Child’s guide to currency board systems – Part IV: Prof. Steve Hanke’s crusade for currency boards

Prof. Steve Hanke

Borrowings from the banking sector by the Government has increased by Rs. 3.7 trillion or 132%. Consequently, the money stock has increased by Rs. 4 trillion or 52%. Inflation is rising at 30% according to official sources. But according to Hanke’s inflation tracker, it is rising by 131%. Sri Lanka has lost almost the entirety of its foreign reserves disabling it to undertake the essential import program. Hence, according to Hanke, this is the best opportunity for Sri Lanka to go for a currency board system

The conversation between Aseni, whiz kid in economics, and her Grandpa, Sarath Mahatthaya, an ex-official of the Finance Ministry, on currency board systems continues. Their previous conversation focused on why colonial Ceylon established a currency board in 1884, its performance during 1884-1950, and why independent Ceylon replaced it with a central bank, while Singapore chose to retain it. (Access them here: https://www.ft.lk/columns/A-child-s-guide-to-currency-board-systems-Part-I-How-colonial-Ceylon-did-it/4-734214; https://www.ft.lk/columns/A-child-s-guide-to-currency-board-systems-Part-II-The-performance-of-Ceylon-s-currency-board/4-734539 and https://www.ft.lk/columns/Child-s-guide-to-currency-boards-Part-III/4-734878). Today, they examine the role of a modern-day crusader of inflation tracking and currency boards, Steve Hanke, an economics Don at the Johns Hopkins University in USA.

Aseni: Grandpa, Steve Hanke has been releasing a tracker of global inflation and marked Sri Lanka’s inflation as the second highest at 131%. But some Sri Lankan economists have disputed Hanke and said that they do not agree with his inflation calculation. Their views have been published by a local English daily and could be accessed at https://www.themorning.lk/local-economists-not-taking-hanke-inflation-seriously/. What is this dispute?

Sarath: Economics is a science, and the main feature of science is that its theories can be questioned by other scientists with proper validation. Science has advanced because of this specific feature. Therefore, there is nothing wrong in the local economists questioning what Hanke has been doing. These disputes and debates surely add to our knowledge. Hanke is a disciplined economist. Therefore, he will certainly welcome such criticisms if they are substantiated by valid facts. But what the newspaper has published is some sweeping statements attributable to those local economists for the benefit of its readers who love to read sensational stories. We must therefore dissect those statements, remove the sensational part, and see how far they have provided a fair criticism of Hanke’s work. 

Aseni: I understand. But is there any validity in what the critics say?

Sarath: What critics say is that Sri Lanka calculates inflation in the same way as other countries do. It implies that there cannot be any deficiency in inflation numbers because Sri Lanka follows the global best practices. That global practice is to collect prices of select commodities from the market, assign weights for each commodity which are simply a measure of the importance of those commodities in a typical consumer’s basket, and incorporate those weighted prices into a consumer price index to see by how much the basket value has gone up.   

The consumer price index so calculated reveals the average cost of living of a typical consumer. If the basket value goes up, we say that the cost of living has gone up. If it goes down, the cost of living is eased. When the increase happens for several months, we call it inflation. The opposite is the deflation. The data for computing the consumer price index are collected through periodical surveys conducted by special data agents. There are several deficiencies in this method. 

Aseni: What are those deficiencies? I thought that they are globally accepted methods. 

Sarath: All economic numbers that we get are estimates and not actual numbers. Estimations have their own deficiencies. Price indexes that we compile also have several deficiencies. One involves the data collection errors. The price data are collected by special data collection agents, and they can make errors by omission or by commission. A second one is the assignment of wrong weights to different commodities in the basket used for compiling the indexes. This is specifically relevant to Sri Lanka today. 

In the Colombo Consumers’ Price Index or CCPI, food category has been given the weight of 28% based on a survey done by the Census Department during 2012 through 2013. These weights may have changed by now, but they have not been revised. There is another change visible after the country was attacked by the COVID-19 pandemic in early 2020. That is, due to the non-availability of non-food goods in the market, consumers now spend a bigger portion of their income on food items. Hence, inflation measured by that index is broadly underestimated. For example, in CCPI, the food category has increased by 47% by the end of April 2022, but the inflation rate is recorded as 29.8% because of the low weight given to the food category. 

The third deficiency is the more alarming one. That is, governments might manipulate the indexes to show a low inflation rate to demonstrate the success of their policies. It is now well established that Argentina had manipulated inflation numbers during 2007 to 2015 to show a lower inflation than the actual one. But Argentina is not the only country which has resorted to this practice. Hanke’s work has exposed these countries. 

Aseni: How does Hanke’s inflation tracker become superior to inflation measured by compiling price indexes?

Sarath: Hanke uses a different methodology. Instead of using price indexes, he tracks it from a macro point. It is quicker, more convenient, and less costly. When calculating money supply numbers, we use a similar method. Money supply is the stock of money in the hands of the public. Instead of trying to find out the stock of money by getting the data from people, we use the balance sheets of the central bank and commercial banks to extract the needed numbers. That method is more reliable and less costly. Hanke uses the purchasing power parity or PPP theory to calculate inflation. That theory was first presented by Swedish economist Gustav Cassel in a paper published in 1916. In fact, this theory has so far not been refuted but further developed by subsequent economists like Bela Balassa. 

It is the basic principle underlying this theory that has been used by the UNDP, World Bank, and the University of Pennsylvania to compute the purchasing power parity concept of GDP calculation. Hence, Hanke does it from the top using the macroeconomic relationships at the aggregate level, while government authorities do it from the bottom collecting data at the micro level. He bases his case for currency boards on these aggregate inflation numbers. 

To avoid depreciation, one should avoid inflation. To avoid inflation, one should curb money printing. To curb money printing, central banks should not be given discretionary powers. To remove discretionary powers, money printing should be done according to a rule. Such a rule can be enforced effectively only by a currency board and not by a central bank. This is the crux of Hanke’s argument

Aseni: Why is this PPP inflation calculation superior to normal inflation that we calculate through the construction of price indexes? 

Sarath: What Cassel said was that if there are two inflation rates between two countries and if there is free flow of goods between the two countries, exchange rate should adjust upward or downward to make the two prices equal or to maintain the purchasing power parity between the two countries. This is based on the concept of the law of one price that is brought into existence by market interactions. Suppose, for example, the price of a shirt in Sri Lanka is Rs. 100 and that in USA is $ 5 and the exchange rate is Rs. 10 per dollar. It is more profitable for Sri Lankans to spend Rs. 50 to buy $ 5, buy a shirt from USA and sell it at Rs. 100 in the local market. Then, at the given exchange rate, he will buy $ 10 and bring in two shirts which he can now sell for Rs. 200. This is called arbitraging, that is, buying from a low-priced market and selling at a high-priced market, and it is quite a legitimate activity. 

What Cassel said was that to remove the arbitraging profits, the exchange rate should adjust itself to Rs. 20 per dollar. This means that if inflation rate in Sri Lanka is higher than the inflation rate in the benchmark country, Sri Lanka rupee should depreciate to maintain the purchasing power parity between the two countries. Though Hanke’s working is complex, in simple terms, if we know the inflation rate in USA and exchange rate depreciation in Sri Lanka, we can work back and estimate the underlying inflation rate in Sri Lanka. This is the basis of Hanke’s inflation dashboard. Unlike the consumer price indexes which cover a select number of goods and services with weights assigned to each good or service, estimation of inflation at the aggregate level covers practically all the goods and services in the economy. Therefore, it is not necessarily confined to a given consumer. 

Aseni: But for Hanke’s inflation estimation to be of relevance, we should have an economy fully exposed to international trade, shouldn’t we? 

Sarath: But today’s economies are fully exposed to international transactions. Even if we produce goods locally purely for local consumption, we use a fair quantity of imported inputs. To the extent they are used, the depreciation of currency should raise their costs and consequently prices. Take for example, the production of rice. We use imported fertilisers, pesticides, seeds, tractors and other farm machinery, fuel or electricity to operate them, etc. If the currency depreciates, it increases input costs delivering a supply shock. If money is printed continuously, that shock becomes permanent by increasing money aggregate demand. 

Now the link is clear. To avoid depreciation, one should avoid inflation. To avoid inflation, one should curb money printing. To curb money printing, central banks should not be given discretionary powers. To remove discretionary powers, money printing should be done according to a rule. Such a rule can be enforced effectively only by a currency board and not by a central bank. This is the crux of Hanke’s argument. 

Aseni: I now understand it. What it means is that politicians should not be given a free hand to abuse central bank’s money printing power and central bank managements should not be given discretionary powers which they use at times to please their political masters. But do we have evidence to prove it?

Sarath: The most recent example is that IMF in its report on Article IV consultations had recommended that that Sri Lanka should refrain itself from funding the Government through bank financing, commonly known as money printing, as a pre-condition for affording a bailout package to the country. The Central Bank Governor Nandalal Weerasinghe tried to adhere to this recommendation by increasing the rates on Treasury bills and bonds significantly and meeting the Government’s funding requirements by borrowing from savers in the market. This was thwarted by Prime Minister Ranil Wickremesinghe by announcing that he will permit money printing because he has no money to pay even the salaries of Government servants. 

As a result, in the Treasury bill auction held on 18 May 2022, the Central Bank had offered Rs. 90 billion to the market but was able to borrow only Rs. 16 billion from the market even at the going rates. This has left a funding gap of Rs. 74 billion which should naturally be funded by the Central Bank. That is the curse of the discretionary powers given to the Central Bank management. Instead of trying to develop a permanent funding line through sustainable tax systems, politicians are now turning to the easy method of getting money from the Central Bank. 

Aseni: Has Hanke found evidence to prove this phenomenon?

Sarath: Yes. He has been working on monetary policy, central banking, and currency boards for some time. He is said to have been fascinated by the idea of currency boards when he learned in early 1980s that Hong Kong had stabilised its currency by setting up a currency board. He set himself on a long research program on the subject and found that even John Maynard Keynes had designed a currency board for Archangel in Northern Russia when the country had been engulfed in civil war following the Bolshevik Revolution of 1917. 

Though Keynes had agreed to loosen the strict rules pertaining to currency issues under currency board systems, the adhesion to strict rules had helped the Northern Russia to have a stable and a convertible currency. What is important is that very same Keynes later recommended money printing as the way out for countries to come out of economic recessions. But later in 1990s, Hanke’s work on hyperinflation in several countries made him the present-day crusader of currency boards. 

Aseni: This Keynes’ following of the strict monetary rules, known as monetary orthodoxy, is news to me. So, what are those other cases which Hanke handled in resolving monetary crises in 1990s?

Sarath: He was actively engaged in setting up currency boards in several countries in 1990s. Apart from Argentina which is a Latin American country, his engagement was mainly in countries that belonged to the former Soviet bloc. They were not pure currency boards but some variations. He helped establish such variations in Estonia in 1991, Lithuania in 1993 through 1994, and Bulgaria in 1997. In Estonia, inflation rate before the establishment of the currency board amounted to more than 1000%. But by 1995, it fell to 29%. By 2003, it was just 1%. Lithuanian inflation rate was 72% in 1994 but fell to 1% by 2004. In Bulgaria, inflation was running above 2,000% in the first quarter of 1997 before the currency board was set up. But it fell to 1% in 1998. Hence, overall, in these former Soviet bloc countries, currency board arrangements have helped stabilise prices. 

Once this target has been attained, it is up to the government to set the country concerned on a long-term real growth path. Currency boards can bring in stability in prices, exchange rates and stability in the foreign sector. Those are nominal achievements which are necessary but not sufficient to attain prosperity and wealth which are real sector attainments. If the government does not seize the opportunity and create an environment conducive for real sector growth, the mere establishment of a currency board does not help a country. 

These success stories of currency boards have prompted Hanke to recommend this prescription to other countries with either hyperinflation or galloping inflation. Sri Lanka is one such case and he has been arguing that the country should replace its central bank with a currency board. In fact, this is not a novelty to Sri Lanka because it had a currency board system before the establishment of the central bank. 

Aseni: Is his case for a currency board system in Sri Lanka validated?

Sarath: Sri Lanka’s politicians had not been very prudent in handling the money printing power of the Central Bank. Instead of developing a viable and sustainable revenue generation system, they have resorted to borrowing from the Central Bank first and from commercial banks later to finance their profligate expenditure programs. It has been a common practice in Sri Lanka that politicians have promised various free goods to people without having a proper funding base. 

When they are faced with the problem of money, they invariably resort to borrowing from the Central Bank. This has been practiced to an extreme level by the Gotabaya Rajapaksa administration during the past two-and-a-half-year period. Borrowings from the banking sector by the Government has increased by Rs. 3.7 trillion or 132%. Consequently, the money stock has increased by Rs. 4 trillion or 52%. Inflation is rising at 30% according to official sources. But according to Hanke’s inflation tracker, it is rising by 131%. Sri Lanka has lost almost the entirety of its foreign reserves disabling it to undertake the essential import program. Hence, according to Hanke, this is the best opportunity for Sri Lanka to go for a currency board system. 

Aseni: Thanks Grandpa. Let’s discuss it further. 

(To be continued.)

Part I of this article was published in the Daily FT on 2 May and can be seen at https://www.ft.lk/columns/A-child-s-guide-to-currency-board-systems-Part-I-How-colonial-Ceylon-did-it/4-734214.

 

Part II, published on 9 May, can be seen at https://www.ft.lk/columns/A-child-s-guide-to-currency-board-systems-Part-II-The-performance-of-Ceylon-s-currency-board/4-734539.

 

Part III, published on 17 May, can be seen at https://www.ft.lk/columns/Child-s-guide-to-currency-boards-Part-III/4-734878

 

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)