Tuesday, August 07, 2012

The macroeconomics and public finance of inflation in India - 3

(Update : I was writing the original series as just one long post. But then, it got too long, so I have decided to split it up into multiple posts. If you haven't, you should read the earlier posts in the series first.)

The Macroeconomics of NREGA

The flagship spending scheme of the UPA government has been the NREGA. Put very simply, this scheme promises to pay Rs 120/day for 100 days to rural labour unable to find work, for doing public-related work. Though the Right to Food bill etc. have come under heavier fire, the NREGA is the one actually held responsible for the downward turn in public finances, for it's the only one which has been implemented for a substantial amount of time.

Now many people cry hoarse about anything that Sonia Gandhi/ Jean Dreze devise. But some have actually attempted some conceptual economic theorizing and predictions around NREGA. a case in point is Nitin Pai, here, about 4 year ago. Now Nitin actually calls his theorizing 'the microeconomics of NREGA', but he only achieves that by restricting his analysis to 'rural markets', an awkward category - nothing particularly micro about it. He then proceeds to talk about how rural markets may be uncompetitive because there are only a handful of shops, which reduces the act of production to the act of selling, and abstracts out of manufacturers and producers completely, and goes further into la-la land, moving sneakily from a steep supply curve to a vertical supply curve by saying that NREGA doesn't boost consumption at all, but only boost prices. I could have let that go simply as a matter of confused theorizing, but I am invoking it because Nitin has been an extremely vocal critic of NREGA on the inflation grounds, mocking Dreze/Sen all over his twitter timeline when inflation (broad-based, not even rural consumption specific) finally came about two years later (!), and because I believe his argument may still have some force, albeit in a macroeconomic sense.

What if Nitin had drawn his demand/supply curves as macro aggregate demand (AD) and aggregate supply (AS) curves? Then, what he would be saying is that the Aggregate Supply curve is steep. Recall that the AS curve is simply the expectations augmented Philips curve. (The original Philips curve was about inflation and employment, but as macroeconomists realised, the argument can be split up into inflation/growth and growth/employment). So Nitin is doing nothing but invoking Phelps-Friedman-Lucas circa 1970. The expectations augmented long run Philips curve is vertical. A pure income effect is a pure price effect.

Now, what if the AS curve is not vertical, simply steep? Then some output/ consumption can be increased by simply raising incomes. It's not clear why this increase is to be mocked away simply because most of the income has gone into prices. Say even 90% of the increase in nominal output is absorbed by prices. So? Why shouldn't we let inflation increase  by 9 percentage points, if that does mean growth increase by 1 percentage point? Why do we care about the level of prices? Why do we care about the rate of change of these prices? Why shouldn't we exploit the Philips curve until it becomes vertical?

There are two challenges to this - the first is the classical macro-theory challenge of an accelerating rate of inflation. Inflation expectations become endogenized fast, so that the risk of over-shooting the Philips curve is imminent and non-trivial. This is what RBI worries about when Subba Rao says that the non accelerating inflationary rate of growth in India has dropped to 7%.

The second is that inflation is a regressive tax with distributive consequences. I don't wish to dwell on this for long, but the macro literature that tries to prove this distributive consequence through consumption effects goes into several hoops, with the result critically dependent on the assumption of economies in scale in credit provision. The other way to get a distributive consequence would be to posit that poor people are more likely to have their assets is cash or other such nominally fixed holdings, and are thus losing real wealth faster. This is quite true, but consider the other effect of inflation - to lower the real value of nominal debts. To the extent that poor people are more likely to be in debt, an inflation tax is actually progressive. Further, inflation in India typically takes the form of food or fuel inflation. The former actually benefits most of our rural poor (Yes, I know, only 33% of the price of food reaches producers, but this is as true of the extra price as the original price. A poor supply chain is not a poor-er supply chain.). The latter is globally driven.

In all, the distributive consequences of inflation in India are unclear. The worst hit are the urban poor, who are neither food-producers, nor NREGA beneficiaries, nor in possession on inflation hedge assets. We need to look out for them, but they are not the only constituency in the calculus of macroeconomic policy.

With that is mind, let's analyse what NREGA does for inflation. In more recent times we have heard how NREGA has caused a shortfall in farm labour/ low-skilled industry labour, by giving people money for nothing (let's assume that the public works envisioned in NREGA are of absolutely zero value). 120 Rs/ day * 100 days = 12000 rupees. 12,000 rupees per annum is all it takes to make people give up the desire to earn money, apparently. I find it almost a perversion of empirical logic to posit that there is a shortage of unskilled labour in India, but let's say that there is. So what? What about the price system? there is a shortage at the current prices of unskilled labour. Why're we assuming current prices must continue?

The rural labourer takes a non-zero risk that he will not have a job when he scampers off to make some money-for-nothing in NREGA. So his reservation wage has not been raised by the full 12,000. What businesses/ farms are these that cannot pay their unskilled labour about Rs. 5000-10000 more per annum, and still be profitable? What fundamental right do these businesses have to exist? These owners - whether of farms or businesses- have to bid up wages to get their labour back, or get out. This will increase the inflationary pressure, yes, but as we saw it is not immediately clear what the big dangers of inflation are. (Notice that this inflationary pressure is not added on top of the NREGA pressure - it is another mechanism through which NREGA creates inflationary pressure, a proper macro one at that and one that lends itself more suitably to analysis through AS/ Philips curves).

Note that what I'm saying is not particularly 'leftist'. Here is Tyler Cowen, a self-described libertarian, talking about how the way to improve the condition of workers is to increase the utility of unemployment. And this is in a developed country, organized workers environment. We're talking about unskilled farm labour in NREGA, people at the very edge of decent existence.

Raise the utility of unemployment to workers.  This could be a guaranteed annual income, better unemployment insurance, more food stamps, whatever.  Call it the welfare state.  Improving the welfare state will improve worker bargaining across virtually all workplace dimensions and in the longer run limit the scope of all the employer depredations.

We’re back to the point that what helps is to give people cash, or something cash-like, including when it comes to the dimensions of workplace quality.  It is also a huge help to institute policies which will raise rather than lower worker productivity

NREGA, shorn of public works, is a cash transfer, pure and simple. There was a time when cash transfers were supposed to be the right way of implementing redistribution, especially by those on the right. So why the outcry when the cash transfer was finally enacted?

For one, we distrust our delivery mechanisms, we suspect leakages. Massive government programs are massive opportunities for rent-seeking. This is right reason to dislike NREGA. But this has nothing to do with  inflation. For another, we distrust the upward creep in the size of the government that redistribution entails, so that we would like indirect subsidies cut first before cash transfers are enacted. This has merit, but again it is a public-choice issue, not a macroeconomic issue. And third, we may simply believe that we were at the right level of redistribution as it were. So anything further shifts the balance. You could say that, and I would have no argument to offer because then we would have widely different priors, to the point that we'd talk past each other.

But if we don't believe that, then we have to analyse NREGA's macroeconomics as the macroeconomics of  a just redistributive cash transfer. And then the corollary observations follow - NREGA increases the fiscal deficit only when it is not backed by an equivalent increase in tax receipts. It is you and I, salaried income city dwellers, that are causing the fiscal deficit. And then, we have to go back to the questions raised in part 1 and part 2 of the series - how does this fiscal deficit translate into inflation when it is not money-financed, and when government bonds are showing no spikes in interest rates?


Kunal said...

"NREGA, shorn of public works, is a cash transfer, pure and simple."

Except that it is not a pure cash transfer, because 100 days of worker productivity are (partially) lost. Plus rent-seekers (both actual and wannabe) crop up, who not only steal from the intended beneficiaries, but also lose any productivity they otherwise might have had, by trying to dream up schemes to loot tax-payer money instead of doing something productive. It is clear, at least to me, that NREGA leads to a loss of national wealth overall. The beneficiaries get a bigger share of a smaller pie. Of course, a social safety net is a must for disadvantaged people, but surely a better solution than NREGA can be implemented.

Also note that you have quoted Tyler Cowen out of context. He was trying to solve for a particular problem when he wrote what you quoted.

Ritwik said...


Sorry, I just saw this. Worker productivity is partially lost only if the economy was initially at full employment. That is, you're assuming that there's no slack of unskilled workers.

I agree, there could be better safety nets, including direct cash transfers. But the smaller pie bit is not clear to me at all.

I've quoted Tyler Cowen in a different context, but not *out of context*. He was trying to solve for the problem of sub-optimal conditions at work. Earning a sub-dignified level of salary (or even other conditions) is a sub-optimal condition at work, one that many Indians are forced to accept because their other option is starvation.

When you take the possibility of starvation out of the table, you create conditions where the work that these people do will start paying them its marginal product. And indeed, by creating demand for all goods ans services through the increased wealth of the poor, you also increase the marginal product of all work that goes towards producing those goods and services.

Kunal Kothari said...

Thanks for your response.

Worker productivity is lost in so far as the marginal worker chooses to work under NREGA instead of a market-based job (as wages under the two are comparable in many cases) (and assuming that the productivity of the NREGA job is lower than the other job).

Of course, this productivity drop for the marginal worker may be countered by the higher number of workers working because of NREGA.

I think the wages under NREGA should have been lower to prevent such great distortions in the labour market. NREGA work should ideally be a last resort for the average worker. Of course, this would lead to a shallower safety net for the unemployed, but on the upside we would have a more dynamic and competitive (and hopefully larger) labour market.

And we haven't even come to the economic and social problems because of leakages, corruption, etc. etc. that usually accompany a government program.

Ritwik said...

"Worker productivity is lost in so far as the marginal worker chooses to work under NREGA instead of a market-based job (as wages under the two are comparable in many cases)"

The 'marginal' worker is unemployed Kunal. If someone leaves his job to take a NREGA handout, someone else, who wasn't doing much earlier, will step in to do the job. There are transition costs, of course - there is no such thing as a seamless transition. However, for the unskilled to semi-skilled spectrum that we're referring to, those costs are not significant.

NREGA promises 120 Rs/day for 100 days. Risk for someone who takes that handout to leave his job is that he won't get his job back. It's not a risk worth taking, unless you're making substantially lesser than 120/day or 3000/month. Is there a vast section of the labour market in India that becomes unprofitable if it pays its labour 3000/month instead of 2000/month? I highly doubt that. Output prices and profit margins can absorb that change.

In my previous firm, our factory manager liked to often complain about how NREGA has led to a labour shortage and he's unable to meet production requirements etc. I asked him why he doesn't raise wages? He agreed with the logic but came up with a number of reasons why we couldn't, including our limited ability to raise final prices of our products.

Couple of months later, a commodity that we needed for our products shot up by 290% in price due to China govt. restrictions on exports. Eeryone panicked. what did we do? Raised prices within a week. It was that simple.

Business managers have a schizophrenic outlook towards wages vs other input costs. Don't listen to them when they talk about labour market distortions. They're ignoring the price system. This is true when high skilled knowledge managers complain about young grads being overpaid, and it's true when managers in low-skilled industries complain about workers being taken away by NREGA.

Ritwik said...

None of this is to say that the usual problems due to leakage aren't there. I say as much in my post.

If you read the entirety of my post and series, I wasn't defending NREGA per se in my post - simply responding to arguments about NREGA causing fiscal deficits, inflation etc.

I have high hopes form the direct cash transfer mechanism being proposed. Let's see who that works out.

Kunal said...

Well, let me give you an example. In the diamond industry downturn in 08-09, many polishing factories (mainly in Surat) laid off their workers temporarily. The downturn proved surprisingly short (mainly because of China's giant stimulus). When the factories called the workers back (in early '09), a great many didn't come back from their native villages. At that time, it was said that they have moved to farming/farm work, but I strongly suspect that NREGA had much to do with it, directly or indirectly (perhaps by creating labour shortages in rural areas).
These workers were paid pretty low, so it is not impossible that they preferred low rural area wages over their former job wages, considering they would also not have to migrate for work.
As for transition of workers, at least in this case, it would have been expensive since it was a kind of a skilled job and you would have to train a new worker. Plus, experience and ethics are important traits in a worker in this industry, making older workers much more desirable.
Sure, the bosses could raise wages by as much as is necessary to retain the workers, but it is a very competitive industry, and it is not unimaginable that with higher wages, over time, some work could move to other countries, or that product prices would have to rise by such a large margin that demand would suffer. (Wages did of course move higher, however their effects on offshore production/lower profitability/lower demand etc. are difficult to ascertain)
I can imagine many industries to be so competitive that a meaningful increase in labour costs would be meaningfully detrimental.
All this need not have been cared about if the work done under NREGA was meaningful, productivity enhancing, asset creating work. I certainly don't grudge workers their higher incomes. And India's competitiveness can be enhanced much more through infrastructure, bureaucratic and judicial and labour reforms, etc. than just by lower wages. My point is that by just increasing wages without a corresponding increase in productivity is not the answer. And yes, I do believe that a program like NREGA causes fiscal deficits, inflation, etc. One way to think about it is to think of an extreme situation like - what if you pay people (comparable wages to market in many cases) to dig ditches and fill them back (through a leaky system)? How would that work out?
Hope this post makes sense!!