Sri Lanka’s Latin-America-style default in peacetime, after surviving a 30-year war, was due to closely following Karl Marx and rejecting the classicals through spurious monetary and fiscal doctrines, received secondhand via the International Monetary Fund in particular.
In the immediate aftermath of the default, when harsh measures had to be taken against the people and businesses to save the busted rupee, the crisis was complex, leading this columnist to refrain from undermining confidence in the chosen path.
However, some of the same policy errors that led to the first default are resurfacing. These include the oft-repeated threat of a 5% annual rise in inflation for helpless Sri Lankans, reliance on a single policy rate, and rising pressure for capital decumulation taxes. Some effort must be made to prevent a second default driven by aggressive macroeconomic policy.
Since 1953, this country, its people, and liberal politicians have been victims of Harvard-Cambridge inflationism. Now that such policies have driven the country to its first Latin America–style external default in peacetime, it is time to stop.
Saving the Money Monopoly
Sri Lanka should not have to go through this type of inflation crisis and this type of stabilisation crisis again. The severe negative effects on the economy that come from IMF-backed stabilisation programmes is a result of trying to save the money monopoly of the Central Bank. It is, however, better than a descent into hyperinflation.
After each currency crisis caused by rate cuts and open market operations (OMO), these stabilisation measures had to be taken to prevent the country from descending into hyperinflation and external default.
Of course, in 2022 the external default could not be prevented as aggressive macroeconomic policy had continued for too long, foreign market borrowings had rocketed from 2015 after IMF-backed ‘data-driven’ monetary policy ‘modernisation’, and confidence was severely dented.
Getting out of external default is a big problem, which is easier and faster if the IMF framework is followed. Since confidence is essential to restoring credibility in a country’s debt and that of banks, it is better not to criticise the wrong policies of the IMF and cloud the issue.
Most of the things that the IMF programme forces Sri Lanka to do have to be done, especially to save the broken money monopoly. The high interest rates and the crushing of economic activities had to be done to save the Central Bank and restore confidence in its rupee (the money monopoly), which was shattered by inflationary open market operations and swaps into multiple exchange rates.
Dollarising and breaking the Central Bank’s legal tender monopoly, of course, would have restored external stability without high interest rates or a steep contraction of the economy. At the time, the most recent crisis dollarisation would have occurred at an exchange rate of 400 to the US dollar.
It must be remembered that even in the last crisis, the Central Bank jealously guarded its money monopoly and worsened hardships on the poor by preventing parallel dollarisation.
“There was a suggestion that at least one or two filling stations should offer that,” then Minister Kanchana Wijesekera said. “The Central Bank Governor told us that, according to money regulations, dollars cannot be used for internal transactions at retail level.”
It is indeed a merciless, harsh doctrine, without any compassion or the milk of human kindness, that modern IMF-backed central banks impose on the masses with their bad money. Market dollarisation would have happened in Sri Lanka below 250 if it had been allowed in late 2021 and around 400 to the US dollar after the 2022 float.
But macroeconomists have made the rupee stronger to 300 to the US dollar in the debt deflation that took place in the stabilisation crisis, which prevented hyperinflation. The strengthening currency has restored some of the wages and savings of the general public so wantonly destroyed by IMF-backed (statistical) monetary policy modernisation.
The credit for the 300 rate has to go to the current leadership of the Central Bank and not the IMF, which has tended to peddle ‘competitive exchange rates’ and social unrest since its Second Amendment through flawed operating frameworks. Having said all that, the benefit of dollarisation would have been that inflationist macroeconomists or the IMF would never in the future have the legal coercive power of the state to make Sri Lankans second-class citizens by depreciating the currency, imposing exchange and trade controls on them, or misleading Parliament.
What are now called ‘Third World’ central banks gained the power to impose higher inflation upon unfortunate peoples than ‘First World’ citizens only after the Second Amendment to the IMF Articles in 1978.
In Sri Lanka, higher-than-Great-Inflation was imposed on the people in the 1980s without an explicit change to the Monetary Law Act and in violation of John Exter’s law, which contains several sections aimed at maintaining the external and domestic value of money.
It must be stressed that John Exter, in drawing up his law that replaced the Singapore-style currency board, did not treat Sri Lankans as second-class citizens deserving higher inflation than his own countrymen, and in fact warned against following US-style monetary activism. He treated the Ceylonese as equal people, but left room for monetary activism and rate cuts. The current monetary law, of course, is another matter, having legalised potential output targeting, making a second default almost a certainty.
The Rejection of Political Economy
Sri Lanka’s troubles, from the time of the creation of the central bank, have come from the rejection of classical economics, called the ‘Political Economy’ during the classical period of the industrial revolution and the golden age of liberalism that put Europe ahead of the rest of the world.
The current spurious monetary and fiscal doctrines that grip Sri Lanka (and the West also) originated in textbooks and academic papers churned out in ‘progressive’ (read socialist and interventionist) universities of the US in particular, and also the UK’s Cambridge.
The Fabians—modern macroeconomists are like Fabians—created the London School of Economics and Political Science (LSE), but it went in an entirely different direction after Hayek was hired and helped create the economic miracles in Singapore, Taiwan, and the rest of East Asia. Japan was directly influenced by German monetary policy from 1948.
What we call ‘economics’ was a term that became popular especially after Alfred Marshall, who unfortunately did not write much about money in his Principles of Economics (it was said to have been planned for a second volume), leaving generations of Cambridge economists, including Keynes, clueless about note-issue banking and the collapse of newly independent British colonies where classical economics was rejected.
The rejection of economics now seeps through the IMF and the World Bank through their technical assistance and training, provided by inflationist universities to bureaucrats in unfortunate countries like Sri Lanka. The countries then get into serious monetary troubles, which then result in social and political unrest, and default if such policies are taken to extremes.
The beliefs held by Sri Lanka’s central bank, the IMF about external problems coming from their open market operations and high inflation targets and the sweeping rejection of Hume and Ricardo—blaming current account (trade deficits) and their narratives about cost-push inflation—are not new at all.
At different times in history, they have surfaced and resur- faced, creating havoc, as the West is experiencing now, and have happened almost continuously in Sri Lanka since 1953.
The Toxic Mixture
Though various Mercantilists spread such doctrines in the 17th and 18th centuries, the particular toxic mixture of cost-push inflation, the rejection of Hume and Ricardo, and the advocacy of capital decumulation taxes that amount to reappropriation is not common.
The ideology of income redistribution was not present in the classical period, and income taxes were low when they started in the 19th century. They could not cause the harm they cause today.
Also, the current narratives spread by the Central Bank and IMF, that some part of inflation is from printing money (demand) and another part is cost-push and is out of the control of the Central Bank (unaccountability), are peculiar, to say the least, since all inflation is monetary and is due to badly anchored money.
Amusingly, both the Central Bank and the IMF have given credit to the PUCSL and the CEB for creating deflation, instead of taking credit for this remarkable achievement. Usually, ‘administered prices’ are blamed for inflation by cost-pushers, though the reason that ‘administered prices’ are slammed in the first place and raised later is due to monetary inflation.
Critique of Political Economy
The current peculiar doctrines of the Central Bank, World Bank and the IMF, however, were effectively articulated almost exactly as they are now, by one economic philosopher.
That is Karl Marx.
Marx, in his Contribution to the Critique of Political Economy in 1859 (Zur Kritik der Politischen Ökonomie), launched a full-scale attack on Hume, Ricardo, and their respective followers, rejecting ‘bourgeois’ (i.e. capitalistic) theories, as the IMF and inflationist macroeconomists do.
“Since Hume is by far the most important exponent of this theory in the eighteenth century, we shall begin our survey with him,” Marx wrote. “We omit the numerous writers whose works appeared between 1800 and 1809 and turn at once to Ricardo, because he not only summarises his predecessors and expresses their ideas with greater precision, but also because monetary theory in the form he has given it has dominated British banking law up to the present time,” he said.
“Like his predecessors, Ricardo confuses the circulation of bank-notes or of credit money with the circulation of simple tokens of value. The fact which dominates his thought is the depreciation of paper money and the rise in commodity-prices that occurred simultaneously.
“The printing presses in Threadneedle Street which issue paper notes played the same role for Ricardo as the American mines played for Hume; and in one passage Ricardo explicitly equates these two causes.
“Just as the palaeontological theories of the eighteenth century inevitably contain an undercurrent which arises from a critical or an apologetic consideration of the biblical tradition of the Deluge, so behind the facade of all monetary theories of the eighteenth century a hidden struggle is waged against the Monetary System, the spectre which stood guard over the cradle of bourgeois economy and still cast its heavy shadow over legislation.”
In addition to his objections to his distaste for ‘bourgeois’ theories, Marx also slams Mill and the entire British Currency School as effectively as any modern macroeconomist.
One of his criticisms is that Hume, Ricardo, and the classicals failed to explain commercial crises (like the collapse of the Housing Bubble or Great Depression in later centuries where prices plunge suddenly), which we now know as a deflationary collapse (debt deflation of banking systems) that follows prolonged credit bubbles from open market operations style activity for a political interest rate of central banks.
Marxian Cost-Push and Reverse Causality Mercantilism
Like modern inflationist central banks, Marx also favoured the cost-push inflation doctrine, which now allows monetary bureaucrats to escape accountability for their actions. A key proponent of cost-push in the Mercantilist period, using reverse causality, was James Steuart.
“Sir James Steuart begins his investigation of specie and money with a detailed criticism of Hume and Montesquieu,” wrote Marx.
“He is indeed the first to ask whether the amount of money in circulation is determined by the prices of commodities, or the prices of commodities determined by the amount of money in circulation.”
Marx also admired Thomas Tooke, but blamed him for initially accepting Ricardo.
“After Hume’s theory, or the abstract opposition to the Monetary System, had been developed to its extreme conclusions, Steuart’s concrete interpretation of money was finally restored to its legitimate position by Thomas Tooke,” he wrote.
“Tooke derives his principles not from some theory or other but from a scrupulous analysis of the history of commodity prices from 1793 to 1856.
“In the first edition of his History of Prices, which was published in 1823, Tooke is still completely engrossed in the Ricardian theory and vainly tries to reconcile the facts with this theory.”
The obsession with statistics (and probability) in trying to explain monetary phenomena and reverse causality (electricity price cuts led to deflation, or the increase in administered prices led to inflation) that grips modern central banks is in keeping with the cost-push tradition and the beliefs of Marx.
Unlike modern central banks and the IMF, the classical cost-pushers did not make silly claims that half the inflation was ‘demand-driven’ and half was cost-push. As correctly identified by Marx, cost-push is a reverse causality argument.
Marx makes involved arguments against the classicals and seemingly praises Adam Smith (Smith supported a version of the real bills doctrine, which allows some discretion), but Scotland had a well-functioning free banking system, so Smith could hardly be blamed.
But Marx was deeply mistaken.
It is too complicated to explain why Marx was mistaken here, but suffice to say that China, from 1993 to 2005, ran the People’s Bank of China (PBoC) according to rules stricter than Ricardian principles (i.e., tighter than the Currency School), collecting vast reserves and keeping the exchange rate absolutely fixed at a time when the US dollar was strong and gold and oil prices fell.
Vietnam operates a system that drifts closer to the real bills doctrine from time to time. When the dong comes under pressure, the State Bank of Vietnam pulls back in the nick of time, selling its own securities as it does not buy government securities to sell later.
What is the excuse of the IMF and the Central Bank for rejecting economics?
However much one may disagree with Marx on the Critique of Political Economy, one has to admit that he had micro knowledge of the monetary theories of the classical liberal which modern macro-economists seem to be completely unaware of.
Marx had a legitimate excuse for rejecting classical economics and Hume and Ricardo. He objected to bourgeois ideologies and ‘burgerliche reichthum’ (bourgeois wealth), and he tried to discredit classical economics.
That is fair enough.
Marx wrote the Critique of Political Economy before Das Capital where the term burgerliche seems to have been replaced by the term Capitalism (Kapitalistische).
But what is the excuse for the IMF and forex-shortage-creating central banks to reject ‘Political Economy’ wholesale, debase money, engage in ‘monetary policy modernisation’ to generate severe forex shortages, trigger social unrest, and default?
And for the World Bank to peddle capital decumulation taxes and discredit VAT in a country that desperately needs non-borrowed capital to reduce its debt?
That is a big puzzle for this columnist.
Let’s say that the IMF, high-inflation central banks, and the World Bank are fully aware of classical theory but pretend that Hume, Ricardo, or Mill did not exist, and follow Mercantilists on current account deficits, Anti-Bullionists and the Banking School on un-anchored money, and cost-pushers on price rises entirely by deliberate choice.
Certainly, diverting attention for monetary instability from their operating framework has allowed central banks to escape accountability and ensure that parliaments do not shut them down.
Then they live another day to create another crisis, blamed on the public for imports and on politicians for doing who knows what ‘reforms’, unlike in the classical period when they were shut down and the leadership forced to flee the country.
Socialism at the Gates
But is escaping accountability for the relentless pursuit of monetary debasement through depreciation and high inflation targets, and misleading parliaments about the real causes of default and social unrest, a deliberate tactic or accidental?
One conclusion we can draw is that the IMF and central banks are excessively socialist and interventionist, and have become too used to misusing the coercive powers of the state against people and businesses. They continue to reject economics because they genuinely believe more in Mercantilism and Marxism than in economics.
The bloodthirst for monetary debasement with 5 to 7 percent inflation and the desire to control market interest rates is not a result of actually reading Marx, but stems from the same motivation of state control. It could simply be bureaucratism.
As a result, the IMF and Central Banks under their control, due to signing the Bretton Woods agreement in general, and also key officials working at IMF HQ, are anti-capitalist to some degree or another, which can vary over time based on the waxing and waning of such ideologies in the US in particular.
Universities, indeed any so-called intellectual, unfortunately have tendencies to drift towards interventionism and the control of their fellow men.
It is the same ideology that drove Marx.
The World Bank’s recent tax report and the IMF’s obsession with taxes on houses—the only real wealth that most Sri Lankan’s have—seems to bear this Marxian bent.
Taxing without cashflows is expropriation of property. Nothing more, nothing less.
Marx wanted to completely abolish inherited wealth. The IMF and World Bank are going half-way with wealth taxes and progressive income tax.
This columnist does not object to capital gains taxes, even on shares, as long as there is cash flow. But if the country can do without capital gains tax on shares and only impose a transaction fee, like Vietnam (that great non-capitalist nation), then fine.
It will lead to greater investment, growth, jobs, and prosperity for all, especially in the next few years, when most urgently needed, and not just the owners of capital.
But wealth tax and the ideology expressed in the World Bank fiscal report are part of the road to disaster.
Also, during the time of the classical greats, the progressive income tax in the vicious form it is now had not yet been invented. When the coercive state began, income tax was initially not progressive and was a small wartime expediency of a few percentage points.
If present-day progressive tax had existed then, the classical liberals would probably have spoken out strongly against such taxes, as income tax and wealth tax destroy savings and investment. The Industrial Revolution probably would not have happened.
The corollary is that, in their time, progressive income tax would not have been possible, as it is a perversion of the right to equal treatment under the law.
The IMF and World Bank do not have to tell this country to impose wealth tax and other capital decumulation taxes.
Sri Lanka has had many socialist administrations, and the first UNP administration also imposed excessive capital decumulation taxes after the Central Bank created the first currency crisis around 1953.
The technical advice for monetary debasement (the single policy rate and state liquidity forecasts is simply the latest in a decades long list of wrong monetary advice in line with the Marxian rejection of economics) is what creates the space for ad hoc complex tax changes.
Expropriation by Tax
Sri Lanka has also experienced more honest and transparent expropriation, which destroyed capital and made it a lagging nation compared to East Asia.
Marx, for example, objected to all inherited wealth.
The same thing happened to many other countries, particularly after currency crises.
Ludwig von Mises, speaking in 1950 in London (when the UK was beset by sterling crises due to Cambridge economists), explained the problem very well.
“…[L]ooking backward upon the past history of the estate taxes, we have to realize that they more and more have approached the goal set by Marx,” Mises said.
“Estate taxes of the height they have already attained for the upper brackets are no longer to be qualified as taxes. They are measures of expropriation. The philosophy underlying the system of progressive taxation is that the income and the wealth of the well-to-do classes can be freely tapped.
“What the advocates of these tax rates fail to realise is that the greater part of the incomes taxed away would not have been consumed but saved and invested.
“In fact, this fiscal policy does not only prevent the further accumulation of new capital. It brings about capital decumulation. This is certainly today the state of affairs in Great Britain.”
The UK reduced its progressive income tax only after Thatcher came to power.
The Waxing Ideology
The foregoing is not to say that everything the IMF says is wrong. The IMF is completely wrong on monetary policy modernisation (pretty much all monetary policy), and it is wrong on some of the tax policies, particularly wealth tax and high progressive income tax.
However, many of the other policies it advocates are useful. This column should not be interpreted to say that we should reject the IMF and World Bank wholesale.
They have considerable experience in getting countries out of the trouble they themselves created through their own monetary policy modernisation. The World Bank also has expertise in setting up social safety nets after IMF technical advice debases the currency.
The Bretton Woods system, and the IMF by extension, was created by Harry Dexter White (Harvard) and Keynes (Cambridge). As a result, it began on the wrong foundation, with some mistaken ideas.
But in the late 1980s and in the 1990s, there were a lot of Chicago and other hard-money economists in the IMF, and it promoted far better policies than it does now.
Countries essentially get into currency crises when reserve-collecting central banks do not follow the rate hikes of the country to which they are de facto or de jure pegged, and continue to suppress rates beyond the credit cycle of the Fed. Before the 1960s, the Fed (or any other central bank, for that matter) did not deliberately fan a credit cycle, and without Bretton Woods, what the Fed did was not a major issue.
Also, before currency crises became normal in the 1930s (after the Fed invented open market operations and the Great Depression followed), macroeconomic/Keynesian stimulus dogma did not really exist, and the question of macroeconomists running central banks to create crises by deliberate rate cuts did not arise.
By 2007, IMF loans had reduced to $9.8 billion, and the agency was almost bankrupt.
This was partly due to the IMF’s superior monetary doctrine at the time, and also because the Fed cycle was extended to eight years from the typical four in order to create the massive housing bubble, resulting in fewer soft-peg collapses in the interim.
To survive, the IMF implemented Voluntary Retirement Schemes (VRS) and laid off many of the hard-money economists, including Chicago economists, who had helped countries adopt better monetary policy.
Now, statistics rule the IMF, not economics. It is both shocking and sad that IMF programmes for reserve-collecting central banks have, since around 2014, been monitored using an inflation target that was selected based on the past failures of the monetary authority, rather than its balance sheet.
Keynes, Steuart, Tooke and Marx are born again, and countries are defaulting.
“The chief root of our present monetary troubles is, of course, the sanction of scientific authority which Lord Keynes and his disciples have given to the age-old superstition that by increasing the aggregate of money expenditure we can lastingly ensure prosperity and full employment,” Friedrich Hayek wrote in 1976, as central bank policies were discredited by the Great Inflation, and Britain—the birthplace of Keynes—shortly became the biggest IMF borrower and nearly entered a debt crisis.
“It is a superstition against which economists before Keynes had struggled with some success for at least two centuries
“The whole theory underlying the full employment policies has by now of course been thoroughly discredited by the experience of the last few years,” Hayek wrote.
“In consequence the economists are also beginning to discover its fatal intellectual defects which they ought to have seen all along. Yet I fear the theory will still give us a lot of trouble: it has left us with a lost generation of economists who have learnt nothing else.
“One of our chief problems will be to protect our money against those economists who will continue to offer their quack remedies, the short term effectiveness of which will continue to ensure their popularity. It will survive among blind doctrinaires who have always been convinced that they have the key to salvation.”
He was right to a frightening degree, as present day troubles show.
Now we have a surfeit of mindless econometrics, inflation fan charts based on probability, the single policy rate rejecting the Lombard rate, and IMF country reports repeating a narrative that the Ceylon Electricity Board and the Public Utilities Commission created deflation.
That statement, more than anything else, perhaps, indicates why countries default serially after the first.
Such narratives, along with the push for expropriation of savings by the IMF and World Bank, show a frightening loss of grip on economics. Of course, there will eventually be a pushback, now that Western nations are facing downgrades and the US is flirting with default.
There is usually about a 10-year gap between some hard-money activists fixing Western economies and those techniques filtering through
to other countries via the IMF.
But Western nations are not in sufficient trouble yet. In pegged regimes, fiscal troubles come fast. It is not so with floats. When the Fed created the Great Depression with the invention of open market operations, the Treasury Secretary had already reduced World War I debt by a third.
In 1971, when macroeconomists busted Bretton Woods, US debt was only 36% of GDP. When Bernanke started the false deflation scare in 2000/2001 and began reflating the US economy (while the government was running budget surpluses amid the so-called deflation), debt was only 54%, and it climbed to a little over 60% by the time the housing bubble collapsed.
Instead of running tight policies like Sri Lanka finally did in 2022 or waiting for recovery to begin, the US went on a printing and spending spree and started the abundant reserve regime.
Now, debt is 120% of GDP, and a crazy man has come to power. Further, unlike in the past, not many people want US debt.
So, whatever is out there will not be pretty.
Sri Lanka should not wait until reality dawns on the IMF, nor wait for a second set of neo-classicals to bring a new dawn of monetary stability.
The path was shown by classical economists two hundred years ago. The classicals had clarity of thought, unlike Marx and the IMF.
Sri Lanka’s parliament must act, follow the advice of true economists, and avoid a second default.