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There is a significant difference between scientists and economists.
Both scientists and economists use certain methodologies when testing
hypotheses in their respective fields of study. However, the end results
differ vastly; in science dogmas cannot prevail but on the contrary
dogmas prevail in the domain of “economic science.” Yet, this does not
mean that we can ignore the importance economic science, instead it
shows the necessity to remove dogmas from economic science which science
that paves the way to thrive human civilization in each country and
globally. I wrote this to point out that dogmas exist in using interest
rates by the Central Banks as policy tools to steer the monetary policy
in any given country and Sri Lanka is no different.
Recently, the Central Bank of Sri Lanka
(CBSL) increased its two main policy rates and as a result the market
rates of interest will go up sooner. On this decision economists are
divided – And some economist hailed the decision while some others
opposed it. It is on record that I did not support the increase of rates
of interest; instead I support the idea of keeping market interest
rates steady in mid-single-digits within normal periods of economic
growth if the government does not intend to deflate systemic bad debt by
a policy known as wage-increase-bound-moderate inflation. For an
example, a study done in the U.S. has shown that if the minimum wage in
the U.S. is increased by 75%, there would be a mild inflation of 2 to
3%. The impact of such a policy would be that it revive the badly weaken
credit cycle by deflating the existing debt in general. This theory is
not in the main stream yet but at least one U.S. billionaire has
supported the idea from a different perspective by writing an article
under the caption, “The Capitalist’s Case for a $15 Minimum Wage” from
which article he demands to double the minimum wage.
However, when come to Sri Lanka, all economists agree that inflation
must be contained and the widening deficit in the nation’s current
account must be kept constantly under check within a desirable range so
that there won’t be any negative pressure on the Balance of Payment. If
there is a severe negative pressure on the Balance of Payment emanated
from an increasing deficit of the current account now, even if there was
no foreign debt obligation originated from Rajapakse regime, the
country has to take foreign loans, if non-credit based inflow of dollars
such as Foreign Direct Investments (FDIs) or foreign grants cannot be
increased significantly.
According to the press release, the CBSL has increased rates in order
to contain inflation and widening trade deficit and to support the
Balance of Payment situation. Some economists and some analysts are
jubilant over this decision but I am not because I do not believe that
rates hike would not support to achieve the very goals mentioned in the
CBSL’s press release. Therefore, I suggested using combination of novel
policy and administrative tools through which the intended goals could
be achieved while keeping the interest rates low and steady. The reason
for my insistence is arising from a clear understanding that the present
money-based system of economy has a severe contradiction and that
contradiction cannot be simply mitigated by adjusting rate of interests
and by floating the rupee.
On the contrary, my suggestion to the monetary authorities and other
economists who work outside the establishment is to understand the
nature of the system’s contradiction and develop comprehensive set of
policy and administrative tools to steer the monetary system so as to
achieve the economic objectives of the nation. Let me give you some
clues in order for you to understand the contradiction that I am talking
of.
When a household gets richer, it becomes debt free. Do you expect the
same thing to happen when a country gets richer? You may say “yes”, but
in general opposite happens. Not only richer countries accumulate vast
amount of debt, they also accumulate the highest amounts of bad debt
too. American economist Hyman Minsky explained that the nature of the
capitalist economy is such that it accumulates enormous amount of bad
debt as the economy grow and the economy would collapse if the bad debt
is not expunged from the system. This was what happened when the U.S.
economy and many large economies of Europe collapsed in 2008.
The contradiction is that, when the economy grows the amount of bad
debt accumulated in the system increases instead of decreasing. Minsky
put the blame on the risky speculators who operate in the financial
market. On the previous point he is correct but on the latter point he
was wrong. This is where I made an invention in 2008 by presenting a new
hypothesis as follows:
“The contemporary economic system can never pay consumers an
aggregate income that is equal or exceeding to the value of
consumption.” If this is true, what impact it makes in the economic
system?
According to the above hypothesis, the economic system is not in
natural equilibrium of demand-and-supply and as such, consumers are
required to consume beyond their aggregate income in order to have the
economic equilibrium. When somebody or a system consumes beyond its
income should it begins to accumulate bad debt. This is the reason to
accumulate bad debt in the system and differ from Minsky’s perspective.
By any chance if consumers began to practice minimalism which idea is
promoted by young Japanese, the economy collapses. This means, we can’t
live as we want as a whole community. The present system of monetary
infrastructure is designed by people and the system we put in place
cannot allow us to be debt free at any level of economic growth.
Managing such a system in order to ensure the best possible economic
wellbeing is not that simple. When the CBSL does not understand the
systemic behavior of the economy, the problem becomes more serious.
Intended goals cannot be achieved by adjusting interest rates. Instead,
we would achieve better results by keeping the interest rates low and
steady, if you can address the issue of inflation, reducing of current
account deficit and having good Balance of Payment situation, by
employing more prudent set of policy and administrative tools. Ad-hoc
measures some time work but not all the time and this proved recently by
the U.S., Europe, Japan, Argentina etc. My advise to CBSL is that, do
not look for success model/s, but look for right theory and do dare to
innovate. (Hema Senanayake)
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The Central Bank Increased The Interest Rates!
The Monetary Board met on July 28, 2016. On that meeting the Monetary Board decided to increase the main interest rates of the Central Bank.
Accordingly, what is known as the Standing Deposit Facility Rate (SDFR)
and the Standing Lending Facility Rate (SLFR), have gone up by 50 basis
points each, to 7.00 per cent and 8.50 per cent, respectively with
immediate effect. The resultant effect of this decision is that the
market interest rates will go up. Why did they do it? On the same day,
the central bank issued a press release explaining as to why the
Monetary Board took this decision.
According to the press release, we can presume that the Monetary
Board had three main concerns in taking this decision. The Board intends
to keep the inflation rate at mid-single digits and secondly, the Board
wants to contain the widening trade deficit and thereby support the
balance of payment situation. This decision making process is
interesting and could appear logical, but unfortunately it is not so.
Hence, the resultant effect could be that the central bank would not
achieve what it wants to achieve namely the above mentioned three
objectives. Why do I say so?
With a view to simplify my answer, now, I invite readers to
participate in making the decision made by the Monetary Board. Let us
begin it. If there is a certain simple parameter in the economy which
parameter correlates to inflation and to the trade deficit then you
could change the inflation rate and the trade deficit by changing that
parameter. Since, the Balance of Payment is strongly linked to the trade
deficit, if any economic parameter changes the trade deficit then that
parameter effectively correlates to the Balance of Payment too. It means
that, if there is an economic parameter that could change the inflation
and trade deficit, then that parameter could effectively change the
Balance of Payment situation too. So far it is simple. I assure you that
it will remain simple until the end of my argument.
Now, you are told that private sector credit growth is the economic
parameter which correlates to the said three variables, namely,
inflation, trade deficit and the Balance of Payment. This means that, if
you allow private sector credit to grow, and as a result the inflation
might increase, trade deficit might get widen resulting to have negative
pressure on the Balance of Payment. Conversely, they might say that if
the private sector credit growth is contained or reduced, then the
inflation might be reduced, the trade deficit might also be reduced
resulting positive effect on the Balance of Payment. So, private sector
credit growth is the important parameter. Based on this information,
what decision you want to make now? You may decide, in favor of the
reduction of private sector credit growth, so that you might expect to
contain inflation and to reduce trade deficit which would result in
having positive impact on the Balance of Payment. Yet, there is one more
step in this process.
Then, again you would further be informed that, if you increase the
rate of interest, then people would borrow less and less and as a result
private sector credit growth would be reduced. As you may see, now, it
made simple, you would decide to increase the rate of interests, as was
decided by the Monetary Board, so that private sector credit growth
would be reduced in achieving the reduction of inflation and trade
deficit; reduced trade deficit would support the Balance of Payment
situation as mentioned above. It seems all very logical but not so. What
is the problem?
The problem is that it is not the private sector credit growth that
matters, instead the total domestic credit growth is what matters and
the total credit growth does not purely depend on the rate of interests.
In fact the total domestic credit growth is something that depends on a
lot of variables. I repeatedly insisted that the central bank lacks
certain important policy tools to contain the credit growth without
increasing the interest rates. Keeping market interest rates low would
reduce inflation than increasing the rates to keep inflation low.
The formula I am proposing is that the central bank must acquire a
few more policy and administrative tools in order to steer the monetary
system to achieve national economic objectives. At least, the central
bank might need a new policy tool to regulate the growth of “credit
money” in the system and to partly change the ownership of the official
foreign exchange reserve without infusing new money into the system.
Perhaps, somebody might now question me to provide empirical evidence to
support my proposal. This is a point where a paradigm shift takes
place. Until the paradigm shift takes place no one can provide empirical
evidence. The empirical evidences belong to old practice. What we need
is a new practice of central banking. (Hema Senanayake)
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