Current General Studies Magazine (November + December 2016)
General Studies - II "Debate Based Article" (High
Costs, Meagre Gains)
On November 8, Prime Minister Narendra Modi announced his
ambitious demonetisation policy initiative to attack the scourges of corruption,
black money and fake currency. He also spoke eloquently in his December 31
address about the need for purifying the nation of these scourges. The
desirability of this policy goal is well-understood and incontrovertible. How
effective has demonetisation, as a policy, been in achieving its stated goals?
How efficiently has it been implemented?
In terms of effectiveness, the move undoubtedly prevents
further circulation of existing counterfeit currency in the two demonetised
denominations (Rs 500 and Rs 1,000). However, it doesn’t necessarily eradicate
the problem since counterfeiters will be hard at work trying to replicate the
new notes, which, by all existing reports, are no less prone to counterfeiting.
More importantly, the size of this problem was small to start with (around 0.025
per cent of all notes in circulation, according to recent Indian Statistical
The move also doesn’t do anything to punish the originators
of fake money. How effective has demonetisation been in dealing with black money
and corruption? As pointed out by many, both black money and corruption are flow
concepts. The move does nothing directly to the flow creation of black money and
corruption, other than through its signaling of possible future moves.
Black wealth is a stock that reflects all past creation of
black money, cash being just one of several ways of holding it. If 90 per cent
of the demonetised cash is returned to banks, back-of-the-envelope calculations
suggest that the demonetisation will likely net about two per cent of the black
wealth stock or one per cent of GDP in government revenues. The revenue gain
could be a bit higher if the income tax department successfully performs the
Herculean task of levying penalties on those who laundered their black wealth
held in cash by depositing it in banks. The Central Board of Direct Taxes, with
its chronic staff shortage, must now examine all cash deposits in excess of Rs
250,000 as well as examine cases with no returns filed. The reported depositing
of large cash holdings in many separate small parcels through paid
intermediaries and the use of tax-sheltered agricultural workers to launder
undeclared cash makes matters more difficult.
On the cost side, anecdotal evidence suggests that the
biggest negative output and employment effects have been on the heavily
cash-dependent informal sector which accounts for 80 per cent of employment and
45 per cent of GDP. Studies have shown this sector’s strong linkages with the
formal sector, which often outsources its tasks to the former to reduce costs.
According to a recent Washington Post article, the demonetisation exercise has
negatively impacted various small and medium-size industrial clusters, which, in
total, employ 80 million workers. For example, the cellphone manufacturing hub
of Noida has experienced a halving of output, with a quarter of employees sent
back to their villages.
On balance, the costs (which the PM in his speech called
“sacrifices” for a noble cause) are very high in terms of output, employment and
the disruption caused in the lives of law-abiding citizens, especially when
compared to the rather meagre gains. With the costs already being felt and
benefits predicted for the future, there is much greater uncertainty about the
latter than the former.
Probably the biggest negative of demonetisation has been its
implementation, as manifested in the chronic shortages of new notes, their
flawed composition with an under-supply of Rs 500 notes, the repeated changes in
regulation on withdrawals and deposits, etc.
In our opinion, the best way to summarise the demonetisation
move is through the insights from the path-breaking work of Jagdish Bhagwati. In
a piece on trade distortions Bhagwati co-authored with V.K. Ramaswami (1963), he
made the trenchant point that the optimal intervention instrument attacks the
source of the distortion directly. In the case of black money, demonetisation
attacks one of the many ways of storing it rather than attacking the problem
directly. At the same time, it creates other distortions in the form of costs
mentioned above. Consequently, it fails the Bhagwati test. Other policies, such
as income tax audits based on computerised algorithms, slashing stamp duty rates
on real estate transactions and raids based on information generated by
suspicious transactions, are more direct policies (closer to the targeted
distortion) which don’t create by-product distortions. These policies would rank
much higher than demonetisation by the direct application of the Bhagwati
In the days since the demonetisation announcement, the
narrative has subtly changed; the goal is now to turn India into a cashless
economy. Even here, demonetisation fails the Bhagwati test of targeting the
source of the problem directly. The low usage of digital payment methods in
India is largely because of widespread financial exclusion and the absence of
reliable digital infrastructure. An optimal approach to encouraging digital
payment methods would be to correct these issues directly.
The Nobel laureate Jan Tinbergen demonstrated that policy
success requires that policy instruments are not outnumbered by targets. In
trying to attack so many targets at once, demonetisation fails the Tinbergen
principle, also emphasised in the work of Bhagwati and Ramaswami.
Last, but not the least, the increase in invasive “babu”
power (for example, bank officials interviewing depositors) will lead to serious
inefficiencies, a prediction based on a straightforward application of
Bhagwati’s seminal work on directly unproductive activities.