Economics and Politics of ‘Demonetization’

Ganesh Manjhi teaches Economics at University of Delhi. He can be contacted at ganeshtrx[at]gmail.com.

ganesh-manjhi

Ganesh Manjhi

What are the most important reasons of the ‘demonetization’ – coming of big elections, initiative against the black money promised during the 2014 election, curbing the tax evasion or streamlining the market economy by cleaning the house itself?

Let’s come to the populism of ‘demonetization’ which the vast educated lower middle class liking and perhaps not the general and upper middle population who are the mover of the market economy. The below poverty line and women in general will be the biggest sufferer. Many poor people do not even have identity cards as well as the account number where they can exchange their hard earns money. Those women who saves for precautionary measures do not have easy way out to this problem because large share of them are in the rural areas and do not even have the account number. And either way so far, financial inclusion dream has a very limited success in India.

In fact, historically there is huge expenditure on elections in India. The government of India already cleared that, the maximum limit for the lok sabha election is from Rs. 40 to Rs.70 lakh for bigger states and from Rs. 22 to Rs. 54 lakh for the smaller states, none the less, large amount being spent in the elections by contestants which are not easily been accounted. In fact, Kapoor and Vaishnav (2011), on their paper, ‘Quid Pro Quo: Builders, Politicians, and Election Finance in India’ (http://www.cgdev.org/files/1425795_file_Kapur_Vaishnav_election_finance_India_FINAL.pdf) states that during the election, builders finance the election expenditure indirectly and in return they get the regulatory benefit once the preferred party comes in power. And this relationship is so powerful that real estate market goes down during the elections in India. Consequently, there will be momentarily effect on the already sluggish real estate market in general and the states going to have assembly elections; in particular. In a way, it’s good for the real estate investor that they face the demonetization now than facing the lower price of the estate in the coming future.

So far, what we know is, UP has given the maximum number of prime ministers to India, as it has the highest number of lok sabha ( and vidhan sabha) seats. Also, winning UP election creates a good base to rule the country for long period and politically this seems to me as one of the reasons. The Samajwadi Party (SP) and Bahujan Samajwadi Party (BSP) have ruled the state in recent times, and in most cases winning election is based on caste, religion, muscle power, money and sometimes by pre-election populist policies such as – bicycle and laptop distribution etc. Now, to make the BJP’s foundation strong in UP, hitting at the opponents root was very important that too when BSP supremo already had a history of income tax glitches in her part. Agony and anxiety has already been reacted as a ‘financial emergency’ by her without really inferring what exactly it can be? Economically it is a good move by the BJP in terms of sending the opponents in their own goal posts but politically huge cost attached to it. The Union government is creating its own economic base cleaning the predecessor’s decrepit and trying to know the size of the shadow/underground economy which is, in fact can be made inclusive to the mobile with the market economy. In consonance, the less informed UP voters will remember the pain and not the some positive consequences in the medium run. So, the idea of populism of ‘demonetization’ will cost incumbent at the centre, as the ‘median voters’ seems to me are the less informed middle most voters. Similarly, big shadow economy of Agriculture works with lot of backdoors in the Food Corporation of India (FCI). In fact, even in Punjab it is going to create shallow edge for the central incumbent which is not really winning the election. So, the case of Punjab is not exceptionally going to be different from UP.

As most of the people including World Bank already said that the share of the black economy is 30% of the GDP, whose transactions are not really be accounted in country’s progress. In fact, the underground economy or black economy is one of the problems of the measurement of the GDP as its transactions are not recorded. It means, if the transactions are recorded in terms of proper transaction bills, cash memos then that can be one of the ways to dig out the black economy. In fact, if the economy moves all its transactions to the electronic system and no cash, the black economy can be dealt better as economists have already expressed their desire. However, the total stock of money as a black is very less in percentage so, the big total effect of ‘demonetization’ in the medium run is also not going to be big, but there will definitely be some gain.

The big ‘Jumla’ lecture of 15 lakh during the 2014 election campaign was quite a painful itching on the back of the incumbent’s as that also contributed in losing the battle of ‘Indraprastha’. The initiative can also be thought in the direction as – the social emancipation should start from home and not from the Swiss Bank but that seems fishy in citizen’s eyes. Anyway, so the surgical strike was not really on target but can strike back to the chest of striker because people have hoped that big fishes will be in the net and not really themselves. The outgoing governor of the RBI was quite adamant about the non performing assets (NPAs) of the borrower and perhaps that seems one of the differences between the fiscal and monetary decisions by two apexes which perhaps cost the governor by its chair. If action on big fishes have been taken that would have been more appreciable people at large would have been in peace than the current alternative which created havoc all over the country.

But any way, black economy in terms of, money hidden in ceiling, sofa sets, money behind the walls with a hidden door or in the account in a Swiss Bank all are part of bad black economy and in fact the piggy bank money in the home is as bad too, because these quantity of money are remained idle for a long time without being part of transaction, no return on it except small precautionary use and do not contribute to the economy. The size of the piggy home bank will be bigger if coin will be of bigger denomination and can harm more to Keynes if such coins come in the future.

One of the very important parts of the economy is to decide the optimal stock of money in the whole economy and at this moment largest share (approximately 86%) of the same is in the denomination of Rs. 500 and Rs. 1000. Delegitimizing the Rs. 500 and Rs. 1000 would work like a speed breaker in the economy at the effect and the velocity of circulation will be less, particularly for these two currencies which cannot easily be compensated by the quantity of other denominated currencies. Hence, from the Quantity Theory of Money (QTM), MV=PY, where M is the stock of money, V is velocity of circulation (no. of times money being transacted in given time), P is the price level and Y is the total output of the economy. Less V will create less total income in the economy until the new denomination start functioning properly. Also, at the event output will be negatively affected but as the shadow economy fades (which in fact seems less likely), output growth will peak up in the medium run. The QTM in terms of growth rates can be expressed as, inflation rate=money growth-output growth + velocity of circulation. Inflation rate will not change at the event and not even in the near future unless there is some external shocks. Rather reduction in money growth at the effect can be higher than output growth and the situation of deflation or dis-inflation can arise, which rather gives very clear way for the already celebrated inflation targeting regime. This will also create the lower interest rate regime because of the lower money stock in the economy as our finance minister was desired for last one year to provide better investment opportunity for the entrepreneurs. The volatile economy at the event will also depreciate the currency at the event but stabilize the market in six to eight months since, the ripples are small. Hence the growth path of the economy has been well streamlined where market economy will play the stimulating role in the medium run.

Finally, streamlining the economy has a huge cost. That is, at the event people at mass are facing the insolvency of their daily survival hard earns few yellows (Rs.500) and reds (Rs. 1000) but in the medium run it will be better. The incumbent at the centre can face counterproductive in the coming elections of UP and Punjab, because of the less informed citizen voters about the future prospects of the economy. The only point of worry is, whether everyone in the economy was uninformed or are there some privileged upper echelon people who have already parked their wealth at the safely? There were some suspicions on this as some banks are showing huge jump in the deposit growth rates in the last quarter. Also, the preparation for the ‘demonetization’ seems meager, as I heard the size of the Rs. 2000 notes are bigger and not fitting in current ATMs. So, the announcement has been done because of the Diwali rush. Finally, the government decision to catch small fishes can backfire and it is not going to give the big solution that it has been sought for.

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