Its proponents suggested that modern monetary theory (MMT) was the magic bullet to fund infrastructure, provide social safety nets and usher in a new era of prosperity for the world. MMT is another way to describe printing money, eschewed by classical economists due to its inflationary impact. Proponents of MMT argue, however, that a link between printing money and inflation exists.

In a public lecture, W.D Lakshman, the former Central Bank Governor, said he doesn’t see any relationship between money and inflation. In facing a large budget deficit due to sweeping tax cuts and the impacts of a slowing economy due to Covid in 2020, Sri Lanka adopted a policy much like MMT. Two years since the monetary expansion began, the country’s inflation rate has topped 50% and continues to rise.

Former Deputy Governor of the Central Bank Dr W A Wijewardena, and Colombo University Economics Professor Sirimal Abeyratne, interviewed by Advocata Institute’s COO Dhananath Fernando, discuss how Sri Lanka should now approach monetary policy after the failed experiment with MMT.

What does MMT (modern monetary theory) mean in your view? Is it just printing money or something more than that?

Dr W A Wijewardena: It is a representation of the old Keynesian economics theory that suggests that if there is a decline in aggregate demand leading to an economic recession, governments can intervene to increase aggregate demand so that suppliers could supply goods by mobilizing resources, which increases output and employment.

The suggestion was that the government increase its budgetary expenditure. It was suggested that getting money out of the economy by borrowing will not help because that is just a redistribution of existing savings in the economy. Therefore, it was suggested that there’s nothing wrong with the government printing money to spend on goods and services and in turn, that would put more money in the hands of the public, who will spend it.

What’s happened recently was some groups started preaching that the same old Keynesian theory can be used in a modified form. They suggested, that it was a myth that the budget deficit is a curse. Instead, they suggested that budget deficits and printing new money could stimulate aggregate demand to guide a country out of recession. This is what happened recently.

The origins of modern monetary theory begin with John Law, a 17th-century Scottish economist who said that money belongs to the king. Therefore, he said, the king has a right to issue money over and about the reserves that protect that money. He suggested to the then monarch of Scotland, that they issue new money, increasing the legal tender in Scotland. However, the Scottish government rejected his idea and he fled to France where King Louis XIV accepted his proposition. France was bankrupt within a few years after the king experimented with John Law’s theory.

Several things have gone wrong here. So is it fair to say Sri Lanka’s economic troubles are due to modern monetary theory, so what is MMT’s contribution to the crisis?

Prof Sirimal Abeyaratna: Issuing more money will bring prosperity; that’s the underlying belief of MMT. I wouldn’t even call it an economic theory because it’s more like an accounting technique.

If we examine the underlying economics, I don’t think anybody’s going to believe in MMT. Issuing more money to the economy drives up aggregate demand and inflation.

There are economic cycles. There are times when money can be issued in abundance, like the last 10 years period in the world economy. During periods of low growth, the relationship between money and inflation is weaker. But during expansionary times, the relationship between money and inflation is stronger.

If the demand is low, for example, during Covid, can there be some level of MMT? Can you add more money to the system?

Abeyratne: We have seen that fiscal policy stimulus, and monetary policy stimulus, are quite common during recessions and crises because the aggregate demand has fallen. The effects can be mitigated if more money is issued. This has been the case in both developed and developing countries.

However, what is happening in the global economy now we cannot say is the adoption of MMT. Whether people believe in MMT or not, countries haven’t adopted it.

How can we undo MMT or modern monetary theory? Can we reverse this?

Wijewardena: You can always reverse whatever you have already done, but at a great cost. For example, this money printing is a misnomer because many people think money printing is the central banks printing new currency notes and coins; which is wrong. It is the stock of money that would affect the aggregate demand of the economy or the total money supply in the country.

Now, if you look at the past 27-month period, beginning from January 2020, there had been an increase in the total stock of money by 4 trillion rupees, which is 53%. If you want to reverse that, you will have to absorb that. The Central Bank must then sterilize that entire amount in circulation with the people of the country.

For that purpose, you will have to increase interest rates to a very high level, which would in turn affect the economic growth in the country. High rates will affect small and medium enterprises which have to borrow money from banks. Whatever mistakes can always be reversed, but it’s at a great cost.

Monetary economists warned the Central Bank not to do this experiment due to the challenges of reversing it. The cost of reversing cannot be borne by the economy of any country.

The former prime minister said we have to print one trillion rupees to pay government sector salaries. So it looks like we cannot even pay salaries without printing money now?

Wijewardena: If Ranil Wickremesinghe wants to print one trillion rupees to pay salaries because he cannot allow the government sector to go bankrupt, then he must also sign an agreement with the Monetary Board of the Central Bank that he will repay it over six months. And during that period, the government will have to raise revenue through other means, whether borrowing from the market, borrowing overseas, or raising taxes.

It may have to be a combination of all that, but he will have to repay that trillion rupees over a given period so that the long impact of increasing the total reserve money of Sri Lanka by 1 trillion can be mitigated.

Abeyratne: There is a cost to these actions and that cost has to be borne tomorrow. But public sector salaries have to be paid today. Even in history, we have done this quite often. For today’s gain, we have often sacrificed the future. In many ways, this is one reason for the economic crisis.

What would be the cost of adding a trillion rupees to the money supply?

Wijewardena: If you look at our reserve money, which is being used as the seed money by the banking sector to create multiple deposits and credit; the reserve money level in Sri Lanka is about 1.3 trillion. If the central bank accommodates the government’s requirements of about 1 trillion or more, the reserve money base will go up to 2.3 trillion. The banking sector in Sri Lanka today will multiply every rupee issued by the Central Bank into eight rupees, as the final level of the money supply.

What would happen is the present money stock of about 11 trillion rupees in Sri Lanka will go up to 18 trillion within a matter of 12 to 18 months. This means that the money supply has already increased by 53%. With Ranil Wickremesinghe’s solution, it will go up by another 60%, which would mean that we are heading towards hyperinflation and we cannot avoid it.

That is why the central bank governor is very concerned. It is the responsibility of the monetary board of the central bank to the people, to protect the value of our money, it is not the responsibility of the Prime Minister. His responsibility is to pay salaries.

Both the government and the central bank must arrive at a compromise and reduce the burden on the people by reducing inflation. At the same time, to pay salaries money will have to be generated through taxation or borrowing from the market.

Abeyratne: In a crisis such as this, we have no easy choices. We have ended up spending beyond our capacity. The solution for this crisis is not to print a trillion rupees more, but to cut spending. Even public sector salaries may have to be cut. Ruthlessly reducing spending is the only solution at the moment.

In a crisis such as this, we have no easy choices. We have ended up spending beyond our capacity. The solution for this crisis is not to print a trillion rupees more, but to cut spending. Even public sector salaries may have to be cut. Ruthlessly reducing spending is the only solution at the moment

70% of government income is spent on interest for existing debt. Is restructuring the domestic debt an option in your view? Because if we restructure and postpone the domestic debt interest payment we may have a solution? Already the government is exploring restructuring the foreign debt?

Wijewardena: Of the 70% of revenue share we use for interest payments, part of it is paid to foreigners, which we have already suspended. So that part has been saved for the budget. If there is any problem with the government repaying the domestic debt, it can always refinance it by issuing more Treasury bonds and generating the required funds to pay the interest payments.

But if there is going to be hyperinflation, the government will not be able to generate any more funds by borrowing because the people will lose trust in the ability of the government to maintain the value of the money the government has produced. It happened to Russia immediately after the Soviet Union collapsed in 1991. Inflation rose 1,000% per month, and as a result, the Russian government could not pay salaries because they could not print any more Roubles. They couldn’t borrow money either. Salaries were paid in the form of vodka bottles. Now, in our case, our government doesn’t have vodka bottles. So there is a problem here.

Which option would you prefer us to adopt? Reduce expenditure or print a trillion rupees? Which is more feasible in your view?

Abeyratne: Restructuring debt, suspending debt payments and printing money to pay salaries; all these are temporary measures which are not solutions to the problem. Addressing the source of the problem is the most important thing. There is no overnight fix.

The public has to bear the cost. We are reaping today what we have sown in the past. Politicians, bureaucrats, businessmen, the public sector, and the general public have all contributed to this current problem.

At the source is a need to raise government revenue, more efficiently. The other part of the challenge is reducing expenditure; from top to bottom.

Some MMT proponents said they have analyzed the money supply and inflation of more than 100 countries and they found there’s no relationship between the two. But according to the classical school of thinking, that’s one of the closest relationships in economics, the one between money supply and inflation. How do you view this?

Wijewardena: There is some analysis by proponents of MMT and they have said that the current economic crisis in Sri Lanka is not due to MMT. What they say is correct.

Our economic crisis is due to structural problems; Sri Lanka’s economy has been like a sick man for a long time. What happened was that sick man had been given the wrong medicine by the people who had been in power after 2019.

So we can agree with the analysis of the MMT proponents that Sri Lanka’s economic crisis is not mainly due to MMT. Due to the current economic crisis, we have lost all our foreign reserves, Sri Lanka’s exchange rate is under continuous pressure to depreciate and inflation is rising due to the wrong medicine that has been administered to the economy by the people in power.

In a public lecture, W.D Lakshman the governor of the Central Bank since November 2019, said he doesn’t see any relationship between money and inflation.

Restructuring debt, suspending debt payments and printing money to pay salaries; all these are temporary measures which are not solutions to the problem. Addressing the source of the problem is the most important thing. There is no overnight fix

What is the solution? There have to be some restrictions placed on the monetary side of things. So what’s your take on the situation?

Wijewardena: When a healthy man gets caught up in a heavy rain shower, he would wipe out his head, and perhaps sneeze once or twice. But when the sick man is caught up in the same downpour the situation will be far more different.

When you consider the global perspective, we know our issuing more money has gone a little too far. Of course, the USA, Japan, Western Europe, and even China, have been issuing enormous amounts of money in the last two decades. But we hadn’t seen inflation rising in the global economy until recently.

There is a distinction between rich countries and developing countries like ours. Rich countries can do that because their currencies are internationally accepted. Exchange rates of the dollar, euro and yen, are not impacted greatly by their monetary expansion.

Our rupee is not accepted anywhere in the world. We can’t do the same thing. To import and repay foreign debt, we have to convert our currency into dollars.

Due to the monetary expansion, we have too many rupees in the country, and we will demand more and more dollars, which is the cause of the exchange rate depreciation.

For western countries to achieve higher growth, they need a little bit of inflation. They have a fear of deflation too. So we need some inflation. But their s.ituation is quite different from ours.

Prices respond slowly; that’s a macroeconomic reality. We printed and issued money massively and the impact of that money on prices will be felt over some time.

If prices respond slowly can we address this with inflation targeting? Could you explain what this means and whether we should go for inflation targeting or flexible inflation targeting?

Wijewardena: Inflation targeting is when we fix projected inflation to a certain level, say 2% or 3%, and stick to that whether the demand comes from the government or from the economy and whatever the shock the economy may experiencing. Inflation targeting is done by countries like Australia, New Zealand, Canada, UK and France.

You control the money supply, and they don’t change the monetary policy stance. In response to any emerging situation in the country, the adjustment should be done in the real sector rather than the monetary sector.

In flexible inflation targeting, we use the same discretionary money printing power of the Central Bank, given to central banks throughout the world to quickly respond to emerging economic shocks. For example, look at the Covid pandemic. That was an external shock and had nothing to do with the Central Bank of Sri Lanka or with the government in power. When the economy goes into recession, the flexible inflation targeting program will enable the central bank to move the target a little higher, unlike with a fixed interest rate target.

That is why the central bank of Sri Lanka has this inflation band of 4% to 6%. They will try to have it at 4%. But if the economy requires certain adjustments and certain flexibility, they will go up to 6%.

But today, what has happened is that 6% has gone to over 30% and 30% will go to 40%.

Abeyratne: As long as the Central Bank has the independence and the authority to act on these things, it’s fine. But if the Central Bank is supposed to finance the government budget deficit, then it’s alarming. The Central Bank cannot do two things at the same time which are contradictory as it is now. The government wants to spend more in the current situation, but the Treasury has no tax income, it has collapsed.

They forget the primary objective of the central bank. No central bank can achieve contradictory objectives simultaneously.

Anything you want to add?

Abeyratne: We have to learn from our mistakes and that’s all I can say at this juncture. The current crisis is our creation; the collapse was instant. We prescribed the wrong medicines, and we made a mess of things during the last two years.

During the last two years, we haven’t done anything to get out of the crisis. Still, we are talking about how to manage our debt, and how to borrow a couple of billion for the next couple of months.

This worries me. We are looking at how to manage and not how to resolve the situation. When are we going to bring discipline to our internal finance, and are we going to improve our cash flow. These are the main issues for an economic recovery.

Wijewardena: In the immediate run, we must plan to keep our heads above the water. There’s no question about it. But in the medium to long run, Sri Lanka has to come up with a new program to grow its economy.

For that purpose, I think the government of Sri Lanka will have to come up with a roadmap for the next 10 to 15 years, to restructure Sri Lanka’s economy, the business sector, government sector, and the sub-sectors of the economy and navigate the challenges emerging in the global economy.

What is emerging in the global economy is the fourth industrial revolution. We are still in the second industrial revolution here. So, we have to bypass the third and move on to the fourth which is difficult but not impossible if you have a proper plan.