Aug 29, 2008 (LBO) - A central bank should not relax monetary policy (print more money) to increase employment, or finance wars and subsidies, because inflation, which is worse than terrorism, would be the result, a top Sri Lankan economist said.

"Though societies should fight terrorism with real resources mobilised from the society, it is not advisable to use central bank’s nominal resources to fight such wars," W A Wijewardene, deputy governor of Sri Lanka’s central bank, said.

"This is because when inflation raises its ugly head, it is also like a terrorist who has no mercy on anyone who fails to index his income with inflation.

"Irrespective of the age, sex, wealth, creed or race, inflation impoverishes everyone. A terrorist exerts fear in the minds of people.

"In the same manner, inflation too exerts fear, helplessness, destitution and hopelessness in people.

"So, a central bank’s best support for fighting terrorism by a government is to maintain price stability and help the society to create more wealth."

Wijewardene was delivering the first John Exter memorial oration in Colombo to a packed audience. Exter, a former Federal Reserve official, devised Sri Lanka’s monetary law in 1950 and was the fledgling central bank’s first governor.

Before the creation of a central bank with money printing powers, Sri Lanka had a currency board, which kept living standards stable, inflation low and the exchange rate strong.

Economic analysts have pointed out that inflation and foreign exchange shortages became a problem in Sri Lanka after the creation of the central bank, which then led to the progressive closure of the economy.

Except for the two and a half decades of a closed economy in the life of the central bank, which ended in 1977, Sri Lanka has had an open trading economy for thousands of years.

Wijewardene, whom his fellow deputy governor Ranee Jayamaha introduced to the audience as a ‘living repository of knowledge’ within the central bank, says to wage wars against terrorism, real resources are needed.

He says when the sovereignty of a country has been challenged; economists accept that a democratically elected government has to re-establish law and order.

"For governments which are already constrained by a shortage of resources, allocating resources for fighting terrorism means foregoing some other useful activity for which such resources could have been utilised," Wijewardene said.

"In order to raise the required resources, many governments have resorted to taxation, borrowing or simply inflating the economy by issuing currency."

But when central bank credit (through printing or issuing currency) is used to fight wars, it results in high inflation, and economic collapse, which is also like a terrorist.

"Financing government expenditure by using inflation tax is what Exter disliked most," says Wijewardene.

"He was a scathing critic of the Fed running its printing press and debasing the value of dollar.

"Having warned the others of the impending danger lying ahead, Exter used his expert knowledge to convert all his dollar assets to gold."