An alternative ‘theory' of inflation

Most analyses of economic phenomena ignore the social, political and historical context in which they take place.

The usual tendency is to view them as exogenous to the realm of ‘pure' economic activity and subsumed under catch-all appellations — from ‘governance' and ‘populism' to the currently fashionable ‘policy paralysis'.

These, in turn, are attributed to irresponsible politicians and governments afraid of taking decisions based on infallible economic logic. But no explanations are given as to what makes politicians inherently populist or governments not act the way economists want them to.

One area where a better understanding of the interaction between politics and economics can yield useful insights is inflation, especially of the persistent kind India has been experiencing in recent years.

Passing it on

Inflation is not simply about prices of goods and services going up in general, caused mainly by loose monetary or fiscal policies. It is also about losers and winners.

The gainers from inflation are the ones who are in a position to pass on their costs — and more — to those consuming what they sell. By doing so, they actually contribute to inflation.

The losers, by contrast, have no such pricing power and are, hence, forced to absorb the higher costs imposed on them. By bearing the brunt, they provide a cushion for an easing of inflationary pressures across the economy.

From this, it follows that persistent inflation occurs when there are no losers or, alternatively, this lot too starts developing pricing power. In the event, each passes on his cost to the other in an unending spiral of price build-up.

In India, the traditional ‘losers' were the largely Dalit or Adivasi groups working as landless agricultural wage labourers. Has anything changed for them?

The accompanying table gives average farm wages in various States for the last nine years, computed by the Commission for Agricultural Costs and Prices based on data from the Labour Bureau, Shimla.

It can be seen that these have doubled or even trebled, while outpacing the 86 per cent rise in the all-India consumer price index (CPI) for agricultural labourers between December 2003 and December 2011.

No longer losers

What does this increase in real wages for farm workers mean? It implies greater bargaining power for a class that has historically occupied the bottom-most rung of Indian society. But in the process, it has also undermined the absorptive ‘cushion' that this section used to provide during past episodes of inflation.

The immediate impact of higher real rural wage rates is to push up cultivation costs for farmers, who, then, have to be compensated through increased minimum support prices (MSP) for their crops. The result is food inflation.

But apart from the effects on agriculture, what rising farm labour costs also do is to raise the benchmark ‘reservation wage' in the economy — the lowest rate that workers are prepared to accept for jobs across sectors.

Both these — higher food prices and increase in reservation wage — eventually get transmitted to the rest of the economy in the form of generalised inflation. This is precisely the kind of inflation — from ‘below', as it were — that we have been witnessing in the recent period. And it is persistent for the reasons stated.

The question that naturally arises is what has led to rural wages going up in the first place. The most obvious answer is a tightening of labour markets due to accelerated economic growth and urbanisation, which have generated new employment avenues outside of agriculture.

That, in combination with the National Rural Employment Guarantee Act and other public welfare schemes, has helped farm labourers to discover a hitherto non-existent ‘opportunity cost' of transplanting paddy or harvesting sugarcane in the fields.

The above ‘economic' explanations, however, fail to provide a complete answer.

They do not tell us why, for instance, rural wages have risen faster after 2007, by which time the really high growth phase of the last decade had come to an end? It points to something beyond just growth, enabling workers to demand and get wage increases in excess of food or overall CPI inflation.

Secondly, even if farm labour costs have gone up in real terms, what is it that is prompting the Government to protect farmers' margins, by allowing the former to be passed through in the form of unprecedented MSP hikes or preventing any upward revision in urea and diesel prices?

Everyone rules here

It all comes down to politics. Growth not only creates various supply-side bottlenecks, including a tightening of labour markets. It also unleashes aspirations. Those who see change happening for the first time, howsoever small, stop behaving as ‘losers' or accepting whatever is on offer.

These hopes and desires find articulation all the more in a world of competitive electoral democracy and free media.

Think about it: All countries that have grown at 8 per cent and more for sustained periods did so under single-party rule (China and Taiwan) or outright military dictatorships (Korea).

India is the first one attempting it on the back of full democracy, where universal suffrage is guaranteed to every adult citizen — Dalit, Muslim or upper-caste Hindu.

The dynamics of growth and inflation in an electoral democratic setup would always be different from that in authoritarian regimes, where neither governments nor elected representatives are under direct pressure to respond to people's aspirations.

For all the fulminations of Team Anna against politicians, voter turnouts have only gone up in these years of high growth, making their job even more difficult and impelling them to do things that economists wouldn't recommend.

If it is politics and social churning that is ultimately behind persistent inflation, rigid labour markets or high fiscal deficits, the limits of conventional approaches to analysing the workings of the Indian economy become clearly apparent.

It's time we have models that incorporate socio-politics explicitly into the equation and not as external, ‘dummy' variables that unexpectedly shift outcomes.

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