Home/ Opinion / Anything but a surgical strike

A surgical strike is supposed to minimize collateral damage. But the recent “demonetisation" is a Himalayan blunder that imposes enormous punishment on the economy and society, especially the poor, not only in India, but also in nearby Nepal and Sri Lanka, and would still not achieve its objective of rooting out black economy.

Money demand arises out of circulation requirements and portfolio requirements. Black wealth is held in a variety of forms: physical assets, including real estate and gold, and financial assets, including stocks, bonds and mutual funds, deposits, and foreign accounts. Only a part of the latter is cash black money.

Black income is the income on which taxes are not paid. Black income could arise on otherwise legal activities, but also on account of illegal activities (for example, bribes, kickbacks in contracts, extortion, and rents sought by officials and politicians). Accumulated savings out of black income take the form of black wealth. Though income on account of illegal activities can only be black since no taxes can be paid on the same, when there is a black economy, illegal income can become part of the spending in the economy. Then, some part of the money in circulation operates in the black economy.

When 85% of the currency is demonetized, circulation money is being pulled back. Morarji Desai’s demonetization of 1978 made some sense since the circulation money would not have been hit. In the current case, the payments mechanism has been brought to a standstill. Public statements that there is enough cash would not cut much ice since, even if the presses were to work at three shifts it would take the Reserve Bank of India (RBI) more than four-and-half months to replace all the old Rs500 and Rs1,000 notes with an optimal mix of new Rs2,000, Rs1,000 and Rs500 notes. Replacing one Rs1,000 and two Rs500 notes with one Rs2,000 note, although equal in monetary terms, would reduce the velocity of money movement, since in most transactions there is a two-way movement of money, and the transaction velocity of circulation of any denomination is a function of the existence and use of other denominations as well. In other words, the RBI multiplied the error by printing Rs2,000 notes since these are of little use in circulation without sufficient 500s, particularly in rural areas, where the pain from demonetisation would be the maximum. The value in circulation right now of Rs2,000 notes is low, but these are useful for recreating black money wealth. Black chests are already being populated with Rs2,000 banknotes. Most of the Rs2,000 notes are being picked up by informal businesses (one leg of the black economy) by asking their workers to queue at banks for the new currency.

The informal businesses that don’t pay tax (and would have paid little anyway) will wait out, if need be for months, and not shift to credit and electronic money transfer, to avoid having to deal with the income tax department. If the department can exercise coercive taxation on public sector units and large corporates by asking them to cough up cash before year closure, one can well imagine the hurt that it can cause to small businesses.

All this will reduce economic activity. Spending will be adversely affected and the already low growth of under 5% (the claimed 7.5% arises from a statistical error in using the wrong deflator), and kept low over the past two years on account of compression in government expenditures due to centralization of spending on projects and programmes, would be further adversely affected. There is need for the fiscal side to counter the expected rapid decline in spending. In the absence of a fiscal stimulus, the brake of demonetisation and the spending multiplier effect will take the economy into a tailspin.

Politically, the government needed a big bang—whatever the bang—since it has been unable to deliver on its promise of jobs and growth. (Besides the dull fiscal side, investment killing high interest rates by the RBI ensured this.) With a weak economy and other campaigns, including version one centered around cow-protection, and version two against “terrorism" not working, what options did the government, which had promised big-bang changes, have? A turn to masochism? That is what is happening now. As long as people think that “big people" are being hurt, (never mind that they are being hurt as well), and as long as they believe that standing in a queue makes them part of a great revolution to make India corruption-free, political gains are to be made even if the move is an economic disaster.

The argument that demonetization was required to get rid of fake currency implies that we are not capable of making notes that are difficult to duplicate, and our law enforcement agencies are not able to enforce the law. Reducing the black economy would require using existing departments or creating an organization, using the information available to catch rent seekers and kickback beneficiaries, giving operational autonomy to enforcement agencies, getting rid of perversities in public procurement and public-private partnerships (PPPs) and in licensing of liquor marketing and mineral extraction, administrative reform, and finding the leverage points for change. All these demand intellectual and organizational capability, which the Indian state lacks. So, the leader in a great hurry is forced to rely on theatrics.

Sebastian Morris is professor of economics at the Indian Institute of Management Ahmedabad.

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
More Less
Updated: 03 Jan 2017, 12:41 AM IST
Recommended For You
Get alerts on WhatsApp
Set Preferences My Reads Watchlist Feedback Redeem a Gift Card Logout