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