The rationality of burning boats
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The government’s demonetization initiative appears to have plunged the country into a financial emergency. Given the magnitude of the already existing black money crisis, one must examine if the government had any better alternatives. Some have suggested that the government could have simultaneously rolled out the voluntary disclosure of income scheme (VDIS) and demonetization with a time window for people to convert their old notes or disclose black money. During this period both old and new notes would have been accepted.
The following game model provides a useful framework for analysis. The players involved are the government, the opposition, the black money hoarders, and the general public.
The government has two strategies—the one utilized that involves sequential rollout of VDIS and demonetization, and the suggested alternative of simultaneous rollout. One of the main differences in these two strategies, apart from the timing, is that those who disclose their black money would be subject to much lower penalties in the simultaneous scheme as opposed to the current scheme in which they lose 90% of their money after the VDIS window is closed.
The opposition has two options—to oppose or to support. The same is true of the public. Black money hoarders have four plausible options—convert old to new notes, consume goods and services (leaving the task of conversion to someone else), confess and pay the penalty, or burn the money rather than risk declaring it.
The ingenious ways currently being used by hoarders to convert notes would have applied with either strategy—leasing unused bank accounts of the poor; using accounts of those exempt from tax (agriculturists, certain sections of the corporate sector); pumping money into sectors which still are allowed to accept old notes; backdating sales; and making advance payments to employees and vendors who would in turn carry out the conversion.
Both strategies have strong advantages and disadvantages. With the simultaneous disclosure and demonetization scheme, black-money hoarders would have a much better opportunity to consume or convert their money. The consumption would give the economy a demand boost. The amount disclosed would be low under both schemes because it brings hoarders into the eye of the income-tax department and places at risk the non-monetary assets amassed with black money (these constitute the large part of the wealth of sophisticated hoarders). But hardly any money would have to be burnt in the simultaneous scheme as is likely to happen in the current scheme which offers little incentive to disclose.
The fact that a large amount of conversion would take place might leave the government open to the charge of colluding with hoarders. However, in the current scheme the government is open to the charge of putting the general public to enormous discomfort and, even, peril for no fault of theirs. The unorganized sector that comprises 45% of GDP and 80% of employment is hard hit in both formulations as the flow of funds in its supply chain dry up. This causes large-scale disruption of the kind envisaged in the move to organized retail. But the larger time window in the simultaneous scheme enables a few viable responses to emerge.
Given the significant pain caused in both schemes, and the gains to the ruling party if it succeeds, opposition parties have a dominant strategy to oppose either scheme. The disruption caused to the politicians themselves is greater with the current scheme and this adds an extra edge to their outbursts. The general public is heartened by the fact that the rich and the mighty are being made to suffer. But once they realize that they themselves are going to feel the brunt, not just for a few weeks but for months and years, what will their reaction be?
Pious platitudes apart, the hard reality is that the government chose whichever scheme was to give it a better chance to win the next election. My hunch is that the simultaneous scheme would have resulted in scenes of the rich splurging on items of conspicuous consumption and created an even greater political backlash. Hence the equilibrium of the game would involve the choice of the sequential scheme, strong expressions of outrage from the opposition, and a large amount of conversion and consumption by black money hoarders with a significant amount of money being burnt.
But did the government not come to power on an agenda of economic growth? What is the impact of the one-pointed focus on the eradication of black money on macroeconomic indicators?
Since black money was a significant growth driver for the black and the white economies, and since the move has created enormous uncertainty, one expects a negative impact on growth in the short term. The differential impact across the organized and unorganized sector will lead to increased inequity in the short and medium term.
Other less disruptive measures to control black money that adopt an incrementalist approach through a portfolio of schemes rather than a big bang approach are also available. For instance, a sharp focus on controlling electoral funding will go a long way in solving the problem.
“Break the kettles and burn the boats”, is an ancient Chinese precept of war that suggests an army may improve its chances of victory by committing itself to a fight to the finish. We can conclude that if this government has burned its boats with the trader class, it is playing for a clean sweep. Opposition parties need to calibrate their responses accordingly.
Rohit Prasad is a professor at MDI Gurgaon. Research assistance by Deep Desai and Prabodh Dasari, students at MDI Gurgaon, is appreciated. Game Sutra is a fortnightly column based on game theory.