Seek Science against myth to protect public interests | Daily News

Seek Science against myth to protect public interests

The immediate response to the present global corona pandemic similar to other economic crises in the past is the historically relaxed monetary and fiscal policies led by the developed countries without any concern over inflation, given the humanitarian crisis caused by the pandemic. In contrast, the network of old monetarists in Sri Lanka opposes this policy drive by citing inflation. They talk about isolated instances of hyper-inflation reported in France in the 18th century and Zimbabwe in the mid-2000s which they perceive as the result of excessive printing of money.

They do not talk about terrible governance systems that destroyed the supply side in those countries causing inflation. Other inflation episodes like Yugoslavia in early 1990s and Venezuela at present are not cited. They also oppose the fiscal policy too by citing the limited fiscal space due to so-called debt-overhang. If their advice is taken, the government has no option but to wait and see how people suffer from the economic pandemic, despite its public duties.

The minds of old monetarists are fearful of an inflation ghost whenever the Central Bank produces money (Monetary Policy) or the government spends through deficits (Fiscal Policy). Therefore, they insist that the central bank be kept independent from the government to keep the inflation and money printing at rates as decided by the central bank under the impression that this independence will provide the central bank with the teeth to avert inflation arising from any source.

The new terminology used by these monetarists to run the monetary policy is the flexible inflation targeting, that is, to pursue monetary policy towards targets of inflation set by the Central Bank from time to time via open market operations based on interest rate targets set for overnight inter-bank liquidity. This version of monetary policy which has come from the central banks of developed countries operating largely in markets is now being spread across developing countries by the IMF and their investor community. Many corners of the society that even know nothing about inflation and mandates of central banks have been made to believe those views.

Money as a medium of exchange and inflation

Old monetarists believe that money is primarily a medium used for exchange of commodities between the buyer and seller. The order of exchange is always from the buyer to the seller by paying money. Therefore, money merely produces demand for and not supply of commodities. The crux of this belief is that whenever more money circulates in the economy, buyers demand more commodities which results in higher prices as the supply is limited for the time being.

For example, if the total production or supply is 500 kgs and total money stock held by the public is Rs. 5,000 (spending ability), one kg of production is to be exchanged for Rs. 10 which is the average price in the commodity market. The view here is that Rs. 5,000 is eventually supplied by the public to buy the production of 500 kgs. Therefore, if the money stock circulating in the economy rises to Rs. 6,000, the average price will rise to Rs. 12 reflecting a rate of inflation of 20 percent (or rate of increase in the average price). In this context, old monetarists believe that inflation is always everywhere a monetary phenomenon.

Modern capitalism with financial instruments

The above view was quite true immediately after inventing paper money to the barter system. However, modern money has evolved to be a factor of production or capital through a global network of financial markets by utilizing the functions of money as a deferred payment system and a liquid store of wealth. The capitalism at the early stage of paper money was the ownership of plant and machinery used for production. However, modern capitalism is largely the ownership of money held in the form of financial assets underlining financial liabilities (i.e., debt and equity) that run production activities. Therefore, producers do not wait for consumers to buy their existing products out of new money first pushing the prices up so that sale proceeds can be invested later as predicted in demand-driven income/output multiplier models. Instead, producers borrow capital or money and hire factors of production to produce more with plans to raise consumer demand through marketing channels. Further money/credit will be created to fund the new demand. That is what modern global credit systems are doing.

Money-demand-supply disconnect

Therefore, modern money has become a source for the supply to create its own demand. As such, the credit/capital-supply effect is so fast and direct, given the global spread of value chains, virtual payment mechanisms and business management techniques, where credit/money-demand-supply lagged connection is not the economic drive operating in modern monetary economies. In times of crises, although central banks print money primarily to restore the confidence in the financial system, money gets accumulated as excess reserves in the banking system without causing any inflation as demand falls due to uncertainties.

In this context, monetary expansion has direct real effects/productive side through financial/capital markets. In addition, lower interest rates arising from monetary expansion will reduce the cost of production and inflation. In contrast, tight monetary conditions will restrict the availability of capital and raise cost of production through higher interest rates, both of which would raise prices and inflation.

Monetary policy being active on supply side

The above active role of money is the common knowledge among the modern investor and entrepreneur community. That is the reason why the monetary policy has gained more influence over the production side of the economy as compared to the demand side of the economy against the belief of old monetarists. However, Sri Lankan monetarists have failed to understand this role of modern money and, therefore, suffer from inflation ghosts.

Inflation hypothesis and reality

Inflation is the rate of increase in the general price level determined by both demand for and supply of all commodities that have taken place through exchange of money. This is the base of the Monetarists’ Quantity Theory of Money that predicts inflation in the long run (Unknown) as the monetary phenomenon without any real sector effects. Inflation here is a hypothetical value (that can change due to so many demand and supply side factors) as no one has a measurement for movements of all prices. Therefore, these monetarists call inflation for the rate of increase in consumer price index (CPI).

In Sri Lanka, CPI is the cost-of-living index for households represented by a basket of basic consumer items largely controlled by fiscal measures such as price controls, subsidies and tax concessions. The index is largely driven by food whose prices are determined by supply side factors. Therefore, the belief that monetary policy can control this inflation in a flexible manner is baseless. In fact, the fiscal policy can do it. That is why the Presidential Gazette on Ministerial duties has declared the price stability at a low rate of inflation and stability of the value of the Rupee as duties of the Finance Minister.

In developed countries largely driven by markets, the CPI reflects movements of some consumer prices, but their monetary policies have never been able to keep their inflation targets because of the movements of consumer prices outside the supply of money. Western central banks printed nearly US$ 12 trillion of money during the decade 2008–2017 to recover from the global financial crisis of 2007/09 with interest rates close to zero or negative, but they could hardly push the CPI inflation towards the annual target of two percent. Japan has been printing money to push inflation towards two percent during the past two decades without any sign of success.

In response to the corona pandemic, money printing of central banks led by Western central banks between March and November amounted to US$ 28 trillion, but there is no expectation of inflation even in the next decade due to heavy disruption of supply and demand chains and loss of business confidence. Now, the US Fed has changed its inflation target as the period average of two percent in the long run, the time period of which is not identified. Similarly, no central bank in the world has any inflation control track-record. Their normal behaviour is to blame the fiscal policy and markets when the CPI inflation rises above their targets and to claim credit to so-called prudent monetary policies when it meets with the targets. (To be continued)

(The writer is a former Deputy Governor of the Central Bank of Sri Lanka and the author of seven books of Economics and Banking.)