How the rural employment guarantee might cause inflation

If rural markets are not competitive, then prices will rise with incomes

After a spate of recent reports confirmed that what manyincluding The Acorn—understood was inevitable, Jean Drèze has risen again to defend the national rural employment guarantee scheme. This time, by dubbing criticisms as propaganda. His strategy is classic: to take a seemingly neutral position by pointing out there is propaganda from both pro- and anti-NREGS sides, and drawing an equivalence between the two. It’s from Schopenhauer. The word propaganda, like socialism, “does not have a definite meaning, and can mean different things at different times”. So let it be.

But you would expect a professor of economics to be more exact in his economics. He writes

By way of illustration, prominent media attention was given a few months ago to a so-called “study by the India Development Foundation,” allegedly showing that the NREGA caused inflation. This is an outlandish claim, and I leave it to the reader to guess why this particular item of government expenditure was singled out as being responsible for inflation, as opposed to, say, the defence budget, which is almost 10 times as expensive. Further enquiry revealed that this “study” did not exist; it was just a speculative remark made at a panel discussion by a member of this Foundation. Nevertheless, this hot air was promptly pumped into the propaganda balloon. [The Hindu]

Now let us grant that the media indeed turned a remark into a report. But is Prof Drèze right about NREGS being less responsible for inflation than say, the defence budget?

Let’s look at the microeconomics of the NREGS. The money that the government puts into the pockets of the NREGS recipient translates into a higher demand for food, household goods and other such items. This is called an “income effect”. The solid blue line in the adjoining chart shows the original demand curve for these goods in, say, a rural district. Since NREGS recipients convert a part of their income into consumption, their individual demand for these goods increases, causing the demand curve to move upwards. This is shown by the dotted blue line.

NREGS and Inflation

What Prof Drèze fails to take into account is the shape of the supply curve (shown in red). How much the price rises depends on how steep it is. In the adjoining chart, you will notice that the price level goes up significantly after incomes increase. In fact the steeper the supply curve is, the higher will the price rise, and the incremental consumption will be smaller. In other words, if the curve is steep, then people will be consuming the same quantity of goods as before, only paying more money for it. In such circumstances the money that the NREGS spends is not ending up with the intended recipients, but in the pockets of suppliers.

And why might supply curves be steep? Well, because the markets are not competitive. Perhaps because there are only a handful of shops selling these goods and the shopkeepers are colluding to keep prices high. They are likely to do this when they know that there is NREGS in the air.

So contrary to what Prof Drèze writes, it is not at all “outlandish” to claim that NREGS causes price levels in rural areas to rise. There is a good chance that a good fraction of the money that does not get siphoned off by officials ends up fattening the profit margins of rural shopkeepers and traders. [It follows that a better way to help the rural poor is to make the supply curve flatter. It’s done with better infrastructure, irrigation and information]

Defence expenditure too causes inflation. But not in the same direct, localised way as NREGS (besides, the fraction that is used to import military goods doesn’t contribute to domestic inflation). But the comparison is bogus. Increases in defence expenditure are not justified on account of improving the lot of the “rural poor”, but rather, recognised as a necessary evil. The NREGS, on the other hand, is solely justified on that basis. To the extent that it raises prices without increasing consumption, the scheme is an “unnecessary evil”.

Update: Ravikiran Rao comments on Drèze’s article over at The Examined Life

19 thoughts on “How the rural employment guarantee might cause inflation”

  1. A few caveats,

    The above analysis looks more theoritical than empirically derived at. How much is the gap between the lines of two demands, that should depend on the lens of clarity on one’s analytical eye. Same is the true for the supply side curve.
    Secondly, the scheme cant be described as “unnecessary evil” as the purpose of increasing rural incomes, despite a certain level of “income effect”, whose magnitude itself is an issue, cant be taken wholly “self defeating” by putting a logical yet pratically unrealistic sequence of inflated economic arguments.
    Thirdly, a complete parellelism cant be seen in the increase in incomes and the demand of commodities. There always occurs some diversification of demand itself that the pressure of price rise doesnt wholly falls on just a few commodities. Diversification of food basket can be taken as an modest example of the same.

  2. Ankur,

    Fair comments all.

    But the onus of proving that the scheme benefits the poor, through empirical and experimental evidence, is on its proponents. But what you see is (a) the government rushing to implement it nationwide in spite of bad results and now (b) Jean Dreze cleverly equating the pro-NREGS spiel with evidence-based anti-NREGS commentary.

    I’m merely attempting to explain observed effects.

  3. seems like you and dreze are both using inductive logic to arrive at an answer to a question that is pre-eminently empirical. why not use the CPIAL — consumer price index for agricultural labour — to first actually see whether there is inflation post the NREGA. then, and only, then should one try to adduce causal mechanisms. of course, yours is a partial equilibrium analysis (what if better fed workers work longer hours and that in turn produces more output so that supply also shifts outwards? you might think this unlikely but your response must be based on an _empirical assertion_ that this is actually unlikely). absent even any nod towards data, I think your argument is at just like dreze (dreze is referencing presumably the literature that shows governmentspending in general can have an inflationary effect)

  4. Have to agree with Get Empirical here.

    If Nitin’s argument is limited in scope to show that NREGA can cause inflation, it is a valid argument. But it does not show that NREGA did trigger inflation.

  5. get empirical,

    The main argument I make is that it is not “outlandish” to suggest that NREGS might cause inflation. The other argument I make is that the comparison with defence expenditure is bogus. So yes, to prove that whether or not this has indeed caused inflation needs an examination of empirical evidence; but that is beyond the scope of this post.

  6. While your argument disproving Dreze’s assertion that the very thought of NREGS causing inflation is outlandish might strictly be true, anyone proposing inflation as a concern is clearly using it as a stick to beat the scheme with. This is disingenuous in the extreme. Any form of development, a new factory which raises local incomes for example, might conceivably be inflationary if the supply curve is steep. So frankly the inflation argument is just as pernicious as Dreze’s if not more so. At least Dreze is not being malicious just deluded. In any case, the scheme has failed miserably.

  7. Rohit,

    What do you think is more dangerous? A deluded policymaker who has already spent 22000 12000 crore rupees (and now wants to spend much more) of taxpayers money in a poorly designed scheme, or a malicious blogger who points out that this might just be a poor idea?

    It is incumbent upon those of us who care about outcomes to beat lousy ideas with everything we’ve got. There’s a difference between any form of development, and this scheme. And whatever the form of development, the role of government should be to make markets competitive. That has been the consistent argument on this blog: be it Vidarbha or NREGS.

  8. >>Any form of development, a new factory which raises local incomes for example, might conceivably be inflationary if the supply curve is steep

    IF supply curve is steep.

    A factory would usher in a genuine local economy involving production of goods, and will bring in its wake markets and services that in turn contribute to that economy. There is no evidence that NREGS is doing any of this.

    And why is Dreze just ‘deluded’ instead of being dangerously pigheaded?

  9. get empirical,

    It turns out that the CPIAL did increase in 2007. Did it increase in all states with NREGS, did it increase because of NREGS, etc…are left as an exercise for the interested reader.

  10. India gave up 50 yrs. for the education of “deluded” politicians, and now few thousand crores for a “deluded” economists. These Do-Gooders come at a cost to the ‘aam aadmi,’ at a terribly exacting price at that. The sad thing is we seem to repeat the same futile exercise over and over. Some charismatic economist comes, charms the politicians and people pay the price. Heaven knows how many more economists will have to be educated at public expense without any significant benefit to the public. The damned socialist thing doesn’t work, no matter how good or bad the motive.

  11. Nitin,Oldtimer: I happen to agree that the scheme is just as wasteful as all those 5 yr plans (Plan was good but not implemented properly etc). The only point I was trying to make is that of all the reasons, inflation is an idiotic criticism. But I do think that in these depressing times ( anything that raises incomes, and most importantly calorie intake is laudable. Cost-benefit, is of course important and while I am as much a believer in the power of markets as any red-blooded TOI edit writer, I do think that pro-market blogs like this one and others should not hesitate from pointing out more often, a nuanced view of things. For example, in the case of agriculture, I fail to see how anything other than serious land reforms, better access to credit and protection from global price fluctuations can make any significant dent. Yes markets can help with some of this if allowed and if massive shifts from agri to industry happen but till then what? Surely a strengthened PDS and massive investment in irrigation are key. Agri is subsidised all over the world and for good reason, its just not very lucrative. Sorry for rambling off-topic, put it down to first time comment venting.

  12. Dreze is one of those imported commies who has parked himself at the Delhi School of Economics and is having a good wankfest in this commie supported govt.

    The first thing the NDA govt. should do, if it comes back to power in 2008/9, is to deport this charlatan ASAP.

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