The Demonetisation announcement of 8/11/16 was a complete surprise, led to some wild reactions in the political and media circles and occupied endless TV panels. For those who have never adjusted to Narendra Modi’s victory of 2014 (those in denial – the Deniers), this was the biggest blunder they thought he had made. After three years of losing the ground to Modi here was their chance to excoriate the Prime Minister. The Deniers took to the media – Facebook, Twitter, emails, blogs, TV news channels, public speeches. Parliament was shut down for several days. Rahul Gandhi accused Modi of ‘firebombing’ the poor, whatever that may mean. Dr Manmohan Singh accused the government of monumental mismanagement and predicted a 2% loss in GDP. (This has been sometimes described as a 2% fall in GDP growth rate. But the records suggest that Dr Singh meant the level. I shall discuss this later.)
I was present in India at the time of the Prime Minister’s broadcast. I was thrilled. I saw immediately what he had done and what the likely effects could be. This is because I had proposed such a scheme myself a few years previously in my inaugural Brahmananda Lecture to the RBI in 2004. I had been thinking about the black money problem for many years. Schemes of amnesty to black money hoarders had not worked. Offering bonds in exchange for black money was also not a success. Black money hoards were not lying idle except in the period between their earning profits and reinvestment. Idle money hoards are not a good way to keep wealth. Money is not an efficient store of value. But the black money hoards are coming in and out of a circuit of black money (Occasionally going in and out of the White economy as well) where they are earning profits. (Marx in Capital Volume 2 lays out the notions of ‘circuits of capital’ and I was adapting that idea to black money. Desai(1974))
Attempts to estimate black economy missed out on the circuit aspect. What lay idle at any time would be a fraction of what was in circulation. The key to fighting Black money was thus not just raiding houses where such hoards may be found but draining the economy of its currency and replenishing it with new clean currency. You had to devalorise the existing currency across the entire economy to strike at black money. It is after all the essence of the black economy that it is not visible. Money is money; it can be White or Black and it is hard to say which amount is White and which Black, it can change its colour like a chameleon.
My Fantasy of Demonetisation:
My own ‘fantasy’ was that if I were ever in charge of the Indian economy, let us say as Prime Minister, I would announce that as of some date the existing currency would no longer be legal tender. But I had to think through how to get the existing (old) money back and replace it with new. My fantasy proposal had to be cleared with the President under whom I would be serving as PM. I could not tell my Cabinet because they would quickly rush to launder their black money hoards!
There are two parts to demonetisation. Collecting the old currency and introducing the new currency. A lot of attention has been paid to the question of getting the old currency back. It was assumed (may be even by the Government) that the shortfall in the amount of currency returned would represent money hoards which had lost 100% of their value. It was described as a windfall gain for the Government as the non-returned money would be a reduction in the liabilities of the RBI.
My scheme would have been to let the degree of devalorisation be determined by the market. I would have proposed that, up to a certain limit, say, 1 crore (per household) all old money could be exchanged for new money at par. Any amount above that would be exchanged for in zero coupon bonds. These bonds would be saleable after a decent interval. When offered for sale, the market would discount them. The discount would be the implicit tax on the hoards. My scheme did not involve any other punishment for the hoarder. For the new currency, my fantasy involved creating a ‘fake’ emergency which required army trucks to be moved all across the country. These trucks would carry the new currency which would then be in place across the banks throughout the country. This was because the Army was the one institution which could be trusted to serve the country loyally.
I had estimated that if the scheme could be implemented smoothly as per my fantasy, the shock to the economy would be a very mild one.
The Real Demonetisation:
When the PM made his announcement on 8/11/16, he warned people of the hardship. All old currency in the two higher denominations – ₹1000 and ₹500. As much as 86% of the currency was estimated to be in these higher domination notes. The key injunction was that all these notes had to be deposited in bank accounts. New currency was going to be made available from banks for people who had deposited old money but the availability of new currency was to be restricted.
The surprise move caused much distress and difficulty. White money holders were as much inconvenienced as the target black money holders. As soon as banks opened queues began to form. PSU banks had longer queues than private banks. There were many complaints about business bring shut down, workers being unable to be hired, farmers in distress etc.. Estimates were instantly made as to the damage to the economy. For a few weeks, there was no other topic of conversation. On a personal note, I lived through the first three months of the experiment as I travelled back and forth between London and Delhi. So I queued at my private bank, with my PAN card and had to make do with limited withdrawals etc.. It was an inconvenience but compared to what I had experienced during my teenage years in the Fifties pretty mild. Queuing for milk, for ration for train tickets, for admission to cricket matches was routine.
The reaction of the sophisticated people especially professional economists and even some finance specialists was pathetic. It revealed elementary ignorance of the basics of monetary economics.
Thus it was said that the Government had destroyed all money. Money by definition consists of cash and demand deposits. The Government did not alter the amount of money in the economy. It changed the cash/ deposit ratio. For those who could write cheques or use their debit cards, there was no shortage of money. This elementary insight was lost.
What caused difficulty was the slow delivery of new cash to replace the old cash. Compared to my ‘fantasy’, reality proved inadequate. The introduction of a new denomination note ₹2000 of different size and hence unsuitable for ATM machines added to the distress. The late arrival of new currency led to many conspiracy theories but I conjecture that the Government had to bring its plan forward to forestall leakage and accusation that it had warned off its business friends. The ‘ Sui- boot ki Sarkar’ jibe was very much in the mind of the PM.
I wrote a number of pieces on the subject at the time. For my weekly column in The Sunday Express, I wrote At Last (13/11/16), 8/11 ( 20/11/16). These were both very supportive as was the article I wrote for the Financial Express where I have a fortnightly column every other Monday I wrote Could Modi have Done Better? (21/11/16) and The Costs of Demonetisation (4/12/16). I wrote Enough ( 17/12/16) criticising the bureaucratic failures of implementation. My last piece was How to Estimate the Costs of Demonetisation? for the Financial Express ( 1/1/17). This last one laid down somewhat formally how I would address the question of estimation of impact.
The basic insight is that money is cash plus deposits. There is a long-standing understanding of how money affects income and prices. The Quantity Theory concentrates on the impact of money supply on price level by specifying the equation
MV= PT where V is velocity, P is price level and at the total number of transactions while M is money. Then there is the Cambridge Equation which Marshall, Pigou and Keynes developed. This says M = kPY. Here k is the proportion of the money income held in the form of money by agents, P is again the price level and Y real income. (Details in Desai, M. (1981) Testing Monetarism (Pinter; Bloomsbury reissue in 2015))
Now the monetary shock was a transfer of cash to deposits leaving money supply nominally unchanged and a slow introduction of new cash which would augment the money supply. The influx of deposits in banks would lower the rate at which they lend. The lack of ready cash affected the transactions in high frequency eg daily purchases. These are normally small ticket items. High-value transactions would not ordinarily be affected because they could be purchased by cheques or debit cards. There was a quick growth in direct payment cards so buyers with limited cash but money in the bank could buy and sellers could sell.
I estimated in my Financial Express 1/1/17 article that the cost would be at most one-half of one percent in the growth rate of GDP. Preliminary estimates released in March 2017 by the CSO vindicate this estimate. Of course, these growth numbers can be, indeed will be, revised. We will not know the definite answer till a year from now. That is the nature of economic statistics even in normal circumstances.
But there is some logic to the low estimate. The financial year runs April to March. Thus by the time the Prime Minister made his announcement, two complete quarters had gone and first five weeks, (almost half) of the third quarter were also over. The early estimate for the first two quarters was around 7% growth rate. This may also be assumed for the first half of the third quarter. The remaining one and a half quarter would have to grow very slowly indeed for the year to end up two or three percentage points below 7%. Thus for the growth rate to be 5%, the remaining one and half quarters (3/8 of the year) at just 1.66%. (5/8×7 + 3/8×1.66 = 40/8 = 5). This would be almost one-quarter of the growth rate in the first 5/8th of the year. This was highly unlikely except in the event of a physical catastrophe like a Tsunami or earthquake or flooding.
Dr Manmohan Singh estimated a loss of 2% to GDP from the experiment. This could mean that the level of GDP in 2016/17 would be 2% below its level in 2015/16. This would, in turn, mean a growth rate of -2% for the year 2016/17. Following the above calculations of 7% growth rate in 5/8th of the year, the growth rate in the remaining 3/8 of the year would have to be -17% to arrive at a 2% drop in the level of GDP. ( 5/8×7 – 3/8×17 = -16/8= -2) To project a 17% decline in the last four and a half months of the fiscal year is, to say the least, extraordinary. One can only say that perhaps the normally cautious and careful Dr Manmohan Singh with his vast experience as an economist was just being a politician.
These calculations are based on the assumption of a 7% growth in the first two and half quarters at 7% and then working out what would the growth rate have to be to fulfil the predictions made. It could be that the growth rate of the first half may be revised downwards. Even so, it will not be by much. So broadly our conclusions should stand.
It would seem that most of the old high denomination currency did return- some 96%. This meant that not many people had idle hoards which lost value by 100%. Thus should not have surprised people. Black money makes money by circulating, not resting. What hoards there were could have been quickly converted into real purchases. It seems this is partly what happened. In that case the loss of value was in the higher prices paid for gold and jewellery and any other quick purchase to launder the black cash. The hoarder’s loss was the merchant’s gain. One way or another black money has to circulate to make more money. We may call it jugaad but it is just economics.
Even otherwise, what Economics tells us that the economy may suffer adversely from an adverse shock. But soon there will be adjustments and mean reversion. The shock to the economy was a sharp one, to begin with, but over the next few weeks, it eased. When things have settled we should be able to study the impact of demonetisation. The following questions are important.
- What is the cash/income ratio (quoted to be 0.12) and what is the demand deposit income ratio? In short, what is the shape of the money demand function?
- At what rate did the new currency enter the economy and how long did it take for the new cash/income ratio to reach near the old equilibrium value of 0.22? Given the development of digit technology and spread of banking habit, we should expect the cash / Income ratio to decline. Has it converged to a new lower value?
- What was the time shape of expenditure as the economy reacted to the initial shock and later infusion of new cash?
I am confident that these questions will be investigated by economists. The whole episode has not been a credit for Indian economists, academic and practical.
Date(s) - 11/04/2017