Mahoshada

One of the fundamental reasons why the free market system has prevailed over government controlled systems almost everywhere in the world is that it is generally able to continue functioning adequately despite most attempts by governments to meddle. A free market economy is driven by the actions of millions of consumers and (mostly) private producers of goods and services as well as workers and investors – not by the targets and plans of the government bureaucracy. That is not to say that the government’s actions have no effect on economic performance; they clearly do. And it is certainly the case that the rapidly deteriorating security situation in the country is having a profound impact on the economy.

One of the most important ways in which the government’s statements and actions influence the economy is through their impact on business and consumer confidence. For the most part, consumers, producers and investors make their decisions based on how they view the future. If they view future economic conditions as being bright, their confidence is high and they are usually more willing to spend and invest, driving the economy. If they are uncertain and gloomy about future prospects, they will hold back, leading to weaker economic performance.

LMD-AC Nielsen Business Confidence Index
This week the results from the monthly survey of business people, conducted by the business magazine LMD and the highly respected public opinion firm AC Nielsen, which is used to develop a measure of the current state of business confidence. The answers to this survey are summarized and quantified in the form of the Business Confidence Index (BCI). This index tells us how conditions change month to month. When the BCI increases, it is an indication that confidence is improving, when it is going down. (Information on the BCI can be found at www.lmd.lk.)

In July the BCI continued what has been a three month sharp decline, falling by 38 percent (from 143 to 88). It is now at a 21 month low and only 57 points above its all time low in September 2001, after 11th September and the LTTE assault at the airport. The year 2001, being one of the worst years for the economy, the only year for which there was negative economic growth.

The July BCI survey found that 60 percent of the business people asked expect the economy to get worse during the next 12 months. According to the LMD, this is a somewhat more pessimistic figure than three months ago when less than 50 percent of those surveyed expected the economy to decline. In this recent survey, only 18 percent of business people expect the economy to improve over the next year. The BCI survey also signals other factors underlying the fall in business confidence. More than 40 percent of those responding expect that their business will get worse in the coming year.

Not surprisingly, these negative expectations concerning future economic performance also translate into a more or less equally negative assessment of the country’s investment climate. According to LMD, “more than two-thirds of those polled [said] that our prospects are “poor” or “very poor” – up almost 12 percentage points from May, and more than double that of April.”

These results come at a time when there has been very mixed economic news. What would appear to be positive news, for example, the reports that the economy has been growing at more than 7 percent this year, does not seem to be reflected in the current state of business confidence. Instead it seems that the negative economic news is having a greater impact.

And there has been a considerable amount of bad economic news lately. For example: The Inflation Rate: During the three months that the BCI has been falling sharply, inflation has risen equally sharply. Between March and June, the year to year inflation rate as measured by the Colombo Consumer Price Index (CCPI) increased from 6.4 percent to 17.7 percent. In July the rate fell slightly, to 14.7 percent, still very high. Higher Oil Prices: During July world oil prices returned to record levels. Growing Labour Unrest: There have been several significant strikes, including at the port and CPC. The Trade Balance: During the first half of the year, the trade balance has increased by nearly 50 percent over 2005, reaching US$ 1.8 billion. And of course, during the last month the security situation in the country has continued to deteriorate sharply while internationally the crisis in the Middle East has erupted. Given this rather dismal record recently, it is not surprising that business confidence has been falling in recent months.

In addition to gathering information on business people’s expectations about the course of the economy in the future, the BCI survey also collected data on how the respondents’ businesses have been doing in recent months. Specifically, among those surveyed, it was reported by more than 50 percent that short term sales volumes have fallen significantly during the last three months. And looking back over the previous 12 months, 61 percent reported that sales volumes have decreased.

One interesting aspect of these specific results is that they very strongly suggest that if the government’s estimates that the economy has been growing strongly – in the 7 to 8 percent range – then the sources of this growth have not been spread broadly throughout the economy. It is of course also possible that the survey carried out for this exercise is not accurately representative of the business sector, although that seems unlikely given that it was done by one of the most highly respected public opinion firms in the country.

Indicators of business confidence are not scientific forecasts of the economy’s future performance. They are, however, the best assessment of the economic direction of the country by men and women who for the most part have had considerable experience ‘on the ground’. That is why policy makers throughout the world, including central bankers, usually pay close attention to indicators such as the BCI.

Addressing Fundamentals
The government and senior policy makers may truly believe that the economy is on the correct path and that much more is going right than wrong. They may be able to dismiss criticisms of the course being taken by those in opposition or commenting on the sidelines as being politically or philosophically motivated. But they should not ignore either the hard facts that point to a deteriorating economy or the opinions of those who actually drive the economy – the private business community. This month’s BCI results should be another ‘wake up call’ for the government that perhaps all is as not well with the economy as they might think.

Like effective government generally, economic policy making is more of an art than it is a science. The essence of this art of effective policy making in a free market economy is to recognize that government can actually do very little to influence matters directly, that its chief power is only to contribute to the environment in which the key actors in the economy make their decisions – consumers, producers, workers and investors. Nevertheless, it is almost always the case that those in government who are responsible for determining economic policies believe that the role of the government and its ability to control the course of economic events are far greater than they are in fact.

But it is not only policy makers that over-estimate the efficacy of the government; the public too tend to share this belief. In every country political leaders are given far too much credit when economic performance is good and, equally, too much blame when performance is poor.

At any given time, there are a great many different factors at work and most of these are well beyond the government’s control. And there is always considerable uncertainty about future events both at home and abroad. For example, several years ago at less than US$ 20 a barrel, the world price of oil was at record low levels in real terms (i.e., corrected for inflation). Now it is approaching four times that price. And several years ago there were also prospects of a viable peace process which greatly boosted business confidence at the time.

What the current BCI results should be telling the government’s policy makers is that despite the official pronouncements that all is going well with the economy, the reality is rather different. The government would do well not to overlook or dismiss this message, because as many economists have found in the past, negative expectations can be self-fulfilling.