Tag Archives: demonetisation

NPR’s Podcast on Demonetization

NPR’s Planet Money did a two part podcast on Anil Bokil and his organization Arthakranti who convinced Prime Minister of India Mr. Narendra Modi about demonetization as a solution to India’s poverty, corruption, and black money related problems. This was back in 2013 when Mr. Modi was Chief Minister of Gujrat.

Arthkranti is a plan conceived by some accountants and engineers to curb corruption and improving tax compliance in India. According to them, limiting the use of cash is one of the solutions. I have already talked about what is wrong with this solution here, here, and here. I also wrote a critique of Arthakranti proposals few years ago while I was grad student and did not think that anyone would take these proposals seriously!

Nonetheless, it is interesting to hear what Mr. Bokil has to say. NPR guys did a good job here.

I thank J P Konning for making me aware of this podcast through one of his tweets.

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Demonetisation and the recent GDP growth estimate

My paper on Demonetisation is now published at the Economic & Political Weekly as Demonetisation through Segmented Markets: Some Theoretical Perspectives.

The analysis therein concluded that there would be a decrease in real GDP over the next few quarters as all the adjustments forced by the demonetisation pan out. The extremely slow remonetisation of the economy on account of shortage of new cash and poor logistics only seemed to be reinforcing this conclusion. Therefore, the recently released GDP growth estimate of  7.1%  does not make sense. It has surprised economists and political commentators alike. For example,  Ajit Ranade expresses his surprise in the following tweet:

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Expressing doubt about the estimates, Mihir Sharma at Bloomberg asks if the Indian data is going the Chinese way.  So how do we explain this estimate when economists as well as the IMF predicted the growth to be down to 6%? The analysis put together by The Wire based on interviews of some economists suggests the following possible reasons:

  1. The downward revision of Q3 F16 growth is pushing up the growth estimate for the current quarter. This downward revision could be because of poor agricultural growth in 2015-16.
  2. Pile up of inventories in the distribution channels could have been recorded as increased consumption expenditure. This is the channel stuffing phenomenon where the wholesalers pushed goods down the distribution channel still probably expecting the sales to revive after remonetisation.
  3. The rich may have spent on big ticket commodities like cars. For e.g. Maruti Suzuki recorded some increase in revenue pushing durable consumption expenditure up.
  4. The official GDP estimates don’t really measure informal sector activity with accuracy and it is the informal sector (unconnected households and firms) that has been hit very hard by demonetisation.

If the above reasons are true, then the growth estimate would most likely be revised downward later as data catches up with the decline in economic activity. However, for now the BJP government  and Prime Minister Modi could take all the credit for the improved growth and boost their political capital when it matters given the UP elections.

 

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How India can reduce the size of its black economy

Here is the link to my article, “How India can reduce the size of its black economy” in thewire.in

It is partially based on an earlier blogpost on the same topic.

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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.

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Demonetization: analysis updates

It has been more than 30 days since Prime Minister of India Narendra Modi cancelled the Rs. 500 and 1000 notes that constitute almost 85% of currency in circulation.

A good analysis of how the policy narrative has changed over these days is by Praveen Chakravarty in Business Standard.

A better economic analysis can be found on Ajay Shah’s blog in  post written by Suyash Rai.

On the other side of the camp, there is Professors Bhagwati, Krishna, and Sunderasen in a blog post on the Times of India who can be seen literally scrambling to justify the policy of demonetisation without much success. I am pretty sure that most economists working for Niti Ayog(for e.g. Arvind Panagariya) had to do the same thing- somehow come up with some arguments to justify the policy as a good move. One wonders if they were consulted at all!

 

 

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