Inflation: Banking on the Governor

“What a question, Son! If you really want to know what’s up, you must be one of the very few persons who are blissfully unaware. Inflation is up!”

“Oh, no! Not again! What’s happening, Dad? Why are prices continuing to go up?”

“If you want my opinion, Son, it’s because nobody is doing anything to bring it down.”

“Who can do anything about inflation, Dad? Isn’t it one of those things that people just talk about when they run out of things to discuss – like the weather?”

“That’s what seems to be happening nowadays. It’s the appalling silence of the good people that is letting things drift – and I’m not referring only to the economy. In fact, people in positions of authority are doing things that could intensify the inflation problem.”

“Like what, Dad?”

“Take the case of corporate dividends, Son. Companies need money to fund their expansion plans. Much of this money comes from internal accruals, also called profits or retained earnings.”

“When the government mandates that a certain amount of profits must necessarily be paid to shareholders, it goes against conventional wisdom. It restricts the company’s access to internal accruals.”

“But, if internal accruals are not enough, can’t the companies borrow from banks instead, Dad?”

“Yes they can, Son – and will. But that would result in an increase in money supply, which results in higher inflation.”

“Hmmm… I see, Dad.”

“Another point: Typically, in almost all economies, interest rates are higher than inflation. However, with inflation in Sri Lanka at almost 20%, there is no savings instrument that will yield as much. This is a disincentive to saving because it is better to spend today than save for tomorrow. Given the choice, people are spending on goods today, while they are still within their grasp.”

“But, that is not sustainable, Dad. What about the future?”

“This will continue as long as inflation is higher than what a citizen can earn on his investment, Son. Why do you think there is so much conspicuous consumption and such a low propensity to save, in our country?”

“So, very little money is going into financial institutions and banks, which have to play a role in channeling savings into productive investments. Is that the case, Dad?”

”Yes it is, Son. And, as a consequence, there is less capital formation in our country than there should be. Productive organisations do not have access to adequate investible funds. They have to borrow to fund their growth.”

“But that would increase the money supply and inflation, Dad.”

“My point exactly, Son. Our economy is in a state of disequilibrium. A vicious circle, if you will. And I’m concerned...”

“Can’t we break out of the circle, Dad?”

“Yes, we can – and must, Son. But first, let me tell you what happened to the world’s only superpower. It’s a story of how disequilibrium cannot sustain.”

“Do tell, Dad…”

“Instead of going for long-term macro economic solutions, they kept raising interest rates to make the dollar attractive to investors – and managed to prop up the dollar. But, by doing so, the Federal Reserve painted itself into a corner. They cannot afford to raise rates any longer because the cost of servicing the debt would be too high. Therefore, the dollar has become unattractive and a fall is imminent in the medium term.”

“Come back to inflation in Sri Lanka, Dad…”

“The banking system needs to pull up its proverbial socks and curb monetary expansion, Son. They should focus on quality of lending rather than quantity. Unless this unbridled extension of credit is reversed, inflation will continue to gallop along.”

“But how can this be done, Dad?”

“This is ideally something that our central bank governor should be addressing, Son. If I was him, one thing I would do is raise interest rates significantly. That would make savings attractive and borrowings unattractive, and would mop up some of the excess liquidity that is sloshing around. I’m sure that he has many more solutions.”

“Maybe it’s the government that is operating on a deficit, Dad.”

“You may be right, Son. It is probable that additional government spending is causing inflation to rise. But that is also because the central bank is printing enough money to accommodate that government spending. The bank should be forcing consumers and businesses – and even the government - to cut back.”

“Hmmm… Looks like the inflation buck stops there, Dad.”

(This is the last episode of a series in recent weeks of fictional conversations between father and son, addressing topics of economic and general interest.)