Economic poverty from loop to loop and to currency crises
It is not secret that they only raise interest rates to survive the modern poverty loop linked to foreign hot capital flows as nobody has alternative policy options to escape the loop despite the fact that it is the core structural economic problem confronted by these countries. The present poverty loop is its open economy version evolved from its closed economy version of low income-low savings-low investment-low productivity-low income, etc., also known as vicious cycle of poverty exhibited by old development economists.
Development economics and old poverty loop
Under the Bretton Woods agreement in 1944, the world monetary and trade order was established on the US Dollar as the global reserve currency with the formation of the IMF/World Bank Group to police the order and rebuild western economies hit by the World War II. In 1960s and 70s, Development Economics was designed by American Universities as a supplementary device to dollarize poor countries for development through foreign investments where these countries were encouraged to open their economies to receive foreign investments and benefit from comparative advantages from trade. However, western economies did not require much of IMF/World Bank support. Therefore, IMF/World Bank later became the most influential part of the new world economic order to cushion the poor countries with financial and ideological support to follow market-based western economic prescriptions for development.
The development ideology prescribed by development economics was built on the macroeconomic hypothesis of vicious circle of poverty that these countries were confronting and that prevented them coming out of tribal stages of human development through markets. These countries were living on per capita income of less than a dollar a day and, therefore, labelled as poor countries based on income levels compared to the industrialized western countries.
Accordingly, the vicious cycle of poverty was visualized as the loop of low income-low savings-low investment-low productivity-low income... with which these countries continued to struggle without options to break the loop. Although sovereign currency-based monetary systems with state central banks were established to monetize the economies, mobilize resources and encourage higher production, real income and living standards through creation of domestic currencies. However, western monetary ideologies discouraged them the use of domestic currency independence for development on the fear of inflation caused by such domestic money creation.
Therefore, the only option prescribed to break the loop was the point of investment by directly injecting foreign investments to the loop. This required fundamental reforms of the economies through various liberalization agendas. The key among them was the liberalization of exchange controls and trade and privatization of supply chains. Such development prescriptions were supported by economic development models such as Harrod-Domar Growth model that linked the real GDP growth to investment rate and capital output ratio. However, most countries did not receive long-term business investments from foreign investors as expected.
Therefore, foreign investment took place mainly as official and IMF/World Bank loans and grants that were used to build a foreign currency reserve to settle balance of payment deficits arising from imports required for development at fixed/pegged exchange rates. In fact, a global culture emerged for developing countries to seek and wait for grants for development. It was the popular habit of country leaders to travel around the world seeking such grants. The political agendas contained artificial demonstrations of higher livings standards without real development which was termed by development economists as the disease of demonstrations effect suffered by these countries.
However, this version of poverty loop ideology was fundamentally incorrect and, therefore, could not deliver real economic benefits to the developing world other than country-specific political agendas.
First, in modern state currency/monetary economies, investments do not depend on savings of income. Instead, investments in reality are financed by credit created by the banking system. Credit is simply created out of thin air in double-entry book-keeping of the banking system subject to demand for credit and certain regulatory restrictions.Second, even foreign capital inflow for investment is nothing but the creation of domestic currency for funding development projects against the debt-based foreign reserve where the underlying foreign reserve helps payment for imports required for development. Therefore, foreign capital/investment prescribed to break the poverty loop is not the real investment actually required or anticipated.
Economic openings, neoliberal ideology and emergence of new poverty loop linked to US Dollar-based foreign hot capital
Later in 1980s, the new open economy macroeconomic management model for development became complex and vulnerable as it was centred around free imports, managed or stable exchange rate and foreign currency reserve. The collapse of gold-based fixed exchange rate system consequent to the suspension of the US Dollar-gold convertibility in 1971, commencement of dollar-based petroleum trade in 1974, rapid development of Petro-dollar market and flexible exchange rates caused developing countries to depend heavily on the US Dollar inflows in managing newly open economies and maintaining macroeconomic balances.
In the meantime, the Washington Consensus led to the neoliberal ideology to manage economies world-wide. The ideology prescribed the governments to cut fiscal deficits, debt and red tapes and privatize state owned business enterprises for small governments largely financed by taxes for maintenance of law and order, make central banks independent for preserving the price stability and control of inflation through adjustments of money printing and allow the private sector to be the engine of the growth whose benefits will be trickled down to the general public through markets. The IMF/World Bank group was the global agent for the spread of the neoliberal ideology and Washington Consensus across the developing world through conditions attached to their numerous financial and technical programmes offered to the countries.
In this background, the centre-point in development and management of developing economies became the dollar currency reserve which was treated as the single most gauge of the strength of countries in the global economy. Therefore, country policymakers started opening domestic financial markets to foreign private capital flows as official loans and grants were not at desirable scales to target the dollar reserve levels. As long-term business capital inflows also were poor mainly due to country red tapes, connected abusive governance practices and poor global business rankings, new foreign capital was largely attracted to government securities and stock markets as highly volatile hot capital responding to on-going market factors rather than long-term growth possibilities of developing countries.
Therefore, a new hot foreign capital-based economic management model led to a new vicious loop of poverty of these countries. It is this loop in which almost all countries including Sri Lanka and India have been trapped during the past three decades where many countries have compelled to confront currency crises from time to time due to unexpected or volatile capital flows.
Therefore, the new loop or vicious cycle of poverty is the high balance of payment deficit-volatile foreign capital/debt flow-volatile foreign currency reserve-overvalued exchange rate-high interest rate-economic instability (low growth and high inflation)-high balance of payment deficit, etc. Real economic activities and living standards crucially depend on the volatility of the loop caused by the foreign capital point as witnessed from currency crises and tensions generally experienced by almost all developing countries from time to time.
IMF/World Bank group as the guardian of the new loop
In this background, the IMF/World Bank group has emerged as the guardian of the loop because its financial programmes provide temporary cushions to foreign reserves under the neoliberal model rules whenever local and global shocks threaten such reserves. Global financial architecture is such that the IMF/World Bank presence in countries helps boost sovereign credit ratings and trust in respective countries and, therefore, foreign investors are encouraged to deal with country financial markets under their portfolio diversification rules in a manner that boost foreign reserves.
Therefore, governments and central banks of these countries have now engineered various currency products linked to foreign reserve targets not necessarily connected to the real economic performances. As such, the single most important macroeconomic management performance cited by all country authorities on a daily basis has become the foreign reserve dollar number together with its national import cover in months.
Macroeconomic balancing myth and impossible trinity
As such, the macroeconomic management of modern developing countries has become largely an accounting exercise to balance selected financial accounts of the economy such as fiscal deficit, foreign reserve, debt and monetary liquidity/currency for selected price targets, primarily, interest rate, exchange rate and inflation rate at arbitrary levels. This policy exercise is labelled as the macroeconomic balancing like balancing a rocket in the sky. However, this macroeconomic balancing is not based on any assessment of the performance of the contemporary real economic sectors and living standards.
Therefore, the balancing rhetoric presented by country authorities is nothing but fixing of few digits of the financial accounts of the economy on-a-day-to-day-basis. As the balancing ends up in arbitrary money printing out of thin air, more money or less money, the work is just an easy desk top exercise. Therefore, the balancing is noticeably contested by another monetary ideology known as the impossible trinity which prescribes that it is impossible for country authorities to keep money printing independent, exchange rate fixed/stable and foreign capital free and mobile simultaneously.
The best example is how current Indian authorities attempt to rebuild the foreign reserve that was eroded in the past few months to prevent the currency depreciation while interest rate is being maintained at current levels and money printing is allowed to sky-rocket. In contrast, many countries including Sri Lanka continue to gamble on the impossible trinity by raising interest rates competitively to attract foreign hot capital to boost foreign reserves for exchange rate stability allowing money printing to rise at excessive levels despite red-hot inflationary pressures. In turn, their day-day-monetary operation is to mop up the excess liquidity/money created by the foreign capital for the foreign reserve at higher exchange rates by printing another round of money to pay higher interest to keep the new money idle in bank book accounts.
The Central Bank of Sri Lanka raised its interest rate by one shot of 100 bps to 8.75% on 26 May, instead of usual 25 bps of gradual hikes and reported today of unchanged rates waiting for transmission of the 100 bps hike on prices in years to come although inflation overshot from 2.2% in March to 8% in August unresponsive to the jumbo rate hike. The 100 bps hike has caused an additional interest cost of 1.25%-2.0% to the government funding. The additional cost of the private sector production and impact on prices are yet to be observed through inflation figures.
Therefore, the balancing model that keeps the economy in the new open economy loop is simply a bureaucratic price control model rejected by neoliberal ideologists due to rigidities and irregularities caused by such bureaucratic interventions that prevent the market mechanism prescribed as the system to solve all basic economic problems.
Therefore, the present version of accounting price-based macroeconomic balancing is unable to stimulate real quantities required for uplifting the quality and level of living standards of developing countries as compared to developed world's counter-parties. It is sad that lives of people and animals of these countries are finally decided by stock and bond trades at New York financial markets that determine hot capital flows and foreign reserves of the countries.
Scarcity of policy options to break the current loop
Many countries staying in the loop blessed by the IMF/World Bank do not seem to have policy alternatives to break or escape the loop. It is not the resource scarcity problem per se. Modern global economy produces and trade ample resources. In some countries, the political instability and the lack of long-term leadership prevent economic ideology and strategies. Therefore, many country leaders are resilient with day-to-day living in the loop at IMF/World Bank hands rather than thinking long-term and getting killed.
The western neoliberal monetary ideology of inflation fear is a major hurdle to many countries as it prevents the country leaders to use domestic monetary system for aggressive and long-term policy strategies to break the loop. The break of the loop requires a significant drive of creation and distribution of domestic monetary resources across the country's supply chains to generate a sustainable real surplus in the global economy with clear targets for improvement of living standards in real terms to replace the presently borrowed foreign reserve for accounting price control targets unconnected to the supply side of the economy. Economic management models of China, Malaysia and Vietnam are some examples. Talks of digitalisation, AI, tax increase, debt sustainability, etc., serve no purpose.
Given the lessons from policy and political literature of recent decades (and current talks of the IMF's exit due in March 2027), it is clear that Sri Lankan leadership will never challenge the loop with or without the IMF/World Bank. Therefore, the only policy dialogue Sri Lankans need is the political media to top up foreign borrowings and foreign reserve on a day-to-day basis in order to keep the loop smooth for prevention of currency crises and tensions. The rest of the system will prevail as balancing agents.
(This article is released in the interest of participating in the professional dialogue to find solutions to present economic policy and system problems confronted by the general public. All contents in the article are based on the author's research and views on the specific subject which have no intension to personally discredit characters or ideologies of any individuals.)
P Samarasiri
(35 years of experience in staff class in the Central Bank, inclusive of Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 13 Economics and Banking Books and a large number of articles published.)
Comments
Post a Comment