Sri Lanka has recorded primary surpluses above IMF targets. This was due to steep tax increases, despite state salary hikes and welfare payments. Deflationary policy kept inflation low, below the Central Bank’s target.
Primary expenditure refers to all expenses incurred before interest costs are included. A country that runs a primary surplus has interest costs higher than its budget deficit.
The high interest bill is not just due to high debt figures, but also due to the nominal interest rate. This is a function of monetary instability and the destruction of domestic capital from depreciation and inflation.
By September 2025, Sri Lanka had run a primary surplus of Rs1,465 billion, over 4 times the Rs300 billion target in the IMF programme. By the same month, a Rs6 billion surplus was run in the current account of the budget, including interest. This means taxes financed capital expenditure. Sri Lanka lost this ability after 1987.
A current account surplus seems revolutionary. However, before high levels of inflation, a surplus was the norm. Budget deficits were also achieved.
Deflationary Policy
By September, Sri Lanka’s large primary surplus and small current account surplus would not have been possible if the Central Bank had not stabilised exchange rates and enacted deflationary policy. Therefore, the 5% inflation target was missed.
A 5% inflation target means that non-in-terest current spending, which is half of current spending, will rise by 5% a year.
Of course, the US Federal Reserve also contributed, keeping coal and fuel prices down.
Before floating or positive inflation targeting, it was not difficult to run a budget surplus and reduce debt by absolute numbers. In the age of inflation, after the collapse of the gold standard, debt cannot be reduced by absolute numbers, as the possibility of running a budget surplus is nil.
The debt-to-GDP ratio is instead brought down, even as deficits continue.
However, that was not the case before the collapse of the gold standard.
World Wars
After deficit budgeting during the First World War, American Treasury Secretary Andrew Mellon returned to budget surpluses even as the Federal Reserve invented inflationary open market operations.
He was able to run budget surpluses until the Great Depression, which experienced stimulus and the beginning of state interventions. This worsened and extended the Great Depression, leading to the birth of Keynesian stimulus.
Graph: U.S. budget surplus after World War I
To reduce public debt, Treasury Secretary John Snyder took a similar approach by running a budget surplus during the Korean War. The U.S. also ran budget surpluses in the middle of what is falsely called the Korean War bubble.
Inflation rose due to the purchase of Federal Reserve Liberty Bonds. These bonds were a 40-year security held amid private credit recovery after inflation rose after the Second World War. It was wrongly blamed on the Korean War, smaller in scale than World War II. World War II was financed by tax hikes amid fears that deficits cause inflation.
Graph: U.S. budget surplus after World War II
Congress refused a second tax hike because the budget was in surplus, showing that macro-economists spread false narratives that budgets were responsible for monetary stability.
It was Governor Marriner Eccles, a former banker who insisted on raising rates, which then led to the Fed-Treasury Accord and so-called independence of the Fed. Using the independence of the Fed, macroeconomists busted Bretton Woods, created the Great Inflation, the housing bubble, the post-2008 stimulus, and the destruction of public finances that the West is left with.
The same ideology drives the potential output and the high inflation target in Sri Lanka.
Long-term Debt, Low Interest Rates
The insistence by John Snyder that the Fed continue the wartime agreement to keep government debt yields down shows another stark fact. The 40-year Liberty Bonds were issued to finance World War I. Snyder insisted on the Fed keeping rates down to protect the secondary market value of the bonds because war widows held these bonds.
Before the creation of the Fed and its “tightening and easing cycle” (like the printing of money in 1950), ordinary people received high interest rates for their long-term bonds, not just pension funds.
In Sri Lanka, people were buying 20-year government loans below 3% when the Central Bank was created, resulting in manipulated rates, triggering pressure on the balance of payments.
The problem also started during the same Liberty Bonds Bubble, as the Central Bank did not allow rates to rise and printed money, triggering the first balance of payments problem in 1952, even as the US tightened policy.
The Central Bank never looked back.
Post-Gold Standard
The US government also lost the ability to run budget surpluses after the collapse of the Bretton Woods system, which led to the Great Inflation and the adoption of floating exchange rates.
In the early 1980s, Paul Volcker brought inflation under control, potentially allowing deficits to be narrowed.
Graph: U.S. federal deficit, 1930–2024
Though Margaret Thatcher was keen on reducing the deficit, the Reagan Administration, advised by monetarists, decided to run deficits. As a result, Volcker had to raise interest rates close to 20% to balance credit.
The UK managed with much lower interest rates under Alan Walters and Margaret Thatcher. It managed to run good budgets until the eve of the Exchange Rate Mechanism (ERM) crisis in 1991, which led to the collapse of the Pound.
Graph: UK public finances from the Thatcher-era tightening to reflation
The UK also managed to run good budgets up to 2000 when macroeconomists in the US, led by Ben Bernanke in particular, claimed there was ‘deflation’ and misled Alan Greenspan into money printing.
The Reflated Housing Bubble
In the so-called “deflation” of the late 1990s, the US operated budget surpluses for the first time since the collapse of the gold standard. In fact, some East Asian central banks bought Fannie Mae and Freddie Mac paper due to the scarcity of Federal paper, amid a global rise in savings and low rates triggered by the lowered inflation.
By 1999-2000, gold was $284 an ounce and oil $16 an ounce, compared to around $800 for gold and $35 for oil when Paul Volcker started to tighten monetary policy (early 1980s).
After the collapse of the housing bubble, fuelled by the reflation that ran from 2000 to 2007, a great crisis was created by macroeconomists, without war. This was similar to the roaring twenties bubble, fuelled by the invention of open-market operations, which led to the Great Depression.
Stimulus
After the housing bubble, the US engaged in stimulus rather than tightening policy like Sri Lanka did after the 2022 crisis, triggered by previous rate cuts, and leading to a quick economic recovery once inflation was squeezed out. Now, the budgets and national debt of all Western governments have been destroyed by macroeconomists who misled politicians into deficit spending.
Persistent inflation made the public unhappy, and nationalism was on the rise. Similar to Germany, it was hit by the spread of open market operations and the onset of the Great Depression.
How It All Began….
53. Interest Rates.—Despite the large expansion of bank credit, the Central Bank did not raise its discount rate. There was also no significant change in the long-term rate of interest. Government paper of 21-26 years’ maturity continued to be quoted in the market at a rate giving a yield a fraction under 3 per cent per annum. The short-term interest rate as reflected in the yield of Government securities below five years’ maturity and the treasury bill rate rose. The latter went up from 0·4 per cent per annum at the beginning of the year to 0·92 per cent in August, 1952, at which level it stood for the rest of the year.
Before the Central Bank’s ‘rate cuts’ Sri Lanka’s inflation (and interest rates) were around the same levels as ‘developed’ nations under a sound monetary standard.
Source: Central Bank of Ceylon Annual Report 1952
Sri Lanka’s budget deteriorated in the 1980s as the rupee collapsed, due to technical advice from the IMF and others demanding competitive exchange rates, even as the US and UK tightened policy.
In fact, in the UK, energy utilities also made large profits as inflation was brought down in the 1980s and newly privatised electricity firms made windfall profits. The UK government heavily taxed these corporations, earning enough to reduce the deficit.
There is no benefit for people or the government in the insistence on high inflation. An annual inflation rate of 5% is more than the Great Inflation rate, suffered by Sri Lanka and the world in the 1970s.
In the 1980s, Sri Lanka’s budgets unfortunately deteriorated due to extremely high levels of inflation from currency depreciation. Even as East Asia, with fixed exchange rates, benefitted from the tighter policies of the UK and the US.
The tighter policies also made free trade possible, and great prosperity came to East Asian countries that ran deflationary policies and invested their savings in the US, also benefitting Western nations.
If the Central Bank insists on creating 5% inflation and depreciating the currency, any or all progress made in the past two years will cease to exist.