Narendra Modi Just Dug Himself a Great Big Hole

In a speech full of faulty economic reasoning, Modi made one factual claim – the number of Indians with official incomes greater than Rs 10 lakh is just 24 lakh. If demonetisation really works, he needs to up that figure substantially in the next two years.

People in Patna watch Prime Minister Narendra Modi deliver his speech on New Year's Eve. Credit: PTI

People in Patna watch Prime Minister Narendra Modi deliver his speech on New Year’s Eve. Credit: PTI

It was a speech of not just shifting goalposts but vanishing playing fields, and yet Narendra Modi couldn’t resist making a rhetorical point about black money that might well prove costly for him by the time 2019 comes around.

“I wish to share some information with you, which will either make you laugh, or make you angry,” he said, with a flourish half-way through his speech. This was the point where everyone expected him to reveal how many old Rs 500 and 1000 notes had become ‘worthless paper’ thanks to demonetisation but he had another number in mind: “According to information with the government, there are only 24 lakh people in India who accept that their annual income is more than 10 lakh rupees. Can we digest this? Look at the big bungalows and big cars around you… If we look at any big city, it would have lakhs of people with annual income of more than 10 lakh.”

Until then, the prime minister had sought to sweep the growing public concerns about the effects of his demonetisation decision under a fraying carpet of nationalism. But by drawing attention to a stark statistic in an attempt to provide some justification for the chaos he has unleashed in the lives of hundreds of millions of poor Indians, Modi has unwittingly laid down a new metric by which the success or failure of his supposed drive against black money must be judged: will he manage to add the “lakhs of people” who have an income of more than Rs 10 lakh to the list of those who pay income tax? If he doesn’t, then what was the point of subjecting the whole country to so much disruption and pain?

Finance minister Arun Jaitley initially claimed that a certain proportion of the demonetised notes would remain outside the banking system and get extinguished, thus providing a blow to the black economy and a fiscal boost to the government.

When they realised there was unlikely to be significant extinguishing and that most of the high denomination notes in circulation would probably end up getting deposited, Modi and  Jaitley claimed the income tax authorities would be able to track down the owners of black money since their funds had entered the banking system.

Astonishing claims about cash

Now that it is apparent the IT department will not find it that easy to undertake such a massive exercise – its inefficiency is the reason the list of those with official incomes of Rs 10 lakh and over is just 24 lakh to begin with and is unlikely to grow – Modi has tried to sell another bizarre idea to the public about why the cashless hardship they are putting up with is in the national interest.

“Over the last ten to twelve years, 500 and 1000 rupee currency notes were used less for legitimate transactions, and more for a parallel economy,” he claimed in his speech on December 31. “The excess of cash was fuelling inflation and black-marketing. Lack of cash causes difficulty, but excess of cash is even more troublesome.”

Let us consider these astonishing assertions one by one. Modi says that most of the old Rs 500 and 1000 notes were used in the black economy rather than for legitimate purposes

First up, he needs to provide some evidence to back up this claim. Second, even Jaitley, who noted that 25% of high-denomination notes got extinguished in 1978 (and were probably used in the parallel economy), believed the corresponding figure for the 2016 exercise would likely be less than that. So on what basis did Modi tell the people of India in a televised national address that most of the notes he demonetised were not being used legitimately?

Modi’s second assertion – that the excess of cash was fuelling inflation – simply reflects his poor knowledge of basic economics. Indeed, it is astonishing that no one in the PMO or finance ministry had the economic literacy – or the moral courage – to tell the prime minister that the opposite is true, that bank deposits are more inflationary than cash holdings with the public. When the public deposits cash, either voluntarily or, as is currently the case, under duress, banks keep only a portion of this with the RBI as reserve (depending on the ‘cash reserve ratio’) and lend the rest. If the CRR is, say 10%, and an individual deposits 1 lakh with her bank, this leads to an expansion of bank deposits by a factor of 9. This increased money supply is bound to be more inflationary than if the individual had held on to her cash. My monetary economics is rusty so I checked the position with a former board member of the Reserve Bank of India. Pat came the answer: “When M1 enters the banking system and bumps up M3, that will, ceteris paribus, give an upward thrust to inflation.”

What about the third claim Modi made, that “excess of cash is troublesome”? World data suggests there is little or no correlation between the amount of cash in circulation and corruption.


Prime Minister Modi delivering his speech. Credit: TV screengrab

Banking on bank deposits

Modi made another assertion that was both naive and disingenuous when he praised himself for having generated a huge increase in bank deposits. “History is witness that the Indian banking system has never received such a large amount of money, in such a short time,” he said, before holding out the promise of easier credit for poor and middle class citizens.

This assertion is disingenuous because the deposits were coerced and are likely to be reversed as soon as people are able to withdraw their hard-earned money from the banks. But it is naive because Modi and his advisors have not understood the theory of money demand. The demand for money is the amount of assets or wealth that people want to hold in the form of cash. This, in turn, is a function of the volume and frequency of their transactions as well as of interest rates (i.e. the opportunity cost of holding cash). There is also a third component, which is the precautionary demand for money. While the transaction and speculative demand for money may be constant, the precautionary demand for money is likely to increase as a result of the cash shortages of the past two months. Indeed, the longer the economy is cash constrained, the higher will be the precautionary demand so chances are that once the banking situation normalises – as Modi has promised it will – there may actually be a fall in aggregate bank deposits compared to what they were on November 8, 2016, when the demonetisation madness started.

Informal economy is not always black, formal not always white

Modi also appears to be guilty of equating the informal economy with the parallel economy. “Economists”, he said, “agree that when cash is outside the formal economy, it is a cause of worry.When it joins the mainstream, it is an opportunity for development.”  In fact, the informal economy in India is very much part of any logical definition of the “mainstream”. Cash may be the preferred medium of exchange  of India’s informal economy but only a fraction of the informal economy consists of fiscally (or legally) illegitimate transactions. Similarly, a fraction of the formal economy too generates numerous possibilities for black income (via over-invoicing, for example, or the various ingenious methods used in the 2G scam).

Whether they occur, black economy transactions need to be stopped but the mistake Modi made was to buy the pup that demonetisation would be a silver bullet. He now knows it is nothing of the sort and that is why he devoted the bulk of his ’50 days of demonetisation’ speech on Saturday night to listing out various welfare measures his government was taking or going to take for the benefit of the poor. At some stage, it sounded as if Modi had stolen a march on Jaitley and was presenting an early version of the national budget. I will leave the parsing of the schemes he announced to those more qualified than me but at least two of his announcements – for pregnant women and farmers – have already been exposed as overblown:

The weakest point of this shifty speech was when Modi sought to address public concerns about the lack of any action on his part against the role of black money in big politics. Here, there was no promise of change, no scheme: “I urge all parties and leaders to move away from a “holier than thou approach,” to come together in prioritising transparency, and take firm steps to free politics of black money and corruption.”

What the prime minister did was to cleverly use the growing anxiety about the role of money power in politics to hard-sell his idea that all elections in the country – Lok Sabha and assembly – be held simultaneously. Whatever its merits or demerits for electoral democracy, as an anti-corruption proposition it is morally suspect: we politicians will always need black money to fight elections, he seems to be saying. The only way to have less black money is to have fewer elections.