I want to focus on a recent decision by the Government of India to demonetize currency of denomination Re 500 and Re 1000. But first some background….
India became independent almost 70 years ago, in 1947. For the first 50 years the economy ran under tight government controls. The private sector suffered from what was called license and permit raj, with all decisions on allocation of capital tightly controlled through a system of bureaucratic approvals. This system of gate keeping resulted in low growth, high corruption as all gate keepers extracted their pound of flesh to allow private parties to take risk and make money. On the other hand private parties used corruption as a means of keeping out competition and enjoy monopoly profits. This is of course an over-simplification. There were legitimate social objectives to imposing controls. India being a poor nation with very low tax revenues, this appeared, I am sure, to politicians as a way to do good by controlling allocation of capital to areas that “needed” it most. It also allowed the government to fight “poverty” by setting prices rather than by spending tax money. This created leverage for the government to use its coercive power to extend its reach and influence the economy.
The results of this “system” was crony capitalism with a strong nexus between politicians, bureaucrats and business. Low growth in the economy, widespread poverty and a population that was disempowered. All this changed with the fall of the Berlin wall and a domestic financial crisis.
At that moment the country lifted controls. In 1991 Finance Minister (later Prime Minister) Manmohan Singh said in parliament “But as Victor Hugo once said, “no power on earth can stop an idea whose time has come.” I suggest to this august House that the emergence of India as a major economic power in the world happens to be one such idea. Let the whole world hear it loud and clear. India is now wide awake. We shall prevail. We shall overcome.” The result was a dramatic change in the fortunes of India with two decades of fast growth and hundreds of millions lifted out of poverty. The time for the idea of India as a major economic power indeed had come.
Cut to the present…
India today is a fast growing developing economy with tremendous challenges. It is infrastructure constrained. It is supply constrained. It has a vast and deep labor pool of a young aspirational workforce. The challenge is still huge – India needs to produce 100 to 200 million jobs in the next decade. Crony capitalism still survives. Now the dynamic has changed though. The cycle goes something like this – rich industrialists with access to political patronage use this access to buy agricultural land. They then use the access to power to convert the agricultural land to industrial use. They use loans from public sector banks to invest in capital intensive industries. In case the businesses do well they enjoy the profits and growth in wealth. In case they do not, they have further access to the banks to tide them over. In all of this, there is strong cover provided by politicians who need money and support to fight and win elections. Again this is an oversimplification. There is genuine public interest in increased industrialization. Politicians want to leverage their influence and incentivize behavior. They use the tools at their disposal – banks, land use policy and influential businessmen who have the wherewithal, risk taking ability and knowledge to further the developmental efforts.
In this backdrop the common man feels disempowered again. It is hard to break through the nexus. The assumption is that if you succeed it is because you are in cahoots with the politicians and powerful people. You give bribes and win favors. And yes all this happens off the books in a “black economy”. The black money represents all that is wrong in the “system”. It represents the lack of fairness, the problem of patronage, the arbitrary nature of success in such a system, the complete lack of apparent merit.
The current government has decided to tackle this problem head-on. They have decided to de-monetize Re 500 and Re 1000 currency. That is about 86% of the currency in circulation worth about Re 14.18 lakh crore (US$210 billion). The idea being that people who were avoiding taxes, receiving bribes in cash will suddenly find all their wealth evaporate. This will send a strong signal that the government is serious about eradicating corruption and the underground economy and will help bring about real social change.
People need good reasons to follow rules in the face of norms of breaking rules. This would give people that reason, they would develop a backbone to insist on clean transactions. The tide would turn as more and more people insisted on clean transactions and the economy would start to clean up.
But will this solve the problem? People avoiding taxes will certainly think twice. In that sense rule following will get better. The cost and pain of this episode would change the cost benefit equation in people’s hearts and minds creating a more positive culture of rules compliance. But the fact remains that only a small portion of “black money” was in currency. Most well connected and sophisticated people moved their money into foreign currency, real estate, gold or other such investments. These would not be impacted by the current move. But the current move could create a greater threat perception that the government was serious and that could start to curb bad behavior.
How about the costs?
The Indian economy is not like the west where most transactions are electronic. For the most part (45%) the economy in India is a cash economy. 80% of the people work on cash wages. What is the impact of this decision? This informal economy will grind to a halt. This will reduce consumption right away (some indications are that since the announcement consumption is down 70%). Your spending is my income. This will lead to loss of sales across the board. It will not be surprising if the major retailers and consumer goods manufacturers see depressed demand and scale back on employment and wages. Balance sheets will be further hurt. This cycle will put further downward pressure on investments. Before we know it the economy could be in full recession.
Price of real estate is dropping. In this sector most transactions had a major (40-60%) cash component. This was a tax avoidance scheme that the entire population was complicit in. With dropping prices people will hesitate to invest in construction. Another major engine of employment will be lost. Increased risk of recession.
The black money in the economy was also an engine of consumption. It was tax free and so “cheaper”. It was often used in consumption. This will slow down. Increased risk of recession.
Let us say that the economy does suffer a recession with all the human suffering attendant on such an event. Would that cost have been worth it? Will the long term benefits of a cleaner culture be worth it? Will it make the economy healthier with better resource allocation decisions?
The deeper question is will it change the dynamic of politician influence on the economy and the resultant misallocation of risk and reward. Here the impact seems minimal. In fact it will make that problem somewhat worse. The banks will get a surge in deposits as the economy moves somewhat more towards an electronic payment based economy. They will have greater ability to give loans. The influence of the political class in “making things happen” with their influence will go up.
The lessons of reform from the 1990’s should be clear. Freeing up the economy can unleash the power of people to make better decisions and make life better for themselves and everyone around them. The nexus to break now is the political interference in land allocation and loan disbursement. If these could be made more transparent and rules based rather than patronage based it would lead to great benefits. This seems to be an independent problem not linked to the hoarding of money.
The real problem in governance is the narrow tax base that does not generate the revenues needed to invest in the commons, creating pressure on the political class to leverage the coercive and regulatory power of the state to further their agenda. The shared infrastructure – of roads, clean water, clean air, water resource management, land management, rule of law is where more needs to be done. All common infrastructure is today bottlenecked. Broadening the base of taxation would allow rates to be reduced. This together with strong enforcement with high visibility punishments would go a long way in generating the resources and trust to move the economy forward. The current move seems to be well intentioned but not well directed. The baby could be out with the bathwater with the real economy and employment shrinking in the next few quarters. The benefits of a changed culture of rules compliance still out of grasp…
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