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Prices, Competition and Markets

Posted by Alex M Thomas on 31st March 2014

It has become commonplace in India to point fingers at the central government when prices of essential commodities such as onion or fuel rise. The underlying arguments behind this accusation could be that: (1) the government is expected to maintain price stability and/or (2) the government should socially engineer agricultural markets in a ‘fair’ manner. But, is the pursuit of price stability not the job of the Reserve Bank of India (RBI)? It is true that the RBI cannot do anything to combat inflation when it is caused by a supply-and-demand mismatch in the domestic vegetable market or the international oil market. What the RBI can do is manage inflation expectations, and that is for another post. The present post is motivated by the insightful analyses of Kannan Kasturi on the Indian vegetable market, published in the Economic & Political Weekly and other places. That is, this post takes up the second of the reasons mentioned earlier.

The price mechanism – adjustments made by producers to the selling prices and consumers to the purchasing prices – is expected to allocate the commodities brought to the market amongst the consumers, in accordance with their needs, reflected in their willingness to pay. The prices therefore act as signals for the producers especially. Sellers can adjust quantity in order to affect prices; hoarding commodities is one such strategy. At equilibrium, producers earn a normal rate of profit, which contains a pure rate of return on capital advanced and a return for risk and entrepreneurship. If producers do not make normal profits in time t, they will cut down production in time t+1. During the equilibration process, producers who are unable to earn a normal rate of profit will exit the market. If entry costs are low, new producers will enter the market. Producers who have large financial resources (or access to easy credit) at their disposal are insulated from temporary alterations in demand. Producers who have enough accumulated earnings can shield themselves from such market volatility. In short, a competitive market is one where prices are not distorted (by the producers or by external intervention), no (especially, cultural and social) barriers to enter the market exist and workers are mobile within and across markets.

Of course, the agricultural markets in India are far from competitive. Since more than 50% of Indians derive their income from agriculture, and particularly because of the poverty of the farmers, these markets require government intervention. This is not to say that any form of government intervention will better the situation. Kasturi quite convincingly shows that the fault lies with the supply-side – the agricultural supply chain. This post will not discuss minimum support prices or other input subsidies, such as for electricity, irrigation and fertilizers. Also to be noted is the specific manner in which the agricultural input markets are inter-linked in India, which has been of an exploitative nature. Finally, social and cultural factors (pertaining to caste and gender) are seen to hinder competitiveness in Indian markets, not just in agriculture.

What are the problems with the agricultural supply chain? Kasturi points out the following: (1) Small farmers lack storage facilities in order to gain from the high market prices. (2) The middlemen (those who intermediate between farmers and final consumers), i.e. the wholesale traders and commission agents have the ability to hoard vegetables and consequently they reap the benefits of the high prices they themselves engineer; the Agricultural Produce Marketing Act governs the agricultural markets (mandis) and it is here where all the proceeds from higher prices are absorbed with nothing reaching the farmers. These traders and commission agents are ‘well entrenched in the mandis, having been in the business on average for 20 years’ (3) Agricultural pricing is not at all transparent and the mandi records are of no assistance in this regard.

To sum up, the nature of government intervention has to change, in such a way that is beneficial to farmers. Proper laws are of utmost importance, not just in protecting the interests of the small farmers, but also that of the consumers.  Moreover, intermediaries in any market perform useful functions but laws should be in place which ensures that they do not become monopolistic and exploitative. Agricultural infrastructure such as storage facilities is paramount in this context. A very detailed study of how these supply-chains operate will be of much help in our attempts to combat inflation.

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Posted in Agricultural sector, Development Economics, Economics, Government, India, Inflation, Markets, Prices | No Comments »

Misunderstanding Economic Growth and Development

Posted by Alex M Thomas on 25th August 2013

If two previous posts dealt with trying to understand how economic growth may or may not translate into development, this post goes a step behind and discusses what economic growth means. More importantly, this post examines what economic growth does not mean. The motivation for this blog post comes from Jagdish Bhagwati and Arvind Panagariya’s 2013 book titled Why Growth Matters: How Economic Growth in India Reduced Poverty and the Lessons for Other Developing Countries. Note that the following paragraphs are not intended to be a detailed review of the book; only their central premise – ‘the centrality of growth in reducing poverty’ (p. 4) – will be engaged with. The blog post, however, ends with a critical commentary on the authors’ methodology (focusing on authors’ engagement with opposing views, presentation of authors’ own arguments and referencing), as contained in the Preface, Introduction and the first three chapters. Also, no comments are offered on the data analysis present in their book.

A premise is ‘a statement or proposition from which another is inferred or follows as a conclusion.’ Bhagwati and Panagariya start with the premise that economic growth entails increase in employment opportunities and an improvement in income per person. This is also their conclusion, and forms the title of their book. They write:

Bhagwati argued nearly a quarter century ago that growth would create more jobs and opportunities for gainful improvement in income, directly pulling more of the poor above the poverty line and additionally would allow the government to pull in more revenues, which would enable the government to spend more on health-care, education, and other programs to further help the poor. Growth therefore would be a double-barrelled assault on poverty. (p. xix)

Further, they write: ‘growth helps by drawing the poor into gainful employment’ (p. 23). A simple question is sufficient to negate this view. Does the market create jobs after taking into account the abilities and skills of the poor? Of course not! If so, there would not be any unemployment or underemployment. A well-educated (and healthy) workforce is necessary so as to actually ‘gain’ from the newly created employment opportunities. [Not to forget the hardships involved in deskilling and reskilling.] And, it is not logically necessary for employment opportunities to increase when the economy grows. Jobless growth is a possibility where the surplus is not used to create further jobs; more often, it is a question of whether jobs are being created at the same pace as at which the economy grows.

By definition, economic growth entails a rise in income. But whose income? Economic growth can co-exist with the rich getting richer. Or, economic growth can give rise to stagnant wage shares amidst productivity rises. Growth can be export-led. It can be service-led. It might favour capital-intensive over that of labour-intensive technology. A rise in real GDP can happen because of a variety of reasons. It is these ‘reasons’ that one must investigate. For, it is here that we will find answers as to who the beneficiaries of economic growth are. It is to the mechanisms or processes which generate economic growth that we must attend to in order to comprehend which sector/classes/groups are losing out. For example, the nature and consequences of service-led growth will be very different from that of growth that is manufacturing-led. Bhagwati and Panagariya repeat the same fallacy, pointed out in the previous paragraph, in the following passage.

Conceptually, in an economy with widespread poverty, labor is cheap. Therefore, it has a comparative advantage in producing labor-intensive goods. Under pro-growth policies that include openness to trade (usually in tandem with other pro-growth policies), a growing economy will specialize in producing and exporting these goods and should create employment opportunities and (as growing demand for labor begins to cut into “surplus” or “underemployed” labor) higher wages for the masses, with a concomitant decline in poverty. (p. 23; see p. 43 as well)

Conceptually, in an economy with excess labour supply, labour is cheap. Bhagwati and Panagariya argue that a growing economy with cheap labour will adopt labour-intensive techniques. This reasoning assumes that an unemployed farmer or school teacher can easily and naturally be employed in a firm which exports computer parts. The authors’ views seem to indicate a gross misunderstanding of the actual economic dynamics of any society (see below as well). Moreover, one is not just concerned with mere employment, but with employment that provides good working conditions – including sick leave, maternity leave, overtime wages, etc.

‘The pie has to grow; growth is a necessity’ (p. xx). Yes, a larger surplus makes it feasible for each claimant to get a greater share, including the government. The contention is with respect to the feasibility and who these claimants are. According to Bhagwati and Panagariya, growth automatically and naturally generates higher incomes per person thereby ‘directly pulling more of the poor above the poverty line.’ Growth is not manna from heaven which everyone gets in equal amounts. It is based on definite political, economic and social institutions/processes – wage bargaining, possibilities of reskilling, mobility of labour, gender, caste, family structure, social security nets (family based or from the government) and so on. In this context, the authors rightly note the negative effects excessive licensing, government monopolies and protectionism can have on the growth of an economy (p. xii).

Given the authors’ belief in a strict one-way causation running from economic growth to development, they argue for carrying out growth-enhancing reforms first, which they refer to as Track I reforms. Subsequently, the surplus can be redistributed by the government to achieve development; this can be through transfer payments of various kinds. These are known as Track II reforms. They argue:

Track II reforms can only stand on the shoulders of Track I reforms; without the latter, the former cannot be financed. (p. xxi)

Of course, they can be financed through government borrowing and there is ample literature on the issues surrounding debt-sustainability in relation to achieving full employment. One wishes to see a more nuanced understanding of such matters.

This separation of growth from development is not just illogical and untrue, but also dangerous to public policy. Often, for purposes of economic theorising, in order to carefully study the causal relations between variables, some boundaries are drawn and certain assumptions are made. But, an import of this technique into the domain of public policy is methodologically flawed, where the abilities of individuals to seek jobs and actually work and earn (higher) incomes crucially depend on their social, cultural and economic backgrounds. In other words, while the distinction between economic growth and development might be reasonable for some purposes, in practical politics, they go together. Moreover, if the policy objective is to ensure good quality of life for all, then it must be the case that, to use the authors’ terminology, both Track I and II should be undertaken at the same time, with perhaps a greater emphasis on Track II reforms.

A fundamental error underlies the authors’ belief that ‘growth’ is an automatic process which takes place when the government lets the private players have a completely free hand, international trade is free, and capital can freely flow in and out of the country. It is this notion which makes the authors’ note that ‘Track II reforms involve social engineering…’ (p. xxi). That is, in their view, Track I reforms require no ‘social engineering’. Nothing could be farther from the truth! A ‘market’ is an engineered institution. The belief that ‘free markets’ will deliver both economic and social justice is quite easily discernible from their statements. Making commodity markets free (from both government and private monopolies) is certainly beneficial for economic growth as well as for wider socio-economic development. But, given the (historical or otherwise) arbitrariness (as opposed to ‘merit’) involved in the ownership of various forms of assets, and the tendency of markets to favour the powerful, there is always a crucial role for the government and civil society to intervene in order to ensure social justice (especially in the arenas of education and health). After all, is this not what we mean by participatory democracy?

The preceding commentary is based on a partial reading of Bhagwati and Panagariya’s book, as noted in the introductory paragraph. Their conception of growth, at best, seems superficial and at worst, they misunderstand the dynamics of economics growth as well as development. The view of ‘free markets’ generating growth with rising incomes per person is never an automatic process. It requires visible hands and is indeed social engineering. We end with a few observations on their methodology. For them, all that their critics say are myths; Part I of their book is titled ‘Debunking the myths.’ On one occasion, some of the critics, who are hardly ever named (and therefore not cited), are accused of being ‘intellectually lazy’ (p. 25; also see p. 32, p. 34, p. 35 for the unnamed critics). On the other hand, the following phrases are used for arguments in their own support: ‘state-of-the-art techniques’ (p. 31), ‘detailed state- and industry-level data’ (p. 31), ‘compelling nature of evidence on the decline of poverty under reforms and accelerated growth’ (p. 33), ‘irrefutable evidence’ (p. 37), ‘evidence…is unequivocal’ (p. 38) and ‘these authors’ superior methodology’ (p. 43). Out of the total number of references excluding data sources and reports (around 125 in number), about 37% (around 47 in number) are references to the authors’ work, either as a sole author, a co-author or as the editor of the volume. This is very striking. And, out of citations to Panagariya’s work (about 27 in number), 14 of them are newspaper articles published in the Times of India or Economic Times. It is indeed unfortunate to come across so many fundamental errors in a book like this, because growth does matter, although not at all in the way Bhagwati and Panagariya expound in their book!

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Posted in Book reviews, Development Economics, Economic Growth, Economics, Education, Employment, GDP, Government, India, Labour Economics, Macroeconomics, Markets, Neoclassical Economics, Poverty, Unemployment | No Comments »

The 2012-13 Economic Survey of India (with Raghuram Rajan)

Posted by Alex M Thomas on 4th March 2013

The Economic Survey (ES hereafter) is a document which presents the macroeconomic situation of India during a given period. It is drafted by the Ministry of Finance (MoF), Government of India with the Chief Economic Advisor (CEA) playing a chief role. The current CEA is Raghuram Rajan. At the MoF website, detailed profiles of the people who drafted the Economic Survey 2012-13 are available.

This blog has analysed the previous three economic surveys (2009-10; 2010-11; 2011-12) undertaken under the guidance of Kaushik Basu, the predecessor to Rajan. The current analysis is broadly divided into two parts. The first part deals with the ES’s view of economic growth and employment and its theoretical underpinnings. Here, we discuss the gloomy industrial performance, issues surrounding productivity of labour and the role of government expenditure. The second part focuses on select policy proposals and examines it in brief; the debates surrounding oil subsidies, high current account deficit and attracting foreign capital fall under this section.

I

The underlying theory of growth outlined in the ES is what economists’ term supply-side growth theory. Growth in output per worker is determined by growth in the supply of factors – labour and capital (more precisely, produced means of production). Whatever be the growth in their supply, the demand will automatically adjust. In other words, aggregate demand adapts to aggregate supply and investment adjusts to saving. Thus, in equilibrium, there can be no unemployment of factors, including that of labour. It will presently be seen that it is such a framework which enables the ES to recommend a reduction of government expenditure which will apparently promote growth.

Rajan deserves praise for underscoring the importance of quality employment right in the beginning of the ES. In Chapter 2 entitled ‘Seizing the Demographic Dividend’, a case is made for improving labour productivity and for increasing both the quantity and quality of employment.

Policymakers are usually focused on short-run economic management issues. But the short run has to be a bridge to the long run. The central long-run question facing India is where will good jobs come from? Productive jobs are vital for growth. And a good job is the best form of inclusion. (p. 26)

‘Productive jobs’ refers to jobs where the productivity levels are high. Growth in per capita income is primarily determined by labour productivity, growth in the working population and growth in the working population who find jobs – the employment rate (p. 30). Labour productivity rises with greater investment in physical and human capital. The reason for low agricultural productivity is identified to be low investment and therefore the solution proposed is an increase in capital per worker (p. 32). Yes, technological advances are necessary but so are transformations in agrarian relations pertaining to caste and gender. Moreover, the presence of inter-linked markets makes agricultural markets very coercive, and less competitive.

Furthermore, low labour productivity is linked to rigid labour laws and excessive government regulations. It is of course necessary that the current labour laws be examined and improved upon whereby workers are provided decent wages, adequate sick and maternity leaves, indexation with inflation, etc. As the chapter rightly concludes, ‘We need to examine carefully whether regulations constrain businesses excessively and, if so, strip away the excess regulation while ensuring adequate protection and minimum safety nets for workers’ (p. 54).

But, the question remains: what is the mechanism by which employment rises? The answer provided is that saving generates investment and investment generates employment. ES points out that investment can be increased by increasing saving.

If India were to follow a similar path [like that of China], it would need to increase savings and investment, both of which will follow from the demographic transformation. But it will also have to increase the intrinsic productivity of jobs…. (p. 31)

But, why will aggregate investment increase without a corresponding rise in aggregate demand? And, where will this increase come from if all the individuals save more, based on the recommendation by the ES? (One only needs to recollect the ‘paradox of thrift’.) Investment is undertaken so that the commodities and services that are being produced can be sold. Only if they are sold can profits be realised.

The adherence to a supply side theory of growth is clearly visible in the chapter dealing with industrial performance (Chapter 9). Owing to this belief, the analysis carried out in that chapter mistakes correlation for causation and also gets the causal chain wrong.

The moderation in industrial growth, particularly in the manufacturing sector, is largely attributed to sluggish growth of investment, squeezed margins of the corporate sector, deceleration in the rate of growth of credit flows and the fragile global economic recovery.

Low investment is considered to be the primary cause of poor industrial performance with a slight mention of decline in foreign demand. Further, the authors’ of the ES maintain that a low investment has resulted in excess capacity (obviously!) and also a decline in capacity utilization. Yet, they fail to point out that it is a fall in demand for industrial products which has caused the fall in capacity utilization and to a reduction in investment! Although, unconnected to their narrative of industrial decline, they note a reduction in the rate of growth of sales of listed manufacturing companies. The rate of growth ‘declined from an average of 28.8 per cent in Q1 of 2010-11 to 11.4 per cent in Q2 of 2012-13, the latest quarter for which comparable set of data are available.’ Hence, in order to increase investment, the authors’ want to attract foreign direct investment (FDI). But, the problem is not a lack of investment but a deficiency of demand.

In a similar line of supply-side thinking, the ES argues that fiscal consolidation or a lowering of government expenditure will result in a ‘higher growth in real GDP.’ As the ES clearly states,

Staying on the indicated fiscal consolidation path is critical to sustaining the desirable macroeconomic outcomes not only in terms of higher growth in real GDP and lower inflation, but also in easing the financing of the widening current account deficit (CAD), for which India’s sovereign credit rating is important. (p. 56)

While it is unfortunately true that credit rating agencies and foreign capital considers government spending to be a threat, the claim that fiscal consolidation enables faster growth seems to lack any solid proof. Unless, we treat inflows of foreign capital to be a source of sustainable and high economic growth!

In sum, the theoretical framework underlying the current Economic Survey is problematic because of its inability to explain labour unemployment (or excess capacity) as a permanent feature of capitalist economies. This unemployment is primarily owing to a deficiency of aggregate demand. Furthermore, owing to the supply-side underpinnings, the recommendations are to increase savings. This is clearly stated as objectives in the ‘Press Statement on Release of Economic Survey: 2012-13’. (1) ‘Increase government savings, especially by reducing distortionary subsidies’ and (2) ‘increase opportunities for savers to get strong real returns on financial investment.’ Therefore, a deficiency in saving is identified as the main hurdle for the Indian economy.

II

In this part we briefly examine the reasons why fuel subsidies are harmful to India in the long run and the problems surrounding India’s current account deficit. Fuel is a basic commodity in the sense that it enters as an input into the production of all commodities. And, petroleum is an exhaustible resource. The price in the international market does reflect its scarcity. A high price indicates that demand is over stripping supply. Fuel subsidies are a short term solution which takes the burden of innovation from Indian oil companies and the responsibility of proper use from Indian consumers onto the shoulders of the Government. Yes, workers need to be insulated from high oil prices. One way to do this is by indexing wages to inflation. A high fuel price also quickens the search for alternative sources of energy and better agricultural and manufacturing machinery which uses less fuel. One final point. The argument that fuel subsidies need to be reduced so as to reduce budget deficit so that there is economic growth is, as pointed out earlier, based on the flawed economics of supply-side growth theory.

India’s current account deficit has reached worrisome levels. The value of imports has been rising mainly on account of higher international oil price. Exports have fallen due to a slowdown in foreign demand. India’s main imports are (1) petroleum, (2) pearls (for re-export) and (3) gold. Owing to the surplus in invisibles (services such as transport and software; and private investment income transfers) some of the deficit in the merchandise trade balance is absorbed. Apart from the surplus in invisible trade, the other avenue for meeting the merchandise trade deficit comes from the capital account. The major source of (net) capital inflow is foreign investment, which comprises foreign direct investment and portfolio investment. The other source of foreign exchange is loans. Given this situation, the Economic Survey proposes measures which attract foreign investors and by imposing duties which make gold imports costlier. Both these are extremely short-sighted measures and the former one makes economic growth to hinge crucially on foreign capital which is not advisable. The long term solution, as suggested in the case of oil subsidies, ought to be technological innovations in the export industries so that they are internationally competitive. Also, the propensity to imports should be reduced by promoting industries which can produce similar commodities. Moreover, there is a huge potential in the Indian tourism industry. And, as the ES also recognises, ‘the best way to reduce gold imports in a sustainable way will be to offer the public financial investment opportunities that generate attractive returns.’

Conclusion

The move to reduce government spending and measures which attract foreign capital are therefore based on the flawed supply-side theory of economic growth; we require an increase in employment and incomes and in aggregate demand. Moreover, the proposed measures to deal with structural problems of the Indian economy are not just short-term but short-sighted and unsustainable in the long-run. These measures also discourage technological innovations especially in the area of alternative energy sources.  Oligopolistic markets should be replaced with competitive markets with good labour laws which ensure that part of the productivity gains go to the workers.

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Posted in Demographic Dividend, Economic Growth, Economics, Employment, Foreign Exchange, GDP, Government, India, Industrial sector, Macroeconomics, Neoclassical Economics, Supply side economics, Unemployment, Wages | No Comments »

Introductory Macroeconomics: On Crowding Out

Posted by Alex M Thomas on 30th June 2012

Macroeconomics textbooks and journalists write in earnest about the crowding out effects of fiscal policy. Government expenditure is widely believed to displace private investment by raising interest rates which increases entrepreneurs’ borrowing costs. On this basis, governments have been ordered to cut down expenditure. Government deficits are identified as the cause of decreasing private investment as well as for creating inflationary pressures in the economy. This blog post argues that crowding out occurs under special circumstances – (1) when the economy is at full employment and (2) money supply is exogenous. In fact, when the economy operates at less than full employment and money supply is endogenous (that is, the central bank conducts monetary policy by adjusting the interest rates and the quantity of money endogenously adjusts to the demand for money at that set interest rate) government expenditure results in crowding in.

The crowding out argument can be represented with the help of the IS-LM diagram. IS refers to equilibrium in the goods market (quantity demanded = quantity supplied). LM refers to equilibrium in the money market (money demand = money supply). The intersection of the IS and LM curves gives us the equilibrium output and interest.

When government expenditure increases, IS curve shifts outwards. Both output and interest rates increase in an exogenous money model (upward sloping LM curve). The automatic increase in interest rate because of government expenditure is then said to result in crowding out of private investment.

Next, we look at interest setting monetary policy (with endogenous money) using the framework of IS-LM. In this case, LM is horizontal because the interest rates are set by the monetary authorities keeping in mind their inflationary target. This scheme is more realistic given the role played by Central Banks today. Interest setting monetary policy can be represented in an IS-LM framework as follows.

The goods market is also referred to as the real sector and the money market as the financial sector. We additionally assume (as is the case with not only the Indian economy but many other economies) the economy to be in a less than full employment position. If the economy operates at full-employment, increase in government expenditure will undoubtedly lead to inflation. In fact, an increase in private expenditure will also create inflation in a full employment set-up. In this realistic model, let us see what happens when there is an increase in government expenditure.

The diagram above clearly shows that an increase in government expenditure, represented as a shift in the IS curve does not raise the interest rates. The entire increase of government expenditure translates into increase in equilibrium income. That is, there is zero crowding out in this case as the economy operates at less than full employment. The increase in demand for money is met by endogenous increase in the supply of money through credit creation. In short, fiscal policy has no systematic effect on interest rates in a setting wherein the interest rates are set by monetary policy.

Therefore, it is clear that the basis of crowding out argument rests on the unrealistic assumptions of (1) full-employment positions and/or (2) exogenous money. Ordering the Indian government or other governments to cut back their expenditure by the IMF or by the ‘top’ economists therefore lacks a sound basis. The role of the government in aiding an economy towards its full-employment levels therefore can never be reiterated enough. Moreover, it is an argument which is based on sound economic principles.

Reference

Smith, Matthew (2012), ‘ECOS 2002: Intermediate Macroeconomics’, Lecture Notes, University of Sydney.

 

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Posted in Economics, Economics Education/Teaching, Government, India, Inflation, Macroeconomics, Neoclassical Economics | 1 Comment »