Friday, November 28, 2014

The Subsidy Trap

CAMBRIDGE – Few policies place good economics so directly at odds with good politics as subsidies for food and energy. The issue of unaffordable subsidies is now front and center for three of the world’s most important new leaders: Egyptian President Abdel Fattah el-Sisi, Indonesian President-elect Joko “Jokowi” Widodo, and Indian Prime Minister Narendra Modi.

Sisi is confronting the need to cut subsidies better than might have been expected. Modi, by contrast, is doing worse than expected – even torpedoing a long-anticipated Word Trade Organization agreement. With Jokowi, it is too soon to tell.

In July, Sisi accomplished what few leaders in North Africa or the Middle East have: he sharply cut longstanding fuel subsidies and allowed prices to rise by 41-78%. Surprisingly, few protests materialized.

Egypt’s food subsidy program, which costs more than $5 billion a year, is in urgent need of reform as well. The price of bread has been kept so low that it is often fed to animals. Past attempts to reduce such subsidies in North African countries have brought unrest and even toppled governments. But the Sisi government appears to be making progress here as well. Bread subsidies have already been cut by 13%.

Sisi had little choice. Even with subsidy cuts, the current government is targeting a budget deficit of 10% of GDP in the coming fiscal year (compared to 14% otherwise). Still, few expected Sisi, who took office in a fragile political environment, to move faster than Modi, who was elected with a whopping democratic majority amid hopes for sweeping economic reform.

In Indonesia, when Jokowi takes office in October, he will inherit a long history of fuel subsidies that, at $21 billion a year (up to 20% of government spending), the country can no longer afford. Outgoing President Susilo Bambang Yudhoyono took a first courageous step by raising fuel prices a year ago. Jokowi’s advisers favor cutting the remaining subsidies, and he has already forthrightly said that he plans to do so gradually, over a four-year period.

Economists feel confident in opposing commodity subsidies because agricultural and energy markets tend to approach the ideal of perfect competition, with a large number of consumers on the demand side and producers on the supply side. Where competition is imperfect, government, not large private monopolies, is usually the reason.

Critics of the invisible hand point out that, left to themselves, private markets can fail in a number of ways. For example, income inequality and environmental externalities are two of the most prominent justifications for government intervention.

What is striking about food and fossil-fuel subsidies is that they are often promoted in the name of the environment or equity, but usually do little to achieve these goals, and often have the opposite effect. Less than 20% of Egyptian food subsidies benefit poor people. Gasoline subsidies in most countries benefit the middle class, while the poor walk or take public transportation. In India, less than 0.1% of rural subsidies for Liquefied Petroleum Gas go to the poorest quintile, while 52.6% go to the wealthiest. Worldwide, far less than 20% of fossil-fuel subsidies benefit the poorest 20% of the population.

Food and energy subsidies can also distort public policy, as Modi’s government, seeking to protect India’s agricultural subsidies, has shown. Indeed, its veto of a WTO compromise has derailed the most important progress in multilateral trade negotiations of the last ten years.

Agricultural subsidies sometimes seek to benefit consumers at the expense of producers, especially in poor countries, and sometimes seek 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, while simultaneously suffering excess supply, because farmers are paid high prices. (Farmers are also subsidized via agricultural inputs – electricity, water, and fertilizer – to the detriment of the environment.) The government has purchased huge stockpiles of rotting rice and wheat, while the limited amount available to consumers is allocated in ways that are 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 WTO rules. Unable to obtain a permanent change in these rules, Modi vetoed the WTO’s eagerly anticipated Trade Facilitation Agreement.

Once subsidies are in place, they are extraordinarily difficult to remove. When world commodity prices rise, 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 officials cannot insulate them from the shock. But people who are accustomed to administratively established food and energy prices hold the government responsible.

That is a strong reason not to adopt such subsidies in the first place. But it does not necessarily mean that, once subsidies are in place, keeping them is a savvy politician’s best option. If the alternative to raising the price is shortages or rationing, angry protesters may mobilize anyway. Similarly, the procrastinating leader is unlikely to benefit if ever-widening gaps force an even bigger retail-price rise when the day of reckoning comes.

Ideally, other, more efficient means of supporting incomes at the bottom will be instituted at the same time that food and energy subsidies 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-Oportunidades program or Brazil’s Bolsa Família, 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. Jokowi and Sisi seem to have adopted this approach. Modi, despite his huge electoral mandate and hype about market reforms, has fallen short.

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    1. Portrait of Jeffrey Frankel

      CommentedJeffrey Frankel

      Thank you all for your comments. To all who noted that I did not discuss subsidies in the US or other advanced countries: (1) I have done so in other writings. (2) The column does say "Agricultural subsidies ... sometimes seek to benefit producers at the expense of consumers, especially in rich countries. (3) The US, in general, gets disporportionate attention. One aim of Project Syndicate, as I understand it, is to devote some attention also to countries like India, Egypt and Indonesia. (4) The PS editors always have to cut down my submissions to fit op-ed length. I think they do a good job of it. (5) The original full draft of my article (which is available on my personal blog site: // ) did include the following paragaraph: "Of course the US and other rich countries have their own distorting subsidies in agriculture and energy. The US still subsidizes oil production and Europe still subsidizes coal. The luckiest crops include cotton, sugar, dairy products, and grain. The subsidies often hurt environmental quality, domestic consumer pocketbooks, and producers in developing countries, as well as the budget and general economic efficiency."
      -- Jeff Frankel

    2. CommentedClaudio Migliore

      I find disingenuous that commenters blame Mr. Frankel for not mentioning US & European subsidies. Although very true and a bit damaging to the professor's overall argument, it is completely misguided and rooted in either bad faith or, more likely lack of understanding of the subsidy phenomenon. In fact, subsidies are not (mostly)countries indulgence in pleasant peccadillos at the expense of the rest of the world, but rather collective masochism of the country's citizens, who do not realize they are hurting most often themselves. When that is clear, even if the US were von Sacher-Masoch himself, it would still make sense to point out other countries with the same penchant, particularly when their more fragile economy makes it more damaging.

    3. CommentedSubhash Garg

      Not surprisingly, Prof. Frankel sees the issue from a First World capitalist anti-poor perspective. He would have more credibility if First World economists were successful in avoiding and recovering from their own market crises. As things stand, world-class economists in Third World countries are right to be skeptical, and try to develop their own ad-hoc solutions. And Prof. Frankel should write on reforming the broken WTO.

    4. CommentedMike Holly

      I got excited after reading the first sentence of Frankel's article because I thought it was an article about US energy and food subsidies. I stopped after reading the second sentence because I saw it was about other countries. Americans need to be a leader for free markets and against subsidies and cronyism themselves before even talking about others.

    5. CommentedRidwan Pahari

      A few months ago EU countries claimed that US subsidy in Boeing is deplorable because its arch rival Air Bus is already in stiff competition with Boeing. Again US, has been subsidising its cotton production for a long time and already turned into the biggest producer of cotton. What percentile of people are getting the benefits?

    6. CommentedFalak Arora

      It was almost as if the article was making a desperate attempt to default India's position relying on oexamples of other developing countries. U.S.A needs to drop its bullish attitude and fall in line.

    7. CommentedNathan Weatherdon

      I think that Modi wanted to reassure that the Ganges would not be filled with floating dead malnourished babies as a result of competition-enhancing measures which are likely to come and which will have short-term negative impacts on many producers, and therefore the buying power of the people working in those industries.

      Food subsidies in a country with Indian levels of poverty is far more defensible, in my opinion, that in the USA, for example, especially after accounting for the impacts that these subsidies can have on world prices of staple crops such as corn and wheat.

    8. CommentedAndrew Zimin

      А почему бы не начать с отмены субсидий Boeing corp.?

      And why not start with the removal of subsidies Boeing corp.?

    9. Commentedhari naidu

      I reproduce relevant para from recent comment in The Hindu(14 Aug 2014) which more or less explains India's veto of WTO - Trade Facilitation Agreement (Bali Dec'13). In fact, GOI has clarified that it does not oppose per se the TFA but the policy framework behind it. While US and EU official subsidy of its farmers is far more larger and politically entrenched.

      “….The present WTO ceiling on domestic support is pegged at a mere 10 per cent of the value of production, which is itself calculated at fixed reference prices of the 1986-88 period. This is ridiculously low, and unrealistic and unfair, not just to India but to many other nations with a large farm sector. It may be useful here to remember that despite all the efforts to move people to urban areas and away from agriculture, the latest United Nations population estimates show that even in the year 2050, around 800 million Indians will continue to live in rural areas. No democratically elected and accountable government of India can afford to ignore the interests of these people, especially given the vulnerability of farming, deeply aggravated by the newly emerging context of climate change. More than 80 per cent of India’s cultivators are small and marginal farmers, who grow crops on less than 5 acres of land. They face increasing challenges of water and livelihood security and need continued government support to enable them to earn a sustainable income. This support that we need to provide our farmers cannot be given within the limits set by the WTO agreements….”

        CommentedSubhash Garg

        The WTO members are in no mood to listen. They see this impasse as a power play and assume that Modi will blink since he's allegedly business-friendly. India should be prepared to let the WTO become a cave relic -- or stop trying for unachievable omnibus deals.