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A story circulating among economists about a ruler in an East Asian country gives a very good example of the impatience of politicians. When 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 explanation. His advisors, the story says, had told him that that was against the ‘laws of nature’. The reference here is that every system is governed by its internal rules that cannot be manipulated by humans. But, his immediate order had been that they should change those obstructing laws of nature by using their majority power in the legislature. 
The impatience which politicians show in doing things is understandable because they have to impress the voters that they are better than their rivals. But it is the duty of the advisors to moderate the speed to match with the installed capacity of an economy. If politicians do not listen and advisors fail in their duty, there will be irreparable damage to the foundation of an economy.
IMF with CBSL onto estimating potential output
In this connection, a working paper just released by IMF on Sri Lanka’s ‘potential output’ or the level economic growth it can achieve without overstretching its installed capacity is a good guidance. This paper titled ‘Estimating Sri Lanka’s Potential Output’ has been authored by Ding Ding, John Nelmes, Roshan Perera and Volodymyr Tulin (available at http://www.imf.org/external/pubs/cat/longres.aspx?sk=41414.0 ). It appears to be a collaborative research project done by IMF with the Central Bank of Sri Lanka or CBSL with one of its reputed economists, Roshan Perera, as a member of the research team.
Working Papers are in fact advance presentation of the findings of an ongoing research study for eliciting comments and views to facilitate the researchers to finalise the final results. Hence, their results are not yet conclusive and awaiting for moderation. Yet, they give a good indication about the direction to which the research under reference has taken the researchers. According to the authors, the preliminary findings of the research work have been presented in a seminar at CBSL and they have been benefited by the feedback received from the seminar participants.
Potential output is the ‘economic stability’ in CBSL’s mandate 
The potential output has to be understood by reference to economic stability which is one of the objectives of CBSL. As argued by this writer in a previous My View in this series, ‘economic and price stability’ with which CBSL has been mandated to achieve means setting the economy’s aggregate demand at a level equal to its aggregate supply (available at http://www.ft.lk/2011/10/10/central-bank%E2%80%99s-mandate-is-to-attain-both-%E2%80%98economic%E2%80%99-and-%E2%80%98price%E2%80%99-stability/).
Once this condition is met, there will be neither inflation nor deflation in the economy. Thus, the potential output is the level of output which the economy can attain without causing either inflation or deflation. Both inflation and deflation are considered two public enemies to be fought. Inflation reduces real wellbeing of people, enriches borrowers at the expense of savers and lenders, taxes exports and subsidises imports, puts pressure on the exchange rate to depreciate and causes havoc and chaos in an economy, to mention but a few of the evils of inflation.
Deflation leads to a reduction in output, employment and the use of resources in an economy. Hence, to sustain economic growth in the long run, a proper economic policy should seek to avoid either one and establish stability in prices. That can be done only by sticking economic growth to its potential output. The objective of the IMF Working 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.
Both positive and negative output gaps are dangerous
If an economy’s actual output differs from its potential output, it generates an ‘output gap’ – the difference between the two expressed as a percentage of the potential output. If the actual output is bigger than the potential gap, it creates a ‘positive output gap’ and if it is smaller, a ‘negative output gap’. One might conclude that a positive output gap is a desirable outcome since it produces more of the goods and services which an economy can produce based on its installed capacity. But this is not so. That is because any positive output gap is a temporary achievement since the economy has no capacity to sustain it forever.
As such, when the output increases above the potential output, it generates a new money income increasing the aggregate demand in the economy. But when the output falls in the subsequent years, the demand becomes higher than the supply creating an excess demand. Economists call this ‘overheating the economy’ just like a vehicle driving above its engine capacity gets overheated. Unless the cooling mechanism of the vehicle is effective, the overheating could cause permanent damage to the engine.
Similarly, in the case of an economy, overheating causes inflation generating all the inflation related evils in the economy. If there is a negative output gap, then, there is deflation causing unemployment and economic recession. Hence, proper economic policies should avoid both. As such, the advantage of estimating the potential output is the availability of a benchmark for policy makers, namely, those in the Central Bank and in the Ministry of Finance, to assess the desirability of economic activities.
Monetary policy action to depend on the type of output gap
If there is a negative output gap, then, of course, it justifies a central bank’s loosening its monetary policy stance to increase the aggregate demand to the level of the potential output. However, once the economy reaches the potential output level, the bank should immediately halt its expansionary monetary policy to avoid the increase in the aggregate demand over the aggregate supply and thereby prevent the economy from getting overheated.
If there is a positive output gap, the Bank’s monetary policy stance should be in the other way about. It should take restrictive monetary policy action to curtail the aggregate demand and eliminate the inflationary pressures. Accordingly, an accurate knowledge of the size of the potential output in an economy is the most important prerequisite for a central bank to design its monetary policy programme.
Potential output is determined by an economy’s installed capacity
The output of an economy is similar to the output produced by an individual. If an individual works longer hours using more of his labour, applies new knowledge bringing his human capital into production and sophisticated equipment facilitating production process, he could produce more. These are called inputs – labour, technology and physical capital – used for production.
At any time, a given level of labour, technology and physical capital will determine the maximum output – or potential output in economists’ terminology – he can produce. If he can acquire more labour, better technology and better equipment, he can increase his potential output. Similarly, for an economy, there is a potential output level fixed by the available labour, technology and physical capital.
If an economy desires to increase this potential output, one of the prerequisites is to increase each one of them. Since an economy is a growing enterprise, these are not fixed but subject to constant change. The infusion of new inputs will make the conditions better; in the opposite, the non-development of new inputs or neglect of the maintenance of the existing inputs will reverse the initial growth.
Temporary episodes of faster growth are not sustainable
An economy might show some periods of faster growth in the output followed by a decline in the output thereafter. These are called temporary improvements in the economy. Any researcher seeking to estimate the potential output will have to eliminate these temporary episodes of increased output and concentrate on the permanent growth as determined by the installed capacity of an economy.
To do so, researchers have to use advanced estimation techniques and subject them to rigorous testing methods. This is exactly what the four researchers under reference have done. They have built an economic model highlighting the output gap, unemployment gap and the capacity utilisation gap and tested the model with the quarterly data for Sri Lanka from the beginning of 1997 to the end of 2012.
Hysteresis Effect: Past behaviour matters
In building the model, an important element they have used is the impact of the past behaviour of a particular factor on its current behaviour, known as the Hysteresis Effect in science and used by economists.
Accordingly, past inflation affect the current inflation by causing to have higher or lower inflation expectations, 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. This is intuitively understandable since what we do today is guided by what we have experienced yesterday. It is valid for both negative and positive experiences but more strongly for negative experiences. For instance, if we our gas cooker had a leak leading to a fire in the cooker yesterday, it is quite natural for us to become extra cautious and restrain ourselves in our behaviour.
Sri Lanka’s potential growth rate is more or less equal to the actual growth
By applying different estimation methods used by reputed economists, the researchers have come up with an estimate of an annual potential output growth experienced by Sri Lanka ranging between 6.5% and 6.8%. On average, this works out to an annual potential output growth of 6.7%. This is more or less equal to the country’s actual average output growth during 2002-12 which stands at 6.4%.
Accordingly, on average, Sri Lanka had had a slight but negligible negative output gap in the past. However, it poses problems for the authorities who aspire to increase the growth rate above 8% per annum over the next decade since there is no installed capacity in the economy to sustain that growth rate as at present. Though the country may have temporary surges in economic growth as it had experienced in 2010 immediately after the end of the war, such growth rates cannot be continued unless there is an expansion in its capacity.
Enhancement of capacity is a matter for the government and not for the central bank
This is a problem to be tackled by the Ministry of Finance and Ministry of Economic Development and not by the Central Bank. Why the Central Bank cannot do it is because it does not have real resources except the power to print money. If money is printed to increase the potential output, the result is the increase in the aggregate demand over the potential output thereby overheating the economy.
But, the Government can have real resources transferred to it through taxation and direct those real resources to enhance the potential output capacity of the economy. But those expenses of the government should be properly prioritised, directed to productive infrastructure and development of human capital including research and technology. But it requires a reorientation of the country’s budgetary policy.
A multi-pronged approach to enhance capacity
To increase the capacity to raise its potential output, Sri Lanka should have a multi-pronged approach. It involves, on the economy side, investment in necessary and productive infrastructure, acquisition of new technology, employment of the unemployed youth in productive employment, acquisition of modern technology and management practices and diversion of a greater volume of output for continuous investment.
On the fiscal side, it involves many reforms in the budgetary processes. One is the diversion of unproductive and inefficient budgetary allocations to necessary human capital development – that is, more investment in education, health and acquisition of technology. Another is the reform of the important but presently loss making public enterprises and closing or handing over to private sector the unimportant public enterprises.
Halt the expansion of the State sector
A third reform is the halting of undesirable public sector expansion 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. On the economic environment side, the necessary reforms should include protection of property rights, observance of the rule of law, maintenance of law and order and establishment of an independent Judiciary to facilitate the concerned citizens to seek redress against what they perceive to be injustice committed by governmental authorities.
On the business side, action should be taken to improve 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 above the country’s aggregate demand could be sold to foreigners. These are difficult but not impossible reforms if the authorities make a firm commitment to undertaking them.
Without these reforms, the continued expansion of the economy through liberal monetary policy and expansionary fiscal policy will only overheat the economy creating inflation and along with that inflation, bringing all the evils of inflation to the economy.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank, can be reached at [email protected].)
