Sri Lanka is now at a dangerous phase where growth is picking up, and the macroeconomists are looking to deny monetary stability to the general public andbusiness by ending deflationary policy or moving to an active inflationary policy. This is the fate of all countries that go to the International Monetary Fund repeatedly by rejecting classical economics. There cannot be growth without monetary stability, only depreciation, high inflation, suffering, forex shortages, social unrest, political instability and a second default. Sri Lanka’s central bank has created a series of currency crises since the end of a 30-year war, using International Monetary Fund-backed statistical frameworks, and rejecting classical economics. During the war, people blamed the war for the country’s ills. But the collapse of the country after the war was much worse than anything that happened during the war.
STABILITY, OR NOTHING
Stability may not be everything, but without stability, everything is nothing. With growth starting from the stability provided by the central bank, now the talk is on how to boost growth and end the stabilisation phase. The IMF and World Bank are also saying that. It is a very serious mistake. Stability has to be provided, and 5% inflation and continued depreciation are not stability. That is why the Germans
said stability may not be everything, but without stability, everything is nothing. This column has warned of baby steps taken towards instability so far. The central banks allowed excess liquidity from dollar purchases to remain unsterilizedin 2025, and failed to defend the currency adequately against the liquidity, except to give dollars to the government, leading to steady depreciation of the rupee even as more dollars were bought. On top of all that, the central bank also cut rates as deposit rates were starting to edge up and unsterilized excess liquidity indicated that reserves were below or the reserves were mopped up and collected (sterilised purchase). Since the 1960s (full employment policies) and the 1980s (post-IMF Second Amendment), the knowledge that depreciation comes
from anchor conflicts was replaced with the 17th-century Mercantilist view of the trade deficit. In neo-Mercantilist terms, the trade deficit was replaced with the current account deficit. Sri Lanka’s rupee is now depreciating amid record current account surpluses, showing the fallacy of the doctrine. The depreciation amid record currency account surpluses shows the danger of rejecting classical economics of Hume, Ricardo and Adam Smith and embracing the statistics of John Williamson. Peacetime credit growth is faster than in wartime, which is why central bank inflationary policies are amplified in peacetime. The Aragalaya took place as the central bank printed
money during and after the Coronavirus pandemic to keep rates down.
THE 1950 LIBERTY BONDS BUBBLE
Like the rupee depreciating amid current account surpluses, and other claims made by macroeconomists who believe inflationary policy leads to growth, also have to be examined carefully. In December 1950, President Truman called for voluntary price controls, and in January of thenext year, ceiling prices were set by the Office of Price Stabilisation’. Since macroeconomists tell whoppers all the time, it
is generally called the Korean war boom, when in fact it was the rise in private credit amid a wartime obligation to defend the price of securities. This was called the Korean War bubble, but in fact, President Truman ramped up taxes, including the introduction of PAYE tax and the small deficit (compared to World War II) was bridged, and by 1951, budgets were in surplus. As then Fed Governor Marriner
Eccles later said, it was the purchase of World War I Liberty Bonds that was causing the ‘inflation and price controls’, not Korean war deficit spending, which was non-existent anyway by that time.
Be that as it may, it led to record earnings for Sri Lanka from commodity exports. With record inflows purchased by the central bank, excess liquidity went up like in the first quarter of 2025. Exter called it the monetisation of the balance of payments. He then raised reserve ratios from 10 to 14% (when the central bank was created, a 10% reserve ratio was mandated according to American and Latin American practice, unlike the self-correcting currency boards). He also asked banks not to convert dollars and managed to keep
domestic prices down, even as traded commodities (prices of imported and exported goods) went up.
THE ORIGINAL 1953 ARAGALAYA
The following year, however, some export prices like rubber fell (it is true that rubber demand went up partly for the Korean war also), but rice prices remained high. Sri Lanka, at the time, was generally a free-trading nation, and the export of commercial crops at good prices more than paid for rice imports. There were several wartime restrictions on the country, as well as some exchange controls stemming
from the Sterling Area due to the Bank of England’s money printing. Sri Lanka, however, had a lot of reserves (though the currency was devalued in 1949 along with one of the Sterling crises). As the cost of rice subsidy went up and the government started development projects (Laxapana, etc), the deficit went up. The central bank then bought bills and also made provisional advances, printing money, triggering a balance of payments crisis. Like the Fed, the central bank stopped supporting the prices of bills, and the government cut
rice subsidies.
There was a leftist protest. Ten people were shot, and Prime Minister Dudley Senanayake resigned. A country which
was flush with dollars amid deflationary policy and was contemplating relaxing controls inherited from the Sterling Area then started tightening them. A full IMF-style stabilisation programme went into effect under the new government, with tax hikes on income and
also some exports and the budgets turned into surplus in the next two years. But the government was turfed out and nationalists – who are always there – gained public acceptance, rose into prominence, and the Sinhala only Act was enacted.
1952 IN JAPAN
1953 is important for another reason. Exactly what happened to Sri Lanka happened to Japan a little earlier. Japan hit the brakes at the same time as Sri Lanka, and there were reports of a businessman committing suicide. Hayato Ikeda, who was the industry minister, was forced to resign in 1952 after he had said that it cannot be helped even if 10 small businessmen commit suicide, but inflation had to be ended. He was a former Finance Minister who hadactions – hiking rates and energy prices took place in 2012. The economy was recovering, and private credit was picking up. The 100-day programme was, of course, a disaster. The higher budget deficit required higher rates, but the central bank printed money under flexible inflation targeting and mid corridor rate targeting, ending the scarce
reserve regime. If the central bank had not cut rates and printed money and maintained stability by allowing rates to go up a little, Wickremesinghe may have had a chance to liberalise trade, though it was engaging in socialist actions like price controls and started the NMRA. The corruption scandals also took a toll. That is a perfectly legitimate reason to lose power. But by 2019, the semi-socialist
Yahapalanaya administration was thoroughly discredited by two back-to-back currency and stabilisation crises from potential output targeting, flexible inflation targeting and REER targeting. So Gotabaya Rajapaksa came to power. The 2020-22 currency crisis was triggered with nationalists in power. Macroeconomists who advised him advocated further rate cuts and money printing to a greater degree than under the Yahapalanaya administration. It did not happen in isolation. The stimulus mania and abundant reserve regime (which is not far from MMT) came from the US. The seeds for potential output targeting were laid several years before. So was the 5% inflation target under which money can be printed for a long period.
WILL ANURA GO THE DUDLEY WAY?
President Anura Kumara Dissanayake is now in exactly the same position as Ranil Wickremesinghe was in 2015. The hard actions – hiking rates and energy prices took place in 2012. The economy was recovering, and private credit was picking up. The 100-day programme was, of course, a disaster. The higher budget deficit required higher rates, but the central bank printed money under flexible inflation targeting and mid corridor rate targeting, ending the scarce reserve regime. If the central bank had not cut rates and printed money and maintained stability by allowing rates to go up a little, Wickremesinghe may have had a chance to liberalise trade, though it was engaging in socialist
actions like price controls and started the NMRA. The corruption scandals also took a toll. That is a perfectly legitimate reason to lose power. But by 2019, the semi-socialist Yahapalanaya administration was thoroughly discredited by two back-to-back currency and stabilisation crises from potential output targeting, flexible inflation targeting and REER targeting. So Gotabaya Rajapaksa came to power.
The 2020-22 currency crisis was triggered with nationalists in power. Macroeconomists who advised him advocated further rate cuts and money printing to a greater degree than under the Yahapalanaya administration. It did not happen in isolation. The stimulus mania and abundant reserve regime (which is not far from MMT) came from the US. The seeds for potential output targeting were laid several years before. So was the 5% inflation target under which money can be printed for a long period.
TECHNICAL ASSISTANCE CAME FROM THE IMF
By all accounts, President Dissanayake is careful in making decisions. There is a danger that the upcoming budget may have ‘government plans’ and big capital expenditure programmes, which may destabilise or misdirect economic agents. He has also said he is not for promoting nationalism and would like to treat everyone equally, regardless of their religion or language. A country and its people can take the shocks of a government’s ‘economic plan’, and the economy may stagnate until the next administration. But currency crises and depreciation generate instant poverty and heap hardships on the people by destroying their salaries. Even stabilisation crises kill SMEs and trigger unemployment, and turn the electorate against the government. It is one thing for the government to get kicked out for wrong economic plans, or any other interventions or corruption, but it is unfortunate for a government to get kicked out for cost of living or currency depreciation brought about by an independent central bank. In the final analysis, it is up to the parliament to control the central bank through a tight anchor, as democratic countries did before open market operations and the policy rate was invented.