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Modi, Sisi & Jokowi: Three New Leaders Face the Challenge of Food & Fuel Subsidies

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In few policy areas does good economics seem to conflict so dramatically with good politics as in the practice of subsidies to food and energy.  Economics textbooks explain that these subsidies are lose-lose policies. In the political world that can sound like an ivory tower abstraction.   But the issue of unaffordable subsidies happens to be front and center politically now, in a number of places around the world.   Three major new leaders in particular are facing this challenge:  Sisi in Egypt, Jokowi in Indonesia, and Modi in India.

The Egyptian leader is doing a much better job of facing up to the need to cut subsidies than one might have expected.  India’s new prime minister, by contrast, is doing worse than expected – even torpedoing a long-anticipated WTO agreement in the process.  In Indonesia it is too soon to tell.

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Egypt

Egypt’s new president, Abdel Fattah al-Sisi, did something In July that few leaders in North Africa or the Middle East had been able to accomplish before: he sharply cut longstanding fuel subsidies and allowed prices to rise (by 41% to 78% and more).   Surprisingly few protests materialized.

Egypt’s food subsidy program badly needs reform as well.  The country has been spending over $5 billion a year on food subsidies.  The price of bread has been kept so low that, famously, it is often fed to animals. Past attempts to reduce such subsidies in North African countries have brought unrest and even government overthrow.  But it looks like the Sisi government is beginning reforms here as well.  Bread subsidies have already been cut by 13 per cent.

In a sense, he had little choice.  Egypt’s fiscal path under his predecessor’s policies was unsustainable.   Even with subsidy cuts, the current government only hopes to bring the budget deficit down to 10 per cent of GDP in the coming fiscal year, as opposed to 14% otherwise.   Still, who would have expected President Sisi, who took office in a fragile political environment, to start off with far more serious fiscal reforms than Indian Prime Minister Modi, who came to office amid hopes for sweeping economic reform and with a whopping democratic majority?

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Indonesia

Also in July, Joko Widodo (“Jokowi”) was elected President in Indonesia, another country with a long history of fuel subsidies that it can no longer afford [currently costing $21 billion, or 13%-20% of government spending].  Outgoing President Yudhoyono took the first courageous step of raising fuel prices a year ago.  [The fuel subsidies problem is even worse in oil-producing countries like Iran, Saudi Arabia and Venezuela, where the right to dirt-cheap fuel is considered the national patrimony.  Indonesia itself is no longer an oil-exporter, in part because low domestic prices have encouraged rapid growth in fuel consumption.]  Jokowi does not take office until October, but his advisers favor cutting the remaining subsidies. He has forthrightly expressed an intention of doing so, gradually, over a 4-year period.

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Market Failure vs. Government Failure

Why do economists feel confident that they are right to oppose these commodity subsidies?  Agricultural and energy markets tend to be relatively close to the ideal of perfect competition, with large numbers of consumers on the demand side and producers on the supply side.  (Where competition in commodities is imperfect, government itself is usually the problem, not the cure.)    Thus the classic economics argument applies:  setting the price artificially low, with the motive of benefiting consumers, works to discourage production and creates a gap of excess demand that usually has to be met by rationing.    Setting the price artificially high, with the motive of benefiting producers, discourages consumption and creates a gap of excess supply that often ends up in wasteful government stockpiles.   And either way, the policy is an invitation to corruption.

Skeptics of the Invisible Hand point out that, left to themselves, private markets can fail in a number of ways.  Two of the most prominent justifications for government intervention in the marketplace are environmental externalities such as air pollution and inequality in income distribution.  What is so striking about subsidies for food and fossil fuels is that, notwithstanding that the policies are often promoted in the name of the environment or equity, in practice they usually do little to help achieve these goals and often have the opposite effect.   Less than 20% of Egyptian food subsidies go to poor people.  In India, less than 0.1 per cent of rural subsidies for LPG (Liquefied Petroleum Gas) go to the poorest quintile, while 52.6 per cent go to the richest.  Gasoline (petrol) subsidies in most countries go to the middle class; they are the ones who drive cars, while the poor walk or take public transportation.  The same is true of other forms of fossil fuel subsidies:  worldwide, far less than 20% of the benefits go to the poorest 20% of the population. 

 

Typically they are also ruinous for the budget, as in all three countries considered here.

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India

Can one single misguided policy do worse than simultaneously hurt economic efficiency, the environment, equity, corruption, the government budget, and the trade balance?  Yes it can.   It can derail the most important progress in multilateral trade negotiations of the last ten years!   This from a country, India, where a new prime minister was widely considered likely to tackle much-needed market reforms.

Agricultural subsidies sometimes seek to keep prices low (to benefit consumers at the expense of producers), especially in poor countries, and sometimes seek to keep prices high (to benefit producers at the expense of consumers), especially in rich countries. India’s policies try to do both. As a result, India has accomplished the extraordinary feat of rationing grain to consumers at artificially low prices through a card system and yet at the same time suffering excess supply from farmers, because they are paid high prices.   (Agricultural inputs are also subsidized — electricity, water and fertilizer — thereby delivering the requisite environmental damage.)  The government has had to buy up huge stockpiles of surplus rice and wheat that are rotting away [reportedlymore than 20 million tons of rice and 40 million tons of wheat reserves, at present].  The limited amount that is available for consumers is allocated in ways that are both corrupt and inconsistent with the stated goal of helping the poor.

The government would like to keep its subsidies and stockpiles. But it knows that this would violate international trade rules.  Modi has taken the unusual step of vetoing the Trade Facilitation Agreement that WTO member countries thought they had reached at a climactic summit in Bali in December.  This was to be the first substantive achievement in the long-suffering Doha Round launched in 2001.  It would have benefited all countries, including India.  But WTO agreements are supposed to require consensus.  Domestic political considerations evidently persuaded Modi to torpedo the agreement, which was to have been finalized by the end of July, if he couldn’t first extract a change in international rules to allow India permanently to keep its subsidies and its stockpiles.

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What is a leader to do?

Of course the US and other rich countries have their own distorting subsidies in agriculture and energy. The US still subsidizes oil production and Europe still subsidizes coal.  The luckiest crops include cotton, sugar, dairy products, and grain.  The subsidies often hurt environmental quality, domestic consumer pocketbooks, and producers in developing countries, as well as the budget and general economic efficiency.    But at least rich country governments don’t usually set a particular low price for an important commodity and lead consumers to think they will never have to pay more.

Once subsidies are in place, they are extraordinarily difficult to remove.  People become accustomed to the idea that the government is responsible for the price of food or energy.  If world commodity prices go up, as they often have over the last decade, citizens who are accustomed to the domestic price being set in the market are more likely to accept the reality that their officials can’t wave a magic wand to insulate them from the unpleasant shock.   But people who are accustomed to the price being set by the government do hold it responsible.  In some countries, the removal of subsidies has led to civil unrest and even the overthrow of the government.

That is a strong reason not to adopt such subsidies in the first place.  But it doesn’t necessarily mean that, once in place, keeping them is the better option for the savvy politician.  If the alternative to raising the price is shortages or rationing through long lines, that can bring angry protestors out into the streets as well.  Similarly, the procrastinating leader is unlikely to look like a political genius if ever-widening gaps force an even bigger rise in the retail price when the day of reckoning comes.  (The gaps that tend to raise the necessary adjustment over time include declining domestic supply as producers respond to low price incentives; widening trade deficits, as the commodity shortfall is imported; and growing budget deficits, as the government pays for the price difference.)

Some subsidies do find their way to the poor.  [Cooking oil is an example.]  Ideally, as a matter of compassion as well as politics, other more efficient means of supporting incomes at the bottom will be instituted at the same time that subsidies for food and energy are cut.  Developing countries have learned a lot about efficient transfer mechanisms, from policy innovations such as the Conditional Cash Transfers of Mexico’s  Progresa/Oportunidad or Brazil’s Bolsa Familia and from technological innovations such as India’s Unique Identification system.  But in countries where the adjustment does not come until a budget crisis forces it, there may be no money left for transfers to cushion the pain.

The savvy politician should probably announce the unpleasant adjustment as soon as he takes office.  That seems to be the approach of Jokowi and Sisi.  Ironic that the third politician, Modi, the one who comes in with the biggest electoral mandate and the most hype about market reforms, is the one who is already falling short.

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[A shorter version, “The Subsidy Trap,” appeared at Project Syndicate.  Comments can be posted there.]

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Combating Volatility in Agricultural Prices

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Under French President Nicolas Sarkozy’s leadership, the G-20 has made addressing food-price volatility a top priority this year, with member states’ agriculture ministers meeting recently in Paris to come up with solutions. The choice of priorities has turned out to be timely: world food prices reached a record high earlier in 2011, recalling a similar price spike in 2008.

 

Consumers are hurting worldwide, especially the poor, for whom food takes a major bite out of household budgets. Popular discontent over food prices has fueled political instability in some countries, most notably in Egypt and Tunisia. Even agricultural producers would prefer some price stability over the wild ups and downs of the last five years.

 

The G-20’s efforts will culminate in the Cannes Summit in November. But, when it comes to specific policies, caution will be very much in order, for there is a long history of measures aimed at reducing commodity-price volatility that have ended up doing more harm than good.

 

For example, some inflation-targeting central banks have reacted to increases in prices of imported commodities by tightening monetary policy and thereby increasing the value of the currency. But adverse movements in the terms of trade must be accommodated; they cannot be fought with monetary policy.

 

Producing countries have also tried to contain price volatility by forming international cartels. But these have seldom worked.  

 

In theory, government stockpiles might be able to smooth price fluctuations, releasing commodities in times of shortage and adding to stocks when prices are low.   A free-marketer will point out that they can undermine the incentive for the private sector to hold stockpiles.  A valid response is that this incentive is undermined regardless, because political economy never allows “hoarders” to “price gouge” in times of food crisis.    It all depends on how stockpiles are administered.  The record in practice is not encouraging.

 

In rich countries, where the primary producing sector usually has political power, stockpiles of food products are used as a means of keeping prices high rather than low. The European Union’s Common Agricultural Policy is a classic example – and has been disastrous for EU budgets, economic efficiency, and consumer pocketbooks.

 

In many developing countries, on the other hand, farmers lack political power.  Some African countries adopted commodity boards for coffee and cocoa at the time of independence. Although the original rationale was to buy the crop in years of excess supply and sell in years of excess demand, thereby stabilizing prices, in practice the price paid to cocoa and coffee farmers, who were politically weak, was always below the world price.  In response, production fell.

 

Politicians often seek to shield consumers through price controls on staple foods and energy.  But the artificially suppressed price usually requires rationing to domestic households. (Shortages and long lines can fuel political rage as well as higher prices can.). Otherwise, the policy can require increased imports in order to satisfy the excess demand, and so can raise the world price even more.

 

If the country is a producer of the commodity in question, it may use export controls  to insulate domestic consumers from increases in the world price. In 2008, India capped rice exports, and Argentina did the same for wheat exports, as did Russia in 2010.

 

Export restrictions in producing countries and price controls in importing countries both serve to exacerbate the magnitude of the world price upswing, owing to the artificially reduced quantity that is still internationally traded. If producing and consuming countries in grain markets could cooperatively agree to refrain from such government intervention, working through the World Trade Organization, world price volatility could be lower.

 

In the meantime, some obvious steps should be taken.  It is too bad that the G20 attempt to do away with bio-fuel subsidies has failed, so far. Ethanol subsidies, such as those paid to American corn farmers, do not accomplish policymakers’ avowed environmental goals, but do divert grain and thus help drive up world food prices. By now this should be clear to everybody. But one cannot really expect the G-20 agriculture ministers to be able to fix the problem. After all, their constituents, the farmers, are the ones pocketing the money. The US, it must be said, is the biggest obstacle here.

 

It is probably best to accept that commodity prices will be volatile, and to create ways to limit the adverse economic effects – for example, financial instruments that allow hedging of the terms of trade.
 

What the G-20 farm ministers — meeting for the first time June 23 — have agreed is to forge an Agricultural Market Information System to improve transparency in agricultural markets, including information about production, stocks, and prices. More complete and timely information might indeed help.

 
The broader sort of policy that President Sarkozy evidently has in mind, however, is to confront speculators, who are perceived as destabilizing agricultural commodity markets. True, in recent years, commodities have become more like assets and less like goods. Prices are not determined solely by the flow of current supply and demand and their current economic fundamentals (such as disruptions from weather or politics). They are increasingly determined also by calculations regarding expected future fundamentals (such as economic growth in Asia) and alternative returns (such as interest rates) – in other words, by speculators.  

  

But speculation is not necessarily destabilizing. Sarkozy is right that leverage is not necessarily good just because the free market allows it.  And that speculators occasionally act in a destabilizing way. But speculators more often act as detectors of changes in economic fundamentals and provide the signals that smooth fluctuations. In other words, they often are a stabilizing force.

 

The French have not yet been able to obtain agreement from the other G-20 members on measures aimed at regulating commodity speculators, such as limits on the size of their investment positions. I hope it stays that way. Shooting the messenger is no way to respond to the message.

 

[This op-ed appeared via Project Syndicate.  Comments can be posted at that site.]

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Food Security: Export Controls are Not the Cure for Grain Price Volatility, But the Cause

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         My last blog post listed some policies and institutions with which various small countries around the world have had success — innovations that might be worthy of emulation by others.  Of course there are plenty of other examples of policies and institutions that have been tried and that are to be avoided.    The area of agricultural policy is rife with them.   Many start with a confused invoking of the need for “food security.”

          The recent run-up in wheat prices is a good example.   Robert Paarlberg wrote an excellent column in the Financial Times recently, titled “How grain markets sow the spikes they fear.”   Grain producing countries point to the high volatility of prices on world markets and the need for food security when imposing taxes on exports of their own grain supplies, or outright bans, as Russia did in July.    The motive, of course, is to keep grain affordable for domestic consumers.  But the effect of such export controls is precisely to cause the price rise that is feared, because it removes some net supply from the world market.    (The same could be said when grain importing countries react to high prices by enacting price controls, because that adds some net demand to the world market.)   

            The current run-up in grain prices is reminiscent of the even higher spike in food prices in 2008.   As Paarlberg argues, many of the other explanations that were put forward for that episode don’t fit this time.   The importance of export controls is now clearer.

            In 2008 Argentina imposed export tariffs to prevent its grain farmers from taking advantage of high world prices.   (This case seemed particularly irrational in that, unlike the usual case, the strongest political pressures came from the growers, not the consumers.)    At the same time, on the other side of the world, India put on export controls to prevent its rice farmers from selling their product on world markets to take advantage of high rice prices.   Controls imposed by Argentina, India, and others were important contributing factors to the global spike in food prices.

            Are governments indeed being completely irrational?   The commodities we are talking about are staples in the consumption of ordinary households.   For simplicity, let’s assume it is an absolute constraint that governments cannot allow grain prices to go above a certain threshold.    Perhaps there will be riots in the streets otherwise.  In this case might it make sense to put on export controls when the price threatens to go above that level?   One can see the motivation in the short run.   But, thinking in the long run, across complete cycles, controls are not a good answer.  

            One can imagine various sensible long-term policies that might assure that this constraint is not violated, such as stockpiling, although in practice many policies sold as “food security” are not in fact applied in a sensible way.

            One solution may be for major countries that are active in the market for wheat or rice to get together and agree not to impose controls.   The result would be to stabilize prices: no more alternation of price spikes and price collapses.  Each country could then rely more on the world market to cover shortfalls than it can now, when trade is made less dependable by the threat of controls by others.   The case of rice controls was nailed in a paper on food security written last year by two students in Harvard’s MPAID program (Masters in International Development), Naoko Koyama Blanc and Diva Singh.  In their model, it can indeed under certain conditions be rational for India to follow the practice of imposing controls when the price goes up, under a regime where volatility is high because others impose controls.  But it would be more rational for India to negotiate a no-controls regime with other countries, because under that regime volatility would be lower, the controls would not be needed, and everyone would be better off.   

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