ECONOMYNEXT – Sri Lanka has expanded state workers 11 percent from 2014 to 2021 after cost cutting was abandoned in 2015 under ‘revenue based fiscal consolidation’ while government spending as a share of also expanded by 3.7 percent of gross domestic product.

Sri Lanka went on an unusual strategy of abandoning ‘spending based fiscal consolidation’ which usually involve cutting costs and re-directing people’s taxes for best uses and instead taxing the people to maintain a bloated public service from 2015, under a strategy backed by the International Monetary Fund.

After the Greenspan-Bernanke bubble burst, Washington has come under grip of the anti-austerity brigade where spending was glorified, critics say.

Classical economists have called revenue based fiscal consolidation the ‘statistical’ method of balancing budgets which fails in democratic countries.

Statistical vs Economic Method

In 1966, when the central bank was printing money to create currency crises despite having revenues of 23 percent of GDP, classical economist B R Shenoy in a report to the Ceylon government said the “statistical alternative of balancing the Budget is to step up Revenue collections sufficiently and produce a large enough Revenue surplus to cover overall Budget deficits.”

“This alternative is beset with pitfalls,” Shenoy explained. ” Past experience in Ceylon, which is in line with experience in virtually all parts of the world, is that in a democratic set up political and other pressures are heavily on the side of more and more spending by the government.

“When Revenues increase, under the weight of these pressures, expenditures too increase to meet, or even exceed, Revenue collections.”

True to form, total government spending which was 17.3 percent of gross domestic product grew to 18.8 percent by 2018.

Monetary Instability

Meanwhile monetary instability ratcheted up even without a war as central bank policies became increasingly more aggressive under ‘flexible’ inflation targeting without floating exchange rate.

A high unstable reserve collecting peg (flexible exchange rate) was bombarded with increasingly aggressive monetary policy and quantity easing style activity (call money rate targeting, operations twists, jettisoning bills only policy in favour of yield curve targeting) creating currency crises in rapid succession.

Money was also printed to target an output gap (monetary stimulus). The IMF itself taught Sri Lanka, which was supposedly engaging in inflation targeting to calculate an output gap which was then invitingly dangling to target.

After two currency crises in 2016 and 2018 busted the currency from 131 to the US dollars to 182 to the US dollar as interest rates were mis-targeted with open market operations, growth slowed.

As the efforts were made to stabilize the economy after money printing to trigger currency crises, both growth and revenue slowed falling to 11.6 percent by 2019.

Tax cut to close output gap

After two currency crises in 2019 December taxes were cut by interventionist economists saying that there was a ‘persistent output gap’ and Treasury bond auctions were crippled with price controls triggering the biggest currency crisis in the history of the 72 year old central bank.

Taxation as a share of GDP which was 10.1 percent of GDP in 2014 (when the country was recovering from a 2012 currency crisis), fell to 7.7 percent of GDP in 2021.

Meanwhile consistent with ‘revenue based fiscal consolidation’ of expanding the state, the public service was bumped up 11 percent from 1.345 million workers in 2014 to 1.46 million in 2019 and 1.49 million in 2021 according to central bank survey data.

In 2022 then Finance Minister Basil Rajapaksa raised state salaries in a ‘relief package’ and raised the retirement age of state workers to 65.

In 2012 after two years of extraordinary money printing, Sri Lanka defaulted after running out of reserves.

Sri Lanka is now printing money to pay state worker salaries, despite forex shortages and attempting to operate a peg at 360 to the US dollar with dollars borrowed from India.

Sri Lanka now has to raise taxes steeply in a bid to stop money printing and further collapses of the currency and also squeeze private credit and re-direct money to the deficit. (Colombo/June21/2022)