Potential output of Sri Lanka: It is dangerous to speed the car beyond installed engine capacity

Impatience

of politicians to accelerate the engine of growth-

Sunday 16th March !1" Politicians# no matter where they are in the globe# are like youngsters at the wheel of a racing car$ %hey want to kick-start an economy# ha&e a 'uick pick-up and accelerate it to a speed ne&er e&er achie&ed by their predecessors$ %heir impatience for a rapid economic growth is not matched by the slow pace in which things are happening around them$ %he 'uick-fi( methods suggested to accelerate growth push e&eryone o&er the limit resulting in a state of panic which then leads to stress$

) story circulating among economists about a ruler in an *ast )sian country gi&es a &ery good e(ample of the impatience of politicians$ +hen this ruler was told that an economy cannot get into a high growth path all of a sudden without damaging its foundation# he had demanded for an e(planation$ ,is ad&isors# the story says# had told him that that was against the -laws of nature.$ %he reference here is that e&ery system is go&erned by its internal rules that cannot be manipulated by humans$ /ut# his immediate order had been that they should change those obstructing laws of nature by using their ma0ority power in the legislature$ %he impatience which politicians show in doing things is understandable because they ha&e to impress the &oters that they are better than their ri&als$ /ut it is the duty of the ad&isors to moderate the speed to match with the installed capacity of an economy$ If politicians do not listen and ad&isors fail in their duty# there will be irreparable damage to the foundation of an economy$ IM1 with 2/SL onto estimating potential output In this connection# a working paper 0ust released by IM1 on Sri Lanka.s -potential output. or the le&el economic growth it can achie&e without o&erstretching its installed capacity is a good guidance$ %his paper titled -*stimating Sri Lanka.s Potential 3utput. has been authored by 4ing 4ing# 5ohn 6elmes# 7oshan Perera and 8olodymyr %ulin 9a&ailable at http:::www$imf$org:e(ternal:pubs:cat:longres$asp(;sk<"1"1"$! =$ It appears to be a collaborati&e research pro0ect done by IM1 with the 2entral /ank of Sri Lanka or 2/SL with one of its reputed economists# 7oshan Perera# as a member of the research team$ +orking Papers are in fact ad&ance presentation of the findings of an ongoing research study for eliciting comments and &iews to facilitate the researchers to finalise the final results$ ,ence# their results are not yet conclusi&e and awaiting for moderation$ >et# they gi&e a good indication about the direction to which the research under reference has taken the researchers$ )ccording to the authors# the preliminary findings of the research work ha&e been presented in a seminar at 2/SL and they ha&e been benefited by the feedback recei&ed from the seminar participants$ Potential output is the -economic stability. in 2/SL.s mandate %he potential output has to be understood by reference to economic stability which is one of the ob0ecti&es of 2/SL$ )s argued by this writer in a pre&ious My 8iew in this series# -economic and price stability. with which 2/SL has been mandated to achie&e means setting the economy.s aggregate demand at a le&el e'ual to its aggregate supply 9a&ailable at http:::www$ft$lk: !11:1!:1!:central-bank?* ?@!?AAs-mandate-

direction to which the research under reference has taken the researchers$ )ccording to the authors# the preliminary findings of the research work ha&e been presented in a seminar at 2/SL and they ha&e been benefited by the feedback recei&ed from the seminar participants$ Potential output is the -economic stability. in 2/SL.s mandate %he potential output has to be understood by reference to economic stability which is one of the ob0ecti&es of 2/SL$ )s argued by this writer in a pre&ious My 8iew in this series# -economic and price stability. with which 2/SL has been mandated to achie&e means setting the economy.s aggregate demand at a le&el e'ual to its aggregate supply 9a&ailable at http:::www$ft$lk: !11:1!:1!:central-bank?* ?@!?AAsmandate-is-to-attain-both-?* ?@!?A@economic ?* ?@!?AA-and-?* ?@!?A@price?* ?@!?AA-stability:=$ 3nce this condition is met# there will be neither inflation nor deflation in the economy$ %hus# the potential output is the le&el of output which the economy can attain without causing either inflation or deflation$ /oth inflation and deflation are considered two public enemies to be fought$ Inflation reduces real wellbeing of people# enriches borrowers at the e(pense of sa&ers and lenders# ta(es e(ports and subsidises imports# puts pressure on the e(change rate to depreciate and causes ha&oc and chaos in an economy# to mention but a few of the e&ils of inflation$ 4eflation leads to a reduction in output# employment and the use of resources in an economy$ ,ence# to sustain economic growth in the long run# a proper economic policy should seek to a&oid either one and establish stability in prices$ %hat can be done only by sticking economic growth to its potential output$ %he ob0ecti&e of the IM1 +orking Paper has been to estimate the potential output in Sri Lanka so that the economic policy makers could design a growth path helpful to its long term sustainable growth$ /oth positi&e and negati&e output gaps are dangerous If an economy.s actual output differs from its potential output# it

money income increasing the aggregate demand in the economy$ /ut when the output falls in the subse'uent years# the demand becomes higher than the supply creating an e(cess demand$ *conomists call this -o&erheating the economy. 0ust like a &ehicle dri&ing abo&e its engine capacity gets o&erheated$ Bnless the cooling mechanism of the &ehicle is effecti&e# the o&erheating could cause permanent damage to the engine$ Similarly# in the case of an economy# o&erheating causes inflation generating all the inflation related e&ils in the economy$ If there is a negati&e output gap# then# there is deflation causing unemployment and economic recession$ ,ence# proper economic policies should a&oid both$ )s such# the ad&antage of estimating the potential output is the a&ailability of a benchmark for policy makers# namely# those in the 2entral /ank and in the Ministry of 1inance# to assess the desirability of economic acti&ities$ Monetary policy action to depend on the type of output gap If there is a negati&e output gap# then# of course# it 0ustifies a central bank.s loosening its monetary policy stance to increase the aggregate demand to the le&el of the potential output$ ,owe&er# once the economy reaches the potential output le&el# the bank should immediately halt its e(pansionary monetary policy to a&oid the increase in the aggregate demand o&er the aggregate supply and thereby pre&ent the economy from getting o&erheated$ If there is a positi&e output gap# the /ank.s monetary policy stance should be in the other way about$ It should take restricti&e monetary policy action to curtail the aggregate demand and eliminate the inflationary pressures$ )ccordingly# an accurate knowledge of the siCe of the potential output in an economy is the most important prere'uisite for a central bank to design its monetary policy programme$ Potential output is determined by an economy.s installed capacity %he output of an economy is similar to the output produced by an indi&idual$ If an indi&idual works longer hours using more of his labour# applies new knowledge bringing his human capital into production and sophisticated e'uipment facilitating production process# he could produce more$ %hese are called inputs D labour# technology and physical capital D used for production$ )t any time# a gi&en le&el of labour# technology and physical capital will determine the ma(imum output D or potential output in economists. terminology D he can produce$ If he can ac'uire more labour# better technology and better e'uipment# he can increase his potential output$ Similarly# for an economy# there is a potential output le&el fi(ed by the a&ailable labour# technology and physical capital$ If an economy desires to increase this potential output# one of the prere'uisites is to increase each one of them$ Since an economy is a growing enterprise# these are not

fi(ed but sub0ect to constant change$ %he infusion of new inputs will make the conditions betterE in the opposite# the non-de&elopment of new inputs or neglect of the maintenance of the e(isting inputs will re&erse the initial growth$ %emporary episodes of faster growth are not sustainable )n economy might show some periods of faster growth in the output followed by a decline in the output thereafter$ %hese are called temporary impro&ements in the economy$ )ny researcher seeking to estimate the potential output will ha&e to eliminate these temporary episodes of increased output and concentrate on the permanent growth as determined by the installed capacity of an economy$ %o do so# researchers ha&e to use ad&anced estimation techni'ues and sub0ect them to rigorous testing methods$ %his is e(actly what the four researchers under reference ha&e done$ %hey ha&e built an economic model highlighting the output gap# unemployment gap and the capacity utilisation gap and tested the model with the 'uarterly data for Sri Lanka from the beginning of 1AAF to the end of !1 $ ,ysteresis *ffect: Past beha&iour matters In building the model# an important element they ha&e used is the impact of the past beha&iour of a particular factor on its current beha&iour# known as the ,ysteresis *ffect in science and used by economists$ )ccordingly# past inflation affect the current inflation by causing to ha&e higher or lower inflation e(pectations# past unemployment will affect the current unemployment by pushing the wages upward and past capacity utilisation will affect the current capacity utilisation by creating constraints for new capacity utilisation$ %his is intuiti&ely understandable since what we do today is guided by what we ha&e e(perienced yesterday$ It is &alid for both negati&e and positi&e e(periences but more strongly for negati&e e(periences$ 1or instance# if we our gas cooker had a leak leading to a fire in the cooker yesterday# it is 'uite natural for us to become e(tra cautious and restrain oursel&es in our beha&iour$ Sri Lanka.s potential growth rate is more or less e'ual to the actual growth /y applying different estimation methods used by reputed economists# the researchers ha&e come up with an estimate of an annual potential output growth e(perienced by Sri Lanka ranging between 6$G? and 6$@?$ 3n a&erage# this works out to an annual potential output growth of 6$F?$ %his is more or less e'ual to the country.s actual a&erage output growth during !! -1 which stands at 6$"?$ )ccordingly# on a&erage# Sri Lanka had had a slight but negligible negati&e output gap in the past$ ,owe&er# it poses problems for the authorities who aspire to increase the growth rate abo&e @? per annum o&er the ne(t decade since there is no installed

capacity in the economy to sustain that growth rate as at present$ %hough the country may ha&e temporary surges in economic growth as it had e(perienced in !1! immediately after the end of the war# such growth rates cannot be continued unless there is an e(pansion in its capacity$ *nhancement of capacity is a matter for the go&ernment and not for the central bank %his is a problem to be tackled by the Ministry of 1inance and Ministry of *conomic 4e&elopment and not by the 2entral /ank$ +hy the 2entral /ank cannot do it is because it does not ha&e real resources e(cept the power to print money$ If money is printed to increase the potential output# the result is the increase in the aggregate demand o&er the potential output thereby o&erheating the economy$ /ut# the Ho&ernment can ha&e real resources transferred to it through ta(ation and direct those real resources to enhance the potential output capacity of the economy$ /ut those e(penses of the go&ernment should be properly prioritised# directed to producti&e infrastructure and de&elopment of human capital including research and technology$ /ut it re'uires a reorientation of the country.s budgetary policy$ ) multi-pronged approach to enhance capacity %o increase the capacity to raise its potential output# Sri Lanka should ha&e a multipronged approach$ It in&ol&es# on the economy side# in&estment in necessary and producti&e infrastructure# ac'uisition of new technology# employment of the unemployed youth in producti&e employment# ac'uisition of modern technology and management practices and di&ersion of a greater &olume of output for continuous in&estment$ 3n the fiscal side# it in&ol&es many reforms in the budgetary processes$ 3ne is the di&ersion of unproducti&e and inefficient budgetary allocations to necessary human capital de&elopment D that is# more in&estment in education# health and ac'uisition of technology$ )nother is the reform of the important but presently loss making public enterprises and closing or handing o&er to pri&ate sector the unimportant public enterprises$ ,alt the e(pansion of the State sector ) third reform is the halting of undesirable public sector e(pansion which has become a serious problem for taming the budget and bringing down the need for borrowing more simply for repaying the principal and paying interest$ 3n the economic en&ironment side# the necessary reforms should include protection of property rights# obser&ance of the rule of law# maintenance of law and order and establishment of an independent 5udiciary to facilitate the concerned citiCens to seek redress against what they percei&e to be in0ustice committed by go&ernmental authorities$

3n the business side# action should be taken to impro&e the country.s ease of doing business$ In the global arena# Sri Lanka should be integrated seamlessly to the international markets so that what it produces abo&e the country.s aggregate demand could be sold to foreigners$ %hese are difficult but not impossible reforms if the authorities make a firm commitment to undertaking them$ +ithout these reforms# the continued e(pansion of the economy through liberal monetary policy and e(pansionary fiscal policy will only o&erheat the economy creating inflation and along with that inflation# bringing all the e&ils of inflation to the economy$ 9+$)$ +i0ewardena# a former 4eputy Ho&ernor of the 2entral /ank# can be reached at waw1A"AIgmail$com$=