ECONOMYNEXT – Sri Lanka’s success in ending the currency crisis and inflation is due to solving the problem through monetary means and free market rates while Bangladesh is still struggling with cost-push myths, an economist has told a Bangladeshi publication.
“In that situation, in that crisis mode, they used their interest rate. It was increased to more than 10 percent within a very short notice,” Ahsan H Mansur, Executive Director of Policy Research Institute of Bangladesh, was quoted as saying in The Business Standard online portal.
“We could have taken steps like Sri Lanka but we did not. We probably would not have needed such drastic steps because our economy is not in shambles.”
A World Bank report has earlier found that only 2 percent of ‘experts’ in South Asia knew that forex shortages was a problem associated with soft-pegged (flexible exchange rate) central banks which tried to target rates without a clean float.
The cost-push ‘real economy’ narrative
Bad central banks and inflationist macro-economist usually blame ‘supply side’ or ‘cost push’ inflation for monetary instability. “Exogenous shocks” is also a favourite whipping boy of macro-economists in the Cambridge-Saltwater tradition. Another is wage-spiral inflation.
“Our economic narrative was that whatever is happening is supply side driven, it happened because of the Russia-Ukraine War and it will go away once the supply side improves and there is nothing we can do to change it,” Mansur said.
“That narrative is not fully right. We should have taken into consideration our demand side.”
The narrative on cost-push inflation re-emerged among Harvard-Cambridge-MIT inflationists after World War II, especially the 1960s was that the cause of permanently rising inflation was some kind of soup between monetary and non-monetary reasons.
The soup theory was publicly articulated by Fed Chief Arthur Burns, the inflationist who was responsible for the collapse of the Bretton Woods system, and the suspension of gold convertibility in 1971.
However, classical Mercantilists who put forward cost push inflation did not claim that inflation was a causal soup or salad, but that that link operated in the opposite direction (see James Stueart – Inquiry into the Principles of Political Economy). Money adjusted through various mechanisms including changes in private sector sterilization (hoarding) and velocity, it was claimed..
They had some excuse for the mistake at that time, as the UK in particular still had free banking until 1840 and reserve money could be expanded above the specie anchor by one or more free banks at will, analysts say.
But modern central banks have legal tender laws for a money monopoly and are in full control of base money. Blaming ‘costs’, shifts responsibility for inflation to economic agents who are victims of the central bank, and more damagingly, the problem does not get solved.
Inflation also comes now from Fed’s monetary policy actions (as in the 1960s and 1970s) to boost growth or jobs which drive commodity prices up as it is the main ‘reserve’ currency in which trade takes place and many countries are loosely pegged or influenced by its actions.
“Bangladeshi policy makers have talked a lot about reducing inflation without doing anything,” Zahid Hussain, a former economist at World Bank’s Dhaka office said in the same media report.
“They don’t have interest rate controls like us. We have a cap on our lending rate, which is why increasing the interest rate or policy rate has no chance of creating an impact on the market.”
Sri Lanka hiked the policy rate and started to roll-over maturing debt at market rates after Governor Nandala Weerasinghe took office in 2022.
At the time the country was on the verge of hyperinflation and market dollarization.
Market dollarization could however have solved the country’s monetary instability problems forever, by blocking the ability of inflationists to unleash monetary violence through open market operations, according to classical economists. (Sri Lanka dollarization, currency competition can end depreciation, instability: Lawrence White)
Sri Lanka’s balance of payments turned in September 2022 and the country has collected reserves as private credit contracted reducing domestic investments and imports.
Sri Lanka’s central bank repaid part of a swap it had borrowed in the course of intervening in the forex market and printing money in the 2020-2022 output gap targeting/currency crisis.
Sri Lanka’s central bank has just imposed lending rate controls. It is not clear whether it is the beginning of the end of the latest IMF program.
Though ‘budget deficits’ are frequently blamed, analysts in Sri Lanka have shown that the problem is actually related to monetizing debt from past deficits by macro-economists obsessed with controlling gilt yields and has little to do with the current year deficit itself.
Like black marketeers and speculators (a type of cost-push inflation0, politicians are easy targets to transfer blame.
In 2018 in particular in Sri Lanka, money was printed through multiple means (outright purchases and dollar rupee swaps as well as overnight and term injections) to trigger external instability when budget deficits were cut with tax hikes and fuel was market priced.
Under an IMF program a central bank which went to the agency after mis-targeting rates is free to print money and trigger a fresh round of instability and blow the balance of payments apart after inflation has been brought down with good monetary policy in the immediately preceding 12 to 18 months earlier.
The encouragement to print money as soon as inflation falls comes from a so-called monetary policy consultation clause (domestic anchor) as soon as private credit recovers by trying to defy laws of nature generally described as the “impossible trinity of monetary policy objectives”.
Unlike in Sri Lanka, where monetary operations became opaque over the last decade, Bangldadesh central bank purchases of domestic assets or “devolvements” as they are called are disclosed publicly.
Bangladesh has been buying long tenor bonds as Sri Lanka’s central bank also did after the end of a civil war. During the war Sri Lanka was operating a ‘bills only’ policy under then Governor A S Jayewardene.
Central banks with depreciating currencies will usually buy bills to sterilize interventions (print money after intervening in forex markets to re-inflate reserve money) and then inflationists will claim that pegs cannot be maintained.
By targeting the interest rate, under flexible inflation targeting or money supply to re-inflate reserve money after interventions, the pegged central bank undermines its own anchor and the country descends in to chaos.
Sri Lanka is now broadly operating deflationary policy (selling its own securities stock down to mop up liqudity from dollar purchases to contract reserve money below the BOP).
However it is also engaging in complex two-way open market operations which tends to make banks dependent on central bank money and could trip up the balance of payments when private credit recovers.
CB re-finance injections
Meanwhile Bangladeshi economists said the their central bank was also creating money to re-finance private credit including – ironically – for exporters.
“Increasing refinancing facilities during inflationary times means you are injecting more money into the economy. Perhaps it was done from an equity point of view, targeting small exporters etc, but that doesn’t help inflation,” Zahid said.
“Suppose we create a Tk25,000 crore refinancing scheme for SMEs, the money goes out but those who require the money do not receive it.
“In that case, we will not get the productivity effect but the money has already entered the economy and that has created a demand which turns into an inflationary stimulus.”
Similar problems are found in the State Bank of Pakistan.
Re-financing private sector credit was a favourite tactic of Saltwater economists (Economic Co-operation Agency) that led to triple digit inflation in Japan until Dodge line stabilization and Korea after World War II.
Because budget deficits and politicians are blamed (budget deficits as a general rule expand in the stabilization year compared to the year in which rates are mis-targeted) these countries can never escape either monetary instability nor the IMF, as the fundamental problem conflicting domestic and external anchors in a ‘flexible exchange rate’ is not solved.
A World Bank report found that only two percent of ‘experts’ in the region believed that the central bank was responsible for external instability.
In Sri Lanka there is wide support from macro-economists and think tanks for money printing in multiple ways particularly for sterilized interventions (using monetary reserves for private sector imports and printing money to inject rupee reserves into banks) and opposition to single anchor consistent regimes, a problem known as status-quo bias.
Related Gate keeping and status quo bias in monetary reform explained to Sri Lanka by top economist
Critics have pointed out that monetary policy errors that led to a sovereign default of a country at peace (excessive deployment of macro-economic policy) has now been legalized in a new Saltwater/IMF backed monetary law.
Under the earlier law, stability was the objective and output targeting was not legally sanctioned though operated to create forex trouble after the IMF taught the central bank to calculate a potential output.