For the last several months now, a debate is afoot about the sustainability of the much-applauded Indian growth rate in the face of a seemingly uncontrollable rate of inflation. The inflation, in turn, has been raging mostly in our agricultural sector and it is worth our while to investigate the nature of the problem.
To start with, an important question to ask is why it is agriculture rather than industry that is more susceptible to inflationary pressures in the context of a growth scenario. An obvious answer to the question lies in excessive demand for food. Even the government’s salutary Mahatma Gandhi national rural employment guarantee programme is being held responsible for the rise in food prices. If so, this is no less than a farce, for it implies that inflation is caused by the poor man’s food expenditure!
This quick answer ignores the supply side altogether. In this connection, Sergio Rebelo’s insights into the area of growth economics calls for attention. Rebelo, like many others, points out that the most important barrier to steady growth takes the form of a fundamental law in economics, namely, the law of diminishing returns. Put simply, the law states that in any production process, extra doses of a variety of resources combined with a fixed quantum of a given resource leads to a rise in output at ever decreasing rates. In other words, the rate of growth of output must fall in the presence of a fixed resource even if all other resources were to increase at constant rates.
The relevance of this law is all too obvious in the context of agriculture, where land constitutes the fixed non-augmentable resource, while seeds, fertilizers, water and so on are the variable resources. As per LDR, equal extra doses of the variable resources will yield less than equal extra quantities of an agricultural produce, say wheat. Alternatively put, to keep the output of wheat growing at a uniform rate, the variable resources must be increased not in equal doses, but in ever increasing amounts. To put this in technical terms, a given rate of growth of agricultural output calls for a larger rate of input consumption in that sector. This, so long as land size is constant and productivity is governed by an unchanging technology. This is not to deny the fact that if productivity rises due to technology improvement (as was the case with the Green Revolution), the constraints imposed by LDR could well be postponed, thereby permitting an equal rate of growth of outputs and inputs in agriculture.
Designating the variable inputs by the generic term ‘capital’, Rebelo argues therefore that in the absence of technology improvement, a steady growth in agriculture can be extracted from a fixed plot of land only if the growth rate of capital use is higher than the growth rate of output.
Once, however, the multiple inputs, fertilizers, pesticides and so on are captured under the blanket term ‘capital’, the word capital itself assumes yet another dimension. The purchase of capital, or all inputs put together, amounts to expenditure of money. On the other hand, money can be spent for non-agricultural activities as well, such as industry, of which manufacturing enjoys a lion’s share. For concreteness, one might choose the production of personal computers as an example. The inputs that go into such production — chips, wires, plastic and so on — are qualitatively different of course from those required by agriculture. However, as opposed to agriculture, extra doses of these inputs do not lead to diminishing extra produce. Two PCs call for twice the quantum of inputs as one PC, three PCs require three times. In a sense therefore, LDR does not work for manufacture the same way as it does for agriculture. But LDR does not disappear altogether. It assumes the form of an overall capacity constraint. Depending on the size of the factory, a certain maximum number of PCs can be produced per week say. Till that capacity is reached, the ratio of PC production to capital remains unchanged. Beyond that limit, it drops as with the case of LDR, but the drop is drastic. It falls sharply to zero.
With excess capacity, equal extra units of capital in manufacture produce a fixed extra units of PCs, while in agriculture, equal extra units of capital produce diminishing extra quantities of wheat. If markets are free, owners of capital will seek maximal returns from the employment of their capital. Since manufacture yields a constant rate of return (a fixed number of PCs) from each unit of capital, and agriculture yields ever smaller units, the capital owner will agree to employ extra capital in agriculture only if the price of wheat increases relative to the price of PCs as capital use increases in agriculture.
Thus, so long as LDR is in force and technical progress in agriculture is stagnant, there will be a natural tendency for agricultural prices to rise relative to that of manufacture, quite independent of demand forces. And, as Rebelo points out, this relative price movement must persist forever, unless agriculture is filliped by technical improvements. Moreover, for sustainable growth, capital employment in agriculture must increase at a higher rate than the rate of growth of agricultural produce.
The conclusions so far did not depend on demand forces at all. However, if demand is brought in and it grows at a rate higher than the rate of growth of agricultural output, the price of agricultural products will rise at an even higher rate than what is indicated by supply considerations alone. As noted, Indian policy planners have been harping on the demand problems alone, neglecting thereby Rebelo’s fundamental supply based argument.
Going back to supply once again, if the required excess in capital growth is not maintained, the desired growth rate of agriculture too cannot be achieved. In the Indian situation, particularly in West Bengal, land policy has reduced the size of individual plots to such an extent that employment of increasing quantities of capital, say tractors this time, has turned literally impossible. The result is that LDR works now with a vengeance, assuming almost the form it has in manufacture. The extra capital being non-employable in agriculture, the extra output associated with it will be close to zero.
These arguments depended on the assumption of free markets where capital is allowed to move in the direction of highest returns. In practice though, markets are not really free. Secondly, endless fragmentation of land has made it technically infeasible for large capital to move into agriculture. Ultimately, therefore, it is only small capital that is attracted towards agriculture in states such as West Bengal. This, in turn, brings about far too small a growth in agriculture compared to industry. Under these circumstances, even if the Rebelo argument of equalization of return to capital in alternative sectors were to be ignored, food prices should be expected to skyrocket. This, in fact, has actually been the case.
The problem can be addressed perhaps by opting for large-scale agriculture, though this is no easy task. Any move in that direction is almost certain to lead to social tensions. On the other hand, the attempt to shackle the food inflation monster by repeated increases in rates of interest charged for borrowing capital does not seem to be based on sound reasoning either. Since it is physically, rather than financially, infeasible to employ capital in agriculture, industry continues to be its only feasible destination. However, with increasing costs of borrowing, industry too is now struggling to survive. Neither agriculture nor industry, it would appear, is poised to attract capital. There is little wonder then that growth rates are not showing signs of improvement. And it is this insufficient growth rate that is the real cause of high inflation, rather than the other way around.