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Subsidies In An Inflated Economy: Is It A Wise Move?

by Apr 21, 2019Economics0 comments

A lot has changed in the world economy post the economic upheaval of 2008 which affected both the developing and the developed nations.

These changes have helped in undermining growth in the emerging markets of the world. By emerging markets, we mostly mean developing nations.

But the policies adopted by these emerging markets have also paved the way for the future policies and economic reforms that will be undertaken by all the major world economies.

With the happenings in the global economy, the balance of power has shifted in favour of the developing countries. The recent economic successes of the developing nations have improved the prospects of the residents of these countries. The recent developments have also furthered the already strong demand for the commodities in these markets.

The curse of the modern economy: inflation

With such a massive shift in demand in the developing countries, the Multinational corporations have completely shifted their focus to these emerging markets. These markets bear huge promise in terms of increased spending abilities of billions of people who have just realize their purchasing power and are eager to consume the latest offering from the international markets.

Although it looks promising right now, these MNCs are also aware that even if inflation moderates due to the energy prices remaining lower for a while, these developing nations will create policies for price control and subsidies to deal with commodity demand to balance the ongoing risk of economic or political upheaval.

We can’t clearly state whether subsidies have a positive effect or a negative on any economy as this can be a normative judgment but as an economic intervention, subsidies have been inherently contrary to market’s demands. The policy has been used as a tool of corporate and political cronyism.

The subsidies that cover commodities like food grains, fuel and metal, utilities like electricity, transportation, services like healthcare, labour and entertainment mostly impact the overall price changes for a diversified set of products and services, and allow the economy to function in a more flexible manner in the highly toxic environment of Inflation.

Certain developing countries like Malaysia have already used such policies to avert public demonstrations and protests. Malaysia has promised food and fuel subsidies of more than 7% of GDP. China has spent a major part of their GDP on fuel subsidies in 2008. The countries have been somehow able to maintain subsidies to win public support and appreciation for a while but in view of the economic slowdown, maintaining subsidies are deemed to become more and more difficult.

Understanding Inflation

Inflation is the rate at which the average price of selected goods and services increases in an economy over a period of time. It is a quantitative measure and taps the constant rise in the general price levels where unit currency buys less than earlier. Inflation is often expressed as a percentage and increase in inflation decreases the purchasing power of any economy.

The simple concept of inflation is based on the theory that money loses its value over a period of time which decreases the value of 1 unit of money and the power of that 1 unit decreases. So if earlier if you could buy X units of goods with that money, over a period of time, you will be able to buy less than X units of goods with the same amount of money.

The phenomenon of inflation has however recently become more dominant in the sensitive economies and thus the value of currency seems to become more unstable and shows movements over a smaller time period. It is not always that purchasing power decreases over a period of time.

The purchasing power of unit currency might also decrease over the period of time as the price of the commodity increases but it can also increase if the price decreases at a later period. The phenomenon is known as deflation and is the opposite of inflation.

Measuring the price changes of individual products over time is easier but in an economy, human needs extend beyond a couple of products and there is a whole basket of goods and services that an economy needs to think about.

Such a diverse set of products, goods and services that provide a comfortable life to the citizens in an economy, also help understand the impact of price changes. Thus there is a need for a single value representation to assess the increase in the price level of goods or services in an economy. This is where inflation comes in to play.

Why Fight Inflation and Disrupt the Forces of an Economy?

For any economy, as prices rise, the currency loses value and this loss of purchasing power impacts the general cost of living for the citizens that ultimately results in the deceleration in economic growth.

Economists are of the common view that if sustained inflation occurs the nation’s money supply growth outpaces economic growth and to bring back this growth, most governments and the country’s monetary authority, as the Reserve Bank of USA, use measures to fight inflation.

These authorities try to keep inflation within limits to keep the economy running smoothly. One such measure used by lawmakers is to provide subsidies to its citizens- A brief respite.

Benefits of Subsidy

Subsidies, commonly given by governments, are any type of support that is generally provided with the core aim of promoting social and economic policy. Subsidies can come in various forms like direct cash grants or interest-free loans, indirect tax breaks, low-interest loans, insurance, rent rebates and accelerated depreciation. It is usually aimed at sectors like agriculture, fuel, infrastructure and the commodities market

In a smaller economy that is just gaining momentum, subsidies can actually help these economies gain traction. Below are some of the major benefits of subsidies:

  • Help to Boost Production:

Most common subsidies are provided to the producers in the economy. The producer/ production subsidies help the producers or goods and services as they help them in getting market price support or payments to factors of production. These subsidies encourage production activities in an economy and help produce more goods and services

  • Helps Increase Consumption:

The consumer/ consumption subsidies are very common in an economy and they help reduce the price of goods and services for the consumer as means of direct subsidy. This is mostly done for oil/ petroleum and any other public goods that are for daily consumption are a must have for the public. This helps regulate market forces and decreases the price of goods and services

  • Increase Savings:

The tax credits and reimbursements provided by the government helps offset the lower overall price through the savings received by the producers.

  • Increases Social Efficiency:

The consumers pay the socially efficient price, this will include external benefit.

Subsidy asa Tool to Lure the Public

The subsidy has been seen as a potential tool by governments to lure the public, especially during elections. The price increase that is caused by inflation turns out to be painful for local consumers and the public then mostly blames the reform-minded politicians, markets and foreign corporations.

If the citizens are upset, this might lead to populist rage which could also be a result of the collapse of subsidies. Such an upset can lead to election upsets, unpredictable regulation and greater nationalization of resources. Such actions by governments could destabilize political regimes. Escalating food prices could, for instance, led to the ouster of political leadership which can obviously have serious consequences to foreign investments.

Potential Problems of Subsidies

Although subsidies have been an age-old resort by governments to offset inflation and have helped these government gain short term brownie points with their voters, the practice comes with its own set of demerits which can’t be ignored. Some demerits have been listed below:

The cost of the subsidy is met through taxation. Some types of taxation like income tax may reduce incentives for workers. The most efficient method to raise revenue to subsidize positive externalities is to tax goods with negative externalities

It is difficult to estimate the positive externalities for the government or the central bank. Therefore these authorities may have less information about services and how much they need to subsidize.

The danger that government subsidies encourage the firm to be inefficient is also persistent. The government has to rely on subsidy rather than on improving efficiency with the key industries that are basic to an economies development like fuel and agriculture. This may give short term gains but in the long run, the industry suffers largely

The effect of subsidy largely depends on the elasticity of demand. Thus it is not always a favorable policy for any government and may in certain cases backfire.

The developing nations that have come out to be the most promising in terms of development have also contributed the most to global inflation as they have brought bigger markets in the international economy. The promising nations are also the most vulnerable economies that get immediately affected by global movements. USA has been one such example. Various governments in USA have been more people pleasing governments then actually trying to stabilize the economy for its longer good. The vote bank in USA has been heavily dependent on short term policies and that has resulted in the use of subsidies as a frequent tool.

Subsidization: An Aid for Sensitive Governments

The economy has heavily subsidized diesel fuel that has led the state-run oil companies to post huge losses. The USA government has been using subsidy as a policy for the longest time. It is an economy that has faced a lot of wrath due to inflation and thus the resultant policies of subsidization.

The country has faced a severe crisis when the price of diesel increased by 10% which led to a massive strike by truckers. Since most of the goods were transported by trucks in USA, the situation was very delicate for the government of USA. A similar situation was seen in Burullus, Egypt after the government stopped the sale of subsidized flour to its citizens.

Energy exporters have been extremely sensitive to the risks that are created by price supports for their consumers. Many countries have used revenues from commodity and high oil prices to subsidize their citizens to minimize discontent. The slowdown in big industrial economies like Russia has been offset by the government spending of oil revenues on providing subsidies to the citizens.

But the bigger question remains- Does the policy of subsidizing consumer goods eventually help these economies?

Ultimately as time will tell the countries that will remove subsidies will be helping themselves. They will attract more foreign investment and with more and more foreign investors in these economies, the economies will become more efficient. It is the rich who take the most from subsidies according to IMF study done in selected emerging-markets the richest of households receive almost half of the subsidies.

Cutting subsidies free governments and help these government divert more resources to poor and toward other social programs like education, health care, environment, and infrastructure projects. It also enhances energy efficiency and increases investment in developing alternative sources of energy.

Nevertheless, the governments will have to proceed cautiously even if they decide to discontinue subsidies. This will definitely risk their substantial short-term plan and outrage a large section of their public, constitution, voters and create temporary outbursts among the citizens.

But if they are successful in making the public understand the impact of removing subsidies and ensure that they let the forces of economics prevail as per their free will, them these governments and lawmakers will definitely attract a lot more positive environment for themselves and also for the multi-national companies investing in them. 

Author Bio:

Michelle Johnson has an MBA degree with 6 years of work experience in multiple fields including marketing, marketing research, analytics and insight development. She has worked with clients in multiple industries like retail. FMCG, BFSI, Insurance and real estate.