An alternative to inflation?

By Usvatte-aratchi

There is much concern about and discussion over inflation. We all realise that the rapid rise in prices, unmatched by a similar rise in incomes in recent months, creates problems for most of us. On the one hand, that process cuts down our real incomes. My income is Rs.100 a day and the price of mangoes goes up from Rs.25 a piece to Rs.50 a piece; my income falls from four mangoes a day to two mangoes a day. In gross fashion, that is what people are complaining about. On the other hand, all cash holders become poorer as prices rise. I own Rs.1,000 and the price of mangoes is Rs.25 each. So I am 40 mangoes rich one day. The price of mangoes doubles the next day. At Rs.50 a piece I am only 20 mangoes rich the next day, no fault of mine. Inflation makes money holders poorer. That is the second common complaint. Some other strange things happen in inflationary processes but let us not complicate matters for now.

It is common to blame the central bank for ‘printing money’. It is even more fashionable to demand that the central bank should act independently of government. Much ire is expressed at the provision that the Secretary to the Ministry of Finance is a member of the Monetary Board which statutorily controls monetary policy and financial system stability. I want to articulate that these arguments are misguided and that when you consider an alternative to inflation, there is none in our specific circumstances.

Mandate from the electorate

In November 2005, Rajapakse was elected President of the Republic by a very small margin over Wickremasinghe. In 2004 political parties led by UNP leadership lost the majority in Parliament. The loss in 2004 was mostly because Prime Minister Wickremasinghe’s government had followed fiscal policies which did not greatly raise inflationary pressure. That administration did not raise government employment. They kept expenditure on the war under control after having signed a cease-fire agreement (CFA) with the terrorists in the north. In 2005 he lost to President Rajapaksa in that part of the island that mattered because he had signed the CFA and could not match President Rajapaksa in the promises held out for larger expenditure on a variety of programmes including subsidies to the poor. Candidate Wickremsinghe came on the band wagon later competing with Candidate Rajapaksa to raise government expenditure. However, Rajapaksa prevailed on both counts, although by a slim margin. In several districts, President Rajapaksa received close to 60 percent of the votes cast. In Hambantota, Matara and Galle that percentage was close to 70 percent. Among postal voters, mostly civil servants, close to 80 percent voted for Mr.Rajapaksa.

The mandates for President Rajapaksa and his administration were quite clear: they must increase government expenditure and they must prosecute a serious war against terrorists. Now, neither party had put forward proposals as to how this increased expenditure by government both for war and for other purposes was to be met. There was only one newspaper commentator who raised the question at all and nobody cared two hoots for him. No party or candidate raised questions about higher taxes or higher borrowing locally or overseas. All parties, the electorate and university men and women were utterly irresponsible when they failed to consider how these expenses were to be met. It appeared as if resources did not matter. All that was necessary was the will to raise government expenditure and to conduct war against terrorists. Candidate Wickremasinghe was vilified as someone who had sold himself to the ‘international community’ and the LTTE and was too beholden to the IMF and World Bank in matters of economic policy.

Choices available to government

Now the reality is a little bit different from the fancy imaginations of the electorate and the political parties. Government had somehow to get hold of resources to keep the promises made to the electorate. After all, they had been elected on that platform and to go back on them would be both immoral (not that that mattered to our silly politicians) and politically suicidal (that mattered). Government expenditure (in current prices) rose from roughly Rs.600,000 million in 2005 to Rs.900,000 million in 2007, about 50 percent, from 25 percent of GDP in 2005 to 28 percent in 2007. Interest payments rose by about 40 percent and expenditure on defence by about 67 percent between the two years. Salaries and wages bills rose by about 45 percent from 2005 to 2007. Net increase in employment was about 50,000, about 5 percent; most of the increase in expenditure was on higher wages. Subsidy and other benefit payments, in fact, fell by about 7 percent between the two years. President Rajapaksa kept his promise that he would both increase employment as well as prosecute the war with greater vigour. It is these measures that pushed him to seek more resources.

What did that ‘somehow’ comprise? First, government could raise tax revenue. But recall that government had made no such promise to the electorate nor had the electorate demanded such policy. Yet tax revenue was higher in 2006 than in 2005 and was probably higher in 2007 than in 2006. Why could the government not collect more revenue from taxes? Because higher taxes may mean more unemployment in the private sector and that is something the government did not want.

Second: Government could borrow in local and foreign markets. Total outstanding public sector debt rose from Rs. 2.2 billion at the end of 2004 to Rs. 2.7 billion at the end of 2006. Heavier, borrowing entailed higher debt servicing costs. Interest payments in 2007 were higher roughly by 40 percent over 2004. Interest payments on domestic debt in 2007 were higher by about 30 percent and on foreign debt by about 200 percent when compared to 2004. As government borrowed more in the domestic market, money became tight and interest rates climbed in the local market; interest rates on 91-day government bills rose from about 7 percent per year in 2004 to about 17 percent in 2007. Government borrowed heavily from the Central Bank which wanted to accommodate the government. Central Bank’s holdings of government obligations rose from Rs. 109 billion at end 2004 to Rs. 119 billion at end 2006.

Now imagine that the Central Bank did not accommodate the government at lower interest rates than would have prevailed in the market. Imagine further that if the Central Bank had not lent to government, market rates on government paper would have risen perhaps to 20 percent per year. Then loans to business may have hit 35-40 percent per year because of tight conditions in the bond market and the uncertainty that would have come with such interest rates. Two results would have followed: first, cost of government debt would have risen further and the screw on the government budget would have got tighter every year; second, economic activity would have collapsed with high-interest rates robbing much remunerative employment. Among other things, that would have negated the government’s promise to the electorate to raise employment. If government had borrowed overseas, interest payments cost in foreign exchange to government would have been lower. However, there would have been severe speculation against the rupee in foreign exchange markets bringing down the value of the rupee against foreign currencies. Without considering other complications of that result, the rupee cost of servicing the foreign debt perhaps would have been of the same order as if government had borrowed in local markets. That would have raised the volume of rupee resources government needed to service foreign debt. On a balance of considerations, it was prudent for the government to have financed expenditure by borrowing from the central bank, that is by printing money, as it did, causing inflation.

Expenditure without taxation?

What was imprudent was for the electorate to demand higher expenditure without agreeing to be taxed higher. Now, the opposition parties cannot go around the country proclaiming peoples’ sovereignty from one end of their mouth and from the other end demanding that the ruling government renege on the mandate given to them by that same sovereign people. They cannot have it both ways. MPs who crossed over to government do have it both ways: their party proclaims that the government is wrong but they implement that wrong policy and even speak eloquently for it.!

Thirdly, government could borrow from the Central Bank and cause inflation and that is what the government chose to do. Inflation is a form of gaining resources for government without formal taxing or borrowing. And the way government gets hold of those resources is by reducing the real value of cash and cash-like assets that the public hold.

According to my understanding, the Central Bank has no business thwarting a government from implementing a programme of action for which government had received repeated mandates, two years running. If the Central Bank stood in the way of government, the latter had every right to pass legislation to compel the Central Bank to let government have its way. There is no widespread protest against polices of government which have caused high inflation. One cannot protest against inflation without opposing government’s programmes. In my judgment, the Central Bank has acted responsibly.

‘Freedmanites’ may repeat ad nauseam that inflation is always and everywhere a monetary phenomenon. However, if they lift that veil of money they will read in shining bold letters in Chapter 21 of Keynes’ General Theory “When a further increase in the quantity of effective demand produces no further increase in output and entirely spends itself on an increase in the cost-unit fully proportionate to the increase in effective demand, we have reached a condition which might be appropriately designated as one of true inflation’. That increase in effective demand coming from a commitment by government to the public to spend more money is not sensitive to the rate of interest and the central bank loses its weapon to fight inflation.

Independence of the central bank

That lands me exactly in the line of fire from those who argue for a central bank independent of government. They would fire at me bullets made of the independence of central banks in many countries. In all these countries, central banks work as a bank to the banking system with the added responsibility of maintaining both price stability and system stability. The central banks’ main concern there is with financial markets: money markets, where banks and similar other organisations principally trade and money, debt and capital markets, where both financial and real sector operators trade. Governments happen to be one party in the debt market. Those who sell government paper in secondary markets and all who buy them have choices to deal with them as they fit government paper into their portfolios after taking into account the risks and returns from government obligations. Government paper is one of the assets available in the market. Contrast that with the situation in Colombo. There is no corporate debt market. The stock market is puny, thin and illiquid. The Central Bank of Sri Lanka has no modus operandi by which it can work in the money market, as in most other countries, to change prices in debt markets and eventually in capital markets and so influence real sector activity. In Colombo financial markets, there is only one boy in town: government. Total outstanding government debt in the domestic market at end 2006 was Rs. 1,500 billion and market capitalisation of the Colombo Stock Market at end 2006 was Rs.835 billion. He had better be accommodated in the best hotel in town. The Secretary to the Ministry of Finance had better have a seat on the Monetary Board.

Obligation to explain

Let us recall that central banks were not invented to discipline government fiscal policy. In contrast the Bank of England gained its special privileges from William and Mary in 1694 by accommodating their request for money. Central Banks were invented and work to discipline money and debt markets and indirectly capital markets. The discipline of government fiscal policy is the responsibility of elected representatives of the people. If the electorate puts in power a group of people with a mandate to spend without raising taxes, what can a government do but tax them with inflation? What right has a bunch of bureaucrats to stand in the way of a government implementing the mandate it was elected to implement? A central bank can advise but so can the Department of Economics of the University of Colombo or the Chamber of Commerce. And a government with a majority in Parliament is under no obligation to accept anybody’s advice, even if it understood it. Now, an economist may consider it imprudent, but what is an economist or the whole bunch of them counted against the people? Economists and other pundits may argue that the people were misguided or worse in giving that mandate. Then, it is their responsibility to have guided the people. Journalists, academics and economists all fail people when they do not explain these things to the public. Let’s try.