Subsidies for food and energy are economically inefficient, but can often be politically popular. Jeffrey Frankel, Harpel Professor at Harvard University’s Kennedy School of Government discusses the efforts by new leaders in Egypt, Indonesia, and India to cut unaffordable subsidies.
In few policy areas does good economics 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 centre politically this summer, 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.
Market failures vs. government failures
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.
Sceptics 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% of rural subsidies for liquefied petroleum gas go to the poorest quintile, while 52.6% 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.
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 materialised.
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 toppled governments. But it looks like the Sisi government is beginning reforms here as well. Bread subsidies have already been cut by 13%.
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% 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?
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. Outgoing President Yudhoyono took the first courageous step of raising fuel prices a year ago. Jokowi does not take office until October, but his advisers favour cutting the remaining subsidies. He has forthrightly expressed an intention of doing so, gradually, over a four-year period.
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 president 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 subsidised – electricity, water and fertiliser – thereby delivering the aforementioned environmental damage.) The government has had to buy up huge stockpiles of surplus rice and wheat that are rotting away. 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 finalised 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.
What is a leader to do?
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.
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 queues, 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. 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 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.
Jeffrey Frankel is Harpel Professor at Harvard University’s Kennedy School of Government. He directs the program in International Finance and Macroeconomics at the National Bureau of Economic Research, where he is also on the Business Cycle Dating Committee, which officially declares U.S. recessions. Professor Frankel served at the Council of Economic Advisers in 1983-84 and 1996-99; he was appointed by Bill Clinton as CEA Member with responsibility for macroeconomics, international economics, and the environment. Before moving east, he had been professor of economics at the University of California, Berkeley, having joined the faculty in 1979. He is an external member of the Monetary Policy Committee of Mauritius and serves on advisory panels for the Federal Reserve Bank of New York, the Bureau of Economic Analysis, and the Peterson Institute for International Economics. In the past he has visited the IIE, the IMF, and the Federal Reserve Board. His research interests include currencies, crises, commodities, international finance, monetary and fiscal policy, trade, and global environmental issues. He was born in San Francisco, graduated from Swarthmore College, and received his Economics PhD from MIT.
Article courtesy of Voxeu.org