Watch: Renowned Economist Arun Kumar Says Demonetisation Will Not Turn Black Money to White

M.K. Venu, founding editor of The Wire, and Arun Kumar discuss demonetisation – the short-term and long-term effects on the economy, the Artha Kranti proposal and more.

To discuss some of the complexities of what lies ahead we have with us a very eminent economist who’s done extensive work on black economy. Probably one of the few to have really studied India’s black economy – the anatomy of black economy­ – professor Arun Kumar who taught at JNU and even now has a keen interest in studying the evolution of India’s black economy. Welcome to our show, professor Arun Kumar!

Thank you.

You have been talking about this for some time now – suddenly this a new subject for many people. But you’ve been talking about this for decades now.


At this moment, the way the whole situation, the economy, the way it’s behaving, evolving – you were the first to have said that at the end of this whole exercise there may not be much demonetisation, because the bulk of the money is getting pushed back into the banking system.


You’re the first to say, probably 95% of the money if it comes back into the banking system will be very embarrassing for the government because the government’s objective was to attack the black component of the cash economy.


So where do you see this going forward?

Okay, let me give an analogy which I’ve been using very often now.

About the blood?

Yes, not the transfusion, no. You’ve withdrawn 85% of the blood from the body and only put back 5% or 10% slowly. Now if that happens, then the body will collapse – the same thing is happening with the economy. Money is actually used for circulation – nobody eats the money, you buy things with it. You know you buy from the retailer who then buys from the wholesale dealer, who then buys from the producer who then pays wages and that’s how circulation happens. This circulation is stopped. Now when you stop the circulation, these transactions don’t take place – whether it be in the unorganised sector, or be it in the organised sector, whether it be transporters, whether it be, teachers doing tuition or, doctors you know – so everybody gets affected.

So, what is your sense about the deflation in economic activity?

That’s what I was coming to – therefore economic activity begins to cease. When people don’t have money to pay for transactions, then transactions begin to slow down. Also, what has happened is that hoarding is taking place. Because currency is short, so people are hoarding small denomination currency notes and, Rs 2,000 currency notes are not circulated because people are not willing to take it – or if they need to buy something small, then they can’t use it. Next, what has happened is that people have postponed discretionary spending. So if you wanted to buy a shirt, you say – okay, at the moment things are uncertain, I don’t have cash, let me postpone it by 3 months. I have the money in the bank but I don’t have cash in hand.

So you’re hoarding money.

So you’re hoarding money and also postponing discretionary expenditure – so whether it be for consumer durables or semi-durables or whether it be for the FMCG goods – everywhere, demand is falling short. Now that affects the large-scale industry also, so even though large-scale industry may be able to transact in terms of credit cards and debit cards, and may not be directly affected by the cash shortage – they have money supply in the broader sense of money supply. But still the demand is being affected and that is affecting transporters, that is affecting wholesale dealers. For instance, last week, the Wholesale Trade Association said business is down to 70%. Now suppose that this is an exaggeration, but even if it’s down by 20% that’s a huge drop.

Actually, you’re right. Even the large industries have been saying on TV channels that they are shutting their factories and that some shifts are being reduced.

Correct. That is because inventories are piling up. Because demand is not there so inventories pile up and when inventories pile up, it’s a signal that you have to cut back on production. When you cut back production, then you retrench workers and when that lasts for more than a month then you begin to have more permanent effects – NPAs (non-performing assets) will increase because if profitability is hit for a month, then you can see that the NPAs will begin increase.

In the initial phase, there was a narrative that banks will gain from it. So the bank stocks went up, but in the last one week, bank stocks actually went down. There was a realisation that banks are also not free from economic effects. They had a downturn.

But there are also going to be other effects on the banking system which we can come to, because this money that has gone back into the savings accounts, is not really bank’s money. This is not something that they can use to cover their NPAs. They will get withdrawn – but even at the moment, they are not their funds. They are the funds of the people who have deposited the money on which they have to try and earn a return. If they don’t earn a return on that and pass it on to the RBI for replacement with new currency – then it will be a loss to them also.

And finally, one argument of the government was that you suffer pain in the short term, but in the medium or long term there will be a big fiscal boost. And partly from the black money extinguished, three lakh crore will come into the government’s hands and they will pump it around the economy. But even that possibility seems remote. According to you, even if 95% of the money is pushed back into the banking system there’ll be hardly anything left for that fiscal space that the government was talking about.

You’re absolutely right. The money that is issued which is currency in circulation – that’s like a liability of the Reserve Bank of India. Assets are created by the government by floating bonds. Now if the money doesn’t come back, then the liability is going down and the assets remain the same. So there is surplus and it was felt that the surplus could be utilised. However, most of the money is going to come back. Secondly, because of the hoarding, the amount of money required in the economy will be larger than what is being withdrawn, because the shortage is likely to continue. And we can discuss what kind of shortage – so they will have to print more than 14 lakh crores to take care of the shortages. You see people’s habits are being affected because now, people will be scared in case this is repeated and they find themselves short. So in other words, they will have to print more than 14 lakh crores. In which case, the liabilities will rise rather than fall. And therefore, there will be no surplus for the Reserve Bank to distribute to the government. So this argument that the RBI will be able to give a special dividend which the government can use to either cut down it’s fiscal deficit or to increase it’s expenditure on various things – that argument will not hold.

Is this why Prime Minister Narendra Modi went to Uttar Pradesh and said that the poor people who have a lot of extra money given by benefactors or people trying to push cash into their Jan Dhan accounts should not give it back? So in a way, is that the prime minister realising that he may not collect much in terms of fiscal surplus? 

So for that, we need to step back and see why this decision was made. I think this decision was made because the prime minister wanted to create a Robin Hood image, that here look at all these black money walas, they’ve earned illegal money and I will give it to the poor in various ways. So, this Robin Hood image – which is very important because that would be a permanent, great boost for the ruling government – did not happen. So in what other way can this be done? So, this Jan Dhan Yojna came up – where people have been putting in money in the accounts of the poor and expecting them to withdraw it. That he [the prime minister] thought, would be another good way of saying ‘Look! At least this much has been achieved’. But, this is very small – it is chicken feed. It’s only 37 thousand crores that has come in, so it is not going to create that kind of an image. And also, we have seen in some cases it was expected that people will put 10, 20, 30 thousand rupees – but in some cases, people have put in a few lakh rupees.

You’re right. In many accounts – in most accounts, it’s below Rs 49,000 – and some say that employers may have paid five-six months advance. Advance salaries, which will just get adjusted for work in the next five-six months. So there is no case for these account holders not returning the money to their benefactors and employers.

Absolutely. And therefore, we have to see how long this disturbance could last. You know, this disturbance which is this sudden withdrawal of currency in the economy. My sense is that, they may have to print not just 14 lakh crores but – because of hoarding – they may have to print 20 lakh crores. The second is that – when you want to print currency that had been released in 15 years over a space of four, five months – you need a lot of paper, lot of ink, and both are in short supply. You don’t hoard that kind of stock and suddenly you are going to print 15 times more in a short span of time. So, they have to tender for it, and the tender for ink was only floated about 7 days back – so it’ll take a while for it to come back. And therefore, my own judgement is that it’ll not be before eight to 12 months before the currency shortage is overcome. Now if the lead time is eight to 12 months and currency shortage continues, then all kinds of transactions will get affected. And therefore, what could be a short term effect will become a more medium and long term effect. So for instance, initially production is being affected, inventories are piling up – then production will get cut, then investment will slow down. So if this lasts for more than a month-and-a-half, I suspect, there will be more permanent unemployment and more investment cut. As it is investment was down ­– capacity utilisation was down to 70-75%. That could drop to 50% and if investment begins to slow down then that will have long term consequences. It will not be confined to quarter three and quarter four –  as some people are expecting – but it’ll last much longer. And if the currency shortage continues for eight to 12 months, then the effects will spill over into the next year as well – in which case you are then seeing a more long term thing – because then we are headed into a recession.

So what you’re suggesting is that people are underestimating the role of psychology.

Yes, of course. A, psychology, and B, the macroeconomics of it. The macroeconomics of it is that if the investment is cut, in the coming four, five, six months – then it will have more long lasting effects because investment is what boosts demand. As it is, investment in India has been slow in the last three, four years and if it slows down any further that’ll have very major consequences. Some data seems to suggest that it had already fallen from 32% to 29% per annum, of the GDP. Now if that is already 29% – and this effect comes in and it drops another three or four percentage points – then your demand shortfall will have effects lasting even longer.

And it also came at a time when rural wage growth had gone down – a worst rate of 0%, from a high of 17% some three years ago.

Right. So you’ve had two droughts because of which agriculture had slowed down. This year the rainfall was good, it was expected that things would improve but because of this particular problem of circulation, people didn’t actually have money to buy seeds, buy fertiliser, buy the water – even where the seed was there and it was planted, buying water has been a problem and buying fertiliser has been a problem because the middlemen to whom the farmer sells, doesn’t have the money to pay. So, temporarily they can make adjustments, get loans from shops. But that, beyond a point cannot continue and that is why many farmers are complaining that they haven’t been able to sell produce. There are two kinds of effects that this will have. The prices in the rural areas will drop and prices in the urban areas may rise because the things are not moving from mandi to mandi, to here. So you may see contrary effects – that rural distress will increase with the farm prices dropping and urban distress would increase because the prices have risen. Simultaneously in the unorganised sector in the urban areas, there is a lot of unemployment that is building up because small producers, cottage producers – they don’t have the cash to buy working capital. And without working capital how will they buy raw material?  That kind of worker is now, migrating back to the village.

What you said was borne out by this news report I saw, that in rural India, people are destroying their vegetable produce – the prices have actually crashed – whereas in urban mandis prices are still high.

Beginning to rise, yes. Like wheat. The wheat sown has slowed down and therefore the output next year might be less – the wheat stocks are not as large as they used to be 3 years back.

So then the next budget will be a huge challenge. Right?

So, the budget will be a huge challenge no doubt, but the government is in a mode of denial.

They are telling people that there will be a huge improvement in the longer run. Some economists – government economists – are suggesting that part of the black money which comes into the white will lead to an increased money multiplier which could result in higher growth. Would you buy that?

No. I don’t buy that because demonetisation is not a mechanism by which the black becomes white. We have to distinguish between black income, black savings and black wealth and black cash. So first, you make an income out of which you save, and the savings then are invested and that becomes your wealth. Now, the wealth is a portfolio of assets – cash is only a tiny percentage.

About 5-6%?

No, even less. Less than even 1%, I would say.

Of the GDP?

Of the black wealth – cash component.

The government is giving a figure of 5-6%.

That is for the GDP. But for the black wealth – according to me, the black economy is roughly 62% of GDP, which in today’s GDP of 150 lakh crores, would be 93 lakh crores. Now black wealth would be at least three times more – so that would be about 300 lakh crores.

I get your point – so you’re saying this net component is very small.

Very small. So, even if you demobilise this entire three lakh crores, you got rid of only 1% of the black wealth. Maybe 3.5% of the black income, but because most of it has already been converted into white cash, into the new currency – therefore what you may be demobilising will be 0.1%

So the point you’re making is that even in the past, from the black wealth component, money keeps coming into the white economy, and going back to black  – so, it’s wrong to argue that for the first time the black will come into the white.

The black economy and the white economy are intertwined – so your currency note in your pocket is neither coloured black nor white. Therefore black and white are interchangeable.

We at The Wire have published an article by the former revenue service tax officer who worked with the UPA government. Subsequently he joined the World Bank as an advisor on tax policy. He was called by Mr Modi who was then the chief minister in Gujarat, in 2013. And Mr Modi had a half-an-hour meeting with him where he says that Mr Modi asked him to study a proposal by Artha Kranti where he talked about two stages of economic revolution. First, it was demonetisation on this scale, where you take away about 90% of the current currency and replace it. The second stage is more interesting – you remove all taxes, direct, indirect state, VAT, excise – and replace all the existing taxes with 1-2% banking transaction tax. And according to Artha Kranti, if our total tax collection today is 18 lakh crores, centre and state together – that 2% of the banking transaction cost will give you 18 lakh crores or even more. Now this appears stunning – most people don’t believe such a thing could happen. Many economists are even scared to go near it to analyse it. So what is your take?

The Artha Kranti people had discussed this with me in 2013. I had gone to Gokhale Institute to give a talk, and there some of them had come and given me their paper. They were also influencing Baba Ramdev, who was pushing both these proposals. So their proposal was that, first you do the banking transaction tax and elimination and then do the demonetisation. What has happened is the reverse. And that way Mr [Anil] Bokil who heads the Artha Kranti – he said in an interview about 10 days back that “this is not the way that we would have done it, this is not the way we would suggest it.” So in fact, even they have also backed out of it. But the banking transaction tax of 2%, on all transactions will be disastrous for the economy – the entire financial sector will collapse. The margins in your stock market may be 0.1% and the margins in the derivative market maybe 0.01%. If you a levy a 2% tax on that, then you can imagine – if you levy a 2% tax on a 0.1% margin that’s like putting a 200% tax on transaction. So the share market would collapse. If you put it on a derivative market – where you get 0.01% margin – a 2% tax then will be like putting a 2000% tax. So, the entire financial sector would collapse, the economy would begin to collapse. So I had suggested that this may not work, and that they would have to look at this proposal much more carefully. I don’t think that anybody sensible should try this – just like anyone sensible should not have gone ahead with demonetisation  because here, for very little gain on the black economy front, you are affecting the entire white economy. Financial markets could collapse as a result of the banking transaction tax. They would have to study public finances in more detail – what is the role of the direct taxes, indirect taxes, why are they there – before they make some such suggestion. There is something like the Tobin Tax, which has been talked about at the international level to prevent international speculation – but that is a very tiny percentage of the profit that is made.  A very small tax, on the profit that is made on international speculation. If you were to put a 2% tax, that’s a huge tax, esspecially for the financial markets.

You don’t agree with the Artha Kranti proposal?

Yes, I had tried to dissuade them and Baba Ramdev from taking this kind of proposal on. But obviously they were quite influential with Mr Modi, and I can see why Mr Modi has gone in for this – a big-bang thing.

Do you think Mr Modi, will actually enact stage 2? 

I hope not because this is not working out. And therefore, he should know that the credibility of what was suggested then was not very good. Therefore, he should not go (onto stage 2), but, it’s clear why Mr Modi is doing this. All the steps that have been taken regarding the black economy have fallen flat in the last two-and-a-half years. So, the SITs that were set up have not produced results, the income declaration scheme has not produced results. Then your scheme to this Foreign Money Bill – that has not produced results either – about four thousand crores, so that’s less a billion dollars whereas the CBI had anticipated 500 billion dollars. Basically, these schemes have not been successful, so you needed something to show success.

But do you think that this has completely backfired?

Completely backfired at the moment, because the gain that you make in terms of the black economy being demobilised is redundant because the mechanisms by which black income is generated – they continue still. So if I’m a teacher doing tuition, then that would continue; if I’m making spurious drugs then that would continue; if I’m a narcotic drug seller then that would continue. So black income generation would continue. Black wealth demobilisation could be 0.1%, which is not worth it – and the economy may have a downturn. Even if Mr Manmohan Singh is right and there is a 2% decline in the rate of growth, then that’s a huge amount of money.

You’re in the same camp as Amartya Sen, Paul Krugman – who are all saying that the disruption will be much more than any pay-off that might, or might not come.

I discussed this in my black economy book in 1999 and I pointed out that this would be far more disruptive than any gain that you might make. And I’ve been teaching this since 1985, in my public finance course.