Evil is not mere money printing, but unbridled government expenditure

President Wickremesinghe as well as the private sector bastions should be more worried about the burden which the elevated expenditure would impose on people rather than the gap in the finances of CEB

What President Wickremesinghe omitted to disclose was that the so-called hole created by the deficit in CEB is nothing compared to the bigger hole in the Government budget. The Consolidated Fund, the constitutional provision for recording all inflows and outflows of the Government and hence, naturally balance itself, is overdrawn to the extent of Rs. 1,000 billion as at end of 2021. Rs. 850 billion of this overdrawn amount is funded through a temporary overdraft facility from state banks and another Rs. 150 billion by a provisional advance from the Central Bank

Huge hole created by CEB

President and Finance Minister Ranil Wickremesinghe, addressing the recently concluded Sri Lanka Economic Summit 2022 hosted by Ceylon Chamber of Commerce, posed a threatening question to private sector bastions packed shoulder to shoulder in a too small auditorium for that large crowd. Briefing them of his new economic model for the next 25 years, he warned them that year 2023 is to open with a huge hole in government financing caused by unsound financial policies of the government monopoly of electricity generation, Ceylon Electricity Board, amounting to some Rs. 300 to 400 billion.

He asked the private sector bastions who are already overburdened by high taxes, galloping inflation, cost increases, forex scarcities, and slowing economy whether they would want the Government to fund the hole by running printing presses (available at: https://www.ft.lk/ft_tv/Economic-Summit-2022/10520-742761). His reference to ‘running printing presses’ is related to the popular slogan among many Sri Lankans today, money printing by the Government to finance the budget causing inflation. His suggestion was that this option should be avoided because it was evil and those who use electricity should be required to pay the cost on the principle that the user should pay and not the general public.

But according to the World Bank’s collection of development indicators, by 2020, Sri Lanka had had a near 100% of population having electricity connections. Hence, the general public and the electricity users in Sri Lanka are one and the same. As such, there is no difference whether it is the public that pays or the electricity users who pay. It is the same group.

But the bigger hole is in the Budget 2023    

What President Wickremesinghe omitted to disclose was that the so-called hole created by the deficit in CEB is nothing compared to the bigger hole in the Government budget. The Consolidated Fund, the constitutional provision for recording all inflows and outflows of the Government and hence, naturally balance itself, is overdrawn to the extent of Rs. 1,000 billion as at end of 2021. Rs. 850 billion of this overdrawn amount is funded through a temporary overdraft facility from state banks and another Rs. 150 billion by a provisional advance from the Central Bank.

On top of this, the Budget 2023 has a much bigger hole on a gross basis. According to the budget numbers, the gross expenditure of the Government in 2023 will amount to Rs. 7.9 trillion including the long-term debt to be repaid by reissuing to the market as against a gross revenue base of Rs. 3.4 trillion. However, this gross expenditure does not include the reissue of the maturing Treasury bills within 360 days amounting to Rs. 3.8 trillion. When this amount is also added to the gross expenditure announced in the budget 2023, the overall total amounts to Rs. 11.7 trillion.

What this means is that the budget deficit on a gross basis will amount to Rs. 8.3 trillion or 28% of the estimated GDP of Rs. 30 trillion for the year. The Government has taken out the reissue costs from the budgetary numbers but the actual burden to be borne by the public constitutes the whole of this expenditure as explained later in this article. The gap in CEB estimated at Rs. 300-400 billion is nothing compared to this huge gap in the overall budget.

Ricardo-Barro Equivalence: No difference between bond financing and tax financing

When a government spends money, it is generally believed that it is the taxes which the current population should pay that will constitute the burden to be borne by them. Therefore, if the government borrows money to pay for the expenditure, it was not considered a burden because it is only a redistribution of the financial assets from taxpayers to bondholders. Therefore, when the bonds are repaid, people will pay taxes to repay them, but it is only a transfer of money from taxpayers to bondholders. Therefore, it does not involve a burden because one section of population owes it to another section of the population. This led to the popular slogan relating to the domestic debt of the government that ‘we owe it to ourselves’. This was changed by the 19th century English economist, David Ricardo, who argued that there is no difference between the tax financing and the debt financing (see: https://courses.lumenlearning.com/wm-macroeconomics/chapter/ricardian-equivalence/).

When people pay taxes today, they bear a burden today by transferring their resources to the government sector. It reduces their spendable income known as the disposable income and force them to curtail both consumption and money available to lend to their private sector peers. When the government charges higher taxes to repay what it has borrowed in the past, the people must pay higher taxes. Hence, debt financing is simply the postponement of the current tax liability to the future. This is known as Ricardian Equivalence, and it was further developed by Harvard Economist Robert Barro who argued that when the government spends one rupee here there is a reduction of one rupee spent by the private sector elsewhere. Therefore, this theory is now known as Ricardo-Barro Equivalence.

Foreign borrowing is more burdensome

This analysis presumes that the Government borrows only from domestic sources to finance the budget. It becomes much more alarming when foreign borrowing for financing the budget is allowed. At the time of making the foreign borrowing, there is an inflow of resources increasing the welfare of the people. However, when it is repaid, there is an outflow of resources more than the initial inflow because the country should now repay the principal along with interest. But it is the people who should curtail their consumption to provide for resources for repayment of the foreign borrowing. Therefore, the crucial requirement for meeting the foreign debt of the Government is not just having domestic savings. The nation should have foreign exchange to convert the domestic savings to usable mode of repayment.

If it does not have, it runs in to a new problem in the form of being taken hostage by foreign creditors who will insist that the available foreign exchange resources should be used to repay their debt before meeting the nation’s normal import requirements. If foreign debt is defaulted, unless a speedy resolution is arrived at, the door for refinancing the maturing foreign debt plus payment of interest will be closed for the Government. It makes the gross expenditure of the government not just a book entry but a threatening reality. This is the issue which Sri Lanka is going through today.

If money is printed over and above the safe levels, that is, much more than the increased liquidity requirements arising from the real economic growth, the excess money leads to both domestic inflation and the pressure for the exchange rate to depreciate. This is because the increases in excess money will increase the aggregate demand above the short-term aggregate supply and if imports cannot be increased to meet the increased amount of aggregate demand, it leads to domestic inflation on the domestic front and to balance of payments difficulties on the external front. With inflation, the country will lose its competitive edge, fail to realise much from international trade, and there will be pressure for the exchange rate to depreciate. Therefore, exchange rate depreciation is not the cause of inflation but the result of inflation

Money printing leads to inflation

Then, what about running the printing presses as warned by the President to meet the holes in the budget? It does not impose an immediate burden on the people, and therefore, there is a tendency to believe that it does not inflict a burden on people. Instead, people will be benefitted by the higher liquidity they now enjoy due to the increase in the cash balances. However, if money is printed over and above the safe levels, that is, much more than the increased liquidity requirements arising from the real economic growth, the excess money leads to both domestic inflation and the pressure for the exchange rate to depreciate. This is because the increases in excess money will increase the aggregate demand above the short-term aggregate supply and if imports cannot be increased to meet the increased amount of aggregate demand, it leads to domestic inflation on the domestic front and to balance of payments difficulties on the external front. With inflation, the country will lose its competitive edge, fail to realise much from international trade, and there will be pressure for the exchange rate to depreciate. Therefore, exchange rate depreciation is not the cause of inflation but the result of inflation. Therefore, money printing over and above the safe levels will cause inflation and inflation is a tax which is being paid by all.

Inflation is a tax on people

But how does inflation become a tax? Suppose the Government pays the salary of a teacher by getting the Central Bank to print a new 5,000 rupee note. The teacher sacrifices, say, 8 hours of her real labour to get that 5,000 rupee note. But the Government spends only the printing cost of the note and therefore, there is an unequal exchange between the Government and the teacher. Why should a teacher agree to such an unequal exchange? Because she is told by the Government that when she goes to the market with that 5,000 rupee note, she can buy, say, a kilogram of rice. But when she goes to the market, she finds there are others who also have got 5,000-rupee notes and are about to exchange for rice.

When the demand goes up, prices go up and assume that they have increased to Rs. 10,000 per kilo. She can buy only half a kilo of rice now and the lost quantity of a half a kilo is a tax she pays to the Government. Since this reduction in the consumption level has arisen due to inflation, it is called due to the inflation tax.

Total government expenditure is the burden on people

What does this mean? Whether the Government finances its budget through tax financing, or debt financing, or printed money financing, it imposes the same burden on people. Tax financing will force them to make the real sacrifice today. Debt financing is simply a mechanism to transfer the tax payment liabilities to the future. Money printing causes inflation to set in the economy and force people to curtail their real consumption. This curtailment is a real sacrifice which they should make to survive in the system. Hence, President Wickremesinghe as well as the private sector bastions should be more worried about the burden which the elevated expenditure would impose on people rather the gap in the finances of CEB.

Even when this cost is passed on to electricity users, who in Sri Lanka’s case constitute the general public, there is still a mounting burden being borne by people when they have to finance the total gross expenditure of the Government. They will do so by paying current taxes, future taxes, or inflation taxes. In 2023, this burden is estimated at Rs. 11.7 trillion or 39% of the estimated GDP. This is an unaffordable burden-bearing for a private sector which is already overburdened by other economic calamities faced by them.

If the Government is desirous of relieving the private sector of the high burden it is called upon to bear, the choice is to cut the total Government expenditure progressively over the next decade

Tariff on government monopolies is also a tax

There is a fine point about government monopolies and their pricing. Since they are monopolies, the prices charged by them are considered a tax imposed on their customers. This does not happen in the case of a firm which operates in a competitive market. There, the prices are determined in the market and the firm has no leeway to pass its cost structures on the customers. But in the case of a government monopoly like CEB, CPC, Railways, and Postal Services in Sri Lanka, the prices known as tariffs, is determined by the governmental authorities and hence, a tax imposed on the users.

Hence, any increase in the tariff relating to CEB to fill its deficit in 2023 is a tax imposed on the private sector. It is an inclusive tax since in Sri Lanka almost all people have been provided with electricity supply. Therefore, the choice before the private sector bastions is whether they should pay it now through increased tariff in the current period, pay for it tomorrow if the Government chooses to cover the costs by issuing debt, or pay through the inflation tax as suggested by President Wickremesinghe who declared that he has no other alternative except allowing the printing presses to run.

Need of the day is to curtail government expenditure

If the Government is desirous of relieving the private sector of the high burden it is called upon to bear, the choice is to cut the total Government expenditure progressively over the next decade. This is similar to the choice given by the California Governor Ronald Reagan in 1960s to the state’s university system. He said that he would cut their budget by 25% in the first year, up to 50% by the second year, up to 75% by the third year, and no more budgetary allocations after the fourth year. President Wickremesinghe too should go for such a plan if he really wants the private sector to take the leadership in resource allocation and ensure the long-term economic prosperity. Without such an expenditure control plan in place, increases in taxes to meet the rising Government expenditure is simply running after an elusive goal.

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