Maitreesh Ghatak, Professor of Economics at the London School of Economics, contends that while the ban on high-denomination currency notes is bad economics, it is a brilliant political move.

By now, there is consensus that the execution of the demonetisation move has been poor, and a significant cost has been inflicted on the whole population. This has resulted in physical hardship and in some cases, death. Also, no one - except the most partisan - would doubt that the move has hurt the average person economically and the poor significantly so, by drying up trade and commerce due to currency shortage. There is no doubt that this move will have a recessionary effect in the short-run. The worst hit has been the unorganised sector where cash is king, and plastic means bags to carry goods, not credit or debit cards.

Demonetisation and black money

Acknowledging the poor execution, and the costs on the average person, can one still make a case that the policy will be successful in terms of its stated objective, namely to curb black money?

The answer is: no. At best, demonetisation would have as much a lasting effect on curbing black money as a one-time effort to remove piles of garbage would have on the quality of sanitation and hygiene. Unless the system of waste management and civic-standards change, a one-time clean up drive would have little impact beyond the very short-run. Black money generation is a continuing process that involves evading taxes and regulations, and engaging in corrupt and criminal activities. Cash is just one of many ways to store the stock of wealth that is created as a result. The following assumptions need to be true for a one-time strike like this one to make a dent on the problem: cash is the main form in which ill-begotten wealth is stored, and those who engage in these activities will fear that the government will keep on taking similar actions from time to time, and will not be able to find other ways of storing the wealth.

Both assumptions are unrealistic.

First, the connection between cash and black money is at best tenuous. Reports such as this and this suggest that only a small fraction of black money is held in cash. One can deal in and store black money by not using cash at all - for example, one can use gold, real estate, financial assets, or foreign exchange.  Also, given that only 1% of Indians actually pay income taxes, while 2.3% file tax returns, and most transactions escape the net of sales tax, excise duty, or VAT (Value Added Tax), most innocuous transactions technically involve black money (other than agricultural income that is legally tax-exempt). 

Second, since it is unrealistic to expect the government to keep on repeating this exercise, the system will find a new equilibrium and all the activities that generate black money will go on. And to the extent they use cash (example, bribery, political donations, real estate) they will go on using the new currency notes. In fact, the Rs. 2,000 denomination will make it easier, not harder to use black money, by the government´s own logic. It is true that economists such as Ken Rogoff and Larry Summers, have argued for clamping down on high-denomination bills in developed countries, where plastic or electronic transactions are accessible to almost the whole population. However, since that is not the case in India, they themselves have noted (for example, here), that this argument does not apply to the present move.

Therefore, ironically, this reform may even increase the stock of black money held in cash in the future by facilitating hoarding in currency notes of a higher denomination. More generally, as necessity is the mother of invention, this move will act as a spur for those who engage in illegal activity to come up with alternative methods of transaction (think of an electronic Hawala¹ network like Paytm for black money!) and storing of wealth.

The only way this policy may have some bite on future corruption is if people believe that this move, however imperfect, is an advance firing shot hinting at a series of future reforms aimed at curbing corruption and is more a signal of intent on the part of the government than something that will be effective by itself. That is what the government has stated to be the case, but even the think tank that supposedly provided the idea behind the move is reportedly disappointed with a set of complementary reforms not being carried out. 

Moditics is a winner

Even if the policy of demonetisation has been proven costly, and is likely to be ineffective or even counterproductive, it is a brilliant move as a political campaign. Earlier innovations like the use of 3D images of Mr. Modi during the 2014 campaign, being the first major national leader to leverage social media like Twitter, or posing with a broomstick during the Swachh Bharat Abhiyan pale into insignificance given the universal and compulsorily participatory nature of this particular move. There are three major reasons for this:

First, while this policy itself will do little to curb black money in the long-run by itself, it does have a great signalling value. It is impossible to deny that a politically risky move like this, given the hardship it inflicts on ordinary voters, does indicate that Mr. Modi is serious about controlling some forms of corruption.

Second, currency notes are universally used and so if you pull people by this string, everyone is affected. No advertising campaign can accomplish 100% outreach, whether is through the media, rallies, or door-to-door campaigns. There is no greater pull than economic self-interest and that is why everyone will have to participate in this campaign, and in the process, form a view about the intent of the government.

Third, because its coverage is universal, ordinary voters will take some satisfaction in the rich and the powerful being inconvenienced along with them. Also, as much as disasters are shown to generate a form of solidarity among those who are affected, however different their backgrounds are, this will create a popular consensus about the importance of curbing corruption and the government´s seriousness about it. This is much more important than inconveniencing the cash-reliant campaigns of rival political parties in the UP (Uttar Pradesh) election, which has been suggested as one of the political reasons behind the move.

The supposed magic of Modinomics remains unproven. But Moditics is a winner. Being a four-term Chief Minister of Gujarat was no fluke, nor was winning the 2014 elections by an absolute majority. The campaign for the 2019 election has begun.

This article first appeared on NDTV: http://www.ndtv.com/opinion/modinomics-unproven-but-moditics-wins-with-notes-ban-1628793 

Note:

1. Hawala is a traditional system of transferring money whereby the money is paid to an agent who then instructs an associate in the relevant country or area to pay the final recipient.