It has now been over a month since the government announced a partial ‘demonetisation’ of Indian currency. Perhaps never before in history have such a large number of people been involved in an economic experiment such as this one. Prime Minister Narendra Modi has argued in speeches that demonetisation was necessary to root out corruption and the long term benefits will surely compensate for the inconveniences experienced in the short run. Although the government has not given a clear idea of what these benefits will be, simple economic principles are sufficient for us to figure what the possibilities are.
It is evident that since the Rs 500 and 1000 notes are no longer legal tender, hoarders of unaccounted money will be sitting on worthless paper. Of course, the government has made it possible for them to hand over all their money at penal rates of tax but it is unclear if many would want to do this as they would have to explain the source of their funds. There are two problems with the approach. First, not all hoards of cash are black money. Some – especially people in rural areas and those who do not use the formal banking systems – hold cash that is perfectly legal. These stashes are maintained to take care of medical or other emergencies that are a common part of life. The demonetisation has unnecessarily punished such people.
Aware of this, the government has made arrangements for them to deposit money into banks, under the provision that amounts up to Rs 2.5 lakhs will not being subjected to any kind of scrutiny. This may have presented an opportunity for those with black money to convert it into white. It is evident that people have already attempted this with many reports detailing how Jan Dhan accounts with almost zero balance have shown a spurt in deposits since demonetisation was announced on November 8.
Secondly, there is reason to believe that persons holding black money have converted the cash into legitimate assets, such as gold, sales of which have surged since demonetisation was announced. But the idea that people with unaccounted income keep it in the form of cash is suspect. They usually try to convert it into assets to escape detection and to avoid losing its real value to inflation.
Trying to get at black money through demonetisation is not very sound, as it can hurt the innocent but, more importantly, may be a case of closing the stable door after the horse has bolted.
Impact on income flow
I have so far argued in terms of its implication for the existing stock of money representing black income but demonetisation also has an impact on the flow of income in the future. This aspect appears not to have been clearly understood by the government and its critics, each of whom has ignored one of the two flows that are now being triggered. The government has pointed out that when money is deposited in banks, the banks’ ability to lend increases. This is indeed true as we have seen happen. We have even seen the lending rate of the major banks come down due to this. This is good for the economy. But of course, a reduction in the rate of interest alone is not sufficient to restore the economy to a better state. This is because there must be a sufficient number of people who will borrow from the bank to invest. This cannot be assumed and it unlikely to happen very quickly due to many reasons.
The second of the flows affected by the demonetisation is the flow of income from consumption activity. Money, it must be remembered, is not only a store of wealth but also the medium of exchange in an economy. Without money, there can be no transactions. When approximately 86% of the money supply is sucked out, a large volume of transactions cannot take place as the cash required is unavailable. Evidence of this mechanism being at work is seen in the empty food markets in India. Commerce has grounded to a halt.
This consequence of demonetisation appears to have been ignored by the political leadership. In the far flung villages of northern India, it will take some time for economic activity to revive, for, when the economy is depressed, investment is unlikely to increase even if the rate of interest has been lowered.
The impact of demonetisation on the flow of income can be assessed from whether the positive flows resulting from larger deposits into banks will exceed the reduction in income due to shortage of cash affecting consumption. When this is lower there will be a reduction in income in the economy.
My judgment is that the net flow of income will be negative or that output will be reduced due to demonetisation. This seems to have been ignored by Modi when he spoke of the inconveniences brought on by the note ban. The loss of income when an economic activity cannot take place is not the same as the inconvenience involved in exchanging old notes.
An end to corruption?
The prime minister has presented the case for demonetisation in terms of rooting out corruption. Of course, to the extent that hoards of black money have been demonetised, corrupt activities of the past have been punished. But there is nothing in the scheme that can prevent corruption in the future. In fact, days after the announcement, Gujarat’s anti-corruption bureau caught two officials from the public sector organisation Kandla Port Trust for demanding a bribe in new currency for the clearing a consignment of goods. Since then, far greater stashes have been unearthed in raids in Chennai, Karnataka and Delhi.
This points to two things. First, periodically changing the currency in circulation can do little to eliminate corruption at its source, for which it is necessary to target the very generation of unaccounted income. In order to target unaccounted income it is necessary to re-engineering the manner in which the government and citizenry interact, with a public record and independent oversight of each interaction. This is not difficult to achieve. There must be a provision for the citizen to register with the government any demand for gratification made by a member of the bureaucracy. To ensure that frivolous or malicious allegations are not made, anonymous complaints ought not to be entertained and all complaints should be made public.
Secondly, as most black money is believed to be in generated in the registration of properties, details of all property transactions – including names of the two parties and the value of the sale – must be entered on the concerned public authority’s website as soon as the deal is concluded. In today’s IT environment such transparency is easy to achieve. The possibility of public scrutiny, as opposed to that of the income tax department in private, would make a difference to the generation of black money. It should also provide some relief to citizens who are otherwise at the mercy of an unaccountable bureaucracy.
If the Modi government is serious about ending corruption it must lay out a plan for ending the generation of black money in the interaction of the citizen with the government machinery, including the income tax department itself.
Then there is the issue of election funding. The prime minister has mooted public funding. This is contestable. In a democracy, it is not clear that citizens should be asked to pay for political parties often campaigning on sectarian agendas. However, there is a strong argument for reforming current practices. First, the limits on spending should go but so must the practice of allowing anonymous donations to political parties. In fact, political parties must be brought under the purview of the RTI Act. Arguments that political parties are not public bodies simply does not carry. Political parties are claimants to the government and if they come to power will control every aspect of the economic activity in the country. The citizen is fully entitled to know about their financial transactions. A demonetisation allegedly aimed at ending the generation of unaccounted income that has nothing to say about the funding of political parties is not credible.
The potential of demonetisation in eliminating corruption is limited. Corruption thrives because surveillance and enforcement by public authority is weak. But we cannot ignore the role of social norms while seeking to end corruption in India. Corruption exists partly because it is tolerated by society. In India, personal freedoms are highly regulated by social sanctions. This repression is mostly justified by references to religious sanctions and cultural traditions. By comparison, there is no shame in amassing illegal wealth or moral injunction against the giving or taking of bribes. It is seen as purely transactional and has no moral resonance whatsoever. This leaves a role for civil society to fill in ending corruption. It would be populist to ignore this.
Pulapre Balakrishnan is professor of economics at Ashoka University, Sonepat, Haryana and Senior Fellow-elect at the Indian Institute of Management, Kozhikode.