**-3-**

9. The twin gaps have been exacerbated by a third gap, the government deficit. Although the size of the deficit has been reduced, it remained unsustainably high at 16-17% of GDP in 1988/89.2 At least 40% of the deficit is financed by the banking system; the deficit is thvrufore a major source of inflation, now conservatively estimated at 25% per year. Inflation. of course, heightens uncertainty, further distorts price signals, engenders negative real interest rates, and complicates managenient of the foreign exchange rate.

10. A few details of some aspects of how the GOE has tried to cut the budgetary deficit are relevant to the situation of the higher education sub-sector. First, because of the inelasticity of revenues with respect to incomes and their heavy reliance on oil, most adjustment has fallen on spending. Most of latter, in turn, is composed of subsidies, public sector salaries, interest on the public debt, and the military. The first two have been protected, forcing most adjustment onto subsidies and public sector salaries. Rather than reduce the government wage bill through lay-offs, the GOE has chosen to reduce real spending on ptublic sector salaries by freezing nominal wages and new hires. (Such policies also reduce employment through attrition and retirement). Real wages in the public sector fell to _55%_ of their 1973 level by 1989. Two consequences follow: 1) adjustment costs are concentrated on new entrants to the job market (including those matriculating from institutions of higher education) and 2) the decline in government salaries has reduced the relative economic attractiveness of such employment.

11. Micro-economic distortions reinforce these macto-imbalances. Egyptian prices bear little relation to scarcities, and price distortions react synergistically with the regulatory environment to create a producers' nightmare. For the higher education sub-sector, the most significant example of this baleful interaction is the increasing capital intensity of production. Partly this phenomenon has been caused by price distortions: the relative price of labor to capital rose as labor emigration pushed up wages while accelerating inflation and financial regulations engendered strongly negative real interest rates. Regulations exacerbate the problem: Individual lay-offs must be reviewed by a tri-partite (management, labor, government) committee, whose ruling is advisory. However, an employee has appeal rights, and for group lay-offs, the committee's ruling is binding. (World Bank, 1990b). Legally the government has a monopoly on all job placements outside of agriculture and the informal sector. It follows that all hiring for the kind of well-paying jobs with a future which most university graduates seek (e.g., in the private formal sector), must be done through the government. In practice, private companies can and do hire either through "head-hunting" agencies or through informal networks of personnel managers. Nevertheless, these cumbersome and inefficient regulations reduce the flexibility of the labor market by converting labor, the "variable cost" example of every elementary economics textbook, into overhead. As Hansen has pointed out, such a complex of forces has created the paradoxical situation of Egyptian producers using too much capital and labor (Hansen, 1991).

2 In flscal 1989/90, the government claimed that the deficit had fallen to 7% of GDP; however, In 1990/91, it returned to former levels of some 17%.