A History of Underdevelopment and Political Economy of Inflation in Sri Lanka: With an Outline of Nationalisms [1st ed.] 9789811556630, 9789811556647

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A History of Underdevelopment and Political Economy of Inflation in Sri Lanka With an Outline of Nationalisms Dhanusha Gihan Pathirana Chandana Aluthge

A History of Underdevelopment and Political Economy of Inflation in Sri Lanka

Dhanusha Gihan Pathirana Chandana Aluthge

A History of Underdevelopment and Political Economy of Inflation in Sri Lanka With an Outline of Nationalisms

Dhanusha Gihan Pathirana Senior Economic Analyst Asia Capital PLC Colombo, Sri Lanka

Chandana Aluthge University of Colombo Colombo, Sri Lanka

ISBN 978-981-15-5663-0    ISBN 978-981-15-5664-7 (eBook) https://doi.org/10.1007/978-981-15-5664-7 © The Editor(s) (if applicable) and The Author(s), under exclusive licence to Springer Nature Singapore Pte Ltd. 2020 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover pattern © Harvey Loake Cover design: eStudio This Palgrave Pivot imprint is published by the registered company Springer Nature Singapore Pte Ltd. The registered company address is: 152 Beach Road, #21-­01/04 Gateway East, Singapore 189721, Singapore

Dedicated to the memory of Dr. S.B.D. De Silva, author of The Political Economy of Underdevelopment, 1982, reprinted 2011, 2013, London: Routledge & Kegan Paul.

Preface

It’s reasonable to say that the title of this work is rather unusual. It indicates primarily a study of inflation. Multitude of approaches not limited to economics struggled as allies and adversaries to unravel its mysteries, transgressing the established borders of the discipline. Despite this blurring of frames of perception in the quest for reaching a clearer understanding, the study of inflation has still remained a primary concern of the economics discipline. Although things stand as such, the title of this work claims to say something about nationalisms and inflation within the same body of work as if the authors are conjuring up some irrelevant affinity between the two processes. Nationalism is of course an object of study mainly in history, politics, anthropology and philosophy while inflation primarily belongs to subject matter of economics. We do not intend to draw a connection between the two processes. We are happy to deliver this good news to our readers as we believe it may ward off some doubts possibly evoked by rather strange title. However, division of labour between above disciplines, probably with the partial exception of economics which according to J. R. Hicks remains ‘on the borderline of history and borderline of natural sciences’ (Harcourt 2017), is forced from outside through same forces of fragmentation and reification that social relations in general experience under capitalism and not inherently contained or dictated in their material (see Bernstein 1991, p. 3). Hence, there are general forces which run across both these mutually independent themes of the present study. They amount to the state of

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historical development and the particular nature of the class structure inherited by a given socio-­economic arrangement within which our objects of inquiry function. Since we do study these general forces in probing determinants of inflation we thought that their specific understanding can be extended to say something about an inherently unconnected phenomenon with the initial object of study, but is nevertheless indispensable in understanding the nature of the new. Therefore, the last chapter of this work can be read independently from the rest while all other sections are intrinsically connected. Both inflation and ethno-religious nationalisms are the heavy artillery of dominant economic and political classes, through which the existing order is made and unmade repeatedly until it reaches equilibrium and an optimum form of servitude of the lower classes. Inflation performs this task directly and smoothly as Keynes remarked while ethno-religious supremacism offers us a realistic means of avoiding the real. These processes are manipulated by exigencies of their time, emerging through coagulations of dispersed forces of private actions, and ultimately serve the interests of dominant classes. In this light we are employing political economic delineations of underdevelopment as a means of probing the determination of prices and inflation. Conversely socio-political aspects of capitalist development and underdevelopment are applied in drawing a preliminary sketch of the rise of different forms of nationalisms across the world. The book therefore seeks to uncover the mechanisms at work within Gramsci’s notions of ‘relation of social and political forces’ in their own right and in their interactions. A combination of these levels of inquiry mirrors the contemporary mode of operation of Gramscian ‘relation of forces’. In Gramsci’s parlance ‘relation of social forces’ refers to the objective structure of society independent of human will, ‘[t]he level of development of material forces of production [which] provides a basis for the emergence of various social classes’ (Gramsci 1971, p. 180). In Marx’s words the relation of social forces ‘can [least] make the individual responsible for relations whose creature he socially remains, however much he may subjectively raise himself above them’ (Marx 1967, p. 10) [emphasis added]. In this light, only an inquiry into its organisation allows us to ‘check the degree of realism and practicality of ideologies born on its terrain’ (Gramsci 1971, p. 181). ‘Relation of political forces’ conversely refers to the ‘degree of homogeneity, self-awareness, and organisation attained by the various social

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classes’ (Ibid, p. 182) examined by differentiating its various moments in their historical evolution and their implications on formation of the general consciousness of society. Hence, Chaps. 1, 2, 3 and 6 are devoted mainly to the study of ‘relation of social forces’ and Chap. 7 specifically examines the ‘relation of political forces’ and outcome of its interaction with the former. Chapters 4 and 5 elaborate quantitative methods used and their inferences. Maurice Dobb remarked long ago one does not always need a new style of brick to construct a new building, what follows similarly is a synthesis devised to afford different perspectives. In this backdrop, possible parameters for left-wing politics in Sri Lanka are outlined. Colombo, Sri Lanka 

Dhanusha Gihan Pathirana Chandana Aluthge

References Bernstein, J. M. (1991). Introduction. In T. W. Adorno, The Culture Industry. Selected Essays on Mass Culture. (pp. 1–28), London: Routledge. Gramsci, A. (1971). Selections from the Prison Notebooks. New York: International Publishers. Harcourt, G. C. (2017). Making the World a Better Place Through Economics [video file]. Retrieved from: https://www.youtube.com/watch?v=7MMK_ 96BfFM Marx, K. (1967). Capital Volume I A Critical Analysis of Capitalist Production (Engels, F., Ed.). New York: International Publishers.

Acknowledgements

I express my deep gratitude to Ms. Sandeep Kaur, Editor at Palgrave Macmillan, for the support, encouragement and guidance extended throughout the long drawn out publication process of this monograph. Her keen advice helped me immensely to navigate through the technicalities of the process. Without her invaluable suggestions and encouragement and her effort the work would have taken longer to complete. I would like to thank Ms. Sunela Samaranayake, Head of Corporate Finance at Asia Capital PLC, Sri Lanka, who provided me office time to continue the study. I like to thank Mr. Ruwan Manawadu at the J. R. Jayawardena Centre, Colombo and officials of the Economic Research Department and Statistics Department of CBSL who put their time and effort in providing secondary data for the study. Emeritus Professor Dr. Nadarajah Shanmugaratnam at Norwegian University of Life Sciences, Norway and Dr. Nirmal Ranjith Dewasiri at University of Colombo, Sri Lanka provided valuable comments on the section that examines the rise of Sri Lanka’s commercial elite during British administration. I would like to thank them for their remarks. Finally, I express my deep indebtedness to late Dr. S.B.D. De Silva, who over the final ten years of his life taught and guided me in Political Economic thinking. I’m grateful to him for his critical insights which opened up the loose ends of the work and enabled me to improve its logical coherence. Dr. De Silva did not live to read any section of Chaps. 3 and 7 which as I see would have gained his attention. As far as I know this piece of writing was the last he read. The study wouldn’t have been possible by xi

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ACKNOWLEDGEMENTS

any means without his guidance. However, the signs of ‘ignorance unconquered’ that may still prevail in these pages solely rest with the responsibility of authors. Dr. De Silva’s absence drew an intellectual vacuum that echoes throughout the deserted landscape in Sri Lanka’s political economic thinking with a heavy sense of permanence. We dedicate this work in his loving memory. Dhanusha Gihan Pathirana

Contents

1 An Introduction to the Critique of Theories of Inflation in the Context of Underdevelopment  1 1.1 Inflation in Sri Lanka: An Empirical Sketch  1 1.2 Fiscal Deficit as an Endogenous Variable in Determining Inflation  4 1.3 Conflict Theory of Inflation and New Keynesian Rational Expectations  7 1.4 Background of the Theoretical Synthesis: From Classics to Monopolistic Competition 10 1.5 Underdevelopment and Structure of Capital Formation 13 1.6 Organic Composition of Capital and Inflation 17 1.7 Unproductive Labour and Laibman’s Allocation Problem 18 1.7.1 Unproductive Labour and Inflation 20 1.8 Uneven Labour Demand in Agriculture and Inflation 21 1.9 Possibility of Communism in Underdeveloped Societies and the Inevitability Thesis 25 References 29 2 Towards a Theory of Inflation in Underdeveloped Economies 35 2.1 Price Determination in Adam Smith’s Formulations 36 2.2 Ricardian System of Prices and His Criticism of Adam Smith 37 2.3 Marx’s Modification of Ricardo’s Price Theory 40 xiii

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2.4 Keynesian Theory of Inflation 42 2.5 Classical Theory of Productive and Unproductive Labour 46 2.6 Laibman’s Allocation Problem and Marxist Theory of Unproductive and Productive Labour 48 2.7 Monetarist, Neoclassical and Demand Pull Theories of Inflation from the Perspective of Cost Push Theory 53 2.8 Global Empirical Studies: Structural Theory of Inflation—A Critical Overview 57 2.9 Theory of Surplus Labour 60 2.9.1 Determination of the Wage Rate in the Dual Economy 61 2.9.2 Elasticity of the Supply of Surplus Labour in Sri Lanka 63 2.9.3 Political Economy of Surplus Labour in Sri Lanka 66 2.9.4 Theory of Surplus Labour and Paddy Supply Price Determination 68 2.10 Empirical Studies: Neoclassical Explanations of Sri Lanka’s Inflation 74 2.11 Theories of Inflation and Underdevelopment 76 2.12 Conceptual Framework 78 2.13 Conclusion 79 References 81 3 Plantations and the Rise of Merchant Cum Usurer Class during the British Rule in Sri Lanka 85 3.1 Introduction 85 3.2 Plantations and Stratification of the Village Community 88 3.3 Profits of Natives in Coffee Plantations and Arrack Renting 91 3.4 Stratification of the Peasantry and Coffee Plantations 95 3.5 Labour Exchange System Under the Purana Village100 3.6 Domination of Sharecropping over Capitalist Development of Agriculture105 3.7 Contemporary Setting: The Rise of ‘Antediluvian’ Agrarian Capitalist109 3.8 Conclusion112 References115

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4 Modelling Inflation in the Context of Underdevelopment119 4.1 Introduction119 4.2 Data Collection123 4.3 Data Analysis Method124 4.3.1 Formulation of Data124 4.3.2 Econometric Modelling127 4.4 Conclusion129 References130 5 Discussion of Socio-Economic and Statistical Results131 5.1 Introduction131 5.2 Analysis of Socio-economic Background133 5.3 Nature of Capitalist Class and Inflation135 5.4 Productivity of the Unproductive Sector and Inflation149 5.5 Agriculture Real Wage and Inflation151 5.6 Mechanisation of Paddy Cultivation and Inflation152 5.7 Conclusion153 Appendix Statistical Tables156 References162 6 Facets of Economic Control in the West and Northeast Asia: Implications to Sri Lanka163 6.1 Introduction163 6.2 Shifting Class Power in 1970’s and Sri Lanka’s Inflation164 6.3 Labour Use Pattern in Paddy Agriculture and Inflation167 6.4 Price Controls in Britain and the U.S. in WWII169 6.5 Absorption of Rural Surplus Labour: Parallels from Northeast Asia171 6.6 Conclusion175 References175 7 Political Economy of Nationalisms and Sri Lanka’s Left-­­ Wing Politics: An Outline177 7.1 Introduction178 7.2 Liberal Secular Nationalism against Ethno-­Religious Supremacism and their Syntheses179

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7.3 Precedence of the rise of Cultural Hegemony of the Elite in Sri Lanka186 7.3.1 A Note on the Absence of a Revolutionary Peasant Movement in Sri Lanka194 7.3.2 Merchant-Manufacturers and the Pre-77 Period in Sri Lanka196 7.4 Contemporary Advanced Capitalism and Neo-fascism199 7.5 Dialectics between Political and Cultural Hegemonies under Capitalism201 7.6 Fusion of Master and Slave: Ethno-Religious Supremacism and Underdevelopment203 7.7 Synthesis of Opposite Forms of Nationalism as Fascism205 7.8 Brief Critical Overview of Theories of Nationalism207 7.9 Weakening Hegemonies: Sri Lanka’s Contemporary Political Sphere208 7.10 Neoliberalism and Left-Wing Politics in Sri Lanka213 7.11 Sinhala-Buddhist Supremacism: From Modernity to Post-Modernity - A Derridian ‘Supplement’ to the Lacanian Approach215 References226 Index231

Abbreviations

ADB CBSL CCPI DCSSL GDP GoSL IMF JVP LTTE OECD SLPP UNP WWII

Asian Development Bank Central Bank of Sri Lanka Colombo Consumer Price Index Department of Census and Statistics Sri Lanka Gross Domestic Product Government of Sri Lanka International Monetary Fund Janatha Vimukthi Peramuna Liberation Tigers of Tamil Eelam Organisation for Economic Co-operation and Development Sri Lanka Podujana Peramuna United National Party Second World War

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List of Figures

Fig. 1.1 Fig. 2.1

Sri Lanka inflation. (Source: CBSL Annual Reports) Real Wage Stagnation and Increasing Per Capita Income. (Source: CBSL Annual Reports) Fig. 2.2 Regional Comparison of Rice Prices. (Source: International Rice Research Institute and CBSL) Fig. 2.3 Increasing Capital to Wage Ratio in Paddy Cultivation. (Source: Department of Agriculture 2012) Fig. 2.4 Comparison of Farm Gate and Retail Price of Rice. (Source: Ministry of Agriculture Sri Lanka) Fig. 2.5 Falling Man Days while Increasing Agricultural Workers. (Source: Department of Agriculture 2012 and CBSL) Fig. 5.1 Inflation in advanced economies and Sri Lanka. (Source: World Bank) Fig. 5.2 Inflation in advanced and underdeveloped economies. (Source: World Bank) Fig. 5.3 Inverse roots of AR characteristic polynomial Fig. 5.4 Normal distribution test Fig. 5.5 ARDL fit, actual and residual Fig. 6.1 A comparative view of the pattern of external debt expansion. (Source: World Bank data)

23 45 58 70 71 72 136 138 145 145 149 166

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List of Tables

Table 5.1 Table 5.2 Table 5.3 Table 5.4 Table 5.5 Table 5.6 Table 5.7 Table 5.8 Table 5.9 Table 5.10 Table 5.11 Table 5.12 Table 5.13 Table 5.14 Table 5.15 Table 5.16 Table 5.17 Table 5.18

One way ANOVA—Inflation in advanced economies and Sri Lanka135 One way ANOVA—Inflation in advanced and underdeveloped economies 137 Stationarity of variables—Trace Test and Maximum Eigenvalues 139 VAR lag length criteria 140 Short-run ARDL model 141 Q-statistic—Serial correlation 142 Ramsey reset test 144 Long-run ARDL model 146 Bounds test and long-run Cointegrated ARDL model 147 Wald test and validity of bounds transformation 148 One way ANOVA—Average retail price and farm gate price of rice 153 Granger causality test 156 Phillips-Perron test – Log(PO) 157 KPSS test – Log(LIA) 158 KPSS test – Log(RWA) 159 KPSS test – Log(ULO) 160 KPSS test – Log(USRI) 161 KPSS test – WP 162

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CHAPTER 1

An Introduction to the Critique of Theories of Inflation in the Context of Underdevelopment

Abstract  Contrary to established approaches, the chapter probes inflation in Sri Lanka and underdeveloped economies employing Marxist categories of mode of production and class structure, productive and unproductive labour and the gap between production and labour time specifically in agricultural sector, which shapes the composition of surplus labour in the economy. The chapter asserts that ‘capitalism proper’ employing capital accumulation, and therefore, dominance of relative surplus value over its absolute form, as the main distinction between itself and its predecessors. Concomitantly it illustrates higher relative inflation in Sri Lanka and underdeveloped economies through predominance of absolute surplus value which stagnate organic composition of capital hand in hand with higher unproductive activity in the economy compared to advanced and industrialising countries. Keywords  Inflation • Unproductive labour • Capital accumulation • Underdevelopment • Surplus labour • Absolute and Relative Surplus Value

1.1   Inflation in Sri Lanka: An Empirical Sketch Existing studies assert that inflation in Sri Lanka is primarily driven by untenable fiscal deficits leading to excess of money supply over goods and services (see Athukorala 2009; De Silva 2009; Indraratna 2009; Ratnasiri © The Author(s) 2020 D. G. Pathirana, C. Aluthge, A History of Underdevelopment and Political Economy of Inflation in Sri Lanka, https://doi.org/10.1007/978-981-15-5664-7_1

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2009; Bandara 2000). This proposition means to say that fiscal deficit is a homogenous entity capable of delivering only one inevitable outcome with regard to internal price level. On the other hand it suggests that theoretical explanation provided in existing studies on inflation in Sri Lanka strictly rests on Monetarist theory and merely reiterates the postulates it predicts. The conventional view on Sri Lanka’s inflation therefore disregards the nature of the relationship the state establishes with production forces through its deficit spending and its particular effect on the internal price level. That is to say the existing literature assumes the effects of fiscal deficit as being homogenous and hence its impact on the internal price level is assumed to yield identical results irrespective of its composition. In our view the deficit yields heterogeneous effects on the price level determined by its composition. This is empirically verifiable from Sri Lanka’s experience since independence. The pre-liberalisation period from 1948 to 1977 saw high fiscal deficits hand in hand with low inflation except during 1973 oil crisis which fused with world grain crisis during 1972–1975. A brief period of relatively high inflation emerged during the partial liberalisation attempted in 1968–70 under the United National Party (UNP) regime. Average CCPI inflation in Sri Lanka from 1953–67 was as low as 0.93% while the fiscal deficit as a share of GDP averaged 4.69% which is significantly high considering the remarkably low inflation during the period. The pre-liberalisation phase of Sri Lanka is a clear example of non-homogeneity between inflation—fiscal deficit nexus contrary to the expectations of Monetarist theory. Specific composition of the fiscal deficit during the period dominated by the food subsidy and social services (Moore 1985; Nicholas and Yatawara 1991; Atapattu 1997; Kelegama 2006) was designed to keep inflation in general and food inflation in particular low. It lowered inflation even below that of advanced economies while subsequently necessitating high fiscal deficits. Deficit spending hence reduced the internal price level and controlled inflation, in contrast to the existing explanations which ascribe inflation to high fiscal deficits. This also contradicts the Political Economic view of inflation proposed by Alesina (1987) asserting that left-wing governments are more averse to ‘unemployment’ relative to ‘inflation’ and right-wing governments are more averse to ‘inflation’ as opposed to ‘unemployment’. Sri Lanka’s experience of inflation after independence does not comply with this contention. On the other hand low inflation maintained through deficit spending assisted the expansion of predominantly the simple reproductive

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manufacturing activity through conversion of former retailers and traders into what Marx called ‘merchant-manufacturers’—whose involvement in exchange/trade predominates their involvement in production structure—during the pre-liberalisation period (see Chap. 7). Manufacturing activity benefitted from persistent low wages facilitated by low inflation. Stability of the internal price level was a product of specific composition of deficit spending, and low inflation which derived from it improved price competitiveness of emerging manufactures. ‘[S]ince part of the cost of production of labour power was borne by the government [during the pre-liberalisation phase] through the provision of education and health facilities and various consumer subsidies, private companies could benefit from a labour supply at a low wage rate’ (Liyanage 1997, p. 438). The deindustrialisation wave which overtook the economy was fuelled by sharp and sudden increase in inflation following liberalisation in 1977 (see Fig. 1.1 below) in an environment where the new regime completely repressed Trade Union activity. It hence indicates unmistakably that sharp increase in inflation following 1977 cannot be attributed to Trade Union pressure for higher wages and to rising wages. The new regime immediately lifted import restrictions and phased off subsidies (Moore 1985) and hence broke the levee which contained the surge of prices. High inflation coupled with significantly high fiscal deficits occupied the economy under the tutelage of neoclassicists and sealed its permanence following liberalisation despite continuous attempts to arrest it. Low inflation–high fiscal deficits nexus which prevailed till liberalisation was hence permanently reversed. The study in this backdrop reflects on the experience of inflation during post-liberalisation period of Sri Lanka since 1977. It analyses causes of inflation through a critique of existing formulations which primarily explain it through continuation of high fiscal deficits. Seriousness of the problem of inflation in Sri Lanka is held in great importance by economists and government authorities as well as by mass of the people. It’s underscored in IMFs policy framework to assist Sri Lanka resolve its balance of payments and public debt crisis. IMF highlights the need to contain inflation and convert Monetary Targeting policy structure of CBSL to an Inflation Targeting regime (IMF 2016). CBSL welcomed these views indicating the great level of significance rendered by authorities on containing inflation. CBSL’s monthly survey of inflation expectations consulting all major financial institutions provides further evidence of significance imparted by monetary authority to understand and contain inflation.

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CBSL ascribed the phase of relatively high inflation in 2016 to persistent growth in private and public credit despite tightening monetary policy in 2016 and raised policy rates twice by 50 basis points during the year. Further, severe floods and droughts prevailed throughout last one and a half years also aided forces of high inflation (CBSL 2017). CBSL under this backdrop restricted credit availability to finance companies through commercial banks to contain inflation. Credit growth to Financial and Business Services subsphere was as high as 70.7% from June 2015 to June 2016 and absorbed 7.3% of total outstanding private sector credit. It’s the second largest subsphere in terms of credit absorption exceeded only by Personal Housing accounting for 9.2% of private borrowings which also grew by leaps and bounds reaching a growth rate of 41.7% during the corresponding period. CBSL imposed these quantitative restrictions on commercial banks’ lending with the aim of restricting the relending activity of finance companies. Hence, in theoretical terms and as a matter of practice, CBSL currently comprehends the issue of inflation in terms of excess demand on one hand and supply shortages in agricultural sector on the other. In this study, both these aspects will be theoretically examined under the context of underdevelopment and monopoly-finance capitalism.

1.2   Fiscal Deficit as an Endogenous Variable in Determining Inflation Crux of the mainstream explanation of inflation is that due to fiscal policy dominance of monetary policy in Sri Lanka money supply increased without a corresponding increase in real output. Hence, large scale fiscal deficits maintained in the long run by successive governments as means of securing political popularity is at the  heart of the issue (see Indraratna 2009; De Silva 2009; Ratnasiri 2009 and Bandara 2000). The established view on Sri Lanka’s inflation therefore has not examined the economic structure when analysing changes in the internal price level. It’s as if money supply, prices and output interact  to realise the internal price level in a political economic and structural vacuum. Monetarist view of inflation therefore considers structure of the economy and class relations as passive elements in price determination. More importantly, mainstream analysis does not elaborate why governments in Sri Lanka resort to expansionary fiscal policy to remain politically popular, in contrast to governments in developed capitalist economies disregarding their conduct under periods of stagnation. The problem was

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also raised by Sebastian Edwards who sought to resolve it through mainly a Game Theoretic approach to relationships between rival political parties contending for political power (see Edwards 1994). However, in contrast, we attempt to develop a structural elaboration of the problem. Public are objectively forced by living conditions produced by state of the economy to strongly expect government’s assistance, given that private sector has not delivered economic conditions required to realise a fair living standard. To fill this political economic void, governments have to maintain expansionary fiscal policy providing subsidies and employment as a means of curbing the ‘supply gap’ within private sector. Hence, fiscal deficit itself can be determined by stagnation of real incomes, unemployment, underemployment, insecurity of employment highlighted by 68.1% of Sri Lanka’s workforce employed in informal sector (DCSSL 2019, p. 48) and indebtedness of lower classes. For instance, high unemployment in Sri Lanka prevailed throughout post-independence history up to the mid-­2000s until labour migration since the 1990s gradually reduced it below 5% in 2010. Despite the reduction of official unemployment rate, underemployment in rural areas and in services remains a major concern. Underemployment in agriculture and services tends to withstand in spite of inflation stemming from rigidities in labour mobility, which will be examined in Chap. 2. ‘It was observed that, because of mono-culture in paddy in the colonisation schemes, about 40 per cent of land and 35–50 per cent of family labour remained annually unutilised in production’ (Atapattu 1997, p.  71). Fiscal deficit is hence shaped by the economic structure and acts as an endogenous variable determined by backward conditions within which resource allocation process functions and not vice versa. Furthermore by attributing inflation to high fiscal deficits it assumes consciously or otherwise that the economy was in near full employment, and capacity utilisation was near optimum and hence inflation is attributed to demand-pull causes. However, during the period under review unemployment in Sri Lanka was high while capacity utilisation remaining well below maximum and balance of payments were in deficits hand in hand with high inflation. This further suggests that causes of inflation in Sri Lanka cannot be simply reduced to changes in money supply triggered by persistent fiscal deficits and also on ‘rational expectations’ of future inflation as the New Keynesians would suggest. This is so given that a wage-­ price spiral of the conventional sense was ruled out by suppression of the labour movement by the government following 1977 liberalisation. It

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further invalidates the Non-Accelerating Inflation Rate of Unemployment (NAIRU) thesis which ‘dominates modern discussions of inflation’ (Shaikh 2016, p. 49). The thesis claims that inflation will continue to rise when unemployment falls below a certain critical minimum. ‘It is defined as a rate such that, as long as unemployment is above it, inflation can be expected to decline’ (Modigliani and Papademos 1975, p. 142). Hence, the NAIRU hypothesis holds that if the actual rate of unemployment falls below NAIRU, inflation should accelerate and vice versa. Aggregate output in the economy should therefore rise to the level that NAIRU equals the actual rate of unemployment for inflation to remain constant in the absence of an external shock to the system. Higher unemployment which went hand in hand with higher inflation following 1977 in Sri Lanka up to 2008 provides empirical evidence against this contention. In this light Scitovsky asserted that an excess of income claims to the sum of incomes generated leading to cost-push inflation ‘can exist independently of what the degree of utilisation of the labour force and productive capacity happens to be. After all, income shares can be incompatible whatever their recipients chose to do with their incomes. That is why cost-­ push inflation can proceed under conditions of depression and unemployment’ (Scitovsky 1979, p. 5). This means to say that cost-push inflation arises from a violation of distribution function of markets with respect to achieving an equilibrating level of income distribution between capitalists and workers. He asserts that income claims cannot exceed the total available income if the distribution of income is merely the function of factor markets while product markets remaining neutral. ‘[I]nfluence of the prices splits the distributive function between factor and product markets and so opens up the possibility of incompatible income shares… [T]he distributive function of the product markets is obvious [under monopoly and oligopoly profits], and so is its coming into conflict with the distributive function of labour markets’ (Ibid. pp. 5–6). In the following discussion it will transpire that not merely the concentration of market power within product markets but also the structure of capital formation determined by the nature of the business elite hand in hand with the character of surplus labour in the economy essentially lead to violation of equilibrating distribution function of the factor markets in income distribution as opposed to product markets highlighted by Scitovsky, which results in inflation. Heterogeneity of labour imposed by its employment in both productive and unproductive spheres and the non-neutrality of its heterogeneity are the two vital underlying conditions

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which permit the violation of distribution function of factor markets in reaching equilibrium in income distribution, but not merely between capitalists and workers as Scitovsky asserts, but essentially between productive and unproductive workers. In an underdeveloped economy, there is no automated mechanism in either product or factor markets which leads to equilibrium in income distribution. In terms of demand-pull inflation Scitovsky asserts that it triggers due to an excess of aggregate demand over the maximum available supply through an outside money creation linked with a budget deficit. ‘To keep prices and wages rising, aggregate demand must continue to exceed total potential supply and therefore also total income. A sustained excess of spending over income, however, is unlikely to be maintained without a sustained Government budget deficit. Concerning demand-pull inflation of that kind therefore, I would agree with monetarists’ (Ibid. p.  4). However, in the following discussion it will surface that Scitovsky’s exposition of cost-push inflation has to be extended into the dynamics of the factor markets determined by the composition of capital formation of the economic elite hand in hand with the structure of surplus labour. This needs to be integrated with an endogenous money growth process emanating from the economic structure to elucidate causes of inflation in an underdeveloped economy in the lights of Sri Lanka.

1.3   Conflict Theory of Inflation and New Keynesian Rational Expectations We therefore maintain that primary means of surplus appropriation in Sri Lanka that concentrates investments on one hand in socially unproductive investments and on the other on technologically stagnant areas are primary causes for inflation. Further, we examine how dominant production relations determine the structure of the labour market in its totality in a way which renders the transfer of surplus labour from villages to towns an inelastic function, specifically to industries. Hence, we observe that dynamics which construct the resource allocation process also cause inflation to be an in-built force within it. ‘Basically, neither individual nor group/class behaviour may be understood without making explicit the economy-wide structures and relationships that provide the backdrop to their behaviour. Similarly, economy-wide structures and relationships not only influence but also are influenced by individual and group/class motivations and behaviour’ (Harcourt 2006, p.  3). Remaining within this. Marxist

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framework of analysis the focus of the study of inflation is primarily grounded on two processes: structure of capital formation and factors shaping mobility of surplus labour. The study therefore differs from the two fundamental strands in political economic theories of inflation. The ‘state-capture’ theories of inflation assert that less democratic governments create inflation to the benefit of itself and rent seeking economic elite (Hellman et  al. 2000) and the populist approach asserts that democratic governments create inflation as a means of increasing government revenue to meet the redistributive demands of the public (Clark 2002). The political economic approach is an extension of the monetarist neoclassical approach to the study of inflation given that both apparatuses assert, in the last analysis, that the state is the fundamental agent of inflation and hence is assumed to be an exogenous variable in the inflationary process. In contrast we emphasise the endogeneity of fiscal policy in economy’s inflationary process. Stephen Marglin’s model of an advanced capitalist economy (Marglin 1984) on the other hand asserts that inflation is triggered by an excess of planned investment over planned savings stemming from a higher rate of actual profits over and above the ‘conventional rate’ which corresponds to the ‘conventional wage rate’, the latter being the acceptable rate of wages to which an acceptable rate of profit corresponds. That is to say equilibrium rate of inflation where rate of wage inflation equals rate of price inflation corresponds to a state of income distribution which falls short of ideal aspirations of both workers and capitalists. But nevertheless, their disappointments are neither increasing nor decreasing. Hence, the exposition of dynamic equilibrium in the model presupposes an ‘uneasy truce’ between workers and capitalists where the sustained rate of equilibrium inflation is a measure of ‘frustration of the wage-earners trying to maintain a conventional real wage and the frustration of the capitalists trying to carry out their investment (accumulation) intensions’ (Marglin 1984, p. 131). The above conceptual framework of ‘aspirations gap’ was further extended to elaborate changing degree of inflationary pressure in different periods by Leonard A. Rapping. ‘When the rise in the living standards is halted by the failure of growth… it is assumed that if real demands are maintained, an “inflationary gap” arises’ (Rapping 1979, p. 38). In the final analysis the foregoing explanation, similar to Rob Rowthorn’s exposition of conflict inflation where ‘conflict over the distribution of income affects the general level of prices in advanced capitalist economies’ (Rowthorn 1977, p. 215), given that ‘rival claims of income

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may exceed or fall short of what is available after the payment of taxes and import costs’ (Ibid, p. 217) suggests that a sustained inflationary process is triggered by a sustained increase in wages enabled by high existing profit rates. In Rowthorn’s model high unanticipated inflation is caused by both workers and capitalists attempting to secure a higher share of the available aggregate income after allowing for deductions of taxes and imports. This exposition designed to uncover causes of inflation in advanced capitalist economies in our view also fails to explain the dynamics of inflation in an underdeveloped economy given that it suffers from the same ‘neoclassical symptom’ (see Harcourt 2006, p. 72) of treating and assuming the effect of composition of investments, its division between productive and unproductive labour on the price level as neutral and homogenous. In the same vein the theory of rational expectations examines systematic variations of people’s behaviour patterns to changes in government policy or what is called ‘rules of the game’ in the lights of administered taxes, government expenditure, monetary policy, etc., and its impact on the price level under given constraints set by laws of motion which people understand (Sargent 2013). That is to say the rational expectations models are built on the hypothesis that people do understand these laws of motion based on which they make anticipations. Further, an anticipation of say monetary easing or fiscal expansion by firms in the face of unemployment would impel them to increase current output expecting an increase in future demand as opposed to an increase in current supply prices in the absence of an increase in current output. Similarly, the contemporary New Keynesian Phillips Curve models assert that current inflation is a function of expectations of business’ future inflation and economic slack, an assumption stemming from the full-information rational expectations hypothesis (Coibion et al. 2017). However, inflation arising from changes in the composition of capital in the lights of productive to unproductive activity and organic capital composition lies outside the sphere of people’s capacity to rationally predict and hence is not accounted for in the rational expectations theory as well as in people’s ex ante behaviour. Given that changes to price level arising from alterations in the economic structure are unanticipated it invariably causes redistribution of income in favour of capital as opposed to anticipated inflation in which income distribution remains unaffected. ‘[I]nflation has no redistributive effect if it is fully anticipated by all concerned, for then everyone takes advance measures to allow for or anticipate future price increases. To redistribute income, inflation must therefore be unanticipated’ (Rowthorn 1977, p. 215). Greater

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degree of unanticipated inflation in underdeveloped economies on account of price increases stemming from structural phenomena in turn leads to exponentially higher income inequality. This is reflected by higher Gini coefficient figures in underdeveloped economies and in Sri Lanka in particular following 1977 compared with advanced capitalist economies. Likewise, determinants of relative inflation between advanced and underdeveloped economies cannot be accounted for with conflict theory of inflation nor rational expectations given that they are designed to explain the inflationary process within an economy capitalistically developed disregarding dynamics of economic composition. The determinants of relative inflation between advanced and underdeveloped economies therefore lie outside the scope of above theories. Moreover, low income earners in underdeveloped economies in general for instance the peasantry, the informal sector workers, workers in free trade zones, etc., are not in a position to demand their respective expectations or let alone accurately predict future price changes to form rational expectations. The latter ‘approach has limited direct applicability, for its extremely demanding assumptions about access to information seem particularly inappropriate for conditions in many developing countries. …The ways in which public reactions can undermine policy intentions will admittedly often differ between developed and developing countries’ (Killick 1989, pp. 54–55). Further, consumers in advanced capitalist economies also tend to neglect the gains of forming rational expectations on inflation given that costs of acquiring information to ‘anticipate inflation’ in Rowthorn’s sense outweighs the potential gains of employing that awareness. This remains particularly true considering the negligible costs involved with disregarding insignificant rates of inflation in advanced capitalist economies by consumers. This phenomenon has been termed the ‘rational inattention’ (Cavallo et al. 2017).

1.4   Background of the Theoretical Synthesis: From Classics to Monopolistic Competition The theoretical apparatus is therefore derived by a synthesis of theories which in turn renders a broader conceptual framework applicable to the analysis of inflation in underdeveloped economies in general with certain modifications to the theories employed in the analysis of staple agriculture specific to Sri Lanka. The latter although embodies phenomena common for agriculture in underdeveloped economies such as the combined use of family labour and wage labour, uneven mechanisation of different

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processors of cultivation, uneven demand for labour across time, etc., there are also characteristics specific to agrarian conditions in Sri Lanka probed in the study which lead to inflation. In this light the first section in Chap. 2 commences with a discussion on general theory of price formation of Classical economists. It reveals that there is a sharp incongruence in conventional coalescing of theories of Adam Smith and David Ricardo on absolute and relative price formation with that of Ervin Fisher’s theory of inflation under Classical thought. Fisher sees inflation purely as a monetary phenomenon. Theorisation of Smith and Ricardo on price formation alludes to distribution of income between capitalists and workers and the ratio of fixed to working capital in different industries. Fisher’s theory therefore foreshadows Monetarism as opposed to Classical doctrine. The latter anchors its analysis on the structure of investment hand in hand with the composition of income distribution in constructing the theory of price formation. It should be borne in mind that there is no conformity between Classical economists on theory of price formation. Hence main components of Smith’s theory of prices are discussed to illustrate how Ricardian system is a further development and more or less a rejection of the Smithian view although remaining fundamentally interrelated with it, in contrast to Fisher’s theory of inflation. Dr. Howard Nicholas in a recent study compellingly argued that Marx’s approach to the study of price determination in a capitalist economy is theoretically accurate and it’s erroneous to transform input values into prices to compute ‘prices of production’. Dr. Nicholas in this light remarks that there is no real recognition by critiques of Marx’s price theory ‘that what Marx is trying to do with this procedure is to explain prices and not simply compute their magnitudes. …[T]here appears to be no appreciation that Marx’s transformation procedure does not require the transformation of input values [into prices of production]’ (Nicholas 2011, pp.  73–74). Mainly criticising the approach of Piero Sraffa (see Sraffa 1960) and others, he asserts that in Marx’s method ‘there is no need to transform the values of inputs into prices of production because values are qualitatively distinct from prices and transforming value magnitudes into price magnitudes in the explanation of prices would result in prices being tautologically explained by prices, albeit lagged prices’ (Ibid. p.  87). Further, his recent paper criticising Piero Sraffa’s theory of price he asserts that ‘[w]ithout a measure of the physical quantity of inputs other than price, it is surely meaningless to argue, as Sraffa does, that a change in the methods of production can be expected to have a determinate impact on the relative prices of outputs (Nicholas 2014, p. 321) given that there is

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no means of understanding an improvement in production methods a priori without a measure of value independent from price in the first place. Hence, in the proceeding analysis we will not be reviewing theories questioning the validity of Marx’s price theory. Under this backdrop we turn to analyse Keynesian theory of inflation. Keynesian view primarily rests on the proposition that free market mechanism would result in excessive inflation crippling an economy in short of resources. It proposes a centrally controlled system in which equilibrating product and labour markets are freed from the inflationary process and rests on carefully articulated planning of production, distribution, saving and prices. Maldistribution of income hand in hand with inefficient deployment of production factors through the free markets is therefore underscored by Keynes as the key phenomenon that leads to inflation in a centrally unmediated allocation process. We combine this insight with the Marxist theory of productive and unproductive labour to indicate how the ratio between productive and unproductive investments is altered in a way that feeds inflation as the income appropriation process expands within the free market mechanism in Sri Lanka and in underdeveloped economies in general. The chapter further seeks to resolve the ‘Allocation Problem’ posed by Professor David Laibman to demonstrate the operational significance of the concept in the study of inflation. The study is conducted within a Marxist approach to inflation in which changes to the price level and money supply is seen as lying outside monetary circulation. Hence, reversal of the monetarist and neoclassical causal link running from money supply to inflation is supported in the study. The idea is well established since it was first proposed by Marx (see Marx 1967a, p. 117) and later by Gunnar Myrdal following Wicksell in his ‘Monetary Equilibrium’ (1939). Myrdal remarks that ‘complicated quantitative relation between the amount of means of payment and the ‘price level’ is by no means such that amount of means of payment determines the price level, rather than the other way around’ (Myrdal 1939, p. 14). He further asserts that ‘changes in the price level and in the amount of means of payment are both simultaneously dependent upon factors which lie outside the mechanism of Payment proper’ (Ibid. p. 15). An increase in price level therefore is not preceded by a corresponding increase in supply of or demand for money but rather the contrary. ‘The development and expansion of [currency] markets, commercial paper markets, commercial bank liability management, and trade credit in its numerous forms have created a loose and uncertain relationship between changes in the composition of Central Bank’s balance sheet and the volume of credit’ (Rapping 1979, p. 37).

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In this connection the concept of ‘administrative inflation’ (Means 1994) portrays price setting by oligopolistic firms independent of demand changes. Similarly, ‘perverse prices’ or ‘oligopolistic inflation’ (Stigler 1962) illustrates the tendency for firms to raise prices when demand decreases as a means of achieving previously established target incomes in spite of the drop in quantity demanded which defy monetarist postulates of inflation. In the same vein Dixit-Stiglitz model asserts that market price under monopolistic competition will remain above the competitive equilibrium despite the number of competing firms rising. This remains true given that firms tend to ignore strategic interactions firstly on account of the consumers’ ‘love for variety’ which drives them to purchase not one particular differentiated product from a variety of others but all (Dixit and Stiglitz 1977). Even if consumers’ ‘love for variety’ does not necessarily impel them to purchase all available products but nevertheless are likely to purchase close to all, hand in hand with the fact that their purchasing decision is relatively independent from income and price and hence is homothetic, prevalence of monopolistic competition will not drive output prices towards market equilibrium and will necessarily remain well above the latter. Secondly, given that there is infinite number of possible differentiated commodities, an increase in the number of firms will not reduce the degree of differentiation between firms. The combined weight of these two phenomena in turn drives firms’ decision making or price setting above and beyond market equilibrium prices. This remains the ‘underlying presumption of the Dixit-Stiglitz model’ (Stiglitz 2017). Hence, monopolistic firms’ pricing decisions face a downward sloping demand curve and remain relatively independent from changes in money supply. Hence ‘sellers must set prices in advance leading to money non-neutrality’ (Cooper 2004, p. 395). Absence of firms facing horizontal demand curves as Stiglitz asserted in turn would incapacitate minor adjustments to exchange rate of a small open economy in resolving demand deficiency and problems of full employment (Stiglitz 2004, p. 134).

1.5   Underdevelopment and Structure of Capital Formation Politico-economic factors cause inflation to be an in-built mechanism within the income generation process in Sri Lanka. The ‘rent seeking’1 relationship sustained by the commercial elite with production forces underlies this mechanism. Underdevelopment and higher inflation in this

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light are necessary outcomes of particularity of mode of production vis-à-­ vis economy’s surplus generating and surplus appropriating method. The mode of production in Sri Lanka is historically characterised by the ‘formal subsumption of labour to capital’ where commodification of labour is achieved by penetration of capital in exchange relations in the absence of a continuous transformation of capital’s relation to itself and to labour in the production process.2 This in turn shapes the nature of class formations in a society. This follows Marx’s claim that ‘It is not the articles made, but how they are made, and by what instruments, that enables us to distinguish different economic epochs’ (Marx 1967a, p. 180) and is indispensable in understanding underdevelopment in general and inflation in Sri Lanka in particular. Marx in this light states, ‘Industrial capital is the only form of existence of capital, in which not only the appropriation of surplus value or surplus product but also its creation is a function of capital. Therefore, it gives to production its capitalist character’ (Marx 1967b, quoted in De Silva 2013, p. 421). The non-industrial character of capital in underdeveloped economies, therefore, signifies predominance of pre-­ capitalist structure of production. The commercial elite in Sri Lanka relates with production forces in the economy by two distinct means. Firstly it does so by ‘formally subsuming labour’ to itself which involves the absence of two dialectically bound processes strictly unique to capitalist mode of production: (a) without continuous extension of division of labour which breaks up previously integrated activities of labour into separate processes and independent branches of industry, enabling diversification and specialisation of machine capital, (b) without increasing the use of machine capital that shifts capital composition in favour of plant, machinery and raw material or constant capital, which in turn further deepens division of labour. Delineating the dialectical relationship between division of labour and mechanisation Marx states that ‘application of machinery increases the division of labour within society, [hence]  multiplies the number of specialised branches of industry and independent spheres of production’ (Marx and Engels 1988, p. 321). Further, ‘differentiation [and] specialisation of the instruments of labour given by the division of labour... is one of the technological, material prerequisites for the development of machinery as an element which revolutionises the mode of production. (Marx and Engels 1991, p. 387). Marx defines the two interrelated processes as capital accumulation (Marx and Engels 1976, pp. 430–2). Accumulation of capital leading to capitalist development renders the variable constituent of capital ‘always smaller and smaller as compared with the constant’ (Marx 1967a, p. 624).

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It alludes as a corollary that surplus generation and appropriation in Sri Lanka is devoid of capital accumulation and therefore does not contain within it the capitalist mode of production. The mode of appropriation is hence subjected essentially to the formal subsumption of labour to capital (see Shanmugaratnam 1984, p. 23) where production of absolute surplus value dominates the relation between labour and capital in the production process. Hence, scope for transformation is intrinsically restricted by setting narrow limits to the development of the capitalist mode of production. In this connection Marx further delineates that ‘absolute surplus value turns exclusively upon the length of the working day’ while production of relative surplus value ‘revolutionises technical processes of labour and the composition of society’ (Marx 1967a, p. 510). Marx further asserts that it’s the production of relative surplus value that pre-supposes the capitalist mode of production as opposed to the  absolute. It can be hence concluded that generation of relative surplus value dominates the mode of production in metropolitan economies as opposed to predominance of absolute surplus value in underdeveloped periphery. The self-­expansionary character of capital underscored by Marx is hence absent in the periphery. Unified progression of the two modes of productions characterises the global capitalist system in its totality. It can be further deduced by this proposition that length of the working day is invariably greater in underdeveloped regions where profit appropriation is dominated by absolute surplus value generation. This we witness by over twelve hour shifts the workers are subjected to in free trade zones in Sri Lanka and elsewhere dominated by garments, electronics assembly firms hand in hand with the service sector ventures such as supermarkets, retail outlets, bakeries, tourism, transport services, etc., which together account for the largest share of non-agricultural employment specifically in Sri Lanka. Domination of absolute surplus value in profits appropriation combined with the inelastic supply of labour in Sri Lanka—of which we will comment at length  in Chapter 2—in turn causes the  business elite to extend the working day beyond that of economies with higher relative surplus value generation and an elastic labour supply. Dearth in variable capital will be recompensed by ‘a proportionate extension of the working day’ (Ibid. p. 305). Therefore labour supply becomes relatively independent from the supply of labourers, although subjected to limits. It emphasises the pre-capitalist production relations which the merchantmanufacturer cum rentier class of Sri Lanka reproduces through its profits appropriation processes, solidifying the underdeveloped character of

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the society in its totality. ‘Conservation of the old modes of production in unaltered form, was …the first condition of existence for all earlier industrial classes. Constant revolutionising of production, uninterrupted disturbance of all social conditions, everlasting uncertainty and agitation distinguish the bourgeois epoch from all earlier ones’ (Marx and Engels 1976, Manifesto of the Communist Party, p. 487) [Emphasis added]. In a similar vein reflecting the prior need for an appropriate class structure for capitalist development to assert itself Gramsci remarks that ‘The disappearance of the semi-feudal type of rentier is… one of the major conditions of an industrial revolution (and, in part, the revolution itself ) and not a consequence’ (Gramsci 1971, p. 293) [emphasis added]. In this light the productive sector of the economy dominated by garments, assembly type industries, foreign  outbound tourism, agriculture, fisheries, etc., is carried out mainly on ‘formally subsumed’ methods of capital formation and employs less plant and machinery per worker and does not encapsulate ‘internal pattern of labour use necessary to increase division of labour and share of plant and machinery in total capital composition’ (De Silva 2013). This in turn stifles the concomitant growth of real wages and lowering of production cost.3 Hence, competition and higher rate of profits in modern industry alone  surplus value do not ‘extend [transformative impulses] to the mode of production’ (Ibid. p. 316).4 However, strong domestic and world demand for the above goods which prevailed over long periods dampened the effects of low labour efficiency on the value productivity of labour. Where demand is strong and competition limited ‘even primitive production methods might rank high in measured “efficiency”’ (see Ibid.). Hence, wages in sectors mentioned above such as garments, tourism, electronic assembly, and so on have increased on account of oligopolistic and monopolistic pricing enabled by product differentiation. This in turn has reduced consumers’ surplus and increased profits and wages while labour productivity remained more or less unchanged. The transfer of consumers’ surplus into profits and wages enabled by the oligopolistic market structure in economies in general is nevertheless erroneously calculated as an increase in ‘value addition’ by firms and increase in labour productivity under the standard national accounting framework practiced today. It calculates the reduction of consumers’ surplus as an increase in labour productivity which draws a smoke screen over the reduced welfare effects stemming from oligopolistic and monopolistic markets.

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1.6   Organic Composition of Capital and Inflation In this light, the perpetually high share of labour expenses relative to machinery and raw material in total employed capital stemming from the low organic composition of capital in underdeveloped economies infuses the groundwork necessary for higher long run inflation to materialise when wages rise relative to advanced capitalist economies. This is to say that even if wages increase by a smaller fraction compared to a wage increase in an economy with higher organic capital composition, internal rate of price increase of the former will be higher. The exact mechanism which brings this phenomenon to life will be elaborated by applying Ricardian and Marxian theory of prices in Chap. 2. This means to say that the long run tendency is for currencies of underdeveloped economies to gradually weaken against advanced capitalist economies and is irreversible within the contemporary market framework. There is no better example for this than the Sri Lankan rupee. Specific mode of production in Sri Lanka provides the groundwork to raise the price level beyond industrialising regional economies and inflation above advanced capitalist economies. The mode of production in developed and industrialising economies is designed to lower internal price level and compete against foreign producers which in turn ‘extend its transformative impulses towards the mode of production’ itself, (here of course, we are abstracting the effects of oligopolistic market structures in advanced economies). The process concomitantly expands their domestic markets and therefore the aggregate demand for labour, investment and consumer goods through incessant multiplication of both machinery or capital goods and consumer durables: the distinguishing trait of advanced capitalism from other modes of production which lends itself the propensity to selfexpansion and hence creates its own markets. In this light, Dr. De Silva highlights the need for an appropriate class structure for capital accumulation  to be established as the dominant mode of surplus appropriation. ‘The technical advances in European societies were predicated on …the emergence of a class structure that was favourable for capital accumulation. …The changes in the socio-political structure provided an appropriate framework for technical progress and were themselves influenced by the latter’ (Ibid. p.  19). Conversely, ‘inwardly oriented investments’ (Hobsbawm 1978) such as banking, finance, real estate, construction, healthcare, entertainment, tourism, food and beverages5 in an underdeveloped economy such as Sri Lanka free itself from international competition as a means of  augmenting profits. Absence of capital accumulation in

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surplus generation causes stagnation of the home market for labour and output (De Silva 2013). Marx in this connection states that ‘laws which correspond to largescale industry are not identical with those corresponding to manufacture. The latter constitutes merely a phase of development leading to the former’ (Marx 1972, p.  335). This is to say further that ‘economic law of motion of modern society’, its particular dialectic, is non-operative in underdeveloped economies although underdevelopment in its totality is a necessary organ and a derivative of capitalism at world scale.6 An equally important corollary is that formulas of both orthodox and heterodox schools of thought, even when the latter incorporates class divisions into its analysis, limit their inquiry within exchange relations of classes and class fractions, while abstracting from it the differences in production structures and their interaction determined by the differences of the former. Reflection on the latter constitutes the fundamental methodological corpus of Marxist analysis.

1.7   Unproductive Labour and Laibman’s Allocation Problem In this light  returning to our discussion on characterisation of Sri Lanka’s capital formation, apart from its pre-capitalist or pre-industrial nature, investments expand further in areas categorised as unproductive, defined by Marx as labour that creates neither value nor surplus value, which can be further categorised as useful (e.g., trade in basic goods, government services, defence, healthcare) and wasteful unproductive labour (e.g., luxury goods and services, real estate, advertising, speculative activity) from the perspective of society. Further, activities such as banking, finance and insurance although unproductive bear both useful and wasteful characteristics which can be delineated according to the nature of the specific activity which they facilitate. In this vein international trade in healthcare, luxury goods and services such as precious stones, tourism, condominiums, etc., that characterise the composition of Sri Lankan economy separates and allocates their productive (from the perspective of the supplier) and unproductive nature (from the perspective of the society and the purchaser) across national boundaries. They remain productive for the country supplying by raising sum total of values of latter by transferring the value produced in the importing nation and are unproductive for the purchasing country by reducing the

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same. In this light Laibman’s ‘Allocation Problem’ in defining unproductive labour (Laibman 1999) is resolved in Chap. 2 of the study. Further, the restricted development of capitalist mode of production in certain unproductive activity in Sri Lanka and in underdeveloped economies in general, in contrast to the relative predominance of pre-capitalist nature of production in the productive sector, is specifically analysed in Chap. 2. Definition of unproductive labour and its ‘operational significance’ was seriously questioned by David Laibman (Ibid) underlining its indeterminate nature and its inability to objectively constitute the conceptual distinction between productive and unproductive labour. The three major definitions of unproductive labour found in literature which Laibman categorises as ‘evaluative’, ‘socioeconomic’ and ‘analytical’ fail to delineate the parameters of the concept sufficiently to render it operationally useful in empirical economic analysis (Laibman 1993). This conceptual deficiency exposed by Laibman was portrayed by Science & Society editors as ‘the allocation problem’ (Editors, S&S 1993). According to the evaluative approach ‘unproductive labor is labor that is wasteful, irrational, or unnecessary from a superior social standpoint’ (Laibman 1993, p. 226). Parameters of this definition invariably conjure up allocative issues when employed in empirical analysis and do not provide an objective framework in the allocative process. The socioeconomic definition encompasses labour that is not capitalistically exploited as unproductive, for instance household work, peasant production and hence fails to reflect on capitalist economic dynamics. In contrast the analytic definition of unproductive labour defines labour that creates neither value nor surplus value employed under capitalist processes and hence paid out of surplus value as unproductive (see Mohun 2014). According to Laibman the analytic definition fails to remain objective in its categorisation of various individual processes and invariably employs the evaluative definition in the allocative process. In our approach to the problem we will seek to extend the analytical definition of unproductive labour and attempt to illustrate that unproductive activity is reflected in all three forms of value, constant capital, variable capital and surplus value instead of its standard reduction into surplus. We further attempt to extend the parameters of the analytical approach and integrate it with the evaluative form through a reinterpretation of Marx’s theorising.

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1.7.1  Unproductive Labour and Inflation Expansion of unproductive labour hand in hand with absence of capital accumulation in productive sector generates additional monetary incomes while current consumable output of the general public remains fixed and potential output reduced by conversion of resources into unproductive sector capital formation. When additional unproductive incomes generate demand for the fixed volume of productive output and reduced potential output, internal price level should necessarily rise until additional monetary incomes appropriated through unproductive labour are fully exhausted by inflation. This does not hold if expansion of unproductive labour was assisting the supply of useful consumable output such as income appropriated in circulation process of productive goods and services. It nevertheless raises the price level above the rational minimum. The latter avoids extraction of surplus (e.g. merchant’s mark-up) beyond cost of supplying useful unproductive labour. For instance, farm gate prices for vegetables and root crops in Sri Lanka are approximately three times lower than retail prices in urban areas indicating the arbitrary extraction of surplus and atrocious exploitation of both consumer and farmer by oligopolies of merchant capital under the market mechanism. Expansion of useful unproductive labour, hence, may not necessarily lead to inflation while it raises internal price level above rational minimum. On the other hand, increasing volume of transactions impelled by expansion of unproductive labour will raise endogenous component of money supply and money velocity, independent of changes in  Central Bank’s balance sheet. This inevitably leads to long run inflation and currency depreciation. Monetary authority has only partial control over endogenous money creation; changing Statutory Reserve Ratio (SRR) and Policy Rates to influence reserve money ‘within constraints of equilibrium in goods, labour and external markets’ (Hicks 1977) can only bear indirect and partial control over endogenous money creation. ‘[B]ank credit does provide an internal mechanism through which current expenditures can exceed current incomes: banks can create new purchasing power which can permit investment to expand faster than savings and consumption to expand faster than income’ (Shaikh 2016, p. 41). ‘The growth in aggregate demand is fuelled by new purchasing power and a modern credit system based on fiat money can fuel virtually unlimited growth in aggregate demand’ (Ibid. p. 45). Hence, only a narrow band exists for Central Bank to alter conventional channels to navigate reserve money and thereby inflation within equilibrium conditions. A component of money supply is therefore privately created beyond Central Bank’s

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regulation, rendering money an active component causing real alterations. It rejects Freidman’s k-percent rule which holds that monetary authority should increase money supply by a constant rate each year as a means of equilibrating money and product markets (Wray 2007). Currency depreciation and inflation arising from increased money velocity and endogenous money creation through expansion of unproductive labour therefore escapes Central Bank’s complete control. Presumably, the ratio of productive to unproductive labour is lower in Sri Lanka than regional industrialising economies. This is empirically indicated by high inflation and higher internal price level and loss of external competitiveness in spite of preventive measures adopted by Sri Lanka’s fiscal and monetary authorities since liberalisation in 1977. Unproductive labour took centre stage as the main mode of surplus appropriation following liberalisation which coincided with deindustrialisation. It is, however, conventionally held that depreciation of the rupee is solely the result of continuous fiscal deficits causing ‘excess of national expenditure over national income’ that is manifested as current account deficits in excess of net capital inflows (Jayasuriya 2004; Athukorala 2009; Wijewardena 2018). There is no account of how additional rupees are created and concentrated in the hands of conspicuous elite through the financial system independent of fiscal expansion and purchasing of foreign and domestic assets by monetary authority. The realisation of conspicuous demand for imports in turn leads to currency depreciation and influence long run inflation.

1.8   Uneven Labour Demand in Agriculture and Inflation Let us pass on to the consideration of labour market of Sri Lanka determined primarily by the state of development of staple agriculture and the manner in which it propels inflation and a higher internal price level. In this light we will proceed to investigate the effects of uneven demand for labour in paddy agriculture across time and therefore underemployment on inflation. Four main phenomena are paramount in determining inflation under the influence of irregular labour demand in agriculture. Firstly, labour demand pattern of staple agriculture determines availability of rural surplus labour to be deployed in other sectors of the economy. Uneven labour demand function of paddy cultivation prevents continuous supply of labour to non-agricultural sector at the existing wage rate plus a transfer margin. This in turn causes surplus labour to seek non-regular employment7 in informal sector such as construction, petty trade, transport, tourism, taxi

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services, etc., which generate monetary incomes in the absence of an increase in productive output while solidifying the pre-capitalist nature of mode of production. The uneven demand for labour in  paddy agriculture which tends to shift rural surplus labour towards informal unproductive activity while productive output remains fixed necessarily leads to inflation. The shift towards casual employment in Sri Lanka is highlighted by a recent report of ADB prepared in collaboration with International Labour Organisation and United Nations. The report states that self-employment and casual labour can wither away ‘as countries move toward middle-­ income status, when self-employment becomes less characteristic of surplus labour at the household level. We see no evidence of this transition in Sri Lanka’ (ADB 2017, p. 55). ADB shows that informal employment in agriculture increased from 78% to 91% while that of industrial sector increased from 55% to 59% from 2006 to 2014. ‘[S]hare of informal employment [in construction fell] from 92% to 90%, it is also quite clear that the levels of informal employment are so high’ (Ibid. p. 58). The report further highlights that casual employment and self-­ employment are reserves of surplus low productive labour, illustrating our claim that the uneven labour demand function of agriculture in turn tends to shift surplus labour into informal unproductive employment. Its effect on the price level is indicated by rapid increase in inflation since economic liberalisation in 1977 (see Fig. 1.1) concomitantly with the proliferation of unproductive activity and deindustrialisation. The suppression of trade union movement during the period precludes the attribution of higher inflation to increasing nominal wage rates and justifies our exclusive attention to particular relation of social forces in understanding inflation and provides empirical support for the contention that expansion in unproductive incomes do lead to inflation. It should be also borne in mind that during the coalition regime higher inflation from 1972–1975 was owing to four-fold increase in world oil prices as a result of OPEC oil embargo and worldwide crop failure in 1972 which led to global food crisis of 1972–75. The combined effect of these incidences escalated grain prices across the globe.8 Therefore, higher inflation during coalition period was due to exogenous causes and not owing to structural phenomena which dominated the inflationary process since liberalisation. Secondly, Sri Lanka is facing significant labour shortages hand in hand with comparatively high labour cost relative to regional economies such as India, Bangladesh, Vietnam, etc., while country’s rural labour surplus remains largely unexhausted. Higher nominal wage rate became a defining phenomenon since the 1980s (CBSL data) which saw nominal wage rates

23

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Sri Lanka CCPI Inflation Inflation rising following liberalisation and growth in unproductive activity

25 Inflation stemming from OPEC oil embargo and world grain crisis of 19721975

20 15 10 5

2017

2015

2013

2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

1989

1991

1987

1985

1983

1981

1979

1977

1975

1973

1971

1969

1967

1965

1963

1961

1959

1957

1955

1953

0

Fig. 1.1  Sri Lanka inflation. (Source: CBSL Annual Reports)

increasing sharply as a corollary to inflation. This paradox of simultaneous existence of surplus labour in rural economy hand in hand with a persistent labour shortage was delineated by Dr. De Silva in his seminal paper titled, ‘Surplus Labour in Underdeveloped Economies’, 1972 (unpublished) in which he criticised the in-vogue theories of labour supply driven mainly on Dual Economy models. Basing ourselves on his pioneering study we will examine structure of labour market and determine its impact on the general price level. Thirdly, uneven mechanisation of different phases of paddy cultivation, centralisation of land tenancy hand in hand with combined use of family labour and wage labour generates complications in determination of supply price of paddy and general price level. The main proposition in this regard is that mechanisation and centralisation of tenancy increased the supply price of paddy rather than reducing it. The resulting higher use of wage labour and machinery instead of family labour and exchange labour reduced the share of non-cash inputs in cultivation while increasing the share of cash inputs. This in turn causes the supply price to rise while productivity of labour measured on output per labour hour rise hand in hand with average productivity of labour measured on output per worker remaining more or less unchanged. Uneven degree of mechanisation of different phases of paddy cultivation increases surplus labour time in rural economy without fully releasing the worker from the farm. It shifts additional surplus labour into informal unproductive employment which does

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not require a permanent labour supply to function, in contrast to industrial production. Consequently, nominal wage incomes rise while productive output remains unchanged and potential productive output is curtailed. It invariably leads to inflation as per theoretical explanation provided so far on growth of unproductive labour. Above postulates will be further elaborated in Chap. 2. Finally, the oligopsony structure of paddy sector where a few traders dominate purchasing of paddy produced by an innumerable number of peasant farmers invariably increases market price while suppressing farm gate price. Similarly, concentration of machinery ownership in a few hands within the paddy economy increases machine rents leading to increasing cultivation costs (De Silva 1972), a fact which was also highlighted by Professor Utsa Patnaik in her study of peasant class differentiation in Haryana (Patnaik 1987). State of historical development in paddy agriculture in Sri Lanka is therefore analogous to an intermediary state between ‘domestic system’ and ‘manufacture’. It’s characterised by a production process held in the hands of households employing machinery acquired on rent and working capital inputs on advances from ‘merchant cum usurers’ without capital itself completely yielding control or directly penetrating the entire system of production (see Dobb 1950, p. 144). This alludes to the fact that an underdeveloped economy is constitutive of different modes of production with minimum interactions that are capable of influencing the different modes of production as opposed to the greater degree of uniformity of the production mode in advanced capitalist economies. For instance, Sri Lanka’s peasant sector is dominated by an intermediary structure of relations between the ‘domestic system’ and ‘manufacture’. The free trade zone manufacturing sector on the other hand is organised under a globalised merchant-manufacturer system, or in other words an international putting-out system hand in hand with the services sector dominated by, but not limited to, unproductive labour in the Marxian sense in the lights of healthcare, banking and finance, construction, entertainment, etc., where modern capital accumulation strides on, however restricted within its limits. Higher real wages in these services including information and communication technology-related services and also transport providers is made possible through capital accumulation although within a smaller horizon vis-à-vis modern industry in the advanced world.

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1.9   Possibility of Communism in Underdeveloped Societies and the Inevitability Thesis In the work process of manufacture which precedes modern industry ‘[t]he result of the labour of the one is the starting-point for the labour of another. The one workman therefore gives occupation directly to the other’ (Marx 1967a, p. 345), and not merely the capitalist. In manufacture the product has to pass through many hands specialising in heterogeneous aspects of the production process which results in ‘each labourer or each group of labourers preparing the raw material for another labourer or group’ (Ibid.). This characteristic is more or less absent in economic activity which dominates capital formation in Sri Lanka and underdeveloped economies in general. For instance, in garments, assembly type industries, plucking tea leaves, tourism, rubber tapping, retail and wholesale trade, and so on, the worker is performing the same activity repeatedly. It therefore doesn’t impel his fellow worker to fulfil his assigned duties as the only means of realising the final product, disregarding quantity of output produced. In other words, provided there is sufficient time more or less one worker can produce the final product in contrast to manufacture proper. In a garment factory for instance, the worker can complete more or less the entire sewing process without the labour of other workers being raw material for her task. ‘[The] same individual can do certain kinds of work just as well on a large as on a small scale. …The allotment [of such functions] to a particular labourer does not become advantageous till after an increase in the number of labourers employed’ (Ibid., p. 346). A production process dominated by this particular type of labour renders its structure a static whole, which we may call static manufacture as opposed to manufacture in general which Marx alludes to. Static manufacture dominates the production processes in an underdeveloped economy such as that of Sri Lanka. Marx in this connection distinguishes two forms of manufacture, heterogeneous and serial, arising from the internal pattern of labour organisation peculiar to the product (see Ibid., p. 342). In his view, it is in serial manufacture characterised by raw materials passing through many specialised work processes in a guided sequence that is most conducive for the transformation of itself into modern industry. Heterogeneous manufacture conversely assembles different individual products in their own right produced independently of one another in realising the final product such as manufacture of clocks and watches. In this backdrop we can assert that there is also a third type currently “specialised” by underdeveloped economies that arise from Marx’s writings which we may call static manufacture,

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in which the pattern of labour organisation dominated by the nature of the product, leads to the more or less complete overwhelming of the dynamic forces by the static. This in turn erects insurmountable barriers to the transformation of itself and hence the mode of production into advanced capitalism as opposed to two other types of manufacture underscored by Marx. A direct corollary of this phenomenon is that in an underdeveloped economy, one workman does not provide occupation to the other, apart from the employer himself, as in heterogeneous and serial manufacture of Marx. The worker is therefore isolated and remains independent from her fellow workers in the process of production while being negatively integrated in performing an identical task, as opposed to the heterogeneous production processes in manufacture proper. The worker in an underdeveloped economy is therefore deprived of relations leading to the conscience that it is his fellow workers themselves who employ him and provide his immediate means of production vis-a-vis the capitalist. This means to say that the necessary production relations for the development of collective solidarity of working classes against capital in underdeveloped economies are absent in general. In this light co-operation of labour discussed by Marx is a feature peculiar to capitalist mode of production, and is conversely absent in commercial, rentier or ‘merchant manufacturer’ type processes like trade, food and beverages, toiletries, tourism, transport, garments, electronics assembly, tea, rubber, coconut, spices, and so on, that dominate the employment share and capital formation in Sri Lanka. These production processes in general are characterised by employment of isolated individual labour of which the degree of co-operation is negligible. More importantly, these processes lack the internal pattern of labour organisation required for cooperation to become an integral component in the production process. Co-operation is more or less absent in underdeveloped economies. For instance, in the production of apparels individual workers are separated in their operations and attached to identical machines functioning independently of each other. Hence, co-operation is irrelevant and immaterial in its labour process. It therefore is the antithesis of ‘dynamic manufacture’ of Marx preceding modern capitalism where ‘detail workers are so many special organs of a single working organism that acts only as a whole, and therefore can operate only by the direct co-operation of the whole’ (Ibid., p. 347). The same applies to all other labour processes mentioned above which dominate the share of employment in Sri Lankan economy. The

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absence of co-operation would impose itself as an additional phenomenon forcing the extension of the working day beyond advanced and industrialising economies as a means of counterweighing the loss of surplus labour and hence surplus value due to absence of the collective power generated through co-operation. Absence of co-operation means to say that the dialectical relation between collective unity and self-realisation among the working classes remains underdeveloped. ‘When the labourer co-operates systematically with others, he strips off the fetters of his individuality’ (Ibid., p. 329) [Emphasis added]. In the absence of co-operation, collective consciousness that springs from the dialectical progression of the forces of equality and individuality—the class in itself—remains therefore objectively unattainable. ‘Self-consciousness is man’s equality with himself in pure thought. Equality is man’s consciousness of himself in the element of practice’ (Marx and Engels 1975, p. 39) [emphasis added]. Hence, if conditions do not exist for the realisation of true authenticity in individuality, social relations acquire its primary meaning and disposition through inequality and vice versa. Realisation of Communist consciousness therefore goes hand in hand with the ‘elimination of fetters to realisation of worker’s individuality’ through systematic co-operation engendered by capitalist transformation of the mode of production. A society ‘can neither clear by bold leaps, nor remove by legal enactments, the obstacles offered by the successive phases of its normal development. But it can shorten and lessen the birth-pangs’ (Marx 1967a, p. 10). This however, does not mean to assert a historical necessity of Communism nor the realisation of collective consciousness through capitalist development per se. The distinguishing processes underlying capitalist development which transforms the fate of Communism to a possibility from its historical inevitability professed in Communist Manifesto is delineated by Marx himself in his later comprehensive studies on the inner nature of capitalist mode of production. He shows that further development of capitalist mode of production, expressed in the rising productivity of capital, in turn leads to growth of revenue, disregarding wages, which is not re-converted back into capital. Therefore, ‘the number of workers grows absolutely, it declines relatively, not only in proportion to the constant capital which absorbs their labour, but also in proportion to the part of society not directly involved in material production or indeed engaged in no kind of production whatsoever’ (Marx and Engels 1988, p. 303) [Emphasis added]. This in turn leads to a ‘constantly growing number of the middle classes …[who] maintain themselves to an ever increasing extent directly

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out of revenue …and increase the social security and power of the upper ten thousand’ (Marx 1968, p.  573). Further, the diminishing value of labour power stemming from the relentless development of production forces under capitalism was expected to increase the relative poverty of the worker which in turn would seal the doom of capitalism and its inevitable replacement by communism. However, Marx made an important exception to this law ‘whenever the decomposition of the [labour] process begets new and comprehensive functions’ (Marx 1967a, p. 350), which is a universal characteristic of capitalist mode of production distinguishing it from all previous modes of production. The tendency delineated by Marx emphasising the relative growth of middle classes with respect to working classes resulting from further development of capitalism hand in hand with its tendency to prevent the value of labour power from diminishing whenever production forces develop, inevitably points to the historical probability of Communism as opposed to being an inevitable outcome of capitalist development, blindly ascribed to Marx by the fraternity of thinkers after him. In doing so they have overcome the difficulties with which history has confronted them in their own minds, by their own wishes (see Lenin 1965, p. 102).

Notes 1. Thorstein Veblen describes rentier capitalist as the modern businessman who has no or minimum involvement with actual functioning of an industry while simultaneously penetrating into most branches of the economy through intervening into ‘interstices space between sectors’. (Veblen 1932) Hence, modern rentier has no or minimum involvement with actual production process while having titles into most of its lucrative spheres. 2. Process should be distinguished from increased use of machinery and software in services sector which does not incite the same self-expansionary properties which industrialisation of manufacturing sector generates. See Chap. 2 for an extended discussion of this theme. 3. A defining feature of underdevelopment was explained by Joan Robinson, ‘misery of being exploited by capitalists is nothing compared to the misery of not being exploited at all.’ (Robinson 1974, p. 46) 4. This is in contrast to dominant class interests of metropolitan economies who are concomitantly hostile to industrial transformation of underdeveloped countries. (De Silva 2013; Lall and Bibile 1977) ‘Industrialization was out of the question as long as the entrepreneurs had no political influence – there would be few enterprises that would not conflict with British interests’ (Peebles 1986, p. 74).

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5. Above sectors including government services account for c.77% of gross value addition in 2016 (DCSSL). 6. Nevertheless, as a globalised system, capitalism requires both these forms of contradictory relations of production to exist in union for its continuous reproduction. Hence, its progression and development as a global system is bound with annihilation of its replication outside itself while outside is firmly within. That is to say opposite of modern capital is at the same time within its arrangement and purview. Hence, law of motion of capital as a global system does not profess to ‘create a world out of its own image’ but on the contrary, whenever it is advancing its main aim is twofold; its internal development simultaneously necessitates underdevelopment of the external (De Silva 2013). 7. Dr. De Silva underscored the tendency in rural labour surplus in Sri Lanka to occupy non-regular employment due to unevenness in labour demand in paddy agriculture. During the British period when plantations were expanding ‘villagers found rubber tapping congenial, not so much as a work operation different from that on a tea estate but the work schedule was more suitable. Work on a rubber estate ends around mid-day, allowing the villagers to attend to their own crops. Thus the Singhalese were among the pioneer labourers on the rubber estates’ (Ibid. p. 228). 8. Severe shortages of essential food items and other consumer goods were not therefore caused by policy measures adopted by coalition government. Restrictions imposed were in fact merely a reaction to turbulent global economic conditions at the time which caused a drain of foreign exchange from government coffers. They cannot be considered as conscious set of economic policies aimed at Import Substituting Industrialisation as held in general. Domestic production was encouraged given that necessaries couldn’t be adequately imported due to dearth of foreign exchange in the economy and not as a conscious policy towards achieving an integrated system of ISI which wards off indivisibility problem.

References ADB. (2017). Sri Lanka: Fostering Workforce Skills Through Education  – Employment Diagnostic Study. Philippines: Asian Development Bank and International Labour Organisation. Retrieved from: https://www.adb.org/ publications/sri-lanka-fostering-workforce-skills Alesina, A. (1987). Macroeconomic Policy in a Two-Party System as a Repeated Game. Quarterly Journal of Economics, 102(3), 651–678. Atapattu, D. (1997). Capital Formation and its Financing. In W.  D. Lakshman (Ed.), Dilemmas of Development: Fifty Years of Economic Change in Sri Lanka (pp. 55–100). Colombo: Sri Lanka Association of Economists.

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Athukorala, P. (2009). Export-Led Industrialisation: Are the Critiques Right? In A. Tennakoon (Ed.), Sri Lankan Economy in Transition Progress, Problems and Prospects a Tribute to Jayantha Kelegama (pp.  143–169). Colombo: Vijitha Yapa Publications. Bandara, A. (2000). Short-run Dynamics of Inflation, Staff Studies, Central Bank of Sri Lanka, Vol. 25 & 26, March. Cavallo, A., Cruces, G., & Perez-Truglia, R. (2017). Inflation Expectations, Learning, and Supermarket Prices: Evidence from Survey Experiments. American Economic Journal: Macroeconomics, 9(03), 1–35. CBSL. (2017). Monetary Policy Review: No. 2. 2017 Retrieved from: http:// www.cbsl.gov.lk/pics_n_docs/latest_news/press_20170324e.pdf Clark, W.  R. (2002). Partisan and Electoral Motivations and the Choice of Monetary Institutions under Fully Mobile Capital. International Organization., 56(4), 725–749. Coibion, O., Gorodnichenko, Y., & Kamdar, R. (2017). The Formation of Expectations, Inflation and the Phillips Curve. National Bureau of Economic Research, Working Paper No. w23304, (Apr. 2017). Retrieved from: https:// papers.ssrn.com/sol3/papers.cfm?abstract_id=2946687 Cooper, R. W. (2004). Monopolistic Competition and Macroeconomics: Theory and Quantitative Implications. In S.  Brakman & B.  J. Hiejdra (Eds.), The Monopolistic Competition Revolution in Retrospect (pp. 375–398). Cambridge: Cambridge University Press. DCSSL. (2019). Labour Force Survey – Annual Report 2017. Colombo: DCSSL. De Silva, H. (2009). Remedies against the Fallout of Global Inflation: Could a more Independent Central Bank Help? In A.  D. V.  Indraratna, S.  De, & S. Vidanagama (Eds.), Inflation, Competitiveness and Growth (pp. 197–222). Sri Lanka Economic Association: Colombo. De Silva, S. B. D. (2013). The Political Economy of Underdevelopment. London: Routledge & Kegan Paul. De Silva, S.  B. D. (1972). ‘Surplus Labour in Underdeveloped Economies’, University of Peradeniya, Sri Lanka, July 1972, Unpublished. Dixit, A., & Stiglitz, J.  E. (1977). Monopolistic Competition and Optimum Product Diversity. American Economic Review, 67(3), 297–308. Dobb, M. (1950). Studies in the Development of Capitalism (4th ed.). London: Routledge & Kegan Paul. Editors, S&S. (1993). Editorial Perspectives. Science & Society, 57(3 (Fall 1994)), 258–261. Edwards, S. (1994). The Political Economy of Inflation and Stabilization in Developing Countries. Economic Development and Cultural Change, 42(2), 235–266. Gramsci, A. (1971). Selections from the Prison Notebooks. New York: International Publishers.

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Harcourt, G.  C. (2006). The Structure of Post-Keynesian Economics: The Core Contributions of the Pioneers. Cambridge: Cambridge University Press. Hellman, J. S., Jones, G., Kaufman, D., & Schankerman, M. (2000). Measuring Governance, Corruption, and State Capture: How Firms and Bureaucrats Shape the Business Environment in Transition Countries. Policy Research Working Paper 2312.Washington, DC: World Bank. Retrieved from: http://siteresources.worldbank.org/INTWBIGOVANTCOR/Resources/measure.pdf Hicks, J. R. (1977). Economic Perspectives: Further Essays on Money and Growth. London: Oxford University Press. Hobsbawm, E.  J. (1978). Industry and Empire: The Birth of the Industrial Revolution. London: Penguin Books. IMF. (2016). Sri Lanka: Staff Report for the 2016 Article IV Consultation. Washington, D.C.:IMF. Indraratna, A.  D. V.  D. S. (2009). Inflation, Competitiveness and Growth: A Nexus. In A.  D. V.  D. S.  Indraratna & S.  Vidanagama (Eds.), Inflation, Competitiveness and Growth (pp.  3–14). Colombo: Sri Lanka Economic Association. Indraratna, A. D. V. D. S. (2014). Policy Issues for Sustained Development of Sri Lanka. Colombo: A.D.V. de S. Indraratna Felicitation Committee. Jayasuriya, S. (2004). Exchange Rate. In S. Kelegama (Ed.), Economic Policy in Sri Lanka: Issues and Debates a Festschrift in Honour of Gamini Corea (pp. 177–192). New Delhi: Sage Publications. Kelegama, S. (2006). Development under Stress: Sri Lankan Economy in Transition. New Delhi: Sage Publications. Killick, T. (1989). A Reaction Too Far. Economic Theory and the Role of the State in Developing Countries. London: Overseas Development Institute. Laibman, D. (1993). Review: The Falling Rate of Profit: A New Empirical Study. Science & Society, 57(2 (Summer 1993)), 223–233. Laibman, D. (1999). Productive and Unproductive Labor: A Comment. Review of Radical Political Economics, 32(2 (Jun. 1999)), 61–73. Lall, S., & Bibile, S. (1977). The Political Economy of Controlling Transnationals: The Pharmaceutical Industry in Sri Lanka (1972–1976). World Development, 5(8, (Aug. 1977)), 677–697. Retrieved from: http://journals.sagepub.com/ doi/abs/10.2190/GBM9-5W7H-BT8J-VVF3?journalCode=joha Lenin, V. I. (1965), Lenin Collected Works Volume 27. Moscow: Progress Publishers. Liyanage, S. (1997). The State, State Capital and Capitalistic Development. In W.  D. Lakshman (Ed.), Dilemmas of Development: Fifty Years of Economic Change in Sri Lanka (pp.  423–455). Colombo: Sri Lanka Association of Economists. Marglin, S. (1984). Growth, Distribution and Inflation: A Centennial Synthesis. Cambridge Journal of Economics, 8(1984), 115–144.

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Marx, K. (1967a). In F.  Engels (Ed.), Capital Volume I a Critical Analysis of Capitalist Production. New York: International Publishers. Marx, K. (1967b). In F. Engels (Ed.), Capital Volume II the Process of Circulation of Capital. New York: International Publishers. Marx, K. (1981). In F. Engels (Ed.), Capital Volume III the Process of Capitalist Production as a Whole. London: Penguin Books. Marx, K. (1968). Theories of Surplus-Value, Part II. Moscow: Progress Publishers. Marx, K. (1972). Theories of Surplus-Value, Part III. Moscow: Progress Publishers. Marx, K., & Engels, F. (1975). Marx/Engels Collected Works, Volume 4: Marx and Engels 1844–1845. Moscow: Progress Publishers. Marx, K., & Engels, F. (1976). Marx/Engels Collected Works, Volume 6: Marx and Engels 1845–1848. Moscow: Progress Publishers. Marx, K., & Engels, F. (1988). Marx/Engels Collected Works, Volume 30: Marx: 1861–1863. Moscow: Progress Publishers. Marx, K., & Engels, F. (1991). Marx/Engels Collected Works, Volume 33: Marx: 1861–1863. Moscow: Progress Publishers. Means, G. C. (1994). In W. J. Samuels & F. S. Lee (Eds.), A Monetary Theory of Employment. New York: M. E. Sharpe, Inc. Modigliani, F., & Papademos, L. (1975). Targets for Monetary Policy in the Coming Year. Brookings Papers on Economic Activity.. The Brookings Institution. 1975, 1, 141–165. Mohun, S. (2014). Unproductive Labour in the U.S.  Economy 1964–2010. Review of Radical Political Economics, 46(3), 355–379. Moore, M. (1985). The State and Peasant Politics in Sri Lanka. Cambridge: Cambridge University Press. Myrdal, G. (1939). Monetary Equilibrium. London: William Hodge. Nicholas, H. (2011). Marx’s Theory of Price and its Modern Rivals. London: Palgrave Macmillan. Nicholas, H. (2014). Whither Sraffa’s Theory of Price? World Review of Political Economy, 5(3), (Fall 2014), 315–330. Nicholas, H., & Yatawara, R. A. (1991). Inflation in Sri Lanka in 1990. Working Paper No. 02. Colombo: Institute of Policy Studies. Patnaik, U. (1987). Peasant Class Differentiation: A Study in Method with Reference to Haryana. London: Oxford University Press. Peebles, P. (1986). Profits from Arrack Renting in Nineteenth Century Sri Lanka. Modern Sri Lanka Studies. Vol.1(1), (1986), pp. 65–83. Rapping, L. A. (1979). Domestic and International Aspects of Structural Inflation. In J. H. Gapinski & C. E. Rockwood (Eds.), Essays in Post-Keynesian Inflation (pp. 31–53). Cambridge: Ballinger Publishing Company. Ratnasiri, H. P. G. S. (2009). The Main Determinants of Inflation in Sri Lanka a VAR Based Analysis. Central Bank of Sri Lanka, Staff Studies, 39(1 & 2), 1–14. Robinson, J. (1974). The Economic Philosophy. London: Penguin Books.

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Rowthorn, R.  E. (1977). Conflict, Inflation and Money. Cambridge Journal of Economics. Vol, 1(1977), 215–239. Sargent, T. J. (2013). Rational Expectations and Inflation (3rd ed.). New Jersey: Princeton University Press. Scitovsky, T. (1979). Home Truths about Inflation. In J.  H. Gapinski & C.  E. Rockwood (Eds.), Essays in Post-Keynesian Inflation (pp.  3–9). Cambridge: Ballinger Publishing Company. Shaikh, A. (2016). Capitalism: Competition, Conflict, Crisis. Oxford: Oxford University Press. Shanmugaratnam, N. (1984). Sri Lanka's "New" Economic Policy and Agriculture. Social Scientist, 12(3), 3–35. https://doi.org/10.2307/3520334 Sraffa, P. (1960). Production of Commodities by Means of Commodities: Prelude to a Critique of Economic Theory. Cambridge: Cambridge University Press. Stigler, G. J. (1962). Administered Prices and Oligopolistic Inflation. The Journal of Business, 35(1 (Jan. 1962)), 1–13. Stiglitz, J.  E. (2017). Monopolistic Competition, the Dixit-Stiglitz Model and Economic Analysis. Research in Economics, 71(2017), 798–802. https://doi. org/10.1016/j.rie.2017.10.010 Stiglitz, J.  E. (2004). Reflections on the State of the Theory of Monopolistic Competition. In S.  Brakman & B.  J. Hiejdra (Eds.), The Monopolistic Competition Revolution in Retrospect (pp. 134–148). Cambridge: Cambridge University Press. Veblen, T. (1932). The Theory of Business Enterprise. New  York: Charles Scribner’s Sons. Wijewardena, W. A. (2018). Rupee’s sad destiny of one-way journey to depreciation. Daily Financial Times, 1 May. 2018. Retrieved from: http://www.ft.lk/columns/Rupee-s-sad-destiny-of-one-way-journey-to-depreciation/4-654254 Wray, L. R. (2007). Endogenous Money: Structuralist and Horizontalist. The Levy Economics Institute Working Paper No. 52, (Sep. 2007), Retrieved from: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1010462

CHAPTER 2

Towards a Theory of Inflation in Underdeveloped Economies

Abstract  The chapter constructs a theoretical framework, examining political economic processes so far unexplored in delineating inflation in Sri Lanka, and underdeveloped economies in general, with certain qualifications pertaining to aspects of labour demand function of staple agriculture, which shows a high degree of diversity across regions. In this connection the chapter reviews theories pertaining to price formation and inflation from the Classics to Moderns along with particular literature specific to the study of inflation in Sri Lanka and underdeveloped economies. Further, it seeks to resolve the ‘Allocation Problem’ posed by Professor David Laibman to reach theoretical clarity in distinguishing productive and unproductive labour which provides operational significance to the concept in studying inflation. Keywords  Inflation • Underdevelopment • Unproductive labour • Organic composition of capital • Surplus labour • Allocation problem • Ricardian price theory The study primarily relies on the systematic examination of literature on inflation and underdevelopment. The chapter will therefore assess views of contending schools of thought on price formation. The review of literature thus weighs the merits and demerits of different theoretical approaches and provides the means of constructing a general theoretical structure for © The Author(s) 2020 D. G. Pathirana, C. Aluthge, A History of Underdevelopment and Political Economy of Inflation in Sri Lanka, https://doi.org/10.1007/978-981-15-5664-7_2

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assessing the dynamics of inflation in Sri Lanka and in underdeveloped economies in general.

2.1   Price Determination in Adam Smith’s Formulations Determination of prices in Adam Smith’s formulation remains key to the further development of theory of prices under David Ricardo in Classical thought. However, fundamental postulates embodied in the Classical framework are abandoned in Fisher’s theory of inflation. In spite of this discontinuity it is uncharacteristically coagulated into the Classical tradition. Fisher’s theory has no continuity with the theories of price determination of Smith, Ricardo and Marx, the key thinkers in Classical tradition. Fisher’s theory can be regarded as foreshadowing the Monetarist re-­ evaluation of inflation theory which concludes that price changes are ultimately a monetary phenomenon. It, therefore, invariably has little or no connection with Classical theories of price determination of Ricardo. In this light we will discuss the main components of Adam Smith’s theory of prices and how Ricardian system of prices is a further development and more or less a rejection of the Smithian view although remaining fundamentally interrelated with it, in contrast to Fisher’s theory of inflation. This is to say that there is no conformity among Classical economists on determinants of price level. The theory of long run price determination in Adam Smith is divided into two component parts which are symbiotically interrelated. First is what he terms the Natural Prices, determined by costs of production or factor payments under the condition that natural rate of profit and wages is realised along with full employment of labour through realisation of Natural Price in the market (see Smith 1994, p. 83). The other is termed Market Price which is dominant in the short run phase of Smithian price determination that merely examines equilibrating of supply and demand in the economy. Smith claims that there is no automated tendency in the economy for the Natural and Market prices to converge and hence contrary to the Neoclassical view the free interaction of market forces in the Smithian formulation does not guarantee an automated realisation of Natural Prices and therefore full employment. According to Smith price determined by supply and demand conditions which he termed as the Market Price is always gravitating towards the Natural Price and hence is

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constantly above or below it yet tending towards it (see Ibid, p. 87). The Smithian view also corresponds with Anwar Shaikh’s proposition of ‘turbulent regulation’ which asserts that ‘balance in the economy is achieved by recurrent over- and undershooting’ (Shaikh 2016). The system of price determination in Wealth of Nations hence implies that profit is a determining factor of price as much as wages especially in the determination of Natural Price, as opposed to being determined by the latter. Hence, as we will see, the nature of profit determination in an economy occupies the most vital role in the long run price determination process. Smith states that there exists an average rate of both wages and profits in any economy and in all different branches of production which is regulated ‘partly by the particular nature of each employment’ (Smith 1994, p. 83) [emphasis added]. This underscores that the long run price determination in the Smithian universe depends not only on the state of division of labour and nature of resource endowments but also on ‘the particular nature of each employment’ which the economy is composed of, hence clearly alluding to the importance of the structural nature of profit appropriation in the economy in the process of price determination. This passage clearly shows that the general Smithian outlook on how an economy functions strictly distinguishes him from the Neoclassicists and Monetarists who disregard the importance of differences between the types of employments in an economy which in turn affect the state of price determination, income distribution and more importantly the state of its development.

2.2   Ricardian System of Prices and His Criticism of Adam Smith The main implication of Smithian formulation of prices is that there is a direct relationship between the Natural Price of a commodity and factor prices. However, Smith held that rent is a residue of demand and supply which is determined ex ante in the interaction of market forces while profits and wages are determined ex post during the phase of production itself. Therefore, rents were considered as a residual form of income which is accrued to the landowners once the wages and profits are compensated through the market. Hence, an increase in wages (similarly profits) would invariably increase the supply price of a commodity, that is to say wages and profits are price determining while in contrast rents are determined by

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prices. Ricardo, however, had different ideas about the process of price determination. There are two main differences of the Ricardian system of price determination in comparison to Adam Smith. Ricardo, in contrast to Smith, claimed that both rents and profits are determined by prices and hence are realised following the process of price discovery in the market mechanism. Hence, both rents and profits are considered to be a residue of price discovery which are determined ex ante in the interaction of market forces while wages alone are price determining and hence are established ex post during the production process itself before the product is released to the market. Therefore, although production-cost-led price determination is in the end a process of adding factor incomes to form the supply price, the addition of these incomes is realised in contradictory processes, where wages are directly added as production costs onto the market price while rents and profits are determined by the market mechanism which discovers market price through the interaction of supply and demand. Hence, Ricardo concludes that the Market Price will remain more or less either above or below the Natural Price of a commodity which he directly insists compared to Smith’s vague reference to the idea. In this connection Ricardo states that, ‘In making labour the foundation of value …we must not be supposed to deny the accidental and temporary deviations of the actual or market price of commodities from this, their primary and natural price’ (Ricardo 1978, p. 48). The second proposition which sets apart Ricardo’s system of prices from Smithian formulation is that Ricardo in contrast to Smith holds that every real increase in income assigned to wages should reduce profits and vice versa; hence, when wages rise profits necessarily fall. ‘There can be no rise in the value of labour without a fall of profits’ (Ibid. p.  21) which made Henry Carey to declare that ‘the system of Ricardo is a system of discord, it creates hostility between classes.. his book is a manual for demagogues who seek to gain power by the distribution of the soil, by war and by pillage’ (quoted in Dobb 1945). Further, Henryk Grossman makes the claim that right-wing economists ‘scented a threat to class harmony in Ricardo’s labour theory of value and avoided any analysis of the production and labour-process in order to get round the ticklish question of the labour theory of value.’ He further states ‘Out of fear of ending up in opposition to prevailing property interests,’ the right-wing economists in the lights of Leon Walras, Bastiat, Jevons, etc., took every effort ‘to give economic theory the most abstract and formal shape possible, divorced

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from any qualitative-concrete content’ (Grossman 2007, p. 43). Justifying the penetrating insights of Grossman on Ricardo’s system and the reaction to it by the Neoclassics, Ricardo held that if a larger portion of nation’s produce is given to the workers then necessarily a smaller portion will be available for the capitalists. Basing himself on this notion Ricardo claims that a rise in wages cannot equally affect commodities produced under different compositions of fixed and circulating capital despite the fact that those commodities maybe employing an equal volume of total capital, i.e., the aggregate of both fixed and circulating capital. To elaborate further, in a particular sphere of production if the circulating capital employed is lower, that is to say less in support of labour, it may be mainly invested in machinery and buildings, etc. In another area of investment identical volume of capital may be invested, but it could be mainly used in support of labour and only a smaller share may be used in employing plant and machinery. In such a situation, a rise in wages according to Ricardo, ‘cannot fail to affect unequally commodities produced under such different conditions’ (Ricardo 1978, p. 19). That is to say that the relative value of the two commodities will alter if wages rise, which is contrary to the formulations of Adam Smith who held that the relative price of commodities will not change if wages are to rise. In this connection he also points out that even in different branches of production where same volume of fixed and circulating capital is employed the effect of rising wages would be different if the durability of fixed capital in the two respective branches of production are unequal. Hence, he states that only if both the durability and the value of fixed and circulating capital employed are the same the effect of rising wages will be the same in two branches of industry; hence, the two commodities would have the same value relation with each other as before. In his Principles, Ricardo asserts that when wages increase the price of ‘only those commodities would rise which had less fixed capital employed than the medium in which price was estimated, and all those which had more, would positively fall in price’ (Ibid. p. 29). Through his criticism of Adam Smith, Ricardo showed that the relative value of the products of industries that employ a higher volume of fixed capital relative to circulating capital will fall if wages rise and only those industries that employ a higher volume of working capital will rise in relative price while the industries in the middle will not witness any change in relative value. Ricardo divided activities in an economy mainly to three sectors: the production processes which contain higher than the average fixed capital to circulating capital ratio; those that contain the average fixed to

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circulating capital ratio; and finally the activities that contain lower than average fixed to circulating capital ratio. He maintained that an increase or decrease in wages would not cause the relative prices of these sectors to behave similarly; that is to say relative prices would not behave according to how Adam Smith expected them to behave. According to the Smithian formulation if wages change the relative prices may alter only according to the elasticities of demand for those specific products, and moreover, the supply price of the product would definitely rise if profits and rents are not to fall. This is to say there won’t be a change in the Natural Price of products in relative terms if wages change. However, the market price may change relatively due to demand elasticities. In the formulation of Ricardo, the relative prices would not behave in the way which Smith expected them to if wages rise. In his view, the relative price of the product that employs a higher capital to labour ratio will fall compared to that of the average product and the product with a lower composition of capital to labour. This is so because the ratio of wage cost is higher in the production process that inherits a lower capital to labour ratio.

2.3   Marx’s Modification of Ricardo’s Price Theory In his Volume III of Capital, Marx accepted in general the main constructs of Ricardo’s theory of prices as well as his criticism of Smith on the determination of relative prices. However, he replaced the term ‘price of production’ for Ricardo’s concept of natural price or cost price although both terms signify long run prices that equalize rates of profit across all investment spheres in the economy due to competition. Hence both terms indicate centre of gravity prices towards which market prices are constantly vacillating. However, despite the essential similarities between Marx’s and Ricardo’s price theory there remains an important difference between the meaning of the terms ‘prices of production’ as expounded by Marx and natural prices or cost prices of Ricardo. The important criticism which Marx brings forth is that Ricardo considered the cost price or the natural price of commodities which equalised rates of profit in different branches of the economy are perfect reflections of value of commodities. Ricardo did not differentiate labour values of commodities and their cost prices. On the contrary he implicitly assumed that the two concepts are identical whereas

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in Marx’s system, ‘prices of production’ essentially differ from cost prices and more importantly from labour value intrinsic to commodities. Marx established, through an arithmetical illustration, that if products were priced at their values, then profit rates of different branches in the economy would be unequal, because of unequal composition of constant to variable capital in different spheres of production. Marx argued that competition among capitals would equalize the profit rates of different production branches to the general rate of profit determined by capital as a whole, which prevents prices from being equal to value of commodities. The prices which equate the different rates of profits in different branches to a uniform rate of profit which at the same time prevents values from being equal to prices were termed by Marx as prices of production. Therefore, Marx provides an accurate exposition of price determination in capitalism in Volume III of Capital compared to Ricardo. Consequently according to Marx, if wages rise production price of commodities of a capital of: ‘1) average social composition doesn’t change; 2) lower composition rises, but not in proportion to the fall in profit; 3) higher composition falls, but also not in the same proportion as profit’ (Marx 1981, p. 303). Note that unlike in the theory of price determination of Ricardo, the absolute price of commodities produced by higher than average capital and lower than average capital industries change in the face of a wage increase or decrease in Marx’s system and not merely the relative price formulated by Ricardo. Marx remarkably explains in this way how supply price of higher capital composition industries falls in absolute terms when wages rise. In this light we set out to elaborate the higher rates of inflation experienced by Sri Lanka compared to advance capitalist economies as well as industrialising economies in the region by employing the price theory of Ricardo and Marx as elaborated above. Through the application of their price theory we will elaborate that when wages increase the relative price level of Sri Lanka compared to economies with a higher capital to labour ratio will rise, hence leading to a higher rate of inflation. This is so given that Sri Lanka’s production structure employs a lower composition of productive capital compared to labour. Ricardian and Marxian Theory both support perfect competition and we view the problem in an imperfectly competitive market. This trade-off is resolved by the fact that the application of Marxian price theory to study relative inflation between underdeveloped and advanced economies does not depend on perfect competition. Product composition of advanced and underdeveloped economies is formed in such a way that they do not enter

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into competition with each other. Advanced economies export modern industrial products while underdeveloped countries export primary products including products based on labour intensive production processes such as garments, electronic assembly, etc. More importantly, in this context, if the rate of profit remains constant in the face of a wage increase of equal degree in both groups of economies, the supply price of both groups must necessarily rise to realise the condition of constant rate of profit. However, given that the organic composition of capital in underdeveloped economies is lower than that of advanced nations the rate of supply price increase in the former should be necessarily higher than the latter, causing higher relative inflation in underdeveloped economies to become an intrinsic mechanism.

2.4   Keynesian Theory of Inflation Keynes formulated his theory of inflation in the pamphlet How to Pay for the War. A Radical Plan for the Chancellor of the Exchequer in 1940 when Britain was preparing to confront the far superior military might of Germany during WWII. At the time under the direction of Hjalmar Schacht, German Minister of Economics during the Great Depression, Germany launched the most ingenious economic planning world has ever seen in the face of mounting external debt repayments, international embargos on exports and raw material imports and high unemployment in the midst of the Great Depression. A debt-ridden underdeveloped economy in the lights of Sri Lanka has much to learn from German economic planning during the Great Depression and WWII which restored full employment, spearheaded the industrialisation process of the economy, freed the German economy from external debt burden, increased real incomes of the working classes while maintaining inflation below 4% during the period which saw real output growing 8% - 10% per annum (see Schacht 1956, 1967; Barbieri 2015). Under this backdrop, Keynes in his How to Pay for the War, developed theoretical standpoints on inflation, income distribution, price controls and suggested methods to prevent continuous price increases while mobilising resources to face war with Germany. Most significant of these methods were direct price controls combined with rationing of subsistent goods and deferred pay or forced savings for both workers and capitalists to temporarily withdraw the additional purchasing power generated by the war effort from generating demand. In turn ‘forced saving’ was utilised to

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refinance the war effort. Keynes holds that absence of rationing and forced savings in the presence of price controls will lead to capitalists and higher income earners buying beyond their immediate consumption needs anticipating a future increase in prices which will ultimately lead to direct shortages of subsistent goods denying the working classes the access to their means of subsistence (Keynes 1940). In terms of distribution of resources into varying needs in the face of resource scarcity coupled with the aim of keeping inflation low, Keynes states that there are two approaches to the problem, on which his theory of inflation is grounded. That is either by ‘fixing the standard of life of the civilian and discover what is left over for service departments and for exports; or by adding up demands of the latter and discover what’s left over for civilians. Actual result will be a compromise between the two methods.’ (Ibid. p. 3) In this light Keynes showed that since total output available for civilian consumption is fixed, effort to increase nominal incomes will not make an increase in consumption possible, negating the fruitfulness of generating additional incomes. Nevertheless, by utilising his or her additional incomes generated through war effort, each individual can increase the share of consumption at the expense of others by enforcing inflation at a rate below the growth of their nominal incomes despite civilians’ cake is fixed. This is under the condition that markets are free from regulation. That is to say by bidding up prices until a section of consumers are denied means of acquiring their subsistent goods individuals can increase their consumption through additional money incomes despite total consumable goods in the economy are fixed. It indicates that primal function of inflation is redistribution of income from working classes to capitalists. Free market mechanism, therefore, grants freedom to those who already have monetary means to deny others freedom to access material freedoms. Under this backdrop Keynes explicitly indicates the contradiction between private interest and interest of the economy and society as a whole in the process of price determination. More importantly he thereby indicates that price determination of free markets in situations of resource scarcity serves the purpose of individual with means at the expense of the broader economy and society. Therefore, Keynes contends that the economy should be brought under a common plan where everyone is governed by a set of rules when accessing their purchasing power created through war vis-à-vis unproductive activity. Hence, subjecting the economy to a planned system of forced savings, price controls and rationing in subsistence goods the economy

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can be brought to equilibrium without the requirement of inflation as the sole mediator of supply and demand. He therefore, states that by planned organisation of the economy ‘the wage and salary earner can consume as much as before and in addition have money over in the bank for his future benefit and security, which would otherwise belong to the capitalist class’ (Ibid.). In the absence of planned mediation of economic forces, according to Keynes prices will rise just enough for the money we spend to be used up by the increased cost of what there is to buy. Important aspect of Keynes’ theory of inflation is that it focuses mainly on the impact of increase in incomes, both wages and profits, due to the war effort on the internal price level when civilians consumable output is fixed. Diversion of resources in the economy towards the war effort from producing consumable output increases monetary incomes while the consumable output, or the civilians’ cake in Keynes’ terms, remains the same. Hence, he argues that internal price level will rise even before available resources are fully exhausted given that additional employment created through war effort will create additional demand for consumables. This is while the latter is fixed before full employment is reached. Therefore, in explaining the British experience during the war he states that ‘Age of Scarcity has arrived before whole of labour absorbed’ (Ibid. p.  18). His theory of inflation, hence, does not assume full employment of resources in the economy, which fits the real conditions of an underdeveloped economy such as Sri Lanka. Keynes underscores the need to put the economy on a war-footing to directly control distribution of resources into their alternative uses, savings and prices to maintain low inflation in the face of heightened level of resource scarcity due to requirements of war effort and increased monetary incomes generated through it. This is a particular exposition of the general theory of inflation we are delineating given that defence expenditure is one component of Unproductive Activity. Keynes’ work on inflation is an application of the general theory we are examining to one of its particular manifestations; hence, it provides further theoretical support for the idea that expansion of unproductive labour does increase inflation. Underdeveloped state of the Sri Lankan economy and severe foreign debt problem it is facing throughout last four decades along with continuation of economic waste through its market-led resource allocation render Keynes’ theory on inflation and his corrective measures directly applicable to Sri Lanka. War effort discussed by Keynes is a particular instance of unproductive activity that dominates the general pattern of investments in

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Sri Lanka. Increased monetary incomes generated by war while consumable output of civilians remaining the same in Keynes’ model is same as the monetary incomes generated through unproductive activity without raising the consumable output of the public. Therefore, similar to effects of war on the economy, which is a particular component of unproductive activity, the latter generates monetary incomes while ‘civilians’ cake is fixed’. That is to say general public cannot increase consumption through their additional monetary incomes, which is reflected by real wage stagnation in Sri Lanka cited earlier (see Fig. 2.1). But individuals with access to higher incomes will be certainly able to do so by bidding up prices and therefore at the expense of average income earning working classes. When increased monetary incomes are spent on a fixed volume of consumables higher volume of incomes with respect to output will be absorbed by increased prices, which is in Keynes’ terms the ‘nature’s solution for balancing supply and demand’. Therefore, I will set out to combine the ideas of Keynes on inflation and price controls with the Classical theory of unproductive activity in order to formulate a theory of inflation that is more applicable to underdeveloped economies in the lights of Sri Lanka.

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Fig. 2.1  Real Wage Stagnation and Increasing Per Capita Income. (Source: CBSL Annual Reports)

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2.5   Classical Theory of Productive and Unproductive Labour Ensuing discussion on classical theory of unproductive activity combines the insight of Keynesian theory of inflation discussed above, to understand the nature of Sri Lankan economy and forces determining inflation in the context of underdevelopment. Idea of unproductive versus productive labour springs from Adam Smith in his Wealth of Nations, is further developed by James Stuart Mill in Principles of Political Economy and reaches its final advancement with Karl Marx in his later writings. Adam Smith divides all economic outcomes into productive and unproductive activity, and the higher proportion of productive activity of an economy according to Smith is what essentially distinguishes advanced capitalist mode of production from feudalism and rich from backward nations. ‘The abundance or scantiness of’ a country’s ‘annual supply’ according to Smith ‘must depend, upon the proportion between the number of those who are annually employed in useful labour, and that of those who are not so employed’ (Smith 1994, p. 13). Sir John Hicks remarked that there can be little doubt that the difference between productive and unproductive labour was intended as ‘the centrepiece of (Smith’s) whole work.’ (Hicks 1965, p. 36) Marx regarded the distinction Smith made as one of his greatest scientific merits. Smith in this light can be foremost interpreted as a development economist rather than an advocate of laissez faire policies. The Wealth of Nations, Book I, explores the causes of improvement in productive powers of labour and Book II the nature of capital stock in accumulation process. His analysis is therefore fundamentally opposed to Neoclassicists who do not distinguish qualitative differences between different types of capital and social relations, within which the process is evolving. In this light we will explore the distinction of unproductive and productive labour expounded by Adam Smith in detail. He famously stated that all labour capital employs and adds to the next production cycle as opposed to remunerated by revenue; i.e., profit, rent and interest are productive labour accordingly, and consequently labour that is remunerated out of revenue such as government officials, prostitutes, physicians, security forces, menial servants, etc., is unproductive. Directly relating his definition of productive and unproductive labour on characterisation of economies and their state of development, he states that ‘proportion between productive and unproductive hands, depends upon the proportion between the annual produce

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destined for replacing a capital, and which constituting a revenue’ (Smith 1994, p. 445). Hence, ‘funds destined for the maintenance of productive labour are much greater’ in the rich countries than in the backward. Recognising the great advance achieved from the previous writers on Political Economy, Marx stated that Smith defined productive labour ‘from the standpoint of capitalist production.…[H]e defines productive labour as labour which is directly exchanged with capital…This also establishes absolutely what unproductive labour is. It is labour which is not exchanged with capital, but directly with revenue’ (Marx 1963, p. 153). When elaborating his position on luxury consumption by the rich Smith states that as opposed to employing menial servants if a man with means purchases material riches such as jewels, gems, paintings, etc., he will enhance his wealth compared to employing the former, and hence does not consider such expenses on material luxury as unproductive although they do not enter into the reproduction of the capital stock of the economy. This accumulation of luxuries in the form of material goods as opposed to expenditure on luxury services such as employing a fleet of menial servants which Smith believed to enrich the individual capitalist was also held to be true by him for the society as a whole.1 As J. S. Mill described in his Principles, ‘to transfer hastily and inconsiderately to the general point of view propositions which are true of the individual has been a source of innumerable errors in political economy’ (Mill 1987, p.  59). We will see that Smith’s error led to an underestimation of the range of unproductive labour within capitalist economies. Mill and Marx corrected this erroneous transfer of particular to the general by Smith. They held on the contrary that labour directly exchanged with capital is productive and hence considered luxuries to be unproductive expenditures which reduce the potential productive output of the society. For instance what productive consumers ‘consume in keeping up or improving their health, strength, and capacities of work, or in rearing other productive labourers to succeed them, is Productive Consumption’ (Ibid.) given that it enables the production process to continue. Mill further states, ‘consumption on luxuries, whether by the idle or industrious, since production is neither its object nor is in any way advanced by it, must be reckoned Unproductive’ (Ibid) [emphasis added]. In other words production process of luxuries is such that it diminishes potential output by converting productively employable resources into unproductive output. For instance, let us assume that only half of the aggregate workforce is employed productively therefore, the other half employed in supplying

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unproductive consumption. But given that the former produces the subsistence needs of the latter even if the latter stops work, the society will be wealthier twice more under the assumption that unemployed workers will be sustained by government transferring the surplus of productive workers gratis to the former. This is so given that destruction of productive resources by supplying unproductive output is now saved and hence society’s aggregate wealth thereby doubled. In this light Mill states that ‘if first half of labourers suspended work, and second half continued theirs, the country would have been entirely impoverished’ (Ibid.).

2.6   Laibman’s Allocation Problem and Marxist Theory of Unproductive and Productive Labour Proceeding section examines how Adam Smith’s view of unproductive labour is confused by the dual character of luxuries which exist as an exchange relation for the individual capitalist supplying it and hence replenishes his capital stock while simultaneously exchanges with revenue from the perspective of individual capitalist purchasing and in terms of the society as a whole. It hence amounts to a reduction of the surplus product of the latter. In our view the contemporary discussion on productive and unproductive labour centred around the ‘Allocation Problem’ raised by Professor Laibman has not addressed the theorising of Marx in allocating luxuries within the unproductive sphere (see Laibman 1993, 1999; S&S Editors 1993, Mohun 1996; Moraitis and Copley 2017). The advocates of ‘Allocation Problem’ assert that unproductive activity according to Marx should be remunerated from surplus value s and hence is a deduction from profits. This means to say that the ‘Allocation Problem’ arises from the incorrect equating of the term surplus product with profits per se and therefore from the reification of conception associated with capitalist mode of production which produced the Trinity formula criticised by Marx in his Volume III of Capital. The surplus product constitutes the consumable revenue of the capitalist, its savings in the form of money capital hand in hand with its potential constant and variable capital. The three components of value are therefore represented by and posited within surplus value simultaneously while in their material existence occupies a separate independent existence from one another. Hence, when it is asserted that unproductive activity is remunerated by the surplus product it does not imply that constant capital and variable capital v are not accounted for in the process. That is to say the ‘Allocation Problem’ arises

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from an erroneous underlying belief that unproductive activity is remunerated by strictly deducting surplus value s only. The volume of variable capital v and constant capital c are therefore believed to be immune to the deductions caused by unproductive activity. In contrast Marx’s economic classification of productive and unproductive labour and his general theory of capitalist production necessitate remuneration of unproductive activity through all three value categories. The following section will seek to shed some light on this theme and reinstitute the operational significance of the theory. Marx in his Grundrisse states that ‘workers [producing luxuries] are productive, as far as they increase the capital of their master; unproductive as to the material result of their labour’ (Marx 1973, p. 273). Hence, in Marx’s formulation ‘Labour becomes productive only by producing its own opposite. Only such labour is productive as produces capital’ (Marx 1973, p.  305). Unproductive labourers therefore according to Marx obtain ‘a share of the surplus product, of the capitalist’s revenue’ (Marx 1973, p. 468) which caused the advocates of ‘Allocation Problem’ to assert that unproductive activity is remunerated by deducting surplus value s as opposed to constant and variable capital. In contrast the costs of unproductive inputs as elucidated in the foregoing discussion are deducted from all three forms of value embodied within the surplus product. On the other hand this means to assert that from the perspective of the individual capitalist whatever work that earns him profit is productive labour, whether it is through real estate, prostitution, garments or wheat farming does not matter to him. But from the standpoint of the purchaser and from the society as a whole only labour that produces and reproduces productive capital remains productive. Hence, despite the fact that labour could be exchanging with capital as opposed to revenue in luxury production it cannot be considered as productive labour given that the output it produces exchanges with revenue of the purchaser. The dual character of luxury goods is such that it concomitantly exchanges with both capital and revenue. It exchanges with capital only from the perspective of the individual capitalist supplying them given that it replenishes his stock of capital in the process of exchange. On the contrary, to the purchasing capitalist and to society as a whole, it amounts to an expenditure; an exchange with its revenue, thus a reduction of aggregate surplus product; hence, the dual character of luxury goods. Marx in this connection expounds ‘Productively employed capital is always replaced doubly, in that the positing of value by a productive capital

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presupposes a counter-value. The unproductive consumption of capital replaces it on one side, annihilates it on the other’ (Marx 1973, pp. 750–751) [emphasis added]. In the following section, based on Marx’s critique, we will explore the erroneous conclusion by Adam Smith and J.  S. Mill that all labour exchanged with productive capital is productive and all activities facilitating the supply of essential wage goods are productive; in Marx’s writings we reach the final development of the theory of productive and unproductive labour. Smith considered all labour directly exchanged with capital as productive due to his inability to differentiate capital that is employed in the direct production process from circulation. The latter is merely engaged in the realisation of surplus value while only the former is productive of surplus value. Smith also included labour employed in trade as a whole, banking, finance, insurance, real estate as productive. With regard to costs in acquiring land Marx states that it ‘forms a weighty element of the individual unproductive costs of production’ (Marx 1981, p.  564) which reduces the capital stock at the disposal of the capitalist for the purpose of increasing production (Marx 1981, p.  946; Ricardo 1978; Mill 1987, p. 57). These activities being individual components of commerce, finance and real estate do not produce surplus value but are remunerated by transfers of surplus value extracted from the productive labourers and hence amounts to transfer payments which deduct the aggregate surplus of the economy. ‘[Merchant] performs a necessary function, because the process of reproduction itself includes unproductive functions. He works as well as the next man, but intrinsically his labour creates neither value nor product’ (Marx 1967b, p.  134). Therefore, Marx states that labour that is directly exchanged with capital is not always productive and that labour is only productive which exchanges with productive capital as opposed to circulating capital or unproductive capital. The latter includes not merely commerce, but the entire financial sector, marketing or sales costs, speculative capital, real estate, healthcare, law firms, trade, etc. For instance, incomes of the healthcare sector as a whole would rise in an epidemic causing the gross national income to increase based on its traditional method of computation. However, do we consider the epidemic-­led additional incomes as productive although it’s absolutely necessary to maintain the production process and is in turn exchanged with capital? Similarly do we consider incomes of financial firms and merchants gained through financing and coordinating respectively, the supply

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of essential products such as food, housing, clothing, etc., to workers as productive incomes? They’re invariably productive for the individual capitalists while from the perspective of the purchaser and the society must be considered unproductive. Therefore in this particular instance unproductive activity is strictly paid out of variable capital or in other words through wages. Marx in this connection states that costs of circulation will be also increasing the output price ‘without adding to its use-value, which therefore are to be classed as unproductive expenses; so far as society is concerned, may be a source of enrichment to the individual capitalist.’ (Marx 1973, p.  139) This is to say that there are two types of unproductive labour: (a) labour which exchanges with revenue as opposed to capital and paid out of surplus value and wages (self-employed workers, doctors, lawyers, government services, etc.,); and (b) Marx’s addition to the above Smithian definition (Moseley 1983, p. 181), i.e., labour which replenishes capital employed yet remunerated by revenue and hence accounted for by surplus product (luxury goods and services, private security firms, law firms, marketing, sales, book keeping, finance, insurance, storage, trade, etc.). From the perspective of the society neither of these produces surplus value. It should be brought to notice that what constitutes a luxury good is historically specific and therefore can be classified as a product which behaves in accordance with its standard economic definition derived through price and income elasticity of demand. Duality inherent in the second type of unproductive activity accommodates both necessary unproductive labour such as healthcare, book keeping, banking, storage, trade, etc., to continue the production cycle regardless of the mode of production and unnecessary unproductive labour which constitutes waste such as luxury goods and services and labour necessary to reproduce the relation between capital and labour such as advertising and supervisory labour. The above classification of unproductive labour in our view solves the ‘allocation problem’ (Laibman 1999, p. 69) raised by Professor David Laibman. We have thereby completed our review on the classical theory of productive and unproductive labour. Combining the same with Keynesian theory of inflation we will set out to generate a theoretical apparatus explaining how proportion between productive and unproductive labour determines to a great extent the internal price level of an economy. In Keynes’ theory of inflation, expanded war effort which did not expand supply of civilians’ consumption goods or in classical terms the productive output, nevertheless generated monetary incomes through additional

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employment and government purchasing. Similarly, the theory of productive and unproductive labour explains that the incomes generated by the latter is merely a claim on the surplus value generated by the former and its production process constitutes a conversion of productive inputs to unproductive output that cannot be utilised to extend the output of the productive goods sector. Hence, higher the proportion of unproductive labour higher will be the magnitude of claims that the latter accumulates on the surplus product of productive labour while productive output remains unchanged. Hence, internal price level of an economy comprising higher share of unproductive employment should be greater ceteris paribus. This further implies that a relative increase in productivity of unproductive labour compared to that of the productive sector say by an introduction of new technology would invariably lower its claims on the surplus value generated by productive labour. While the proportion of productive to unproductive labour in the economy shifting towards the former which would increase the output and labour availability of the productive sector. Under this backdrop even if there is no increase in output due to shift in total employment towards the productive sector1, it would nevertheless tend to reduce the wage rate in the productive sector by increasing its access to surplus labour. Therefore, a reduction in the internal price level of the economy should be its consequence. On the other hand, the total wage bill of the unproductive sector will fall in the short run in the face of a technological improvement in the sector. This in turn will reduce the claims of the unproductive workers on the output of the productive sector, leading to a reduction of the internal price level of the economy, ceteris paribus. However, the reverse outcome may occur in the long run given that productivity increases in the unproductive sector will invariably increase its wage rate while the productive output of the economy remaining the same. Hence, the long run outcome of productivity increases in the unproductive sector will bear an opposite effect on the internal price level compared to the short run effects of the same. Theoretical position we arrived at that states productivity increases in unproductive sector will lead to contradictory changes in price level in the long and short run contradicts the outlook of Piero Sraffa who claimed that the effect of a technological improvement in unproductive sector would merely reduce its supply price with no further impact on rest of the economy. If capital and labour required to produce a luxury good is halved by an invention ‘the commodity itself would be halved in price but there

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would be no further consequences; the price relations of other products and the rate of profit would remain unaffected’ (Sraffa 1960, p. 8). Sraffa states that the productive goods which he terms as ‘basic goods’ indirectly or directly enters into the determination of prices of all other goods while the unproductive goods which he terms as ‘non-basic goods’ or luxury products ‘have no part in the determination of the system’ (Ibid.). He is perfectly correct in stating that the productivity of the luxury goods sector does not affect the cost price of other goods from the production side of the closed economy. His error in declaring thereby that there is no impact on the system of prices on the economy by an increase in productivity of the luxury goods sector springs from the absence of analysis of its effects on aggregate monetary incomes and hence from the demand side of the economy. Further, it goes without saying that the depreciation of the currency due to the conversion of productive surplus into unproductive luxury goods fuels inflation in the economy. In the context of Sri Lanka the depreciation of the currency can be attributed mostly to the conversion of country’s productive surplus into luxury imports which in turn raise the price level of the economy. Outcomes of labour productivity increases in the productive sector on the internal price level in the context of the Sri Lankan economy will be analysed in the section devoted to the structural theory of inflation. Further, in the context of monopoly capitalism, higher the degree of monopolisation of the economy (Kalecki 2010; Foster and Magdoff 2009; Baran and Sweezy 1966), higher will be the tendency on prices to rise as a consequence of economy’s higher unproductive labour composition and the lower composition of productive capital to labour ratio in the long run.

2.7   Monetarist, Neoclassical and Demand Pull Theories of Inflation from the Perspective of Cost Push Theory Under this backdrop following analysis will set out to critically review theories of inflation in monetarist and neoclassical tradition or in other words mainstream view of inflation. First systematic formulation of inflation in classical theory is believed to be expounded by Irvin Fisher in his ‘Purchasing Power of Money’, (Fisher 1922). However, as noted in our review of classical theory of price determination, it was shown that Fisher’s theory of inflation bears no continuity with defining postulates of classical

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theory. But rather forms the basis for neoclassical and monetarist view on inflation. Fisher’s theory states that if velocity of money (V), real output (T) and productivity remain the same, money supply (M) will determine the price level (P) and hence, rate of change in money supply will determine rate of change in prices, therefore inflation in an economy. MV = PT, hence, P = MV/T This basic postulate is the foundation on which monetarist and neoclassical theories of inflation are constructed. From practical aspect of things monetary authority of Sri Lanka as in most around the world formulates policy decisions based on this position. Hence, we will set out to provide a critical account of Fisher’s theory of inflation and thereby demonstrate the faulty conceptual base on which monetarist and neoclassical theories are constructed. Mimicking Fisher’s theory Milton Freedman famously proclaimed that ‘Inflation is always and everywhere a monetary phenomenon and can be only produced by a more rapid increase in quantity of money than in output’ (Freedman 1970, p. 24). It can be said that the main proposition of demand pull theory of inflation is similar to that of monetarism and neoclassical theory of inflation, which holds that increase in money supply without a corresponding output causes price level to rise. Hence, shared basis of Fisher’s theory, neoclassical theory, demand pull theory and monetarism saves us the time from having to critically focus on the marginal differences that exists between them. Neoclassical theory or what is known as Cambridge version of inflation theory is a reformulation of Fisher theory taking into account greater role of demand side of the economy in determining price level. It states that money demand (MD) determines level of prices (P) when real output (Q) and constant portion of income people are willing to hold in the form of money (k) remains the same. That is to say: MD = kPQ, hence, P = MD/kV In money market equilibrium, theoretically arrived at by combining classical and neoclassical theories of inflation, therefore, velocity of money should equal the inverse of constant portion of income people wish to hold in money form. That is, when Money supply MS  =  MD then, V  =  1/k given that, MD = MS = kPT = PT/V Hence, both theories hold that price level is the determined element in the formula and a passive variable in system’s functioning. Theory therefore, rules out any possibility of reverse causality. That is to say increase in price level could independently determine money supply and money

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demand as much as the latter could determine price level. On the contrary, it is our view that determined and determining variables in the formula can change their respective places depending on the structural causes in the economy which cause the price level or money supply and money demand to rise. We can hence, theoretically reject the entire basis of monetarism and neoclassical theory of inflation by refuting Fisher’s theory of inflation by demonstrating the overwhelming possibility of reverse causality. One of the main components of cost push inflation theory, the Kaleckian theory of monopoly capitalism can be utilised to demonstrate how prices rise prior to an increase in money supply or money demand. Theory states that degree of monopoly is inversely related to degree of price competition in the economy and hence an increase in the former will cause internal price level to rise (Kalecki 2010). Probably anticipating this development Adam Smith stated that, ‘In reality high profits tend much more to raise the price of work than high wages. …Our merchants and master manufacturers … say nothing concerning the bad effects of high profits’ (Smith 1994, p. 141). Further, G. C. Means in his theory of administered prices states that price determining firms tends to keep prices constant for long periods of time and do not tend to alter them according to short run changes in demand or costs and when they change ‘they are likely to be adjusted only partially to short run changes in demand or costs’ (Means 1994, p. 65). Hence, in the short run, rate of change in price level will increase if degree of monopolisation of the economy is reduced as the level of responsiveness of prices to short run demand or costs will rise. This is to say that profit is price determining contrary to neoclassical and monetarist view which holds that profit is determined by price and, hence, is a residue in the process. It’s our contention that an increase in price level is not always preceded by a corresponding increase in supply of or demand for money as the three theories discussed above would imply. Hence, prices would increase before any increase in supply or demand for money. That is to say if degree of monopoly rises, the resulting increase in price level itself will cause supply and demand for money to rise. Exact functioning of this process can be explained as follows. Say the degree of monopoly in investment goods sector increased leading to an increase in its general price level while supply of money is unchanged. Price increase therefore occurred independently of the latter. In turn, additional demand for money caused by additional requirement of investable funds due to increase in investments goods price level generates a corresponding increase in demand for money in the form of loan capital. Additional

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demand for investment credit will raise borrowings and thereby raise money supply, which was initially triggered by an increase in price level of investment goods not vice versa. Let us now look into this possibility in consumer goods sector. Increasing sales effort through product differentiation, promotion of consumer credit, payment through instalments and more importantly, commodification of society’s value system in turn lures the public into increasing consumption, which is a defining characteristic of contemporary Monopoly-Finance capitalism. This occurs while prices are higher than in a free competitive stage of capitalism. This is to say that consumers’ unmet demand is heightened on one hand while their real income is reduced or stagnating, given that under monopoly capitalism, equilibrium of forces is reached below full employment level. As a result financial system and monopolistic firms increase disbursement of consumer credit to maintain aggregate demand for their overpriced and mostly spurious products shifting the credit composition from investments towards conspicuous consumer borrowings (Baran and Sweezy 1966). Hence, supply of consumer credit and therefore supply of money increased following the increase in consumer prices indicating that predominant way the economy functions renders prices to determine money supply rather than the converse. It elaborates that real functioning of the economic system in modern age of capitalism defies theoretical conclusions of three mainstream theories of inflation discussed herein. Hence, conventional policy measures proposed to curtail inflation would no longer be compatible with general macroeconomic aims of realising full employment, optimum resource allocation and balance of payments when monopoly-finance capitalism is a defining feature of the economy. Further, all three theories discussed above hold that an increase in the supply of or demand for money with a corresponding supply of output will not cause price level to rise ceteris paribus. From our discussion on theory of productive and unproductive labour it should be clear that this theoretical position is grossly misleading. According to neoclassicists any income generated is productive and the effect of an expansion in one type of income on economic variables is not different from that of another. That is to say incomes are an economically homogenous category. Hence, even an increase in incomes of unproductive labour and the unproductive class through which money supply and money demand will increase will not cause internal price level to rise. The proposition sounds preposterous because as we’ve seen increase in output of unproductive labour will not

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produce a corresponding volume of productive goods which the former demands with additional monetary incomes earned. Hence, an increase in money supply caused by a corresponding volume of real output will still result in inflation depending on composition of additional output, contrary to the theoretical conclusions of monetarists and neoclassicists. Finally, dominance of a merchant class that appropriates the surplus product without direct involvement in the cultivation process, without reinvestment of the monetised surplus in transforming the agrarian system on a capitalist basis in turn aggravates the uneven pattern of labour use of paddy agriculture. It impels the expansion of informal unproductive activity by constituting the availability of rural labour surplus as an uneven function in time. Further, the disequilibrium in factor proportions of paddy economy which employs expensive capital inputs while regional economies employ cheaper alternatives further escalates domestic production costs. This indicates that underdevelopment of the economy on account of the relationship the capitalist class maintains with production forces directly shapes the supply price of paddy independent of and prior to determination of money supply. The former hence influences the latter rather than the converse.

2.8   Global Empirical Studies: Structural Theory of Inflation—A Critical Overview Structural theory of inflation attempts to provide an alternative explanation to causes of inflation specific to underdeveloped countries which are not explored by neoclassical and monetarist theories of inflation. The latter by their nature are incapable of grasping real causes leading to persistent inflation in underdeveloped economies. Although, structuralist stream of thought broke away from conventional methods of inflation analysis the theory still provides superficial account of causes of inflation in underdeveloped economies. Structuralists hold that inelastic food supply of underdeveloped economies is a key reason for causing inflation. Technological backwardness, unequal arable landownership, inadequate agricultural infrastructure, inadequate investment and saving, weather conditions determining food production are cited as reasons for inelastic supply of food in underdeveloped economies (Kirkpatrick and Nixon 1978). In the context of Sri Lanka supply of food cannot be considered inelastic given that production

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increased over the years simultaneously with population growth. And contrary to the structuralist view, new technology in terms of machinery and fertilizer is heavily utilised in Sri Lanka’s paddy production. Hence, lack of investment cannot be cited as the reason for food inflation in Sri Lanka as significant volume of investment by both public and private sector flew into the sector. Further, pattern of paddy landownership remains more or less the same in Sri Lanka compared with major paddy producers in the region. Despite similarities in pattern of landownership and notable volumes of investments flowing into paddy economy, in fact in excess of what is prevalent in regional economies in the lights of India, Bangladesh, Vietnam, and Burma cost of production of paddy in Sri Lanka relative to the latter remains considerably higher. Hence, generalised reasons given by the Structuralists as the causes of food price inflation do not apply to conditions prevailing in Sri Lanka (Fig. 2.2). An analysis of the paddy production in North Central Province of Sri Lanka is required to explain conditions leading to higher price of paddy compared to regional producers. Professor S.B.D.  De Silva’s theory of ‘Surplus Labour in Underdeveloped Economies’ states in this connection that on account of the unevenness in labour demand function of paddy sector a large reservoir of labour remains underemployed within the

Regional Comparison of Rice Prices USD/MT 2016

600 500

446

469

570

486 400

400 300 200 100 0

India

Viet Nam

Myanmar

Bangladesh

Sri Lanka

Fig. 2.2  Regional Comparison of Rice Prices. (Source: International Rice Research Institute and CBSL)

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sector, whose surplus labour time cannot be easily shifted to industry in the absence of a reduction of paddy output or in the absence of a complete reorganisation of cultivation process.2 Hence, the workforce held within agricultural sector remains underemployed and unavailable to be deployed in industrial sector which requires a continuous labour supply. Paddy sector as a result does not entirely free the worker from its bounds and nor does it fully employ them; hence, straddling him between being employed and unemployed within a short span of time. It renders transfer of surplus labour from agriculture to industry a discontinuous function at existing wage rate while industrial sector requires a continuous supply of labour to remain in operation. Given that demand for labour in paddy agriculture is not even across production time, and ‘production time does not overlap with labour time’ (Marx 1967), shortages of labour arise in agricultural sector itself, especially during harvesting and land preparation. This in turn raises real wage rate of paddy agriculture above other sectors (see Fig.  2.1). Hence, in the absence of reorganisation of totality of paddy production vital supply of surplus labour will be denied to industrial sector of the economy (De Silva 1972). It should be borne in mind that despite higher rate of real wages in agriculture total real wage income will be low owing to discontinuity in agricultural employment. This phenomenon in our view prevents agricultural real wage from influencing non-agricultural real wages. It’s empirically indicated by services and manufacturing sector real wages remaining significantly below agricultural real wage (see Fig. 2.1). It indicates that non-agricultural real wages have not increased beyond agriculture to draw rural labour into industry and services. Hence, real wage rate of agriculture has not influenced non-agricultural real wage. Increase in nominal wages and inflation following liberalisation of the economy, hence, should be considered as an effect of inflation rather than the converse. Owing to the unavailability of rural surplus labour to be continuously deployed in industry, the workers will in turn transfer their surplus labour time into informal unproductive sector which does not require continuous supply of labour to remain in operation. Hence, we see the phenomenon in Sri Lanka that construction, trade, transport, tourism, three wheel taxi services, etc., that expanded ferociously is characterised by a discontinuous supply of labour which returns to rural economy during latter’s peak labour demand periods. Hence, uneven labour demand function of paddy cultivation tends to favour expansion of unproductive employment. Expansion of the latter in turn generates monetary incomes while

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productive output remains fixed, leading to a continuous increase in internal price level of the economy. Further, unevenness of labour demand function, combined with considerable use of family labour in cultivation with wage labour, leads to further complications in determination of supply price of paddy in the economy. Firstly, concentration of land holdings and an increase in mechanisation of paddy cultivation will in fact raise supply price of the sector than reducing it as commonly assumed. This phenomenon can be explained by the interaction of concentration and mechanisation with composition and pattern of employment in paddy sector and also by the shift in released surplus labour from paddy economy to the unproductive sector as stated in Chapter 1. The other peculiar phenomenon we will attempt to explain is that, based on degree of usage of family labour, an increase in agricultural real wage rate would reduce supply price of paddy and vice versa, until use of family labour in cultivation reaches zero. Main corollary of the two processes cited above is that an increase in paddy output in the economy would invariably increase its supply price. This is so given that share of cash cost of cultivation would in turn increase while non-cash component of production falls when mechanisation and wage labour use increase to expand paddy output. These three complications—the initial two are causations of the last—are stemming from the structural phenomenon characterising the nature of the labour use in the paddy economy in the North Central Province of Sri Lanka. In this backdrop we will set out to explain the first proposition stating that increased concentration of land holdings and mechanisation of paddy cultivation in the face of family labour use would increase the supply price of paddy and therefore the price level and proceed towards explaining other postulates. Furthermore, the growing concentration of machine ownership coupled with overall oligopsony structure of paddy economy significantly increases the supply price of paddy and in turn the internal price level of the economy. This is to say ‘The moral for policy makers [should be] not to rely on “trickle down” to benefit the traditional sector, but to attack the problems of that sector directly’ (Lewis 1978, p. 216).

2.9   Theory of Surplus Labour Surplus labour in underdeveloped economies is considered analogous to the presence of disguised unemployment or underemployment and the terms are treated as interchangeable hand in hand with the understanding

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that the underdeveloped economies are characterised by the existence of traditional and capitalist sectors. Surplus labour is said to be residing in the former. Traditional sector not merely includes peasant agriculture. ‘Another large sector to which it applies is the whole range of casual jobs. …Petty retail trading is also exactly of this type’ (Lewis 1954, p. 141). Further, ‘Self-employment …in developing countries with dualism and underemployment largely remains a reserve of surplus low-productivity labour’ (ADB 2017, p. 55). ‘…there are likely to exist unlimited supplies of labor conditions in the so-called urban informal sector where families, lacking sufficient cooperating capital, are forced to pursue small-scale service and distributive trade activities, yielding low marginal labor productivity’ (Ranis 2012, p. 3). The wage rate in the sector is said to be above marginal productivity of labour due to sharing of poverty within households which causes the wage rate to be set by average productivity of labour as opposed to its marginal product. This is to say that if a neoclassical solution to the wage rate is applied wages would sink below the minimum level of subsistence (Ranis 2004). 2.9.1  Determination of the Wage Rate in the Dual Economy Transfer of labour from traditional to the modern sector therefore raises the average productivity of labour in the former and hence implies that an unlimited supply of labour from traditional to the modern sector would not be available at a fixed wage rate if population growth does not keep up with the rate of labour transfer. ‘When workers are drawn out of the traditional sector into the modern capitalist sector those who remain enjoy higher average output and thus receive a higher income than before, in the absence of population growth or when the transfer outweighs any population increase’ (Wang and Piesse 2013, p. 88). This problem is neglected in Lewis model as irrelevant for a realistic theoretical reflection of development process in underdevelopment economies with surplus labour. ‘[T]he wage determination mechanisms in both the traditional and modern sectors …lack sufficient detail and are still unclear [in the Lewis model]’ (Ibid. p. 83). The Lewis model and the subsequent dual economy models also implicitly assume that the rate of exploitation of merchants and usurers remains unchanged within the traditional sector when average productivity of the sector rises with labour transfer from traditional to modern sector. This implicit assumption through neglecting the production relations of the

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traditional sector has led the writers to rely on population growth and the pace of labour transfer to hold the wage rate constant in their respective models. However, Lewis does underscore the fact that average product based wage determination is not applicable if the peasantry has to pay rent given that rent payments will ensure that peasant’s income is a net income which corresponds to subsistence wages (see Lewis 1954, pp. 148–149). Despite his recognition of the fact that average productivity would cease to be an objective basis for wage determination in the traditional sector if the peasant has to pay rent he nevertheless did not take into account the role of merchant cum usurers in suppressing the peasant’s income to a net income which is a minimum requirement for subsistence. Hence, even if the peasant is an owner-cultivator who does not have to pay rent he is nevertheless subjected to the stranglehold of the merchant cum usurers which removes the objective basis of average productivity to function as a wage index in the traditional sector. Lewis considered the method of wage determination in the traditional sector to be of less importance in explaining the presence of unlimited supplies of labour at a constant wage rate (see Ibid. p. 149). There is, however, ample evidence to show that merchants and usurers increase their stranglehold on the peasantry through increase in machine rents and suppression of the farm gate price for grain when average productivity increases in the traditional sector through labour transfer from traditional to modern sector. This in turn causes traditional sector wage rate to remain constant and fall below average productivity of labour. Hence, it is our contention that the wage rate of the traditional sector would fall below the average productivity in the face of labour transfer enabling unlimited supplies of labour from traditional to modern sector at a relatively constant wage rate when population growth remains below the rate of labour transfer and irrespective of the pace of labour transfer. This is to say that rising rate of exploitation in the traditional sector hand in hand with transfer of labour from subsistence to modern sector prevents terms of trade between the traditional and the modern sector from altering in favour of the former. Alternatively, increase in average productivity of labour in the traditional sector through transfer of labour will lead to an increase in the marketed share of the aggregate produce of the peasantry. Increased marketed share of the produce increases the market supply of grain while aggregate agricultural output remains unchanged. The higher grain supply in the market invariably suppresses the farm gate price for grain leaving the peasant’s average real income constant even after the

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transfer of labour from the traditional to the modern sector. Suppression of the farm gate price in turn shifts the terms of trade against the traditional sector and in favour of the merchants cum usurers without bearing an impact on modern sector. This is to say that rate of exploitation has an objective basis to increase when average productivity of the traditional sector rises through labour transfer to the modern sector. In turn this holds the traditional sector wage rate constant enabling unlimited supplies of labour at a constant wage rate. 2.9.2  Elasticity of the Supply of Surplus Labour in Sri Lanka The labour surplus in the traditional sector is assumed to be immediately transferable to the capitalist sector without a significant fall in its output at the average productivity of labour with a small transfer margin, given that there is demand for labour from the modern sector. Therefore labour supply is believed to be elastic. Relocation of labour from traditional to modern sector is hence assumed to cause an automated reorganisation of the traditional sector enabling the transfer without a fall of output of the traditional sector. ‘[W]hen some workers with low marginal productivity are withdrawn, those who remain are likely to work harder and other technology changes of the reorganization variety are likely to result’ (Ranis 2012, p.  4). In the following section we will attempt to address the intricate empirical and analytical problems posed by the distinct features of Sri Lanka’s rural labour organisation shaped by the monsoonal rainfall pattern of the dry zone and the rural production relations which evades the key postulates of standard dual economy model briefly stated so far. Subsequently, we will delineate the role they occupy in determining the aggregate mode of production of the economy and its influence on inflation. Contrary to the standard dual economy model which assumes an elastic supply of labour Sri Lanka is characterised by an inelastic labour supply from the subsistence sector before the labour surplus in the traditional sector is exhausted. This is complemented by simultaneous existence of labour shortages hand in hand with excesses of labour in the country side and persistent deficiency in the formal sector of the economy. The high degree of unevenness in labour absorption pattern in paddy agriculture peculiar to Sri Lanka partly stemming from specific geographical features is a main factor rendering the labour supply function inelastic before the labour surplus in the traditional sector is fully absorbed by the formal

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sector. Marx indicated the existence of this phenomenon in English agriculture: ‘There are always too many agricultural labourers for ordinary, and too few for exceptional or temporary needs of cultivation. Hence we find in official documents, contradictory complaints from the same places of deficiency an excess of labour simultaneously’ (Marx 1967a, pp. 692–693 – indicated by late Dr. S. B. D. De Silva). Non-availability of unlimited supplies of labour in underdeveloped economies according to Lewis is due to low land/man ratio and he therefore assumes that despite the non-development of capitalist sector the labour surplus is fully absorbed by the traditional sector itself through spreading out of the population across abundant land. Existence of unlimited supplies of labour ‘is not true either of some of the countries usually now lumped together as under-developed, for example there is an acute shortage of male labour in some parts of Africa and of Latin America’ (Lewis 1954, p.  140). Further, ‘…in most of Africa and Latin America labour is more or less fully employed, since there is no shortage of cultivable land’ (Lewis 1958, p. 25). This is to say that shortages of labour or an inelastic supply of labour is synonymous with absence of surplus labour. However, on the contrary a simultaneous existence of shortage of labour with excess of labour is documented in the case of Sri Lanka which indicates existence of surplus labour hand in hand with an inelastic supply curve for labour in the economy. Apart from the natural disposition of the paddy plant which renders the labour demand pattern of paddy cultivation an uneven function across time we will underscore other factors which intensify the degree of unevenness in Sri Lanka greater than regional paddy growing economies. The weak soil structure in North Central Province, the main paddy growing region in the economy, is exposed to monsoonal rainfall delivering a heavy downpour in a short time span followed by a protracted dry season (Brohier 1998; Kahawita 1951). ‘[S]urface of the land is undulating with hardly a square mile actually level. The District receives from 50 to 75 inches of rain during the year, but, instead of being distributed, the great bulk of it falls during the periodicity of one monsoon. Long and severe droughts are by no means unknown. No combination of physical conditions could have offered greater natural disadvantages to irrigation’ (Brohier 1998, p.  1). Further, strictly ‘time-scheduled release of water from irrigation schemes’ (Crooks and Ranbanda 1981, p. 33; Gunasinghe 1976) rendered the operation of these schemes ‘not to allow for variation in the dates on which water is led to different fields served by any single

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scheme, and a considerable land area has therefore to be ploughed or sowed at the same time. By contrast, several small irrigation works in lieu of one major project would permit greater degree of flexibility in crop planning and the timing of cultivation operations over the total land area irrigated’ (De Silva 1972, p. 17). These geographical and institutional factors peculiar to Sri Lanka lead to irregularity in labour demand across time by setting specific uneven time constraints to complete different operations in paddy cultivation such as land preparation, weeding, planting, harvesting, etc.,. ‘The total land area cultivated would in these circumstances correspond to the labour inputs available during the peak periods of farm activity, and at the same time urgency with which certain agricultural operations must be completed, although they are separated in time, necessitates the retention of a large workforce than the actual volume of labour inputs would suggest’ (Ibid, p.  16). This is in contrast to other paddy growing economies such as Vietnam, Malaysia, Philippines, Burma and India where rainfall is more evenly distributed; hence, labour demand is comparatively even across time. Further, Dr. S.B.D. De Silva in this connection states that ‘Both the land and the labour force comprise a multitude of autonomous production units over which the total volume of employment is not distributed according to an overall plan which relates the size of a labour unit to the employment potentialities of the agricultural holding to which it is attached. Chronic underemployment may thus co-exist in an area with an acute lack of wage-labour. The maldistribution in the supply of labour which characterises such a situation is aggravated …by sporadicity in the labour requirements on any given farm as well as by other factors which influence the organisation of grain cultivation in traditional economies’ (Ibid. pp. 8–9). Uneven labour demand during and between periods of cultivation, which exacerbates inflationary pressure, is further aggravated by monetisation of paddy surplus outside the rural economy without transforming fragmented peasant cultivation on large-scale capitalist basis by merchants and usurers on whose hands the paddy surplus is concentrated. This rejects the view that if one agent occupies a monopolist position and is a utility maximiser, say for instance the money lending merchant, “then the market outcome will be Pareto efficient”. In this connection Basu states that ‘An important cause of suboptimal equilibria is the existence of triadic interactions between individuals (multiple contracts between agents such as money lending merchants providing credit to farmers and the repayment being contingent upon terms of trade of the harvest between the

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merchant by the peasant). These can sustain customs and norms which are economically inefficient and thwart innovation and technical progress’ (Basu 2003, p.  40). However, the exact mechanism that sustains sub-­ optimality in the rural economy characterised by peasant cultivation simultaneously employing both family labour and wage labour are not delineated in existing literature. 2.9.3  Political Economy of Surplus Labour in Sri Lanka Irrigation settlement schemes in Sri Lanka promoted since the 1930s in the lights of Gal Oya and Mahaweli projects, instead of organising cultivation under large-scale cooperatives of farmers extended small-scale fragmented peasant farming onto a large reservoir of labour with the aim of building a traditionally minded politically partisan peasantry that provides an unshakable vote base for ruling fractions. It gradually swept away the social basis of the left-wing politics in Sri Lanka by converting a potentially progressive rural semi-proletariat into a reactionary peasantry. Prevailing Marxist parties were fully aware of the adverse political repercussions the colonisation schemes would create for the Left movement in Sri Lanka. The resettlement schemes entrapped them in an unsolvable political dilemma as the two possible opposite responses to the colonisation schemes endorsing and denigrating would produce equally adverse political outcomes for the Left2. Their rational response was to promote cooperatives, especially the cooperative credit bill which received the fiercest opposition from the right-wing political elite led by C. P. De Silva forming the basis for Left factions’ withdrawal from the Mahajana Eksath Peramuna coalition and shortly after in September 1959 Prime Minister S.W.R.D. Bandaranaike, a keen supporter of the land reforms and an open promoter of Socialism, was assassinated. His assassination also dismantled the implementation of Ten Year Plan of 1958 which was internationally recognised for its depth and thoroughness. It envisaged a centrally controlled transformation of the Sri Lankan economy through state-led industrialisation interlinked with agricultural modernisation. Politically motivated settlement schemes in Sri Lanka thereby entrapped a large reservoir of labour under the uneven labour absorption function of paddy agriculture. It prevented Arthur Lewis’s assumption that an ‘unlimited supply of labour at the prevailing wage rate plus a transfer margin exists in underdeveloped economies’ from being a truism in Sri Lanka. The combined effect of the above phenomena raises production costs of

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paddy beyond that of regional economies. Further, the imbalance in factor proportions of paddy economy which employs expensive capital inputs while regional economies employ cheaper alternatives further escalates domestic production costs and price level. The amount of labour hours required in the cultivation process is disproportionately small relative to the large number of workers needed (De Silva 1972). Thus paddy cultivation in Sri Lanka is not labour intensive but worker intensive. The time constraints which each agricultural operation sets determine the number of workers needed while it has no impact on the total labour hours expended. For instance harvesting should be completed before the crop is exposed to the destructive forces of nature. It requires a large number of workers for a short period of time. Thus the number of workers required is determined by the nature of the time constraint which each operation sets. Hence, when the time constraint of a specific operation is low the number of workers required falls while the labour hours expended remaining unchanged. For instance even if the labour hours required to complete two distinct processes such as weeding and land preparation is the same, the number of workers required for the two processes would vary relative to the difference in the time constraints objectively set by the two processes. The cycle of paddy cultivation constitutes different agricultural processes with variable time constraints. Therefore, labour hours spent is low compared to the number of workers involved in cultivation. If there are no time constraints objectively determined by the plant’s biology and geographical conditions, one worker can complete the entire range of agricultural processes releasing rest of the workers from the bounds of rural economy and hence rendering the labour supply function more elastic. Therefore, elasticity of the labour supply from agricultural to non-agricultural sector or the transfer of surplus labour from agriculture to modern sector is determined by the nature and variability of the time constraints of agricultural processes objectively fixed by geographical and biological structure of the staple plant. In the Lewis model elasticity of labour supply itself on the contrary is assumed to be an objective condition. There are barriers to mechanisation for agricultural processes in the absence of reorganisation of the entire agrarian system. Hence, productive capital to labour ratio does not remain even for different cultivation processes, for instance, in different processes in paddy agriculture. Preparation of bunds cannot be mechanised although harvesting is conducive for the process and so on. Hence, workers released from a particular process of

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cultivation through mechanisation are still required in other processes that are not conducive for mechanisation. This means to say the worker cannot permanently abandon the field and find employment in the industrial sector without causing aggregate agricultural output to decline. 2.9.4  Theory of Surplus Labour and Paddy Supply Price Determination A ‘reservoir of labour’ exists in Sri Lanka’s agricultural sector which accounts for the largest share of employment in productive sector of the economy given that share of employment in manufacturing (sans construction, mining, electricity and water supply) is low at 17.9% compared to 27.1% of agriculture in 2016. Hence, impact of increased mechanisation in productive sector will be largely determined by degree of mechanisation in agricultural sector. In this connection an important outcome of labour use pattern of paddy agriculture is that increased degree of mechanisation of cultivation process within existing structure of production relations, would either lead to a shift of labour from productive to unproductive sector of the economy or increase underemployment of labour within paddy sector. This in turn would lead to an increase in internal price level hand in hand with supply price of paddy. An increase in supply price of paddy due to mechanisation of its cultivation process and concentration of land holdings as stated earlier is stemming from the condition that half of labour employed in the sector is family labour which has been mostly replaced by increased mechanisation and concentration of land holdings while commensurately increasing proportion of wage labour employed in cultivation process. Supply price of paddy will tend to rise as a result until family labour use reaches zero. This is so given that a shift from family labour towards wage labour combined with additional cost of machinery indicates a shift in cost structure of cultivation from non-cash inputs towards cash inputs. In this setting an increase in supply price of paddy and therefore the internal price level should be the inevitable outcome. It should be borne in mind that non-­ cash inputs in agriculture mainly in the form of family labour do not enter the cost price of output given that non-cash inputs are remunerated by the non-marketed share of the aggregate product. Hence, an inverse relationship is formed between wage labour share of labour inputs and the non-­ marketed share of the aggregate product and a direct relationship between the former and supply price of rice until family labour share reaches zero.

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On the other hand increase in mechanisation and use of wage labour enables increasing output of the individual holding while land productivity and therefore aggregate agricultural output in the economy remain unchanged. Hence, increase in mechanisation and use of wage labour merely causes a redistribution of aggregate agricultural output in favour of the tenant while aggregate output of the sector remaining unchanged, in turn causing unit cost and supply price of agriculture to rise. Impact of mechanisation was greater on family labour compared to wage labour in dry zone’s paddy farming. In 2003, a total of 37 man days were employed in an acre of paddy land of which 20 were family labour and the rest wage labour, producing a family labour to wage labour ratio of 1.18. By 2012 the ratio dropped to 1.08 which saw total man days required falling to 27 out of which 14 were family labour and 13 were wage labour (Department of Agriculture 2012). It indicates the shift of cost composition of paddy cultivation towards cash inputs from noncash inputs which in turn increases cash cost of production and commensurately increases supply price of paddy. Paddy supply price increased during the period in review hand in hand with increased use of machinery in the sector (see Department of Agriculture 2012 and Wijetunga 2013 for data and Fig. 2.3). The rational in employing machinery when cost of cultivation is increased springs from the fact that release of family labour as a result of increased mechanisation allows the increase of non-farm income of the peasant household. The released surplus labour due to mechanisation will in turn seek employment in the informal unproductive sector such as construction, three wheel taxi services, etc., which maximises total household income despite increasing cultivation cost of paddy. Therefore, mechanisation is determined by the ratio of machine rent to unproductive sector wage rate and not by the former to farm wage rate as commonly held. Therefore, mechanisation of paddy cultivation can increase until ratio of machine rent to unproductive wage rate is below parity despite the fact that cost of paddy cultivation increases with increased mechanisation. Hence, in spite of relative decline of farm wage rate compared to machine capital due to higher increase in machine rent, mechanisation nevertheless replaces labour in paddy cultivation under the condition that machine rent to unproductive sector wage rate is below parity (see Fig.  2.3). This in turn increases cost of cultivation and therefore supply price of paddy and the internal price level of the economy while simultaneously increasing household income of peasantry. Hence, relations of production in paddy

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LKR/Acre 14000

Increasing Capital to Wage Ratio in Paddy Cultivation 12000

12000 10000 8000 6000 4000

3800

4300

4200

2000 0

farm wage cost

machine cost 2003

2012

Fig. 2.3  Increasing Capital to Wage Ratio in Paddy Cultivation. (Source: Department of Agriculture 2012)

sector are organised in a way that raises social cost beyond private cost to an extent that alters the capital composition of the economy to a sub-­ optimal arrangement, leading to negative external economies. The phenomenon contradicts the position of Yujiro Hayami who concludes with respect to Japan that ‘relative decline in the price of machine capital above the farm wage rate has been a stimulus in the substitution of machinery for labour’ (Hayami 1975, p.  34). In Sri Lanka, despite the decline in farm wage rate to machine rent, capital continued to replace labour given that unproductive sector wage rate is higher than the latter. Hence, increased mechanisation and therefore increasing productivity of productive sector raises the internal price level. It does so on one hand by increasing the share of cash inputs in cultivation and on the other by increasing the unproductive incomes of peasant household by shifting labour towards informal unproductive employment while productive output remains fixed. Similarly, an increase in real wages of agriculture would force peasant based family farms to shift from wage labour towards family labour reducing cost of cultivation in next cultivation cycle. This is so given that indispensable need for labour at peak periods would not allow the shift to take

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place within the immediate phase of cultivation. Corollary of the analysis is that any attempt to increase paddy production within existing production relations of rural economy would invariably increase relative share of cash inputs in total input cost by increasing the use of wage labour and machinery. This in turn will raise supply price of paddy and therefore general price level in the economy. Further, it is quite revealing that despite the reduction in total man days necessary in paddy cultivation by as much as 27% from 2003 to 2012 the share of agricultural workforce employed by agriculture as a whole fell merely 3.8% from 31.3% to 29.7% and total agricultural workforce increased during the period. Approximately 2.2 million acres were harvested in paddy in 2012 indicating that nearly 70% of all agricultural labour is involved in paddy cultivation in Sri Lanka. However, the sharp reduction in man days per acre of paddy cultivation has not comparatively reduced the share of agricultural workforce, its total volume nor the supply price of paddy (see Fig. 2.4 and 2.5). If man days in agriculture are perceived as directly related to the number of agricultural workers, logical outcome should be that mechanisation should reduce the share of agricultural workforce. Reduction should take place at a rate similar to the fall in man days employed per paddy acre and commensurately reduce supply LKR 70

Comparison of Farm Gate and Retail Price of Rice

60 50 40 30 20 10 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

0

farm gate avg

retail avg

Fig. 2.4  Comparison of Farm Gate and Retail Price of Rice. (Source: Ministry of Agriculture Sri Lanka)

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Falling Man Days while Increasing Agriculture Workers 2700

37

37

37

40 32

2600

32

33 28

2500

30

30

35 27

25

2400

20

2300

15

2200

10

2100 2000

30

5 2003

2004

2005

2006

2007

agricultural workforce ('000)

2008

2009

2010

2011

2012

0

man days/acre in paddy

Fig. 2.5  Falling Man Days while Increasing Agricultural Workers. (Source: Department of Agriculture 2012 and CBSL)

price of rice in the economy. However, difference between two parameters is crucial especially in paddy agriculture (De Silva 1972). We shall see how in paddy agriculture number of man days can fall due to increased mechanisation simultaneously while number of agricultural workers involved in cultivation remaining more or less the same. Increasing number of agricultural workers hand in hand with falling man days per acre of cultivation in paddy agriculture means to say that despite the increase in mechanisation, replaced agricultural labour is still trapped within the sector. And they are incapable of transferring themselves to other sectors of the economy that require continuity of employment as opposed to discontinuous nature of labour demand in paddy agriculture. That is to say mechanisation reduced man hours or man days required for cultivation but not total number of workers, proportionately (see Fig. 2.5). This is so given that despite the reduction of labour hours utilised in paddy economy by incorporation of machinery, it cannot be evenly used across different phases of paddy cultivation. Therefore, land preparation, sowing, maintenance, harvesting, postharvest work, etc., cannot be evenly mechanised in the absence of a total reorganisation of paddy economy which enables a full degree of mechanisation of totality of processes. Free market by itself is incapable of realising this transformation

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given that it goes beyond immediate motives of profit accumulation of the merchant class, the agent that determines pattern of surplus appropriation. Hence, owing to mechanisation, number of workers employed in the sector as a totality may not fall or will reduce sparingly compared to greater reduction in per acre man days employed. Hence, mechanisation will cause labour productivity measured on output per man days to rise while stagnating labour productivity based on output per worker. Although it’s possible to mechanise the harvesting process at an increasing rate, land preparation, sowing, postharvest work, etc. are not so conducive to introduction of machinery. Despite increased degree of mechanisation and reduction in man days needed to cultivate, total workforce trapped in the rural economy therefore remains more or less the same. This is so because mechanisation only reduces labour needed in a particular phase of cultivation which does not affect the amount of labour needed in other phases of cultivation. Hence, worker who is made redundant in one phase of cultivation process such as harvesting is still needed in others, such as postharvest work, land preparation, etc., which are not equally susceptible to mechanisation as harvesting. Therefore, mechanisation reduced total man days required without proportionately reducing total workforce needed for cultivation. Hence, unevenness of labour demand function in the sector would prevail hand in hand with uneven degree of mechanisation of different cultivation phases in agriculture. Therefore, although labour time necessary per acre of cultivation is reduced by mechanisation, number of workers required is not equally lowered but only their degree of work span is shortened. This is while increasing spells of idle time within the period of cultivation, hence increasing underemployment or shifting surplus labour into discontinuous unproductive employment. Inflation caused by this series of integrated events is further enforced by the fact that increase in mechanisation in peasant agriculture does not increase total output of the sector but merely raise per man hour output and output of the individual farm by enabling the increase in extent of its cultivation while per worker output stagnates. Worker is not entirely ousted from cultivation process by introduction of machinery, which means to say that unemployment in paddy sector is not increased due to mechanisation but rather underemployment is increased. This in turn tends to shift surplus labour time towards unproductive informal sector which does not demand permanent and continuous flow of labour to remain in operation. Hence, nature of labour demand

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of unproductive sector in general, compliments the structure of surplus labour in paddy economy and is suitable to absorb the latter. For instance, work in construction sites, tourist hotels, trade, three wheel services, etc., does not employ an entirely permanent workforce given that their demand for labour is not continuous or is seasonal (tourism) across time. This suits the nature of labour surplus in agricultural sector which is also not continuously available to be deployed in non-agricultural work due to unevenness of labour absorption and release in paddy economy. In turn, increase in share of unproductive labour as a result of mechanisation in paddy cultivation will increase demand for productive output of the economy with its increased monetary incomes while productive output remaining the same. Internal price level will therefore rise until additional monetary income generated by increased unproductive employment is entirely absorbed. This peculiar phenomenon is further enforced by the fact that increase in labour productivity in agriculture does not increase total output of the sector but merely raise per man hour output. Only an increase in productivity of land by improved use of fertiliser, crop rotations, water management, etc., at a rate greater than additional labour use will increase both total output and output per man hour in agriculture.

2.10   Empirical Studies: Neoclassical Explanations of Sri Lanka’s Inflation Chapter 1 showed that Sri Lanka’s inflation is explained from monetarist perspective and hence merely reiterates conclusions expected by the theory. Crux of the mainstream argument is that due to fiscal policy dominance of monetary policy in Sri Lanka money supply of the economy increased without a corresponding increase in real output. That is to say maintenance of largescale fiscal deficits in the long run by successive governments as means of securing political popularity among masses is at heart of the issue of inflation in Sri Lanka (see Indraratna 2009; De Silva 2009; Ratnasiri 2009; Bandara 2000). The explanation has not considered structure of the economy when analysing change in internal price level. It considers rise in money supply due to fiscal indiscipline devoid of its interaction with investment structure of the economy. It’s as if money supply, prices and output interact to realise the price level in a political economic vacuum. Monetarist view of inflation therefore considers structure of the economy as a passive element

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in price determination. An increase in fiscal deficit cannot lead to inflation if resources in the economy are underutilised and hence below full employment in the long run. However, mainstream view states that long run cause of inflation in the economy is mainly due to increase in money supply triggered by continuous and largescale fiscal deficits. This is to say that the view assumes, consciously or otherwise, that the economy was in full employment and capacity utilisation was near optimum during the period. However, during the period under review unemployment in Sri Lanka was high except for past few years while capacity utilisation in the economy is well below maximum and balance of payments were in deficits hand in hand with high inflation. This further suggests that causes of inflation in Sri Lanka cannot be simply reduced to changes in money supply. More importantly, mainstream analysis does not elaborate why governments in Sri Lanka has to resort to expansionary fiscal policy to remain politically popular, which is not the reality in developed capitalist economies. Public are objectively forced by living conditions produced by state of the economy to strongly expect government’s assistance given that private sector has not delivered economic conditions required to realise a fair living standard. To fill this political economic void, governments have to maintaining expansionary fiscal policy providing subsidies and employment to masses as a means of filling the ‘supply gap’ within private sector. Hence, we hold that fiscal deficit itself can be determined by stagnation of real incomes, unemployment, underemployment and indebtedness of masses in the context of underdevelopment of the economy. For instance, high degree of unemployment in Sri Lanka prevailed throughout post-­ independence history up to the mid-2000s (see CBSL Annual Reports, Special Statistical Appendix, Table  1) until labour migration since the 1990s gradually reduced unemployment below 5% in 2010. It indicates the inability of domestic private investments to productively absorb the surplus workforce of the economy. This in turn compels state sector to provide employment and relief to masses made redundant by underdeveloped form of capital accumulation that pervades the economy. Hence, in our view, fiscal deficit is a function of the structure of the economy and not vice versa. That is to say fiscal deficit acts as an endogenous variable determined by backward conditions within which resource allocation process in the economy is functioning. This is contrary to the view of economists who hold that inflation is mainly a product of fiscal deficits in Sri Lanka.

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2.11   Theories of Inflation and Underdevelopment ‘[G]iven two countries of equal incomes, in which distribution is more unequal in one than in the other, savings may be greater where distribution is more equal if profits are higher relatively to rents’ (Lewis 1954, p. 159). Lewis in this light also remarks that the economic elite in underdeveloped countries—landlords, traders, moneylenders, priests, soldiers— whose incomes are predominantly accrued in the form of rent is detrimental to the development of capitalism in those economies. Transformation of the production process which also entails a transformation of the nature of the investing class (Dobb 1955), is confined in Sri Lanka to the unproductive sector where construction, healthcare, banking, finance, insurance, supermarkets, etc., have mostly witnessed continuous advancement in technology employed while productive sector organic composition of capital remains low and is confined to industrially primitive labour intensive techniques. Capitalist development in the unproductive sector hand in hand with its non-development in productive sector in turn prevents the imposition of its imprint on the totality of society by fettering the historical leap from formal subsumption of labour to capital to its real subsumption which in turn reproduces the domination of absolute surplus value generation over relative surplus value. This happens for the reason that unproductive output does not enter the next production cycle through its inclusion in the capital stock of the economy as held by Adam Smith; it prevents the sector from transforming the totality of production on a modern capitalist basis confining the development of production forces within its own limited purview. This is in contrast to the self-expansionary properties infused to modern capitalist relations by industrial transformation of productive sector. ‘A radical change in the mode of production in one sphere of industry involves a similar change in other spheres. This happens at first in such branches of industry as are connected together by being separate phases of a process’ (Marx 1967a, pp. 383–384). On the contrary, the disconnectedness of unproductive sector from the general requirements of capital formation in the economy as a whole prevents the permeation of changes in the mode of production that is taking place within itself to other spheres, hence, perpetuating the general pre-­capitalist character of the economy and its underdevelopment. The dual economy theories of underdevelopment resting on existence of a modern commercial sector alongside a traditional subsistence sector (Bardhan and Udry 2000) and income deflation theory of Imperialism

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(Patnaik and Patnaik 2017) alike do not account for the dynamics discussed above. In the same vein Amya Kumar Bagchi describes underdevelopment as the non-transformation of third world economies from mercantilist phase to the industrial phase and underscores it as the reason for the prevalence of pre-capitalist social organisation along with permeation of commercial relations (Bagchi 1985). These delineations do not reflect on the restricted development of capitalist relations in the unproductive sector alongside the absence of its penetration in the productive sector in turn leading to underdevelopment of the economy with regard to Sri Lanka. In this backdrop we will discuss key ideas put forward on the inflationary process in the context of underdevelopment. Cristobal Kay in his study on Latin American theories of underdevelopment stresses that the determining force of inflation in underdeveloped economies is the outcome of the class struggle within the existing institutional framework. Thereby the main cause of inflation is reduced to a struggle for distribution of the surplus between competing classes (see Kay 2010, pp. 56–57). The discussion on inflation so far attempted to extend beyond this view. Inflation in Latin American economies between 1930 and 1970 in Jon Kofas’ study is ascribed predominantly to chronic food shortages on the grounds that the economic elite (exporters, manufacturers, bankers and politicians) were willing to ‘pay the price of high inflation in exchange for growth’ (see Kofas 1996, p. 129). Attributing high inflation in Latin American economies to food shortages, as we have underscored, is an oversimplification and a misguided view of inflationary process in underdeveloped economies in general. Steward and Fitzgerald attribute inflationary deficit financing and scarcity of goods as the main causes for inflation in underdeveloped economies (see Stewart and Fitzgerald 2001, pp. 40, 149–150). We have contested this view at length so far in the study. In his path breaking study on Underdevelopment Geoffrey Kay views inflation as a conscious strategy of the capitalist politico-­economic elite as a means of acknowledging the growing working class power while simultaneously controlling its ability to gain greater access to the rising surplus product due to increasing productivity. So in his view inflation is a means of reproducing the capitalist relations in the face of greater political mobilisation of the working class by allowing the wages to rise while on the other hand increasing prices to negate the effects of the former (see Kay 1975, pp. 184–187). Although this delineation bears merit we illustrate that inflation in underdeveloped economies cannot be reduced to this process.

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2.12   Conceptual Framework Review of literature enables us to formulate a conceptual framework which will guide the continuation of the study from herein. In this setting I will produce a flow chart indicating the expected long run relations between variables. Long Run Dynamics of Inflation 1. Increasing Share of Unproductive Labour in total employment 2. Increasing Productivity of Unproductive Labour 3. Higher Inflation in Sri Lanka compared to Advanced Capitalist Economies due to lower productive composition of capital

Structure of Capital Formation determined by Class Structure

Increasing Lerner Index -Higher Degree of Monopolisation of the economy

Increasing Internal Price Level in Sri Lanka in the Long Run

Increased Mechanisation of the Paddy Economy simultaneously with Family Labour use

1. Reducing Agricultural Real Wage in the face of family labour use 2. Increasing Paddy Output with family labour use

Structure of Labour Supply determined by Agriculture

Inflation i at time t should therefore be equal to share of unproductive income k over share of productive income which can be denoted as 1-k adjusted for relative productivity of the two sectors (u for productivity of unproductive sector and p for that of productive sector), share of unproductive employment n over share of productive employment 1-n, degree of monopoly in the economy derived by Lerner Index m and ratio of available stocks of productive sector to unproductive output x. Further, given that full employment is not assumed, price elasticity of supply of productive sector e should be incorporated. On the other hand, wage labour to family labour ratio in staple agriculture w which is a function of mechanisation c calculated by production coefficient of capital employed in peasant agriculture needs to be incorporated in the formulation. c under peasant agriculture should remain below approximately 0.6 hence w rises at a greater rate than c,

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e it = é( u / p ) .k / (1 - k ) . ( n / 1 - n ) .m - x + c. log ( w )) ù ë ût

- é( u / p ) .k / (1 - k ) . ( n / 1 - n ) .m - x + c. log ( w )) ù ë û t -1 e



Where, 0