In Sri Lanka, politicians are blamed for the country’s economic ills, but it is only partly their fault, as for the large part they seem to be misled by economic advisors and bureaucrats who are trapped in Mercantilist ideology that dates back to at least 1929.
And if that was not enough they have lit a fuse underneath the monetary system with Modern Monetary Theory. Why do policy makers think that imports are ‘A Problem’?
Why does Sri Lanka try to compress trade and imports? Why is there an obsession with the current account? Why does Sri Lanka try to ‘save foreign exchange? Why do people think exports are good (postponed consumption or austerity) and imports are bad (actual consumption of the proceeds of exports)?
Why is the country now in danger of default? Why did the last administration raise so much foreign debt? Why did the last administration stop gold imports and re-exports? Why did Sri Lanka sell rupee debt at higher yields than dollar debt? Why oppress the poor with import substitution and make a few cronies unbelievably rich?
Why are Mercantilists (who go by the label economists in Sri Lanka) so obsessed with the current account deficit?
While many people including the ordinary man on the street have a vague idea of what the trade deficit is, many surely do not know what the current account is made up of. That obsession is clearly with the ‘educated’ lot. And here is the clincher.
Why do people think that foreign debt cannot be repaid by raising domestic debt? While it is true that money printing by Sri Lanka’s Latin America-style central bank and its single minded obsession to keep interest rates down is at the root of most of Sri Lanka’s monetary problems, driving illiberal anti-growth policies and controls, it does not answer all questions.
The answer to the question lies in a Keynesian mis-understanding of international trade that is generally called the non-existent ‘transfer problem’.
THE TRANSFER PROBLEM
The mis-understanding that is currently prevalent about trade and current account deficits, dates back to the roots of Keynesian Mercantilism which is widely taught in universities and schools not only in Sri Lanka but also in many Anglo-Saxon areas. Because there is a centralized syllabus like in a communist state in Sri Lanka, everyone is brainwashed with the idea which is generally referred to as the ‘transfer’ problem.
In 1929 John Maynard Keynes published a piece in the UK based The Economic Journal (The German Transfer Problem) that claimed in a nutshell that Germany would not be able to make war reparations, because it had a trade (or current account) deficit and it would not be able to make payments unless it increases exports to do so. And it also had to reduce domestic wages and costs.
Economists on the opposite side argued that it was not so, and that Germany only had a ‘budgetary problem’ in that it had either slap reparation taxes or borrow money, and the act would take away domestic spending power and make available resources and foreign exchange (or gold) to make the payments. The act of making outward payments they pointed out would create a trade surplus. It was not a ‘price effect’ they pointed out but it was simply an ‘income effect’.
But it was a difficult concept for people and politicians to grasp. The debate took place between the so-called Dawes Plan and the Young Plan. In the end the politicians and Keynes had their way, and the Socialist Weimar Republic collapsed in hyperinflation.
Keynes sort of accepted that the budgetary problem could be solved but continued to insist that there was a transfer problem based on an idea that exports could not be priced attractively enough to get a higher market share or ‘price effect’ and Germany had to deflate. Keynes edited The Economic Journal between 1912 to 1944. That probably helped in the spread of Keynesian ideas in the UK, though to be fair, he has published criticisms as well.
BERTIL OHLIN
One economist who pointed out the error of Keynes’ thinking was Bertil Ohlin. Ohlin was from Sweden. The Stockholm school of Economists (led by Knut Wicksell) had proposed Keynesian style remedy to downturns before Keynes himself. Nobody however would accuse Stockholm economists of not knowing international trade or monetary policy. Gunnar Myrdal in 1974 shared a Nobel Prize with Hayek.
Ohlin pointed out (Transfer Difficulties, Real or Imagined) that the excess of imports over exports came from higher spending power that was given to the German economy through foreign borrowings. Foreign borrowings not only increase the demand for imports, they may also increase the domestic demand for previously exported goods
“A and B are two countries with normal employment for their factors of production,” Ohlin tried to explain in the June 1929 issue of ‘The Economic Journal’. “A borrows a large sum of money from B this year and the same sum during each of the following years. This transfer of buying power directly increases A’s demand for foreign goods while it reduces B’s. Thus A’s imports grow and its exports fall off.
“If the sum borrowed is 100 mill. Marks a year the excess of imports A brought about in this direct manner may be 20 mill. Marks. For in large countries only a small part of demand turns directly to foreign goods or to export goods. The rest, 80 mill. Marks increases the demand in A for home market goods.”
This is the type thinking in Sri Lanka that goes to say tourism receipts have some imported inputs, therefore the net earnings is the difference. If we stop imports and make a good domestically we will only pay for the inputs. This year the statement is made that out of a large volume of 2.5 billion dollars of foreign direct investments expected 1 billion dollars may be imports, and the rest will be domestic inputs, like the 80 million marks in Ohlin’s illustration.
Here is the crux of the problem. “Evidently Mr Keynes and the school of economists who share his view think that this is the end of the 80 mill. Marks. As they do not directly increase the excess of imports they can have no effect whatever on the balance of trade. They can be left out of the reasoning altogether,” Ohlin wrote.
“I venture to suggest that, on the contrary, this amount of borrowed buying power deserves special attention. It set in motion a mechanism which indirectly calls forth an excess of imports in A of about the same magnitude (as the borrowing). Just as the loss of this buying power indirectly creates an export surplus in B: or rather, these changes in buying power bring about, at the same time, an excess of imports in A and of exports in B
“A corresponding adjustment takes place in B. Home market industries grow less as a result of reduced demand for their products, and the labour and capital turns in greater proportion to export industries and industries which manufacture goods which compete directly with imported goods. The outcome is an excess of exports. B finds a widened market for its goods in A as a result of the adaptation of production which takes place in that country. Thus, the readjustment of production is the consequence of change in buying power in the two countries.”
“The monetary mechanism which brings about the change varies with the organization of the monetary system.” Monetary systems are credit systems. They work like banks. A pegged central bank is an agency which takes deposits in dollars and issues a ‘bank note’ as a commercial bank will issue a fixed deposit with zero interest.
Decades later when East Asian central banks mopped up large volumes of inflows through the sale of sterilization securities and built up forex reserves and purchased US Treasury bills (transferring large volumes of capital below the line) America ran a trade deficit. Mercantilists then sort of got it (the reference ‘Asian savings glut’) but they are clueless about the actual operations of a successful East Asian central bank that gives the result.
America ran a trade surplus when it financed Marshall Plan lending as European demand for goods suddenly surged. The demand fell away as Marshall Plan loans were repaid. However Keynes did not get it. He did not appear to know how banking systems worked. This was his rejoinder. He said the loan will not increase money incomes in the recipient country but will “enable German workmen to be employed in producing capital goods.
Neither did the First World War winners. Neither do the policymakers here get it. Neither do Trump or any other economic nationalist. The current account deficit is – roughly – the inverse of the financial account.
JACQUES RUEFF
Another Economist who replied to Keynes was Jacques Reuff in the same issue explaining what he called was the principle of conservation of purchasing power and that in “all cases one’s loss is another man’s gain…” Keynes, Rueff said, seemed to believe that ‘the balance of trade at any moment is largely dependent upon the economic structures of the various countries, and that it cannot adjust itself rapidly to the requirements of an equilibrium balance of payments when the conditions of this equilibrium are abruptly modified. “
This is also true in Sri Lanka. Many policy makers seem to believe that there is some inherent structural flaw that makes Sri Lanka run a current account deficit and it is not the import of capital and the exchange controls that prevent their export.
Monetary systems are credit systems. They work like banks. A pegged central bank is an agency which takes deposits in dollars and issues a ‘bank note’ as a commercial bank will issue a fixed deposit with zero interest
Rueff (a Frenchman who was Deputy Governor of the French central bank) said in 1919 British and American governments halted the payments of about ’20 milliards of francs’. According to Keynes this should not have reduced the ‘commercial balance’ (trade deficit).
“The facts show, however, that this was by no means the case,” Rueff explained. “In 1919, the deficit in France’s commercial balance was approximately the same. But in 1921 it had been reduced to approximately 2 milliards of frances, and remained more or less during 1922 and 1923.”
Rueff went on to explain that in 1923 France started to export capital and in 1924 it had a ‘commercial surplus’ of 1,450 million francs
Thus, during all this period France’s commercial balance has always adjusted itself very definitely to modifications in the financial factors of the BOP (first political credits and then investments abroad), although these modifications were extremely rapid and involved exceptionally large amounts, and although they had no relation to what Mr Keynes called the economic structure of the countries concerned.” Reuff explained that between 1872 to and 1875 when France was repaying a war debt imposed by Germany, there was a trade surplus.
MONETARY INSTABILITY
The Weimar Republic went further. It printed money. When money is printed, not only does the trade deficit increase it also causes the currency to fall as there is no foreign exchange or gold to import goods. The Weimar Republic then collapsed into hyperinflation. The allies then suspended payments.
Ludwig von Mises, an Austrian economist later wrote that the Western Allied politicians were misled by “a spurious “transfer” problem.
“They were disposed to accept the German thesis that a “political” payments has effects radically different from payments originating from commercial transactions. The truth is that the maintenance of monetary stability and of a sound currency system has nothing whatever to do with the balance of payments or of trade.
“If a country neither issues additional quantities of paper money nor expands credit, it will not have any monetary troubles. “An excess of exports is not a prerequisite for the payment of reparations. The causation, rather, is the other way round. The fact that a nation makes such payments has the tendency to create such an excess of exports. There is no such thing as a “transfer” problem.”
By the time he died Keynes left the UK in a mess. Though it won the war against German nationalism and socialism; and Keynesianism destroyed the country. When Sri Lanka got independence from Britain, UK had to ask Ceylon not to withdraw currency board reserves precipitately.
Germany on the other hand forged ahead under Ordoliberal after striking zeros off with a new Deutschemark, achieved monetary stability and paid reparations and also Marshall Plan money, which it was not very keen on. Rueff advised Prime Minister Charles De Gaulle to overhaul the French central bank and created the new Franc after a series of devaluation at the rate of 100 to one, and helped save the country in 1960.
to solve Sri Lankas ‘budgetary problem’ in repaying debt, Treasuries auctions have to succeed. Failed Treasury bill auctions filled with printed money under Modern Monetary Theory will lead to forex reserve losses and turn Sri Lanka into a Weimar Republic or another Argentina
Britain continued to struggle until monetary policy was tightened and exchange controls were removed under Prime Minister Margaret Thatcher allowing the country to finally dig itself out of currency crises and IMF bailouts. Thatcher reportedly went about carrying Friederich Hayek’s Constitution of Liberty in her handbag and pulled it out once when an ‘economist’ at a conservative think tank advised her to tread the ‘middle path’ or ‘mixed economy, the favoured road of fascists and violators of private property and individual freedom.
MONETARY STABILITY AND DEBT
Like the Weimar Republic, Sri Lanka is printing money and creating forex shortages. The dollar inflows that come into the country do not belong to the government. Even when they are converted to rupees, the rupee proceeds belong to private citizens. To get hold of the rupee the government has to tax or borrow the rupees. Since taxes have been cut borrowing is the only alternative.
However to solve Sri Lankas ‘budgetary problem’ in repaying debt, Treasuries auctions have to succeed. Failed Treasury bill auctions filled with printed money under Modern Monetary Theory will lead to forex reserve losses and turn Sri Lanka into a Weimar Republic or another Argentina.
Opening imports will not be a problem. It will only impact the interest rates and not the exchange rate. But it will bring more tax revenues and reduce the rate of interest that is needed for successful bill auctions, while allowing economic activities to resume and prices to fall. Moreover it will save the people from rent-seeking import substitution cronies.
There is no harm in the government’s attempt to boost inflows to 32 billion dollars a year in 2021 as announced. The problem is Sri Lanka has no plan to get hold of the dollars if Treasury bill auctions fail.
The central bank has imposed a surrender requirement on banks. That will create more liquidity. Ideally the dollars should be sold to the Treasury not the central bank, for existing rupees – rupees taken through auctions on which imports have been halted – without expanding reserve money. There is nothing to stop the Treasury from buying dollars, with the rupees taken from bill auctions.
The central bank has imposed a surrender requirement on banks. That will create more liquidity. Ideally the dollars should be sold to the Treasury not the central bank, for existing rupees – rupees taken through auctions on which imports have been halted – without expanding reserve money. There is nothing to stop the Treasury from buying dollars, with the rupees taken from bill auctions.
The International Monetary Fund is a useful tool since they have a ready-made debt repayment mechanism. Sri Lanka’s intention not to default is laudable. However IMF also generally subscribes to the spurious Keynesian theory of a ‘price effect. Hence they advocate depreciation and real effective exchange rate targeting.
MONETARY RULE
Successful East Asian nations have had either currency boards (unsterilized sales to defend the peg, and unsterilized purchases to match the growth in reserve money) which are neutral or monetary authorities that collect vast forex reserves. Countries such as Vietnam follow the rule of partially unsterilized sales which drives call money rates up, and sterilized purchases to buy and build up reserves.
The US Treasury is mistaken when claiming that the State Bank of Vietnam is undervaluing its currency, when it sterilizes purchases (buys dollars and kills the dong with securities sales), and so is the IMF in advising it not to do so.
Floating and depreciation are not the same things. A floating currency is fundamentally different from a pegged one. Sri Lanka has to be successful by not violating the rules of the impossible trinity if it enters an IMF program. It is not possible to control the exchange rate and print money to keep rates down. And it is not possible to print money and repay debt without losing reserves.
There is nothing wrong with Sri Lanka. There is nothing structurally flawed. Sri Lanka’s private savings are in excess of 20 percent a year. At the market interest rate it will be quite easy to sterilize 1 percent of gross domestic product and build up reserves year after year. As soon as the capital account is opened there could even be a current account surplus. When chronic depreciation stops with a floating call money rate, capital destruction and high nominal rates will end, creating an abundance of capital.
There is nothing inherently superior about current account surpluses or trade surpluses. Neither are they due to a price effect. They are just an outcome of income effects or a transfer of capital out, either above the line through foreign investment or below the line by the central bank or both.
Like Western Allied politicians in the 1920, politicians in this century are being misled about import and current account deficits. It took 40 years for Thatcher to shake off the Keynesian exchange controls. Germany did it shortly after the War. Singapore and Hong Kong which had currency boards, never had such problems.
Until Mercantilist policy makers realize this or some politicians succeed in reforming the central bank, Sri Lanka will suffer the same fate it has suffered since the Latin America style central bank was created. In 2021 Sri Lanka is closer to Latin America than ever.