For many years the destabilizing central bank of Sri Lanka set its own inflation target at around 4-6%. It printed money to meet the anchor and triggered forex shortages, currency crises and excessive foreign borrowings that ended in default in 2022.
It was not the case when inflation was not permanent. There was no balance of payments troubles, 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 the system started to deteriorate.
The gold standard kept inflation down (and budgets under control) and the balance of payments stable through free market interest rates. Central banks did not generally print money and float currencies (thus breaking the gold targeting rule) except in war times.
BEFORE OPEN-MARKET OPERATIONS
The aggressive open market operations through which Sri Lanka’s central bank and those in Latin America now create a high level of inflation were absent.
When the UK became a great imperial power, the Bank of England – as a private agency – was accountable to the public and the parliament. It could not depreciate at will and impose exchange controls to hide its perfidy as third-world SOE central banks do now, turning their countries into basket cases.
The so-called Lombard and bank discount rates frequently moved as banks targeted a specie anchor at zero. Now inflation is targeted at 2% by Western central banks that 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 remember 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,” Burgess says.
UNACCOUNTABLE CENTRAL BANKING
That liquidity injection flows like water and the concurrent loss of gold reserves were well known to classical economists in Europe. The price specie flow mechanism described by David Hume and other classical economists was the bedrock of low inflation and external stability.
The Fed then created the Great Depression and the UK went off the gold standard in 1931 in a complex set of circumstances without parliamentary approvals. Other central banks in countries which recovered from the downturn 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 classical led by David Ricardo and later the currency school fought back against the private Bank of England.
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 Walters came to power, rejecting these ideas.
Ironically it was the classical economists 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).
Through Bretton Woods, an attempt was made by the US and UK to stop devaluations and preserve free trade. But with open market operations and fixed policy rates now 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.
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 accord almost collapsed in 1950/51 and was saved by Fed Governor Marriner Eccles. But within 20 years, it was dead.
SECOND CLASS ANCHORS
By and by, a 2% 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% rule however failed to prevent 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, 4-6% was enough to bankrupt entire governments.
Sri Lanka’s repeated currency crises in 2012, 2015/16, 2018 and 2020/22 came from trying to target inflation at 4-6%, almost three times the positive inflation target of more successful 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 currency crises triggered forex shortages and defaulted
Central banks in Sri Lanka and Pakistan also borrowed through central bank swaps, another deadly invention of the Fed in the desperate dying days of the Bretton Woods to cover up its money printing
Before swaps, central banks could only run down their reserves and float (suspend convertibility). After Fed swaps, they could print money until reserves were negative.
Sri Lanka’s lawmakers should ban the central bank from borrowing through swaps. All borrowings should be made only with parliamentary approval like any other loan not through an unaccountable central bank 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 classical economists.
That a reserve-collecting central bank loses reserves is a law of nature, long ago discovered and described by classicalists ranging from Ricardo to Hume to Adam Smith. Scotland had a well-functioning gold-restrained free banking system at one time, which could lull anyone. Therefore, the real bills doctrine could operate as long as there was no fixed policy rate for extended periods.
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 on some econometric real effective exchange rate index, as academic mercantilists make out, but a law of nature discovered and described by classicalists centuries before.
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
But now 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 2%. Basket case countries like Sri Lanka targets 4-6% under the benign Mercantilist stamp or approvals of the IMF.
Other recently defaulted countries have targeted inflation indices as high as 7%. India until around 2011 successfully targeted a 5% wholesale price index which had a lot of traded commodities and was the antithesis of the core inflation index.
Sri Lanka’s legislators should therefore deny the central bank and its economists the right to continue to set their preferred de-stabilizing 4-6% inflation target and get not only the instrument but also goal independence.
Central bank independence is a flawed concept. Central banks should be subject to tighter rules to lower inflation, and lower the room to create banking crises and sovereign default.
Even in the flawed concept of giving independence to money-producing SOE, it is accepted that it should not be given ‘goal independence’ but only instrument independence, a reference of operational frameworks.
That operational frameworks of countries with forex shortages and exchange controls are also flawed is another matter. That a 2% 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 deadly central bank law, apparently drawn up by the central bank itself under IMF tutelage, has given economists room 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% could tame the central bank. 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% 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.
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 Africa and Latin America.
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 conflict 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.
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 to the lack of a doctrinal foundation in sound money.
Keynes was the most influential economist/Mercantilist in the last century and classical economics took a back seat. 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 programmes.
Macroeconomic 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 easily destroy Sri Lanka as they had from 1950 after the currency board was abolished.
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% inflation target with conflicting money and exchange policies (dual anchors) is inferior to a single anchor regime (a floating rate with a 2% inflation targeting or fixed exchange rate target at zero). But it is better than nothing.
The core problem is trying to separate Mercantilism from economics, which is what Adam Smith did successfully until the Great Depression hit and Keynesianism and econometrics infected Western academics in the last century.