High inflation due to high econ activity – eminent economist

By Natasha Gunaratne

Prof. W.D. Lakshman

While the debate on inflation rages on, Emeritus Professor of Economics at the University of Colombo, W.D. Lakshman believes high inflation is indicative of high economic activity in the country.

In an interview with The Sunday Times FT this week, Lakshman – who completes 40 years as an economist - said the current inflation rate which is 21.6 percent according to the new Colombo Consumer Price Index, the CCPI(N) and 24 percent according to the old CCPI for February 2008, is actually on par with conditions from 1978 to 1982, the period just after the 1977 liberalization of the economy.

He said the late 1970's and early 1980's was one of the most active economically in the post liberalization era. "In my reckoning, that was the best period post liberalization but this thing called ‘overheating’ is also happening now. There are cyclical factors. Oil prices for example or food prices have gone up. We have an element of cycle. In 1973, we had the first oil shock and in 1974, there were drought conditions extensively in the Asian region and prices of food items had risen in essential commodities such as rice. It looks to me as the same repetition of the same kind of phenomena and people are very concerned about these developments."

Lakshman said Sri Lanka's inflation rate is definitely high from whatever standards but that economists have known much higher inflation rates in other parts of the world. "In Latin America in the 1960's and 1970's, inflation rates were 1000 percent per annum. Even now, there are high inflation rates in African countries but I am sure that we are unlikely to get into that kind of critical situation because we have the institutional framework."

Economic managers in the Central Bank (CB) and Finance Ministry have to be concerned he said but added that he wasn't sure if even they have the best possible instruments at hand to control some of the international price movements. Lakshman said another criticism of the local management or macro management of the economy is the budget deficit. "The budget deficit nowadays has not been all that high. In the late 1970's and early 1980's, the budget deficit was much higher. Now it is around eight percent of GDP. Back then, it was over 10 percent of GDP in some years."

The average growth rate of around six percent over the past three to four years should be quite satisfactory for a country like Sri Lanka, given the current state of the economy. Lakshman said one can see economic activities extensively spread in areas outside of the north, in particular construction based activities. "Roads are being built, bridges are being built, there are irrigation programmes, port and airport development programmes, village development programmes and quite a lot of largely infrastructure programmes. There are other community and technical development programmes to improve the conditions of the people." In terms of infrastructure development programmes, Lakshman said there is reason to believe that a lot of things are also taking place in the Eastern province.

"On this basis, in terms of what you observe, I feel there are expanded and enhanced economic activity programs which means the economy is very active." Lakshman explained that other statistics which are available to indicate this particular pattern relates to employment. He said the total labour force survey shows that over the last few years, the unemployment rate has been declining. Lakshman said that statistics and collecting mechanisms are always subject to various criticisms and that the last available report was for the third quarter of 2007 which showed unemployment at around 5.6 percent. Historically, this is a low rate for Sri Lanka and is another indicator that economic activity is high.

Lakshman reiterated that in a liberal environment, the exercise that the CB can bring to bear is limited. The CB uses interest rates as an instrument to control the money supply but is limited on how to use this tool to control conditions. "You can raise interest rates to very high levels but it goes and hits somewhere else which is not the intention," he explained. "For example, high interest rates today are the response of the CB to inflationary pressures. I suppose the business sector has to pay more than 20 percent for their short term credit. This sort of situation was found even in the late 1970's and early 1980's and interest rates can kill investment, particularly in the industrial sector which competes with international producers.

It can be a killer so this is a double edge weapon. There were certain ideas such as controlling the money supply to keep it in step with real production but this has not been successful, even in other countries." Lakshman said the CB is an institution which is strongly established in Sri Lanka and has its traditional and conventional methods which are not always effective but added that if inflation starts accelerating further, they will step in.

Lakshman said the other empirical issue which people ignore when discussing inflation is that there are certain elements going parallel between inflation and economic growth. "When economic growth starts accelerating, there is also some inflationary pressure. In literature, it has been called the Philips Curve phenomenon. There is a large volume of literature which tries to debunk the phenomenon yet when you examine the statistics, there is a relationship which can be seen. The other point is that international research does not indicate what exactly the danger level of inflation for a country is. International financial agencies say to keep it in single digits and the same argument is made in Sri Lanka." However, he said there is no theoretical or empirical evidence to say that single digit inflation is the best. "I'm not very concerned about a short period of high inflation. Five or six years of high inflation can create problems but I'm confident of the institutional framework to put a stop to it if it becomes a problem."

Lakshman attributes the growth achievements made after the liberalization of the economy in 1977 to the government and the huge investments it made in the Mahaweli programme, housing programmes and other infrastructure. It was also an opening up of opportunities for the private sector but Lakshman calls it 'government expenditure led growth' although huge deficits were also incurred. "I consider this period the best because we did not have these problems of war. It was a fairly peaceful time but of course the things which came up later were already developing."

Lakshman said the government cannot continuously go towards deficit budgeting, print money and continue spending. Although people say that the private sector is leading, in Sri Lanka, he said one observes that whenever the government started leading in a liberal environment, the private sector also took some initiatives and responsibility. "The private sector is much more competent today than then but I don't know if the private sector now is that independent. There is a characteristic of dependence on the government," he said.

In terms of current policy, infrastructure development is considered to be the responsibility of the government and the public sector although some association is there with the private sector. "Invariably, a proportion of this spending is going in the wrong direction for commissions and briberies but that proportion wasted on commission and bribery cannot explain all of this," he said referring to the current economic conditions.

Lakshman said peace should be brought about quickly through negotiations or other means. The government does not seem to expect the war to continue for a long time and seem to be sticking by its statements. Conditions are different today than what it was in the early 1990's and there is little evidence of significant backtracking by the government. "In the 1990's, the government side took great steps forward but many more steps backwards and that hasn't happened," he said.

"It would be ideal if we could achieve these results without the war but if it is the choice by the powers that be, you hope for the best. The way things are moving, there seems to be an attempt to do what is practical and feasible. Given the constitutional framework and the electoral system, I think no major constitutional reform can come within this side of 20 years and even that is doubtful. We have been fighting for 30 years. The best is to implement what is there and improve," Lakshman concluded.