Sri Lanka’s economy is now shrinking, lifetime savings of the people have been halved, and inflation is the highest created in the history of S the Latin America-style central bank, and the worst fears of those who nervously watched the money printing agency as it was created in 1950 have been realized.
Unusually it has been politicians who have sounded warnings from the beginning, though they went along with the interventionist economic ideology that sprang up among Anglo-Saxon academics of the day.
A POLITICIAN’S WARNING
A politician sounded the first warning on the day Sri Lanka’s central bank was created.
“There are some I know who think that we should not have established the central bank. It is true that our experience in the realms of so-called high finance has been brief,” then Ceylon’s Prime Minister D S Senanayake was quoted as saying in a news report reproduced in the publication Central Bank in Retrospect.
“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 were fully aware that the central bank had been abused in many countries in the past. 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.”
GREECE
Greece descended into hyperinflation because the post-World War II administration failed to put the brakes on the wartime money printing of the Nazi military currency. A communist insurgency was feared in Greece fanned by monetary instability.
Significantly, Greece was a country where the Marshall Plan agents (Economic Co-operation Agency) and Harvard-style Keynesianism had strong influence; unlike in Germany where the hard-money Austrians and Ordoliberals did everything they could to avoid its interventions. Significantly, the Greek currency also continued to depreciate in the post-Bretton Woods era from around 30 to over 360 to the US dollar, unlike Germany and German-speaking countries in Europe.
Germany descended into hyperinflation in the 1920s and defaulted on its debt. Two US-led plans, the Dawes plan and the Young Plan (with some central bank reform in the Dawes Plan) were unable to bring permanent stability and Germany was unable to repay debt and also World War I reparations.
As a result, Germany went to the National Socialists and Hitler came to power. However, after Hitler’s defeat, West Germany went into full stability mode, junking printing and stimulus and became a stable export powerhouse. In China, the KMT also faced troubles, somewhat similar to the problem Sri Lanka finds itself in now.
CHINA
Several years before the communist uprising, China faced difficulties in repaying debt due to depreciation. The initial problem was the inability to repay gold standard debt with its silver-backed money due to the fall in the value of silver.
The self-same Young who tried to help Weimar Germany backed by Kemmerer – a money doctor who had set up several mostly stable Latin American central banks which Fed’s Robert Triffin later tinkered based on the model of Raul Prebisch’s Argentina central bank – cooked up a plan to restore external viability to China by charging customs revenues in gold.
However, China descended into high inflation later and the communists won. Later when the KMT fled to Taiwan, they learnt their lesson. Taiwan the country now operates like a currency board and is an export powerhouse with a very stable exchange rate which brings low inflation. In general, to operate a strong exchange rate and collect reserves, a monetary authority has to run a deflationary policy.
China’s communist regime also fell to its knees in the 1970s when the Bretton Woods collapsed. One of the first reforms of Deng Xiaoping was to reform the central bank and halt its ability to print money to finance industrial and commercial activities.
In the same way, as CB Governor A S Jayewardene stopped rural credit re-finance and built a barrier between the central bank and Rural Development Banks, economists under Deng separated the industrial and commercial credit divisions of the People’s Bank of China and built them into commercial banks. A similar reform was carried out in Vietnam in 1989 when the Vietnam Dong collapsed after the open economy started in 1983 creating unrest, boat people and poverty.
SHENOY’S WARNING
B R Shenoy, the Indian classical economist who advised JR in 1966 to tame the central bank issued a similar warning to Jawaharlal Nehru when the second 5-year plan was developed by Prasanta Chandra Mahalanobis. An arch planner, he could probably outdo Gosplanners themselves. The 5 –year plan involved money printing state spending, now called stimulus or targeting an output gap.
“To force a pace of development in excess of the capacity of the available real resources must necessarily involve uncontrolled inflation,” Shenoy wrote in his now famous Note of Dissent. “In a democratic community where the masses of the people live close to the margin of subsistence, uncontrolled inflation may prove to be explosive and might undermine the existing order of society. In such a background one cannot subsidise communism better than through inflationary deficit financing. Probably the greatest enemy of the Kuomintang in China was the printing press.”
In Sri Lanka communist insurgencies were also fired, the economy controlled and kids starved developing Marasmus and kwashiorkor amid trade controls on food. Now Ranil Wickremesinghe is claiming misleadingly that ‘Fascists’ are raising their head and is cracking down on the Frontline Socialist Party and university students.
NO CHANGE
Nothing will change in Sri Lanka with monetary instability now a part of regular policy through flexible inflation targeting and ‘data-driven monetary policy’. In 2012 and 2018, the central bank missed reserve targets within IMF programs due to suppressing rates with printed money in a recovery. Make no mistake, save for a few, Sri Lanka’s neo-Mercantilists have been fully behind the monetary instability triggered by the agency by printing money to suppress interest rates. They will cry from the rooftops to depreciate the currency instead of raising rates to stop money printing. Economists who call for a float (isolating reserve money from the balance of payments) however are not the same as those who ask to break the peg.
In Sri Lanka, the central bank’s suppression of interest rates, its re-financing of rural credit, including in years where there was no budget problem, and its deficit financing at times, were fully backed by the economists of the day. After 2015, its open market operations, overnight auctions, term repo auctions, yield curve targeting through outright purchases, the buffer strategy, operation twists and money creation through Sorosstyle swaps, including when there were no budget problems, inflationist-devaluationism of REER targeting have been almost universally backed by almost 98% of the economists of the day.
Most people in the country hardly have any understanding of how the central bank creates forex shortages and its opaque and liquidity injections justified with technical sounding esoteric words like open market operations, to pull the wool over the eyes of its victims.
It is the helpless public who suffer most at the hands of the central bank. Their future destroyed, their lifetime savings destroyed and driven to social unrest and anti-government activity, they sometimes pay the ultimate price. The politicians are ultimately blamed for policy errors and get kicked out, sometime before their term ends.
LEGISLATIVE POWER CAN BEAT FLEXIBLE POLICY
In the same way, it is politicians who can beat the neo-Mercantilists, the planners, and the Harvard-Cambridge (KeynesHansen) interventionist nexus. In all other countries with monetary stability, it was politicians (advised by classical economists in some cases) who finally brought the Mercantilists to heel. It was the case far back in 19th century England. Ricardo, Thornton, and Prime Minister Peel come to mind. In Germany (after the Weimar Republic) it was Ludwig Erhard, in Singapore, it was Goh Keng Swee (after Japanese Banana money) in China, Zhu Rongji.
Greece had no domestic ideology to get itself out of trouble. In fact, there were calls by neo-Mercantilists to Grexit, depreciate the currency like Sri Lanka and reach debt sustainability through inflationist-devaluationism. To be fair JR tried twice to get classical economic advice by bringing in B R Shenoy and Goh Keng Swee, the best hard money economist in South Asia and the best hard money economist in East Asia.
Like Greece and Latin America, there is no domestic monetary knowledge except in the case of economists like W A Wijewardene who practised what he preaches in the central bank along with his then-chief A S Jayewardene.
Politicians have the legislative power to undo the wrong done under D S Senanayake, which was worsened in later stages by setting up a rural credit department and making it easy to depreciate the currency without parliamentary approval instead of market pricing interest rates. A politician, a finance minister, or a prime minister can undo the wrongs of 1950 and tame the crisis-prone flexible inflation targeting peg.