May 15, 2016

The Perversity of Market Signals

Prabhat Patnaik

IF we leave aside the problem of deficiency of aggregate demand, ie, of generalised over-production, then the only demand-supply mismatch that can arise in an economy is when too much of some commodity is produced relative to demand, and correspondingly too little of some other commodity is produced relative to demand. When such a mismatch arises, the market gives a clear signal about it through the actual level of inventories of commodities being either too much or too little relative to the “normal” level. These inventory movements in turn may give rise to price movements, with “abnormally low” inventories, at the base price, giving rise to an increase in price and “abnormally high” inventories, at the base price, giving rise to a price fall.

If such mismatches are to be eliminated then the output of goods with “abnormally low” inventories should increase and of goods with “abnormally high” inventories should decrease; and this is exactly what the functioning of the market is supposed to bring about. Market signals in other words are supposed to bring about self-corrections of demand-supply mismatches (though this mechanism fails in the case of generalised over-production at base prices). And what is more, not heeding market signals, it is argued, can only make the demand-supply mismatch worse, whence it follows that even the government, in taking its decisions, should pay heed to market signals.

It is on this basis that many have argued that since in India there are huge amounts of foodgrain stocks, far in excess of what the government considers “normal”, which are lying with the Food Corporation of India, de-emphasising foodgrain production is what is required, and that such de-emphasis is in conformity with the market signals. We are in short producing far too much foodgrains relative to demand and that this should be rectified.

It is indeed true that foodgrain stocks in the country have been far in excess of what is considered “normal”. In July 2012 there were 82 million tonnes of foodgrain stocks in the country; and even though substantial exports have occurred since then, as much as 42 million tonnes during two years 2013-14 and 2014-15, the level of stocks with the FCI on January 1, 2016 was still 49.8 million tones. True, the current year is going to be a drought year which should see a running down of stocks, but, leaving aside such fluctuations in output, the trend clearly is towards an excess supply of foodgrains in the country, which requires, it is argued, a scaling down of the production efforts: there must of course be shifts within foodgrain production, from cereals to pulses, but the sector as a whole needs de-emphasis.




What is paradoxical is the fact that precisely when such excess supply of foodgrains has got built up, the extent of food deprivation compared to such chronic food deficit regions like Sub-Saharan Africa has increased. In fact at present India has a lower level of foodgrain absorption per capita than even Sub-Saharan Africa. According to the FAO, per capita annual foodgrain consumption for all purposes (food, seed, waste, feed, processing and industrial use) is currently 176 kilogrammes for India compared to 225 for Sub-Saharan Africa and 212 for the Least Developed Countries. Following market signals in this situation and cutting back on foodgrain production will obviously make matters worse from the nutritional point of view; but on the other hand not following market signals is likely to lead to an even greater stock pile-up, once the effects of the drought have passed.

Why in other words are the market signals giving us a directive that is the very opposite of what simple observation on food intake would suggest? The answer lies in the fact that market signals can be totally perverse, and in the Indian context they are, a fact that is so alien to bourgeois economic theory that its very recognition undermines much of this theory.

This perversity can be understood with a very simple example. Let us assume that the government invests either in the foodgrain sector for boosting foodgrain output, or in the “non-foodgrain” sector for boosting non-foodgrain output. But 70 percent of its investment expenditure in the foodgrain sector is spent on foodgrains and 30 percent on non-foodgrains (because such investment is more labour-intensive and hence food-intensive); while the reverse is true of its investment expenditure on the non-foodgrain sector. Let us also suppose that the output effects of this investment are identical in the two sectors (with an output-capital ratio of one-third): spending Rs 100 in the foodgrain sector will raise foodgrain output by Rs 33 and spending it in the non-foodgrain sector will likewise raise the non-foodgrain output by Rs 33.

Now, suppose the government decides, for whatever reason, to invest Rs 100 less in the foodgrain sector and divert it to non-foodgrains. Immediately the net demand for foodgrains will go down by Rs 40 (which is Rs 70- Rs 30), so that Rs 40 of extra foodgrain stocks will be held. In the next period, foodgrain output will decline by Rs 33 and non-foodgrain output will rise by Rs 33. Let us assume that incomes in the two sectors are spent on the two goods also in the same ratio of 70:30 and 30:70 respectively. Then the decline in foodgrain output by 33 will mean a decline in foodgrain consumption by Rs 13.2 (which is 40 percent, (or 70-30 percent) of Rs 33). The foodgrain stocks at the end of this period will therefore be 40 – (33-13) or Rs 20. Even though stocks have declined (from 40 to 20) they continue to be abnormally high; and if, in response to this signal, investment shifts further from foodgrains to non-foodgrains, then stocks will rise again. And so on.

If the market signal is followed, then foodgrain consumption would keep going down, even as foodgrain stocks continue for long to remain “abnormally high”. This is the perversity of market signals, which entails, first, that far from “clearing” the market in a situation of excess supply, a cut in output can make excess supply persist for long; and second, such a process is accompanied by a worsening in the nutritional standards of the population.




Why does this perversity arise? The logic of the numerical example above, which illustrated this perversity can be explained as follows. When the government invests in foodgrain production, it does so through providing irrigation, extension services, rural infrastructure and such like, which are highly labour-intensive. But when it invests in the non-foodgrain sector, the labour-intensity is on average less. Besides, the labour employed on investment projects in the foodgrain sector is in general simple labour earning modest wages, much of which is spent on foodgrains. This means that government investment in the foodgrain sector, unlike in the non-foodgrain sector, is actually more “food-intensive”.

Even when foodgrain output increases, the incomes accrue to persons who are on average poorer compared to those to whom incomes accrue when non-foodgrain output increases; hence the former spend more on foodgrains out of a unit increase in income than the latter.

It follows therefore that a shift in investment from foodgrains to non-foodgrains reduces ceteris paribus the demand for simple labour and hence for foodgrains. And what is more, when foodgrain output is reduced as a result, foodgrain consumption of those engaged in production is also curtailed to such an extent that the net supply does not reduce much. Hence any initial cut in government investment in the foodgrains sector creates “abnormally large” inventories of foodgrains, which the subsequent cut in output can eliminate only slowly; and if cuts in investment continue, then the elimination of excess supply is even slower.

Put differently, a de-emphasis on foodgrain production is itself an act of demand compression of foodgrains, and this demand compression can be large enough to make the state of excess supply persist for long. The solution to a situation of excess supply of foodgrains therefore lies not in cutting back foodgrain production but rather in putting larger purchasing power in the hands of the poor who are undernourished and who would spend more on food if only they had the purchasing power.

Such purchasing power can be put in the hands of the rural poor through employment programmes like the MGNREGS. It can be augmented in real terms through the universal provision of a certain quantum of foodgrains at low prices (since any “targeting” leaves out a substantial segment of the poor). Such measures will get rid of excess foodgrain stocks. But an increase in foodgrain production, since it increases foodgrain demand considerably even while increasing foodgrain supply, can complement these measures. In other words, MGNREGS, a universal PDS, and the engagement of the State with peasant agriculture to raise output, together create a virtuous cycle of improving nutrition, reducing income inequality, and increasing employment of “simple” labour.

Many economists have noted that while earlier, during the dirigiste period, the growth of the economy as a whole was tethered to that of the agriculture sector, especially foodgrains, this link seems to have loosened during the neo-liberal era. The economy’s growth rate has supposedly accelerated compared to earlier, but the growth rate of foodgrains has slowed down to no more than the rate of population increase, keeping per capita foodgrain output more or less unchanged between the start of liberalisation and now. At the same time, no imports of foodgrains have been resorted to; on the contrary the country has made massive exports of foodgrains and that too out of “excessive” stocks which have characterised this period. And it is not even the case that foodgrain prices have risen faster than the general level of prices for the period as a whole. (This happened only for a period in the current century when the terms of trade in the world economy as a whole moved in favour of primary commodities, but is no longer the case).

The reason for this loosening of links between agriculture and the rest of the economy is precisely because of the vicious circle of growing inequality, reduced employment growth, growing labour reserves and de-emphasis of agriculture that neo-liberalism has entailed. This has also worsened the nutritional levels of the population even in the midst of massive foodgrain stocks. Reversing this requires not following, but rather violating, the market signals.