by R.M.B. Senanayake

I wish to respond to that part of Mr Samarasiri’s article on Monetary Framework published in the Island of the 15th, because it contains some dangerous illusions.

He has rightly explained that money printing is not used in economic parlance in the ordinary sense of printing currency notes by the Central Bank but in the broader sense of creating bank deposits which is an equally important component of Money Supply. Banks create new money in the form of new bank deposits when they give out loans or overdrafts (they are extinguished when repaid). Their capacity to do so is limited by the statutory reserve requirement to keep 10% of their total deposits with the Central Bank, which forms the pool of Reserve Money. The Central Bank can increase the Reserve Money and enable a multiple expansion in the Money Supply up to a limit of 10 times (in practice the money multiplier is about 5 only). When the Central Bank lends money to the government or subscribes to Treasury securities it increases the Reserve Money and propels the banks to create more money by way of new or larger bank deposits.

I am genuinely surprised that Mr S doesn’t think that creating new money in excess of the demand for it to sustain the growth in GDP is not inflationary. I am more surprised since he like me has studied in an American University. I studied Macro-economics and Growth Theory for my Masters degree in the University of Pittsburgh.

He seems to be confusing the productive nature or otherwise of public expenditure with its impact on Aggregate Demand and contribution to inflation. I must remind him about the Government sector Multipliers even the Balanced Budget Multiplier in macro-economic analysis. Government expenditure has a multiplier effect on Aggregate Expenditure. Mr S rightly points out that even when government expenditure is funded by private savings it could still be inflationary. It will be so if there is macro-economic imbalance as a result. All government expenditure is expansionary and whether such expansion in Aggregate Demand is inflationary or not will depend on the macro-economic balance.

The conditions for macro-economic equilibrium are based on the well known IS & LM curves like in the Supply & Demand curves in micro-economic theory of price determination. Macro-economic equilibrium depends on simultaneous equilibrium in both the Goods market (Output) and the money market (where the Demand for money absorbs the supply of money at a prevailing level of output and interest rate). We can have growth with imbalance or lack of equilibrium which is what we are experiencing now in the form of high and rising inflation and rising interest rates. We can repress the interest rates and have still higher inflation.

What I am most alarmed and which prompted me to write this response is Mr S’ justification of inflation tax. I hope he is not reflecting the views of the Central bank. He says if the public are not paying their taxes the government is justified in collecting money through the inflation tax. Firstly it must be said that he is lumping the public with the small number of income taxpayers who are defaulting. He forgets that 80% of the tax revenue is from indirect taxes like VAT, tariffs and Excise where this question of default is hardly applicable. If the tax authorities fail to collect income taxes or are in cahoots with dishonest businessmen to engage in VAT frauds, is the public to be blamed? The Government must run an efficient tax administration.

Of course I sympathize with the Central Bank because it is blamed wrongly for the rising inflation despite its honest efforts. No doubt that the increases in the world prices of oil and food increase our general price level. So does the depreciation of the Rupee. But these are one-off increases in prices. Attempts by private economists to correlate money supply and Reserve Money with inflation are misplaced. Correlation is not necessarily causation and such attempts are based on the Quantity Theory. But modern macro-economic analysis is built on the Keynesian analysis of the economy in terms of Consumption, Investment, the Government Expenditure and the Net Exports of goods & services (including unilateral migrant employees’ remittances.)

What economists mean by inflation is the continued increases in the general price level and this economists generally agree cannot take place unless the Central bank permits the money supply to increase beyond what is required to sustain the increase in real GDP. Economists refer to inflation as due to macro-economic imbalance where the actual GDP exceeds the potential GDP and then growth is accompanied by further imbalances in the form of inflation and current account deficits in the balance of payments. Economists also agree that such growth is unsustainable and will collapse with a soft or hard landing. Already growth in 2007 is below that of 2006.

Mr S also justifies the Central Bank lending to the government and appeals to Exter as if he is the last word on the subject. Central banking has changed much since John Exter and during the fifty year anniversary celebrations a distinguished scholar whose name I can’t remember explained these changes both with regard to Central bank Independence as well as the need to restrict the objectives of the Central bank by law to maintaining only price stability. The Monetary Law Amendment Act of 2002 restricted the objectives of the Central bank to maintaining price and economic stability and the stability of the financial system. But the objectives are too wide as per current central banking practice. It says the bank is charged with the duty of securing, so far

as possible by action authorized by this Act, the following objectives,

namely –

(a) economic and price stability; and

(b) financial system stability,

with a view to encouraging and promoting the development of the

productive resources of Sri Lanka.

The Labour Government of UK gave complete independence to the Bank of England and introduced inflation targeting which is widely practiced in developed countries except USA.

When the Monetary law Act of 1950 was passed it allowed provisional Advances to the Treasury up to a limit of 10% and required them to be repaid in 6 months time not rolled over. At that time the Treasury funded its expenditure largely through Rupee loans and the issue of Treasury Bills was insignificant. There is a time lag in collecting taxes while government expenditure had to be incurred continuously. So this provision was to relieve the temporary cash flow problems of the Treasury and was never intended to be a permanent source of funding for the Treasury as it has since become. As for funding the Treasury through subscribing to Treasury bills in the primary market this is a later development. When the Fiscal Management ( Responsibility) Act of 2003 was being drafted the late Dr Lal Jayawardene discussed this matter with Mr Nadeem Ul Haque the IMF Representative in his home to which I was invited too and we insisted that the Central bank should be permitted only to deal in Treasury securities in the secondary market. I understood that the government was unwilling to do so.

Mr Samarasiri’s comparison of the current Federal Reserve policies is also misleading. Whether Keynesian fiscal stimulus will work or not remains to be seen. The EU Central bank is wary of following the Fed’s rate cuts although bailing out banks to avoid systemic failure is a function of the Central Bank as a lender of last resort. There is no room for us to engage in fiscal stimulus without causing higher inflation. It is true that the IMF has asked emerging countries also to have contingency plans for fiscal stimulus but it could not have intended Sri Lanka or Zimbabwe. This is to avert the US recession becoming a global recession. But even if we suffer from the US recession any fiscal stimulus here will only cause stagflation- higher inflation with output stagnation.