

The country is now growing at 5 to 6 percent a year (Cambodia grew faster in the initial years after dollarization) getting several billion dollars of FDI and is moving from apparel into electronic items including solar panels, riding the renewable energy wave amid the stability brought by dollarization and currency competition.

As a result of dollarization (or currency competition) the central bank cannot conduct monetary policy like in Sri Lanka to (print money to cut rates and generate high inflation and depreciation) effectively.

The IMF remains relentlessly opposed to the status quo and stability and is trying to de-dollarize and give a few unelected economic bureaucrats the power to destabilize the nation again.

“Cambodia has experienced rapid growth over the past decade, outpacing many regional peers. Growth was driven by industrialization, increased foreign direct investment, and a surge in exports, particularly in labor-intensive manufacturing,:” the IMF said in its latest staff report on the country issued in January 2024.

“The Cambodian economy is continuing its recovery from the pandemic, with a GDP growth of 5.2 percent in 2022, driven primarily by manufacturing exports, especially in garments and electronics. Tourism saw a continued rebound in 2023, reaching close to 80 percent of pre-pandemic tourist arrival levels by September 2023.”

“Inflation, after dropping significantly in H1 2023, has since rebounded,” the IMF claims.

The IMF’s ‘rebounded’ inflation is a little over 3.0 percent.
.
“The fiscal deficit is projected to widen in 2023 due to temporary increases in spending and is expected to decrease in 2024,” the agency also claimed.

However, budget deficits are also around 3 to 4 percent. The debt to GDP ratio is 34 percent, a trend that is common in countries with currency boards or are dollarized where monetary policy is constrained. Currency unions with liquidity tools do not have the same benefit.

The IMF however wants to give more power for ‘monetary policy and enhance “monetary
transmission and support de-dollarization” by “modernizing” monetary and FX policy operations.

“Establish an effective interest rate corridor and develop an accurate liquidity forecasting framework. Strengthen the market determination of exchange rates and improve operation of FX intervention procedures.”

The entire benefit and stability Cambodia got from the denial of monetary and fx policy discretion to economic bureaucrats from 1990 will be lost if Cambodia become increasingly de-dollarized and its monetary policy is ‘modernized’ based on various inflationist fads developed in the US and elsewhere and transplanted by the IMF as potential output targeting was planted in Sri Lanka eventually taking a country without a war to default.

Eventually Cambodia may return to its 1970s and 1980s fate or to the fate its unfortunate neighbor Laos, where domestic and IMF bureaucrats have full ‘monetary and fx policy’ discretion and is a basket case.

Then China, a top lender to Cambodia, will be blamed for default.

Unlike an Inflation Index, a Nominal Exchange Rate Target Cannot be Fudged

By constraining monetary policy discretion of bureaucrats and forcing them to maintain the exchange rate – which is a transparent price unlike inflation indices or the REER and cannot be fudged by changing the base – stability can be given for growth and prosperity.

Maldives also has low inflation around 1 to 3 percent without macro-economists to do complicated ‘monetary policy’.

The Maldives Monetary Authority however does print money from time to time and get into trouble. When the peg breaks, inflation soars.

Any technical assistance from the IMF to engage in more aggressive monetary policy would land the country in default.

Maldives actually has borrowed too much, from China and also some of its Middle Eastern friends during about two decades of loose money starting from the Greenspan – Bernanke bubble when easy dollar borrowings were possible.

What policy-makers and politicians have to understand is that denying monetary stability by various in-vogue third rate monetary regimes is not a foundation to base a policy framework.

But from 1950 onwards that is what happened to this country.

To be fair, current Central Bank Governor Nandalal Weerasinghe is doing a good job.

But the relaxation of standing facilities, which do not have a penal rate in Sri Lanka unlike in stable countries, is a key tool for banks to overtrade and goes against prudent policy. It could be the first step in the next default, as targeting call money rates in the middle of the corridor and narrowing the policy corridor was in the current default.

However, the way to achieve stability is not to depend on personalities but to constrain discretionary policy by law.

That is to either have a very low inflation target like 2 percent which has been mostly successful elsewhere, or a hard peg or currency competition through dollarization.

All of these have worked. Where had a 7 percent inflation target worked? This country ran into a default without a war with the room given for open market operations and outright purchases with a 5 percent inflation target.

A 2-pct Target is Better, But Also Has Problems

This columnist is fully supportive of a 2 percent inflation target, but it is not as good as earlier anchors of the classical period or what is advocated by Austrian economists, which drove the policies of Germany after World War II, and made it a stable export powerhouse.

Now Germany is also in trouble with the ECB.

It must be noted that the constant price level, which also denied private sector productivity growth to the poor, was advocated by the Chicago school, at a time when post-Keynesian policy was in full swing in the 1960s, with completely un-anchored policy, leading to the eventual collapse of the gold standard.

Austrian economists warned that even a constant price level would also lead to a boom and bust scenario if there was a capitalist productivity boom, coming after a period of stability, which allows research and development.

“The long-run tendency of the free market economy, unhampered by monetary expansion, is a gently falling price level, falling as the productivity and output of goods and services continually increase,” explained US economist Murray Rothbard in 1971 in the dying days of the Bretton Woods.

“The Austrian policy of refraining at all times from monetary inflation would allow this tendency of the free market its head and thereby remove the disruptions of the business cycle.

“The Chicago goal of a constant price level, which can be achieved only by a continual expansion of money and credit, would, as in the 1920s, unwittingly generate the cycle of boom and bust that has proved so destructive for the past two centuries.

This was graphically demonstrated after Ben Bernanke misled Alan Greenspan to try and reverse private sector productivity growth from 2000, and kept rates near zero, firing an 8-year Fed cycle (also enabled by core-inflation which discounted commodity prices), leading to the housing bubble.

In the Great Moderation (Volcker/Greenspan) period, gold prices fell to 800 to 484 dollars, free trade was accepted, East Asian poverty fell under fixed exchange rates and largely deflationary policy (reserve collections).

In a reserve collecting peg forex troubles emerge before the asset bubble.

The low US interest rates in the run up to 2008 bust as well as quantity easing that followed is one reason for bondholders and China to finance unstable countries with dollar credits. (Sri Lanka’s collapse in new sovereign default wave is not really China’s fault: Bellwether)

In the wake of these monetary blunders not only is Sri Lanka in trouble, but also the US, showing how bad money leads to bad budgets once again.

At the moment the central bank is providing monetary stability seen in the exchange rate and inflation, allowing a battered, long suffering people to raise their heads.

It is not clear when inflationary rate cuts will start. Already 2026 bonds are being bought outright.

Sri Lanka has gone through easy money booms, involving private credit surges financed by central bank credit to boost growth, and the resultant forex shortages, tightening of exchange and import controls, all too often since the agency was set up in 1950.

That Sri Lanka cannot get away from the cycle of inflationary rate cuts, and cannot end exchange or trade controls, is a mute testimony to the false monetary doctrine that is dogging this country and rest of the ‘third world’ that is economically backward.

The IMF is good at imposing stabilization programs, by rate spikes, but is unable to stop the next crisis, or the generation of poverty from currency collapses or drip-drip-drip depreciation, due to flawed regimes it peddles, that encourage money printing for growth, now called potential output targeting.

Monetary Instability

Stabilization programs do not really ‘stabilize the economy’, but involves slowing economic activities steeply to restore the lost confidence of a currency monopoly.

It impossible for a country to grow steadily without monetary stability.

Extensive dollarization and currency competition which reduces the ability of a central bank to conduct monetary policy (print money), can reduce the chances of a next currency or economic crisis, better than any IMF program can.

Meaningful monetary reform, which eliminates potential output targeting (printing money for growth) and money and exchange conflicts inherent in a non-floating ‘flexible exchange rate’ which has been unfortunately legalized in the new monetary law, can eliminate future crises and the need for stabilization programs.

Whether it is drip-drip-depreciation or steep currency collapses, conditions are created in the country of their birth by the bad-money-central-bank to make it impossible for millions to make ends meet and drive them into currency-board-like regimes in the Middle East or East Asia, to the Maldives, or to other low inflation single-anchor, clean-floating countries, with higher real wages.

In the countries to which Sri Lankans leave their homes for, central banking is restrained by tighter laws and depreciation is legally difficult or impossible for potentially inflationist economic bureaucrats or the IMF to engineer.

IMF rhetoric peddled to countries without a doctrine of sound money, that currencies depreciate due to ‘economic fundamentals’ which must be matched by a flexible exchange rate, have no effect on countries where there are legal restraints against money printing.

“Selling FX should be limited to disorderly market conditions and not prevent the exchange
rate from moving in line with economic fundamentals,” the IMF told Sri Lanka in the December 2023, staff report.

All such Anglo-American inflationist talk disappears without trace, when faced with tight laws restraining bureaucratic rate cuts found in Dubai, Saudi Arabia, Qatar, Oman or indeed Hong Kong, who send money to the victim nation.

The sad truth is that, it is not ‘economic fundamentals’ that drive the value of a currency produced by a state-run central bank.

It works in the opposite direction, with the overproduced bad money of the SOE, which has been given a legal monopoly by misled politicians, driving countries into crisis and blasting economic fundamentals in to smithereens.

Who recovers first?

The consumers whose purchasing power recovers first, are the families of the people who have fled the country with the 5-percent-or-higher inflation targeting, ‘flexible exchange rate’, central bank, without a clean float.

In remittance receiving countries which cannot create jobs – or the real wages of whatever jobs are generated are destroyed with a 5 percent inflation target and a depreciating flexible exchange rate – a significant part of the labour force has been driven out by previous monetary instability based on similar ‘impossible trinity’ IMF-backed monetary regimes.

Currency crises – especially in peacetime – do not appear out of the blue, but are necessary outcomes of persistent beliefs in spurious monetary doctrines.

Therefore, there is an existent community outside the country, whenever rate cuts trigger the latest crisis. There is an ecosystem of job agencies, a network of friends and family who will help get into these countries through legal and informal means.

Most clean floating countries usually have tight work permits and visas, making illegal entry more likely.

In periods of extreme instability and deployment of macro-economic policy, there will also be boat people and people smuggling activities as well.

It is a shame upon all Saltwater-Cambridge economists to see this happen in a country at peace, as their stimulus mania (specifically printing money to target potential output under a flexible inflation targeting now), to see boat people.

Unlike wage earners in other sectors, remittance families get dollarized earnings from their family members outside, and their real incomes adjust automatically.

Sri Lanka’s Monetary Board or Monetary Policy Board cannot cut their wages impoverish them since their wages are denominated in a currency issued by a better central bank or currency board like regime, and not Sri Lanka rupees.

Farmers Also Recover

As long as there are no price controls – like those imposed on eggs leading to the closure of layer chicken farms – vegetable and grain prices go up with depreciation or inflationary policy.

Small holder tea farmers, whose green leaf prices are linked to export prices will also see incomes go up to pre-crisis levels.

Food is generally an item that people will consume even when incomes fall, so farmers will tend to get pre-crisis incomes quicker.

Farmers are also getting a boost from El Nino rains, this year, which is a silver lining.

However, next year conditions are less certain for farmers. If there is a bust in the US, commodity prices may also fall further.

Tourist Sector

If there are no price floors – minimum room rates – to drive out tourists to other countries in East Asia, tourism is also a sector that recovers with dollar incomes.

There is usually money to be paid as service charges or wages. Wages take time to adjust, but may be faster than other sectors.

Those engaged in transport and operation of small hotels and are business owners, will be able to fill their hotels and taxis – unless there are minimum room rates to worsen the off season.

The exodus of workers from the sector, where progressive taxes have also taken a hit on real wages, show that the recovery in wages is below pre-crisis levels. But a good season will help.

However small hotel and restaurant owners will get pre-crisis incomes as long as occupancy is maintained. A part of their incomes, especially in larger hotels with debts, will go to settle bank loans.

Wage Earners

The hardest hit are wage earners in other sectors, which are usually the last to recover. They are fully in the grip of a bad-money central bank.

Many small businesses, especially highly leveraged ones, will go down in the stabilization period when real incomes of people fall and their sales also drop in proportion.

Among the wage earners, the higher income categories are the first to get used to the high prices after depreciation and begin to spend.

This time, progressive taxation had also taken a toll on the recovery through that path.

However, in some of the larger companies, salaries have been raised to adjust for the higher income tax.

When income tax rates are raised – as opposed to giving an inflation adjustment to account to bracket creep – recovery to pre-crisis levels takes time.

It may take up to two years or more for prices and wages to adjust to a currency fall.

Typically, in bad-money-central-bank countries, by the time their wages recover, the agency would again be engaging in currency depreciation, would have depreciated some more, making workers either engage in strikes, bloating the ranks of unions or leave the country to other regions with greater monetary stability.

Even in the year that their salaries make a full real recovery, they are vulnerable to the seductive voices of economic charlatans of the right (nationalist) or the left, which will hurt the government in power. It may be moderated by who was responsible and who is carrying out the stabilization program.

Construction

The construction sector will be one of the last to recover. Construction and capital goods sectors are the ones that gain most from easy money (rate cuts from inflationary open market operations).

With outright purchases of bonds from the banking sector or term money injections, a flexible inflation and output targeting central bank or even a clean floating one will make it possible to finance projects that would never have been able to, if only real deposits were available for credit.

Since money created to cut rates and target potential output will end up as mal-investments, capital goods industries will take a hit when the bottom falls out of the market.

The current troubles in China, and the US housing bubble, that led to quantitative easing are also reflections of the same phenomenon.

The phenomenon was very well explained by Austrian economists.

“The Austrian theory further shows that inflation is not the only unfortunate consequence of governmental expansion of the supply of money and credit,” explains US economist Murray Rothbard, a strong critic of the Federal Reserve’s policy errors.

“For this expansion distorts the structure of investment and production, causing excessive investment in unsound projects in the capital goods industries.

“This distortion is reflected in the well-known fact that, in every boom period, capital goods prices rise further than the prices of consumer goods.”

So, there are also bad loans amid the downturn.

“The recession periods of the business cycle then become inevitable, for the recession is the necessary corrective process by which the market liquidates the unsound investments of the boom and redirects resources from the capital goods to the consumer goods industries,” notes Rothbard.

In 1980, when the unfortunate J R Jayewardene was opening the economy from the 1970s closure, and the central bank was triggering a crisis in 1980, Singapore’s economic architect Goh Keng Swee said, building materials was the fifth item to watch.

The first being the Treasury bill stock of the central bank where all troubles start, followed by foreign reserves (which will fall in proportion to the money printed very quickly), the exchange rate (which will also respond fast) and the inflation index. By that time the index responds, it may be too late.

READ How Sri Lanka rejected Singapore monetary advice and politicians, people paid the price

Default and Caution

The resilience of a long-suffering people will always lead to a recovery from an inflationary rate cutting crisis.

But there are several threats to the cyclical recovery.

Sri Lanka’s debt is being restructured and market access is expected to be restored after an ISB restructure, if all goes well.

Sri Lanka’s sovereign default has dealt a blow to confidence. Before the 2022 default, Sri Lanka’s flawless debt repayment record did inspire some confidence.

Having said that, there is usually no shortage of bond buyers for defaulting countries like Argentina, especially when US rates are low.

Repeated defaults do not seem to deter lenders, since default has become fairly commonplace in the wake of post-1980s intensive currency crises.

It may well be the case in Sri Lanka. However, it is also likely that ISB holders and other lenders who give credit lines to banks will be faster off the mark in the next cycle of flexible inflation targeting driven instability.

Sri Lanka will be more vulnerable to external default in the future as some of the lenders will remember what happened in 2022.

Stock market investors will also remember how they were locked in and were unable to remit money out.

Rupee bond holders also seem to be much more cautious now.

Sri Lanka’s recovery can also be slowed by reserve collections where part of the inflows are directed to the US or other reserve currency countries.

In East Asia deflationary policy has led to large reserve collections (below the line capital outflows) and even current account surpluses (total outflows), but the confidence from currency stability tends to bring in more capital and FDI.

As long as there is monetary stability and liquidity is not injected to suppress rates and bust the currency, consumer spending will recover and people’s lives will improve and the economy will grow as a result.

Eventually there will be a need to expand capacity. It is not just easy-money credit that drives growth.

External Threat

A big threat may come from a US and Western economic disruption.

Economist Steve Hanke, who accurately predicted Fed’s inflation based on money supply movements, among other indicators, has said a steep recession is ‘baked in the cake’ based on current broad money movements in the US.

In the last few years, a big volume of money printed by the Fed went into government debt, not housing mortgages like in the 2008 crisis.

People largely spent pandemic cheques, where the government was the borrower and not just private investors like in the Great Depression, when the fixed policy rate busted a country with a fairly benign situation after World War I ended.

A default of US debt seems unthinkable, but the country’s credit is weaker than ever before with downgrades. Confidence is fickle and can be lost in a hurry. The US political system is in disarray.

The effects of US and general Western disruption are already being seen in Sri Lanka’s export numbers, even though a recession is not official in those countries based on econometrics and definitions as yet.

An unusually bad disruption of the US and Western economies are possible whenever monetary ideologies deteriorate as was seen in the 1970s, in 2008/9 and the 1920 Great Depression.

Multiple Mandate Threat

The biggest threat in Sri Lanka, as always, is internal. The ‘flexible exchange rate’ or depreciating soft-peg and potential output targeting can destroy money here and de-stabilize the country within and on top of US problems.

The inflationist monetary regime, currently peddled by the IMF to unfortunate countries without a doctrinal foundation in sound money, can trigger an external crisis as soon as the economy recovers, as it had done before.

The 5 plus 2 percent inflation target is a big threat. It gives the leeway to the central bank to trigger crises easily with room to spare. After the war crises were created with a 5 percent target.

If the central bank can maintain monetary stability without printing money, a chance will be available for battered people to raise their heads.

However, the prospects are dim. In monetary policy statements, mentions of potential output figures larger than life.

“The Board arrived at this decision following a careful analysis of the current and expected developments in the domestic and global economy, with the aim of achieving and maintaining inflation at the targeted level of 5 per cent over the medium term, while enabling the economy to reach and stabilise at the potential level,” the last monetary policy statement said in the second sentence, rivalling Powells reference to employment, indicating that there is a very strong belief in a dual mandate and the supposed effectiveness of money printing (macro-economic policy) for growth, despite the carnage wrought in the past few years.

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The central bank also paused rate cuts. This is good. The rate cuts were not inflationary, and general interest rates have fallen due to low private credit, improvements in government deficit and state enterprise profits.

The exchange rate is also volatile but not depreciating so far. Exchange rate stability is an overt reflection of monetary policy.

If the central bank does not try to sell large volumes of Treasury bills above the dollar purchases and re-finance them overnight, rates will fall faster. Allowing some excess liquidity from dollar purchases to remain – while private credit is weak, will bring down rates faster.

There is no need to buy 2026 bonds and inject long term money.

But to keep the market marginally short is a good idea, especially as credit recovers.

If stability is provided for a few years, rates will fall as real wages and savings recover as seen in countries like China and hard pegged countries, Sri Lanka will never see a default again.

Because this country like most Asian nations has a high private savings rate it is easy to collect reserves or repay debt.

As mentioned before stabilization periods are also fertile grounds for nationalism to rear its head, despite economic conditions being not that bad as earlier.

It has happened in many countries from Nazi Germany to Sri Lanka.

When nationalists or authoritarians trigger a crisis, and more liberal reformists come to power, countries can progress.

The current President did not create this crisis, so like the Ordoliberals of post-World War II who inherited a messed up economy from the nationalists, there is a chance, provided stability is provided by the central bank.

As the Germans said, stability may not be everything but without stability everything is nothing.

Critics of the IMF slam the agency calling it neo-liberal (whatever that is) but it is definitely not liberal as was understood by classical liberals. There can be no freedom for the people with unsound money.

The IMF was never really liberal as it was a product of Harvard-Cambridge interventionists, but before the collapse of the Bretton Woods in 1971 and widespread depreciation promoted from the late 1970s and 80s, the agency supported a sounder form of money based on its founding principles.

With inflationists’ hands partly tied by a commitment to specie-linked tighter currency pegs (maximum of 10 percent devaluation after mis-firing macro-policy) the poor and marginal income brackets were not harmed as much by collapsing un-anchored ‘flexible’ exchange rates as they are now.

Central banks before the collapse of the Bretton Woods and the IMF’s Second Amendment to its articles had limited legal room to steeply depreciate currencies and tip large sections of the people into poverty and countries into default.

As a result, monetary and exchange rate policies through which economic bureaucrats bust currencies now, were constrained to some degree. The main purpose of the Bretton Woods and IMF when it was set up was exchange rate stability and free trade, not depreciation as now.

According to the Article I of the IMF, the purposes were

(iii) To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation.

And

(iv) To assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of world trade.

The original Article IV did not permit depreciation of currencies more than 10 percent, helping maintain some semblance of good money, as well as social cohesion.

According to the original Article IV:

Section 5 (b) – A change in the par value of a member’s currency may be made only on the proposal of the member and only after consultation with the Fund.

Section 5 ( c ) (i) … does not exceed ten percent of the initial par value, the Fund shall raise no objection.

And under Section 06,

If a member changes the par value of its currency despite the objection of the Fund, in cases where the Fund is entitled to object, the member shall be ineligible to use the resources of the Fund unless the Fund otherwise determines.

Then how did this agency, which withheld support if a currency was depreciated more than 10 percent, end up presiding over programs with the central bank monetary laws that permitted and encouraged horrific currency collapses, triggering social unrest, civil wars, mass poverty and mass migration after 1978 in particular?

It happened in the absolute confusion that gripped the policy makers in countries that drove the Fund following the break-up of the Bretton Woods system, when they were clueless without a credible anchor for money.

But the collapse of the Bretton Woods system and the Great Inflation of un-anchored money goes back the origins of the Fund itself, which was based on Harvard-Cambridge flawed doctrine, that was in fundamental conflict with monetary stability, as well as being prey to shifting fads of the day.

Roots of Illiberalism

The roots of illiberalism go back to the foundations of the Bretton Woods system and the IMF.

As the IMF was set up by the US Treasury’s Harry Dexter White and John Maynard Keynes of HM Treasury (the Bretton Woods was mostly the White Plan not the Keynes one), the agency is necessarily driven by Saltwater-Cambridge monetary confusion that led to collapse of the Bretton Woods and Great Inflation.

The joint statement issued after talks between Keynes and White (and 30 experts) can be accessed at this link.  (https://www.elibrary.imf.org/downloadpdf/book/9781451972511/ch006.pdf)

After the bureaucratically fixed policy rate was devised by the Fed, which led to the Great Depression and later infected the Bank of England, many countries went off the gold standard as their economies went through a cyclical recovery in the 1930s.

Unlike the US, which had its banking system shattered, and Roosevelt’s New Dealers engaged in vicious interventionism scaring the living daylights out of investors with ad hoc policy changes like in Sri Lanka, other countries were not in the same position and recovered fast. (See: Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War – Robert Higgs)

The UK went off the gold standard in 1931 amid problems in Germany which led to capital flight. Keynes cheered the inflationism and discretion trumping rules as the pound fell and then stabilized.

White was himself a Harvard educated New Dealer therefore by definition an illiberal, who was further suspected to have links with the Soviet Union. USSR eventually did not join the IMF though White was willing to make concessions, over its gold contribution and voting rights.

Keynes also wanted to keep exchange controls longer than the original 3 years proposed as the UK was expected to mis-target policy rates.

But Bretton Woods and IMF was based on a liberal idea

Despite having its roots in illiberalism, monetary confusion, the Bretton Woods itself was based on a fully liberal idea of having free trade and some semblance of monetary stability which had been shattered by the fixed policy rate in the 1920s.

The architects of the post-World War II monetary order wanted to stop the devaluations that took place in the 1930s as the fixed policy rate infected countries while some like the US did it deliberately.

A key US politician with liberal ideas was Secretary of State Cordell Hull, a Southerner who opposed protectionism.

Hull’s ideas not only led to the United Nations but also to the WTO.

Classical liberals had always maintained that free trade was a key tool to avoid war, based on irrefutable logic that is too involved to go into now.

Hull in fact led the US delegation to the 1933 London Economic Conference which sought to stabilize exchange rates. Roosevelt opposed the plan eventually.

The illiberal inflationist Keynes who had cheered the float of the pound, said Roosevelt was ‘magnificently right’.

The US dollar which was not under pressure due to the depression was deliberately devalued by Roosevelt. The Supreme Court upheld the decisions, despite a constitutional requirement to coin money. Recall Sri Lanka’s Supreme Court which nixed a plan to ban provisional advances.

The Cost of the Inflationist Bureaucratically Fixed Policy Rate

As a result of bad monetary policy, the UK was weakened after World War II and had no reserves and little gold left.

It was just deserts for Keynes as he had to pay dearly for his policies implemented in the UK including after the War ended.

The US was still on the gold standard in the 1940s and he had to knuckle down before Dexter White and have his idea for a ‘Bancor’ and international clearing union rejected.

The UK owed money to the Ceylon Currency Board and the Reserve Bank of India. India, which was one of the countries in the original 44 in the Bretton Woods conference, wanted the issue of ‘blocked reserves’ taken up.

There were very few people in 1944 who knew how to run a self-correcting central bank. The French knew and submitted a plan. It was rejected.

J Walter Kemmerer, a Princeton economist who had set up a number of self-correcting central banks including in Latin America and helped set up the Fed originally, without a fixed policy rate and based on the gold standard, also proposed a plan.

Kemmerer’s Latin American banks were later modified and smashed by arch-Keynesian Robert Triffin into Argentina-Sri Lanka style interventionist sterilizing central banks, leading to severe currency trouble and hyperinflation and those agencies becoming top customers of the IMF.

If they had accepted Kemmerer’s ideas, or even later the proven stability of German liberals who came to power after the nationalists were defeated by the Allies in World War II, the later monetary debasement which drove social unrest, civil wars, military coups and communism which spread like wildfire from the 1960s would not have taken place.

Millions would have been saved from death, rape and mass migration.

The Khmer Rouge would not have emerged and Cambodia would have been a stable country like it is under dollarization now.

The IMF itself would not have been needed.

After the collapse of the Soviet Union, countries with monetary instability are now largely ending up in military coups, not communism.

The Second Amendment

An obligation to maintain an exchange rate is the best check on the ability to conduct macro-economic policy, generally known as the lack of monetary independence.

After the US ended gold convertibility in 1971 and countries went to floating rates, the IMF changed the specie fixed exchange rate undertakings contained in its Article IV.

Countries could now depreciate more than 10 percent. Countries also no longer could use gold as an anchor.

The exchange rate is an anchor or a very transparent restraint on macro-economists’ ability to print money.

With its removal unfettered money printing and devaluations could be done by rate cuts and other means.

By sterilizing interventions or engaging in open market operations by repurchasing government debt to inject money, budget deficits could be blamed. As the currency depreciated, budgets and state energy enterprises went haywire, just like the financials of individuals deteriorated.

Sri Lanka devalued steeply after JR came and the country continued to destroy the rupee, until A S Jayewardene came and policy changed, albeit slowly and industrial strikes reduced.

The currency started to fall again rapidly after W A Wijewardene retired in 2011 and overt potential output targeting began.

Steep depreciations hit Latin America after 1980 which had similar central banks and market access, defaults began.

Newly re-opened Eastern European countries suffered the same fate.

These countries did not have clean floats unlike the US, Japan, Germany, Switzerland and Canada to name a few.

They were reserve collecting central banks with un-anchored policy. As they ran from crisis to crisis, repeated stabilization programs were put in place.

Pakistan’s rupee slid alarmingly within the IMF program and is still wobbling. Argentina is still sliding.

Stabilization Programs on Liberal Lines

Unlike IMF programs, stabilization programs implemented on liberal lines with strong controls on the central bank are once-in-a-lifetime affairs.

Unfortunately, there are very few Americans who know how to do this, due to the lack of a history of central banking or deep monetary debate and the proliferation of so-called Saltwater University money printing and interventionist ideologies.

A key post-Keynesian was Alvin Hansen of Harvard. Others include Paul Samuelson from MIT.

A small group of universities led by Chicago where Hayek and later Friedman taught, know how to control central banks.

Other than Kemmerer, who died in 1945, only a few Americans have stabilized countries for a long period.

Joseph Dodge, a banker who worked with the Austrian economists and Ordoliberals (Ludwig Erhard) in the stabilization of West Germany also stabilized Japan at an exchange rate of 360 to the US dollar in 1948.

This was after Harvard types nearly destroyed the country with a central bank financed Reconstruction Development Bank which sent inflation soaring to triple digits in peacetime.

Korea was similarly de-stabilized by US economists with the Hwan currency and people starved until a halfway decent won was re-built in 1960.

Both Japan and Germany became export powerhouses and remained stable in the Bretton Woods period and their currencies appreciated against the US currency after the dollar collapsed and floated in 1971.

Another country that a US official helped decisively was Saudi Arabia. The Saudi Arabian Monetary Agency was set up on currency board lines by Anthony Young, who learned a lesson in the mis-use of a full central bank in China which led to communism. But that is another story.

Once in a Lifetime

Japan also underwent a stabilization program soon after the Meiji restoration in the late 1880s when the Bank of Japan was set up and other money printing central agencies were abolished and the world’s first mass privatization was done by then Finance Minister Matsukata Masayoshi.

The French Franc collapsed in the 1950s and by the end of the decade the country was mired in exchange and trade controls and the Algerian crisis was in full swing.

Finance Minister Antoine Pinay and Jacques Rueff, an ‘anti-Keynes’ economist, presented a stabilization plan, re-worked the new Franc after a devaluation and removed all trade controls, allowing France to meet free trade commitments under the European Economic Community.

The Pinay-Rueff stabilization plan made France a strong country again with a strong currency and allowed President de Gaulle to tread an independent path from the US when he wished. Stability held until shortly before the turmoil around the Bretton Woods collapse.

If a country does not want to go back to the IMF, it cannot follow Fund advice on central banking, which involves depreciation and more depreciation and instability and a new stabilization program.

The UK had exchange controls and instability until Thatcher with the intellectual backing of Friedrich Hayek himself, as well as Milton Friedman, stabilized the Sterling after high inflation and two back-to-back IMF programs.

When Steve Hanke fixed Bulgaria or Estonia, they stayed fixed. Once the monetary authority’s activism is constrained, other reforms can be done at leisure. Successful reformers will come back to power.

Japan’s Finance Minister Hayato Ikeda, a liberal who firmly believed in fighting inflation was once forced to resign after saying that even if five or ten small businessmen commit suicide it cannot be helped. He later became Prime Minister.

Stabilization programs are painful and should be once in a lifetime affairs. To stop them, the root cause, which is flexible central banking, should be blocked with strong rules which stop discretion or flexibility.

No Awards for Illiberal Recidivism

But that does not happen with the monetary reforms as advocated by the IMF. The flawed regimes trigger a crisis in a few years, a phenomenon that some economists call recidivism.

Sri Lanka’s new monetary law is a deeply regressive one which incorporates all the policy errors made after the civil war ended.

If the central bank is operated, as intended, to target potential output with printed money on top of monetary and exchange rate policy conflicts, a second default is inevitable.

The post-war near hyperinflation in countries under US influence like Japan (before Dodge line stabilization) came from the advice of experts from the Economic Co-operation Administration, the agency that administered the Marshall Plan.

There is also another difference. Whatever their faults, White, Keynes and company did not prescribe a third rate monetary regime to some countries and single anchor regimes to themselves.

Joseph Dodge prescribed to Japan, a fiscal and monetary regime that was superior to the US and was based on the German model.

IMF on the other hand is prescribing third rate monetary regimes to countries like Sri Lanka, with 5 percent inflation, which have a proven track record of failure in Sri Lanka and Africa, while clean floats with 2 percent inflation (whatever flaws that has) are operated in the home countries of its architects.

Joseph Dodge was decorated with the Grand Cordon Order of the Rising Sun by Emperor Hirohito on the tenth anniversary of Japan’s postwar independence, on April 28, 1962.

If the IMF was liberal and it prescribed a sound monetary doctrine, whatever the critics say in the first two years, the country will stay stable and grow and the people will be grateful.

But due to the illiberal third-rate monetary regimes prescribed through its programs to countries in Africa, Latin America and Asia, and ad hoc taxation, which cannot make up for denied monetary stability, no one will give awards to the IMF or the politicians who follow difficult fiscal policies to stop crises coming from bad money.

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Notes:

IMF Article I Purposes

• (i) To promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems.
• (ii) To facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic policy.
• (iii) To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation.
• (iv) To assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of world trade.
• (v) To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.
• (vi) In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members.

———–

A hike in value added tax still leaves money in the hands of wage earners and others giving them the freedom to make economic decisions and spend.

A 3 percent hike in VAT to 18 percent is less damaging on the people than a 5 percent inflation tax, which the country’s inflationist central bank imposes on the people at a minimum.

It must be remembered that the central bank’s 5 percent inflation tax or currency depreciation through flexible exchange rate is imposed to on the very poor through higher food prices while foods are exempted from VAT.

Indirect value added taxes are collected after an economic transaction is made. Income and wealth taxes prevent a gainful economic decision from being made.

Value added tax however is somewhat complex for businesses to operate.

Thought retail businesses operate on cash, businesses that operate on credit will have to borrow 18 percent of revenue to pay the tax on the 20th of the next month.

Businesses operating on credit therefore will have to borrow to pay VAT encouraging false accounting or raising costs.

This may not be a problem in countries with legally controlled central banks with tight inflation targets, sound money and low interest rates, but it is problem in flexible inflation targeting countries where inflation and interest rates are high.

Giving Power to Rulers to Decide Through Income Tax

Capital consumption taxes like income taxes and wealth taxes transfers economic decisions to bureaucrats and the political class, and tends to mis-direct the economy.

The US, which is heavily focused on income tax has no VAT and small state level final sales taxes are found.

The IMF, perhaps due it US progressive (read socialist) or New Dealer origins may favour income tax like most socialists.

However, in Sri Lanka people are whacked with both income and value added tax.

All capital consumption taxes destroy investible resources which are then frittered away in bureaucratic current spending.

The very sudden tax hike, involving a low threshold, and no deductions, is also contributing to brain drain.

However, the heavily socialist thinking behind income tax – tax the rich – does not help anyone.

High progressive taxes were a feature of Roosevelts New Deal interventions – which delayed a recovery from the depression, as well as Hitlers program. The Social Market economy architects cut the marginal tax rate.

Post 1980 IMF programs which do not stabilize the currency unlike before the Second Amendment when the agency was less vilified but attempts other reforms, are supposedly based on Thatcher era reforms.

But Thatcher not only stabilized the currency (in parallel US also raised rates strengthening the dollar), reducing fuel and energy prices, helping public acceptance of the power sector privatization (but hurting coal miners).

Giving Freedom for People to Choose through VAT

A key reform was raising VAT while cutting income tax.

Unlike in Sri Lanka, Thatcher campaigned on cutting high progressive taxes and giving freedom for people to choose after they came to power.

This is how Thatcher’s finance minister, Geoffrey Howe boldly gave choice to the people on the street and a boost to economic decisions of the community vs the bureaucrats, hiking VAT and cutting income tax.

“We made it clear in our manifesto that we intended to switch some of the tax burden from taxes on earnings to taxes on spending,” Howe said in his budget speech in 1979, where the clarity of thought, reason and interconnected logic was worthy of any 19th century classical liberal.

“This is the only way that we can restore incentives and make it more worthwhile to work and, at the same time, increase the freedom of choice of the individual. We must make a start now.”

In the late 1970s the UK was also in the same position as Sri Lanka. High income taxes were hitting skilled workers.

In fact the ‘brain drain’ originally started in the UK during its period of monetary instability.
“The upper rates no longer affect only those on very high incomes,” Howe said.

“They apply – and Labour Members may find this surprising – not only to senior executives and middle managers in industry but increasingly to skilled workers, as well as to professional people and the proprietors of small businesses.

“These are the people upon whom so many of our hopes for initiative, greater enterprise and national prosperity must depend.

“Our long-term aim should surely be to reduce the basic rate of income tax to no more than 25 per cent.”
The basic rate is now 20 percent.

This column said before the IMF program started that Sri Lanka should go for 20 percent VAT and eventually 15 percent corporate income tax eventually (The Yellen Tax). If 15 percent tax is given for new companies the IMF cannot object since that is official US policy.

However spending must be brought down.

READ MOREWhat Sri Lanka’s IMF program should look like

Thatcher also raised the slabs to account for inflation. A five percent inflation target should lead broadening tax slabs.

Eliminate the Social Security Contribution Levy

In the next tax reform, the cascading social security levy should be eliminated and the VAT raised to 20 percent.

The SSCL should be eliminated simultaneously with the raising of VAT so that market prices will remain the same and the government will recoup some of the money lost from the cascading tax.

Charge VAT on Fuel and Electricity

Value added tax should also be charged on electricity and the turnover taxes the excise taxes on diesel and coal should be removed or reduced.

Fuel taxes are in the nature of road taxes and should not be charged from electricity. Import duties on fuel should not be passed on to exporters. Zero rating and charging VAT will eliminate the problem.

This will allow exporters to reclaim VAT on energy, making the country competitive.

As a result, industries will not have to be given a different electricity tariff.

Vat should not be charged on electricity while excise taxes on diesel remains. Import duties on coal should be converted to VAT.

Brain Drain and Dependents

Sri Lankan politicians and politicians look at East Asia with envy, but does not follow their policies either on central bank control, or taxes.

Countries in East Asia that have good monetary regimes and do not go to the IMF regularly tend to have low value added taxes (about 10 percent) and corporate tax rates (about 20 percent).

Anecdotal evidence show that professionals are migrating because they are unable to pay school fees and medical expenses in addition to being unable to make mortgage and lease payments.

In social media there are posts of migrating families seeking good homes for pets.

Though politician claim that people are taxed for education and health, income tax payers end up sending their children to private schools and they go to private hospital.

One way out is to give tax credits for dependents and housing mortages like in East Asian countries, whose policies IMF countries do not follow.

The state should be limited to 20-pct VAT

World Bank and IMF claims that 20 percent spending to GDP is not a problem should be rejected.

Sri Lankans know how the state was bloated due to giving jobs to unemployed graduates by both the JVP ideology and the Rajapaksa regimes which put them to practice.

After raising VAT to 20 percent and with income tax at 20 percent, the rulers will take about 40 percent of a persons’ income.

That should be enough for the rulers and state workers to survive.

The state should be limited to the taxes than people can pay.

The government should also impose a 2 percent inflation target on the central bank. Putting on inflation tax on top of VAT increases is an invitation to disaster.

The 5 percent inflation tax is to be imposed on the people every year. An annual 5 percent inflation tax is worse than a one time VAT hike.

However unless the central bank is restrained printing money for growth, preferably with an exchange rate target as it is simple and transparent, no other reform in taxes will either stop the out-migration nor investment driven growth. (Colombo/Nov08/2023 – Update IV)

By these actions, inflationists escape accountability for money printing or the deployment of inflationary policy to trigger monetary instability by cleverly transferring the blame to the victims, which include not only the general public but also politicians who lose office.

In order to escape Sri Lanka’s 73 years of monetary instability which started with the setting up of the central bank and frequent trips to the IMF, it is important to examine the truth or otherwise of these claims.

This is the first of a series that will attempt to show how countries suddenly started to experience balance of payment deficits in the last century in peacetime and various narratives stopped any correction.

These red herrings were not developed in Sri Lanka, but by Western inflationists as ‘macro-economic policy’ advocated by US post-Keynesians in particular, undermined the Bretton Woods soft-peg system and the last vestiges of the gold standard were shattered.

The mis-labelling of monetary instability as macro-economic instability was also one of the ways the victims of central banks were misled.

But the most enduring and oft-repeated false excuse given by these inflationalist working within and without what were effectively ‘independent’ central banks of the West was that the budget deficit was the cause of forex shortages and inflation.

In Sri lanka in the year the central bank triggers the currency crisis, deficits have been stable or barely grown nominally, indicating that very small rises in rates early under a wide policy corridor would have prevented a currency crisis.

On the other hand, deficits tend to grow steeply in the year the balance of payments was brought back into surplus through a stabilization program, which tends to slow growth, push up rates, and the debt to GDP ratio.

In the next currency crisis, especially if there is commercial debt, the country tends to default.

The Deficit Lie/Fiscal Dominance

The false narrative around deficits goes like this: politicians expand the budget deficit and the central bank is subject to de facto (by the large deficit by itself) and de jure fiscal dominance through operational dominance by politicians or Treasury officials blocking rate hikes.

There are two problems with this claim. One is that there is no data to support this claim, especially in Sri Lanka, especially after the end of the civil war.

The other is that Treasury Secretaries in Sri Lanka have almost always been ex-central bankers, therefore, it is a problem of economists and not politicians or the general public anyway. Politicians are clueless in third world countries and when they had a clue, they did not interfere.

A close examination of recent currency crises shows these trends. Some of these trends are also present in older crises before the civil war started as well as in many countries including Latin America that experience peacetime currency collapses and default.

Trend One: the deficit expands in the stabilization year when currency crises are eliminated and the BOP returns to surplus. This deficit apparently is not subject to ‘fiscal dominance’ either de facto or de jure.

Trend Two: In the year the currency crisis is triggered and money printing suddenly expands, the deficit to GDP sometimes falls and nominally the increase is small.

Trend Three: The money printed in the year that the central bank triggers crises is disproportionately higher than any nominal increase in the deficit, compared to the previous year when there was monetary instability. This is because central banks trigger BOP deficits not by printing money for the current year deficit, but by printing money to buy back government debt held by banks from deficits decades ago to target the call money rate initially and then sterilize outflows as panic sets in.

The Recent Crises

In the 2008 crisis, which happened in the middle of an intensified war and the Great Financial Crisis, some of these factors were present, but it was also driven by capital flight within a stable exchange rate, but monetary policy was tight.

In the 2001 crises, which also took place in the middle of a war also some of the characteristics can be seen, though the currency collapse was steeper.

This column is prepared to make some allowances for war, since, even in classical liberal days, private central banks like the Bank of England got into trouble in wartime. It also must be kept in mind that the country that did not print money or printed the least was usually the victor. But there can be no excuse for peacetime monetary instability.

The trend of expanding deficits in stabilization years holds true even in war years. In 2001 for example, when monetary stability was restored and reserves were re-built with a BOP surplus of 219.8 million US dollars, the deficit went up steeply from 9.5 to 10.4 percent of GDP.

The nominal deficit went up from 119.4 billion rupees to 146.7 billion rupees, yet money printing was reversed by 5.7 billion US dollars.

In 2009, a stabilization year, the budget deficit went up from 309.6 billion rupees to 476.4 billion rupees, yet the BOP was in surplus with higher interest rates.

In peacetime currency crises came in rapid succession as money was printed to keep rates down as the economy recovered.

The Crisis year

In the 2011/12 currency crises the central bank triggered a BOP deficit of 1,059.4 billion rupees without a war as the economy strongly recovered and private credit recovered. The deficit in the crisis year of 2011 went up only by 5.2 billion rupees from 445 billion rupees to 450 billion rupees.

This deficit could have been easily managed if interest rates were allowed to move up a little. But the central bank printed 184.6 billion rupees that year to keep rates down and effectively finance the private sector.

In 2015, however there was a substantial increase in the deficit due to Yahapalana salary and subsidy hikes, where an excuse can be made that there was de facto or otherwise fiscal dominance.

However, the central bank started injecting money from the third quarter of 2014 before that government even came to office to suppress rates. As the deficit went up by 238.3 billion rupees the central bank printed 80.4 billion rupees, according to the rise in credit to the government, which however did not tell the whole story.

In 2016, when the deficit was reduced by 189.2 billion rupees to 640.3 billion rupees, the central bank printed 183.0 billion rupees.

Then, in 2017, the stabilization year, the deficit went back up to 733 billion rupees or 93.2 billion rupees and the central bank reduced its credit to the government by 188 billion rupees. In terms of GDP also the deficit fell marginally.

In 2018, in another currency crisis year, the budget deficit went up by only 27.3 billion rupees but the central bank printed 247.7 billion rupees as massive amounts of money was injected to target the call money rate and then sterilize interventions when foreigners fled re-financing the private banks to buy the debt.

In 2018 as well as in other crisis years, the budget deficit could have been easily bridged by a 100 or 200 basis point rate hike and reducing private credit or boosting savings, as the difference in deficits of the two years show.

Instead of which rates were cut in that year, just like in earlier crisis years. As a share of GDP, the deficit fell from 5.5 to 5.3 percent of GDP in 2018.

In 2019, the stabilization year, the budget deficit went up to 6.8 percent of GDP but the BOP came back into surplus. In rupee terms the deficit went up to 1,016 billion rupees from 760 billion rupees, but 109.6 billion rupees in central bank credit was reduced.

It can be very clearly seen that the budget deficit was not the problem, for the external deficit in the previous year as it was lower.

No Escape under Data Driven Monetary Policy

Then what is the problem?

The problem is data driven monetary policy, or the belief that rates can be cut with printed money to get easy growth, when inflation falls.

In 2015 when the deficit went up, the central bank had no business cutting rates. The central bank was already printing money from the third quarter of 2014 and running forex shortages.

Yet the agency cut rates in April 2015 suicidally and injected money to target the call money rate claiming inflation was low.

Based on this argument it was justified in doing so under data driven monetary policy, where econometrics triumphed over laws of nature.

In 2018 it cut rates while the deficit was down. The excuse at the time was that fiscal policy was tight, therefore monetary policy must be loose to boost growth.

That is the time it was quite evident that Sri Lanka had no future. The central bank would print money whether the deficit expanded or narrowed. The people and the economy had no escape from monetary instability.

To suggest that Mangala Samaraweera or Eran Wickremeratne was putting pressure on the central bank to print money does not hold water. Harsha de Silva publicly asked rates to be raised.

Whatever the fiscal authorities did was not relevant, the central bank would cut rates and trigger currency crises as soon as private credit recovered.

And post the currency crises, 12-month inflation tends to fall around the same time as private credit recovers, giving excuses for a fresh round of money printing.

Why does all this matter?

There is a further complication for a reserve collecting central bank. To collect reserves, a country must finance the deficit of a third party reserve currency country.

If Sri Lanka buys US securities, then the American deficit is financed. Raising taxes and reducing the deficit domestically is not enough, domestic investment must be curtailed sufficiently to build reserves (finance a reserve currency country deficit).

So why does all this matter?

This matters because it shows why deficits and debt go sharply up in countries with bad central banks. The deficit and debt (including the rupee value foreign debt) go up for reasons that have nothing to do with fiscal policy.

While good fiscal policy is important, no amount of fiscal fixing will help if the central bank is triggering monetary instability and depreciating the currency, because repeated stabilization cycles will destroy growth and fiscal metrics.

The reason for spikes in bad loans in the private sector and bad fiscal metrics is virtually the same – it is bad money.

This is also important for another reason, which these columns have explained before.

Mistargeting of rates is the reason IMF programs fail in the second year. It is important because Sri Lanka is now about to make the same mistake again under data driven monetary policy.

This is what happens in peaceful Latin American countries and it is what happens in Sri Lanka and in all IMF countries.

Politicians in particular must take note.  Ranil Wickremesinghe and his ministers must not put pressure on the central bank to cut rates.

Already the writing is on the wall. Noises are coming about ‘high real interest rates’.

It is when private credit gains momentum that the real problems will begin. Under a flexible exchange rate, even a small pick up like in 2018 can create havoc.

The IMF itself has warned that the pace of reserve collection has slowed. And no wonder. The central bank started injecting money on a gross basis in May. From June the external sector started showing signs of instability.

But the IMF warning about reserve collections is disingenuous.

The IMF itself is at Fault

It is the IMF that promotes econometrics (data driven monetary policy and the monetary consultation clause that promotes money printing as soon as inflation falls) that go against laws of nature well described by classical economists to avoid balance of payments troubles.

The IMF suggests there is monetary financing. There was minimal monetary financing of the deficit, except after 2020. There is however ‘monetary financing’ of banks consistently (by repurchasing old bonds from prior year deficits), which is way higher than the deficit.

This mistake did not happen in classical days. Financing of banks (or discount houses initially) was through bills of exchange and it was clearly visible.

Hence classical economists, some of whom got themselves elected to parliament to bring laws against central banks, easily made the distinction between financing of ‘merchants’ and the ‘government or the King.’

Unlike the IMF or present-day economists of third world central banks that go for bailouts frequently, classicals had a deep knowledge of note issue banking operations.

As the data shows above, in the crisis year, the reason large volumes of money – much higher than the increase in the deficit is printed – is because the central bank is actually financing the private sector.

In Argentina for example crises are driven by the failure to roll-over BCRA’s own sterilization securities like (Leliqs).

In Sri Lanka it is the re-financing of banks by either outright, term or overnight purchase of securities from banks, through inflationary open market operations claiming inflation is low.

That is why IMF programs are destined to fail and second or third defaults happen in many cases.

4-6 pct inflation targeting is an invitation to disaster

All this matters because of a third reason.

An examination of the data table in Sri Lanka shows that all post war currency crises had taken place by targeting a 4-6 percent inflation range.

What the numbers show is that targeting 4-6 percent failed to stop currency crises, which eventually led to growth shocks and spikes in debts as the monetary brakes were hit.

The post-2020 “macro-economic policy” deployed had tax cuts on top of money printing. During that crisis also inflation was relatively low initially despite large volumes of money being printed.

Sri Lanka’s problem and that of other African and Latin American countries is that monetary regimes are fundamentally flawed.

There is a propensity to deploy macro-economic policy despite the existence of a reserve collecting central bank in the legal and operational frameworks themselves, despite such actions defying laws of nature.

Sri Lanka, Africa and Latin America and unstable countries in East Asia like Laos are in the same universe as stable countries with 2 percent targets and subject to the same laws of nature described by classical economists when BOP deficits and monetary instability were absent.

No amount of reforms in other sectors, including in budgets which are undoubtedly required, can help a country, if monetary stability is denied by targeting 5 percent inflation and failing to defy laws of nature, repeatedly. (Colombo/Oct23/2023)

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.

Dowload Sri-Lanka-monetary-law-Act-2023

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)

But high taxation is not a substitute for monetary stability.

There is no dispute that removing exemptions is necessary as it is a denial of equal treatment under the law, if nothing else, but all these efforts will come to nought without sound money.

Now that there is a default and a crisis, taxes have to be paid to maintain a large 20-pct of GDP government and reach debt sustainability, but that is not the way to bring prosperity to the ordinary people in the long term.

Neither is tipping people into poverty with currency depreciation and giving them a social safety net. Sound money is the ultimate social safety net and will reduce the need for subsidies. Indeed, in the stable exchange rate East Asia, the clamour for subsidies and their use to win elections is absent.

If monetary stability is denied to the people through flexible exchange rates or flexible inflation targeting and their cousins, the fallout in terms of currency crises and economic slowdowns, deal devastating blows to the fiscal framework itself which no amount of taxation can fix, as clearly shown in Latin America and in Sri Lanka in recent years.

IMF policy and Washington consensus is not Thatcherite

It is essential to clear some misconceptions or ‘narratives’ that are spread by talking heads in Western media.

People are told time and again that IMF’s reform based programs which started in the 1980 to fix defaulting Latin American soft-pegs which collapsed repeatedly – sometimes called the Washington consensus – were based on Reagan and Thatcher style reforms.

Nothing could be further from the truth.

The IMF programs which were originally peddled to Latin America and by extension to Sri Lanka, lacked the basic ingredient of sound money that was the bulwark of the Thatcher program of reform and stability. In fact, Thatcher took over from two back-to-back IMF programs.

IMF effectively or may be unknowingly, eggs on currency collapses by empowering reserve collecting central banks to do aggressive floating rate style monetary policy through ‘central bank independence’ and then claims the currencies are ‘overvalued’.

One reason for debasing money is the vain hope that some magic export competitiveness will come from debased unsound money. But the resulting trade controls, social unrest and political instability, keep foreign capital out and triggers flight or domestic capital.

Depreciation is the standard Mercantilist dogma that drove social unrest in the third world and also disrupted developed nations in the 1930s but was rejected by Germany, Japan and the most successful East Asian export powerhouses after World War II.

The IMF programs are far from the Margaret Thatcher/Geoffrey Howe/Alan Walters style policy, which was intellectually backed by Friedrich Hayek and Milton Friedman, among others.

The basis of Thatcher reforms was sound money. Howe’s budget and monetary policy, came after IMF programs in the ‘Great Inflation’ period, failed to stabilize or put the UK on a growth path, or remove exchange controls.

The UK had 11 IMF programs when it ran Sri Lanka style contradictory monetary and exchange rate policy, with Keynesiansim and output gap targeting, though not all were drawn down.

Sound Money

This is what Geoffrey Howe said.

“It is crucially important to re-establish sound money. We intend to achieve this through firm monetary discipline and fiscal policies consistent with that, including strict control over public expenditure.”

Present day economists and IMF have little or no idea of what sound money is.

Pushing aggressive monetary policy based on the in-vogue anchor conflicting monetary regime – money supply targeting conflicting with reserve collections then and domestic inflation targeting conflicting with the balance of payments now – does not solve anything.

It failed in Latin America and it failed in Sri Lanka from 2012 to 2019 and then up to 2022 taxes were also cut Barber boom style in fully fledged macro-economic policy. Thatcher also served in the Barber boom administration and seems to have learned well.

The fiscal probity of the Thatcher/Howe program was to reduce the deficit and reduce the size of the government. Not to expand the state as a share of GDP through taxation, allow spending to catch up and leave the deficit unchanged, as happened from 2015 by abandoning spending based consolidation.

In Sri Lanka spending went up from 17 to 20 percent of GDP under revenue based fiscal consolidation under the previous IMF program as spending-based consolidation was abandoned and monetary instability from flexible inflation targeting triggered currency crises and reduced growth.

The repeated Western statist dogma is that 20 percent spending to GDP is not a problem for a developing country.

But people in this country know how the state was expanded with unemployed graduates and spending is bloated with high nominal interest rates coming from high inflating unsound money.

In Sri Lanka IMF’s driven income tax rates also led to a backlash from some professionals, who helped bring Gotabaya Rajapaksa to power along with tax cuts.

The regime used an output gap – taught by the IMF to calculate – to also cut taxes and print money to bridge the gap.

It was unintelligent in the extreme to teach a central bank which had gone to the IMF 16 times and triggered a currency crisis in 2012 within a program, to calculate an output gap. That was an invitation to disaster, as Singaporeans economic bureaucrats would say.

Monetary stimulus, and output gap targeting – which is legalized in the new monetary law – is a sure-fire formula to debase money and is eons away from the sound money ideology of the Thatcher administration.

There is nothing neo or otherwise liberal about printing money and output gap targeting. There is nothing liberal about expanding the size of the government based on a cookie-cutter 20 percent statistical average. There is nothing liberal about raising income tax rates either.

These are not liberal or neo-liberal ideology but pink or left leaning ‘American progressive’ ideas that brought down the UK and lost Sterling its pre-eminent status, busted the Bretton Woods, and is also creating problems in the US itself now.

Thatcher came to power promising indirect taxes, for a reason.

But there is one advantage of income taxes.

The major drawback of indirect taxes, like value added tax, is that people do not ‘feel’ the hit, since they pay in small bites.

Because these taxes do not hurt, the burden of government is not felt by the public.

Value added taxes and other indirect taxes in small percentages (but not high import duties) conforms to the Kautilya’s principle of taxation – that taxes should be charged in the same way as a bee takes honey without hurting the flower.

Income taxes on the other hand come in big chunks and are designed to hurt and make people ‘feel’ it when they pay. Income taxes and wealth taxes – sometimes imposed without any incoming cash flows – destroy savings, investible capital and future jobs, while satisfying the socialist needs of “taxing the rich”.

Progressive taxes are also illiberal in that they deny equal treatment under the law. They become expropriationary at high rates.

Transferring choice from people to politicians

In true socialist style, income taxes also take away individual choice and transfer the power of spending decisions to the politicians and economic bureaucrats, while killing economic transactions that solve people’s problems.

The consumption hit that some Sri Lanka companies are complaining of in the first quarter of 2023 is a result of taking away that choice.

This is how Geoffrey Howe boldly gave choice to the people on the street and a boost to economic decisions of the community vs the bureaucrats, hiking VAT and cutting income tax.

“We made it clear in our manifesto that we intended to switch some of the tax burden from taxes on earnings to taxes on spending,” Howe said in his budget speech in 1979, where the clarity of thought, reason and interconnected logic was worthy of any 19th century classical liberal.

“This is the only way that we can restore incentives and make it more worthwhile to work and, at the same time, increase the freedom of choice of the individual. We must make a start now.”

“The upper rates no longer affect only those on very high incomes. They apply – and Labour Members may find this surprising – not only to senior executives and middle managers in industry but increasingly to skilled workers, as well as to professional people and the proprietors of small businesses. These are the people upon whom so many of our hopes for initiative, greater enterprise and national prosperity must depend.

“This year I propose taking a first and significant step to deal with these complaints by reducing the rate from 33 per cent. to 30 per cent. Our long-term aim should surely be to reduce the basic rate of income tax to no more than 25 per cent.”

He followed the same strategy that Ordoliberals of West Germany had done in cutting Hitler’s progressive tax rates.

The UK’s basic rate is now 20 percent. Progressive tax rates of 60 percent failed to fix the UK in the 1970s, driving it to the arms of the IMF.

Howe also broadened thresholds.

“These reductions in the burden of income tax, which are as substantial as they are unprecedented, mean that wage and salary earners will have more money in their pockets to buy the goods and services they help to produce.

I fully realise that this increase in value added tax will result in a rise in prices.. This is, of course, a once-for-all effect. But there never will be a time when it is easy to effect the switch from direct to indirect taxes, and the present moment is clearly no exception. That much-needed reform has been postponed too long already.

“True, the prices of a good many of these goods and services will be increased by my tax proposals. But we have done everything we can to ensure that every family in the land will have more money coming in to pay the increased bills. What is more, the choice of the way they spend their income will rest increasingly with people, and not with the Government.”

In subsequent budgets, thresholds were increased at rates higher than inflation, reversing bracket creep. Then spending was cut, bringing deficits in line and reducing the burden of the state on the people and businesses.

The lesson from tax rates

The top income tax rates were very high in the UK. So was the basic rate. But that did not help the country grow nor bring inflation down.

The important lesson is this.

It is not only that income tax reduces choice and kills economic activity and mis-direct economic activity away from serving the community’s needs to that of the priorities of the economic bureaucrats including the IMF and politicians but that high tax rates fail if money is unsound.

When there is monetary instability with a forex collecting central bank triggers shortages with a 5 percent inflation target, government borrows and debt goes up.

High tax rates, high corporate taxes failed to fix the UK. Due to operating contradictory exchange and monetary policy, UK foreign reserves plunged.

In 1976 the UK – the home of Keynes – went to the IMF for the largest loan at the time – 3.9 billion US dollars.

Foreign debt goes up when there are forex shortages as happened in Sri Lanka when stabilization measures are applied after flexible inflation targeting/flexible exchange rate crises.

Despite high rates under IMF programs, the UK suffered and its foreign debt went up. Like in Sri Lanka debt rockets in currency or economic crises, disproportionate to the actual deficits run.

“In our external policy we have also to take account of our official external debts,”</i< Howe said.

“These at present amount to $22 billion – a massive increase on the $8 billion which the previous Government inherited in 1974. It is our intention to reduce that burden of external debt substantially during the life of this Parliament.”

Central Bank Independence vs Sound Money

In that budget Howe raised policy rates by 2 percent to 14 percent.

The problem is not central bank independence but whether the central bank or politicians or anyone else believes in sound money or ‘flexible’ policy where rules triumph discretion or econometrics like potential out.

He said fiscal measures alone cannot sort out the monetary morass.

“Particularly given the continuing surge in bank lending, I have concluded that there is no option but to act directly to reduce that growth. It is not enough to speak of the importance of monetary policy, unless one is prepared to carry one’s words into practice.

The Bank of England is accordingly rolling forward the supplementary special deposit scheme, or “corset”, by three months on the existing basis. In addition, the Bank is announcing, this afternoon, an increase in its minimum lending rate by 2 per cent. to 14 per cent.

Taxing everything in sight with more wealth taxes are planned in 2025, cannot fix a country, where monetary stability is denied.

The IMF can fix a country in crisis with a sudden hike in rates and an economic contraction.

But it has no consistent stable monetary framework to offer pegged central banks which collect reserves, to prevent the next crisis.

The hit from monetary instability (flexible inflation targeting/flexible exchange rates) on the fiscal framework is massive.

Peaceful countries in Latin America and Africa and Asia are driven to default by such policies. In Sri Lanka, the value added tax cut for output gap targeting was dumb, but the country tipped over the edge as debt had rocketed in the previous years and growth had declined with instability.

Several East countries cut taxes in the coronavirus pandemic – but did not print money – and saw their debt go up some, without a currency collapse.

Flexible inflation targeting and their cousins practiced by Latin America – and UK during its period of exchange controls in particular – kills growth. Each currency crisis kills consumption, makes it more difficult to collect taxes, expands deficit and debt to GDP ratios while also driving foreign borrowings to fill payment gaps from forex shortages.

IMF style ‘competitive exchange rate’ monetary instability also drives up nominal interest rates and makes the interest bill a large part of public spending.

Countries with monetary stability tend to have low income and VAT rates. Among the lowest corporate tax and VAT rates and debt to GDP ratios are found in East Asian nations with the hardest money. Thailand has a 20 percent corporate income tax rate (VAT 7 percent), Singapore 17 percent (VAT 8 percent) and Cambodia (dollarized) also 20 percent (VAT 10 percent).

A good tax framework is indispensable, but it is not a substitute for monetary stability. To borrow a word from the West Germans, without stability everything is nothing.

Big Government

The revenue based fiscal consolidation ideology, which rejects spending-based consolidation, puts the entire burden of fiscal adjustment on the private sector, with no responsibility for the rulers or bureaucrats to cut spending.

In Sri Lanka, people know that there is plenty of excess spending. There are also serious doubts about the gross domestic product calculations, which will tend to reduce the tax to GDP ratio. When work in progress was added to GDP for example there are no taxes.

In the case of Sri Lanka, the magic number was decided as 15 percent of the econometrically expanded GDP at a time when it was around 12. In Ghana, which defaulted and now has about 15 percent of GDP revenues, the magic number is 18.

In Latin America, revenues are in excess of 20 to 23 percent but the pegged currencies still collapse with flexible or contradictory policies. triggering default.

The second part of the big government ideology is to hike income tax rates. Making the ‘rich pay their fair share’, a key Western leftist or ‘progressive’ slogan.

A key problem with income tax, where money is transferred directly to the hands of politicians and bureaucrats, is that it kills economic activity and individual choice. Maldives, Dubai, grew and created jobs and imported labour without income tax.

They also had superior monetary stability and not permanently depreciating currencies.

The IMF uses stock and flow indicators to decide or claim that debt is “sustainable” or not.

Econometrics

A key indicator is debt to GDP ratio (a stock) and a GFN or the rollover of old debt and raising new debt in a given year under their Debt Sustainability Assessment.

Until floating rates, the debt to GDP ratio was the key indicator until floating rate countries started to survive with high levels of debt.

A high GFN is supposed to measure roll-over risk. Sri Lanka’s GFN is now over 30 percent of GDP.

The DDO, which involves extending the maturities of rupee debt, is aimed at reducing the roll-over risks of debt or the gross financing need (GFN) which the IMF believes will bring debt back to sustainability or make it manageable.

Sri Lanka has proposed re-structuring domestic debt as required under an International Monetary Fund program to make debt ‘sustainable’ according to some statistical requirements that the agency has devised.

Sri Lanka’s authorities have tried to minimize the fallout on domestic debt, in a debt re-structure. Sri Lanka has to do it, there is no choice.

In Sri Lanka GFN hit 34 percent and the debt to GDP ratio 128 percent after default and currency collapse. The aim is to bring GFN down to 13.5 percent and debt to 95 percent by 2030.

Like debt to GDP ratios and revenue to GDP there is a wide variation of GFN numbers among countries and also among defaulting countries.

In Ghana according to an IMF report in 2021, public debt to GDP was 83 percent and the IMF to be fair warned that debt was growing too rapidly, up from 57.9 percent in 2018.

Singapore according to the IMF had a GFN of 26 percent of GDP and debt to GDP ratio of 150 percent in 2020, amid Covid.

However, the country has monetary stability due to operating on currency board principles (no policy rate). Exchange rate depreciation is zero and interest rates are low.

And Singapore’s debt comes partly from the GIC, set up by Goh Keng Swee, the structure of which is too complicated to explain in this column. Regardless, that there is a balancing item abroad, the GFN is in the 20 percent levels, which has to be rolled over.

Due to the stability, it is easy to roll-over debt. And there is no real problem with repaying debt. As long as monetary stability is there, a government can raise money domestically (at a higher interest rate) reduce domestic investment, buy dollars and repay debt.

It is more difficult however with bullet repayment debt like sovereign bonds. Confidence matters here more than if a country had syndicated loans, which can be settled in installments.

If ISB holders lose confidence and start selling down debt, it will be difficult to roll-over debt. Countries with ISBs are especially vulnerable to default if the bond holders rightly or wrongly lose confidence.

In Ecuador, macro-economists or the International Monetary Fund cannot trigger monetary instability flexible policies because the country is dollarized. As with currency boards and dollarized countries, public debt to GDP was low.

But a socialist president, debt went up steeply including from China with cheap credit under Fed quantitative easing, shortly before Covid hit.

Still in 2019, the IMF framework did not find serious problems.

“Under the baseline projection, Ecuador’s public debt is on a sustainable path, thanks to the envisaged fiscal consolidation,” the IMF said in 2019.

“Debt is expected to peak in 2020 at around 50 percent of GDP and decline to below 40 percent of GDP by 2024. Gross financing needs are estimated at 8.1 percent of GDP in 2019 but are expected to decline to 5.2 percent of GDP in 2020 and further to 2.7 percent of GDP in the medium term. The debt profile is particularly vulnerable to unexpected and large terms of trade shocks and a sharp deceleration in growth though debt remains sustainable even under the stress scenarios.”

However, when Covid hit, and oil prices fell, ISB holders panicked and sold, pushing up yields.

ISB holders perhaps do not know the difference between a dollarized and non-dollarized Latin American country.

Public debt was around 50 percent of GDP and GFN was low.

Ecuador negotiated a re-structuring. The country serviced its debt up to the point of the debt exchange and then got some reductions as well.

The ISB holders had effectively hit an own goal.

There are two lessons in Ecuador. If a country has marketable sovereign debt (ISBs) a low GFN is not going to save it, if confidence takes a hit, rightly or wrongly.

The second lesson is that, like in the gold standard days, dollarization is a check on the debt to GDP ratio.

The discipline of markets came but people did not grow hungry because there was no dual anchor flexible inflation targeting the central bank to steal food from their mouths, like in Sri Lanka, Ghana or other countries like Laos.

The lenders took a hit, not the population. With an impotent central bank unable to engage in ‘monetary policy’, there was no ‘pain’ as seen in Sri Lanka.

So, confidence matters, particularly for countries with international sovereign bonds.

Cambodia

Another case in point is Cambodia which also had an exceptionally bad central bank and market-dollarized at 4000 local units to the US dollar.

Ecuador dollarized at 25,000 sucres to the dollar with a little official help, in a perhaps unusual situation.

It is not as if Cambodian politicians, and its leader Hun Sen is a paragon of fiscal virtue. Is this former Khmer Rouge fighter some genius reformer? He orchestrated a coup when the country’s currency was collapsing three decades ago.

Cambodia now also has a low debt to GDP ratio, in the same lines as Hong Kong and Bulgaria. Countries which are dollarized or are currency boards usually have debt to GDP ratios of around 30 percent of GDP.

Such countries also do not have big banking crises as there is no central bank to finance credit without deposits.

The lack of standing facilities at fixed rates, and the enhanced prudential lending protects such countries, even if the anchor currency country (the US) suffers a banking crisis.

These countries, which are unable to print money, engage in macro-economic policy have stability, low interest rates and low inflation.

If Sri Lanka prints money under flexible inflation targeting and output gap targeting, de-stabilizes money through flexible exchange rate, using policies prescribed by the IMF and which have been rejected in their home countries, nothing can save this country.

Nobody will say there was monetary instability which hit the debt.

That were exchange rate shocks from the currency crises from mis-targeted rates, that there was a growth shock and a concurrent a revenue shock and widened the deficit bloated the debt. And that frequent currency crises and depreciation led to high nominal rates.

Inflationist macro-economists write the narrative. Politicians will be blamed. The people will be blamed for electing the politicians.

Those who engage in discretionary flexible policy, which is destined to fail, not only in Sri Lanka, but in Argentina or Ghana where they are followed, will escape scrutiny and accountability.

People will go hungry as the flexible exchange rate collapses. It will be impossible to do reforms as the bottom falls out from under the home economy from depreciation.

Desperate voters will be blamed for asking for subsidies because currency depreciation and inflation robs their real salaries, making them vulnerable to economic charlatans and nationalists.

The usual suspects

The usual cracked record will be played. The politicians did not do the reforms.

There will be new twists now.

The debt restructure was not deep enough.

The GFN at 13.5 percent was not low enough, as well as that politicians did not do the reforms.

That domestic debt was rolled over, interest rates started to fall, with GFN at 30 percent when there was confidence in the currency and before open market operations began to destabilize the currency, would be forgotten.

Meanwhile, Singapore will have a GFN higher than 20 percent, Cambodia will make steady progress with weak policy making capacity but with neither the IMF nor other inflationists able to engage in ‘macro-economic policy’ to destabilize the country, drive out elected governments and keep out out foreign investors by scaring the living daylights out of them.

At least until de-dollarization is achieved and macro-economists get the power to destroy money through flexible policies.

Then Cambodia will also go back to the 1970s and 1980s like Argentina and Latin America do. Sri Lanka runs the same risk with flexible inflation targeting.

If a reserve collecting central bank cuts rates on an inflation index number as private credit recovers, and enforces them with inflationary open market operations, forex pressure will emerge quickly and the currency will fall.

It has happened repeatedly in Sri Lanka in the recent past, it happens in all countries that go to the IMF frequently and it happened in the US in the run up to 1971 and in the UK up to 1979.

In Sri Lanka, the so-called ‘flexible inflation targeting’ with output gap targeting, eventually drove the country into external default within and without IMF programs, due to faster transmission of monetary policy after the end of a 30-year civil war.

The same phenomenon can be seen in Pakistan, Bangladesh, Africa, Latin America and Laos in East Asia where the IMF has clout to push the doctrinally flawed flexible inflation targeting/flexible exchange rate style regimes.

The value of money is destroyed and people are impoverished by repeating a false doctrine that was developed in the last century using econometrics and rejecting laws of nature by inflationist macro-economists at Cambridge (J M Keynes), Harvard (Alvin Hansen), MIT (Paul Samuelson) among others.

The gold standard collapsed, newly independent nations became basket cases, millions were pushed into poverty, had to flee their native lands and market access countries defaulted, due the false doctrine propagated by these macro-economists which was enabled by sterilizing central banks.

Why do currencies fall?

Currencies, whether pegged or floating, fall (and strengthen) due to central bank action. When a reserve collecting central bank (pegged) buys any domestic asset from any party, or transfers profits to the Treasury, rupee reserves of commercial banks will go up.

The central bank will also inject money in most transactions it does with the rest of the world, including paying salaries or pensions. That is why central banks should be lean organizations with minimum expenses and staff.

Usually, Sri Lanka’s central bank buys Treasury bills from banks to target the call money rate, not to monetize debt in the current year deficit.

The newly injected money will be loaned to private investors who will invest them in buildings or machinery which will then trigger imports above dollar inflows, triggering forex pressure. That is why in 2020 to 2022 even when car imports were banned, the rupee came under pressure and reserves were lost as investment goods imports soared.

Does Sri Lanka have a pegged exchange rate?

Yes. Definitely. Without a pegged exchange rate, there cannot be BOP deficits or BOP surpluses. There also cannot be foreign reserve collections or foreign reserve losses without a pegged exchange rate.

In a floating exchange rate regime, there are no BOP deficits or surpluses.

The reason there are BOP deficits in Sri Lanka and other flexible exchange countries is due to flawed pegged arrangements, which have a variety of labels but their common denominators are forex shortages and exchange controls (free flow of capital is barred).

There cannot be an IMF foreign reserve target (a BOP surplus) without a pegged arrangement, however flawed.

How are reserves lost?

Reserves are lost permanently when dollars are sold by a pegged central bank to commercial banks to redeem rupees created through open market operations (printed money), which have been loaned to customers or used to buy Treasury bills and boomerang as imports.

When credit demand is high, reserves sold to facilitate investment imports in particular can lead to liquidity shortages. Under a flexible inflation targeting arrangement or soft-peg or managed float, this liquidity shortage is again filled (sterilized) with newly printed money, worsening reserve losses and further expanding the BOP deficit, fixing the interest rate and preventing a correction in credit.

Because there is no confidence in the flexible exchange rate, when it starts to fall, exporters and importers panic, capital flight begins and rating agencies downgrade as happened in 2018 and other years.

In the past Sri Lanka’s state banks also used to borrow printed money from standing lending facilities of the central bank (artificially keeping down the interest rates in the process) and loan to the CPC or CEB or to the Treasury as overdrafts, creating forex shortages with the excess rupees.

When dollar reserves are sold for rupees, liquidity should go down, eliminating the ability of banks to give new loans, automatically pushing up rates and reducing credit and bringing the external sector into balance. This was the case around the world before 1920s when balance of payments deficits were absent.

However, if the policy rate is targeted with new money from open market operations or standing facilities, there will be no correction of credit and the rupee will fall and more reserves will be lost as money is injected. This employment of inflationary open market operations to inflate rupee reserves of banks is called a sterilized foreign exchange sale.

This is why reserve collecting monetary authorities with unsterilized or mostly unsterilized interventions are able to have fixed exchange rates or mostly fixed exchange rates and those that sterilize, collapse and run into currency crises.

To collect reserves and meet IMF reserve targets this process has to be reversed.

If the central bank is barred from targeting interest rates with open market operations and interest rates are forced to fluctuate, with a wide policy corridor or no corridor, like in stable East Asian countries, the currency will not depreciate, the money will have a stable value, and economic activities will grow steadily. The resulting stability and confidence will draw foreign investors and not make them run away, like in a flexible inflation targeting regime.

How does an East Asian fixed exchange or UAE monetary authority maintain reserves?

Reserves are maintained by operating open market operations to keep the balance of payments in balance. In a pegged exchange rate, the BOP determines the interest rate.

In countries like Vietnam or China before 2005, deflationary open market operations were used to build reserves exceeding the reserve money of the country.

If the interest rate is determined by econometrics, either to target growth or to target inflation (to push up inflation when it is low), there will be external instability as reserves are lost and the currency is depreciated.

Currency boards or fixed exchange rates have stable reserves, which match the reserve money supply, and no BOP crises because interest rates match domestic credit and also the credit cycle of the anchor currency, through the same mechanism.

How are reserves built?

In order to build reserves, domestic credit has to be reduced by a little more than it would have been to keep the exchange rate fixed by deflationary open market operations. That is to say interest rates have to be a little higher than the market clearing interest rate of a currency board or fixed exchange rate.

In order to build reserves the central bank has to sell down its domestic assets stock and withdraw liquidity from banks as dollars are bought. In a float, dollar purchases or reserve building does not happen.

In order to be able to purchase dollars, domestic investments will have to be curbed by a market clearing interest rate that matches the net international reserve target. The rate will be higher than that needed to keep stable reserves matching the money supply (a fixed exchange rate) where reserve run downs (a currency crisis) was avoided originally through a moving policy rate.

In order words, the monetary authority has to sterilize or offset its international operations in the opposite direction through domestic operations compared to when it was creating a currency crisis. Open market operations will therefore have to be deflationary, not inflationary like in 2015, 2016, 2018, 2020, 2021 or 2022 up to July.

Related Sri Lanka is recovering, Central Bank threat looms: Bellwether

Is rebuilding reserves austerity?

You could call it that. Cutting state spending or deficits is not austerity obviously. Any cuts in state spending leaves more money in the hands of private citizens to spend or invest and interest rates will also tend to fall. Cutting state spending will boost private citizen growth.

But under an NIR target capital is exported and loaned to developed nations. Capital that would have been invested domestically will have to be appropriated by the central bank, and loaned to the US. As a result, in the reserve re-building phase, growth may be lower than in a fixed exchange rate or a floating regime. If the exchange rate is stable and confidence is built among foreign investors there may be a lot of investments and this condition may be mitigated to some extent. But under a flexible exchange rate, which depreciates permanently, confidence will be weak.

In order to build reserves, interest rates in the country will have to be higher than in a floating exchange rate regime or a currency board that does not sterilize interventions in either direction.

Both currency boards and dollarized countries and floating exchange rates have very low interest rates. All of these regimes operate according to laws of nature, roughly described by the impossible trinity of monetary policy objectives.

Cutting rates based on an inflation target (data driven monetary policy) without a floating rate, goes against the laws of nature and these countries suffer monetary instability. If they have market access and credit ratings are low, they can quickly default again as investors sell down bonds as the currency falls, pushing sovereign dollar yields up.

If interest rates are cut and money is injected like in 2015 and 2018 and 2020, the same results will be seen in the near future when private credit recovers this year.

As soon as interest rates are out of line with the BOP, net foreign assets of the central bank starts to fall (see blue line in above graph).

That is why countries with flexible inflation targeting regimes end up in BOP crises and default as pegged countries that tried to target a money supply and depreciated their currencies in the 1980s defaulted.

What happened in Sri Lanka is not new. Only the labels are different. The anchors may be different but the conflict is the same.

The Fed’s ‘lean against the wind’ policies of the 1960 (also a type of output gap targeting) based on econometrics and not its actual anchor of gold, led to high inflation, soaring gold prices and the eventual collapse of the Bretton Woods.

Many poor countries without a doctrinal foundation of sound money started to have very high inflation after the collapse of the Bretton Woods, in the 1980s as the Fed tightened because they were encouraged to depreciate by Western inflationists – including inflationists within the IMF itself.

In order to survive a Fed tightening, reserve collecting countries have to run the same credit cycle as GCC countries and Hong Kong now does. Or they should have an independently floating exchange rate with an entirely different credit cycle like Australia or New Zealand.

As a result of inflationism or macro-economic policy, there was an epidemic of social unrest from the mid 1960s and into the 1970s (except in Germany and Japan) and a sovereign default epidemic in the 1980s.

Is the strength of the currency anything to do with the strength of the economy?

No. The causation runs in the opposite direction. Currencies can strengthen when economic activities collapse due to shrinking private credit as long as money printing is contained with higher rates. This is what happened in Sri Lanka over the past year.

The currency will fall generally when economies do well and private credit picks up and central banks employ open market operations to target the policy rate or call money rate or economic growth.

That will happen to Sri Lanka soon if rate cuts are enforced with open market operation as private credit recovers as it happened in 2018 and in 2021 in the post covid recovery. Pakistan and Bangladesh were also hit by the post covid recovery.

There is only one agency that can drive the rupee down and that is the central bank, which enables private credit with printed money.

What about the new monetary law? Will that prevent a crisis and second default?

There is nothing really to prevent a second default. The new monetary law has three anchors.

The central bank is empowered to target the exchange rate (exchange rate policy) it is empowered to print money to keep artificially low interest rates as in the past in direct conflict with the exchange rate policy mentioned above (inflation targeting) and it is also empowered to print money to target growth (a potential output arrived at by econometrics).

Furthermore, it is also empowered to depreciate the currency when all these targets inevitably conflict and confidence disappears (flexible exchange rate).

Is there anything in the IMF program to stop a default of restructured debt?

The IMF program has a ceiling on domestic assets of the central bank, which can serve as a check on money printing. However, it is not directly complementary to the reserve target and there is room to print money for open market operations and bring the rupee and the economy down.

“For the program monitoring purpose, government securities acquired through purchases of government securities, solely for monetary policy purposes (e.g., standing lending facility and short-term open market operations) and emergency liquidity assistance (ELA) operations, on a temporary basis with an agreement to reverse the transaction in less than 90 days, will be excluded from the CBSL’s claims on the central government,” according to the IMF program.

Based on past performance it takes only about 4 to 6 weeks for open market operations money to boomerang on the exchange rate when private credit has recovered. Three months is an eternity.

While there is some complementarity in the ceiling on domestic assets there is a fundamental conflict between the NIR target and the inflation target which is described by a monetary consultation clause. The conflicting targets come from a weak understanding of operations of pegged central banks.

Any reserve collecting central bank with discretionary open market operations unchecked by law, can and will trigger external instability if they try to boost growth by printing money. In the case of a flexible inflation targeting country, both money printing for growth against currency stability, and currency depreciation is sanctioned by law.

However legislators may be able to curb the central bank’s room to de-stabilize the external sector with a very tight consumer inflation target of 1 or 2 percent.

Related Sri Lanka legislators should deny high inflation goal independence to the central bank

Is currency depreciation an economic or legal phenomenon?

Currency depreciation is a monetary phenomenon. However, if a pegged central bank is barred by law from targeting interest rates with open market operations (like in Hong Kong or Singapore or Dubai to a great extent) and is compelled to allow short term rates to fluctuate, the currency will not depreciate, money will have a stable value, and economic activities will continue over the long term without currency crises intervening in the middle, interest rates will collapse close to the level of the currency of the country that domestic money is pegged to (the anchor currency).

Whether the rupee falls or not is therefore a matter of law in a manner of speaking, not ‘economic fundamentals’ as claimed by inflationist macro-economists. Blaming economic fundamentals also allow inflationists to transfer the blame away from themselves. As a result, the problem of forex shortages, lack of free trade or imposition of capital controls, does not get solved.

If the parliament permits inflationists to target the call money rates while domestic credit picks up, the currency will depreciate and the ruling regime will become unpopular and be ousted.

Is reserve collection always austerity?

Reserves can be collected by deflationary open market operations and sequencing credit (delaying credit until banks raise deposits) in a stable exchange rate by taking the voluntary savings of the people, like in East Asia. It can be done slowly at relatively low rates, not a shock re-collections like an NIR target.

In East Asia these reserves were recycled back in the form of import demand from the US where the reserves were invested. In effect the US government borrowed from East Asia and triggered imports as Sri Lanka borrows from China and the World Bank or ADB to trigger imports.

Reserves can be built by depreciating the currency and forcibly destroying the purchasing power of the people and lowering their living standards by force like India’s RBI is doing or like Sri Lanka did in the 1980s at the risk of social unrest and nationalism.

This is the preferred method of the IMF after 1980, hence the political instability and social unrest that is associated with countries that frequently go to the IMF after rejecting classical economics as well as East Asia or Dubai or Oman style monetary policy.

However, it is a shame upon all macro-economists that a country with a 20 percent domestic private savings rate cannot build reserves and depreciates the exchange rate with BOP deficits, imposing a regressive inflation tax on the poor. It is perhaps a reflection of the success of Cambridge-Harvard inflationist dogma.

Can reserves be used for imports?

No. That reserves are needed for imports is a myth or a lie repeated by macro-economists in countries with flawed soft-pegged or flexible exchange rates. If reserves are used for imports, the central bank ends up re-financing the private sector through open market operations in the course of fixing the policy rate. Neither floating exchange rate central banks, nor fixed exchange rates (currency boards) give any reserves for either imports or capital repayments.

Because Treasury bills are used for open market operations to mis-target rates, private sector re-finance is then blamed on the budget deficit, one the statistic that claims on government went up.

READ MORE Sri Lanka use of reserves for imports is a deadly false choice: Bellwether

A floating exchange is also very stable and strong. That is why they are called hard currencies.

The IMF’s ARA metrics (Assessing Reserve Adequacy) and the so-called ‘external financing gap’ are also based on false doctrine. If a country is building reserves and is financing the US deficit or is financing the US mortgage market by purchasing agency debt, there cannot be an ‘external financing gap’.

The only ‘gap’ comes from inflationary open market operations to target an output gap. Sri Lanka and IMF-prone countries in general pay a heavy price for these mistaken ideas. (Colombo/Aug14/2023)

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.

Countries that go through severe crises due to bad money, have fixed themselves in the past. But in Latin America and in Sri Lanka and in Africa, countries go through crises after crisis, but the central bank is not tamed.

Whether inflation is pushed up to drive workers to strikes in the West, or tipping the people over the poverty line with ‘food inflation’ or robbing economic freedoms through import, price or exchange controls the perpetrator is the state-owned central bank.

The central bank, through these controls, get more time to enforce rate cuts, and worsen a credit bubble and forex shortages.

A Legislative Crime?

Western central banks accumulated these powers through the last century as the fixed policy rate was invented in the 1920s, abandoning the so-called flexible ‘Lombard rate’ that kept the balance of payments in balance.

A post 1920 central bank usually gets away from being accountable, through the support of ‘macro-economists’ who help shift the blame to the victims after gaining ‘independence’ to print money to operate a fixed policy rate and trigger exchange and money policy conflicts.

The central bank through this law is seeking to target output (print money for growth) despite the havoc such actions have caused in Sri Lanka, triggering multiple currency crisis in the recent past in particular.

“When the President signs this bill, the invisible government by the Monetary Power will be legalized, the people may not know it immediately, but the day of reckoning is only a few years removed … The worst legislative crime of the ages is perpetrated by this banking bill,” representative Charles Lindberg warned when the Federal Reserve was set up as a peculiar SOE.

It is sad that a century after ‘reckoning’ has come – in the case of Sri Lanka every few years – legislative crimes are being committed again and again in unstable countries whose currencies depreciate, who have trade and exchange controls and who default repeatedly.

Impossible Trinity Guaranteed

The central bank is seeking to simultaneously operate money and exchange policies, the problem that has dogged this country for 73 years and led to forex shortages.

The central bank is free to print money to boost growth depreciate the currency pretty much as it had done in the past.

Section 6 (4) lays out the exact policies that drove the country to default particularly from 2022, and laid the foundation through three earlier back-to-back currency crises by violating a law of nature, generally expressed as the ‘impossible trinity’ of monetary policy objectives.

“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.”

And

Subject to the provisions of this Act, the powers, duties and functions of the Central Bank shall be to –
(a) determine and implement monetary policy; (b) determine and implement the exchange rate policy;

What is being accountable? Is being accountable giving excuses for generating high inflation and not giving even an excuse for depreciating the currency and imposing regressive inflation taxes on the poor?

“The Central Bank shall be autonomous and accountable as provided for in this Act.

(3) The autonomy of the Central Bank shall be respected at all times and no person or entity shall cause any influence on the Governor of the Central Bank or other members of the Governing Board and Monetary Policy Board or employees of the Central Bank in the exercise, performance and discharge of their powers, duties and functions under this Act or interfere with the activities of the Central Bank.

(4) Except in the exercise, performance and discharge of the powers, duties and functions under this Act, the Governor of the Central Bank or other members of the Governing Board and Monetary Policy Board, employees of the Central Bank or any person authorized by the Central Bank shall not seek or take instructions from any person:

The following accountability that is promised by the act.

RELATIONSHIP WITH THEPARLIAMENT, THEGOVERNMENT ANDTHEPUBLIC

80. (1) The Central Bank shall, once in every six months and at such additional times as it deems necessary, inform the public regarding the implementation of its monetary policy, and the achievement of its objects.

(2) The Governor of the Central Bank may, at the request of the Parliament or on his own initiative, be heard by the Parliament or any of its committees periodically, regarding the functions of the Central Bank.

(3) The Central Bank shall, within a period of four months after the close of each financial year, publish, and lay before the Parliament through the Minister, a report approved by the Governing Board, on the state of the economy during such financial year emphasizing its policy objectives and the condition of the financial system. The report shall include a review and an assessment of the policies of the Central Bank followed during such financial year.

No Sanctions?

There are no sanctions on the central bank or its offices for creating forex shortages through inflationary open market operations to enforce rate cuts.

There are no sanctions for keeping interest rate artificially low for long periods and suddenly hiking them after triggering external instability and pushing up rates to high levels and triggering bad loans in banks.

There are no sanctions for pushing people get barely out of poverty back into poverty through permanent depreciation of the flexible exchange rate.

For what this central bank has done, in the recent crises or in the past, there is no punishment.

No one can be punished by law for destroying the currency, the bank deposits or the salaries of the people or driving the economy into a currency crisis.

An SOE like no other

According to then Prime Minister D S Senanayake there were warnings against setting up the central bank and abolishing a floating interest rate. There have been even more warnings this time and people went to court, against this SOE with unusual powers.

READ MORE:

Sri Lanka’s tragedy and the lost wisdom of D S Senanayake on money printing

Sri Lanka warned on dangers of new central bank law

Many of petitioners did not understand the danger of macro-economic policy, but they understood that the SOE had unusual and peculiar powers.

A state-owned central bank, particularly in a third world country with chronic forex shortages and currency depreciation is not like any other state-owned enterprise.

It has a monopoly to produce money.

In Sri Lanka the central bank has depreciated the currency from 4.70 to 320 and has gone to the IMF 17 times without taking any action to tame its money printing powers through the policy rate, standing facilities or open market operations in general.

The central bank is the only agency that can create forex shortages. It is the only agency that can trigger a currency collapse.

Third world central banks in particular make it impossible for people to live in the countries where they operate monetary policy while collecting reserves.

In the first place it is a travesty of justice that a perpetrator of these act is making its own law to give itself room to mis-target rates and continue on the same or worse path by calling its actions by different names.

The Perpetrator

The central bank is like no other SOE or regulator in another way.

It is a cardinal principle in regulation that the producer of goods or services is separate from the regulation.

But in the case of central banks, the regulator is the very agency that produces bad money.

The central bank like no other SOE in that it can impose sanctions on the public and businesses through exchange control and its own monetary law or the banking law, after triggering forex shortages by over-producing money to suppress interest rates.

Under the principle monetary law anyone who produces a 500-rupee note is committing a crime.

But the central bank which prints billions and trigger forex shortages and push millions into poverty through the flexible exchange rate face, no sanctions and it is not a crime.

The perp in fact is making its own law to give itself immunity. It is not just Sri Lanka but all third world central banks do that.

The ‘first world’ central banks also did that from around 1931 to 1980 when Keynesianism displaced classical economics but have been controlled to some extent especially after 1980, when policy took a turn for the worse in Latin America and Africa.

Germany till the end of World War II until the Deutsch Mark was produced by the Bundesbank. In France until Jacque Reuff produced the New Franc for de Gaulle and in the UK until Thatcher and Alan Walters and Geoffrey Howe in 1979.

The most successful East Asian nations also rejected macro-economic policy and chose stability instead.

In Sri Lanka and other third world countries, the perpetrator of monetary instability has enormous powers not only for exchange controls but also to influence other agencies to control imports.

In this crisis the central bank also barred forward contracts after printing money, in addition to controlling the exchange flows and trade.

Central banks use these powers to engage in their favourite game in Sri Lanka and elsewhere – that is delay market interest rates and continue to print money for another month or another year.

A central bank through its exchange controls, has absolute control over the lives of citizens. When import and price controls are added the tools for absolute totalitarian control is available to bureaucrats and politicians. Price controls and rationing, are also a knee jerk reaction to aggressive monetary policy for growth. Under active monetary policy, these have become common place in Sri Lanka.

This is what classical economist Friedrich von Hayek, who got a Nobel prize in the 1970s shortly after the US dollar collapsed using the very policies that are to be legalized in Sri Lanka’s new law.

“..[W]hoever controls all economic activity controls the means for all our ends, and must therefore decide which are to be satisfied and which not,” explained Friedrich von Hayek in Road to Serfdom.