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Sri Lanka needs peoples' monetary policy, not rulers': fuss-budget
01 Sep, 2010 06:44:16
By Fuss-Budget
Sept 01, 2010 (LBO) - Fiscal dominance of monetary policy or the mis-use of money supply by finance ministries to plug budget deficits, is back in the spotlight as Sri Lanka's central bank celebrates 60 years.
Sri Lanka's finance ministry secretary P B Jayasundera in a speech to mark the anniversary has detailed the tricky relationship between the two institutions contributing to the ongoing debate on the deadly nexus.

"Although there is a separation of responsibility in terms of the Central Bank being primarily responsible for monetary policy while the Government is responsible for fiscal affairs and general economic policy, in reality such a demarcation is only a myth," Jayasundera put the problem in a nutshell.

"In essence all these policies come within the purview of the broad macro-economic framework.

"The effectiveness of the workings of the two institutions depends very much on the way that relationship is maintained."

Freedom over Enslavement

These comments have been true for this country for the past six decades except for one or two years. But that does not mean that the downtrodden people should suffer the jackboot of deficit spending and interest rate suppression in silence and allow the status quo to continue.

It is now quite evident that each time the Central Bank lost out to the Treasury in the past 60 years, people have suffered high inflation, balance of payments crises, exchange controls and impoverishment.

The Treasury Secretary's speech also said: "No Central Bank can pursue policies that run counter to the objectives of national economic policies, however much some critics keep talking of the need for the separation of the two institutions."

This however is unfortunate because, ten years ago, when the Bank of England Governor Eddie George made a speech in Colombo to mark 50 years of the Central Bank, it was about central bank independence, which increases the liberties of the people.

A central bank Governor that tries to do the right thing by the people in preventing the rulers from stealing their wealth through inflation should not be shackled in any way. George himself was newly set free by his then finance minister, when the speech was made.

Separating money from the grip of rulers and subjecting it to a non-discretionary rule of law (like 2.5 percent inflation or a currency board anchored to such money) is not about macro-economic policy but about the triumph of liberty and freedom over arbitrary rule.

This is because liberty and individual freedom comes from just rule of law, not merely from rulers who are native.

Jayasundera's speech said the Bank of England Act of 1946 which made the previously privately owned bank a state agency recognized that the government may give directions to the bank from time to time when it is in the 'public interest'.

Unfortunately in the 20th century, with the rise of Keynesianism and fascism, public interest was usually a euphemism for ruler's interests - in Britain and elsewhere - at best in operating a welfare state and at worst in running an oppressive fascist-nationalist nation.

It was due to fiscal dominance of monetary policy (putting government financing needs before inflation) that triggered calls do away with the ex-officio post of Treasury secretary from the rate setting committee as freer countries with more stable economies have done.

But the current Treasury secretary in his speech also expressed a commitment to cut the budget deficit. If this goal is achieved, conflicts between the central bank and the finance ministry will be a thing of the past.

Central Bank credit backed deficit spending and currency depreciation is a key reason for the country's post independence economic slide. It helped make Sri Lanka - a net importer of foreign labour under British rule- an exporter of domestic servants.

It was with deficit spending that unscrupulous rulers of 'welfare states' both in Sri Lanka and elsewhere, stole from wage earners, the poor and the aged - the very people they claimed to protect.

Paper money central banking powered deficit spending is not merely esoteric 'economics' which only a qualified few can talk about.

It is also an extremely complex deception unleashed upon an unsuspecting people by those in power, and those with knowledge of finance and banking systems, about which everyone should be aware of.

As former Fed chairman Alan Greenspan himself said (Gold and Economic Freedom, 1966) : The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth.

Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard."


To understand what Greenspan is getting at it is necessary to look at monetary history and understand the nature of modern central banking and the role played by gold earlier.

Gold and later, gold exchange central banking was the most successful and stable money devised so far in human history.

Under gold, any sovereign attempts to expropriate peoples' wealth and savings through minting smaller gold coins or mixing with copper or other alloys were clearly transparent.

With paper money - even when backed by gold - it was easier to secretly debase the currency and create inflation, though devaluation was transparent. This is where central banking came in.

Most modern 'central banks' are styled after the Bank of England and also the monetary authority of Sweden, which also has its origins in a private bank.

European and American banks originally operated as 'free banks'. They took deposits in gold, which was money at the time, and issued deposit slips or 'bank notes'. Before central banking, there was no sustained inflation, so most banks did not pay interest on deposits.

Unless there were large new gold discoveries, which could create inflation until it was dissipated globally through what was known as the 'specie exchange mechanism', the world generally went through gentle deflation.

No interest payments were needed to protect the real value of savings, and depositors would be happy to pay fees to banks under mild deflation. Originally deposits were not considered balance sheet assets of banks, hence the peculiar legal status still afforded to 'deposits.'

To make profits however banks had to lend the gold, or keep the gold and create fresh credit (at the expense of inflation) to real borrowers who engaged in productive economic activities. This however had a default risk.

Easy Money Scheme

In the UK, a speculator named William Patterson came up with an easy money scheme involving giving loans to the Sovereign (king), via a specially chartered bank, whose credit was backed not by real economic output, but coercive taxes on the ordinary people.

Under King William of Orange, the Bank of England was set up in 1694 to give a loan of 1.2 million Sterling to the Sovereign. Unlike earlier British Sovereigns who objected to usury on religious grounds William was more amendable to banking, coming from banking oriented Holland (remember the Tulip mania?).

Following public pressure in 1844 the Bank of England was compelled to issue fully gold backed money. Unfortunately it was also given a note issuing monopoly, the precursor of what we now call legal tender laws, giving it a stronger grip on the whole economy.

But like a forex backed central bank which loses foreign reserves, excessive printing of notes (central bank credit) caused gold reserve losses as the paper fired a commodity bubble and people demanded the suddenly expensive gold back.

In its self-interest to protect its own reserves, a private 'central bank' had to curtail credit and stop inflation. Devaluing the currency against gold - which was transparent - would result in a public outcry. Sterling under the gold standard, which did not devalue, therefore became a globally accepted currency.

Outside Britain, a vigilant public took strong action against central banking types of entities whenever they caused excesses. Johan Palmstruch the man behind what eventually became Sweden's central bank for example was condemned to death, (though a part of the problem was actually caused by Sovereign fiscal dominance), and later given clemency.

John Law (of Mississippi Corporation fame) who was blocked in his attempts to create paper money in Britain but did so across the channel had to flee France after causing a bubble.

Paper money creators in revolutionary France (despite the experience with John Law and ostensibly backed by land) who caused high inflation and an economic bubble, were guillotined to death and the presses burnt in public.

A 'Bank of the United States' styled somewhat after the Bank of England was later closed down by President Jackson who is credited with this famous quote: 'You are a den of vipers and thieves. I intend to rout you out, and by the grace of the Eternal God, will rout you out.'

That is one reason there was strong opposition in the US against the creation of the Fed in 1913. But central banking is now 'respectable' and considered to be sophisticated 'monetary economics'.

Unfettered Expropriation

The fall of Sterling started in 1914 when convertibility was lifted at the start of World War I. Without gold convertibility there was no longer any safeguard for ordinary people. Notes could be printed with impunity. Inflation rocketed.

At around the same time the Federal Reserve System was established as a semi-state agency, not to finance the war, but to bail out free banks which had given excessive credit and faced runs.

The New York Fed under its then governor Benjamin Strong became a dominant force, though there was no legal status for one Fed to be more important than another.

Unlike the profit earning Bank of England, the Fed started to tinker with 'macro-economic policy' within a few years of its creation, giving rise to yet another role for 'central banks', resulting in disastrous consequences for the entire world later.

In 1925 Britain tried to resume convertibility after generating massive inflation during World War I - but without devaluing or raising interest rates to very high levels. Britain started to lose reserves promptly.

According to Greenspan, the Fed was persuaded to print money faster than Britain to stem to British gold losses: "The Fed" succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom.

"Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in breaking the boom.

"As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures.

:The world economies plunged into the Great Depression of the 1930's, Greenspan wrote.

The rest is history.

Benjamin Strong died before the crisis really took hold. Montagu Norman, his partner in crime at Bank of England across the Atlantic, is reported to have had a nervous breakdown as the European financial system melted.

It was later revealed that Britain's Winston Churchill had expressed a desire to 'hang Norman' in a letter he wrote to his secretary.

In 1933 the US devalued under Franklin Roosevelt's so-called New Deal. The US currency which had been kept at about 20 dollars to an ounce of gold from 1792 was devalued to 35 dollars an ounce just 20 years after the Fed was created.

The devaluation probably helped US preserve its gold reserves which were already high after World War I. The UK had lifted gold convertibility again in 1931 further diminishing confidence in the Sterling.

With gold as a monetary anchor, exchange rates were essentially fixed, unless there were devaluations due to excessive printing. Inflation was rampant during the war, resulting in price controls and rationing in Britain. After World War II, sustained inflation started to spread under the Bretton Woods system of unstable pegs while the link with gold began to break steadily.

In 1971-73 Bretton Woods and later the Smithsonian agreement collapsed because of uncontrolled Fed accommodation of the Vietnam War spending and President Nixon's populism. Gold soared to over 80 dollars an ounce.

The 1970s saw some of the worst inflation in history after the creation of completely paper money un-backed by gold under a system of floating exchange rates.

War and Central Banking

According to the Treasury Secretary's speech; "Prolonged conflict, external vulnerabilities, natural disasters etc, may not always permit the implementation of certain theoretically sound recommendation which support the conduct of money policy."

But this columnist would take the opposite view. It is during such times that orthodox monetary policy is most needed.

Because people are already suffering, there is no need to heap more suffering on them or endanger the stability of the economy further by destroying the integrity of the currency.

Monetary history has taught very good lessons, ranging from German hyperinflation to what happened to the Sterling, about mis-using the money supply to fight wars.

At the height of the recent war in this country, Sri Lanka had some of the tightest monetary policy in its history. Instead of printing money, tight monetary policy in 2007 and 2008, kept the currency stable and allowed the country to sell sovereign bonds to raise money.

A key reason that the dollar emerged stronger and Fed built up gold reserves after World War I while the Sterling got hit was because New York Fed governor Benjamin Strong helped the US Treasury raise money through war bonds (Liberty bonds), and printed less money.

Governor Cabraal in flogging dollar junk bonds with tight monetary policy in 2007 trod the same path that Benjamin Strong did 90 years earlier.

It is unfortunate that Strong, after keeping the dollar strong during the war started doing 'macro-economic' policy with the national money supply and plunged the world into a depression.

He got a taste for it soon after World War I when declining European war demand slowed the US economy. The Fed increased bank reserves and it was thought that the reserves did the trick, rather than the American people.

This is what gave Strong a taste to print money and eventually trigger the Great Depression. Unlike Europe, the US has still not learnt the lesson as is seen by Fed's so-called 'dual mandate.'

The key lesson in Sri Lanka also, that the war was won with tight monetary policy and Germany and Japan (and indeed Imperial Russia and China's KMT) lost it with loose policy should not be forgotten by people who may mistakenly think that wars can be won with an accommodating central bank.

No good can come from undermining the very foundation of your economy - the money supply - for fiscal purposes. Germany in fact had a plan to counterfeit British five pound notes as a military strategy.

If Greenspan/Bernanke had not cut interest rates and kept them so low for so long during the Iraq-Afghan war, the current economic collapse would not have happened either.

No Example

The Treasury secretary's speech quoted former President J R Jayewardene, who as finance minister abolished a currency board that kept Sri Lanka's economy stable under British rule and created the inflating central bank in 1950, as saying the following:

"But ultimately in the last analysis, I think it would be admitted that the Monetary Board cannot come into direct conflict with the Government."

Jayewardene is an unfortunate person to quote and not an example to follow. When he became President he created the worst deficits and inflation the country has seen after independence until 2008.

He ran budget deficits of over 20 percent of gross domestic product. Amusingly his deficits had also shrunk posthumously after the deficit numbers were manipulated from 2009 to make them look smaller. The 1980 deficit fell from 23.1 percent of gross domestic product to 19.2 percent. Oh what a tangled web we weave...

In fact it was his macro-mismanagement that prevented the country from fully reaping the benefits of free trade and export industry policies.

Jayewardene is also credited with creating a fascist constitution and destroying the last remnants of a once revered public service which exposed senior officials to arbitrary actions of politicians and thereby destroyed their ability to implement just rule of law.

The Future

No country can re-establish a gold standard on its own. But the people of Sri Lanka can reform the Central Bank. It can be stopped from giving provisional advances to the Treasury.

The minutes of central bank's monetary policy meetings should be published a few weeks later.

Sri Lanka also has to change the composition of the monetary board, or create a separate monetary policy committee made up of people who know about monetary policy to make decisions by majority vote instead of consensus. The voting also has to be made public.

Governor A S Jayewardene, who reformed the monetary law once, probably erred in bringing private sector people who are clueless about monetary policy to the board.

In the past there were three members. The third was a qualified economist, who could support the governor in his efforts to resist low interest rates or calls for central bank credit.

It is good to remind ourselves of what Governor Eddie George said in his speech in Colombo ten year ago. The words remain golden to this day:

One can argue endlessly about the precise composition of the Committee, their term of appointment and so on," he said.

The key consideration for me is that all nine members need to be genuinely independent, technical experts in the field of monetary policy or a closely related field, not representatives of any particular social or industrial grouping.

The objective of policy is appropriately determined by a democratic process; the Committee's job is, as I say, a technical one, which requires relevant technical expertise.

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2. fuss-budget Sep 02
Thank you for your comments. Yes, it is indeed a reversal of a global trend towards a better understanding of monetary policy and more transparency and less discretion.

The problem is not many people debate this issue. They only feel the effects when prices go up and the economy or the banking system collapse. Then they get excited but it is often too late.

Even then people will adduce non-monetary reasons for price inflation. Of course from the point of view of authorities it takes the pressure off them so it is in their interest to foster any stories about 'cost-push' inflation. Developed country central bank's pushed the idea of cost push inflation very effectively in the 60s and 70s.

The Treasury secretary's speech also contained allusions to that effect. He said:

"Very often with imperfections on market and financial system and structural characteristics particularly with regard to supply side behaviours in commodity markets and external trade, controlling money supply through various instruments may not be sufficient though necessary to control price stability.....Over reliance on such models may also have over simplified the framework for understanding complex socio-economic and real factors affective price."

However elsewhere, the value of simple rule based monetary policy is now being seen.

A few months ago Philadelphia Federal Reserve Bank President Charles Plosser said this (the relevant report is linked):

A rule-based approach can also lend more transparency to policy making, Plosser said, as the public can more easily see when policy is deviating from the norm, and policy makers will be forced to explain their actions.

"Because such a rule is transparent and easy to monitor, it helps the public form expectations of future policy," he said.

1. EconoCautious Sep 01
The new paradigm of central banking created by PBJ in his speech deserves greater debate and final reconciliation. It essentially warns the CB that 'it should fall in line with government policy' rather than the government falling in line with CB as has been taught to students of monetary policy for generations.

This is a topic that should be debated hotly by the nation. With the top management of the CB, including its MB, aligning itself to the thinking and ideology espoused by PBJ, a reconciliation is needed because he has the power to carry his doctrine.

History will one day judge whether the silent nation was wise or unwise on this occasion.

Fuss Budget should be complimented for bringing this bitter truth home so valiantly.