By H. N. Thenuwara –

The Crisis

The fourteenth-century painter Ambrogio Lorenzetti has painted magnificent frescoes entitled Consequences of Good and Bad Government on the walls of the historic city council chamber in Siena, Italy. Those frescoes show that when bad policy decisions are made death and destruction are everywhere in the city. When the government makes good policy decisions, peace, justice, wisdom and harmony triumph. With good policy judgments, citizens engage in all forms of productive labour, and abundance prevails.

In the twenty second year of the twenty-first century, Sri Lanka faced a textbook case of economic and political crisis as a result of a series of incompatible and unsound public policies, and unchecked anti-competitive practices and corruption. Shortages in essential food, medicine, energy, and other industrial inputs are everywhere, while social disharmony prevails.

In early April 2022, Sri Lanka’s Central Bank disclosed quite abruptly that it had run out of foreign reserves. The Central Bank did not warn the general public that it was going to run out of reserves, nor did it have any plans to avert the adverse outcomes. The result was the inability to import and supply essential consumption goods such as fuel and medicine, and honour foreign debt obligations. Sri Lanka defaulted on foreign debt and faced the consequence of being downgraded to the default grade (junk) by the international rating agencies. The default grade makes it harder to borrow further from financial markets. Meanwhile, the stubbornness of the government and severe economic hardships have led to a political revolt akin to an ‘Arab Spring’.

Immediate Response

The government is pursuing the only immediate response available to them. That is to use its diplomatic connections and international relations to secure funds to maintain an uninterrupted supply of energy, food and medicine. It is the prime responsibility of all government institutions involved in policy making.

The controls on exchange rate have to be dropped for it to freely float. Initially there will be over-depreciation. But, it will discourage non-essential imports, and encourage domestic production, exports, tourism and inward remittances.

The government may request that all individuals give up corruption voluntarily, or severely crack down on it. The new Prime Minister has already warned the country of impending hardships. It is unavoidable that people have to practice a frugal way of living. At the same time, the government has to look after the poor and vulnerable groups of the society. Assistance has to be given immediately, utilizing existing government structures.

It is the responsibility of all political parties to come together to find a solution to ease political agitation by the general public. In the long-run a set of sound economic policies needs to be implemented after carefully analysing the causes of this crisis.

Comparison with East Asia and Greece

The East Asian crisis began in 1997 in Thailand. Thailand was maintaining a fixed and overvalued exchange rate. In addition, Thailand had an open capital account where private firms and individuals freely sent or received foreign exchange. When the exchange rate was unsustainable and had the risk of sudden depreciation, foreign exchange flew out of the country. The government and private sector could not meet their debt obligations. The crisis propagated to several other East Asian countries such as Indonesia, Philippines, South Korea, Taiwan, Malaysia and Singapore. Most of the countries sought assistance from the International Monetary Fund (IMF). As the exchange rate stabilized, and interest rates raised, foreign funds began to flow back. However, even during the worst times, all those countries had international reserves sufficient for more than three months of imports according to data from the World bank.

The Greek crisis began in 2009 with the government’s inability to honour debt repayments. The exchange rate was not an issue because Greece had adopted the Euro as its currency, the common currency of many European countries.

Greece had a large government expenditure and low tax revenue. Greece had been borrowing from international markets to fill this gap, but an accurate accounts of those borrowings had not been maintained. At a point when the Greek government could not borrow to repay loans, the government had to be bailed out by the IMF and other strong European countries. The recovery was very slow because the economy was weak, government revenue was weak and any changes to government expenditure were not flexible.

Sri Lanka’s crisis is different from the East Asian Crisis but somewhat similar to the Greek crisis. Sri Lanka has a problem of inability to pay government foreign debt, and inability to afford energy imports. However, availability of energy was not a serious problem in East Asian countries or Greece. The recovery in Sri Lanka would not be easy since the net inflow of foreign exchange has to come from further borrowings and foreign aid.

Causes of the Crisis

Sri Lanka has been living with a series of severe political and economic problems caused by successive governments. The collective errors caused by the government in the recent past were the ‘last straw that broke the camel’s back’.

The already strained public finances had an unbearable negative shock with massive tax cuts initiated by the new government. The government began to lose over Rs 500 bn annually. The hitherto unseen commitment to fix the exchange rate at Rs 200 per US dollar decimated the country’s reserves. In the past, when the reserves came closer to three months of imports, the Central Bank sought help from the IMF. This time the Central Bank remained taking no action until the last dollar was gone. Furthermore, the country was given shock therapy with the fertilizer policy. These shocks were too much to bear for an economy already compromised by the COVID-19 pandemic.

There are multiple other long-term causes of this crisis. Several textbooks can be written to highlight those reasons. However, this note presents a very brief account.

The first and foremost is the misguided monetary policy as well as the wrong exchange rate policy of the Central Bank of Sri Lanka. The Central Bank has been maintaining a money growth of about 15 percent continuously. Money was finding its way to the hands of the general public, increasing their purchasing power. This, coupled with an overvalued exchange rate, increased the demand for imported goods (such as luxury cars further fuelled by duty free permits) and imported services (such as education and travel). The high demand created a large deficit in the current account of the balance of payments. This was filled with high-cost borrowings from the international commercial debt market. This practice became unsustainable.

Other factors contributing to this crisis were the slow growth of the economy (since independence), inefficient public finance management, excessive government expenditure, high real wages, irresponsible debt accumulation, anti-competitive practices, insider trading, deficiencies in human resources running the government, and vulnerability to external shocks.

This note highlights each of those factors and outline lessons for a new age in Sri Lanka.

Failure in Maintaining Economic and Price Stability by the Central Bank

The ignition point of the economic crisis was the incompatibility of monetary policy and exchange rate policy adopted by the Central Bank.

First of all, Sri Lanka’s historic mistake was the setting up of a central bank by dismantling the currency board in the 1950s. That was done as a proud symbol of economic independence. It allowed the government to print money at their will to satisfy popular needs. More money and few goods have been driving up inflation.

In contrast, Singapore maintained a currency board. They knew that being a small country, they have to depend on international trade as the main driver for the success of their economy. Thus, exchange rate stability was also an important factor. A currency board was best suited to meet both these requirements. Similarly , Sri Lanka is also a small country that would benefit immensely from international trade, and exchange rate stability. Instead, Sri Lanka chose to set up a central bank with the ability to print money and destabilize the exchange rate by generating high inflation rates.

This historic mistake may not have affected Sri Lanka, if the monetary board running the central bank implemented sound policies to maintain a low rate of inflation, i.e. price stability. A persistent low rate of inflation may have resulted in exchange rate stability, without requiring costly intervention in the foreign exchange market using precious foreign exchange reserves.

Since inception, the central bank has been running a money growth of about 15 per cent. This misguide monetary policy kept the flame of inflation ablaze. After allowing for a modest economic growth of about 5 per cent, the rest of the money growth becomes inflation of well over 10 per cent.   While running a high inflation, the monetary board was trying to prevent the depreciation of the rupee using scarce reserves until all reserves were gone. This is similar to using precious water to keep a bucket full, while using another sharp tool to make a large hole in the bucket.

When the exchange rate is not allowed to depreciate in line with higher domestic inflation than the inflation in trading partner countries, it leads to an overvaluation of the rupee. The overvaluation has serious economic consequences both in the short run and the long run.   It encourages imports and discourages exports, destroys domestic industries and agriculture, encourages foreign travels and import of similar services. The more serious consequence is what Sri Lanka is going through now, a painful economic crisis.

The extent of the overvaluation of the rupee can be explained using the concept of ‘real exchange rate’, which is defined as the number of foreign goods that can be bought by exchanging one Sri Lankan good. If the nominal exchange rate (rupees per US dollar) is allowed to freely float, it either depreciates or appreciates to maintain purchasing power parity. This allows only one foreign good to be exchanged for one Sri Lankan good. When the nominal exchange rate is overvalued, the real exchange rate also appreciates, meaning one Sri Lankan good is worth more than one foreign good. Thus, instead of buying Sri Lankan goods, Sri Lankans prefer to buy foreign goods, and foreigners prefer to buy their own goods rather than importing from Sri Lanka.

In contrast, countries like China maintain an undervalued currency, leading to a depreciated real exchange rate as shown in Figure 1.   The undervalued Chinese currency leads to more than one Chinese goods exchanging for one foreign good. Thus, it is cheaper to import goods from China.

Figure 1 – Real Exchange Rate of Sri Lanka and China viz a viz USA

China maintains low real exchange rates which encourage exports and discourage imports.

The overvalued currency leads to a large deficit in the ‘current account’ of the balance of payments. This deficit needs to be filled with international borrowings raising the country’s debt levels, or selling Sri Lanka’s real assets to foreigners. Since this cannot be done forever, it creates a balance of payment crisis eventually.

For example, In 2021, the current account deficit was US Dollars 3 bn. In addition, the debt repayments were 4 bn. Thus, in 2021, the central bank had to find US Dollars 7 bn to cover the deficit and repay loan instalments.

One of the two major objectives of the central bank as mandated by the Monetary Law Act is to maintain economic and price stability. The other is maintaining financial system stability. That is not letting the country fall into a financial crisis, and maintain the inflation at a moderate rate of around two percent. Apparently, the Central Bank has failed in meeting the first objective.

The monetary board running the Central Bank has apparently been making continuous policy mistakes as they may not have recognized the incompatibility of the monetary policy regime and the exchange rate regime. When the monetary board fails to recognize the impact of high money growth on inflation, the impact of inflation on exchange rate, and incompatibility of fixed exchange rate and independent monetary policy, the country will inevitably go through a currency crisis first, followed by an economic crisis and eventually a full scale political crisis.

Slow Growth of the Economy since Independence

Since independence, Sri Lanka has been growing very slowly. Its per capita income is among the poorest in the world with US Dollars 3670 in 2021. In contrast, Singapore which had a similar per capita income level in 1960s, now has a per capita income of nearly US Dollars 60000. This is because Sri Lanka failed to set off an industrial revolution.

Industrial revolution is a rapid increase in industrial growth. Industrial output emanates mainly from efficient infrastructure, skilled human capital, unhindered commerce, corruption free markets, protection of property rights, and the supply of public goods. Most of these have to be provided by the government.

Some international organizations state that Sri Lanka has already gone through a series of industrial revolutions. In fact, Sri Lanka has embraced a series of technological innovations made elsewhere in the world, but it has not gone through a single genuine industrial revolution. If we had gone through an industrial revolution, we would be at a per capita income level of at least US Dollars 60000 today.

The developed world as well as a large number of emerging economy countries have set off industrial revolutions at some point in the past. England set off an industrial revolution in 1760. After fifty years the USA set off one. After another fifty years, Japan set off an industrial revolution. As recent as the 1980s, East Asia set off industrial revolutions followed by China. This is a result of creating an environment conducive to industrial development as well as the government making concerted efforts to set off the industrial revolution.

At the time of independence in 1948, Sri Lanka had all initial conditions to set off an industrial revolution. Since then, no meaningful economic policies to develop the country have been taken. Instead, wave after wave of wrong and disastrous policies have been implemented.

During the reign of ancient kings, Sri Lanka was second to none in technology. Before the Portuguese and Dutch invaded the country, Sri Lankan Kings had been using the best international technology to build reservoirs, construct canals, develop agriculture, and build monuments. Remnants of those developments still generate income for the country, through agriculture and tourism.

Portuguese and Dutch invaders conquered the coastal areas of the country from about 1505 to 1796. At the time, internationally, the only mode of transport was rivers, canals and the sea, because the steam locomotive was not invented until 1804.   Thus, the Dutch had built canals along the coastal area of Ceylon to promote domestic and international trade.

After the country fell into the hands of the British in 1815, they brought in locomotives and built a network of railroads, similar to the railroad system in Great Britain and Europe. The railroad system in those countries propagated the industrial revolution.

Locomotives were the principal mode of transport until Karl Benz produced the first motor vehicle in 1888. By 1958, Great Britain had built its first motorway, and the USA had built its first highway.

This was ten years after Sri Lanka had gained independence from Britain. If Sri Lanka had insightful leaders, Sri Lanka could also have built its first motorway in 1958, and within five years, would have connected all corners of the country.

By 1968 Sri Lanka could have built mass transport systems such as underground railways in all major metropolises. At the time, the cost of capital as well as material was very low.

Similar to Singapore, Sri Lanka could also have strengthened the university system. By 1958, Sri Lanka’s universities could have offered doctoral degrees in natural sciences. Sri Lanka had all economic and social opportunities to become a first world economy by 1970.

After the independence, neither the Sri Lanka merchants nor the government was able to develop an even rudimentary industrial base. Thus, ‘proto-industrialization’ never happened, and an industrial revolution never took off.

Instead of implementing policies to set off an industrial revolution, Sri Lanka’s leaders implemented policies that had the unintended result of destroying the economy.

Infrastructure essential for economic development was not established. Human capital development was retarded. Sri Lanka was not able to provide basic undergraduate degrees for all qualified students. As a result, many Sri Lankan students have to travel abroad for basic undergraduate degrees. This is importing education. In fact, Sri Lanka has skills to develop international universities, and export education. The best of the few who managed to enter a university end up leaving the country looking for post graduate opportunities, or better employment opportunities.

Agriculture policy has not generated a highly productive agriculture sector. We still import seeds. Farmers suffer from life threatening diseases. Fertilizer policy is a disaster.

Industrial policy has not been able to develop large scale industries. International trade policy is primarily used to generate fiscal revenue through import taxes. The policy is not used to promote an export-oriented economy.   All other sectoral policies are also not geared to promote the economy.

In the 1950s and 60s a major policy mistake was made in the form of the language policy. Ideally, language should not be a barrier to carrying out economic transactions. People should be allowed to use the language they prefer. If there are two or more languages, there is employment for interpreters and translators.

Favouring one language wins votes, and boosts nationalism but leads brain-drain, fools the population, and divides the country. A divided country destroyed economic growth. In contrast, Singapore had one business language, English, and three national languages: Chinese, Malay and Tamil. It united Singapore and boosted economic growth. With the blessings of political and economic stability, Singapore continued to build infrastructure; ports, airports, roads and universities, and support continuous high economic growth..

Another major mistake made in the early 1970s was the policy package of closed economy, land reforms and nationalization. With this drastic policy, politicians wished to achieve self-sufficiency in every industry. Instead, it imploded the economy overnight like a balloon losing its air. Foreign investors fled the country to Singapore and Malaysia. Those countries had embraced open economies.

There were lines for food, clothing, and everything else. In this era of scarcity, politicians and government officials became powerful distributors of essential goods. Bribery and corruption was born in Sri Lanka, and became a daily staple. With the private industries being nationalized, the government became the sole employer. This brought in serious adverse selection and moral hazard problems.

Unemployment became widespread. Available government jobs were handed down to party loyalists. As a direct result, Southern and Northern insurgencies erupted. The northern insurgency became a civil war.

As the economic growth faltered, there were no resources to build infrastructure. The country became a muddied place and a small pond with a lot of hungry fish.

Insurgencies continued. In an unfortunate turn of events ruling party politicians and their supporters in the 1980s mocked the judiciary. This led to a decline in the sense of law and order. This era witnessed some people rising above the law.

In 1990s the terrorism intensified while the government remained ineffective. After several decades of economic stagnation, the civil war ended in mid 2000. There was a renewed hope for faster economic growth.

At least two highways were built, but the government finances continued to deteriorate, and much anticipated growth and development did not take place.

Sri Lanka does not have a high international ranking in competitiveness. The Global Competitiveness ranking compiled by the World Economic Forum ranks Sri Lanka at 85 out of 137 countries (top 3 – Switzerland, United States, and Singapore) (Bottom 3 – Chad, Mozambique and Yemen). Thus, there are 84 more competitive countries than Sri Lanka in the world.

Inefficient Public Finance Management, Excessive Government Expenditure and Irresponsible Debt Accumulation

Inability to raise tax revenue and uncontrollable government expenditure lead to inflationary financing of the government budget deficit that occurs year after year. High expenditure is a result of maintaining an oversized government consisting of a large number of politicians and government employees. This is exacerbated by high salaries, non-contributory pensions and large fringe benefits offered to politicians and senior government officials.

In addition to printing money, the treasury also borrows from the banking sector, and the general public. This is domestic borrowing. Borrowing from banks is as bad as borrowing money from the Central Bank. While the Central Bank prints money, banks create money with similar impact on inflation. Furthermore, when the government borrows from banks it crowds out resources available to the private sector investors.

Furthermore, the treasury borrows from foreign sources as well. The external debt stock of the Sri Lanka’s government as at 2021 was US Dollars 33 bn. Out of this, US Dollars 18 bn was recent borrowings from international financial markets at fairly high interest rates (as per Central Bank Annual Report 2021, the borrowings from Financial markets is Rs 3.5 trillion). This is a substantial amount. In comparison to the cost of building a highway similar to Southern Expressway it could have built at least 6000 highway miles.

Commercial borrowing from financial markets including international sovereign bonds has been a waste of resources. In addition to paying high interest rates, international investment bankers take a large commission for organizing these loans and bonds. The remainder of foreign exchange is deposited in foreign banks as the Central Bank reserves. An equivalent amount of rupees are printed and transferred to the Treasury. The Treasury uses those funds to pay for current expenditure and retire old government treasury bills and bonds, i. e. pay for past expenditures. The Central Bank uses the foreign currency to defend the exchange rate, which is similar to selling them at a low price.

At the beginning of commercial borrowings, the central bank would have thought that it had discovered a never-ending source of foreign funds through a system of Ponzi games. Eventually, when commercial lenders felt that the country had borrowed beyond their creditworthiness, they stopped further financing and demanded their debt back. The Ponzi game ended, and the country declared bankruptcy.

The fiscal deficit and the current account deficit are called the ‘twin deficits’ which are not sustainable in the long run.

Corruption, Anti-Competitive Practices, and Insider Trading

There are allegations of corruption in many government institutions, especially institutions responsible for approving foreign direct investment and domestic investment. This may have discouraged export growth as well as economic growth.

The world keeps a watchful eye on Sri Lanka. The corruption perception index compiled by the transparency international ranks Sri Lanka at 102 out of 180 countries. Rank 1 is Denmark, Finland and Switzerland while the rank 180 is South Sudan.

In Sri Lanka monopolies such as electricity generation and supply make losses while providing an unreliable supply. Many believe that this is because of anti-competitive practices. Similarly, petroleum corporation, and the national airline also make losses. The treasury continues to bail them out. The new Prime Minister has recognized the futility of running a national airline which makes losses of about 50 billion rupees annually. Such institutions suffer from massive principal-agent problems, where the principal is the government (or the general public) and agents are the board of directors, who have no financial stake in the institution.

Sri Lanka’s regulatory institutions have not been very forceful. There are insinuations on insider trading in the stock market, leakages of information on bond auctions and bond auction scams. Those do not encourage foreign investments into the country.

There is unchecked monopoly pricing in the services sector. Service providers charge high prices for their services, and the rest of the population raise prices and wages whenever possible to match the professional fees.

Vulnerability to External Shocks

The world is not always a hospitable place for small open economies like Sri Lanka. Adverse international developments create external shocks to Sri Lanka’s economy. The government institutions should be ready to absorb those external shocks to some extent. Recently, the Ukraine War, global monetary policy tightening, prolonged global pandemic, and several other external shocks plagued the countries. The countries who had built strong measures of resilience in terms of strong foreign reserves, oil reserves and other buffers are escaping from those shocks, while others who were oblivious to those shocks are falling down like houses made of straw.

Politicians, Civil Service, Adverse Selection and Moral Hazard

Adverse selection refers to unsuitable individuals trying to get government positions attracted by large benefits attached to those positions. Moral hazard (or principal-agent problem) refers to individuals not performing the required tasks of the employment, and behaving in a manner hazardous to an institution and the country.

Politicians and senior bureaucrats receive substantial benefits, and ensuing adverse selection and moral hazard problems suffocate the country.

One landmark judgment exacerbated the moral hazard problem among politicians. The judgment overruled the requirement for a politician to seek a fresh mandate from the constitution if the politician changes the party affiliation. There is an urgent need to reverse this judgment.

The country has to depend on a credible civil service (all government employees) to carry out government functions. Over the years, instead of having a permanent civil service, politicians have been appointing personnel outside the regular civil service to important government positions. This causes ‘loss of institutional memory’. To make things worse, there are allegations of some civil servants indulging in corrupt practices.

Some bureaucrats are not subject to scrutiny by anyone above them. Many of them are close allies of ruling party politicians. They draw massive power from those politicians. Hence, they run mini dictatorships in respective institutions. They promote or demote junior officers not on the basis of their skills and usefulness to the institution, but on the basis of peculiar personal interests, and loyalty.   In fear of the wrath they could bring on junior officers, no junior officer would wish to disagree with the mini dictator.

Apart from these problems, there are other substantial adverse selection and moral hazard problems. Senior officials grant themselves lucrative benefits. The unfortunate fall out of such acts is two fold. Wrong people will join government institutions driven by greed for facilities, and the rest of the government employees will demand similar facilities. High salaries to one group of employees or in one institution spreads demands for higher salaries in all levels of employees in government institutions as well as private sector institutions. They stage protests and win their demands. Since the government revenue is low with slow growth of the economy, it has to borrow from inflationary sources or printing money and pay high salaries.

The salaries and wages of both the government and private sector have to follow the path of productivity and real economic growth in the country. When this relationship is broken, high salaries and wages generate a vicious cycle of higher inflation and higher salaries and wages. As was discussed before, when the central bank maintains an overvalued currency it destroys domestic industries and lowers real economic growth. When we add policy incapacity to this, the outcome is an economic disaster.

Long Run Policies for a New Age

The government of a country is a vital organ of its existence and development. The government can be thought of as the embodiment of a vast array of public policies. Those policies broadly fall into four spheres; political, economic, social and ethical. In this paper, I explain the scope of policies in the economic sphere. We need experts on political, social and ethical spheres to explain the respective policies in those spheres for the government to be effective.

Economic theory as well as experience of successful countries point to five major roles of the government in the economic sphere. First, the promotion of economic activities leading to high economic growth and setting off industrial revolutions. Second, maintaining the law and order, a sound legal system and an independent judiciary to create markets and new economic activities. Third, maintaining economic stability to ensure low rates of inflation, low rate of unemployment, exchange rate stability, debt sustainability, and financial sector soundness. Fourth, regulating the economy to counter anti-competitive practices, to address market failures, and to take action against evils such as insider trading.   Fifth, legitimizing the markets by providing safety nets and social welfare measures to those who are weak and destitute.

To carry out those functions, there has to be politicians and bureaucrats, who do not commit adverse selection and moral hazard offences.

Policies for Promotion of the Economy

Different countries have taken different paths to promote their economies and set off industrial revolutions. It is difficult to predict which industry will be a winner. Hence, the best course of action is to create an environment that promotes private sector engagement in all economic activities while simultaneously, providing public goods essential for growth and development that the private sector cannot produce.

Government may also supply large scale infrastructure facilities such as highways, invest in high level university education and invest in sustainable energy solutions. Providing public goods such as public health facilities, and environment protection are also important.

Small government is a catchphrase among some political groups. However, the size of the government has to be decided on the extent of government services necessary for a growing economy.

The sectoral policies may be developed in a coherent manner to promote industrial development. The free and open markets, free trade, protection, deregulation, and reregulation are few of the many tools available to policy makers. They have to use entrepreneurship to choose the right combination of those policies.

Creating Markets and New Economic Activities

Markets and new economic activities are created when there is a high degree of law and order, protection of property rights, resolution of conflicts and honouring contractual obligations. For these to happen the government has to strengthen the legal system and legal institutions in the country. Nobody can be above the law.

Maintaining a free market environment is an expensive public good. The government has to spend resources to provide safety and security necessary to maintain a free and fair market.

Creating a corruption free and law abiding society is also a priority. To this effect, Sri Lanka should maintain a high rank in transparency, and high rank in global competitiveness. The performance of any political regime may be measured using those ranks.

Regulation of Markets and Setting Up Anti-Competitive Laws

Perfect competition is the most welfare enhancing market condition. However, sometimes, the nature of production technology or the size of the market does not allow perfect competition. For example, electric utilities tend to be natural monopolies. The monopolies need regulations to deliver welfare enhancing outcomes.

There have to be regulations to ensure product quality, safety and the environment. Regulations are also necessary to counter negative consumption and production externalities. Government must strengthen institutions responsible for administering such regulations.

The institutional set up of legal provisions must be strengthened to counter insider trading in the financial markets and other scams.

Regulation strengthens markets and encourages investments. Regulators are like referees in a football game. When a player makes a mistake, the player is given a yellow flag, or a red flag or expelled from the game. If the game is not well refereed, players will go rogue, and spectators abandon the game. The game becomes stale.

Deregulation was a catchphrase in the 1980s and 1990s both in the USA and UK. Excessive deregulation in those countries have led to financial and economic crises. Therefore, essential regulations must be maintained by considering the nature of the evolving economy.

Stabilization of Markets and the Economy

Stability in markets and the economy is a public service that has to be provided by the government.

Economic stability is price stability, high economic growth and stable exchange rates. Price stability is the low and steady inflation that does not interfere with investment decisions of firms and households.

The Central Bank is the primary institution responsible for maintaining economic and price stability. They are governed by the Monetary Law Act, and responsible for conducting the monetary policy.

The treasury is responsible for conducting fiscal policy to support maintaining economic stability, while promoting long run economic growth and development.

The government incurs a massive expenditure mostly through inflationary financing in maintaining the central bank, treasury and their staff. They have a legal as well as moral obligation to deliver stability of the markets and the economy. If this is not delivered, there is a need to re-examine legal structure, institutional structure and human resources management in those institutions.

Government institutions should also develop mechanisms to face external shocks that would create extreme financial and economic distress.

Legitimization of Markets, Social Welfare and Equity

The first fundamental theorem of welfare economics states that perfectly competitive markets generate pareto optimal outcomes. However, pareto optimality does not guarantee equity.   For example, dividing ten oranges between two people where one receives eight and the other receives two is pareto optimal, but not equitable. Hence the government has to devise social security systems and welfare measures to look after the poor and destitute even in an economy with all perfectly competitive markets.

Sri Lanka does not have a comprehensive scheme to look after the poor and those who are not able to work. While healthcare is free, other needs of the poor are not looked after well. Furthermore, there is a vast inequality in income and wealth, which is called the end-point inequality.

Process inequality is a much more serious problem than end-point inequality. Process equality is providing individuals with equal opportunities to uplift their standard of living.   Those opportunities are equal access to education, healthcare and other social needs.

We should also note that as a country gets richer, billionaires and rich private corporations have to be born. This is a tolerable natural occurrence as long as such wealth is accumulated through legal means, and not through corruption and rent seeking. To fight corruption there has to be an agency responsible for investigating every incident of corruption and solutions to eliminate such corruption have to be found. In this reality, there has to be a gradual strengthening of welfare measures in the country.

Civil Service Reforms

To carry out government functions, the government hires employees (civil service). The civil service has to be free from adverse selection and moral hazard problems.

Politicians and senior bureaucrats have to be subject to high ethical standards. In the USA, the President’s office employs an official to look into ethics violations in the government.

Though the existing form of government already has an established structure, it suffers from serious deficiencies. A careful analysis may be conducted to identify those deficiencies and identify reform requirements. The weaknesses and reforms may be identified with a renewed focus on promotion of the economy, creating markets, regulating markets, stabilizing markets and legitimizing markets, while addressing adverse selection and moral hazard in the civil service.

Conclusion

Sri Lanka’s current economic crisis is a result of gross mismanagement of the economy. Sri Lanka’s population is in dire need of a political party or a political leader who can maintain democratic principles, set off industrial revolutions, fight against corruption, embrace competitive market principles, promote private sector engagement in economic activities, employ the government to carry out essential functions as outlined above, and find solutions to adverse selection and moral hazard problems among politicians and bureaucrats.

Some existing political parties have embraced liberal market principles, but suffer from major shortcomings of ineffective policies, while not being free from corruption. There are other political parties which are committed to fight corruption but have embraced a nineteenth-century political ideology. They are not sufficiently explicit about how they would solve twenty-first century economic problems facing Sri Lanka.

Sri Lanka needs a leadership willing to manage the economy in the correct way as explained in this article.

*Dr H N Thenuwara has worked at the Central Bank of Sri Lanka as the Superintendent of Public Debt, Director of Economic Research, and an Assistant Governor. At present he teaches Economic Theory and Policy at the University of Iowa, USA. He may be contacted through thenuwarahn@gmail.com