What can the country do to address its soaring inflation?
Sri Lanka, an island nation of 22 million people, is in the grips of an economic meltdown. This slow-motion train wreck first began in November 2019 when Gotabaya Rajapaksa won a decisive victory in the country’s presidential elections. He immediately placed family members into key government positions and suspended Parliament. Then in August 2020, his Sri Lanka Podujana Peramuna party — the Sri Lanka People’s Front — posted a landslide victory. The win gave Rajapaksa the ability to amend the country’s constitution, which he quickly availed himself of. In total control, President Rajapaksa and his brother Mahinda, the prime minister, went on a spending spree that was financed in part by Sri Lanka’s central bank. The results have been economic devastation. The rupee has lost 44 percent of its value since President Rajapaksa took the reins, and inflation, according to my measure, is running at a stunning 74.5 percent per year. Last week, Sri Lanka announced that it was unilaterally suspending payments on its external debt. These economic developments have led to Sri Lankans protesting in the streets and a government in disarray.
To determine the cause of Sri Lanka’s inflation, I did what I have done in other cases and calculated the “golden growth” rate for the money supply for the period 2010–2019 — the trend rate of broad money growth that would allow the Central Bank of Sri Lanka to hit its inflation target — and compared it with the actual growth rate of Sri Lanka’s money supply.
To calculate the golden-growth rate, I use the quantity theory of money (QTM). The QTM states that MV = Py, where “M” is the money supply, “V” is the velocity of money, “P” is the price level, and “y” is real GDP. I then rearrange the QTM identity and solve for percentage growth in “M,” which is equal to the inflation target plus average real GDP growth minus the average percentage change in velocity. According to my calculations, for the period 2010–2019, Sri Lanka’s golden-growth rate was: 5 percent + 4.4 percent – (-6.4) percent = 15.8 percent.
For 2010–2019, the average growth rate of the money supply (M3), which was 15.5 percent, essentially matched the golden-growth rate of 15.8 percent. This resulted in an average inflation rate of 5.2 percent per year for that period — right on Sri Lanka’s average inflation target of 5 percent per year. But once the Rajapaksas came to power, the growth rate in M3 began to skyrocket and peaked at 23.8 percent per year in February 2021. M3 growth exceeded the golden-growth rate of 15.8 percent per year from August 2020 to October 2021. As a result, inflation is soaring.
What can be done to end Sri Lanka’s economic crisis? It should adopt a currency board, like the one it had from 1884 to 1950, before it changed its name in 1972 from Ceylon to Sri Lanka. Ceylon established a currency board in response to the failure of the Oriental Bank Corporation on May 3, 1884. At the urging of the Madras Bank and other businesses, the governor proposed a government-note issue so that the government might recoup its losses and prevent future problems. The imperial government conceded reluctantly. Ceylon’s Paper Currency Ordinance (No. 32 of 1884), passed on December 10, 1884, and with that, a currency board was established. Three commissioners — the colony’s secretary, treasurer, and auditor — supervised the board.
Like all currency boards, the Ceylon board issued notes (of five to 1,000 rupees) convertible on demand into a foreign anchor currency (Indian silver rupees) at a fixed rate of exchange. It held anchor-currency reserves equal to 110 percent of its monetary liabilities. Most important, the board could not loan money to the fiscal authorities, imposing a hard budget on Ceylon’s fiscal system. The net effect was economic stability — and while stability might not be everything, everything is nothing without stability. That’s why today, the reinstatement of Sri Lanka’s currency board is just what the doctor ordered.