The outstanding achievement of modern inflationist macro-economists is their ability to elect a new government, usually socialists or nationalists if liberals are in power, after driving countries into currency crises or asset bubbles by cutting rates for growth.
No liberal government, with free trading aspirations, can survive in a country where forex shortages are created by spurious economic doctrines founded on statistics, backed by the International Monetary Fund more often than not.
Sri Lanka’s first currency troubles began to intensify soon after the central bank was set up in 1950.
The Fed fired a commodity bubble, by purchasing Liberty bonds (in what would now be called quantitative easing) pushing up Sri Lanka’s export prices until 1951. At the time the currency board had just been abolished and 3-month T-bills were 0.4 percent according to central bank data.
The Fed tightened in 1951, and some export commodity prices fell, but rice prices rose requiring more subsidies from the budget. Sri Lanka ran BOP deficits in 1952 and 1953 as the central bank printed money. Reserves fell from 216 million US dollars to 114.3 million by the end of 1953.
Stabilization Programmes and Illiberalism
Then 2-month bills were pushed up to 2.48%. Attempts were made to cut food rations. Food rations had started during the Second World War as the Bank of England lifted convertibility and ran un-anchored policy. As the Fed fired a commodity bubble in 1950, Sri Lanka’s budget came under pressure due to high rice prices.
Sterling monetary instability worsened after World War II, with Keynes driving British economic policy and Sri Lanka also had some exchange controls dating back from British policies. However, the country had at independence, a currency board regime and did not need them.
There was a leftist hartal in 1953. In 1954, Sri Lanka’s politicians acted decisively and pushed the budget into surplus in what would be the country’s first stabilization programme without IMF help with reserves at $114.3 million.
Growth fell, inflation also fell, but in the slowdown, the nationalists started to peddle their wares. The Sinhala Only Act was an election issue. The Sinhala only by nationalists upset the Tamil community. When nationalists come, or leftists come, policies reverse.
Rewind to 1931. Much the same happened in Germany, during the administration of Chancellor Heinrich Brunings, where a stabilization programme helped bring Hitler to power.
In Germany, the Social Democrats (Marxists essentially) were ruling at the time, and with their policies discredited, nationalists under Hitler peddled their ideology and came to power, targeting the Jewish minority.
The usual socialist messing up of the economy, and expropriation, coupled with the global depression leads to a belief that a ‘strong man’ can also solve the problem, economist Friedrich Hayek later explained.
West Germany Stands Out as Central Banker Win Elsewhere
By the end of World War II, with Germany in shambles, nationalists were defeated by outside forces and liberals came back with a hard money and stability doctrine.
They closed the Reichsbank, set up the Deutsche Mark under full control of the politicians, and established free trade and full free market competition under a full liberal democracy. The Deutsche Bank as an institution was established later.
West Germany’s Ordoliberals were so successful that the Social Democrats were relegated to the political backwoods until shortly before the break-up of the Bretton Woods. In 1959, the SPD officially abandoned its Marxism of expropriation and anti-capitalism under its Godesberg Programme as the economy boomed and support for a strong currency and the private sector grew gaining strong public support.
But the UK, the country that defeated Germany, remained mired in Cambridge economics, Sterling crises and IMF programmes till Thatcher came. The US was only slightly better. Economics was under siege from the so-called Saltwater universities with a virulent form of post-Keynesianism, coupled with toxic statistics displacing economic principles.
Paul Samuelson of MIT was a key driver of mindless econometrics. Monetary policy deteriorated in the Fed with macro-economics coming to the fore with a lean-against-the-wind policy, with the ‘wind’ also being originally fanned by the Fed with rate cuts.
In Sri Lanka in 1961, the Bank of Ceylon was expropriated and the People’s Bank was set up.
In 1961 the Federal Republic of Germany appreciated its currency around the same time as the Fed invented central bank swaps to borrow from other central banks without going to the IMF. Sri Lanka’s economists were pushing import substitution and after severely depleting reserves, started going to the IMF from 1965.
J R Fails to Defeat Macroeconomists
J R Jayawardene, the Finance Minister who created a central bank in 1951 and made the country a member of the IMF, brought B R Shenoy – probably the greatest classical economist produced in South Asia – to help in 1966.
Shenoy advises the country not to print money and float the currency, and avoid periodic devaluations saying these calculations about equilibrium exchange rates are suspect. This is advanced thinking as the Fed has not floated yet.
Macro-economists in Ceylon predictably ignored his advice and instead, printed money for rural credit and started multiple exchange rates, Latin America style.
In 1969 with reserves severely down, an import control law was brought into Sri Lanka, discrediting Dudley Senanayake’s free trade plans amid central bank activism. In 1969 as the Fed fired global inflation, Social Democrats were able to form a coalition government in Germany for the first time. As the Bretton Woods and the US dollar collapsed, Sri Lanka closed the economy completely.
Econometric Corruption Spreads
The collapse of the US dollar led to the Great Inflation of the 1970s as reserve currency countries struggled to find an anchor for floating exchange rates. Statistical corruption of economic principles reaches a new high.
Academic inflationists, apparently with no knowledge of central bank operational frameworks, clutch at the latest statistical formula. Blaming statistical formulae, imports and trade deficits have the added advantage that allow macroeconomists to escape accountability.
Nominal effective exchange rates are made popular by Fred Hirsch and Use Higgins. Econometricians then came up with real effective exchange rates as currencies collapsed and inflation diverged widely in the 1970s and worsened in the 1980s.
The deep knowledge of operational frameworks of note-issuing banks that classical economists from Ricardo to Hume to Torrens had developed in the 19th century seems to have disappeared in the brainwashing at Anglo-American universities.
In 1978, the IMF effectively ended external anchoring without a credible replacement domestic anchor, plunging many countries like Sri Lanka into a black hole of monetary instability. The exchange rate goes haywire and inflation rockets. As inflation goes up budgets go haywire. The macro-economists artfully blame budget deficits for monetary instability (which is dumb, since credit is credit whether private or state), not central banking.
In the 1980s East Asia latched on to the dollar with currency boards or currency board plus regimes where foreign reserves exceeded reserve money and imports the stability the US Fed achieved under Volcker and Greenspan which was called the Great Moderation.
These countries grew with both monetary and political stability and used the renewed free trade agenda of Western nations to grow their economies. J R Jayawardene came to power on the back of trade and economic controls of the 1970s, driven by money printing as well as bad Fed policy involving the so-called ‘Great Inflation’. In the belief that the ‘strong man’ can take the economy forward, an authoritarian constitution was enacted.
Open Economy Discredited by Unanchored Money, REER
But the depreciation of the rupee led to a period of Great Inflation within Sri Lanka until 1995, even as the US, Europe and East Asia grew in the Great Moderation of low inflation, directly as a result of the IMF depriving the country of a credible monetary anchor.
J R ended up with severe social unrest and a second leftist uprising on top of the northern rebellion which turned into an intensified civil war after the 1983 nationalist riots. JR brings the greatest classical economist East Asia has produced, Singapore’s former finance minister Goh Keng Swee, as Sri Lanka is shunted into an IMF bailout within two years of the most radical economic reforms the country had ever seen.
Goh tells J R not to print money and not to depreciate the currency as Sri Lanka is similar to Singapore and is a trade-dependent country. Macroeconomists ignore the advice. Instead, in 1985 macro-economists set up Regional Rural Development Bank linked to the central bank to give re-finance credit.
Jayewardene held on to power with electoral gimmicks and authoritarianism as the currency collapsed and inflation soared. Import substitution again came to the fore, spreading to onions and potatoes.
Stabilization and Jana Bala Meheyuma
Fast forward to 2001. Ranil Wickremesinghe came to power on the back of the 1999/2000 currency crisis and IMF stand-by arrangement, the Pariwasa government, and the Jana Bala Meheyuma. He completed the stand-by and started a new IMF programme – not to restore stability, but a pure reform programme, labelled Regain Sri Lanka. The economy recovered strongly.
The JVP attacked him on fuel pricing as oil and fertilizer prices soared with Ben Bernanke misleading Greenspan into printing money to target positive inflation in what was then called the ‘mother of all liquidity bubbles’.
The 2001 crisis also saw Sri Lanka’s CPC borrowing from Iran to import oil amid forex shortages. Though inflation is low, and the economy is in full recovery mode, Wickremesinghe is attacked by his political foes on a peace deal with the Tamil Tigers. When then-President Chandrika Kumaratunga takes over ministries while he is in the US, people flock to the road to support him as he lands in Katunayake. Wickremesinghe sends them home empty-handed and later he ends up without a government.
Because the Fed is targeting positive inflation using core inflation, ignoring the commodities, hedonics and other tools understating inflation amid a private sector productivity boom, a massive asset price cum commodity bubble is formed by 2008.
Amid a civil war and the Fed’s housing cum commodity bubble, Sri Lanka has another currency crisis with capital flights from rupee bonds and goes to the IMF in 2008. In the next election, Mahinda Rajapaksa wins, despite the IMF stabilization programme with a war victory. The rupee is allowed to re-appreciate from 120 to 113. But in 2012 rate cuts with printed money triggered a currency crisis within the IMF programme triggering another stabilization programme. The rupee falls to 130 to the US dollar.
Ranil Defeated by Potential Output Targeting
Fast forward to 2015. Wickremesinghe came back to power in 2015, just as the economy was recovering very strongly from a currency crisis triggered by central bank rate cuts in 2011/2012.
The IMF then teaches Sri Lanka to calculate potential output. The central bank printed money to cut rates in 2015, amid spending bout for the 100-day programme and triggered another crisis. In this IMF programme, there is no cost-cutting. Instead, revenue-based fiscal consolidation, a type of IMF-backed estate expansion which rejects cutting government spending is in operation.
Spending is ok, but deficits are supposed to be cut by tax hikes only, putting the entire burden of adjustments on private citizens. Sri Lanka then starts to print money to narrowly target the call money rate in another deterioration of the central bank’s operating framework. The rupee falls from 130 to 152.
There is a stabilization programme which discredits Wickremesinghe’s administration and taxes are hiked. Hot on the heels of the 2016 crisis, another currency crisis was triggered in 2018 despite tax hikes on revenue-based fiscal consolidation, due to targeting potential output with printed money as inflation falls.
Instead of borrowing from Iran, the petroleum utility gets supplier credit after potential output targeting and then converts them into state bank loans. CPC runs losses despite market pricing oil. The borrowings later add to the national debt after a default. The rupee falls to 182 and another stabilization programme is put in motion. Wickremesinghe’s goose is cooked and his economic policy is discredited.
Nationalists Rise on Stabilization Programme
Nationalists have a field day on the stabilization programme and revenue-based fiscal consolidation in 2018. This time Muslims are targeted. Hitler blamed the Jews for a ‘stab in the back’. Muslims are blamed for sterilization pills. A prominent Buddhist monk calls for someone like Hitler to come to power.
Gotabaya Rajapaksa comes to power and takes oath in front of Ruwanwelisaya, a Buddhist dagoba, built by King Dutugamunu.
Macroeconomists and think tanks, who are advising descend on him like vultures and taxes are cut on top of rate cuts saying there was a ‘persistent output gap’ in the most extreme macro-economic policy seen in the island. Covid comes. As the economy recovers from covid, printed money triggers forex shortages despite import controls. All kinds of shortages appear.
People come to the streets dwarfing the 1953 hartal and the Jana Bala Meheyuma. Gotabaya Rajapaksa’s goose is cooked. Poor people starve. Poverty rockets Latin America style as the rupee collapses. Outward migration picks up.
Another Stabilization Programme
After the Rajapaksa’s ouster Wickremesinghe comes to power again and goes about fixing the country, helped by newly appointed central bank Governor Nandalal Weerasinghe who markets prices at interest rates.
Unusually, going against the usual IMF advice to destroy the currency, destroy savings, destroy salaries and trigger more social unrest, he is allowing the currency to appreciate amid deflationary policy.
Because nationalist elements are supporting him, nationalism is muted in the current stabilization programme. Instead of Muslims, nationalist elements tried to use archaeology against Wickremesinghe.
However, the strategy is less successful than in the past since it was a nationalist-backed administration that created the crisis in the first place.
Sri Lanka has destroyed the currency as well as domestic capital since 1977 but has not become an export powerhouse like East Asian nations with monetary stability did, or services hubs like the Middle Eastern currency board style nations.
The rupee is now probably allowed to appreciate on some econometric formula, not with any belief in sound money. Wickremesinghe has been duped into legalizing potential output targeting through a deadly monetary law and giving ‘independence’ to macroeconomists who believe in 7% inflation and central bank swaps.
Mercantilists and macroeconomists who earlier spread the narrative of imports, trade deficits, domestic production and real effective exchange rates to escape accountability now blame the lack of reforms for monetary instability and repeated trips to the IMF.
Each time leftists and nationalists are elected, by a desperate public who are looking here and there for saviours, liberal policies are rolled back and post-independent policies that gripped the nation from 1956 to 1977 are brought back.
Monetary instability is unchanging and continues under different labels. Corruption is also blamed for the crisis. Exporters are themselves blamed for forex shortages and the currency crisis by some in another strange twist, which however is rejected by the central bank.
Who will the IMF and the Central Bank Elect in the Upcoming Elections?
In summary, history shows that a stabilization programme is when fringe elements are most likely to be elected.
The JVP, a leftist party which believes in expanding the state (in line with IMF’s progressive Saltwaterist revenue-based fiscal consolidation) is now doing well on social media. Some of the younger demographics that supported Gotabaya after the 2016 and 2018 stabilization programmes are active on social media hoping to find salvation in the JVP.
In the confusion, a widespread belief that the currency crisis and default was caused by corruption, and not aggressive macro-economic policy, is being strengthened. The belief also helps the JVP, which has not been in power and is projecting a clean image, regardless of its economic credentials and violent past.
That the 1970s problems came from Laski’s Marxist ideas on top of monetary instability from the central bank is not known. In any case, it was before the time of the current generation of young voters.
On rare occasions, stabilization programmes have helped build liberal democracies in the past, when nationalists and socialists were responsible for the crises.
Germany after WWII when the Social Democrats were confined to the backwoods for three decades and Korea in 1987 are key examples. Korea’s Great Peoples’ Struggle which made the country a liberal democracy, better than Japan, came on the back of stabilization and the first currency appreciation in the history of its central bank.
Springtime of the People
The 1847-1848 Commercial Crisis or the 1847 Panic in Britain also did not lead to nationalism but to the enhancement of liberal ideas sweeping the region, with most countries under monarchs. The 1847-1848 saw widespread crises in the gold area, not just in the UK and Ceylon. It was also called the ‘Revolutions of 1848’ or the ‘Springtime of the People’.
The ensuing crisis was mostly a liberal democratic struggle that led to the end of monarchies, and freedom of the press in several dozen European nations.
As commodity prices deflated and coffee prices collapsed, many plantations in Ceylon went bust and Torrington had to put new direct taxes on the people, IMF style.
The 1848 ‘Matale Rebellion’ was seen in Sri Lanka. This is why the IMF’s progressive taxation has caused so many problems for the people and made the reformist government unpopular and should be a warning to the ruling class.
Politicians on both sides of the aisle, have socialist tendencies, like direct taxes and only criticize VAT, which is a superior tax. But people feel income tax, where money is taken in big chunks before a voluntary transaction is made.
The IMF’s planned wealth tax is a type of expropriation where people who have invested their savings and built houses are punished even when there is no cash flow and are also likely to turn people away from reformist leaders.
The wealth tax, like the progressive taxation and revenue-based fiscal consolidation, is in line with old communist ideas, which are coming to Sri Lanka as progressive Saltwaterism of the West. There is no wealth tax in socialist Vietnam and no wealth tax in the US. European-style wealth taxes have been resisted by Republicans in a country which already has inheritance taxes.
Progressive Saltwaterism and Unsound Money
Under IMF influence Sri Lanka now has US-style inheritance taxes and personal income taxes, European-style VAT and Wealth Tax and Argentina-style monetary policy under flexible inflation targeting with up to a 7% target. A country can still survive socialist-style big-government taxes with higher levels of unemployment, like in Europe, if monetary stability is provided.
Before the policy rate for economic intervention (macro-policy), devised in the 1920s by the Fed, monetary crises were relatively rare, which is why the British were able to rule with only a few rebellions here and elsewhere.
Sri Lanka’s central bank which has given coercive powers to a few bureaucrats to cut rates with printed money and create forex shortages, is a key reason for this country’s monetary as well as political instability.
Unlike in West Germany or the UK under Thatcher (the UK was IMF’s top client until Thatcher-Hayek-Walters), the reforms will not bring any long-term benefits.
As a result, all the reforms that are being done now will be so much water under the drain, as they have been for the last 72 years since monetary stability will be denied to the people by the use of inflationary rate cuts.
Sri Lanka was a fully free trading, stable country in better shape than Singapore when it gained independence with a currency board. There were hardly any economic controls to reform. Singapore on the other hand was devasted under Japanese occupation and banana money, just like the rupee with potential output targeting.
In the final analysis, whoever comes to power may be academic, as the IMF has already denied a single anchor monetary regime to the country with the new central bank law and legitimized printing money for growth which devastated the country after the civil war ended.
In Latin America countries default repeatedly with 23% plus revenue to GDP and 5% budget deficits, due to rate cuts enforced with printed money under operational frameworks similar to Sri Lanka.
After the Second Amendment Argentina is now IMF’s biggest client. The undermining of Milei’s monetary plan, which would have stabilized the country, shows macroeconomists and the IMF rules Argentina. Sri Lanka’s central bank has allowed the rupee to appreciate, giving immediate benefits to the people, in sharp contrast to earlier programmes.
History Set to Repeat
It is however not stable or consistent sound money, but only a temporary gain from external anchoring. However flexible inflation targeting and the flexible exchange rate need to be revised.
The benefits are coming now because external anchoring has supplanted the domestic 5 to 7% anchor. Inflation is now only 0.9% with currency appreciation from deflationary policy. Unlike in East Asia, deflationary policy is not assured.
On the other hand, external instability is almost guaranteed under flexible inflation targeting, with a 5% or 7% inflation target, the latest spurious monetary doctrine peddled to hapless countries which then end up in default, where a reserve collecting central bank is urged to cut rates claiming inflation is low, disregarding domestic credit.
With Sri Lanka having market access, a second default is likely as the money exchange conflicts re-emerge as the economy recovers. Meanwhile, after a decade of quantitative easing, US government finances are shot, and the chickens are coming home to roost. Sri Lanka will also have to cope with that.