COLOMBO (EconomyNext) – Sri Lanka new administration seems to be travelling on an increasingly risky path, stirring a deadly witches’ brew of deficit spending, subsidies, wage hikes for state workers and assaults on large and small businesses perhaps not seen since the 1970s and reminiscent of Sozialpolitik in Germany.

It is ironic that these problems are happening under a regime headed by the United National Party, which in the past had a reputation for creating better conditions for private enterprise and ordinary people to exercise their entrepreneurial spirits.

Dangerous Path

It is happening under a regime where key politicians who actually understand the value of economic freedoms want to have a social market economy.

The Trade Ministry by imposing price controls is making a mockery of the Policy Planning Ministry where the Prime Minister says he wants capitalism. The Consumer Affairs Authority is demonizing small businesses and threatening even hopper makers with a 10 rupee price control in the time honoured fashion of European bureaucrats.

"It is further true that bureaucracy is imbued with an implacable hatred of private business and free enterprise," wrote economist and philosopher Ludwig von Mises half a century ago and he could well have been writing of the CAA in 2015.

"But the supporters of the system consider precisely this the most laudable feature of their attitude.

"Far from being ashamed of their anti-business policies, they are proud of them. They aim at full control of business by the government and see in every businessman who wants to evade this control a public enemy."

With a massive consumption boom fired by state salary hikes, it is likely that the prices will be sticky downwards for a while, and may even face upward pressure depending on how such spending is financed, such as by excess liquidity of central bank credit.

This column warned some months ago that the Rajapaksa administration was acting Zwangswirtshaft fashion (Sri Lanka drifts from Ernährungsautarkie to Zwangswirtshaft in 2015 budget: Bellwether). But price control are also part of Zwangswirtshaft

The new administration had also enacted a pharmaceuticals regulation authority, whose operational costs will fall on the people.

But more dangerous is the plan by the promoters to limit the number of drugs in the market, which will reduce competition and choice and push prices up to levels higher than they would, if the market was freer.

However there are hopes that direct price controls which will lead to shortages will not come. (Sri Lanka drug regulation bill given cabinet nod; no price controls planned: Minister)

The drugs authority is promoted by some doctors based on a plan originally devised by Senaka Bibile, a well-known Marxist and Trotskyite.

Make no mistake, any administration or any political party, given the present-day tools of European-style coercive powers backed by the taxation machinery, police, price controls and inflation can bring an economy of unarmed citizens to its knees, regardless of its past reputation.

These policies will not lead to a social market economy (Soziale Marktwirtschaft) and an economic miracle like in post-World War II Germany but economic stagnation, inflation and currency depreciation of pre-World War II Germany’s Sozialpolitik.

The economic woes of Germany in the 1920s were brought by the Social Democratic Party whose policies were driven by Marxian ideology as well as loose monetary policy.

In the 1970s Sri Lanka was brought to its knees by such polices, even without a war. During the Rajapaksa administration this country was hit by bubbles every five years.

When the state and rulers engage in unrestrained spending and subsidies to favoured interest groups including state workers, while imposing controls on other enterprising private citizens, there are inevitable consequences.

"…[G]overnments and parliaments have been eager for more than sixty years to hamper the operation of the market, to interfere with business, and to cripple capitalism," Mises wrote in 1944.

"They have blithely ignored the warnings of economists. They have erected trade barriers, they have fostered credit expansion and an easy money policy, they have taken recourse to price control, to minimum wage rates, and to subsidies.

"They have transformed taxation into confiscation and expropriation; they have proclaimed heedless spending as the best method to increase wealth and welfare."

Heedless Spending

Sri Lanka’s state finances have been structurally damaged by an unprecedented salary hike to state workers.

The Rajapaksa budget for 2015 bill planned to increase the salary bill including provincial councils by 80 billion rupees from 478 billion rupees to 558 billion rupees. The 478 billion rupees salary cost out-turn for 2014 was substantially higher than the 410 billion rupees originally budgeted.

Compared to the 80 billion rupees planned by the Rajapaksa administration for a 3,500 rupee salary hike plus probably other increases, the January Sirisena administration budget only provided for 138 billion rupees for a 10,000 rupee increment, of which 8,000 kicks off in February.

That may be an underestimate, in that higher outlays may be needed for statutory agencies to also pay salaries. In addition profits from various agencies may also be less.

The interest cost of 425 billion rupees, the same as the Rajapsaksa budget, also does not look credible given the domestic financing needs.

There are also many subsidies. Meanwhile the fiscal costs of a price guarantee scheme for tea and rubber is unknown. With commodity prices set to go down with a stronger dollars the budget is exposed to additional spending.

In the 1950s, when the US dollars weakened due to purchases of the Liberty Bond setting off a global inflation boom around the time of the Korean War, Sri Lanka was exposed to higher rice prices from a subsidy to consumers. This time the opposite is happening.

Subsidies are also given to rice farmers through price support and import duties. But at least taxes on wheat have been brought down giving a way out, though not much.

A 25 percent ‘super gains tax’ slammed retrospective on large business groups is similar to a situation of having "transformed taxation into confiscation and expropriation."

Wage hikes are going to push up costs. If private sector wages are pushed up by legislation it will be a dead ringer for Sozialpolitik. Mandated wages was the crowning glory of Socialpolitik.

Such polices can reduce export competitiveness, damage companies from which can take many years to recover and also reduce tax revenues.

What the new administration should have done is to throw out the bad policies and keep the good ones. But what has been done is to throw the baby out with the bathwater.

Silver Linings

But not all is lost. Sri Lanka’s private citizens are enormously resilient. Whatever the rulers and bureaucrats throw at them, they have eventually risen like a Phoenix from the ashes.

And there are some liver linings. The changes to the constitution, unless they are watered down could make the public service more independent and improve rule of law. Militarization has been stopped.

Cutting import duties on food was a good move to improve trade freedoms. This can also increase state revenues, as protected industries lose market share or are forced to be more competitive.

If state salaries are not raised next year it is possible the annual tax revenue gains will clear part of the problem.

The finance ministry is also tackling the widespread manufacture of tax-unpaid alcohol, using imported ethanol, which will push up revenues.

There may also be higher revenues from the import of small cars, through there may be revenue losses from reduced hybrid car imports.

Increasing consumption by state workers with high salaries can also boost taxes and economic growth temporarily until the debt overhang dampens growth in the future. However there will be some drag from the effects of halted infrastructure projects. The super-gains tax will further reduce money available for future investments.

There are opportunities for rationalizing defence spending. With a very high wage bill, some public sector rationalizing would needed in the future to save the poor from the burden of a bloated state.

Immediate Problem

The immediate problem again relates to state revenues. The Rajapaksa regime planned a 1.5 billion US dollar bond for January.

Every January new spending in the budget kick in and there are not enough revenues to pay. The finance ministry also had a habit of running payment arrears in the last quarter not only to contractors and suppliers but also to state energy utilities to keep the deficit numbers down.

These were cleared with the dollar bond in January. A 500 million dollar maturing sovereign bond also had to be paid off this year. The bond has been settled against foreign reserves.

Still there is a 130 billion rupee gap from the foregone bond, compared to the planned Rajapaksa budget, which had much less expenditure in any case, especially in the wages front. Therein lies the problem.

Unlike suppliers like contractors, salaries cannot be delayed. Usually money is printed in all third world countries mainly to pay salaries, which then depreciates the currency.

The Rajapaksa regime also planned to get higher revenues from fuel with falling oil prices by resisting price cuts. This administration can still benefit from a further fall in oil prices.

Linking oil-based taxes to tea and rubber subsidies can be one solution.

Credit Markets

Because the dollar bond was not sold, there has to be more domestic borrowings. That means interest rates have to remain elevated.

Higher rates can reduce consumption and drive more savings towards the budget deficit, helping keep the economy in balance.

At the moment private credit growth is low. By keeping rates high, the government can borrow more, pre-empt the private sector and keep the country going until next year when revenues can improve.

This can help keep the currency stable. The recent hike in interest rates and the commitment to auctioning debt will be good for the economy in the short term.

If all else fails, rulers can resort to the standard Keynesian interventionist remedy of poverty and state expansion.

That is to allow the currency to depreciate and create an inflationary blow off.

The currency depreciation and inflation will expand nominal revenues, reduce the real cost of wages for both the state and private sector.

It will also kill off some rupee debt by destroying its real value, but not the dollar denominated debt. This is where foreign market borrowings come in.

Sri Lanka can no longer take the fiscal risks of the past, because we are now exposed to high levels of foreign market debt. Bond yields have moved up by around 30 basis points over the last three weeks.

Ranil Wickramasinghe in a prepared statement to parliament said earlier in March that shareholders punished John Keells Holdings by selling out and pushing its price down. Rising sovereign bond yields indicate that the shoe may be on the other foot.

With an underlying strengthening of the US dollar and falling commodity prices, it may in fact be possible to depreciate the currency without generating too much domestic inflation. In fact Singapore has already allowed the currency to slide.

The idea of currency depreciation is to reduce real wages at least temporarily. It can work without long-term harm if the monetary authority can strengthen the currency again when Fed policy fires global inflation, like Singapore and Australia does.

It is in this context, that the current administration’s Sozialpolitik-style push to hike wages artificially borders on lunacy. Sooner these policies are reversed the better.

This column is based on ‘The Price Signal by Bellwether‘ published in the April 2015 issue of the Echelon Magazine. The column was written before a rate cut further loosened monetary policy last week. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.