ECONOMYNEXT – Sri Lanka can dollarize or allow currency competition to get over repeated central bank failures and re-establish sound money for people and investors, Lawrence White, a global expert on money banking and monetary history said.
A central bank creates inflation and currency depreciation because there isn’t an effective anchor or constraint to limit its note issue. It continues to do so for years and years in a country with monetary instabilibecause there is no accountability and gatekeeping economists block the shift to alternative regimes.
There is a mistaken belief that ‘central bank independence’ can reduce inflation. In the 1970s many ‘independent’ Western central banks created inflation, credit bubbles later, as well as high inflation in the past two years.
Why Central Bank Independence Failed
Central bank independence is simply supposed to stop direct financing of deficits but not inflation created by the central bank themselves through monetary policy.
“But independence doesn’t specify a constraint on the central bank,” White, a professor at George Mason University in the US, told a seminar organized by Sri Lanka’s Bastiat Society.
“It doesn’t say what is supposed to regulate the monetary policy. And it doesn’t, therefore, prevent high inflation.
“As I mentioned, we saw high inflation in the 70s and 80s because independent central banks tried to use their discretion to reduce unemployment by creating a surprise inflation.”
White specializes in the theory and history of banking and money, and is perhaps the world’s foremost living authority in free banking, the more stable self-correcting specie constrained monetary system that existed in many countries before central banking emerged.
In an draft monetary law planned in Sri Lanka under an International Monetary Fund printing money for growth (output gap targeting or mis-using money for macro-economic policy) is to be legalized.
Sri Lanka also has a reserve collecting central bank, where rate cuts enforced with open market operations under ‘flexible inflation targeting’ can lead to forex shortages and depreciation in a matter of weeks, under a flexible exchange rate, analysts have said.
“Sound money means healthy money. Money that is institutionally robust,” White said. “That implies that there are some safeguards against government printing money for money that, is consistent with maintaining stability of its purchasing power.”
Exchange Rate Anchors
“So what kind of constraints can you put on a central bank? One of the most popular is a fixed exchange rate,” White said.
“And a fixed exchange rate that is a weak peg doesn’t provide much of a constraint because the central bank will devalue it when it issues too much money and there’s no penalty for devaluing.”
“A stronger form of fixed exchange rate is a currency board. And the strongest form is simply to adopt an anchor currency as your own currency. That’s called dollarization, if the anchor currency is the US dollar. On the periphery of the Eurozone, you have Euroization.
“I think that may be the best way forward for Sri Lanka.
“I don’t know how dollarized the Sri Lankan economy is already, but I suspect with the high inflation you’ve had over the last two years that a lot of people are already keeping their savings in dollars.”
Sri Lanka also saw a spurt of sovereign liability dollarization over the past several years which ended in default in 2022.
Many developing countries in particular are suffering high inflation and balance of payments trouble due the lack of an effective rule to control central banks which try to push growth by inflating reserve money to cut rates, eventually ending up high inflation, high interest rates and falling growth or economic contraction.
With the collapse of the Bretton Woods system, the world lost the gold standard, the best restraint selected by the people or market to keep central bankers in the straight and the narrow, found up to now.
When note issue banks were compelled by the market to maintain gold standard without centrally planned interest rates, high inflation and balance of payments troubles were prevented, up around the 1920.
Through the price specie-flow mechanism (see David Hume, On the balance of trade) exchange rate parity was maintained between different countries or different central banks.
Restraining Fiat Money
In order to have an exchange rate anchor, there has to be a better managed central bank to peg to.
Post 1971 fiat money central banks, without the gold rule to control them, created high inflation especially in the Great Inflation period. Fiat central banks could ‘float’ and deny convertibility and destroy the value of money.
“And now the central bank has control over the quantity of money, because without the obligation to redeem their liabilities, there’s no limit to the amount of money they can issue,” White explained.
“So that’s the question that faces us today, has faced us since 1971, when the Bretton Woods system broke down.
“Without a constraint like a gold standard, how do we avoid the over-issue of money by central banks? That’s been a big problem. If you look at comparisons of systems with a gold or silver standard against systems on fiat money, every country has had higher inflation on the fiat.”
“It’s a case for rules rather than discretion.”
Now many fiat money central banks use an inflation index as an anchor or constraint to limit their money issue.
Inflation targeting has turned out to be a ‘milder kind of constraint’, White says.
“Officially, the European Central Bank has an inflation target of under 2 percent,” White said.
“Last year inflation was over 10 percent with the Eurozone. In the US we have an inflation target of 2 percent.
“Our (US) inflation is currently 5 percent and it hit 9 percent last year. So inflation targets are not very binding.
“They don’t really constrain central banks very effectively.
“An alternative, a sort of more fundamental alternative, providing this constraint, is to allow competition among alternative monetary standards.”
In Sri Lanka critics expect legislators to rubber stamp an inflation target of 4 to 6 percent, about twice or three times that of floating rate central banks, giving room for high inflation, banking troubles as in the recent past.
Monopoly Money
In Sri Lanka and in many unstable countries in this century, a central bank is the monopoly money issuer, with people forced to use and denominate goods and services in depreciating bad money through legal tender.
Even possession of foreign currency, to escape the bad money produced by the central banks, have been made into an offence, by persuading politicians to enact laws against competition and perpetuate the monopoly in bad money.
Exchange controls prevent money being taken abroad as well to protect against expropriation of savings through inflation and depreciation. The laws allow central bankers to continue artificially low policy rates or conflicting money and exchange policies and build greater imbalances, critics say.
When salaries are denominated in the currency and it crashes like in Sri Lanka or Latin America people go hungry and all except the well-to-do find themselves in difficulties.
The note-issuing state enterprise itself is mostly unaccountable, but politicians who passed the laws to give money printing powers and exchange controls and legal tender restrictions, are held accountable by the people and lose power, when currencies are debased, analysts say.
The world did not always have central banks. Many countries had free banking systems, which were controlled and regulated by the classical gold standard, without creating permanent long term inflation as now.
Many countries set up central banks, some like the Bank of England – originally privately owned – to print money for governments for wars. But with flexible policies for ‘macro-economic management’ central banks started creating inflation in peacetime with macro-economic policy, critics say.
“If you look at the origins of central banks, they don’t lie in market forces,” White says.
“They lie in legislation. They were created by governments. And there are different stories in different countries, but often they were created to lend to governments on favorable terms.”
In Sri Lanka also a currency board that had kept the country stable through two world wars and great depression was abolished legislatively in favour of a central bank that would give ‘provisional advances’ to the government.
READ How Sri Lanka, Latin America was busted by Fed money doctors creating strongmen, anti-Americanism
In the controversial new monetary law where numerous provisions have been struck down by the Supreme Court, up to 10 percent of the budget can be printed, despite a prohibition elsewhere.
“Notwithstanding the prohibition in section 86 of this Act, the Central Bank may make new direct provisional advances to the Government to finance expenditures authorized to be incurred out of the Consolidated Fund within the first month of the financial year,” says the draft law.
The US Fed was set up for different reasons.
“In the United States, the Federal Reserve System was created to serve as a lender of last resort to a very weak banking system,” White says.
“And our banking system was weak because of legislative legal restrictions on the commercial banks that made them prone to failure.”
The US had a large number of small banks, in part due to branch banking restrictions which rapidly worsened banking panics.
Canada historically had a better system.
Free Banking
Before central banking, countries had multiple private banks issuing money, restrained by gold or silver.
“In a free banking system, banks are issuing notes, competing commercial banks, just as they issue checking accounts today,” White said.
“But they’re also issuing paper currency in a form that is redeemable for basic money by gold or silver.”
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Such systems were found in Canada and Scotland, but also Sweden, Australia, Switzerland.
“The role that’s now played by the central bank as the banker’s bank or as the clearinghouse was played by private clearinghouse associations, which were clubs of the leading banks, the clearing banks.
“The clearinghouse associations did a certain amount of regulation of their paper banks.
“That is, they had minimum capital requirements, because it’s in the interest of every member of the clearinghouse to make sure that the other members really will pay what they owe to each other at the end of the day.
“So, among the banks in a clearinghouse association, the loss of reserves to other banks that follows if a bank issues too much money, kept every bank in line with the other banks.
“But the system as a whole is pinned down under the classical gold standard by the loss of gold to the rest of the world. (Price specie flow mechanism). So that governed the quantity of money in the country, not the central bank.
“In the United States, the clearinghouse associations also acted as lenders of last resort when necessary.”
“There are still a few places in the world that have competing private currency issues. Scotland, Northern Ireland, Hong Kong, and Macau still have private note-issues.”
Multiple Currencies
Countries get dollarized or people start to use multiple currencies automatically when currencies depreciate rapidly, there is hyperinflation and it is difficult to price mark products.
Friedrich Hayek, who won a Nobel Prize shortly after the Bretton Woods collapse, proposed multiple currencies as a solution to inflating, independent central banks.
“And Hayek responded to that by saying, why do we have such lousy money?,” White says. “Why is the quality so low? Well, let’s see. For other goods and services, for automobiles and television and so on, we rely on competition among multiple providers.
“We don’t let one brand switch to another brand. And that’s what enforces the kind of quality standards we want. But in money, we’ve eliminated competition. We’re all captured by the central bank. And we don’t have any way to constrain the central bank.
“So, at the very minimum, people should be free to use whatever money they want to use from other central banks. So people can keep their savings in Swiss francs if they don’t trust the local currency. But beyond that, we should allow private competitors.
“Maybe they can provide a more credible currency than governments can.
“And let people choose what kind of money they find the most honest, the most credible, the most trustworthy. Now that message has become more relevant in recent years because we have new competitors above monetary standards.”
Popular Dollarization
A country can quickly get dollarized and displace the domestic monetary base when governments lose the ability to enforce legal tender laws amid high depreciation, export and tourism workers begin to pay for goods and services with dollars.
As the dollars displace domestic currency reserve money, the central bank then loses the ability to conduct ‘monetary policy’ and inflate or depreciate money.
Countries like Panama, and several countries where the US Fed helped set up interventionist central banks are now dollarized.
Stability
Without a central bank to cut rates artificially and drive them up later, interest rates fall dramatically under fixed exchange rate arrangements.
“So you get lower inflation,” White says. “Because of that, you get lower interest rates. And not just nominal interest rates, you get lower real interest rates, because there’s no longer a devaluation risk premium built into interest rates.
“And with that, you get a sounder banking system.”
Analysts say sounder banking systems result in part due to less dependence on central bank liquidity factilities which forces banks to give loans only against deposits and manage liquidity prudently.
Even when banks collapse in the anchor currency area with lender of last resort facilities, dollarized or Eurorized or currency board area banks remain more stable, history shows.
In Panama, banks have solved the problem of filling temporary liquidity shortages or lack of a lender of last resort facility with credit lines from US banks, White says.
Another ‘disadvantage’ of dollarization was lack of profits from note issue. But the profits come at the expense of inflation and suffering of the people.
In Sri Lanka the central bank made a loss in 2022 after it borrowed dollars (swaps and IMF loans) and gave loans in rupees (central bank credit).
There were however six benefits to dollarization.
“Lower inflation, lower real interest rates, a sounder banking system, deeper financial markets, lower transaction costs, and encouragement for foreign direct investment,” White says.
Sri Lanka’s inflation hit 70 percent in 2022.
“And I don’t know what the prospects are for bringing it back down, but it seems to me you have a right to be skeptical,” White says.
“And therefore, dollarization seems to me to be a practical solution. So, look at the examples of Panama, Ecuador, El Salvador, East Timor: all dollarized countries.”
Gatekeeping Mainstream Economists
Mainstream economists, especially those with links to central banks may act as ‘gatekeepers’ and block the establishment of sound money, White has found.
“And it imparts a kind of status quo bias where people will do research on helping the Central Bank choose its operating targets and procedures and technical problems like that,” White says.
“But there’s very little research on the question of what are the alternative institutions and how would other systems work compared to the central banking system we’ve got.”
In Sri Lanka, mainstream economists who support depreciation and inflation through macro-economic policy have opposed currency boards.
However in Sri Lanka the China-backed Colombo Port City area has been protected from monetary policy through dollarization. It will officially be a currency competition area without balance of payments troubles.
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Now digital or cryptocurrencies have also come. Blockchain in particular is useful for payments.
Bitcoin has a disadvantage that its price is too volatile, White says.
Gold is widely used as a store of value even now. However, its use as a currency is blocked by the state, through taxation and other means.
“But the technology that Bitcoin introduced, the blockchain technology, is also available to use by issuers of gold-backed currency,” White points out.
“So we now have tokenized gold available on blockchains. So you can buy and sell gold as easily as you can buy and sell Bitcoin. And you can transfer it to other people through that mechanism, through exchanges. And so digital gold is now a plausible candidate.
“I don’t expect either of these, Bitcoin or digital gold, to rise from the bottom up and become a new monetary standard until fiat money really begins to inflate.” (Colombo/June19/2023)
