Much has been written about demonetization and the impunity with which the elected leader of a country destroyed the currency of the fastest growing economy in the world. How can a rational and intelligent leader, who got elected on a platform of development, make a decision to undo the very development that he so articulately and obsessively promotes?
This is a classic case of political leaders overreaching on economic issues. The economy is a very complex mosaic of consumers, producers, exporters, importers, farmers, manufacturers, labor unions, banks and countless other stakeholders. It is a dynamic and somewhat chaotic system that is too complex for anyone to try to run, manage, plan, or design. Economic history is replete with evidence of hubristic leaders who thought they could fix the economy but ended up ruining the lives of millions. Add Mr.Modi’s demonetization decision to the failed efforts to manage the economy by leaders in Venezuela, Argentina, Cuba, North Korea, Zimbabwe, China under Mao, Brazil and countless other countries.
Every economic decision has some obvious and visible consequences, but it is the unforeseen second and third order effects that are hard to evaluate, and which make economic decision-making so complex. It is probably not Mr. Modi’s fault that as a non-economist he failed to foresee these unintended consequences. But it is hard to understand why the economic experts in his government failed to appraise him of the complications, challenges, and unintended consequences of a major economic decision that affects the lifeblood of an economy–its currency.
To see how demonetization affects economic growth let’s take a country with 5 citizens and a money supply of Rs. 100. Arun the architect gets the Rs. 100 and uses that to pay Cary the carpenter for helping build a house. Cary gets sick and goes to Dhruv the doctor and pays him the Rs. 100 for his services; Dhruv uses the Rs.100 to buy groceries from Gauri the grocer who then uses the Rs.100 to get a haircut from Bob the barber.
This is how money, black or white, moves in an economy and it is the movement of money that creates growth. The turnover of money, called the velocity of money, is key to economic growth. The higher the velocity of money, the higher the GDP. In this example, the GDP of the country, calculated as the sum of the products and services produced by its citizens, is Rs. 500. And, the velocity of money is 5 since the same Rs. 100 note changed hands 5 times.
Notice that in this example, the GDP of Rs. 500 is equal to the money supply ( Rs.100 ) multiplied by the velocity of money ( 5 times ). This relationship GDP= Money supply x Velocity of money is called the Equation of Exchange in Monetary economics. From the equation, it is obvious that the GDP of a country will go down if either money supply and/or the velocity of money go down.
Now let’s see what happens if Rs. 85 is removed from this economy through demonetization and not immediately replaced with new money. Arun now only has Rs. 15 to pay Cary who in turn does not have enough money to go to the doctor, who in turn now does not have the enough to buy grocery from Gauri who in turn can’t get a haircut. Since there was no money no transactions happened and the velocity of money is now only 1, and the GDP of the country drops from Rs. 500 to Rs. 15 ( 15 x 1). It is clear from this example that removing money from the economic system has devastating effects on transactions, the velocity of money, and on economic growth.
Let’s put this in the context of the reality of demonetization. Let’s give Mr. Modi some credit, and assume that his decision to demonetize did manage to destroy Rs. 3 lakh crores in black money. Then of the Rs. 16 lakh crores of notes in circulation prior to November 8th, only Rs. 13 lakh crores will eventually be deposited or exchanged. As a result, the money supply of the country will drop by about 18%. Also, the velocity of money will drop since millions of prospective transactions will have been canceled due to the unavailability of cash. And, as the example of our hypothetical country shows, a reduction in both money supply and velocity of money will greatly reduce GDP.
Let there be no doubt: demonetization will affect India’s GDP adversely. The only issue is how much wealth will be destroyed. While it is too early to accurately estimate the reduction in GDP from demonetization, econometric estimates have ranged from a drop of 1% to a drop of 3%. I personally think the GDP loss will be much larger and more sustained, but even if we average out these estimates to a GDP drop of 2%, it would suggest a loss in wealth of about Rs. 3 lakh crores at the minimum ( India’s GDP last year was about Rs. 150 lakh crores). Add to this the indirect loss of about Rs. 1 lakh crore in lost wages from time wasted by millions waiting in queues, and the lost revenue for the banking sector in foregone business which the President of the Bankers Association estimates at about Rs. 4000 crores a day. The total direct and indirect losses from demonetization are at the very minimum in the neighborhood of Rs. 5 lakh crores.
The biggest hit, unfortunately, is likely yet to come from the long-term impact on the credibility of both the government and the RBI. The perpetually changing narrative on demonetization has become so distant from reality that there is a risk that foreign investors, many of whom are still smarting from the massive overreach of “ retroactive taxation” introduced by Mr. Parnab Mukerjee in 2012, will decide that the political risk of investing in India is not worth the potential returns. Investors hate uncertainty (and taxes) and are particularly wary of reckless government overreach with policies like retroactive taxation and demonetization.
It is clear then that the loss in wealth far exceeds all the black money the government could conceivably collect from demonetization. The relevant question to ask then is why? Is this loss in wealth and credibility worth the small gain in additional taxes from black money? What is really paradoxical is that demonetization hurts precisely what the government thought it would benefit –increased tax collection. A slower economy and a reduction in the velocity of money will lower direct and indirect tax collection by as much as 20% over the next few quarters. These are the unintended second-order consequences that Mr. Modi and his advisers completely missed. Instead of demonetization filling the coffers of the government with black money, it will likely lower fourth quarter tax collection and increase the 2016-2017 fiscal deficit.
In spite of the huge loss in wealth and the hardship faced by millions, it is still surprising to see that a large number of Indians still bask in the illusion that their sacrifice is worthwhile for some ‘greater cause’. Maybe there is perverse pride in seeing their Prime Minister sock it on the chin to all the “bad” people with black money. There is a German word “schadenfreude” that means roughly “hurt-happiness”. It’s the visceral feeling we get when someone we don’t like gets his comeuppance. We smile and praise demonetization when we hear of a politician or a rich business person getting raided by the tax authorities. A few crores get recovered and we blissfully argue that demonetization is working. But we are completely oblivious to the large costs that have been incurred to pick those few pennies. I am not condoning either tax evasion or the corruption, but I am pointing out that whatever support Mr. Modi appears to have from the common man on the street, comes, most likely from schadenfreude.It is hard to imagine that any reasonable person would think that the wanton destruction of real value can be a boon or a blessing.
Many in the country also have this misconception that once the government collects all this black money that somehow India will be magically transformed into El Dorado. Even if the government could somehow recover all the stashed black money, the proceeds would go back into the hands of the same state whose departments and agencies are the major sources of this embezzlement, to begin with. And, sadly, instead of fixing the institutions and tax policies that create black money, politicians will continue to perpetuate the myth that the only thing stopping India from becoming a major super power is not their incompetence, but the black money.
Let’s be clear: Less black money will not make India richer. It will only mean more tax collection for the government and a bigger government. What makes a country richer is human capital: either more people working, or the same number of people working longer, or the same number of people working harder (more productively). This human capital needs to be treated fairly, and when a government becomes obsessed with raising tax rates to a point that it discourages human capital, it drives off the top contributors of ideas, products, and services. The French government drove away many top entrepreneurs to Belgium by raising taxes to 70%. Similarly, the Government of Maryland passed a special tax on millionaires in the hope of collecting an additional $106 million in revenue. However, it didn’t account for human behavior as 1 out of every 3 millionaires left the state resulting instead in a tax loss of $200 million.
An unwise tax policy and a government obsessed more with black money than the creation of growth, will unfairly tax those who create wealth and in the end, make everyone poorer. What may appear obvious is often an illusion in a complex ecosystem like the economy where behavioral responses like greed, fear, loss of confidence are far more relevant than the obvious and measurable responses. How demonetization has affected investor and consumer psychology is unclear, but if economic history is any guide it will not be pretty.
Mr. Modi and his team need to wean themselves away from this obsession with squeezing every drop of tax revenue out of the economy. Increased tax revenue is the result of economic growth and not the cause of it. The outdated notion, that taxing the private sector and transferring that spending power to the government will expand the economy has been thoroughly discredited, yet lawmakers continue to return to this strategy. Historically, governments have rarely outperformed the private sector in generating productivity growth.
Instead, Mr. Modi should focus on building institutions that grow the economy. The only way to get millions out of poverty is to create wealth by removing impediments to growth, reducing regulations, simplifying the tax code, lowering regulatory and political risk and making it easy for businesses to create wealth. When it comes to economics the government is not the solution; it is the problem. Libertarian novelist, Ayn Rand put it best when she referred to it “ as the separation of State and Economics—the abolition of any and all forms of government intervention in production and trade–in the same way and for the same reasons as the separation of Church and State.”
If Mr. Modi had instead spent the time and energy wasted on demonetization on big bang proposals for reforming corrupt government institutions, and focusing on more efficient delivery of public goods like electricity, clean water, basic education, health care, transportation, he would have made a huge contribution to the development of the country. Unfortunately, his obsession with black money will hurt his development moniker and could create problems for him in 2019.