How demonetisation hampers economic activity

Most bankers, it seems, are not aware that discretion is the better part of valour. Which is why we have a non-performing assets-induced mess that is holding back economic recovery. Which is also why some bankers aver that economists talk nonsense.
 
Many years ago, Irving Fisher formulated the quantity theory of money, the fount of monetarism. The simple identity of exchange was that the value of transactions that a given stock of money could support would depend on the velocity of money, viz the number of times money changes hands in the process of completing transactions. What this means is that if the price level and the velocity are stable, there is a direct proportional relationship between the stock of money and the volume of transactions it can support. Now comes the rocket science part: If the stock of money contracts, so will the volume of transactions. And, heaven (or the government) forbid, if the velocity of money falls (likely when 86 per cent of cash is demonetised), then the decline in the volume of transactions would be even sharper.

 
Now, all economists and management-types (hopefully, including bankers) have encountered Fisher's theory at some point. The critical point to note is that it is an identity. That is, it is always true; it is not some esoteric equation cooked up by economists.
 

Now what does this have to do with demonetisation? Everything. Reducing the stock of money will result in a reduction in the value and volume of transactions. What sort of transactions? Employers paying wages in cash, consumers buying household staples, producers paying cash for parts required for production, farmers selling produce in the wholesale market, daily purchases of fruits and veggies, sales at a paanwallah’s, paying school fees, hospital admission charges… the list could go on, but you get the idea. Demonetisation and the limited supply of lower denomination notes imply that most of these transactions will not go through, that is, these remain contracts/trades that simply cannot be concluded.

 
The consequences: Some industries come to a grinding halt (cycles in Ludhiana and textiles in Tiruppur, Indian Express), reverse migration of daily wage labour (Indian Express and this newspaper), farmers unable to harvest the kharif and in difficulty about planting for rabi (this newspaper, The Mint, The Telegraph), shutdown of roadside vendors (look around yourself), the road transport industry facing major problems, huge negative impact on the “informal” sector (all daily and business newspapers). Conclusion: The reduction in the volume of transactions directly impacts the level of economic activity. And so will it affect the size of economic output (gross domestic product or GDP).

 
And, there are second-round effects: As incomes decline so too does demand. Sales of fast moving consumer goods have slowed; demand for other goods (clothing, automobiles, trucks and other commercial vehicles) has contracted. Finally, expenditure on discretionary consumption has been cut back. The outcome: A reduction in the real value of economic output.
 
Many (economists, finance companies, equity analysts, academics and politicians) will try to estimate the impact on real GDP. And, they will come up with different numbers. But, any way you cut it, the answer must be a slower rate of economic growth, with the possibility that there could actually be a contraction in GDP (compared to the corresponding quarter last year). Forget what the economists hypothesise or project. Look around you. See the daily hassles of queuing up for cash (only a symptom of the underlying disease). Read the reports in the newspapers. Economic activity has been hurt. And, this may go on for the next three to five months. Now, make up your mind: Is this nonsense?

 
To be fair, not all bankers would make the outrageous statement one of them did. Obviously, there is another proverb that remains unknown: the one about glass houses.
  The author is former chairman, Telecom Regulatory Authority of India