Sri Lanka, after 1977, provides a good example of a reform effort that was
considered credible by private investors. The private sector had no doubt that
the government was committed to sustained liberalization. It was widely
perceived that the state-led, interventionist, alternative had been discredited by
very poor economic performance between 1970 and 1977, and that a fresh start
was needed. The reforms were implemented by the newly elected United
National Party (UNP) government, which won 140 of 168 seats. It was
strongly committed to liberalization and had campaigned on that agenda. For
the first time in Sri Lanka since independence, the anti-market Marxist parties
failed to win a single seat. Trade and payments were liberalized, import
controls largely abolished and tariffs rationalized, export licensing phased out,
and the currency devalued. Public sector monopolies were ended, opening up
new swathes of the economy to private sector participation. Price controls were
replaced with a greater reliance on market signals to determine resource allo-
cation. Unlike many other reform efforts during this era there was no contrac-
tionary stabilization; instead there was expansion. There was large-scale
government investment in transportation, telecommunications and energy.
This was backed by a surge in foreign aid, which financed 20 per cent of total
72 Sources of Growth in the Modern World Economy since 1950
Box 3.2 John Maynard Keynes, growth and
investmentJohn Maynard Keynes, the British economist, studied the economics of depres-
sion in the 1930s. His insights have achieved new relevance in the current global
financial crisis. Keynes wrote his seminal work The General Theory of
Employment,Interest and Moneyin 1936 at the height of the world depression.
Incomes in many developed countries had dropped by up to one-third and unem-
ployment had risen to a quarter of the labour force. Keynes asked what had
caused the depression and placed investment at the centre of his analysis. Keynes
argued that investment was dependent on the expectations of entrepreneurs about
future market size and profitability. He argued that such expectations were
subject to waves of optimism or pessimism or what he called the ‘animal spirits’
of investors. This effect Keynes argued is exaggerated by what he called the
‘accelerator effect’. An investment of $400 million in new machinery might be
necessary to produce an extra $100 million in output (in economics this is known
as having a capital-output ratio of 4:1). The prospect of an expanding market will
therefore call forth a much greater increase in investment to supply it. The
Accelerator Effect will impact on demand in the economy and so amplify both
booms and busts. What Joseph Stiglitz called the Roaring Nineties in his 2003
book about the US boom in the 1990s (and subsequent bust) was driven by over-
optimistic expectations about the future profitability and market growth in
telecommunications and the internet. No government, Keynesians argue, can
hope to stabilize the economy at a high level of employment and output without
understanding and accounting for these ‘animal spirits’.