Saturday, July 17, 2010

Sri Lankan central banker writes pro-poor book

Lanka Business Online

A former Sri Lankan central banker has written a book that can open the eyes of third world policy makers and pave the way for millions of poor people to escape the poverty caused by state-induced high inflation.

"Money does not raise economic growth, but it is the fundamental cause of high rate of inflation that is detrimental to economic growth," H N Thenuwara, a former assistant governor of Sri Lanka's central bank says frankly in a newly released book.

"High inflation and low economic growth jointly account for the poverty of nations."

Many so-called 'third world' states which restricted the economic freedoms of their citizens and kept growth down also appropriated their wealth stealthily through an 'inflation' tax slashing the real value of people's salaries and lowering their living standards.

High inflation is usually created by using central bank credit (printed money) to finance budget deficits, by governments that do not collect enough revenue to finance its expenditures and also does not want to borrow at market rates.

Though increasing economic freedoms of people and reducing state controls (open economies and liberalization) can create real jobs, even the employed will remain poor in such countries if inflation is high and the exchange rate falls constantly.

By imposing draconian exchange controls a money printing central bank can also block citizens from protecting their property rights by shifting their savings into a stronger currency, again destroying real wealth.

South Asian Central Banks

The tool came from central banks which have the power to inflate without limit by increasing the money supply and depreciating the currency.

"Central Banks in South Asia were established as symbols of political independence," says Thenuwara in his book Money Inflation and Output, which pulls no punches or tries to cover up central bank mistakes in any country.

An exception to the rule was the Reserve Bank of India, which was established as a private corporation before independence from Britain.

LBO's economics columnist fuss-budget says India had a rich tradition in good money, both in the form of gold and silver. Its rupee was used widely in Africa and the Middle East as do 'dollarized' nations today by using the dollar, sterling or euro as their currency.

Sri Lanka's currency board also had the Indian rupee as the anchor currency for most of its life.

Fuss-budget says the Indian rupee started to lose its value after RBI was nationalized and made into a state entity following independence from British rule due to excessive money printing.

Middle Eastern countries, ranging from Kuwait, to Abu Dhabi, to Qatar soon dumped the Indian rupee and adopted Saudi currency or created their own.

The UK pound also lost value after the Bank of England was nationalized as a suspicious public that kept its excesses under check as a private corporation was lulled into a state of complacency under state ownership.

Thenuwara's book points out that a private central bank was abolished by an angry public in the United States, a country that had history of gold as money and free banking.

Sustained large scale inflation started in the US only after the establishment of the Federal Reserve, a semi-state institution in 1916.

India's rupee started to appreciate only after policies changed in 1991 following a severe balance of payments crisis and its Treasury secretary was no longer sitting in on monetary policy meetings.

Sri Lanka's central bank is also now starting to pursue low inflation policies with its current governor firmly committed to stability, though concerns remain about its ability to stay on the straight and the narrow given fiscal pressures..

Currency Board

Sri Lanka started a pegged exchange rate central bank in 1950 abolishing a currency board arrangement that kept the exchange rate stable from the previous century under British rule.

A currency board targets only the exchange rate and does not print money to manipulate interest rates, thereby eliminating foreign currency shortages or currency depreciation, giving a stable money to the people, provided the anchor central bank was keeping good policy.

"If there is a foreign currency outflow, the currency board has to absorb domestic currency from its economy which reduces the domestic money supply," writes Thenuwara.

"A central bank on the other hand, does not obey the rules followed by currency boards."

Thenuwara says countries that kept currency boards or re-established them including Brunei and Hong Kong in Asia have had low inflation and high growth.

Estonia and Lithuania have had very high rates of inflation prior to establishing currency board like systems after the end of the Soviet Union and a collapsing ruble.

"Their success is seen in the low interest rates seen since the 2000."

Soft Pegs

Sri Lanka's pegged exchange rate system was devised by John Exter, a US Federal Reserve official.

The bank which was designed to keep a peg with the US dollar and print money at the same time, targeted both the exchange rate and the interest rates in a policy contradiction an arrangement.

Some economists call the arrangement a soft peg as opposed to a 'hard pegged' currency board.

The US exported the model first to Latin America where it wreaked havoc and created massive inflation and wealth disparities by enriching landowners and real asset owners who were protected against inflation.

The model was exported to the rest of the world under the Bretton Woods system. In the early 1970s most of the so-called developed world exited soft pegs and became true floaters.

True floaters though not vulnerable to 'balance of payments crises' that comes from peg defence, can still be vulnerable to economic bubbles and bank runs when the bubble collapses as happened after 2007.

"In developed countries, crises have been caused by productivity slowdown, and insufficient attention paid to the formation of asset price bubbles," writes Thenuwara candidly.

"In developing countries, crises are driven by populist policies of governments, expansionary fiscal policies, and the pursuits of fixed exchange rate regimes by monetary authorities.

"In all countries, the monetary authority has always been either a part of the cause of the crisis or the part of the solution to the crisis."

© Lanka Business Online

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