by Analyst
It is necessary to first diagnose the causes of the current economic crisis before one could formulate a solution to it. What is the malaise in the economy? Is it not the macro-economic imbalances in the economy, the imbalance between aggregate demand and aggregate supply? Aggregate demands greatly exceeds aggregate supply or GDP. In fact aggregate demand has been outstripping aggregate supply for many years.

We have not achieved economic growth rates of more than 4-5% per annum for most of the period since 1977. The rate of growth earlier was in the range of 2-3%. But aggregate demand in money terms expanded each year by as much as 15%. Equilibrium in the markets was achieved by massive imports or if the flow of imports was discouraged or curbed by direct controls, high tariffs etc.

The domestic price level increased considerably with a rate of inflation exceeding 10%. It is largely the government through its massive budget deficits that created the extra aggregate demand. Fortunately all this increase in aggregate demand has not been spent. A good part of it has been saved or rather hoarded. To an economist whatever is not consumed is saved. Savings are an important variable in the process of economic growth. It is savings that are invested by entrepreneurs.

The banks play an important role in mobilizing the funds of the people who save and lend them to borrowers who wish to invest. It is investment that drives economic growth. But if the savings are kept under mattresses without being deposited in the banks, they will not be available to the banks for lending to others for investment. But why do people who save keep their money under mattresses and away from the banking system? It is because they have not declared to the tax authorities the income from which they have accumulated the savings. This is black money. If they invest such money they risk being detected by the tax authorities. So they prefer to bust up their savings in consumption.

The black money owners prefer to spend on luxury motor vehicles, on consumer durables, on consumption in five star hotels. They also prefer to travel abroad to Singapore and Bangkok where they live it up and bring back all sorts of goodies without paying any duty courtesy of the customs officers. Such expenditure of course is socially wasteful. The current account of the Balance of Payments goes into deficit and Foreign Reserves may decline. To the extent they spend such black money on domestic goods, they drive up the prices of such goods, causing inflation.

Continuous and ever-increasing budget deficits have therefore brought about the collapse of economic growth under the PA government as predicted by macro-economic theory. It was the same in Argentina where the fiscal profligacy of the ruling politicians under a fixed exchange rate regime finally brought on disaster.

What Macro-economic policies

Macro-economic policies are policies towards the broad aggregates in the economy, the level of public expenditure, the level of taxation, the level of monetary expansion and the policy towards the exchange rate. The World Bank /IMF makes their diagnosis of the economic crisis in accordance with current macro-economic theory. They diagnose the crisis as an imbalance in the aggregate demand and supply, which gets reflected in an imbalance in the current account of the Balance of Payments and in the government budget. So they recommend an appropriate policy package, which could contain both expenditure switching (from imported goods to domestic goods) and expenditure reduction and deflationary policies.

Expenditure switching policies like devaluation take time to bring about the desired results. In any case expenditure-switching policies alone cannot eliminate the deficit in the Balance of Payments, because more resources are being consumed than produced (the initial disequilibria). So what is needed is deflation to reduce consumption in line with domestic production and higher prices for imports to make people switch from imported to domestic goods.

Aggregate demand reducing policies therefore include cuts in government expenditure, increases in taxation, reductions in real wages and monetary and credit restraint. These are the unpleasant choices before the new government whatever the Hundred Day program. These policies cut into real incomes of the people by reducing employment and real wages (which have hitherto been artificially maintained at the expense of growth) of those employed and raising the prices of consumption goods as indirect taxes are raised and prices liberalized.

Electricity prices will have to be raised to cover the costs of generation. Fuel prices will also have to go up to wipe out the accumulated losses of the Petroleum Corporation. If these prices had been raised earlier instead of accumulating losses the disequilibria would not be as bad. Subsidies to loss making state corporations are a colossal waste. They provide employment for supporters of the politicians at an enormous cost. Current transfers to public corporations, other state institutions and various subsidies like Samurdhi absorb nearly 5% of GDP.

Annual losses sustained by state corporations exceed several billions a year. According to the prime minister’s statement the CEB is losing 6.2 billion a month, the Petroleum Corporation has an accumulated debt of 230 billion. And the CWE 8 billion. Many more corporations are in the same predicament. Of course the accumulated losses over the years for the CEB are 156 billion. Compare this with the 2.3% of GDP, which the prime minister says is spent on education. Many of these subsidies are regressive and do not benefit the poor. The only exception perhaps is the subsidy for fertilisers.

Indirect taxes

The provision of public goods free on a universal basis is neither economically feasible nor socially desirable. It has meant that the large majority of the public in the rural areas who need such free services like free education do not get even the basic services. The rural schools are housed in decrepit buildings; they lack teachers and equipment while the urban middle classes get many superior facilities for free. If this can be justified, educationists must be suffering from myopia.

World Bank/IMF often recommend reductions of the marginal tax rates on income and corporate taxation. But indirect taxes bear more heavily on the poor and are therefore unjust. The argument is that high tax rates cannot be enforced because of widespread tax cheating by those who are liable to them. But taxes on income, property and financial assets are more progressive. The direct tax reduction policies of the PA Government reduced drastically the ratio of tax collections by about 3% of GDP, a totally unwarranted state of affairs given the massive budget deficits.

New specific taxes can be earmarked for social sector provision. For instance South Korea levies a small tax on interest and dividends to finance part of government spending on education. A similar tax on unused agricultural land may be useful. It is better to raise taxes at least to fund the basic services like primary health and primary education since the social gains from such services are high. It is not so with university education or curative medicine.

Reducing government expenditure on investment has been the easy resort taken by the PA government to confine the budget deficit. But reducing government capital expenditure has knock on effects on the private sector. There is the effect of the reverse multiplier on private sector investment. The PA of course privatized whatever state enterprises could be sold, in order to use the proceeds to fund the budget. The new government will have to do the same. But instead of funding the budget it should use the proceeds to retire public debt and thereby bring down the ever-increasing debt burden.

But the government must realize that privatizing highly technical enterprises like the CEB or the Railway requires skills and experience that the country doesn’t have. It is better to hire foreign consultants to do so. A Dutch economist, who remained in the background, not a mere academic, constantly guided Lee Kuan Yew. He was a man experienced in both theoretical and applied economics.

There is much that the government can do to raise revenue. It can privatize many state enterprises and trim losses of the others. It should trim the generous pension system. No country in the world gives 90% of the retiring salary as a pension to public servants and MPs. Samurdhi should be overhauled and confined to the genuinely poor not to be used for political patronage.

Deflationary policies and income distribution

In principle, demand restraint could be borne proportionally by all groups in society and then it would not worsen the income distribution. But the precise effects on income distribution will depend on which elements of expenditure are reduced — consumption or investment, public sector or private sector. A cutback in consumption will have to be selective since the poor’s propensity to consume is high. Policies that tend to reduce investment such as government capital expenditure or credit restraint policies or high interest rate policies affect economic growth adversely. But to the extent that they cut investment they allow consumption to be higher — the usual economic dilemma of sacrificing present consumption for a higher future income and consumption.

Our people and their politicians have not understood this trade-off, the traditional choice faced by Robinson Crusoe who had to go without food for the time he spent on making the fishing rod with which he would catch more fish than with his bare hands. The PA government’s choice of the present for the future has led to zero economic growth. Popular writers on economic subjects who don’t seem to grasp the complexity of the macro-economic issues oversimplify problems. But there are no simple solutions in economics. Any simple solution is bound to be a wrong solution.

Solutions to macro-economic imbalances are based on choices and these choices must be made consciously. The prime minister has certainly grasped them and sought to make them explicit to the public. One hopes his large retinue of ministers will understand them too.

Deflationary policies

Most of the negative effects of deflationary policies affect the urban sector rather than the rural sector. People in the rural sector are affected primarily by the prices fetched by their produce in relation to the rising cost of their agricultural inputs. The decision to import rice is fraught with danger. A buffer stock is necessary to be released when rice prices go too high. But can private importers be expected to perform this function without damaging the farmer’s economy?

The Food Ministry in the days of Alvapillai knew better. There are many links between the urban and rural sector activities through urban migration, markets for farm produce in urban areas and the flow of remittances from the urban sector to the rural sector by those employed in the urban sector who have come recently from the rural areas. The government must not try to do too much under the false belief that it is the government that develops the economy. It must get the macro-economic environment right before undertaking demand expansion. Those who want fiscal stimulus to regain growth must not mislead it. But there are essential reforms that do not need money like the reforms in the labour laws.

The Chamber of Commerce wants an international workshop to discuss national competitive advantage. But it is obvious that in a globalize environment, we cannot tie the business firms to providing job security. They must have the freedom to restructure their businesses without having to pay too much by way of compensation to retrenched employees. Then fiscal stability must be maintained with minimum inflation to remain competitive.

In fact the government must not try to be too ambitious and seek to spend money at any cost in the name of economic growth. Its useful to recapitulate that what Adam Smith said about economic growth is still valid. "Little else is required to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes and a tolerable administration of justice; all the rest being brought about by the natural course of things. All governments which thwart this natural course, which forces things into another channel or which endeavour to arrest the progress of society at a particular point, are unnatural and to support themselves are obliged to be oppressive and tyrannical." What is important is good governance. The new ministers have yet to show that they are good administrators.

Military expenditure

The prime minister is right to give priority to restoring peace. The statistics he cited on war expenditure are colossal. A total of Rs. 500 billion have been spent on the war for the past 19 years. Currently the government spends 80 billion a year on the war. The budget deficit however is 480 billion. This shows that ending the war is not enough to restore public finances to good health. Large cuts in public expenditure have to be made or taxes increased considerably. The government should wipe out the losses in the state corporations and even rationalize the social service expenditure. Welfare expenditure cannot be met from borrowing. They must be met from taxation.

It may be better to levy user fees for some social services like higher education and for the more advanced medical care while providing free the basic medical care and medical facilities for the poor, the mothers & children. The government faces hard choices in public spending on social services. The choices have hitherto been ignored. But it’s not possible to postpone them forever without perverse results. Demands for social services like free education and free health care are unlimited or infinite in the jargon of economists. But the financing capacity of the government is limited and rationing is inevitable.

But these services are not uniformly provided throughout the country. So the rationing process is biased against the poor, against the rural folk and in favour of the middle classes and the urban folk as the famous JVP phrase about "Colombata kiri, gamata kekiri" shows. This is unfair and the position must be changed. The so-called national schools should have reduced funds from the government and allowed to raise funds from the public. In the case of expenditure on health, the health professionals should not be allowed to determine the allocation of the health budget. It is a matter for the representatives of the people, not for bureaucrats.

Military expenditure is of course unproductive expenditure and should be reduced. Targets should be set for reducing military expenditure if the peace talks go on course. The aim should be to reduce military expenditure to below 4% of GDP in the first instance.