Adverse effects of demonetization are finally trickling down into the economy. Although a lot can be said about the poor implementation part of the policy, this article will focus just on the economics. One very important point to keep in mind during this whole discussion is to not cloud the economics judgement of policy through moral lenses. Morality of a society cannot be changed over night and hence all discussions in that direction are futile.
The developments in the last few weeks have confirmed YP predictions in the past:
1) It would lead to slowdown of economy: The service sector contracted in November which is the first time in last 18 months. This is what BS had to say:
The Nikkei Services Purchasing Managers’ Index (PMI) fell to 46.7 in November from 54.5 in the previous month, the sharpest reduction in three years. A reading above 50 indicates growth and a reading below shows contraction. This may be an early indicator of deceleration of the gross domestic product (GDP) in the December quarter.
You can also take car sales as another metric of economic performance. Here again, November saw an 8% decrease in car sales pointing towards decrease in demand. Since India still has a large informal segment, cash contraction has hit the economic growth. Since not all money has returned back to the economy, the effect would linger on for much longer.
2) Big fish have found ways to escape: IT raid at the residence of two government officials found 6 crores of unaccounted cash, out of which 4.7 crore was in new currency. So while the poor and middle class are lining up at banks and ATMs and are restricted to withdraw puny amounts, those with large stash of black money have found illegal ways to change their currency.
The worst part in this whole exercise is the chest thumping by free market economists on rise of temporary tax revenue for GoI. In his article in Indian Express, Surjit Bhalla has tried to show how great this policy has been till now. But he has not actually given any logic to justify how the GDP will not fall. Basically his argument boils down to saying that tax income increase from demonetization will offset the GDP loss in growth. He has simply written a lot of buzzwords hoping to confuse the common readers into thinking the demonetization effects are blown out of proportion. But that is not how economy works. Tax money for the Govt is just tax money of the government. It does not indicate the actual GDP of the country or economic growth.
For example, if people of the country are earning/producing 150Tn ₹ in total output and government tax rate on it is 10%, the Govt tax revenue will be 15Tn ₹. Let’s say if the Govt raises the tax rate by 1% to 11%, and the economy “contracts” by 1%, then GDP of the economy will go down by 1.5Tn ₹ to 148.5 Tn ₹, while the tax income for the Govt will still increase by 1.15 Tn ₹ to 16.33 Tn ₹. So, tax income increase for the Govt doesn’t automatically equal to GDP increase/growth/income for the public/citizens. So his basic argument that economic growth won’t be hit because tax returns from black money will offset it (if that was even possible) is pathetically stupid.
The same can be said about the other assumptions used by the author. The extrapolation to get the figure on black money by comparing with M1 usage in other emerging markets does not give any estimate for Black Money. An informal sector can have large cash circulation and still not have big black money component. Most of the figures quoted everywhere for black money are just guess-estimates with government or economists having little clue about the numbers. For example- GoI initially expected some 4-5 Tn ₹ out of 15 Tn ₹ to not come back, due to it being black money. They now have to revise down their numbers as according to some sources more than 12 Tn ₹ are already back in the system.
But Bhalla’s analysis is flawed even from the welfare perspective of the policy. He is saying GDP growth would not fall by 1 percent. Now the question is what number should this fall be compared against? Last year’s GDP growth or potential GDP growth (if there was no demonetization).
1) The way regular economists would evaluate any policy is by comparing growth with the counter-factual scenario. Agricultural sector picking up due to better monsoon is not an effect of demonetization and would have been there irrespective of the policy implementation. So, the benchmark comparison would be to compare post demonetization GDP growth with the counter-factual growth which would have happened if there were no demonetization. We would not see the latter number (because this reality will not occur), but using agricultural growth to show diminished impact of demonetization on GDP growth is farcical. The right comparison is to compare current GDP growth with hypothetical GDP growth that would have occurred with bumper agricultural harvest this year.
2) Bhalla’s gains also rest on future increase in tax net (again don’t forget these are tax gains for GoI and do not show GDP growth). People who pay taxes today are in no way liable to pay taxes in the future and a large number of them can drop out again. Hence the push for digitizing the economy to make it easy to track the transactions. But unless GoI strictly bans notes, there is no way to force people to not revert to old ways thus resulting in shrinking the tax base once again.
3) And it is really difficult to understand how increase in government tax revenue at the cost of decrease in overall GDP growth (which seems to be happening) is hailed as success of the policy? Once accounting for the pain faced by regular citizens plus deceleration of GDP growth, some temporary increase in GoI revenues does not seem such a great policy. Specially introduction of 2000 ₹ note would not dent the future generation of Black Money in any way, so transitory gains and losses of the policy need to be compared.
But as of today, it does not seem that policy has succeeded even in its attempt to destroy the stock of black money. As predicted by YP, thanks to the jugadu nature of Indians and help of government officials (bankers in this case), people have converted their old notes to new notes (especially those with big amounts of black money). Effectively, the claims of removing 4-5 Tn ₹ of black money from the total stock of money would not materialize. So, GoI has failed on its primary goal in the short run. On top we are witnessing a contraction in the economy, which would linger on for the next few quarters. The one percent decrease in growth is a very conservative estimate and the results could be much worse as RBI has not been able to pump back the money yet. Not to forget the immense pain common people had to endure due to this sudden change. Once taking into account these all factors, it seems that the whole policy was big farcical show for nothing substantial.
But governments around the world are often over-smarted by common folks and this is nothing new. Read this great piece on government planning by Gilles Saint Paul.