Household indebtedness may gradually increase to unprecedented levels. This may increase the instability of the financial & banking system. This vulnerability must be arrested in order to make a sustainable economic recovery possible. Photo credit: AFP

During the 2016 U.S. presidential campaign, a macroeconomic theory, Modern Monetary Theory (MMT) has become an interesting topic in United States politics. Stephanie Kelton, a proponent of this theory, was among the advisors of 
Bernie Sanders. 

A special feature of MMT is public debt. According to MMT, public expenditures can be financed by public debt or even by printing more money without negative economic side effects such as inflation, crowding-out of (private) investments. Another school of economic thought, the ‘post-Keynesian economists’(PKE) were among the first to emphasise that money supply responds to the demand for bank credit, so that Central Banks cannot control the quantity of money, but only manage the interest rate by managing the quantity of monetary reserves. According to PKE, in contrast to the neoclassical (mainstream) approach, investment is not constrained by the availability of savings, but may be constrained by the availability of 
bank credit.

Many governments around the globe expanded their budgets in response to the COVID-19 crisis. The response was large budget deficits combined with Central Bank actions involved in the purchase of treasury bonds which are funding these budget deficits. Some economists seem to accept thispolicy of budget deficits and are abandoning neo-classical economic models and ‘monetarist economics’, thus funding these budget deficits by buying government bonds, what is often called ‘printing money’.  The above two macroeconomic theories directly impacted the way policy makers/central banks create fiscal and monetary policiesto stimulate economic activities in response to COVID-19.

Policy adopted by the government/CBSL
When the government expenditure increases, it raises aggregate demand for goods and services, and policymakers would expect some increases in supply of goods and services due to enhanced money income in the hands of the public.  In addition, the government could reduce taxes as a policy to induce investments. 

This fiscal policy, together with low interest rate regime was expected some increases in the economic growth. The Sri Lankan government adopted this policy since 2020 (beginning) till end of 2021 with a view to providing relief to people and businesses in order to overcome negative effects due to COVID 19. However, whether the economy really produced goods and services to the extent that is required is questionable. 

The outcome was the high inflation from beginning of 2022. It is true that during the year 2021 they have been able to convert the negative growth rate of 3.6 percent in 2020 due to COVID 19 impact into a positive growth rate of 3.7 percent in 2021. Commencing 2022, CBSL adopted a policy of tightening the monetary policy by increasing the interest rates in order to reduce inflation and inflationary expectations. 

One can argue that all these policy measures are in accordance with the accepted macro- economic theories put forward by eminent economists stemming from, a) Classical economic theory and Neoclassical economists,b) ‘Monetarist economics’ Vs ‘Keynesian economics’ theory,c) Post-Keynesian economists and Modern monetary theory (MMT). Let us briefly touch on the evolution of these economic theories.

Evolution of economic theories
(a) Classical economic theory and Neoclassical economists
Scottish economist, Adam Smith was the leading figure of the classical economic theory of growth. Smith is most famous for his 1776 book, “The Wealth of Nations.” Smith’s ideas–the importance of free markets, assembly-line production methods, and gross domestic product (GDP)–formed the basis for theories of classical economics. Neoclassical economists believe that a consumer’s first concern is to maximize personal satisfaction. Therefore, they make purchasing decisions based on their evaluations of the utility of a product or service. 

While classical economic theory assumes that a product’s value derives from the cost of materials and labour, neoclassical economists say that consumer perceptions of the value of a product affect its price and demand.This economic theory states that competition leads to an efficient allocation of resources within an economy. The forces of supply and demand create market equilibrium.

(b) ‘Monetarist economics’ Vs ‘Keynesian economics’ theory
‘Monetarist economics’ refer to Milton Friedman’s direct criticism of the ‘Keynesian economics’ theory formulated by John Maynard Keynes. The difference between these theoriesis that Keynesian economics involves government expenditures while monetarist economics believe that government spending causes inflationand therefore need to control the supply of money that flows into the economy.
In contrast, Keynesian economists believe that a troubled economy continues in a downward spiral unless an intervention drives consumers to buy more goods and services. They believe in consumption, government expenditures and net exports to change the state of the economy. Governments should balance out the cyclical movement of the economy by spending more in downturns and less in prosperous times (thereby 
preventing inflation). 

 (c) Post-Keynesian economists and Modern monetary theory (MMT)
Post-Keynesian Economics (PKE) is a school of economic thought which builds upon John Maynard Keynes’s argument that effective demand is the key determinant of economic performance. In contrast to the neoclassical (mainstream) approach, investment is not constrained by the availability of saving, but may be constrained by the availability of credit. (term ‘Mainstream economics’ is used to describe theories often considered part of the neoclassical economics tradition) Money in a modern economy mostly consists of bank deposits which are created by commercial banks as a side effect of their lending decisions. The money supply is not therefore under the direct control of central banks 
or governments.

Modern Monetary Theory (MMT) has recently moved from the periphery to become part of the intellectual discussions at Central Bank level. Governments around the globe expanded their budgets in response to the COVID-19 crisis. The response was massive budget deficits combined with Central Bank actions involved in the purchase of treasury bonds which are funding the budget deficits. Some economists seem to accept this policy of  budget deficits and tend to abandon neo-classical economic models and 
‘Monetarist economics.  

These macroeconomic theories, especially the Post-Keynesian economists and Modern monetary theory (MMT) directly impacted the way policymakers/central banks create fiscal and monetary policies in response to COVID-19.Government of Sri Lanka and CBSL have also followed these macro- economic policies in the past to stimulate economic 
activities/growth.

Printing more money and maintain price stability
It may be true that the governments could continue to print money to service its domestic debt and meet development & other expenditure, however the governments cannot rollover foreign debt so easily and therefore it is tantamount to   government’s inabilityto repay its debt. Therefore, the debt sustainability needs to be constantly evaluated by comparing present and future debt obligations with available reserves to ascertain whether it could meet the debt obligations on a sustainable basis. 

Under the Monetary Law Act (amendments in 2002), the economic and price stability and financial system stability were made the core objectives of  the   CBSL. Therefore, it should focus on maintaining stable price levels, means containing inflation and inflationary expectations. In order to attain ‘price stability’, CBSL is required to keep liquidity and money supply of the country at appropriate levels so that the total demand for goods and services known as the ‘aggregate demand’ is more or less equal to the total supply of goods and services called ‘aggregate supply’. If this objective can be achieved, then it would encouragepeople to save and businesses to plan for their future activities taking in to consideration a long- term view on price stability.Neo-classical economics traditions advocate this policy.

Address the structural weaknesses in the economy
The economic downfall with special reference to issues in external debt sustainability, current high inflation, forex shortages is mainly due to failure on the part of successive governmentsto address the ‘structural weaknesses’ in the economy overthe last three- four decades. Thestructural weaknesses can be explained through vulnerabilities. It can be argued that a structurally strong economy, an economy based on a more viable range of activities, will be more resilient to the risk of external shocks, say COVID pandemic situation. 

Sri Lanka on the other hand, is a structurally weak country and cannot withstand the external shocks. We are a small economy and our foreign exchange reserves are low.  Due to the persistent trade deficits and lack of FDI receipts, the forex reserves have come down to aroundone billion US$ only, whereas the annual trade deficitis around nine billion US$. Due to continuous trade deficit, we depend on tourism revenue, which is a high- risk business in terms of external shocks. Our exports as a percentage of GDP have been coming down from 28 percent to about 14 percent over three decades. 

Exports are not properly diversified and main exports are textile & apparel, tea and rubber- based industry. The value addition thereon is not sufficient and mostly cater to private labels. As such, due to high cost of productionour exports are not competitive enough in the global market place in order to increase export revenue substantially. 
The agricultural practices are still being deployed following traditional methods and productivity is relatively low. The technological advancements and mitigating strategies to adapt to climate change phenomena etc. are limited to policy papers only. There seems to be a resistance to change. We could also look at some performance indicators to see the structural weaknesses; poor tax system to generate income, huge losses of SOEs, over dependence on fossil fuel to generate electricity, slow progress on developing battery storage for solar and balancing the electricity grid-supply and demand etc. It is easier said than done, but we need to address these ‘structural weaknesses’ in the economy as a matter of priority.

Renewed interest in the subject of ‘financial fragility’
Recent events have globally caused renewed interest in the subject of ‘financial fragility’, meaning vulnerability of the financial system and future outbreaks of serious financial disorder. CBSL has been trying to control inflation by way of increasing bank interest rates. However, this has adversely affected SMEs - the micro and small and medium enterprises have serious issues, where they cannot afford to borrow any more or repay the debts already taken. As a result, household indebtedness may gradually increase to unprecedented levels. This may increase the instability of the financial & banking system. This vulnerability must be arrested in order to make a sustainable economic recovery possible. In the event, a bank/ banks have temporary liquidity problems and require them to be bailed out by the Central Bank, then CBSL has the authority to provide necessary assistance to such banks and ensure that the financial system stability is maintained. This action may result in printing new money.

We have already explained our structural weaknesses through vulnerabilities. The Sri Lankan economic crisis has been further aggravated partly due to persistent ‘twin deficits’ that continued for a long period of time, meaning (a) the current account deficit in the BOP of US$ 3,343 million in 2021; (b) the government budget deficit of 4-6 percent, is now exceeding 12 percent. Cash flow deficits on a monthly basis still persist even without servicing debts. As a result, forex reserves have become near zero. The responsible governments in other countries make every attempt to maintain deficit to be financed through 
non-inflationary borrowings.

Economy as systems of cash-flows;need to arrest Over spending
There have been excessive spending patterns both by the government of the day as well as average citizen/ firms. The successive governments did not pay adequate attention to increase domestic production and exports and secure forex inflows but continued to depend on imports. Even Stephanie Kelton, proponent of government spending and creating deficits, says that it is important to maintain the right level of the deficit- one that gets you a balanced overall economy; one that allows you to achieve high levels of employment and low inflation-
As can be seen above, we in Sri Lanka tend to overspend without corresponding economic benefits, but for materialistic possessions only.The modern economies should be viewed as systems of cash-flows. The Sri Lankan economy can be re-builtin the medium term by successfully addressing the structural weaknesses as discussed above and thus eliminating the twin deficits. However, the point is the time it can take for the economy to adjust to these changes and how to manage the cash flows during the interim period.
(The writer is a company director and the former Chairman of Sri Lanka Tea Board)