Category Archives: money search

On Black Money, Corruption, and Demonetization

Money facilitates more trades and improves welfare than what is possible without it. Monetary theorists would call this as money being ‘essential’ because the total volume and value of transactions achievable with money is much bigger than the one achievable without money (see pp. 47, Nosal and Rocheteau, 2011). From this perspective, demonetization of November 8, 2016 definitely reduced economic well-being of Indian people at large overnight. However, the effect may not be just this as temporary one-time reduction in the achievable set of transactions but also the ones in immediate future. While current markets in goods and services facilitate current consumption and investment, credit markets allow economic agents to smooth production and consumption over time. A pervasive reduction in liquidity therefore, however short term, is bound to adversely affect both current and future consumption and investment decisions. This effect could be pronounced in case of the Indian economy where a huge proportion of transactions are in cash including cash used for lending through informal channels like money lenders as well as microfinance. Accordingly, it should not be a surprise if there is a significant reduction in real GDP over at least 3-4 quarters if not more.

So what was the objective behind the policy? Initially, we were told that the main objective was to curb corruption, terrorism, and black money. However, the narrative slowly changed as days passed and the outcome discussed now is making India a cashless economy. Accordingly, there are two separate sets of questions that need to be asked. They are as follows:

  1. Is demonetization the best way to deal with corruption and black economy?
  2. Is there something inherently good about a cashless economy over a cash based economy that makes it a desirable goal?

Let us look at these one at a time.

Dealing with corruption and black money:

In order to figure out how to curb corruption and black money, we first need to know what gives rise to these phenomena. If we do not know that then treating these problems by demonetization would be akin to treating a person with high blood sugar by replacing all the sugar laden blood with fresh healthy one without any thought to what lowered sugar absorption in the first place!

It turns out that almost all the countries have some degree of black economy (also called shadow or informal economy) and hence there has been significant amount of research on its causes and determinants. According to a survey of such literature by Schneider and Enste (2000) , the most important and often cited causes are:

  1. the rise of the burden of taxes and social security contributions;
  2. increased regulation in the official economy, especially of labor markets;
  3. forced reduction of weekly working time;
  4. earlier retirement;
  5. unemployment; and
  6. the decline of civic virtue and loyalty towards public institutions combined with a declining tax morale.

Clearly, all of the above reasons seem to be relevant for India with varying degree of intensity giving rise to the black economy. Even if demonetization reduced the existing stock of black money, a different set of policies would be required to reduce its growth in the future.  Research substantiates these claims. For example, studying the old and new EU member states, Fialova and Scneider (2014)  indicate that one institution that unambiguously increased shadow economy is the strictness of employment protection legislation. Besley 2004 shows that the states in India that implemented pro-worker laws experienced lowered output, employment, investment, and productivity in registered or formal manufacturing and an increase in output in unregistered or informal manufacturing. Pro worker laws were also associated with increase in urban poverty. So in order to reduce black economy one of things that the government could do is reform the labor laws that currently make hiring labor through formal channels costly. Now that is a tough decision with significant political cost makes it a less attractive option for any political party in power.

Other regulations that introduce opaqueness in implementation of and compliance with them also increase the size of black economy. The policy of GST is right step in this regard and so would be streamlining of other direct and indirect tax laws and regulations. India has consistently fared worse on the ‘ease of doing business‘ index and one of the main reason is the lack of transparency in rules and regulations governing business transactions. Reforms in these laws would certainly reduce the growth of informal or black economy.

I think India suffers from a low tax morale because people do not trust the government to deliver on public goods and hence avoid paying taxes. In response to poor quality of public goods, it is natural that people would hoard cash to solve the lack of public goods problem for themselves. For example, some people may evade taxes because of high cost of private education for their kids, the necessity of which arises because of serious shortage of affordable public education. If people cannot meet the needs that should be satisfied by public goods, then they are more likely to engage in corruption in addition to tax evasion making corruption and black economy complementary goods. This is not mere speculation but something that research substantiates. For example, analyzing a sample of 51 countries around the world over the period 2000 to 2005, Buehn and Schneider (2011) present empirical evidence for a complementary (positive) relationship of corruption and the shadow economy.

In short, the set of policies that could influence the size and growth of black economy as well as corruption have to do with transparency of policies governing different economic transactions in the economy. Unfortunately, demonetization is not one of them.

Desirability of Cashless Economy:

Let us go back to the way monetary theorists think about use of money in its various forms in the economy. As mentioned above use of money expands the size of economic pie. What if we still use money but now only in its electronic form- that is we go totally cashless? Is that desirable from a theoretical point of view? We will use the same logic as before: look at the set of transactions that use of cash makes possible and compare that to the one made possible with use of electronic money. Clearly everything that can be done through use of actual cash can be done by use of electronic money. There will be some kinks to smooth out- for example the infrastructure required to go totally cashless should be present and all that- but let us for a moment assume that all the preconditions to go cashless have been met. Would it lead us to a better size of the economic pie or bigger set of allocations compared to what is possible with just cash? From a pure theoretical point of view, the answer is no because actual cash has an important advantage over its electronic form- possibility of anonymity!

For transactions that could be completely legal, but out of privacy concerns I may not want them recorded. Secondly, may be the value of the transaction may not be high enough to justify the cost of using the electronic payments infrastructure. If we move from predominantly cash based economy to the one just based on cash in electronic form, all such transactions would be difficult and that will reduce the size of economic pie or even worse push such transactions to the underground or black economy. Therefore, the policy of going cashless will most likely give rise to a different kind of black economy or alternative hard to trace forms of payments like crypto-currencies.

To make use of electronic payment systems economical, commerce would have to organized in a different way. The smaller neighborhood grocery shops may have to give way to larger ones to benefit from economies of scale. This might be easier said than done because these small neighborhood grocery stores also provide credit to their customers. Because each of these stores deal with a smaller set of consumers, it is easier for them to monitor repayment. This ability of smaller grocery stores to provide and monitor credit allows credit constrained consumers to manage the mismatch between expenditure and income flows. If we want people to shop in bigger stores instead, then we will have to provide people access to formal credit markets. The presence of informal economy makes verifying income flows difficult and therefore access to formal credit markets limited. Hence, reduction in the black economy would make it easier to increase the use of electronic payments rather than the other way round.

Policies to reduce corruption and black economy:

We are back to the question again-what are the policies that would reduce the extent of black economy? A preliminary look at the data tells that tax evasion, corruption, and black economy are problems more acutely present in developing countries than in developed ones. This suggests there is something more fundamental than availability of high denomination currency notes that is causing this. Besley and Perrsson (2014) provide some answers and they are closely related to the importance of institutions argued very convincingly in Acemoglu and Robinson’s Why Nations Fail. Economic institutions are the set of rules that govern our economic transactions and outcomes. Most developing or poor countries have extractive institutions that allow access to resources and economic opportunities to only few and often at the cost of the majority. They do not provide clear property rights making it difficult to claim returns to investment in physical and human capital. We can see clearly from the analysis above, corruption and black economy are a result of extractive institutions. For example, poor property rights also make it easy to hide unaccounted cash in real estate. So to reduce black economy, we need to replace the extractive institutions with ones that broaden access to resources and opportunities and help build capabilities. Such institutions are called inclusive institutions examples of which would be impartial rule of law, clearly defined property rights, access to public education and health care, and well-functioning markets. Unfortunately, there are no shortcuts- and demonetization is not even that- it is actually stripping people of their rights over their income making it an extractive institution.

3 Comments

Filed under current economic issues, demonetisation, indian economy, macroeconomics, Monetary Policy, money search

On Cows and Central Tenets of Capitalism!

Santosh Anagol has been doing interesting research on several phenomena concerning the Indian economy. In a recent paper, he and his coauthors estimate that returns to owning a cow in India are negative and hence the continued existence of cows violates the central tenets of capitalism.

Daron Acemoglu and James Robinson discuss these findings in their extremely interesting blog here. They argue that social embeddedness could help us understand why cows are still a part of a typical Indian farmer’s portfolio. I think that their arguments certainly makes sense, however, one might also look at new monetarist economics for an answer to this question. For example, Lagos and Rocheteau (2008) analyse an economy with money and capital as competing media of exchange and their model I think could explain this puzzle that Anagol et.al pose.

In their economy, agents over-accumulate capital in a non-monetary equilibrium because the capital asset performs the function of a productive asset as well as a liquid medium of exchange when needed. The introduction and use of money therefore allows the liquidity use to be separated from the productive use and corrects the inefficient over-accumulation of capital. Thus, fiat money plays a welfare enhancing role in this economy. However, that precisely does not seem to be happening in India and that is the puzzle that Anagol and his coauthors are referring to.

So why do Indian farmers seem to be preferring to invest in an asset that has negative returns, despite the availability of a liquid medium of exchange? Here, it is important understand what constitutes return on capital. Lagos and Rocheteau propose that return to capital in such an economy can be thought of being comprised of two parts: a liquidity return referring to capital’s role in exchange process and the intrinsic return associated with the productive use of cows. Anagol’s analysis seems to be capturing only the intrinsic return while cows continue to have a liquidity return (premium) in the minds of Indian farmers. Ideally, this perceived positive liquidity return for cows should not prevail if fiat money does provide the necessary insurance against uncertainty. The fact that it does implies that the insurance provided by access to fiat money is not enough.

Anagol and his coauthors do raise this point but dismiss it citing the proliferation of different forms of microfinance institutions in rural India increasing access to savings. However, research has shown that actual use of these institutions is quite uneven and tends to depend on factors that could be explained using the economics of networks. For example see Matt Jackson’s work here. I think the factors mentioned above still continue to influence the basic uncertainty that farmers face in a substantial way. I am not sure if microfinance would be able to provide enough insurance in case of a crop failure for example. Because provision of funds in such case may require access to a mechanism to transfer funds from non-affected areas to affected areas to meet the demand and microfinance in its current state most likely is not in a position to handle that.

I still think that social embeddedness plays an important role. On the one hand traditional socioeconomic relationships have broken down reducing the access to mechanisms that could serve as partial insurance mechanisms and on the other hand access to modern monetary economy is still hard to come by. Lack of roads, absent storage and refrigeration facilities, ineffective or absent land reforms, inadequate irrigation facilities keeping agricultural output sensitive to rainfall shocks, all imply that the benefits from participating in the market economy only add to the existing uncertainty that these farmers face. Till these issues are addressed Indian farmers will continue continue to hold cows despite their negative intrinsic return.

Leave a comment

Filed under indian economy, macroeconomics, markets and efficiency, money search, social perspectives

Dual currencies in a Bangladeshi Slum!

This link  was brought to my notice by my advisor on how a second currency emerged in a Bangladeshi slum in Mombasa. As with all the stories of how monetary arrangements emerge to solve some or other friction that holds exchange back, it yet again vindicates the basic idea behind search models of money.

The credit nature of this arrangement signifies how debt might have evolved before money as argued by anthropologist David Graeber here.

Leave a comment

Filed under money search

Payment Systems in India

Recently, the Governor of the Reserve Bank of India (RBI), Dr. Subbarao emphasized the need to move to electronic payments system in India from its current primarily cash based one. It seems to be a reasonable proposition coming from a central banker especially such transition might mean a better control over an economy with a large informal sector. However, is it economically feasible to have such a transition in India right now? Dr. Subbaroa’s answer is yes and he cites other emerging economies like Brazil that use way less cash than a typical Indian does. But I believe that the nature of payment systems practiced only partly depends on deliberate policies and a whole lot on the economics involved. This is especially true for the retail transactions which was the focus of Subbarao’s statement.

Cash is preferred in many transactions in India as a significant number of people lack access to banking facilities. The RBI has time again pursued various initiatives to spread the banking access, but such efforts have not meant much in terms of transforming retail payments. The way commerce is organized in India (a large number of small sellers- large scale retailing is a new and urban phenomenon) make electronic payment systems prohibitively expensive. Further, use of electronic platforms like Visa or Mastercard for payments subjects the economy to economics of two sided markets. There are many issues involved, and most resolutions suggest a preferred cash used in equilibrium for a country like India (For a review of economics of two sided markets see Rysman 2009. For a non-technical discussion of payment systems in India see Waknis (2010)).

A large informal as well as black economy adds to the necessity of cash use in transactions. Lastly but not the least, the level of economic growth itself is a good determinant of the payment system used. While one could argue that Brazil uses less cash than India and hence the later should follow suit, these countries are not exactly in the same league. To further shed light on such cross country comparisons, one probably needs a careful analysis controlling for country specific characteristics to understand the factors that determine the use of electronic payment systems. In addition, questions like do the existing payments systems evolve to address the frictions in payment system and how do they affect economic efficiency also need to be given thought (See Kahn and Rehbords 2009 for a survey of empirical and theoretical literature on payment economics.).

Cash allows anonymity in transactions and in itself can be looked upon as a solution to anonymity of buyers and sellers. This implies that there will be always some transactions that will use cash. The money search literature pioneered by Lagos and Wright (2005) makes this point very well where money as a store of value gets valued in the centralized Walrasian market because the participants are anonymous. This literature is rich and has handled many issues related to payment systems. For an introduction see Williamson and Wright (2010).

So what could Dr. Subbarao do to make it economically attractive for market participants to use electronic payment systems instead of a cash one? Now that is a question worthwhile some thought!

Leave a comment

Filed under current economic issues, Monetary Policy, money search

Lagos-Wright with a New Keynesian Flavor!

There is so much one can do with a simple 2 subperiod model. For a brief survey, take a look at this. More recently, however, I came across this yet another addition by Aruoba and Schorfheide in the latest issue of the American Economic Journal: Macroeconomics. The paper features a version of the Lagos-Wright (a 2 subperiod divisible goods divisible money search) model. The first subperiod is still the decentralized trade, but the second subperiod (centralized market) features a standard new Keynesian economy with rigid prices!

Leave a comment

Filed under money search