On August 23, 1950, Sri Lanka, then Ceylon, barely two years after independence, dumped the country’s single anchored money regime and replaced it with a pseudo currency peg that sealed the newly independent country’s economic fate for the next 73 years. In 2023, as the unfortunate country celebrates 75 years of independence it (the pseudo currency peg) is to be replaced by pseudo-inflation targeting.

PSEUDO PEG

At the time the claim made by US Keynesians who promoted pseudo pegs was that economic bureaucrats could have monetary policy independence (print money to fix the exchange rate) with an exchange rate peg, unlike the currency board era. Sri Lanka’s unfortunate citizens lost their economic freedom due to the pseudo peg shortly after 1950 with an exchange control law enacted in 1952.

The US soft peg went down the drain with the collapse of the Bretton Woods accord in 1971 and the Fed, or to be precise the American academics and bureaucrats who designed it, took the gold standard down with them.

The Bank of England which kept the gold standard through three centuries did not have a fixed policy rate for itself to manipulate interest rates for very long, though it had also briefly floated on several occasions after suspending gold convertibility.

The US and major reserve currency central banks floated as the gold price (as well as other commodities) relentlessly kept rising, plunging the world into floating exchange rates. But floating rates did not have a credible anchor to replace gold. As a result, the 1970s came to be known as the period of Great Moderation. In 1980 Paul Volker tightened interest rates in the US to 20% and brought inflation down.

There were various experiments with money supply targeting as an anchor. By and by, Sweden and New Zealand invented inflation targeting as a credible anchor for clean floating regimes, where rates were hiked when inflation was seen to rise, disregarding other considerations like growth or employment.

PSEUDO INFLATION TARGETING

Now the International Monetary Fund and US academics are peddling a pseudo inflation targeting regime to Sri Lanka called flexible inflation targeting. Instead of a floating exchange rate, which is a very strong exchange rate where reserves are not used for imports – because there aren’t any – a pseudo exchange regime rate called flexible inflation targeting is proposed.

As the country celebrates its 75th year of independence, pseudo-inflation targeting is coming in as flexible inflation targeting. The pseudo peg is very much worse than a flexible exchange rate. Sri Lanka has been messing with a flexible exchange rate a pseudo floating rate – with money supply targets as an anchor – in the 1980s. That unstable regime destroyed J R’s attempt to bring back an open economy and plunged the country into chaos: widespread strikes and social unrest.

BAD MONEY AND MACRO-PRUDENTIAL REGULATIONS

A central bank that provides sound money will not only reduce price inflation but the other negative effects of inflating money. If money is unsound, price inflation will just be one lagged effect. If there is an exchange rate peg, forex shortages are the first fallout. Mal-investment, and asset price bubbles are another.

A raft of bank regulations and the Securities and Exchange Commission came after the Fed fired the roaring 20s bubble and triggered the Great Depression. During the 1980s and 1990s as Fed Chiefs Volcker and then Alan Greenspan maintained monetary stability ignoring Fed’s employment objective bank regulations were relaxed. Enter Ben Bernanke.

In November 2001 he made a speech on Deflation: Making Sure “It” Doesn’t Happen Here to the National Economists Club in Washington, setting the tone for rate cuts that followed and ended in the housing bubble.

“The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation,” he said. “By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entail.”

Bernanke persuaded Greenspan to loosen monetary policy fearing that deflation was about to happen. Rate cuts followed. The deflation of the Great Depression was a result of the monetary shock and banks were collapsing with people withdrawing money. No such monetary shock existed in 2001. The mother of all liquidity bubbles and the collapse of the Housing Bubble followed. And then more monetary loosening. Many parts of his speech became true later as the effects of the rate cuts ended in a macro-prudential disaster in 2008.

Choice picks include:

• Of course, the U.S. government is not going to print money and distribute it willy-nilly
• Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it.
• To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.
• A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years).

Sri Lanka’s former Central Bank Governor W D Lakshman borrowed from Bernanke’s playbook in setting ‘explicit ceilings’ for Treasury securities in driving the country into default. Ironically, Bernanke was given the Nobel Prize for Economics recently. In earlier ages, he would have been beheaded or expelled from the country for his actions. As a result of his actions and subsequent injections the threat of mal-investments and asset price bubbles are now greater.

In the classical period, central banks targeted their anchor at zero not two per cent and periods of inflation were followed by periods of deflation. That is why prices remained stable for centuries. The inclusion of macro-prudential regulations – a global trend – is an admission that money is bad.

Sri Lanka is going to target inflation at around five per cent, not zero, not even two per cent. This is the rate that led to serial currency crises, heavy foreign borrowings forex shortages and ultimate default. But the monetary juggernaut is rolling along, driven by the International Monetary Fund agreement which requires the bad money law to be enacted as the island celebrates its independence.

HISTORY REPEATS

The unelected interventionists who go by the name of economists who devised unsound money law with macroprudential will persuade politicians to enact this law as they did in 1950. They then misled politicians to enact an exchange controls law as forex shortages emerged. They then persuaded the politicians to enact an Import and Exchange Control Law.

Sri Lanka will adopt this third-rate monetary regime – not practised by any stable country – but is operated in many of the countries that defaulted – Ghana was targeting inflation at eight per cent, and Argentina at 17% when it collapsed in 2018 for the nth time.

All warnings against this unsound money law which requires macro-prudential regulations to cover its shortcomings will be ignored as warnings were ignored in 1950. When the central bank was built in 1950 with a law promoted by Washington to Latin American nations that have since collapsed, there were warnings that it was a mistake – mostly from abroad – according to then Prime Minister D S Senanayake:

“There are some I know who think that we should not have established the central bank,” he was quoted as saying. We made our decision to establish the central bank deliberately and with the full realization of its great possibilities for harm as well as its great possibilities for good. We need only to remind ourselves of how excessive use of central bank credit reduces the real value of the currency and resulted in the dissipation of foreign exchange reserves in countries like China and Greece after the war.”

Sadly, both the pseudo-external anchor set up in August 1950 and the pseudo-domestic anchored regime is coming from the same source – US salt-water university style thinking that drove the IMF at its inception and is driving it now in the wake of the Great Recession.

Ceylon joined the IMF the day after the central bank was set up on August 23, 1950. The Central Bank of Ceylon was set up in the style of a model developed by Fed’s then Latin America division chief Robert Triffin in the style of Argentina’s BCRA. Countries where the model was replicated collapsed repeatedly and also defaulted repeatedly if they had market access.

Sri Lanka got market access around 2005, but did not initially default due to the tight monetary policies of Governor A S Jayewardena and later Deputy Governor W A Wijewardena. Many of the countries in Latin America which were unfortunate recipients of this US advice are paying the price to this day.

Some have dollarized and escaped the curse of the policy rate and open market operations. But they are beset with the corruption and illiberal socialist or nationalist ideology that takes hold of the polity and urban intelligentsia in the aftermath of each economic crisis.

In Sri Lanka politicians have repeatedly paid the price for the privilege given to the Monetary Board to suppress interest rates. The people have paid a higher price. But the economic bureaucrats who demand monetary policy independence to print money escape censure.

UNACCOUNTABLE ECONOMIC BUREAUCRATS

The unaccountable economic bureaucrats have become adept at deflecting blame from themselves and transferring it to their victims. They have blamed exporters, they have blamed importers, they have blamed expatriate workers.

And they have blamed deficits after printing money for rural credit and manipulating bond yields when politicians raised taxes and the market price of fuel.

But politicians should take note. In Latin America and Sri Lanka, unlaced bureaucrats who draw up laws to give themselves independence to print money to suppress rates to stimulate growth, employment, output gaps or other goals which cannot be achieved by liquidity injections and plunge countries into chaos are unaccountable.

The account- ability provisions of the flexible inflation-targeting law are laughable. Not only is there no jail sentence, but there is also no loss of jobs, demotions or pay cuts. But politicians will lose their jobs. They will be subject to violence from an angry electorate.

Sri Lanka United National Party – which was responsible for the central bank – and was supportive of free markets – paid the biggest price. Their plans and anyone else’s plans for free trade and economic prosperity will be lost as they were lost to Dudley Senanayake as Prime Minister, J R Jayewardene as President and Mangala Samaraweera as Finance Minister if this flexible law is enacted to continue.

BAD MONEY, BAD RESULTS

Many of the actions that led to the current crises were illegal under the existing law. In his wisdom, A S Jayewardene put the objective as economic and price stability. Sound money stops not just price stability but also financial bubbles and mal-investment which are outcomes of inflating money. Hyperinflation and external default at lower levels of inflation are also outcomes of inflating money.

Money is bad not only in Sri Lanka but also in the west where thinking had been corrupted. The rush for macro-prudential regulations in Sri Lanka and the West is an open admission that money is bad. Now Western central banks which tried to inject money without any banking trouble to solve a real economy – let us say fiscal problem – like Covid with liquidity injections are now forced to back peddle, killing a recovery.

Both macro-prudential regulations and Bernanke winning the Nobel are signs of severe corruption of monetary theory. There can be no good economic outcome from bad money. Stability can only be brought by an inflation targeting law with genuine clean float. Or stability can be brought by a hard peg with genuine, floating short-term rates.

Both macro-prudential regulations and Bernanke winning the Nobel are signs of severe corruption of monetary theory. There can be no good economic outcome from bad money. Stability can only be brought by an inflation targeting law with genuine clean float. Or stability can be brought by a hard peg with genuine, floating short-term rates.