A few days ago Ajay Shah, whom I refer to a lot on this blog had yet another excellent piece on inflation. I asked him on his blog, what he thought of the Sri Lankan situation with inflation and repeated claims by the Central Bank of Sri Lanka they are not responsible for it. Inflation hovers around 25% according to a newer CPI(N) index which among other things, excludes alcohol due to moral reasons. The old Index, which is no longer published, should be well above 30%, which is the highest inflation I have lived through. Anyways, here's what Ajay had to say replying to my questionon his blog, which I'm reproducing here in full :

Deane, I don't know a lot about Sri Lanka. I can see a few problems, though.

From 1/1/02 onwards, LKR depreciation has averaged 2.2% per year. This doesn't sound very good, at a time when inflation has been high. Could this be setting the stage for trouble in the form of a speculative attack and a large depreciation?

When inflation is at 25%, why should citizens hold currency notes or nominal bank deposits? What is the trigger at which dollarisation (or rupeeisation) takes off? When that happens, LKR money supply to GDP will drop, the revenue potential of the inflation tax will go down, and the government will then have to set about building a better fiscal system. But along the way, on this route, things could get very painful.

Either in such a crisis, or ideally before it, the government would have to evaluate a monetary policy reform. This involves rewriting the core legislation governing the central bank, and getting it going afresh. One possibility is to run a currency board - though a currency board to the Indian rupee might make more sense to the extent that Indian GDP probably has a higher correlation with Sri Lankan GDP when compared with the correlation against US GDP.

Are intellectuals in Sri Lanka thinking about these things? They should be. It's better to think through these things ahead of time. Crises are good times to do economic reform - provided fully articulated and well thought out reforms proposals are at hand and can be pressed into service. Else, crises can lead to all sorts of wonky ideas getting used.

I'm totally unsympathetic when central bankers make excuses about inflation not being in their control. Look around the world: There are a lot of countries, all of which are facing the same shocks, but inflation hasn't crossed 5% in lots of them.

There are two kinds of blunders taking place. One class of blunders is the intellectual one - of people who haven't properly figured out monetary economics being placed in roles of running central banks. The other kind of blunder is that of institutional design - of a central bank that is not properly structured to focus on the task of inflation. [link | comments section. we have seen this movie before, Ajay Shah June 7, 2008]

A few notes,

1. The question of why there wouldn't be market-led dollarization in high inflation is something I've thought about earlier. See my comments and LBO's fussbudget's thoughts here. What Ajay is saying is something a like people holding less of Sri Lankan Rupees and more of some other stuff, like foreign currencies. In Zimbabwe, where there's hyperinflation, there's a parallel black market trading in US dollars and other foreign currencies which is keeping the economy there still alive.
   
   
2. Most Sri Lankan economists I've met have long being advocates of Central Bank independence. Some have articulated the need for institutional reform by way of going for a currency board or inflation targeting (discussed towards the end in this post). Most economists seems to be publicly mum on the issue possibly because they don't want to spoil the relationship they have with the Central Bank. I'm just speculating here, but this can be a real possibility given there aren't a lot of think tanks with economists in their payroll in Sri Lanka. I will discuss more CB reform later, although I have said many times it would be impossible to make do without firing Cabraal as governor of the Central Bank.
   
   
3. As we all know the Central Bank of Sri Lanka thinks inflation is a petroleum phenomenon, unfortunately however, they don't articulate this theory very well, they should at least have produced a paper on this by now. Further, CBSL and it's governor have dismissed comparisons with other regional inflation rates as being incomplete because of the different ways they are being measured. While that is certainly true, you cannot possibly account for 20% point difference between Sri Lanka's inflation and say, Singapore's or India's for that matter.
   
   
4. Although there are some NeoKeynesians who still believe in cost-push inflation (Joe Sitglitz for example), not even Stiglitz will not come to the CB's rescue as the Central Bank has managed to sustain high inflation for a longer period of time, whereas Sitglitz beef with Milton's monetarism has to do with inflation at low levels. Bottom line is I know of no credible economist (if stiglitz qualifies as being credible), who's willing to argue that high levels of inflation for a longer period of time is possible without high money supply growth.
   
   
5. Thankfully the central bankers in Sri Lanka seems to be realizing this, although we haven't seen the effects of this recent (reported) monetary tightening reflected in the index just yet. Meanwhile, governor Cabraal keeps on harping that "core inflation" isn't all that high, although that too is about 9.6%.
   
   
6. My revised thoughts on the best institutional reform for Central Banks coming up soon.