Why Claims Backing Demonetisation Are Faulty

Proponents of demonetisation say it was required for market correction. However, given the magnitude of government interference involved, it is likely to disrupt markets rather than correct them.

Demonetisation may significantly disturb the markets, which may adversely affect economic activity and employment. Credit: Reuters

Demonetisation may significantly disturb the markets, which may adversely affect economic activity and employment. Credit: Reuters

Prime Minister Narendra Modi’s 50-day deadline for a return to normalcy post demonetisation is over and the move has proved to be a failure. But despite clear evidence of its failure, the supporters of demonetisation still consider it to be successful, making several vague claims in its defence. One of the commonly made claims is that demonetisation will clean up the economic system. Another is that of employment generation.

It has been argued that India had jobless growth because a large share of the transactions were not accounted for. Some point out that high denomination notes were hurting the economy. The problem with such claims is that they are often accepted as the truth simply because they come from a renowned person or a minister. Even if these ardent supporters accept failure, it is attributed to the faulty implementation of demonetisation and not the policy per se.

But some of the claims made by those supporting demonetisation need to be looked at in more detail.

Claim: Black money generated in the past was negatively affecting growth rate, job creation

To understand the problem with this claim, one has to first understand the way in which black money affects the economy. There are two major sources of black money – corruption and tax avoidance. Corruption affects economic activity by increasing the cost of doing business. For example, if the cost of producing a commodity is Rs 100 and Rs 20 has to be paid to a government official as a bribe, then the actual cost of production is Rs 120. The higher cost of production has a negative effect on economic activities.

The second source – tax avoidance – does not affect economic activity directly. Instead, its effect is through a higher burden of tax on a small number of businesses. The higher burden of taxes affects the growth of these businesses, whereas the businesses that can avoid taxes enjoy higher growth.

Although it is difficult to say whether aggregate welfare loss due to lower production for some businesses is higher than the gains from higher production of others, there are other consequences of this that may hurt economic activity in the long run.

Three negative effects of tax avoidance may be identified. First, it leads to higher corruption and other wasteful activities in the economy. Second, it prevents businesses from shifting to more efficient production methods, and third, it interferes with the people’s consumption choices by changing the relative cost of commodities.

Even though corruption and tax avoidance hurt economic activity, the damage cannot be undone by recovering the black money that has been generated earlier. The government can only avoid future damage by preventing these activities.

For instance, if a firm had produced less in a previous year due to corruption, then recovering the bribed money from the corrupt official is not going to increase the production of that year. Similarly, the higher burden on tax-paying businesses in the past is not going to vanish just because the government had recovered some money today. It is because corrupt actions and not the previously created black money are responsible for the damage. The growth rate is hurt by the present creation of black money and not due to the existence of black money in the system.

Therefore, even if demonetisation had destroyed some of the existing stock of black money, it would not have any positive effect on economic activity. Some do claim that demonetisation will scare the dishonest and corrupt. However, the cases of money laundering by bank employees and recovery of crores of currency in new Rs 2,000 notes fly on the face of such claims. If the corrupt are not scared while the demonetisation exercise is going on, how likely is the move going to control the problem in the future?

Claim: Demonetisation was required for market correction

Ironically, this claim is made by some of the supporters of market economy. The bizarre thing about this claim is that demonetisation is against the basic philosophy of a market economy. Market economy requires inaction of the government. The believers in market economy ask for less interference. They believe that the markets are inherently good and it is the interference of the government that disrupts the working of markets and creates inefficiency.

It is the demand and supply forces that lead to market adjustment. In fact, the working of a market is not affected by the existence of black money. The advocates of market point to corruption and tax evasion as the outcomes of government interference and higher tax rate, thereby leaving no logical connection between demonetisation and market correction.

Demonetisation, on the contrary, is one of the biggest government interventions in independent India. Given the magnitude of this interference, it is likely to disrupt markets rather than correct them.

There is also the possibility of a demand-supply mismatch, which will require reallocation of resources. As per the estimates of the government and of several experts, black money in the form of cash was about three lakh crore. The media reports suggest that many hawala traders, corrupt bank officials and other such middlemen are converting the old currency notes into new ones for a commission of about 30-40%.

As a result, 30-40% of the black money kept in the form of cash will go to these people. These unintended beneficiaries of demonetisation are likely to put this money into different use than the original hoarders of the money. This new use may require the reallocation of resources. For instance, if those who lose the cash were not using the money, whereas the new recipients start spending it, then its effect will have the effect similar to printing new currency.

If it is the opposite, then it will lower the money supply in the economy. If the original owners were the producers of houses and the new owners are buyers, then production of houses will decline, whereas the demand will increase. There are a number of other possibilities. Most of these possibilities will require the markets to readjust.

If the estimates of black money are true, then demonetisation may significantly disturb the markets, which may adversely affect economic activity and employment. This problem would have existed even if the government were successful in destroying all of the black currency. In fact, the situation might have been worse as the whole money – instead of 30-40% – would have been put to a different use.

Claim: High denomination currency notes were hurting the economy and  cause for black money

It is argued that several economists have recommended the demonetisation of high denomination notes to control black economy and illegal activities. Some researchers, like Kenneth Rogoff, had argued for the gradually phasing out high denomination currency. However, this suggestion was not made for developing country like India.

Another problem with this argument is that it considers the value of currency to be fixed. High denomination notes are only problematic if they have high purchasing power. In reality, the value of currency note does not remain the same as its purchasing power declines with inflation.

The consumer price index of agricultural labour shows an increase in prices of about 47.76 times between 1960-61 and 2015-16, i.e. a bundle of goods that used to cost Rs 100 in 1960-61, costs Rs 4,776 in 2015-16.

Also read: The Dangers of Playing With Money Supply

In other words, there was about 48 times decline in the value of a currency note between 1960-61 and 2015-16. It means that the purchasing power of a Rs 1000 note in 2015-16 was almost equal to the value of a Rs 20 note in 1960-61. Therefore, Rs 500 and Rs 1000 notes in 2016 were no more ‘high denomination’ than the Rs 10 and Rs 20 notes in 1960-61.

The low value of Rs 500 and Rs 1000 notes is also evident from the fact that, unlike in the past, the high denomination currency was widely used by common people before demonetisation.

Moreover, the existence of black economy does not need the existence of high denomination notes, as the corrupt can accumulate wealth in other forms. For example, the corrupt can start using gold and silver in their illicit transactions. Given the lower value of demonetised notes when compared to the same denomination notes of the past and possibility of using other methods of accumulating wealth, the claim that high denomination currency was hurting the economy is not based on any sound reasoning.

Claim: Economy will bounce back once the currency notes are replaced

Pulapre Balakrishnan, Radhika Pandey and Rajeswari Sengupta have already pointed out that economic recovery may take longer than what is being claimed by the government. Claiming that the economy will recover once currency notes are replaced ignores the effect of income and expenditure decline on the expectations of the producers and consumers. Once the decline in money supply affects economic activity significantly, it is very difficult to bring the economy back to normal. The decline in income of the people in one period affects the sales in the next period.

A significant decline in sale increases the uncertainty in the economy and producers respond by lowering their production and postponing new investments. Given the uncertainty in income, the people may also start curbing their consumption, which will amplify the problem. In such a situation, even the banks may prefer to ration the credit if they fear an increase in their non-performing assets.

Claim: All currency will become accounted for, lowering black money generation

There is no clear logic behind this claim. Even if the government knows who possesses how much money today, it will not have any positive impact. The economic activity requires money to change hands. The benefits from economic activities are not the same for all.

As a consequence, the distribution of money changes over time. Since it is not possible for the government to ensure a 100% cashless economy, future changes in currency distribution will leave the government in as much dark about the money as it is now.

Claim: All money will come to the banking system, which is good for the economy

This claim is also the result of a misunderstanding regarding the use of money in the economy. The income level in an economy depends on the production of goods and services, and not on the money printed. The growth rate of the economy does not increase just because people have started keeping their money in the banks. To understand the reason behind this one needs to first understand the link between consumption and investment.

The first lesson in economics starts with the definition that resources are scarce and have alternative uses. In an economy, a part of the resources are allocated for the production of commodities that are to be consumed by the people (called consumption goods), while others are used to produce commodities which increase future production (called investment goods).

The growth of an economy depends on the production of investment goods. Since resources are scarce, an increase in production of investment goods requires people to postpone their consumption. More money in banks can only increase investment if somehow it can motivate people to postpone their consumption or lower the wastage. There is no reason to believe that more money in the banking system can do that.

Some do claim that it will make it easier for people to get a loan, which would mean lower wastage of resources. This claim, however, is not convincing. The clearing of a loan and the speed with which it is done depend on the bank’s assessment of the customer’s credit worthiness and the cost of recovering a loan. Both of these have nothing to do with all the money coming to banks or demonetisation.

If the government is serious about increasing investment, they must come up with solutions that can lower the wastage of resources and increase productivity. For instance, delays in projects due to inefficient regulations and weak contract enforcement lead to wastage of resources and adversely affect growth.

The faulty implementation of regulations such as environment laws also creates an atmosphere where people prefer to oppose otherwise beneficial investment.

In addition, investments in education and health increases the productivity of the labour force. Many researchers have pointed out that India must work to improve educational and healthcare facilities to reap the benefits of its demographic dividend. Any effort of the government directed to these issues will benefit the Indian economy much more than thoughtless moves like demonetisation.

Indervir Singh is assistant professor in the department of economics and public policy, Central University of Himachal Pradesh.