Published:  12:02 AM, 27 May 2022

Causes of Economic Crisis in Sri Lanka & Lessons for a New Age

 H N Thenuwara


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.

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