Minimum Support Price (MSP) for Farmers – Ruminations for the Grassroots.

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Minimum Support Price (MSP) is an insurance given by the Government of India to insure farmers and agricultural workers against any sharp fall in farm prices. MSP is a policy instrument at the disposal of the government and is introduced based on the recommendations of the Commission for Agricultural Costs and Prices (CACP) generally at the beginning of sowing season. The major objective of MSP is protecting and supporting farmers during bumper production periods by pouring food grains for public distribution. There are two ways in which an effective MSP can be implemented, viz. procurement of commodities and as remunerative. The remunerative nature for farmers compensates the difference between MSP and the prices received by them.

With the agrarian crisis looming large, the policies need to emphasize on measures that can bring forth immediate results. These results could be achieved through the components of price and non-price factors. Non-price factors are long-term oriented and rely on market reforms, institutional reforms and innovations in technology in order to bring in an upward drift growth and income brackets of the farmers. Price factors are short-term oriented that necessitate immediate upward drift in remunerative prices for farm produce. It is within the ambit of price factors that MSP stands. The government notifies MSP for 23 commodities and FRP (fair and remunerative price) for sugarcane. These crops cover about 84% of total area under cultivation in all the seasons of a year. About 5% area is under fodder crops which is not amenable for MSP intervention. According to this arithmetic, close to 90% of the total cultivated area is applicable to MSP intervention, leaving a small segment of producers amenable to price benefits, if the MSP were to be fully implemented.

So, how exactly does the CACP determine the Minimum Support Price (MSP)? CACP takes the following factors under consideration while determining the MSP:

  1. Cost of cultivation per hectare and structure of costs across various regions in the country and the changes therein.
  2. Cost of production per quintal across various regions of the country and the changes therein.
  3. Prices of various inputs and the changes therein.
  4. Market prices of products and the changes therein.
  5. Prices of commodities sold by the farmers and of those purchased by them and the changes therein.
  6. supply-related information like area, yield and production, imports, exports and domestic availability and stocks with the Government/Public agencies or industry.
  7. Demand-related information, which includes the total and per capita consumption, trends and capacity of the processing industry.
  8. Prices in the international markets and the changes therein.
  9. Prices of the derivatives of the farm products such as sugar, jaggery, jute, edible and non-edible oils, cotton yarns and changes therein.
  10. Cost of processing of agricultural products and the changes therein.
  11. Cost of marketing and services, storage, transportation, processing, taxes/fees, and margins retained by market functionaries, and
  12. Macroeconomic variables such as general level of prices, consumer price indices and those reflecting monetary and fiscal factors.

As can be seen, this is an extensive set of parameters that the Commission relies on for calculating the Minimum Support Price (MSP). But, then the question is: where does the Commission get access to this data set? The data is generally gathered from agricultural scientists, farmer leaders, social workers, central ministries, Food Corporation of India (FCI), National Agricultural Cooperative Marketing Federation of India (NAFED), Cotton Corporation of India (CCI), Jute Corporation of India, traders’ organizations and research institutes. The Commission then calculates the MSP and sends it to the Central Government for approval, which then sends it to the states for their suggestions. Once the states given their nods, the Cabinet Committee on Economic Affairs subscribes to these figures that are then released on CACP portals.

During the first year of UPA-1 Government in the centre in 2004, a National Commission on Farmers (NCF) was formed with M S Swaminathan (Research Foundation) as its Chairman. One of the major objectives of the Commission was to make farm commodities cost-competitive and profitable. To achieve this task, a three-tiered structure for calculating the farming cost was devised, viz. A2, FL and C2. A2 is the actual paid out costs, while, A2+FL is the actual paid-out cost plus imputed value of family labour, where imputing is assigning a value to something by inference from the value of the products or processes to which it contributes. C2 is the comprehensive cost including imputed rent and interest on owned land and capital. It is evident that C2 > A2+FL > A2

The Commission for Agricultural Costs and Prices (CACP) while recommending prices takes into account all important factors including costs of production, changes in input prices, input/output parity, trends in market prices, inter crop price parity, demand and supply situation, parity between prices paid and prices received by the farmers etc. In fixing the support prices, CACP relies on the cost concept which covers all items of expenses of cultivation including that of the imputed value of the inputs owned by the farmers such as rental value of owned land and interest on fixed capital. some of the important cost concepts are C2 and C3:

C3: C2 + 10% of C2 to account for managerial remuneration to the farmer.

Swaminathan Commission Report categorically states that farmers should get an MSP, which is 50% higher than the comprehensive cost of production. this cost + 50% formula came from the Swaminathan Commission and it had categorically stated that the cost of production is the comprehensive cost of production, which is C2 and not A2+FL. C2 includes all actual expenses in cash and kind incurred in the production by the actual owner + rent paid for leased land + imputed value of family labour + interest on the value of owned capital assets (excluding land) + rental value of the owned land (net of land revenue). Costs of production are calculated both on a per quintal and per hectare basis. Since cost variation are large over states, CACP recommends that MSP should be considered on the basis of C2. However, increases in MSP have been so substantial in case of paddy and wheat that in most of the states, MSPs are way above not only the C2, but even C3 as well.

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This is where the political economy of MSP stares back at the hapless farmers. Though 23 crops are to be notified on MSP, not more than 3 are are actually ensured. The Indian farm sector is also plagued by low scale production restricted by small-sized holdings, which ensures that margin over cost within the prevailing system generates at best low income for the farmers. This is precisely the point of convergence of reasons why the farmers have been demanding effective implementation of MSP by keeping the MSP 50% higher than the costs incurred. Farmers and farmers’ organizations have demanded that the MSP be increased to cost of production + 50%, since for them, cost of production has meant C2 and not A2+FL. At present, the CACP adds A2 and FL to determine the MSP. The Government then adds 50% of the value obtained by adding A2 and FL only to fix the MSP, thus ignoring C2. What the farmers and farmers’ organizations have been demanding is an addition of 50% to C2 to fix the MSP, which is sadly missing the hole point of Governmental announcements. This difference between what the farmers want and what the government gives is a reason behind so much unrest as regards support prices to the farmers.

Ramesh Chand, who is currently serving in the NITI Aayog, is still a voice of reason over and above what the Government has been implementing by way of sops. Chand has also recommended that the interest on working capital should be given for the whole season against the existing half-season, and the actual rental value prevailing in the village should be considered without a ceiling on the rent. Moreover, post-harvest costs, cleaning, grading, drying, packaging, marketing and transportation should be included. C2 should be hiked by 10% to account for the risk premium and managerial charges.

According to Ramesh Chand of NITI Aayog, there is an urgent need to take into account the market clearance price in recommending the MSP. This would reflect both the demand and supply sides. When the MSP is fixed depending on the demand-side factors, then the need for government intervention to implement MSPs would be reduced only to the situation where the markets are not competitive or when the private trade turns exploitative. However, if there is a deficiency price payment mechanism or crops for which an MSP declared but the purchase doesn’t materialize, then the Government should compensate the farmers for the difference between the MSP and lower market price. such a mechanism has been implemented in Madhya Pradesh under the name of Bhavantar Bhugtan Yojana (BBY), where the Government, rather than accept its poor track record in procurement directly from the farmers has been compensating the farmers with direct cash transfers when the market prices fall below MSP. The scheme has had its downsides with long delays in payments and heavy transaction costs. There is also a glut in supply with the markets getting flooded with low-quality grains, which then depress the already low crop prices. Unless, his and MS Swaminathan’s recommendations are taken seriously, the solution to the agrarian crisis is hiding towards a capitalist catastrophe. And why does one say that?

In order to negotiate the price deficient mechanism towards resolution, the Government is left with another option in the form of procurement. But, here is a paradox. The Government clearly does not have the bandwidth to first create a system and then manage the procurement of crops for which the MSP has been announced, which now number 20. If there is a dead-end reached here, the likelihood of Government turning towards private markets cannot be ruled out. And once that turn is taken, thee markets would become vulnerable to whims and fancies of local politicians who would normally have influencing powers in their functioning, thus taking the system on their discretionary rides.

There obviously are certain questions that deem an answer and these fall within the ambit of policy making. For instance, is there a provision in the budget to increase the ambit of farmers who are covered by the MSP? Secondly, calculations of MSP involve private costs and benefits, and thus exhibit one side of the story. For an exhaustive understanding, social costs and benefits must also be incorporated. With a focus primarily on private costs and benefits, socially wasteful production and specialization is encouraged, like paddy production in north India with attendant consequences to which we have become grim witnesses. Would this double-bind ever be overcome is a policy matter, and at the moment what is being witnessed is a policy paralysis and lack of political will transforming only in embanking the vote bank. Thats a pity!

How Permanent Income Hypothesis/Buffer Stock Model of Milton Friedman Got Nailed?

Milton Friedman and his gang at Chicago, including the ‘boys’ that went back and put their ‘free market’ wrecking ball through Chile under the butcher Pinochet, have really left a mess of confusion and lies behind in the hallowed halls of the academy, which in the 1970s seeped out, like slime, into the central banks and the treasury departments of the world. The overall intent of the literature they developed was to force governments to abandon so-called fiscal activism (the discretionary use of government spending and taxation policy to fine-tune total spending so as to achieve full employment), and, instead, empower central banks to disregard mass unemployment and fight inflation first. Wow!, Billy, these aren’t the usual contretemps and are wittily vitriolic. Several strands of their work – the Monetarist claim that aggregate policy should be reduced to a focus on the central bank controlling the money supply to control inflation (the market would deliver the rest (high employment and economic growth, etc); the promotion of a ‘natural rate of unemployment’ such that governments who tried to reduce the unemployment rate would only accelerate inflation; and the so-called Permanent Income Hypothesis (households ignored short-term movements in income when determining consumption spending), and others – were woven together to form a anti-government phalanx. Later, absurd notions such as rational expectations and real business cycles were added to the litany of Monetarist myths, which indoctrinated graduate students (who became policy makers) even further in the cause. Over time, his damaging legacy has been eroded by researchers and empirical facts but like all tight Groupthink communities the inner sanctum remain faithful and so the research findings haven’t permeated into major shifts in the academy. It will come – but these paradigm shifts take time.

Recently, another of Milton’s legacy bit the dust, thanks to a couple of Harvard economists, Peter Ganong and Pascal Noel, who with their paper “How does unemployment affect consumer spending?” smashed to smithereens the idea that households would not take consumption decisions with discretion, which the Chicagoan held to be a pivot of his active fiscal policy. Time traveling back to John Maynard Keynes, who outlined in his 1936 The General Theory of Employment, Interest and Money a view that household consumption was dependent on disposable income, and, that in times of economic downturn, the government could stimulate employment and income growth using fiscal policy, which would boost consumption.

In Chapter 3 The Principle of Effective Demand, Keynes wrote:

When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income …

The relationship between the community’s income and what it can be expected to spend on consumption, designated by D1, will depend on the psychological characteristic of the community, which we shall call its propensity to consume. That is to say, consumption will depend on the level of aggregate income and, therefore, on the level of employment N, except when there is some change in the propensity to consume.

Keynes later (in Chapter 6 The Definition of Income, Saving and Investment) considered factors that might influence the decision to consume and talked about “how much windfall gain or loss he is making on capital account”.

He elaborated further in Chapter 8 The Propensity to Consume … and wrote:

The amount that the community spends on consumption obviously depends (i) partly on the amount of its income, (ii) partly on the other objective attendant circumstances, and (iii) partly on the subjective needs and the psychological propensities and habits of the individuals composing it and the principles on which the income is divided between them (which may suffer modification as output is increased).

And concluded that:

1. An increase in the real wage (and hence real income at each employment level) will “change in the same proportion”.

2. A rise in the difference between income and net income will influence consumption spending.

3. “Windfall changes in capital-values not allowed for in calculating net income. These are of much more importance in modifying the propensity to consume, since they will bear no stable or regular relationship to the amount of income.” So, wealth changes will impact positively on consumption (up and down).

Later, as he was reflecting in Chapter 24 on the “Social Philosophy towards which the General Theory might lead” he wrote:

… therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.

For if effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him …

It was thus clear – that active fiscal policy was the “only practicable means of avoiding the destruction” of recession brought about by shifts in consumption and/or investment. That view dominated macroeconomics for several decades.

Then in 1957, Milton Friedman advocated the idea of Permanent income hypothesis. The central idea of the permanent-income hypothesis, proposed by Milton Friedman in 1957, is simple: people base consumption on what they consider their “normal” income. In doing this, they attempt to maintain a fairly constant standard of living even though their incomes may vary considerably from month to month or from year to year. As a result, increases and decreases in income that people see as temporary have little effect on their consumption spending. The idea behind the permanent-income hypothesis is that consumption depends on what people expect to earn over a considerable period of time. As in the life-cycle hypothesis, people smooth out fluctuations in income so that they save during periods of unusually high income and dissave during periods of unusually low income. Thus, a pre-med student should have a higher level of consumption than a graduate student in history if both have the same current income. The pre-med student looks ahead to a much higher future income, and consumes accordingly.Both the permanent-income and life-cycle hypotheses loosen the relationship between consumption and income so that an exogenous change in investment may not have a constant multiplier effect. This is more clearly seen in the permanent-income hypothesis, which suggests that people will try to decide whether or not a change of income is temporary. If they decide that it is, it has a small effect on their spending. Only when they become convinced that it is permanent will consumption change by a sizable amount. As is the case with all economic theory, this theory does not describe any particular household, but only what happens on the average.The life-cycle hypothesis introduced assets into the consumption function, and thereby gave a role to the stock market. A rise in stock prices increases wealth and thus should increase consumption while a fall should reduce consumption. Hence, financial markets matter for consumption as well as for investment. The permanent-income hypothesis introduces lags into the consumption function. An increase in income should not immediately increase consumption spending by very much, but with time it should have a greater and greater effect. Behavior that introduces a lag into the relationship between income and consumption will generate the sort of momentum that business-cycle theories saw. A change in spending changes income, but people only slowly adjust to it. As they do, their extra spending changes income further. An initial increase in spending tends to have effects that take a long time to completely unfold. The existence of lags also makes government attempts to control the economy more difficult. A change of policy does not have its full effect immediately, but only gradually. By the time it has its full effect, the problem that it was designed to attack may have disappeared. Finally, though the life-cycle and permanent-income hypotheses have greatly increased our understanding of consumption behavior, data from the economy does not always fit theory as well as it should, which means they do not provide a complete explanation for consumption behavior.

The idea of a propensity to consume, which had been formalised in textbooks as the Marginal propensity to consume (MPC) – which described the extra consumption that would follow a $ of extra disposable income, was thrown out by Friedman.

The MPC concept – that households consume only a proportion of each extra $1 in disposable income received – formed the basis of the expenditure multiplier. Accordingly, if government deficit spending of, say $100 million, was introduced into a recessed economy, firms would respond by increasing output and incomes by that same amount $100 million. But the extra incomes paid out ($100 m) would stimulate ‘induced consumption’ spending equal to the MPC times $100m. If the MPC was, say, 0.80 (meaning 80 cents of each extra dollar received as disposable income would be spent) then the ‘second-round’ effect of the stimulus would be an additional $80 million in consumption spending (assuming that disposable and total income were the same – that is, assuming away the tax effect for simplicity). In turn, firms would respond and produce an additional $80 million in output and incomes, which would then create further induced consumption effects. Each additional increment, smaller than the last, because the MPC of 0.80 would mean some of the extra disposable income was being lost to saving. But it was argued that the higher the MPC, the greater the overall impact of the stimulus would be. Instead, Friedman claimed that consumption was not driven by current income (or changes in it) but, rather by expected permanent income.

Permanent income becomes an unobservable concept driven by expectations. It also leads to claims that households smooth out their consumption over their lifetimes even though current incomes can fluctuate. So when individuals are facing major declines in their current income – perhaps due to unemployment – they can borrow short-term to maintain the smooth pattern of spending and pay the credit back later, when their current income is in excess of some average expectation.

The idea led to a torrent of articles mostly mathematical in origin trying to formalise the notion of a permanent income. They were all the same – GIGO – garbage in, garbage out. An exercise in mathematical chess although in search of the wrong solution. But Friedman was not one to embrace interdependence. In the ‘free market’ tradition, all decision makers were rational and independent who sought to maximise their lifetime utility. Accordingly, they would borrow when young (to have more consumption than their current income would permit) and save over their lifetimes to compensate when they were old and without incomes. Consumption was strictly determined by this notion of a lifetime income.

Only some major event that altered that projection would lead to changes in consumption.

The Permanent Income Hypothesis is still a core component of the major DSGE macro models that central banks and other forecasting agencies deploy to make statements about the effectiveness of fiscal and monetary policy.

So it matters whether it is a valid theory or not. It is not just one of those academic contests that stoke or deflate egos but have very little consequence for the well-being of the people in general. The empirical world hasn’t been kind to Friedman across all his theories. But the Permanent Income Hypothesis, in particular, hasn’t done well in explaining the dynamics of consumption spending.

Getting back to the paper mentioned in the beginning, it finds deployment of a rich dataset arguing to point where the permanent income hypothesis of Friedman is nailed to the coffin. If the permanent income hypothesis was a good framework for understanding what happens to the consumption patterns of this cohort then we would expect a lot of smoothing going on and relatively stable consumption.

Individuals, according to Friedman, are meant to engage in “self-insurance” to insure against calamity like unemployment. The evidence is that they do not.

The researchers reject what they call the “buffer stock model” (which is a version of the permanent income hypothesis).

They find:

1. “Spending drops sharply at the onset of unemployment, and this drop is better explained by liquidity constraints than by a drop in permanent income or a drop in work-related expenses.”

2. “We find that spending on nondurable goods and services drops by $160 (6%) over the course of two months.”

3. “Consistent with liquidity constraints, we show that states with lower UI benefits have a larger drop in spending at onset.” In other words, the fiscal stimulus coming from the unemployment benefits attenuates the loss of earned income somewhat.

4. “As UI benefit exhaustion approaches, families who remain unemployed barely cut spending, but then cut spending by 11% in the month after benefits are exhausted.”

5. As it turns out the “When benefits are exhausted, the average family loses about $1,000 of monthly income … In the same month, spending drops by $260 (11%).”

6. They compare the “path of spending during unemployment in the data to three benchmark models and find that the buffer stock model fits better than a permanent income model or a hand-to-mouth model.”

The buffer stock model assumes that families smooth their consumption after an income shock by liquidating previous assets – “a key prediction of buffer stock models is that agents accumulate precautionary savings to self-insure against income risk.”

The researchers find that the:

the buffer stock model has two major failures – it predicts substantially more asset holdings at onset and it predicts that spending should be much smoother at benefit exhaustion.

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7. Finally, the researchers found “that families do relatively little self-insurance when unemployed as spending is quite sensitive to current monthly income.” Families “do not prepare for benefit exhaustion”.