Can the Indian Economy Recover From the Shock of Demonetisation?

The government must announce fiscal measures to stimulate demand if it wishes to repair some of the damage it has willfully wreaked upon the economy via demonetisation.

The update to the IMF’s World Economic Outlook paints a mixed outlook for India. On the one hand, GDP growth is poised to take an immediate hit, with growth projected to slow down to 6.6% for 2016-17 – a whole percentage point lower than its earlier estimate of 7.6%. This reduction is largely due to the negative shock experienced due to demonetisation. The reduction in growth rates is expected to persist into 2017-18, with growth set to reduce to 7.2% against an estimate of 7.6%. However, the situation is set to return to normal by 2018, when the negative effects of demonetisation are supposed to peter out.

There are two problems with regard to these forecasts. Firstly, the notion that the current negative shock to the economy brought about due to demonetisation will not result in a permanent fall in growth rates rests on certain key assumptions – that consumption will rebound in the medium term and that more firms will shift into the formal sector as a result of the government’s measures to demonetise high-value notes, leading to a boost in growth. Both these assumptions are problematic.

Secondly, even if the economy grows at the same rate as it was forecast to in the absence of demonetisation, the level of unemployment would be permanently higher, due to the negative demand shock. The return of economic growth to trend does not invalidate the necessity for additional measures like a demand stimulus to reduce unemployment.

The revival of growth

The explanation for why growth will return to normal in the medium-term is as follows – as a result of demonetisation, individuals decided to put off purchases of certain consumption items and durables such as consumer electronics etc. This can be evidenced in the reduction of sales in the auto industry and of products like scooters, motorcycles etc. This led to a short-term contraction in output and employment. However, as the cash situation in banks and ATMs returns to normal and as more consumers decide to shift to cashless means of payment, economic activity would rebound and return to normal as people begin to spend on those purchases that they had put off due to the cash crunch. The only variable in question would be the time taken for the economy to reach back to its optimal position.

This reading assumes that short-run shocks do not have any long-run effects on the economy. Consider a worker who wishes to purchase a motorcycle. As a result of demonetisation, she loses her job and is unable to make this purchase. Even if the cash situation returns to normal, as long as she remains unemployed, she will not be able to purchase the motorcycle and hence demand in the economy is permanently lowered.

To assume that the economy will return to normal is to assume that the increase in unemployment has no effect on the ability of consumers to make purchases. It is implicitly stating that there is no reason to expect unemployment and incomes to remain low in the future, without ever providing a reason as to why that might occur.

Some versions suggest that the move towards digitisation will benefit the economy and bring about greater growth rates. The increase in taxation of ill-gotten wealth would increase revenue for the government, which they could use for a fiscal stimulus. Moreover, demonetisation has helped – some claim – move firms from the informal to the formal sector, thereby allowing for a more efficient economy.

These arguments do not hold. For one, the ability of the government to use increased revenues for a stimulus is bound by its adherence to the fiscal deficit rules. The under-estimation of the possible negative effects of demonetisation indicate that the fiscal deficit target – expressed as a percentage of GDP – would rise for any given increase in the absolute deficit, since GDP would have decreased by a significant amount. The ability of the government to implement a fiscal boost depends on whether it would be willing to loosen its adherence to the Fiscal Responsibility and Budget Management targets – there is no indication that the current government would be willing to do so.

Furthermore, the link between demonetisation and greater formalisation of the economy is tenuous. What demonetisation might lead to is the taxing of illegal wealth – this has nothing to do with the notion of the formal and informal economy, which has more to do with the structure of production. Manufacturing enterprises are classified as belonging to the informal sector if they do not fall within the ambit of the Companies Act, which applies only to those firms that operate with more than ten employees. It is unclear, therefore, how taxation of the firm owner’s ill-gotten wealth will lead to her increasing the size of her firm.

All these explanations do not address a central question. What are the motivations to induce investment? Investment is a forward-looking activity and will be carried out if business-owners are confident of the prospect of profits in the future. To assume that growth will rebound in the medium-term is to assume that investors will be willing to carry out investment regardless of the short-term demand contraction. This amounts to asserting that the economy will face no problems of demand in the future because investors foresee no problems of demand in the future. But this begs the question as to why would investors be so confident in the first place, given the current reductions in output and employment.

The future of growth

Let us assume that investment revives in the economy and the normal pattern of growth is resumed. This does not necessarily imply that the loss of employment would be made good.

Assume an economy that is currently experiencing no unemployment. Let the number of those seeking employment each year grow at 3% – this is labour supply. Let output per worker – or worker productivity – grow at 5%. The rate of growth of labour demanded by firms is equal to the rate of growth of output minus the rate of growth of productivity. In this instance, if the economy grows at 8%, then labour demand (8% – 5%) equals labour supply, and there would be no unemployment.

Now assume that the economy faces a temporary demand shock that is forecast to last only one period. Let the economy now grow at only 6%, with productivity growth unchanged at 5%. The rate of growth of employment is now only 1% (6% – 5%), short of the 3% growth in labour supply. This implies an increase in unemployment in this period.

In the next period, the economy regains its growth momentum and continues to grow at 8%, ensuring that all new entrants to the labour force – which grows at 3% – are able to find jobs. But this implies that those workers who have lost employment during the period of the demand shock will remain unemployed through all periods in the future, because the economy has not generated enough jobs for them. For an unchanged rate of productivity growth, the economy will have to grow by more than 8% for a few periods, to provide employment for the new job-seekers as well as those who were rendered unemployed due to the demand shock. The unemployment rate has been permanently increased even though the slowdown in growth is temporary.

The economy could grow at the same rate as before (8%) while generating and maintaining full employment if the rate of productivity growth were to reduce. But since the level of national income depends on productivity and technology growth, it amounts to saying that the economy must sacrifice some income growth in order to maintain full employment. This is not an illegitimate demand to make, if wealth could be distributed from the rich to the poor during this period of slowing income growth. It is hard, however, to expect the BJP to steer the economy down this route.

Furthermore, capitalists all wish to reduce their costs of production so as to increase profits and hence strive to make use of the very latest technology. There is no reason to expect them to shift to lower levels of technology of their own volition, for their main aim is to increase profits, not provide employment. Since globalisation allows Indian companies access to the latest technology of the developed world, the rate of productivity growth would continue to increase, given the rapid changes in technology currently being experienced. This would imply falling labour demand even though aggregate growth rates remain unchanged.

Attention has now shifted towards the budget and the policy measures to be announced in the aftermath of demonetisation. Some caution against fiscal stimulus, citing the fact that growth is forecast to return to trend. Stimulating demand in such a context, the argument goes, risks exacerbating inflationary pressures. These arguments are untenable. It is imperative that the government announces fiscal measures to stimulate demand if it wishes to repair some of the damage it has wilfully wreaked upon the economy.

Rahul Menon is a professor of economics at St. Xavier’s College.

Read Comments