No, the people do not wish to commit economic suicide

by Harsha de Silva

(September 16, Colombo, Sri Lanka Guardian) Two very interesting pieces on the ongoing inflation debate appeared in the press last week. I say interesting because of the sometimes differing and other times concurring views expressed by the two eminent personalities. The first one was by former Central Banker Usavatte-Aratchi [Between a rock and a hard place; the controversy over monetary policy, The Island 8 September]. The second was also by Mr. Ajith Nivaard Cabraal, current Governor of the Central Bank [CBSL] [We’ll let the figures do the talking, The Island 11 September]. Since the former piece mentions me by name, I thought it would be good to clarify, and then the latter appeared. So I combined the two and here is what I came up with.

Mr. Usvatte-Aratchi argued that the critics were on "rock solid ground" when they argue that the CBSL has the "authority and indeed the instruments to control inflation." He took pains to explain that the technical staff at the CBSL is as good as the best anywhere else implying that they were fully aware of the need for tight monetary policy to fight high inflation; albeit the real consequences of lower growth and even some chaos. He added however, "The CBSL is in a hard place because while it has authority it has no power to pursue monetary policy independent of Government" and went on to substantiate it by saying that "the appointment of Mr. Cabraal as Governor, a party man, by the current President is symbolic of this relationship." Mr Mr Usvatte-Aratchi then presented his case to fend off criticism levelled against the CBSL; "Now, you must see that the fundamental problem is not that the CBSL is irresponsible, but that we have a Government which has lost control over Government expenditure." It is clear to all what he is saying; that without an independent central bank, it will be impossible to eliminate fiscal dominance of monetary policy which is at the bottom of the inflation problem. He then stops and points to reality. He says "Do not blame the President and the Cabinet of Ministers entirely. They were elected precisely to spend as now," and points to the endorsement of economic policy of the Government at the recent provincial council elections. I am sure he made many readers sit up and take notice when he said "In a democracy, if a large majority of the public ardently wishes to commit economic suicide, as they seem to here, there is nothing a CBSL can do to prevent it. Do not expect staff in the CBSL to tell Government that they are stupid to do what they do now." He ended by saying that everyone better "identify the fundamental cause of the problem, uncontrolled government expenditure" and hoped that the CBSL be left alone from criticism.

I agree with the logical analysis of Mr Usavatte-Aratchi that tight monetary policy is the need of the hour to rein in soaring inflation. I also agree with him that tight monetary policy will result in real consequences of unemployment and other socio-political issues and that it may cause social disturbances. Many other economists and I agree that in the medium term independence of the central bank is critical in pursuing the type of monetary policy that ought to be implemented, as opposed to what may be in the best interest of the Government in ‘power’.

However I disagree with Mr Usavatte-Aratchi that the people wish to commit economic suicide and that they are perfectly fine with the current Government expenditure programme. The very narrow majority the President obtained does not give this Government [or for that matter any Government] a licence to damage monetary stability through high inflation, unsustainable balance of payments and reckless foreign borrowing for questionable purposes. I also disagree with Mr Usaatte-Aratchi that CBSL cannot advise the Government on the ill-effects of their current expenditure programme; which, as he himself says, is out of control. After all, the CBSL is the chief economic adviser to the Government. If not the CBSL, then who is to point out to the Government they are attempting ‘mass economic murder’ [as opposed to mass economic suicide]? I don’t think to stand up and say what is wrong is wrong is ‘romantically heroic’ as he put it; but being intellectually and professionally honest. Nothing less is expected of the staff of the CBSL, whom I have always acknowledged as highly technically competent except when they were ‘used’ by certain political forces to advance technically flawed or dangerous ideas. Finally, if Mr Usaatte-Aratchi is implying that the democratic process is not working for us in Sri Lanka and that we will continue to self-destruct, then I believe we are in real trouble as the democratic process with all its limitations is the best we have.

I take a more positive view in that I believe it is still possible to create the independence the CBSL requires to pursue monetary policy without interference from the Government. The literature on how various democracies achieved this critical aspect of good governance is voluminous. Perhaps those who have been advocating good governance, including the Governor, could benefit from this literature. Also voluminous is the negative relationship between central bank independence and inflation; in that as the independence increases inflation moves to a lower structure. In fact, we were beginning to witness increasing independence of the CBSL in the earlier part of this decade with the reforms to both the institution and amendments to the Monetary Law Act. At the institutional level the focus and transparency of activity has increased significantly over the years. With respect to implementing the legal provisions for independence of the CBSL the reestablishment of the Constitutional Council and reappointing the majority of members of the monetary board with its concurrence is essential.

Now to the Governor’s piece. It is an interesting practical example of the case put forward by Mr Usavatte-Aratchi; that "The CBSL is in a hard place because while it has authority it has no power to pursue monetary policy independent of Government." In fact I think it is worse than that. The interview reads more like the CBSL is a willing accomplice of the Government rather than a reluctant collaborator.

Responding to a question on Government expenditure, the Governor says, "The Central Bank does not have anything to do with government expenditure. As to how the Government wants to deal with expenditure is the government’s call and the Central Bank does not have a role as far as overall government expenditure is concerned." Technically, the Governor is perfectly right; the CBSL has no role in fiscal policy, but there is more to it than being technically correct. In Sri Lanka, the CBSL is the Government’s official economic adviser. The President praising the involvement of CBSL in advising on fiscal policy of the Government said, at the launch of the CBSL Annual Report on 30 March 2007, that the "Role of the CBSL as the Government’s official economic adviser is conspicuous. We consider very valuable the economic advice constantly provided by the CBSL to the Cabinet in taking decisions." Presumably, the Cabinet consisting of many dozen ministers has some role in fiscal policy in this country. So, for the Governor to say the CBSL has nothing to do with Government expenditure, in light of the President’s statement then raises a question. The real issue is not that, but it is the monetary accommodation of this Government expenditure by the CBSL; be it in terms of providing Central Bank finance, or creating money, for unsustainable increases in the state sector, to establish questionable state enterprises or financing so called development projects. This is where fiscal dominance of monetary policy comes in; and with a willing partner in the CBSL, as explained by Mr Usavatte-Aratchi, fiscal dominance becomes more of a home-and-home matter.

Asked the question: ‘What are your comments on the contention that indiscreet supply of currency by the CB has helped in boosting inflation?, (i. e. loose monetary policy), the Governor retorts, "It is an allegation which we reject upfront." The Governor asserts that because the CBSL has continued to successfully meet its pre-defined reserve money targets, that monetary policy is sufficiently tight. He ridicules critics by saying "…all that I could say is that they are people who do not understand the subject…" I doubt those involved in this debate over the last several years lack the minimum level of understanding of economics that is required to carry on the debate. Most of the critics are economists with many years experience both here and abroad. Perhaps, it would be better if we stick to the facts instead of speculating on the economics knowledge of critics. And the facts are indisputable.

There has been serious monetary accommodation going on in the recent past; particularly in 2004, 2006 and partly in 2007. And we have seen unusually high inflation since 2004, and particularly since 2006. It is true that current monetary policy regime is tighter than the mean of the last few years. It is also true that after ridiculing critics for calls for further tightening of policy by reducing the reserve money targets set in January this year, the CBSL actually reduced these targets. This again goes to show that original targets were not tight enough. The Governor says "We see the efforts taken by the Sri Lankan authorities bearing fruit now." Absolutely true Mr. Governor. It is nice to see the CBSL acknowledging the problem as a domestic issue as well instead of a purely external supply side issue as argued so hard all these months. There is no disagreement that global fuel and commodity price shocks had an impact on inflation globally, including Sri Lanka and that in the region inflation reached a mean of a little more than 10 percent. But the debate is on the massive residual between that and 25 percent.

The Governor says that he would rather let the figures do the talking and that the inflation figures will continue to fall. Let’s hope for the country’s sake that the Governor’s prediction about falling inflation is correct since all his earlier predictions have been plain wrong. But let us give him the benefit of the doubt since nobody can know today what the inflation will be next month or the month after. But some past experience will be helpful to evaluate the Governors statement. First, if one looks at CBSL monthly figures for inflation between July and August using the CCPI (N) what they prefer, in percentage terms they are 2003 (0.2); 2004 (1.0); 2005 (0.4); 2006 (0.5); 2007 (2.1) and 2008 (1.5). One notices that the inflation has come down from 2.1 percent to 1.5 percent. Second, that for the rate of inflation between July and August is second highest for 2008 compared to all the five years. Third, given seasonality factors one expects the inflation rate to come down between July and August and also September compared to the average monthly rates for the year. Thus, it is not clear that "figures are doing the talking" for the Governor.

Perhaps, the most interesting analysis of the Governor is related to exchange rates. He says, "The current exchange rate policy is that which we have been following since 2001, where our foreign currency dealings have been based on a floating exchange rate policy. We have been following this policy continuously. This is the policy which is in place right now as well. The market determines the exchange rate, depending on the supply and the demand of foreign currency into the market." I am not sure if this statement is factually correct. As far as I know, the IMF reclassified the exchange rate regime of Sri Lanka from a free-float to a managed float since 2006 to account for the continuous interventions by the CBSL. So, is it the same regime that we have been following since 2001?

Be that as it may, it seems that the Governor is continuing the myth that the exchange rate of the LKR is determined by free market forces [or ‘miraculous exchange rate’ as described recently by a past Assistant Governor of the CBSL whose column has suddenly disappeared]. The fact is the exchange rate is managed by the CBSL interventions to keep it low. Moreover, the Governor seem to spin that the current exchange rate regime is good for the country when he says "We are seeing the policy serving the country well because we believe that having a market-oriented foreign exchange is the appropriate one for the country" But, this is not the reality. The current regime is creating huge problems to Sri Lanka’s exporters and producers of import substitutes. The trade deficit is ballooning; worsening by some 92.5 percent for the first half of this year over the same period last year. It is hoped that the recent Article IV consultations made by an IMF team has clarified for the Governor the danger of using the exchange rate to stabilize prices.

While we all are very pleased to see inflation coming down gradually with the CBSL sticking to its tight monetary policy stance it is making everyone aware that however much the it attempted to attribute the sky high inflation purely to global oil and commodity prices that it was not so. There was a significant domestic component, as explained by Mr Usavatte-Aratchi, the reduction of which we are now witnessing with tight monetary policy. If not, we will have to see inflation down to single digits very soon with the burst of both the commodity and the oil bubble. Mr Governor, let the figures do the talking. In the meantime, please don’t think we, the people, wish to commit economic suicide. No way! Don’t interpret the recent election results in that way! Sri Lanka Guardian