The flagship spending scheme of the United Progressive Alliance (UPA) government has been the National Rural Employment Guarantee Act (Nrega). Put very simply, this scheme promises to pay 120 a day for doing public-related work for 100 days to rural labour unable to find work. Though the Right to Food Bill, etc., have come under heavier fire, Nrega is the one actually held responsible for the downward turn in public finances, for it’s the only one that has been implemented for a substantial amount of time.

Now many people cry hoarse about anything that Sonia Gandhi/Jean Dreze devise. But some have actually attempted some conceptual economic theorizing and predictions around Nrega—based around simple demand and supply analysis. Rural markets are inefficient, so rural supply curves are steep. Thus, shifting the rural demand curve through doling out income will only lead to an increase in prices, not in real income and consumption.

While this analysis is intuitively appealing, it is severely incomplete. It talks of specific markets, not the broad-based economy. It is a microeconomic argument for the quintessential macroeconomic phenomenon of broad-based inflation. What if we were to draw the demand/supply curves as macro aggregate demand (AD) and aggregate supply (AS) curves? Then, the argument is that the aggregate supply curve is steep. Recall that the AS curve is simply the expectations-augmented Philips curve. (The original Philips curve was about the tradeoff between inflation and employment, but as macroeconomists realised, the argument can be split up into inflation/growth and growth/employment.) So we’re ostensibly doing nothing but invoking the Phelps-Friedman-Lucas argument circa 1970, that there is no such exploitable tradeoff, that the expectations-augmented long-run Philips curve is vertical. A pure income effect is a pure price effect. You can’t help rural families by doling out funds.

Now, what if the AS curve is not vertical, simply steep? Then some output/ consumption can be increased by simply raising incomes. It’s not clear why this increase is to be mocked away simply because most of the income has gone into prices. Say even 90% of the increase in nominal output is absorbed by prices. So? Why shouldn’t we let inflation increase by 9 percentage points, if that does mean growth increase by 1 percentage point? Why do we care about the level of prices? Why do we care about the rate of change of these prices? Why shouldn’t we exploit the Philips/ AS curve until it becomes vertical?

There are two challenges to this -- the first is the classical macro-theory challenge of an accelerating rate of inflation. Inflation expectations become endogenized fast, so that the risk of over-shooting the Philips curve is imminent and non-trivial. This is what RBI worries about when Subba Rao says that the non-accelerating inflationary rate of growth in India has dropped to 7%.

The second is that inflation is a regressive tax with distributive consequences. The macro literature that tries to prove this distributive consequence through consumption effects goes into several hoops, with the result critically dependent on the assumption of economies in scale in credit provision. The other way to get a distributive consequence would be to posit that poor people are more likely to have their assets in cash or other such nominally fixed holdings, and are thus losing real wealth faster. This is quite true in as far as it goes, but consider the other effect of inflation—to lower the real value of nominal debts. To the extent that poor people are more likely to be in debt, an inflation tax is actually progressive. Further, inflation in India typically takes the form of food or fuel inflation. The former actually benefits most of our rural poor. (Only one-third of the price of food reaches producers, yes, but this is as true of the extra price as the original price. A poor supply chain is not a poor-er supply chain.) The latter (fuel inflation) is globally driven.

In all, the distributive consequences of inflation in India are unclear. The worst hit are the urban poor, who are neither food producers nor Nrega beneficiaries, nor in possession of inflation hedge assets. We need to look out for them, but they are not the only constituency in the calculus of macroeconomic welfare and that indicates towards a safety net for them, not the removal of safety nets for others.

With that in mind, let’s analyse what Nrega does for inflation. In more recent times we have heard how Nrega has caused a shortfall in farm labour/ low-skilled industry labour, by giving people money for nothing (let’s assume that the public works envisioned in Nrega are of absolutely zero value). 120/ day*100 days = 12,000. 12,000 per annum is all it takes to make people give up the desire to earn money, apparently. I find it almost a perversion of empirical logic to posit that there is a shortage of unskilled labour in India, but let’s say that there is. So what? What about the price system? There is a shortage at the current prices of unskilled labour. Why are we assuming that current prices must continue?

The rural labourer takes a non-zero risk that he will not have a job when he scampers off to make some money-for-nothing in Nrega. So his reservation wage has not been raised by the full 12,000. What businesses/ farms are these that cannot pay their unskilled labour about 5,000-10,000 more per annum, and still be profitable? What fundamental right do these businesses have to exist and make profits? These capital owners—whether of farms or businesses—have to bid up wages to get their labour back, or get out. This will increase the inflationary pressure, yes, but as we saw it is not immediately clear what the big dangers of inflation are. (It’s worth noting that this is not to be added on top of Nrega—it is just a mechanism through which Nrega creates inflationary pressure, a proper macro one at that and one that lends itself more suitably to analysis through AS/ Philips curves).

Note that what I’m saying is not particularly ‘leftist’. Here is Tyler Cowen, a self-described libertarian and co-author of Marginal Revolution, one of the most popular economics blogs in the world, talking about how the way to improve the condition of workers is to increase the utility of unemployment.

“Raise the utility of unemployment to workers. This could be a guaranteed annual income, better unemployment insurance, more food stamps, whatever. Call it the welfare state. Improving the welfare state will improve worker bargaining across virtually all workplace dimensions and in the longer run limit the scope of all the employer depredations.

We’re back to the point that what helps is to give people cash, or something cash-like, including when it comes to the dimensions of workplace quality. It is also a huge help to institute policies which will raise rather than lower worker productivity."

He is talking about employed labour in organized first world environments, which anyway doesn’t suffer from the debilitating endowment failures that rural labour in India does. The argument is even stronger in our case, where we’re talking about people who live at the very edge of decent existence. Nrega, shorn of public works, is a cash transfer, pure and simple. There was a time when cash transfers were supposed to be the right way of implementing redistribution, especially by those on the right. So why the outcry when the cash transfer was finally enacted?

For one, we distrust our delivery mechanisms, we suspect leakages. Massive government programmes are massive opportunities for rent-seeking. This is the right reason to dislike Nrega. But this has nothing to do with inflation. For another, we distrust the upward creep in the size of the government that redistribution entails; so that we would like indirect subsidies cut first before cash transfers are enacted. This has merit, but again it is a public-choice issue, not a macroeconomic issue. And third, we may simply believe that we were at the right level of redistribution as it were. So anything further shifts the balance. You could say that, and I would have no argument to offer because then we would have widely different priors, to the point that we’d talk past each other.

But if we don’t believe that, then we have to analyse Nrega’s macroeconomics as the macroeconomics of a just, redistributive cash transfer. And then the corollary observations follow—Nrega increases the fiscal deficit only when it is not backed by an equivalent increase in tax receipts. It is you and I, salaried income city dwellers, who are causing the fiscal deficit. And then, we have to go back to the questions raised in part 1 and part 2 of the series—how does this fiscal deficit translate into inflation when it is not money-financed, and when government bonds are showing no spikes in interest rates?

The writer is a London-based consultant. This is the third of a five-part series in which Ritwik Priya examines the macroeconomics of inflation in India through the lens of the fiscal deficit, NREGA, tax policy and investment.

“These are the author’s personal views."

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