Tuesday, February 23, 2010

Food Inflation - Distored Case of Permanent Subsidies

Unintended consequence of permanent subsidies which was supposed increase yield of food production actually decreased it. Wall Street Journal has an excellent story on the perverseness of industrial lobby, farm vote bank politics, and the ultimate devastation of farming yields - the devastation of which always shows up years later than the perversion of lobby.

What should have been a subsidy that was targeted and for limited in duration became a socialist model of profit making for fertilizer companies - licenses for which were probably obtained by corruption.
In 1967, then-Prime Minister Indira Gandhi imported 18,000 tons of hybrid wheat seeds from Mexico. The effect was miraculous. The wheat harvest that year was so bountiful that grain overflowed storage facilities.

Those seeds required chemical fertilizers to maximize yield. The challenge was to make fertilizers affordable to farmers who lacked the cash to pay for even the basics—food, clothing and shelter.

Back then, giving cash or vouchers to millions of farmers living all over India seemed like an impossible task fraught with the potential for corruption. So the government paid subsidies to fertilizer companies, who agreed to sell for less than the cost of production, at prices set by the government.

The subsidies were designed to make up the difference between the production price and sale price—and to give the producers a 12% after-tax return on any equity investment.

Fertilizer manufacturing companies sprang up around the country. Nagarjuna Fertilizers & Chemicals Ltd. became one of the most profitable publicly listed companies in India.

By the time subsidies based deficits became crippling on the national budget and tax burden, industry lobby was fat and powerful.
In 1991, with the cost of the subsidy weighing heavily on India's finances, Manmohan Singh, then finance minister and now prime minister, pushed to eliminate it. Most fertilizer companies lobbied fiercely to retain the program. Many legislators also resisted ending the subsidy, fearing a backlash from farmers.

Then the perverseness of lobbying and vote bank politics distorted the cost curve of fertilizer with producers of Urea, essential but not only needed nutrient, continuing to get subsidies, probably because urea margins were high, while subsides on other fertilizers, such as potassium and phosphates, were eliminated. The outcome was predicable by basic economic theory - uninformed farmers started using mostly the cheap Urea, and more and more of it, degrading the soil. Over 15 years, yields actually declined. Now the yields in green-revolutionary India are actually lowered than neigbouring countries and about 50% less than China, which is ironic because the country's agriculture economy was destroyed overnight by Mao's cultural revolution in the 60s.

The story doesn't stop with lower yields, reduced food supply, and increased food prices. The fertilizer industry lobby that created the distortion to perpetuate rent seeking from the state also lost.
The subsidy theoretically gives companies a 12% profit margin. Today, in part because of the way the government calculates the subsidy, it offers the average company a 3% margin, according to K. Rahul Raju, joint managing director of Nagarjuna Fertilizers & Chemicals, and Mr. Awasti, the fertilizer cooperative head.

No one - farmers, industry, tax payers, and food consumers - came ahead in this massive subsidy and economic distortion story, perhaps not even the politicians - because political power from patronage is short lived.

If there is a case for helping the needy, that help has to be short term, targeted and with an end date, with no extensions, announced prior to starting the program. Only then will farmers, industry, and other impacted groups will adjust to the non-permanence of the subsides and prepare for normal undistorted economic activity.

More than subsidies and entitlements, the permanence of those programs create distortions in economic activities just as non-permanence of tax cut does not generate economic activity intended. The latest rage in entitlement program is the so-called "right to work" NREGA program and newest avatar of it is direct cash transfers to apparent guaranteed employees. What exactly are the unintended consequences of this permanent entitlement, beyond extensive corruption throughout rural India, is anyone's guess.

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