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Sri Lanka's central bank, polite fictions, fiat money and the political economy: fuss-budget
05 Jun, 2007 23:29:23
By Fuss-Budget
June 05, 2007 (LBO) – The controversy that has erupted over an innocuous graph published in The Thrift Column is raising important questions about the role of central banks in Sri Lanka and elsewhere, and why they act as they do.
Last week fussbudget was indeed impressed by what Governor Nivard Cabraal told some regional central bankers in a speech (Read Steady Stance) in Colombo.

That speech is probably among the best any third world central bank governor has made anywhere. He said, among other things, that central banks in the past have intervened in economies, even with direct lending.

"However, in the end we have always had high inflation without an appreciable reduction in unemployment or improvement in growth. There is no trade-off between inflation and unemployment. In the long term monetary policy could influence only inflation."

This is plain speaking. Plainer speaking even than Alan Greenspan or Ben Bernanke, who hum and haw but continue to print money and give all their followers a false sense of security.

In this background it was all the more surprising that Assistant Governor H N Thenuwara and Governor Cabraal himself suddenly turned their guns on the graphic published in these columns at two public forums. (Read Money Money)

What they said was that a graph frequently used in these columns and also by the economist Harsha de Silva which showed a close co-relation with 12-month point-to-point inflation and either total central bank credit or t-bill holdings was 'spurious'.

Polite Fiction

Fuss-budget is happiest when people raise questions and challenge what is said in these columns. This kind of skepticism is good.

In that sense it is very good if some good research can be done to find the time lags. Even if fuss-budget is ultimately proven wrong, in the end everyone, including fuss-budget would have learnt something in the process.

But to understand the problem we need to step back a bit from the immediate controversy and take stock. Let's ask ourselves this question. Why do central bankers - all over the world - economise with the truth?

The short answer is that central bankers lie because they want to print money and dupe the users of their worthless fiat money into believing that there is 'credible monetary policy' behind it.

The US for example wants to pass on their counterfeit gold, the dollar, to as many people as possible and collect the seigniorage revenue. So there is an elaborate fiction being built up to support this fiat money.

They are so successful that even international criminals use their money. But eventually the dollar falls against the Euro, giving the lie to their claims and the 'hedonic regression' manipulation of US inflation data.

Only last month, Kuwait cut its links with the dollar saying it was causing domestic inflation. China's central bank said last month that it was increasing Euro assets.

You can't deceive markets forever. Eventually markets adjust. For example, why is the oil price rising? It is rising partly because the dollar is falling and oil is priced in dollars.

What this shows is that notes and coins did not 'replace' the barter system. Notes and coins are also barter, except that we measure all the goods and services in terms of notes and coins only.

The Graph

So when we print a large volume of Sri Lanka rupees, its price falls. It does not take a long time to do that. Not two years at any rate, though its effects may linger for two years (See The Thrift Column – Index Scam) That is why there is a close co-relation.

Rupees are created in two ways. When the central bank buys dollars in the market and gives rupees (purchase of foreign assets) or buys treasury bills or gives straight printed money to the treasury in the form of provisional advances (domestic assets).

The graph in question which this column has called 'Printflation' tracks the growth of components of domestic assets in the monetary base over 12 months, with the growth in inflation over 12 months.

Why were domestic assets used? Because foreign assets did not expand much during the period. So they could not have affected inflation. Foreign assets in fact fell when the central bank engaged in 'sterilized intervention'.

This so-called 'sterilized intervention' not only does not work but is deadly to a country and its financial system when it is done in large volumes. (see the Monetary Blunder section of The Thrift Column – Monetary Plunder)

This raises another question. There is broad agreement that aggressive open market operations (which is similar to non-sterilized intervention) can transmit itself to the exchange rate markets in a few weeks, even in the United States.

If money supply changes are transmitted to the external value of a currency in a few weeks why doesn't it do for the domestic value, which is inflation? These two positions are clearly at odds with each other.

Another point is that when the money supply was dis-aggregated to its basic elements - like in the Thrift Column graph - you can see a co-relation. The broader the money supply the harder it is to co-relate it to inflation.

M1 narrows when you print a lot because ultimately there is a balance of payments crisis and 'sterilized intervention' stops when you run out of reserves.

M2 slows for the same reason. M2b has elements outside the domestic monetary system anyway. So naturally you find it difficult to co-relate with inflation.

All this allows central banks the world over to print more money on the sly, through deceiving the public by fudging the relationship with what is called 'money supply'.

Political Money

Milton Friedman did not really have to say that "Inflation is always and everywhere a monetary phenomenon". People long before him said the very same thing in different ways.

The authors of the Bullion Report in 1810, who defined inflation as 'an increase in the supply of money' and all the hard currency economists that have advocated the gold standard including John Exter, said the same thing.

But Friedman actually said more. What he said was "Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output."

Unlike the gold standard advocates, this made Friedman more acceptable to the Fed and the power hungry politicians. He allowed them a window to engage in their favourite game of printing money – up to a point.

Because economists like John Exter, who set up our own central bank, wanted the gold standard brought back – a non starter - they were in the minority. But Exter is rather special because he was a central banker.

In an interview with The Moneychanger, Exter said this when asked about his arguments with Paul Samuelson and Keynesianism. (Read full interview here)

"I was always in the minority -- there were very few people on my side. Most were Keynesians, or, later on, Friedmanites. I’ve battled Friedman more than Samuelson…

In a book published in the late 1950s Friedman laid out his view. The key was that the Treasury should sell off all its gold in the marketplace over a period of 5 years, go to floating exchange rates, & have the Fed increase the money supply at a fixed rate every year -- he didn’t give the rate. [laughing]"

Franklin Sanders, the editor of The Money Changer who conducted the interview with Exter wrote this at the end.

"Even though central banking & fractional reserve banking form a terrible system, as long as there were men with character, that system could be made to work. Those men understood that there were monetary laws as fixed as the law of gravity, & respected them. It was a bad system, but by substituting character for gold, it could be made to work -- for a while.

Fractionalised banking is the child (or is it the mother?) of politics, & sooner or later politics will demand its due. Frail human character, in the face of politics, is no substitute for gold."

This then is the answer.

This is perhaps why J R Jayawardene converted the colonial currency board to a central bank in 1951 giving him the power to create money, unlike Singapore's first finance minister Goh Keng Swee, who said central banks and budget deficits were an invitation to disaster. (Read Why a Currency Board?)

Exter called this paper money 'IOU nothings.' The temptation to do something without raising taxes is too irresistible for politicians. That is why politicians do not want to give up central banks.

But as Governor Cabraal said in his recent speech, quoting former Federal Reserve Chairman Paul Volcker, "the truly unique power of a central bank is the power to create money and ultimately the power to create is also the power to destroy".

Status quo bias

Why people like Exter are in the minority is explained by another aspect of the politics of central banking.

In 2005, Lawrence H White, an economic history professor, published a paper: The Federal Reserve System’s Influence on Research in Monetary Economics. (Download)

White pointed out that over the preceding five years more than 30 percent of the articles by US-based economists published in the Journal of Monetary Economics had at least one Fed-based co- author.

More than 80 percent had at least one co-author with a Fed affiliation (either Fed employment or visiting scholar). In the Journal of Money Credit and Banking, 39 percent had at least one Fed-based co-author and 75 percent had a Fed affiliation.

The editorial boards (editors and associate editors) of these journals were even more heavily weighted with Fed-affiliated economists (9 of 11, and 40 of 46, respectively).

He points out that the Fed is the biggest employer of monetary economists and the biggest sponsor of research.

All this led to a 'status quo bias' where the research agenda was shaped by the Fed.

Quoting other researchers White said, "by manipulating the size of staff and the activities for which they are rewarded or penalized, Fed officials help to shape the agenda of contemporary economic research on monetary policy", and "censorship is present in a significant portion of the Federal Reserve research departments' publications. Therefore, this voluminous research, distributed at little or no charge, should not be disguised as the work of an independent think tank."

This indicates that Sri Lankans should take with a pinch of salt anything said in a central bank annual report about money and inflation. The 2004 report (see Thrift Column – Full Astern) was a prime example, though the 2006 one seems to be an unusually frank one, about which the authors can be justly proud as it had lots of little home truths.

Quoting a view expressed by Friedman himself, White's paper says "since the Federal Reserve Board and its district banks hire a large number of economists in the field of money, the central bank has a sort of oligopoly on monetary opinion."

In Sri Lanka there is a pithy Sinhala saying which puts this succinctly; 'Horage Ammagen Payner Ahanawa Wagay'. This old adage advises people not to go and ask the thief's mother who the thief is.

People who opposed the established 'facts' about central banks had existed throughout the centuries. David Ricardo shot to fame for his relentless opposition to money printing by the Bank of England.

His writings in the newspaper Morning Chronicle eventually helped commission the Bullion Report of 1810 by the British Parliament.

He is credited with being perhaps the first 'political economist' and giving rise to an entire discipline of economics in Britain.

It now seems that the economist Harsha de Silva has been credited with the same honour at a recent seminar for starting the discipline in Sri Lanka.

Currency Board

'Honest central bankers' then are a rare species, because you are bound to defend your institution. Such people are only found at currency boards. Then you come against a kind of oxymoron because currency boards are not really central banks.

That is why Governor Cabraal's speech last month is very significant.

Previously you found only people like former Singapore finance minister Goh Keng Swee doing very plain speaking like this. (Read The Thrift Column – Invitation to Disaster)

A currency board will not 'print' money. That is to say it will not issue local notes against domestic assets or IOU's from the treasury. It will only do so if foreign exchange comes in. This is an automatic check against both inflation and balance of payments problems.

The graph in these columns captured the difference between a currency board and a central bank.

Actually if you think about it, the Central Bank is now acting more and more like a currency board at this moment. It has stopped having a policy rate regime. There is virtually no lender of last resort facility.

Dollar backing of the rupee is rising.

If laws are changed to allow the central bank to convert the provisional advances to the treasury into tradable securities and sell them off, you can have a 100 percent foreign reserve backed domestic currency by the time foreign reserves go up to 3.3 billion dollars.

In fact our banks are now in a fix, by being caught in a proverbial nutcracker. They have to keep reserves at the central bank, but cannot borrow from the discount window. That means a significant advantage of being a commercial bank has been lost.

Coupled with the high taxation of profits through the 'financial VAT', and the bad loans that have to now pile up because of reckless lending earlier due to artificially low policy rates, banks are heading for trouble.

Even HSBC made a one billion rupee provision this quarter. But then prudential standards are very high at foreign banks.

To get back to the subject, currency boards also earn seigniorage. That is the interest on its reserves less the cost of the note issue. So if we are not too greedy, we can still rake in the shekels and have economic stability as well.

Classic Stories

If you honestly do not want to print money, which Governor Cabraal's speech seems to indicate, then there is no point in keeping up any polite fictions or outright lies. There is no point in manipulating inflation indices.

There is no point also in building lagging indicators like the core inflation index, which this column, in jest, has previously called the Central Bank's plastic wrap bikini.

Core inflation indices are constructed by central banks that want to print money and get everyone else to use their currency, like UK and USA. Of course it may make sense also because they are measuring very small changes with a two percent inflation target.

But in Sri Lanka inflation rose 3 percent in a single month this May. Central Bank claimed that this was due to changes in 'administrative prices', while its critics say it is because of money printed in late March and April.

Let's face it. Our central bank is new to the game of fighting inflation as they have simply been igniting inflation and covering up for five decades. For 50 years the central bank has been able to hide their culpability with various stories as inflation went up and up… and up… and the rupee fell and fell… and fell.

One of the classic stories is the 'administrative price' increase story. An administered price increase simply means that earlier price increases have been suppressed.

If changes in administrative prices caused inflation now, how come the central bank claimed credit for tight monetary policy bringing down inflation in earlier months? You can't do both.

Other classic stories are, external shock (there is no external shock - it is just stupidity and a deficit budget), drought, floods (sometimes both at the same time), oil prices (thank goodness very few say that now) and infrastructure bottlenecks.


There is a lot of criticism even in the US about the use of core-inflation. But as long as it is the headline inflation that is the target, the use of core-inflation doesn't really hurt the public.

In May 2007 the biggest price increases were seen in vegetables and fresh fish, which are domestically produced.

This is why countries like Australia and New Zealand who were pioneers of inflation targeting, constructed a non-tradable inflation index.

Non-tradables, that is items in the index that are not imported or exported widely, respond quickest to domestic money printing, like vegetables and fish for example, while imported items go up only after exchange rate depreciation.

Statistics New Zealand started computing a non-tradable index on a request from the Reserve Bank of New Zealand.

"Tradable and non-tradable component series can be utilised in monetary policy by the Reserve Bank, as tradable inflation reflects external price shocks, whereas non-tradable inflation can be targeted with domestic monetary policy," says Statistics New Zealand.

We have done the exact opposite. We have dumped food out of our core inflation index, so that we are left with some lagging items which do not respond to domestic money printing quickly.

The census department says out of the 151 index point rise in May, 141 was caused by food, which in turn was caused by a short supply in vegetables in Pettah. In January it was supposed to have been rain which caused a sudden jump.

No mention is made of the almost one percent of GDP rise in reserve money the previous month. Of course rain does affect vegetable prices. But then it has to come down later. Over the years it has not come down as fast as it goes up.

Sri Lanka would obviously be better off using a non-tradable leading indicator than a lagging core-inflation index. Or at least use both.

But just because New Zealand has a non-tradable index does not mean their problems are easily solved. They have the same problem as us.

Monetary policy is being tightened, and their interest rates are probably the highest in the developed world, but there is no fiscal restraint and the government is spending beyond its means, so economic growth is being threatened.


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12. j Jun 26
Politics = Corruption or Corruption = Politics.

Therefore Politician = Corrupt Man or Corrupt man = Polititian.

11. Sena Jun 26
Hey Fuss,
How close do you think we are to a crash? a proper economic meltdown? before 2010?

And what power do people have to protest against this? If the corporates say "we;re not going to pay corporate tax unless u give us our VAT refunds that are 2 years due" etc...

PB is highly stubbon and NivCab is not really an economist so ... the slope looks slippery. If things in the middle east flare up and our employees have to return there goes the balance of payments too!!!

10. harsha de silva Jun 25

keep in mind the issue of price elasticity of demand and income elasticity of demand are two seperate things.

At any given income level if i am willing and able to buy a little less of beans [as oppossed to a lot less of beans] when the price of beans increase, then my price elasticity of demand for beans is relatively inelastic.

on the other hand, if at any price level, i am now willing and able to buy little less of beans [as oppossed to a lot less of beans] when my income goes down, then my income elasticity of demand for beans is relatively inelastic.


9. fuss-budget Jun 09
Hi Murtaza
In general you are sort of right, because in an economy agriculture seems a relatively stagnant sector as income grows.

But,......I will tell you a little story
If you are born into a working class family you will know that you will usually buy two vegetables of 250 grams and a mallun mitiya maximum at a time.

After the father gets the increment you will buy 3 types if you were buying 2 and 2 types if you were buying 1 earlier and perhaps 500 grams of one type. Also you switch from snake gourd (pathola) and pumpkin (wattakka) and radish (rarboo) to beans and carrots and beetroot.

When you have more money for each meal you will have instead of one vegetable and parrippu and dry fish, you will have two vegetables and fish. That is a quantum leap in consumption. If you are really feeling wealthy you will have three vegetables and fish or meat.

No, the demand for vegetables is definitely not inelastic. Any working class person who is reading this or who has grown up in such an environment will attest to the truth of that.

By the end of the year, when the rupee has depreciated and everything else had gone up, and the politicians and the central bank has printed billions of rupees and robbed your salary, you will be back to 250 grams and not kola mallun but only pol sambol.

By the time you retire, they will have robbed your EPF as well. This then is the plight of the working class family.

This was very noticeable in the early 80's when JR printed money left and right. Even government servants felt this. The pensioners feel this even now.

If veggies were simply a supply problem, it should come back to the old price. It doesn't. The problem is veggies are also denominated in rupees.

But the reason inflation shows up in veggies first is that there is a fairly efficient market there, where transactions are frequent and price discovery is quicker. (That is why supply shocks are also felt earlier).

House prices will go up only slowly because there are fewer transactions and it is not transparent. As a result inflation will show up in the share market for example faster than in houses.

But eventually replacements costs will ensure that house prices will also go up even if there is no transparency. Demand and supply impacts all markets and prices will change, but that does not explain why each year veggie prices settle at a higher level. See the central bank weekly veggie price graphs. Over the years the curves are floating higher, though the volatility is there.

Then of course you come to the final bottom-line. If countries that are given an inflation target by the parliament, or countries that have currency boards, can magically keep their prices at bay, how come only countries like us have 20 percent inflation?

The people who get the printed money appropriate the production of a country. They need not actually appropriate food, it will eventually feed through. But food is very, very quick.

If you are interested, read up on the shortages and food riots in Paris during the French revolution and what happened to the French Assignat. That is really a classic and a tragic example of what happens when govts print money and pays themselves fat salaries.

Marie Antoinette is supposed to have said eat cake if you do not have bread (it is disputed whether she actually said it). You can't move up like that, because not everyone gets the printed money. By the time everyone gets it, you are back to square one. It is the people and businesses who supply goods and services to govt, who get it first.

The difficulties the people had with the livre, and the national debt (it was a war related depression) under the monarchy was nothing compared to the collapse seen after the assignat was brought in. The first assignats were issued with the king's picture actually.

Andrew Dickson White, diplomat and economics professor, wrote a book on it about a century later. If you lived in Paris say about 1795, you would have been guillotined as a speculative unpatriotic stock-jobber, because stock prices went up as ordinary wage earners could not feed themselves.

Also check on china pork prices now, there is some interesting stuff happening. China has to lift exchange controls now.


8. fuss-budget Jun 09
Hi sena, hi don't know
Sterilized intervention is when you prop up the rupee by selling dollars in your reserves and make up the contraction in the money supply by buying t-bills.

When you sell dollars in the market, the central bank has to buy rupees. That money is taken out of the economy - from reserve money that is. This should raise rates.

Instead, through the purchase of treasury bills, the central bank will sterilize this effect and add cash.

This will eventually create a huge balance of payments crisis like in 2000 or 2004 or Aug/Sept 2006 by adding new demand to the economy. If you allowed the money supply to contract and raised rates, the economy will stabilize.

In a currency board system this happpens automatically.

This is why most central banks now raise rates to strengthen a currency. Raising will also make assets denominated in that currency attractive to investors.

But raising rates is achieved by a contraction in money supply (ie open market operations -repo that is).


7. Murtaza Jafferjee Jun 09
Fuss, I would presume fish and vegetables are inelastic products so how do prices increase due to money printing.

I would assume if people have more money in their hands they are not going to try to consume more fish and vegetables, on the contrary you may have some income elasticity effects like increase in demand for chicken and fruits.

My understanding is the principle causal factors for vegetable and fish price increases are supply related.

I would argue that if people have more money in their hand they would probably buy consumer durables and discretionary products.

6. dont know Jun 07
What is sterilized intervention?
5. prudence Jun 06
In one sense I think the political power of the Gov is working in our favour. At least he has the power to whisper the truth in th ear of the president who othrwise would be told that all is fine by the treasury.

The other issue is that we should judge a man by his actions not his words. Fortunately this gov has the habit of saying the wrong things in public but doing the right thing in practice.

Lets hope he sticks to this policy.

But in the mean time the real culprit i.e. the deficit budget needs to be attacked from all fronts. We need to show the people that nothing comes free.

We need to pay for all the goodies we hand out in some way or another. We should show how much the bloated public sector cost us in terms of development etc etc.

4. harsha de silva Jun 05
Once again a brilliant piece! i doubt many will understand all of it, but i think it is very clear that cabraal et al have done a u-turn on money printing and as you have made the point many times over, inflation is falling, because of it.

it was interesting to read in the mirror today that PBJ had told the president so!

re. the comment on being a political economist... ha ha! thanks! if not for the few of us who stick our necks out to fight the system i am convinced things would be worse off.

keep up the great work!

harsha de silva

3. Das Samuel Jun 05
There is no doubt that printing money causes inflation, by artificially increasing the money supply.

Bunkum has said it all.

Dear Fuss-Budget, you have to be careful. Those with vested interests in & out of sri lanka dislike your exposures.

2. I Bunkum Jun 05
Dear Fuss,
Thank you so much for your great analytical piece. Your ability to bring clarity to complex monetary issues and also bring interesting historical meaning is amazing.

It is regretted that Governer has taken a U- turn. He is perhaps one of the few in this administration, apart from Amunugama may be, who could appreciate the danger of Printflation.

Vast majority of economic illiterates in this administration are likely to disregard your graph as "Thenuwara Coefficient of Correlation between bars and brothels".

Governor's behavior is not entirely unexpected given the dilemma he is facing; how to maintain professional integrity, public interest while pleasing political masters.

This clearly illustrates the need for political independence and professional integrity at the helm of Central Banks.

We may be better off without a Central Banks, from monetary management perspective, as highlighted by you many times, but now that we have one let's hope future leaders will reinstate the tradition of career central bankers leading the central bank.

1. Sena Jun 05
Welcome back fuss!