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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ »  Economic growth has its costs

Economic growth has its costs

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1 Economic growth has its costs Empty Economic growth has its costs Mon Apr 16, 2012 11:38 pm


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by R. M. B Senanayake

The national economy grew at 8.3% last year, the highest ever, up from 8.0% in 2010. The per capita income went up from (US) $2,400 to $2,836. Fine but we need to ask two questions-

What are the costs incurred?

Is this growth sustainable?

But, before that a word of caution regarding interpretation of the Gross Domestic Product or the GDP. It is the value of all goods and services produced at their market value. There are many services which are not traded and hence do not have a market value. For example the services provided by the government by way of Defence or the Administration of the justice system are without market prices as such. So, the entire expenditure of the government is included in the computation of the Gross Domestic Product however wasteful or unproductive such expenditure may be. The government might spend money trying to win the rights to host the Commonwealth Games and fail to win it. This expenditure goes into the GDP. Similarly, the expenditure on sending large delegations to the UN in New York or to the UNHCR in Geneva are costs and not benefits but they, too, add to the GDP. Another point is that the GDP statistics doesn’t distinguish between items that are costs and items that are benefits. Expenditures on dengue prevention, flood control and costs associated with population growth and increasing urbanization — including crime prevention, highway construction, water treatment and garbage disposal increase gross domestic product, although they are attempts to restore or protect the quality of life we have already had earlier rather than improvements to the standard of living. The point to note is that such expenditure while boosting growth statistics does not contribute to sustained economic development. Another point is that a nation that grows by borrowing will see GDP rise, but much of the increase in income may go out of the country as interest payment.

Government Services constitute 7-8% of the GDP and make a similar contribution to the increase in the GDP. So let us not pay too much attention to the growth in the GDP or GDP per capita. Gallup Poll has come up with a different scenario. Not that either is correct but that both must be used cautiously.

Economic growth and its costs

There are the opportunity costs which refer to the benefits that are foregone because we chose to build a highway rather than a new hospital or school. The way in which the growth is funded also matters. When free education is funded from taxation the costs are different from its funding through newly created money. Common sense tells us that if we want an accurate accounting of change in our level of economic well-being, we need to subtract costs from benefits and count all costs, including costs to the eco-system such as the depletion of our forest reserves and the impoverishment of our soil fertility.

Let us consider the costs at a more elementary level. What are the costs of generating the current economic growth we enjoyed during the last two years? The economic growth was driven by large government infrastructure investments funded by borrowings instead of domestic savings. Where expenditure is funded from domestic savings the increase in government expenditure is matched by an equal reduction in private expenditure and there is no direct increase in the Aggregate Demand. (There are indirect multiplier effects, though). But, where the government expenditure is funded by foreign borrowings, there is an increase in the Aggregate Demand since the expenditure of the government flows into the hands of the corporate and household sectors as higher incomes from which there will be a higher demand for goods and services. Similarly, when the government expenditure so funded has to be spent on import of construction machinery and equipment like bulldozers, tractors etc and construction materials like cement or iron and steel then imports will increase. So, the generation of a higher GDP through infrastructure investment funded by borrowings foreign or non-market borrowing from the banking system has a cost by way of increased imports. Unless exports also increase the trade deficit will increase and be unaffordable as happened in 2011 when the trade deficit rose to a near US$ 10 billion.

Cost of growth funded by foreign borrowings

Apart from foreign borrowing the government also borrowed locally and a sizable part of such borrowing was from the banking system which means the creation of new money. This new money, when spent, also increases the incomes of the people and causes an increase in the Aggregate Demand. Since the Aggregate Domestic Supply cannot increase as much, much of this extra demand spills over into imports. So, the growth strategy the government has followed inevitably brings about a balance of payments crisis. The current account deficit in 2011 is at 7.8% of GDP – a prudent limit is 5% of the GDP. The Foreign Reserves have come down to a worrisome level with short term foreign debt being too high relative to the Foreign Reserves.

Remedial action to arrest trade deficit

To counter the balance of payments crisis the government has had to curtail imports. So, it recently gave up the Exchange Rate peg to conserve the Foreign Reserves. This increased the volatility of the Exchange Rate and has acted as a disincentive to the much-needed foreign capital inflows. So it has raised the rate of interest to compensate for the exchange rate risk and also to curb the expansion of bank credit which fuelled imports. But these monetary measures take time to take the desired effect. The government imposed high taxes on vehicle imports to curtail automobile imports which not only eat into the current foreign reserves but create an increased demand for petroleum products which are likely to go up in price in 2012 apart from the difficulties of obtaining it owing to the US sanctions on Iran. Further our Foreign Exchange Reserves are not enough to fund even a controlled trade deficit and the debt repayments falling due this year. We need a Foreign Reserve of at least three months imports and another 800 million dollars for debt servicing this year. So we have to raise foreign currency loans to tide over the looming balance of payments crisis. The IMF is the last resort. But, the IMF loans come with conditions. It is not that those conditions are not necessary or desirable. They invariably want the government to cut down on its budget deficit and re-build Foreign Reserves by promoting exports. These constitute the natural solution and are better than direct controls which not only lead to restrictions on international trade but also provide no permanent solution to the problem. The country has lived beyond its means! The government, of course, is living beyond its means when it runs large budget deficits and funds them by borrowings from the banking system. It wouldn’t matter if there is a corresponding reduction in consumption by the private sector businesses and households. The government did not take any steps to promote savings. In fact, by reducing the duties on vehicle imports last year it gave a boost to consumption. By holding the rupee at an unrealistic value it made imports of consumer durables and other goods cheap relatively to the domestically produced goods. The only way for the infrastructure investment strategy to produce sustainable growth is to increase domestic savings to make up for the foreign funded investment or at least to prevent any increase in money incomes of the people from such investments being directed to consumption. But the government also failed to stop the dis-savings arising from its own public sector corporations. The CEB, CPC, Mihin Air and SriLankan Airlines among a host of other government owned businesses continue to incur losses and hence add to the deficit budget instead of helping generate surpluses. Instead of tackling these deficits, the government has raised taxes to reduce imports directly. Of course, the prices of petrol and electricity had to be raised because they were being subsidized. But, the question of their efficiency should also be looked into. State corporations which are monopolies have to be broken up and exposed to competition if their efficiency is to improve. Privatization is one option which will lessen the need for curtailing government expenditure to balance the budget. Of course, it is a one-off solution but it could prevent too much hardship to the poorer segments of the people who would otherwise have to pay higher indirect taxes to reduce the budget deficit or face cuts in social welfare expenditure. Over borrowing always ends badly, whether for an individual, a company, or a country. Sooner or later, credit conditions become tighter and no one will lend you money on anything close to affordable terms. We may see something of this nature when we borrow from foreigners.

But even if we can raise sufficient foreign funding to meet the expected current account deficit, we cannot carry on the same growth strategy and aim for the growth rates of the last two years. Direct controls are likely to bring on a recession and adversely affect the growth in the private sector.

Why go for infrastructure investment strategy?

Don Boudreaux refers to prosperity as one big pool. Little drops of water go to make the pool. Material prosperity is like water contained in a gargantuan swimming pool. The higher the "water" level, the greater is our prosperity. How is this pool filled? Mostly, small drop by small drop. Countless people line the edge of the pool, each dripping in a drop or two of additional "water" – additional prosperity – from time to time. Very few single drops have any noticeable effect on the prosperity level. New goods come into the market from time to time and add to prosperity. A very few drops are large – say, the polio vaccine, and Henry Ford’s innovation for producing automobiles. But almost all drops are tiny. These tiny drops, however, together bring about an enormously high level of material prosperity. They all arise from the actions of individuals and firms but they are small in themselves. They constitute the private sector.

Those in power want the prosperity level raised noticeably by one gigantic infusion. They believe that we don’t "change the world" by contributing little drops; they want to make a big splash – a move that raises the prosperity level noticeably.

"To make a big splash, the government makes unusually large infusions into the prosperity pool. Unfortunately, because government officials are not directed by market signals, because of public-choice problems, and because the nature of market prosperity is for it to grow de-centrally and incrementally, the big splashes that government makes are too often the result of giant boulders bureaucratically tossed into the pool. These boulders often do make big splashes. They often noticeably change the level of the prosperity pool – too often downward. Much of the splash ends up outside of the pool, where it dissolves. And even if the measured level of the prosperity pool is higher after the big splash, this higher level might well be due to the fact that a large boulder is now in the pool; the volume of prosperity in the pool might be lower".

2 Economic growth has its costs Empty Re: Economic growth has its costs Tue Apr 17, 2012 12:52 am



Good one from Mr.R. M. B Senanayake.
Thanks for sharing.

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