ECONOMYNEXT – In a bid to fix interbank rates to within a few basis points, which leads to excess liquidity, external instability and brings a second sovereign default closer, Sri Lanka’s central bank has claimed that the Bank of England had a ‘single policy rate’ since its inception.
“The Bank Rate of the Bank of England, one of the oldest policy rates in the world, has remained a single policy interest rate since its inception in 1694,” the central bank says in its Market Operations report of December 2024.
Oh My Gosh
That statement is so wrong on so many counts over so many centuries, that this columnist does not know even where to begin.
There was no such thing as a policy rate anywhere before open market operations were invented by the Fed in 1923, leading to a peacetime credit bubble and Great Depression and permanent inflation and accompanying political unrest in the ensuing years as the Treasury ran budget surpluses.
The Bank of England was prohibited by its own convertibility undertaking to gold coin at its inception from having a policy rate, single or otherwise.
It was legally barred from 1844 by the Bank Charter Act from defending a pattern of interest rates and creating balance of payments deficits or runs on its own reserves.
The policy rate as we know it now was the brainchild of John Law, an idea which was defeated in England and his own Scotland which had an exceptionally well-run free banking system.
Scotland was exempted from the Bank Charter Act which applied to England and Wales, which then prohibited any kind of single policy rate whatsoever as the note issue was strictly restricted.
It was implemented in France, which went in to meltdown like Sri Lanka.
Fast forward to the 1980s.
When the Thatcher administration, backed by Alan Walters and Peter Middleton took inflation by its short hairs.
They also made the Bank of England run an undisclosed band, called the Band 1 Dealing Rate, which far, far from a ‘single policy rate’ as claimed by Sri Lanka’s central bank.
The rate began to be called ‘bank rate’ only recently.
Depoliticize Rates
The wide margin allowed the interbank markets to work and ‘depoliticize’ interest rates according to its architects in the Thatcher administration.
In fact, there were four bands. It was done by purchasing short expiring securities, private securities also, so that the money automatically expired. There were four bands to accommodate more securities, Band 1, Band 2, Band 3 and Band 4.
On August 20, 1981 the minimum lending rate (MLR) of the Great Inflation years ended.
It was the wide margin that is what made it possible to end Great inflation and Stagflation put the UK on the path to stability and growth, even though the overall operating framework was not so great as the anchor was inferior to the gold standard and they were struggling to find a better one.
Lets take 1694
Rewind to 1694. In 1694, the Bank of England was so tiny, that it had no ability influence interest rates in the UK and it had no political ideology of its own to either boost growth, employment or inflation, like central banks do now. It was not really central bank at all.
Its only idea was to make some profits by financing the government and financing private borrowers in the bill discount market.
It was so small, that it was nothing in the overall scheme of things in the UK at the time. The country ran on gold coins of the royal mint and bank notes of London, country and Scottish banks which were under convertibility undertakings to gold.
Sri Lanka’s central bank has set itself two political goals, potential output and a 5 percent inflation tax on an innocent and helpless citizenry’s salaries and savings, while the nation’s parliament sat like a plum pudding and allowed it to do so.
Without political objectives it the Bank of England did not need a policy rate, single or otherwise. However it had one problem, that was the usury rate, which put a ceiling.
If we take published rate, from another central bank like the Fed system, the UK policy rate looks like this.
It looks as if the rate was flat over a long period. In fact, this is because of the UK had a usury rate.
Bank of England researchers who went through the ledgers found that the actual rates and which loans were given – basically trade bills of merchants were discounted – were vastly different.
And market rates, including very long rates of market instruments including government perpetuals and East India Company bonds were lower or higher. Higher when there was a crisis.
No Political Transmission Mechanism
There was no political ‘transmission mechanism’ set by the parallel cabinet of the monetary policy committee to achieve their own ends which was directly opposite to the interest of the public who wanted no inflation.
The bank also had Consols in its books as anyone who read Lombard Street will see.
After Usury Laws were lifted and the Bank Charter Act came in, Bank of England researchers found, the bills were discounted above the published rate.
After the Bank Charter Act in particular, the BoE’s influence in the city became stronger as new competitors could not come.
This was not a floor rate that was enforced for political purposes of the Court of Directors of the Bank of England like now, but a rate at which officials of the Banking Department of Bank of England refused to lend. Under the law the issue and banking department was separated.
So, it was rate like the modern currency boards have, Fed plus 50 basis points plus formula.
Some customers seem to have got special treatment during crisis as the published bank rate was lifted.
A further complication is that the Bank of England took deposits from the inception.
Now it is silly to imagine that it got deposits and discounted bills at the same rate. There had to be as two-way rate to get make profits. Which it did. David Ricardo said that every farthing should go to the Exchequer due to the Charter.
In fact, in a trick to extend its 11 year first charter, the Bank of England gave interest free loans to the English government, and lowered the rate of its original rate sharply.
There is no point in going through every decade to show what happened. Suffice to say the Bank of England suspended the gold standard in 1914 on the eve of World War 1.
Permanent Inflation
The reason inflation is created is basically due to the lack of knowledge about inflation and banks of issue that comes from time to time to parliaments and the executive also.
Mercantilists and what we call macro-economists have emerged from time to time, but they were always defeated by legislators (who were lawyers for the most part) and classicals who got themselves elected.
One of the peculiar facts about classical economists were that they were very well versed in law. That is why they did not allow central banks to play politics with policy rates and set them on a zero inflation rule.
The mistaken ideas about central banking or the operation of a ‘bank of issue’ that now exist spred from the US. The Fed also was set up on a limited Charter.
The Fed invented open market operations and created the Great Depression as Andrew Mellon, Treasury Secretary, ran budget surpluses. He was de facto chair of the Federal Reserve but he could not do anything about it.
After the US economy collapsed from open market operations, Mellon refused to do stimulus and he was sacked and threatened with impeachment. The congressional inquiry failed to hold central bankers accountable, unlike in the 19th century.
That is how macro-economists won the game and misled the Congress and permanent inflation was upon the people. Before that, classical economists, who got themselves elected to parliament, always held central banks account.
The debate in the House of Commons during the Gold Standard Act of 1925, showed little of the personal conviction with parliamentary commission reports and monographs were written by 19th century legislators cum classical economists.
Legislators were already differing to the academic inflationists by 1925. And Section 1 (2) of that Act contained a fatal flaw. A member of the public with a small amount of notes could no longer demand gold coins from the Bank of England to control BoE and drive up the discount rate.
Most of the bad ideas in subsequent come from Cambridge (Keynes) and US Universities like Harvard (Hansen). The attempt to rebuild the system through the Bretton Woods was flawed as its architects, from Cambridge and Harvard wanted to keep the policy rate.
All this came to a head in the 1970s as oil and food prices soared and the concept of ‘core inflation’ was invented.
The statistical craze combined with post-Keynesianism was taken to new heights by academics of MIT, an engineering college.
The inflationism does not come from politicians. It comes from the peculiar ideology held by macroeconomists and ecometricians that spread in the last century. It matters little whether they are in the central bank, Treasury or is the Finance Minister.
The essential ingredients are to brush aside classical economics, believe that there was salvation in positive inflation and that that it should be two percent or higher.
Then, every time the two percent target was missed due to targeting core inflation, believing that some mysterious part of the inflation was not ‘demand driven’ which the central bank could not control, all hell broke loose.
Tackling the Great Inflation
All this inflation and rise of macro-economists in controlling the people, started in the 1930s, briefly halted after World War II till around 1959 and rapidly worsened in the 1960s.
The key ideology of the macroeconomists was there was a trade-off between inflation and employment followed by others including that the unions created inflation (wage-spiral inflation).
Concepts like ‘real’ interest rates and inflation indices came into being as inflation became positive over long period. In the classical period of the industrial revolution there was no need for inflation indices, because there was none. Any inflation from a credit bubble, reversed as convertibility kicked in.
All this came to a head in 1971, after the Bretton Woods collapsed, and Great Inflation was upon the world.
In the 1970s, during the Great Inflation when macro-economists drove everything haywire, there was indeed a policy rate called the minimum lending rate (MLR), at the Bank of England.
When Margarat Thatcher got elected, her advisors especially Alan Walters, and also Peter Middleton Deputy Secretary to the Treasury and Under Secretary N J Monck, negotiated with the Bank of England to stop printing money and end the minimum lending rate.
The MLR ended on August 20, 1981, along with reserve ratios.
In the letter reproduced above, written by Monck to Middleton shows, that a 12.5 percent, plus or minus 100 basis points was the plan for the first day.
Data at the Bank of England, shows that Under Secretary Monck was spot on.
The interest rate quoted as the Bank Rate on August 25, is 12.69 percent. Then it changes to 14.00 in September, to 15,00 percent and 15.13 percent in October, 15.06 percent, 14.63 percent and 14.56 percent, on the days that are reported.
The current bank rate operates in a different way.
The central bank’s Monetary Operations Report says many other peer central banks like “Pakistan and Bangladesh also use a single policy interest rate in the process of monetary policy communication.”
Words fail this columnist.
How does one respond to a statement like that? If that is the path down which Sri Lanka’s central bank wants to go, and want to benchmark against, then there is nothing more to be said.
Thailand is mentioned. Bank of Thailand for many years has had negative domestic assets, so there is no comparison. There is no time to dwell on Malaysia and India. Following RBI has got us into serious difficulties in the past. When the RBI did get it right by targeting a Wholesale Price Index, until 2011, Sri Lanka did not follow. Though there is a lot to say, now is the not the time.
Economic Fantasy
Monetary policy modernization promoted by IMF is nothing other than new and innovative ways to print money, under the very eyes of the legislature.
The single policy rate is a way to print large volumes of money, through an abundant reserve regime as was seen from October to December and enforce a non-market interest rate on the credit system, and trigger imports and external pressure.
That a monetary ‘cabinet’ knows the interest rate of an entire credit system and can ‘signal’ a rate is pure fantasy and omniscience bordering on religion.
If ‘signalling’ happens without printing money, then it is not so damaging. That can happen only if the floor policy is higher than the credit demand. If not, rates can fall by psychology and the belief that the central bank knows better than the market.
Any such fall, out of line with credit demand, however will lead to mis-allocation of credit and pain later, even if the ‘heavy lifting’ is not done through excess liquidity immediately. Messing around with the price system has bad consequences.
Rate reflects all kinds of risks and asset allocation requirements.
It is not the same as fixing exchange rates, which is an attribute of money.
Many academic papers on monetary policy (the proper word is perhaps inflationism) is absolute economic fiction.
And these papers are cited by subsequent writers without fact checking. Statements from central banks with exchange controls and high inflation taxes are absolute fantasy.
After a few years one cannot separate fiction from fact.
It is better to read Hardy boys.
Reading IMF’s staff papers on monetary policy (with some honorable exceptions) and technical advice on ‘monetary policy modernization’ is like reading Nancy Drew with mathemarical formulae.
Financial media is no better. The problem is that people in government who do things correctly, don’t explain.
Some of the documents quoted in this column in UK, were declassified, many years later.
The bottomline is this.
Sri Lanka has a central bank which has imposed exchange controls and import controls on the people to keep its operational framework going. That means the OF is flawed.
The OF is driving millions of people to countries that have money with basic attributes exchange rate stability ( a store of value and a means of deferred payment), including the Maldives.
People have a right to live in the country they are born. Sri Lanka does not have to be remittance earning country.
All the recent pyrotechnics about vehicles import control are not required if the central bank’s operating framework and discretion (flexible) is tightly controlled by law.
Sri Lanka can be an outward remitting country that imports labour within a decade, and all the mothers and daughters can start to come home, if the parliament is bold enough to tame the central bank and its deadly operating framework, which is progressively worsened by ‘monetary policy modernization’.
Sri Lanka defaulted once, and the central bank has done an exceptional good job up except from September to December 2024 when the operating framework plunged into an abundant reserve regime with government liquidity forecasts.
But unless Sri Lanka operates a scarce reserve framework with a wide corridor, with a ‘depoliticized’ rate, the second default will come. (Colombo/Feb13/2025)
