Demonetisation: Flawed in planning, not in principle

There was a short-term price but that may dissipate as resources idled by demonetisation are redeployed elsewhere. But are we prepared for this short-term pain?

The anniversary of demonetisation calls for an exploration of the rather empty space between paeans to its glory and hysterical diatribes. Its purpose was to control black money — a purpose that raises two issues. First, was control of black money desirable?  Second, was demonetisation the optimal method?
 

The answer to the first question is not quite obvious. Before November 2016, our economy ran largely on black money. Sixty per cent of the value of any real estate transaction was demanded and paid in cash and was unreported and tax-exempt. The construction industry was founded on a mountain of black money. Linked with it were industries that supplied its inputs, extraction of material for them and  services of countless workers. Jewellery and high-value luxury durables derived their demand largely from black money.  The decimation of this demand and consequently of output, employment and growth is the unavoidable price of the demise of black money. It is a short-run price and may dissipate as resources idled by demonetisation are redeployed elsewhere. Even so, are we prepared for this short-run pain?

If we are (as the left intelligentsia will undoubtedly claim to be), consider our second question on which the leftists have concentrated their fire.  Demonetisation, they claim, was “witless”, “inane”, “the grandest hoax in India’s political history”, state terrorism inflicted on a hapless people for no discernible economic benefit whatsoever. Their principal argument is that black money is not a stock but a flow, created whenever tax is evaded, not necessarily through a cash transaction. Even when cash is acquired while evading taxes, it is not hoarded, but converted into other assets. To stop evasion, tighten tax administration, don’t destroy 86 per cent of the currency.

FUTURE GAIN: Demonetisation made future tax evasion complex and hazardous. It produced another collateral benefit since almost all premeditated crime was funded by high-value notes

Undoubtedly, demonetisation is no insurance against tax evasion. It does not replace enforcement, but simplifies tax administration and complicates evasion. Evasion results in unaccounted wealth — land, farmhouses, diamonds, BMWs, Old Masters. None of these, however, has the advantages of cash. Cash is the most liquid of all assets — finely divisible, universally acceptable and highly portable. That is why cash or credit — not specific durables — is the favoured exchange medium for normal transactions. This is the first lesson of monetary economics — one known to chaiwallas, though not apparently to critics of demonetisation. If, however, we want to hoodwink the tax collector, cash offers us a further boon. Unlike credit, it leaves no paper trail. It is virtually invisible and — unlike jewellery or Rolex watches — does not lose value from invisibility. Cash transactions are therefore the preferred instruments of tax evasion. Demonetisation, return of cash into bank accounts and consequent widening of the tax net reflected in the vast multiplication of tax returns filed this year make this totally irrefutable.

Of course, demonetisation cannot touch bank accounts in Switzerland, Bermuda or the Cayman Islands.  However, additions to or payments from these accounts generally require misreporting of import and export prices.  Since international prices of standard goods are known, such over- or under-invoicing involves the risky enterprise of bribing collectors of customs. It is not quite a walk in the park.

Undoubtedly, the black economy will regenerate itself even in India.  Shopkeepers who want cash payment to evade the goods and services tax acquire unaccounted cash. But these are only thin trickles, because earlier cash hoards are now valueless and withdrawal of new cash from banks is limited and closely monitored. So the cash circuit that earlier engulfed much of our economy will revive but slowly.

A second argument against demonetisation: It failed to expropriate holders of black money since 99 per cent of the banned currency returned to the banks in exchange for new notes without penalty. Presumably, owners of vast cash hoards escaped detection by parcelling them out in small lots deposited by hundreds of agents. However, no agent performs such illegal services without a substantial cut and blackmailing gains over the indefinite future.  The initial holder of black money may escape detection but only at a major financial cost, with possibly more to come.

Demonetisation made future tax evasion complex and hazardous. It produced another collateral benefit since almost all premeditated crime was funded by high-value notes. This included contract killing, kidnapping, human trafficking, betting and match-fixing, organised prostitution (especially pimping), smuggling (especially of drugs and weapons) and terrorism. Demonetisation turned off the tap. These businesses — possibly, small businesses — suffered because their customers now lacked the means to pay. I wouldn’t shed too many tears for them.

Further, unaccounted cash constituted an incentive, indeed a compulsion, for cash expenditure on consumables and in bars, restaurants and brothels. As the cash melted away, so did pressure for such consumption, stimulating private savings.

Certainly, demonetisation was incompetently implemented without preparation or forethought. A short-run crisis was precipitated that was totally avoidable had the bureaucracy been toned up earlier. It was not — and that was a major flaw in planning demonetisation, not in its basic principle.

Finally, what of the argument that demonetisation ruined the poor and the very small businessmen who rely exclusively on cash? Surely these people have little to do with high-denomination currency. They earn largely in Rs 10 and Rs 100 notes. Certainly, the Bharatiya Janata Party’s (BJP) overwhelming victories since November 2016 in some of our poorest states indicate that the government has not alienated the poor, only the wealthier intellectuals. Or are we to believe that the poor are so Islamophobic that they insist on voting for the BJP regardless of the depths of misery to which Narendra Modi has reduced them?

The author is professor emeritus in economics, School of International Studies, Jawaharlal Nehru University