Inflation has gone up in December to 6%. Consumers have to brace themselves for higher food prices and higher inflation in the months ahead. The CB expects inflation to fall after April, an unlikely outcome. The main culprit for dearer goods is the cheap money sloshing around the economy due to excess liquidity not to mention the large amount of black money. This together with a rise in global commodity prices will lead to higher inflation.

Higher prices will eat into disposable incomes of the poorer segments of the population; the cost of living in urban areas will go up. The Governor has said an increase in the statutory Reserve ratio cannot be ruled out. But this will only reduce credit to the private sector where the credit aggregate has hardly increased from last year. The government is to blame and no amount of increases in interest rates or SRR will make the government reduce its spending.

The budget deficit will increase and so will money printing.  Have our political leaders been financially reckless? Contrary to conventional thinking our political leaders do respond to what we want. It is not a "We vs. They" problem. If we want tax reductions, a popularly elected government will respond. If we want more funding for education and for higher education, they respond. If we want more money for free health care, they respond. We cannot blame the governments for the enormous budget deficits.

The only political leader who did not respond to these demands was Ranil Wickremesinghe and he paid the price for financial prudence in a populist democracy. Things have to become much worse before they can get better as it happened in Latin America where only after they experienced runaway inflation that the people realized  the costs of populism.

President Rajapaksa has pledged that in his second term he will concentrate on economic development. In his first term he engaged in a vast infrastructure investment program. He may succeed in achieving higher growth rates but like in the past term it will be high growth will higher inflation. There are some economists who argue that if there is growth inflation doesn’t matter. But try telling that to the poor who suffer most from high inflation. In any case inflationary growth according to orthodox economics is not sustainable. It will lead to the inevitable current account deficit in the balance of payments increasing and it will mean more foreign borrowing to fund it through issue of government bonds at higher and higher rates of interest depending on the Sovereign rating which is even now below investment grade. More short term borrowing through marketable securities will mean greater vulnerability to sudden flights of capital which brings on a currency crisis.

Infrastructure investment is a necessary but not a sufficient condition for economic growth. Economic growth is a multi-faceted process and as Amartya Sen has pointed out it includes the establishment of sound institutions for governance and the establishment of the Rule of Law. On both these fronts we have faltered. The 1972 Republican Constitution destroyed the environment for independent thinking and free expression of opinion by the bureaucracy.

A modern economy cannot be run efficiently or for that matter can only muddle through with economic and political crises unless competent persons are appointed to hold positions of authority in the public service. Democracy in its popular version enunciated by Abraham Lincoln as government of the people, by the people, for the people doesn’t provide good or efficient governance. The people are not superior in wisdom or knowledge. If they are wise they will elect capable and honest leaders. But they are more likely to elect persons who are like them and with whom they are in rapport. They are often swayed by emotions and passions which are easily roused by the mob orators.

What is attractive in democracy is not the election of the people, by the people, for the people formula but rather the fundamental freedoms and the Rule of Law which prevails in a democracy and not in a police state where there is an autocracy. The mob oratory phenomenon which leads people to make wrong choices of persons and policies has been so since the birth of democracy in ancient Athens where mob orators who stirred up the people had to be ostracized.

So how does one get good governance? The solution was to build an efficient bureaucracy which will be in place despite changes in the rulers. It was first introduced in China but was developed in the Roman Empire. Its success in the Roman Army was noticeable and the principles of good public administration such as the need for unity of command, hierarchical arrangement of staff subject to the principle of span off control were all first adopted in the army. Later these same principles of sound organization were adopted in public administration.

The British were perhaps the best administrators in history which explains how a small country could run a huge scattered empire which included vast territories many times its own size. Wherever they ruled they introduced the sound administrative practices they were used to. In our pre-colonial culture we had a system of rule by the nilames and dissavas who were hereditary inheritors of power with no claim to administrative competence. They operated in an environment of an autocratic king. The system prevailed until 1815 when the Kandyan nobles outraged by the king’s cruelty conspired to hand over power to the British. Last week we celebrated another anniversary of Independence. But self government does not necessarily produce good governance.

Since Independence we achieved low growth of an average 3% until 1977. In that year President J.R. Jayewardene opened the economy in the manner that Deng Tsiao Peng was to do two years later in China. India followed in the 1990s. This rethinking was spurred partly by mainstream thinking about development policy but mainly by the example of the superior performance of many East Asian countries.

The main lesson economists learned from this comparison was that the economic system needed to be redesigned. The previous system was characterized by extensive government controls over private sector activity in the form of investment licensing and price controls, high levels of tariff protection combined with quantitative restrictions on imports, restrictive controls on foreign investment, and so on. This system came to be regarded as dysfunctional and in need of change.

There was an immediate increase in the growth rates to 6 and 7% following the change.  But it petered out after a few years. Some blame the 1983 anti-Tamil riots. The political instability discouraged several multi-nationals like Motorola from setting up business here. They went to Malaysia instead.  Nor were the reforms made to last. President Jayewardene was afraid of the trade unions to privatize the State owned enterprises which were consuming capital with no returns. President Premadasa however carried out privatizations which relieved the government budget of the need to find money to fund their ever recurring and increasing losses. The main lesson was that these state corporations cannot make profits unless they were given the freedom to operate without political interference.

China has shown how to reform them without privatization by listing them on the domestic stock exchanges and making them submit to market discipline. But we have continued to run these enterprises at losses.  Enormous amounts of capital are wasted in the process in running such enterprises. We have still not been able to break up the CEB, a necessary reform to obtain cheap funding for investment in electricity generation.

Although the control system was not altered since 1977, piecemeal controls have re-emerged in the forms of high tariffs and various levies called cesses, VAT, Nation Building Tax etc.  Such controls have re-appeared under the present regime. The enthusiasm for the market economy has not been part of the economic policy of the present regime. Many economists feel that deeper and more systematic reforms are needed. The process of liberalization has not proceeded. So the private sector continues to be hamstrung.

Recently the Japanese ambassador pointed out the areas where Japanese investors would like to see reforms. The government should pay attention to them. The governor of the central bank has been perhaps a lone voice for liberalization. He was to introduce some partial convertibility for the capital account of the balance of payments but has had to put it off owing to some criticism from the Opposition imputing motives.