Choking Money Supply Is Not the Way to Tackle the Black Economy

Making India a less-cash economy will not necessarily end the generation of black money. It only means that the circulation of black income will take place differently.

A bank employee takes out a bundle of old 500 Indian rupee banknotes from a sack to count them inside a bank in Jammu, November 25, 2016. REUTERS/Mukesh Gupta

A bank employee takes out a bundle of old 500 Indian rupee banknotes from a sack to count them inside a bank. Credit:Reuters/Mukesh Gupta

Prime Minister Narendra Modi recently announced the government’s decision to demonetise high denomination currency notes in order to tackle the black economy in the country. Most analysts, however, believe that a note ban will not make a dent, much less eliminate, the black economy in India.

The notion that banning high denomination notes will damage the parallel economy comes from the idea that the black economy is fuelled by cash; the logic is that once a substantial amount of cash is sucked out of the economy, the black economy gets strangled. But this isn’t necessarily true.

Manmohan Singh, the former prime minister, has said that this move will lower the growth rate of the economy by at least 2%. Those in the government have challenged this assertion and have defended the move by saying that the inconvenience from demonetisation is a temporary pain which will give long-term gain.

However, according to official data, the India economy was doing well and had become the fastest growing major economy in the world. So why a sudden move that threatens this achievement – even if temporarily?

The reasons for it are political and not economic. The economic consequences – both in the short and the long term – need to be understood because they have the potential to impact the political calculus as well.

Money is not consumed by individuals so its shortage should not have a direct effect on them. However, in a modern economy, money is crucial because it is circulated in the form of incomes – which people need to live. It enables people to exchange goods and services, which is crucial for the production and generation of incomes. It removes the need for a double coincidence that is required in a barter economy. Bartering can become very circuitous and lead to a lot of wastage of time which could have been used to produce more of goods. Hence, in a complex economy, barter leads to inefficiency and the presence of money simplifies exchange.

Money does not mean cash alone. One can use cheques, credit and debit cards and electronic money to conduct transactions. But the currency that is issued by the central bank is the base on which the other forms of money are created. Hence, a shortage of currency means that the medium of exchange is in short supply and it affects the production and distribution in an economy.

While several businesses along with the well off and the middle classes maybe using cheques, cards or electronic transfers, the unorganised, small and cottage sectors, and the poor and illiterate who do not have bank accounts, are not as fortunate. They use cash for their transactions and a shortage of cash hits them the most. As for the more fortunate ones, it is a matter of habit whether or not they use cash for transactions. No wonder then there are long lines at the banks to withdraw cash. The government is proposing a ‘cashless society’ since it feels that this will eliminate corruption. Unfortunately, they are mixing up two different things.

In the US, where credit and debit cards have been in use for 50 years, the use of cash continues. It is a question of habit. Despite the widespread use of plastic cards and electronic money in the US, the black economy flourishes. So, the link between cash and black income is weak.

If money is in short supply, gold may be used, payments can be made abroad or money can be held in foreign exchange. Thus, the demand for gold and foreign exchange has shot up in India since demonetisation was announced. Under the gold monetisation scheme, the government has minted gold coins which can be easily used. So, a less-cash economy does not imply that black income generation will stop. Only the circulation of black income will take place differently.

Yes, the nation should move towards a less-cash economy in order to reap the benefits of efficiency, but that should not be confused with curbing the black economy. That requires a whole different approach. The black economy does not mean only cash. Besides, there is nothing stopping the new currency from becoming part of the black economy. If less cash is issued than what there was earlier, it may cause problems for the white economy, especially the unorganised sectors, but the black economy, which is concentrated in the hands of the well-off, is unlikely to be affected.

In government and private institutions, salaries and payments may be made in cheque, but bribes are extracted in a variety of ways. Post demonetisation, many ways of converting black money stashed in old currency into new currency have been devised. Jan Dhan accounts are being widely used. If an unscrupulous deposit of Rs 10,000 per account is made in 20 crore accounts, Rs 2 lakh crore would be converted into new currency. Thus, the black income circulation will continue as earlier.

Currency is neither coloured black nor white. So, the cash in the economy can be used to circulate both the black and the white economies. Thus, the idea of demonetisation and less-cash economy have little to do with the curbing of the black economy.

The banking channels, share markets, informal money markets, hawala and the flight of capital will continue to be available to circulate in the black economy. In fact, some of these ways of circulating the black incomes will become more active, leading to loss of savings to the economy. There are reports that the poor, the farmers, the small producers, big business and industry are all hurting due to a fall in demand and loss of employment.

Would the government get a windfall as a result of some of the Rs 14 lakh crores of notes not coming back into the system? This could be used to argue that the black economy has been tamed. It may also enable the government to increase pro-poor spending and the Robin Hood effect could politically help the government.

When cash is deposited in the bank by an individual, it goes into that person’s account as saving. The bank is obliged to return that to the RBI so that the old notes may be destroyed. The banks’ deposits will increase above what they are required to keep with the RBI – which is called the cash reserve ratio. The currency issued by the RBI was its liability, so as soon as the demonetisation was announced, its liability decreased by the amount of demonetisation. But its assets did not fall. So, in its balance sheet, there is now a huge surplus. Can this be used by the government for the pro-poor schemes?

The RBI is, however, obliged to give new currency in lieu of the old extinguished currency. People are going to banks to withdraw what they have deposited in their accounts so that they can carry on their transactions. The banks are obliged to give people the money they ask for from their accounts and they will have to get it from the RBI. But the demand for cash will be higher than before since people are hoarding currency and not circulating it. So, even if some of the old money does not come back into the banking system, the RBI will have to issue more cash than earlier to maintain the credibility of the system, otherwise, the cash shortage will continue with all its adverse effects.

Hence, the black economy cannot be curbed by choking off cash. What can be done to get out of the morass that the economy is in? Liquidity needs to be immediately restored by allowing the old notes to be used. Some of the adverse effects in the economy would then reverse. But if the current situation is allowed to continue for a month or more, there would be irreversible and long-lasting damage to the economy and the political fallout would be huge.

Arun Kumar is the author of The Black Economy in India and is a former professor of economics at Jawaharlal University.