Foundation research

How Sri Lanka’s Attempt at Modern Monetary Theory Went Horribly Off Course

Developments over the past few months in the small island nation of Sri Lanka have captured the attention and concern of many around the world. The images have gone viral on social media protesters storm the president’s house and occupy the streets of the capital Colombo, prompting the country’s government to declare a state of emergency.

The upheaval in Sri Lanka is largely the product of an economic crisis that has led to a chronic shortage of essentials such as food, fuel and medicine, leaving a rate of inflation in its wake. more than 70 percent. The fingers of mainstream economists have pointed to a variety of explanations for the numbers, from a declining tourism industry to the country’s ban on chemical fertilizers to the Russia-Ukraine conflict.

While these factors undoubtedly contributed to the economic crisis, there remains a key element almost conveniently overlooked by many economists: the monetization of Sri Lanka’s debt, an economic policy strongly favored by proponents of modern monetary theory ( MMT).

MMT argues that the federal government can spend as much money as needed to achieve full employment without being constrained by tax revenue or debt issuance. Instead, the government can finance these expenditures by borrowing money from the central bank, essentially printing new money in the process known as debt monetization.

MMT proponents argue that as long as the economy is below full employment, this debt monetization tactic not trigger inflation. Sri Lanka, however, serves to refute this rather hollow belief. Although its economic crisis is defined by a critical shortage of basic needs, such a disaster can be traced to years of inflation under MMT-guided policies.

In particular, the adoption of MMT in Sri Lanka triggered runaway inflation which, in turn, triggered a currency crisis that prevented the developing economy from importing its basic necessities. It is important, however, to see this process unfold over time.

Sri Lanka and the MMT attempt

On the eve of December 2019, Sri Lankan President Gotabaya Rajapaksa introduced an unprecedented series of tax cuts that have 33.5% decrease among registered taxpayers, not only dramatically reducing government revenue, but downgrade the country’s credit rating in its ability to repay outstanding debt.

As a result, the central bank under Governor WD Lakshman embarked on a campaign to increase the proportion of domestic debt through the central bank assuming a large portion of the debt financing, arguing that, “domestic currency debt…in a country with sovereign powers of money printing, as modern monetary theorists would say, is not a huge problem.” Economist Mihir Sharma writes for Bloomberg identifies that with this statement, “Sri Lanka is the first country in the world to officially refer to MMT as a justification for printing money”.

With MMT as official policy, Sharma sees a 42% increase in Sri Lanka’s money supply between December 2019 and August 2021. This mirrors the findings of Professor Sirimevan Colombage of the Open University of Sri Lanka, who observed a 156 percent increase in bond currency derivatives (the Sri Lankan equivalent of Treasury securities) purchased by the central bank in 2021 alone, the equivalent of $6.5 billion.

Contrary to the predictions of MMT proponents, however, strong money supply growth has led to a high rate of inflation. While 2019 saw a rate of 3.5%, inflation immediately jumped 5.7% in January 2020 then an unprecedented 17.5% in February 2022.

It is important to remember that this rise in inflation was not in itself the defining problem of Sri Lanka’s economic crisis, but rather a catalyst for it. Nevertheless, the five-fold increase in inflation over a period of about three years has resulted in a skyrocketing cost of living while economic growth stagnated the erosion of price signals.

Inflation and the monetary crisis

MMT and its inflation corollary still paint a much worse scenario for developing countries that depend on imports for much of their economic activity, such as Sri Lanka. The small island nation, as many others developing economies, runs a considerable trade balance deficit, highly dependent on importing everything from food and medicine to oil and machinery.

This is important because most countries finance their imports with a global reserve currency such as the US dollar, which means that to maintain imports, Sri Lanka must first exchange its own currency, the rupee, for other currencies such as the dollar. Yet, as the rupee has experienced severe inflation during the years of MMT policy, it is regularly depreciated against the dollar before collapsing in March.

Since December 2019, the cost of one US dollar, in terms of Sri Lankan rupees, has almost doubled. And since imports into Sri Lanka have to be financed with a global reserve currency like the dollar, that means imports have practically become almost twice as expensive. Meanwhile, the collapse of the rupee has made it much more expensive to buy or borrow dollars on the foreign exchange market, while the country’s trade deficit means Sri Lanka cannot generate enough funds through to exports.

The result is a disastrous situation of economic and social collapse in the nation. The drivers had to queue For days for rationed gas. Furniture of life-saving drugs have become incredibly scarce and, for some drugs, completely exhausted. At the same time, chronic shortages left millions in a situation of food insecurity.

A lesson to remember

Although a grim story that will continue to plague the country for months to come, the economic crisis in Sri Lanka should serve as a lesson to all other countries considering the lure of Modern Monetary Theory. . Not only does the monetization of debt and seemingly unlimited spending lead to drastic inflation, but also potential economic collapse when a country can no longer afford to import the goods it depends on.

Rather, it goes back to the old adage that if something seems too good to be true, it probably is. MMT, with its promise of achieving full employment by simply printing money, proved to be a complete failure when first applied in Sri Lanka. Whether other countries can understand this in light of the seductive appeal of the ideology remains to be seen.