The Central Bank presented the Annual Report on the Economy for 2007 to the President recently. It seeks to explain the health of the economy. President Mahinda Rajapaksa who listened to the presentation by Dr Weerasinghe, the bank’s Director of Economic Research, on the creditable performance of the economy asked the pertinent question - why when the economy has done well, private economists are so critical and predicting imminent collapse of the economy?

My friend, a former President of the Institute of Chartered Accountants, says the Report is all spin. We are often prone to let the language do the thinking for us. The economic data referred to in the Report made the President say that we must get out of the old mindset that we are poor. He said we are a middle income country as our per capita income is over US$ 1,600. Unemployment has come down last year to 6%, the lowest ever and growth for the third successive year has been around 7% (6.8%). Is it a question of seeing the glass as half empty instead of half full?

When we make statements about the economy we are also making value judgments. Economic data is not entirely value free and although the numbers are said to reflect the objective world and people assume them to be true. Whether these value judgments are right or wrong only time will tell. They depend for their validity not only on the correct understanding of the data but also on the under-lying beliefs about economic growth.

I wouldn’t view my task as an economist to be judging good or bad or persuading the reader one way or the other; but rather to analyze and explain the performance so that the reader can reach his own conclusions.

There is no way to judge the health of any economy without a set of principles of what that means. Those principles vary according to what each individual economist thinks is important. One may think inflation is important and another that the current account of the balance-of-payments is important. Does this prove spin? I think not. It reflects a difference in view about what conditions must obtain if the economy is to have healthy and sustainable growth.

It is not a difference due to an objective view by some and a subjective view by others. Some people will say the economy is doing well when they see the luxury vehicles on our roads, the high rise buildings and our affluent flaunting their wealth in hotels and night clubs. Others might look at the urban poor some of whom eat only one meal as I saw in some homes in Wanathamulla. Some will point to the stock market which although not booming is still not faring too badly. Some will point to the worsening income distribution with a larger share of the GDP going to the upper 25% and point out that the gains from growth should be evenly distributed, which it is not.

Some like me who believe that economic growth is largely dependent on the supply side and on modernization of political, social and economic institutions will point to the collapse of the Rule of Law, the poor quality university education, and the adverse environment for risk taking and entrepreneurial activity due to high inflation and the consequent high interest rates. They will say that there must be incentives for people to work, to save and to invest and for business to produce and take risks with reasonable certainty about taxes, regulation and government policy. These are lacking today.

Nor do I believe that the government can create wealth except at an enormous cost which has to be borne by the taxpayers, disproportionate to the benefits they will gain. I would say that budget discipline is important and that public expenditure should not be funded by borrowing from the Central Bank and the banking system. But the President, Dr Jayasundera and the Central Bank will think otherwise. I would say growth should be with equilibrium, both internal and external. This means growth should be with low inflation relative to the rate in our export markets and competitor countries. But some others will say growth at any cost is worthwhile.

I might say control of inflation and reduction of the deficit in the current account of the balance-of-payments should have priority over growth and point out that there is a trade-off between inflation and growth when the potential output of the economy is exceeded. The government would say unemployment has come down to 6% but I would point out that employment should be productive and that public sector recruitment is not driven by economic but rather political factors and is only heaping burdens on the people who are all taxpayers, since the new recruits cannot add value and are paid for no work. They are in effect enjoying a dole.

I might consider expenditure on the war as wasteful but the President thinks the war on terrorists must have priority and has promised to make all funds available for the war effort. I would then say, cut down government expenditure elsewhere, even reduce the public investment program in the Ten Year Plan But the President thinks both public investment as well as the war expenditure must go on without any cuts.

I would say it is not possible to do so without causing high inflation and high interest and consequent hardship to the people and to business. Of course if the government borrows from the banking system or from foreigners, instead of from the public, then interest rates will not go up but inflation will go higher and the deficit in the current account of the balance-of-payments would increase. The Central Bank would say there is a surplus in the over-all balance of payments and that the Gross Foreign Reserves have gone up enabling funding of 3.4 months of imports.

I will say that this includes the $ 500 million borrowed from international capital market and point out that there are also loan repayments falling due shortly and that unless there is continued foreign borrowing we may not be able to repay foreign debt. The Central Bank would say it is possible to roll-over the private foreign debt falling due for repayment. I would say the sustainability of the Current Account deficit will depend on our Current Receipts (not capital inflows to the GDP ratio) which should fall over time. I would say the Net Foreign Assets to Currency ratio is important and that it should not be allowed to fall below a critical level.

GDP per capita may be viewed as a rough indicator of a nation's prosperity, while GDP per employed person can provide a general picture of a country's productivity.

These indicators are only approximations. National prosperity consists of many things that are not included in its GDP and some items included may not contribute to a country's well-being as in the case of the large expenditure on the war.

Nevertheless, GDP, GDP per capita, and GDP per employed person, are

commonly used to compare the economic performance.

The Central Bank Report contains the nominal GDP per capita which it converts to the US dollar and says that it has gone up to $1,617 from a previous years $ 1,421 - an increase of 14%.The President seemed to have been misled by this figure to proclaim that we are no longer poor but middle income.

But this calculation is fraught with serious flaws. It must be converted not into the prevailing foreign currency rate but at a conversion rate that allows for different rates of inflation. What is valid is to convert at a purchasing power parity (PPP) rate of exchange.

A PPP for a given country is a ratio, in which the numerator is the number of national currency units needed to purchase a basket of goods and services in that country and the denominator is the number of currency units needed to

purchase a similar basket of goods and services in the base country - say the USA. The market exchange rates seldom reflect the relative purchasing powers of different currencies.

Market exchange rates are also affected by influences entirely unrelated to the

relative values of any goods or services. These influences include currency traders’ views of the stability of governments in various countries, relative interest rates among countries and other incentives for holding financial assets in one currency rather than another. So this measure of per capita income in dollars is misleading.

I did some calculation of the real GDP per capita using the GDP deflator and came up with the figures for 2006 and 2007 as Rs 65,971 and Rs 69,774, showing an increase of only 5.7%. Since war expenditure per head is not contributing to welfare another Rs 5,850 must be deducted to allow for it.