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The Government has introduced a package of administered price reductions and seeks to boost consumption. Administered prices are entirely under the control of the government and it can hold them. But the question is how the government will fund the consequential increase in the budget deficit. There is no doubt it will be through printing more money. But this will affect the prices of all other goods in the markets from rice and subsidiary foodstuffs and milk foods.
Inflation has come down in recent months primarily because of the fall in oil and food prices in the world markets. Any fall in inflation is due primarily to the fall in prices of imported oil and food. There is a divergence between headline inflation and core inflation.
Even if one assumes that these lower imported prices will continue, the excess monetary demand caused by printing money will once again push up inflation or at least prevent the people from benefiting from such lower world prices.
Some policy makers seem to be under the impression that money printing is alright to fund fiscal stimulus because of the global recession. Keynes talked of fiscal stimulus through unbalanced budgets funded by borrowing savings from the public and not by printing money.
Paper money makes cash trash
In 1925 the countries of Europe had given up the precious metals as a base for money with the dumping of the Gold Standard. Paper money had made its appearance earlier in the 18th and 19th centuries with the banks issuing their notes which like the goldsmiths receipts changed hands in settlement of transactions. Now there would be no restriction in the supply of money. It depended on who could issue the paper money. The State took the sole monopoly for the creation of paper money.
During the First World War the European states realized that they could print enough money to fund the war. Two great economists, Schumpeter and Keynes, saw this momentous change, which gave a spurious solution to the perennial shortage of revenue that governments all over the world face. Schumpeter wrote ‘——In the past the inability of the state to tax more than a very small proportion of the GNP or to borrow more than a very small part of the country’s wealth, had made inflation self limiting.
Governments discovered that with paper money they could raise revenue through the inflation tax. Monetary factors like deficits, money, credit taxes were going to be the determinants of economic activity in the future
The present Sri Lanka government like the government of CBK has resorted to extensive money printing. It is continuing to do so and the Central Bank is obliging them perhaps under the illusion that during a financial crisis more money must be printed to relieve the liquidity shortage caused by the drain in foreign exchange, which itself is due to the current account deficit in the balance of payments.
In order to keep the inflation rate from rising, policymakers have to raise the interest rate. However, the increased interest rate would most likely slow down the economy.
In order to check the build-up in inflationary pressure, tightened monetary policy should be combined with greater fiscal restraint and with more flexible exchange rate management. Now is the right time to let the exchange rate move more freely in the foreign exchange market so that it can depreciate to protect our export earnings. Of course it will mean higher debt service burden for the government.
The depreciation of the exchange rate, by raising the prices of imported goods, can actually reduce the inflationary pressure. But that is on the assumption that the government and the CB will not expand the money supply while the balance-of-payments deficit reduces it. In essence, the exchange rate determines only the relative prices between imported goods and domestically produced goods. Eventually the general price level is entirely determined by domestic money supply and monetary policy.
What needs to be done
A connected question is whether CB’s exchange rate intervention is going to be successful for a country when it suffers from current account deficits.
When the terms of trade aggravate, the exchange rate should be depreciated to rebalance the trade account. The flexible exchange rate will help to lessen the impact of external shocks; if not, the domestic sector should have the burden of adjustment. This would require reduced incomes since the demand for imports should be lowered. It is in this context that the Government’s stimulus package for consumers is likely to come apart.
The oil price increase is one of the worst in terms of trade shocks. Hence, in order to rebalance the trade account, it is desirable for the exchange rate to depreciate. However the depreciation of the exchange rate will aggravate the inflationary pressure. The problems of today stem from a decade of deficit finance and double digit monetary expansion. Yet the policy prescription to pull the economy out of its downward spiral is the same recipe of deficit finance and easy credit that caused the problems in the first place. In other words, consumption whether from government spending to household credit cards to bailouts should not be financed by selling ever larger amounts of printed money.
The printing of growing quantities of cheap money will lead to a whopping increase in public debt which got us into the problem in the first place. This assumed Keynesian reflation has caused runs on financial assets needing more government capital and a massive deterioration of the government’s balance sheet. Is all this money doing any good?
A need to restore confidence in financial institutions
Trust is everything in finance but little has been done to restore this essential ingredient. Savers and Investors are left wondering whom they could trust. Indeed recent events such as the Golden Key collapse due to failure to profile the risks in a credit card company and permitting card holders to pay only interest while ignoring the borrowed capital was bound to come a cropper. A run on finance companies is an ever present danger.
* Savers are dumping financial assets in finance companies. Capital preservation rather than growth has become more important than yield to them.
* Instead of bailing out businesses, the government seems to be bailing out the consumer. If it is selectively raising consumption of domestic goods it can be justified, but not imported goods.
Similarly, the reduction in overnight interest rates and very short term rates has not worked because the velocity of money or the rate at which money turns over has not picked up as the banks hoard cash and scale back lending. At still lower rates of interest money will become worthless - it might even be better to keep savings under the mattress.
In the thirties, the Fed in USA, slashed interest rates and Roosevelt’s devaluation of the dollar sparked a "beggar thy neighbor" competitive devaluation race and a round of protectionism. We have no choice but to follow what our competitor countries are doing with their exchange rates. We cannot afford protectionism either. Where will the rupee end in terms of the dollar?
In the 1930s US stock prices fell almost 90 percent. Our stock market has fallen by about 40% but it is still falling. Recapitalization is essential if financial institutions are deemed to be trustworthy. De-leveraging is a must. The non-banking financial sector does not have enough equity. A further consolidation of the financial sector is needed; and most needed is a restoration of trust.
We have borrowed from foreigners for some time. The key instead is to boost domestic savings which are grossly insufficient to meet the government’s monstrous requirements. Years of high inflation and negative real rates of interest have been a disincentive to savings. There is no prospect of the government borrowing from foreigners whether they are foreign investors or foreign bankers. Even the UK and Italian governments are experiencing financing difficulties. In Germany, a November bond auction failed.
Our government must borrow or tax but not simply print money to keep its economy afloat. There is no possibility for the Treasury to borrow from the public without paying higher interest rates and several bond auctions have been cancelled because the investors ask for high yields. So will the Treasury be able to raise money from the bond market to fund the stimulus packages or de-leverage the economy or recapitalize the banking system?
But the increase in the demand for imported goods arising from money creation instead of borrowing savings of the people, will further worsen the current account deficit. No one will bail out the government. The private sector financial firms in trouble will only attract bargain hunting foreigners looking for cheap assets. Al Futtaim or Al Fayed will soon be household names.
