{"id":18568,"date":"2017-10-18T14:18:28","date_gmt":"2017-10-18T18:18:28","guid":{"rendered":"http:\/\/www.megalextoria.com\/wordpress\/?p=18568"},"modified":"2017-10-18T14:21:39","modified_gmt":"2017-10-18T18:21:39","slug":"indias-demonetization-effort-has-demonstrably-failed","status":"publish","type":"post","link":"https:\/\/www.megalextoria.com\/wordpress\/index.php\/2017\/10\/18\/indias-demonetization-effort-has-demonstrably-failed\/","title":{"rendered":"India’s Demonetization Effort Has Demonstrably Failed"},"content":{"rendered":"

\"\"<\/a><\/p>\n

Dormant for a while, the debate over India\u2019s demonetization program of last fall has been revived by new evidence. The new evidence on note returns and GDP vindicates the critics and has the defenders in strategic retreat.<\/p>\n

What Happened<\/strong><\/p>\n

To recap: On November 8, 2016, India\u2019s Prime Minister Narendra Modi shocked the nation by announcing the immediate \u201cdemonetization\u201d of the two largest rupee currency notes (Rs 500, worth about $7.50, and Rs 1000, worth about $15). Noteholders would have only 50 days to turn them in for new Rs 500 and Rs 2000 notes. The move, Modi promised, would sharply penalize holders of unaccounted \u201cblack money,\u201d namely tax evaders, bribe-takers, professional criminals, and terrorists. Their currency hoards would become worthless \u2014 a welcome one-time wealth loss \u2014 or they would expose themselves to detection by trying to swap or deposit large batches. Anyone depositing a large sum in old notes would face scrutiny by tax authorities.<\/p>\n

In order to keep the move a surprise (the better to catch the black money holders), new notes to replace all the discontinued notes had not been printed in advance. The canceled notes represented 86% of the currency in circulation, and more than half of M1 (currency plus checking deposits), India having a highly cash-intensive economy with half the population unbanked. As criminals were far from the main users of currency, the impact was unavoidably felt well beyond the black-money set. A serious currency shortage immediately arose, with predictable consequences. Honest wage laborers in the huge cash economy went unpaid, honest construction projects came to a standstill, honest shopkeepers saw sales dry up, and honest businesses failed. Honest people wasted billions of hours waiting in queues to exchange old notes for the trickle of new notes.<\/p>\n

As Shruti Rajagopalan and I\u00a0noted in November last year<\/a>, there was also a fiscal angle: for every billion of old rupee notes not turned in (for fear of being scrutinized), the government could issue a replacement billion and pocket it as one-time seigniorage revenue. For example:<\/p>\n

If 20% of the old notes are never turned in, the government\u2019s revenue windfall is up to Rs 2.9 trillion ($42.5 billion).<\/p>\n

The destruction of the private wealth of non-redeeming old-note holders, combined with the revenue windfall to the government, makes the currency policy effectively a large\u00a0capital levy, a massive one-shot transfer of wealth from the private to the public sector.<\/p><\/blockquote>\n

We speculated: \u201cThe wealth transfer to government may help to explain Prime Minister Modi\u2019s enthusiasm for the currency cancellation and re-issue, despite its likely ineffectuality against black money.\u201d<\/p>\n

Economically literate defenders of demonetization have been fewer than critics. The most prominent defenders have been the well-known trade economist Jagdish Bhagwati of Columbia University together with his former students Vivek Dehejia and Pravin Krishna, and with his Columbia colleague Suresh Sundaresan.<\/p>\n

The Defense<\/strong><\/p>\n

In a\u00a0December 2016 piece<\/a>\u00a0in the prominent\u00a0Times of India<\/em>, Bhagwati, Krishna,\u00a0and Sundaresan (hereafter BKS) praised the demonetization program as \u201ca courageous and substantive economic reform that, despite the significant transition costs, has the potential to generate large future benefits.\u201d BKS recognized that \u201cthe process is inconvenient, and subjects many households to hardships,\u201d but thought it worthwhile for \u201cpotentially increasing transparency and expanding the tax base and revenues to the government from taxes and surcharges.\u201d\u00a0The fiscal angle was foremost: since \u201cunaccounted deposits will be taxed, this will yield a windfall for the government permitting large increases in social expenditures.\u201d In addition, it would promote a \u201cswitch into digital transactions\u201d and \u201cput a major dent in counterfeiting.\u201d<\/p>\n

In an Op-Ed published on December 27, Bhagwati, Dehejia, and Krishna (hereafter BDK)\u00a0defended the demonetization program<\/a>\u00a0entirely on the grounds that it would impose an effective capital levy. It was, they wrote, \u201ca policy designed, in effect, as a one-time tax on black money.\u201d They noted that the government\u2019s revenue gain would not come just from replacing unreturned notes. Under \u201cvoluntary disclosure\u201d rules promulgated after the initial announcement, depositors of old notes who acknowledged their holdings as illegitimate would also pay: \u201cdeposits of unaccounted money will be taxed at 50% \u2014 with a further 25% taken by the government \u2026 as an interest-free loan for a period of four years.\u201d Thus there would be a one-time fiscal gain to the government not only from notes never returned, but also from notes returned under such terms.<\/p>\n

BDK proposed the size of the revenue gain as a sufficient criterion for judging the success of the program: \u201cat least from the perspective of its effectiveness in dealing with the black money issue, success has to be measured by the sum of tax revenue generated [from the 50% tax on acknowledged black deposits] and black money destroyed [i.e. revenue from replacing unreturned notes].\u201d For the sake of illustration, they supposed (calling it an \u201cestimate\u201d) \u201cthat one-third [Rs5 trillion] of the approximately Rs15 trillion in demonetised notes is black money.\u201d Then if by the end of the turn-in period \u201cRs1 trillion is unreturned, as is believed, and we further assume that only half of the remaining Rs4 trillion of black money that is returned falls within the tax net, the net gain works out to Rs1 trillion of black money destroyed and 50% times 2 trillion = Rs1 trillion in tax revenue.\u201d With such a total fiscal gain of Rs2 trillion, \u201cthe government could reasonably claim this as a successful outcome.\u201d<\/p>\n

In a\u00a0commentary on the BDK piece<\/a>, Rajagopalan and I pointed out that, from the economist\u2019s point of view, the costs of any measure must be taken into account before judging it worthwhile or efficient. What matters is effectiveness per unit cost. Unlike the earlier BKS piece, BDK had simply neglected the costs incurred in collecting revenue or suppressing black money through demonetization. We noted a think tank\u2019s estimate of Rs. 1.28 trillion in losses during the transitional period from expenses of printing new notes, lost income of those waiting in queues, additional costs to banks tied up with exchanging currency, and (the largest item) lost business sales due to the currency shortage. It was then too early to replace the estimate of lost business with measured effects on GDP, but we noted that one percentage point of lost annual growth equals Rs1.45 trillion.\u00a0These costs need to be set against the revenue. Even if the revenue were as high as Rs2 trillion, collecting it at a deadweight cost of 64% or more would be a very bad bargain.<\/p>\n

Doesn\u2019t it matter that the transfer, in this case, is coming from bad actors whose welfare one may disregard? No. In the above reckoning, as in standard tax analysis, the pure wealth-transfer losses of taxpayers don\u2019t figure in the deadweight loss calculation, which only counts the costs associated with extracting the transfer.<\/p>\n

BDK had noted in passing the argument \u201cthat the short- to medium-run economic impact post 8 November will be contractionary\u201d due to a \u201ctemporary liquidity shortage induced by an insufficiently fast replacement of old notes with new notes.\u201d But they dismissed on theoretical grounds that \u201cthis is not necessarily the only outcome possible.\u201d Government could avoid a currency shortage by promptly providing new notes, they reckoned. This was a very odd line to take seven weeks into demonetization, given that the government was not in fact providing new notes sufficiently fast, and when the evidence of currency shortage was plain to see. Alternatively, they proposed, hoarded currency could come out from under mattresses, be deposited in banks, and actually expand M1 \u201cvia the classical money multiplier.\u201d This was an odd line to take given that expansion of deposits (even should it happen) would not remedy the currency shortage being suffered by the unbanked half of India\u2019s population.<\/p>\n

In\u00a0March 2017<\/a>, Bhagwati was quoted by the Indian newspaper\u00a0Firstpost<\/em>\u00a0making the surprising claim in an email interview that demonetization had actually promoted economic growth: “On the effects of demonetisation on growth, I should say that I was the one economist who had argued (with my co-authors), from first principles, that demonetisation would increase, not diminish, growth. And that is exactly what appears to have happened.”\u00a0The factual basis for saying that it appeared to have happened was not clear.<\/p>\n

In a\u00a0March 30 piece<\/a>, BDK cited a new 2016Q4 GDP report as showing that GDP had suffered \u201conly a modest dip \u2026 of roughly half of a percentage point\u201d below pre-demonetization projections. This was not an increase in growth. But they counted it a victory compared to \u201cthe economic disaster that the critics had imagined.\u201d<\/p>\n

The Evidence Against<\/strong><\/p>\n

The debate over demonetization was revived this month (September 2017) after the Reserve Bank of India finally announced the count of returned currency. It announced that 99 percent of the discontinued notes, Rs 15.28 trillion out of Rs 15.44\u00a0trillion, had been returned. As\u00a0Vivek Kaul<\/a>\u00a0has noted, \u201cThe conventional explanation for this is that most people who had black money found other people, who did not have black money, to deposit their savings into the banking system for them.\u201d<\/p>\n

The trivial size of unreturned currency, of course, obliterates BDK\u2019s projection of a government seigniorage windfall.<\/p>\n

What about BDK\u2019s other projected source of revenue, the 50% tax on acknowledged black deposits? Whereas in BDK\u2019s scenario, black currency holders would make Rs2 trillion in voluntary-disclosure deposits, which would yield Rs 1 trillion in revenue, the\u00a0actual collections<\/a>\u00a0under the scheme were reported in April at Rs 23 billion, or 2.3% of the BDK-imagined sum. Such paltry revenues mean that demonetization, from the fiscal perspective, was all pain and no gain.<\/p>\n

The accumulating evidence on economic growth, meanwhile, has become damning. Between July and September 2016, India\u2019s GDP grew 7.53 percent. Between January and March 2017 it grew 5.72 percent. Former head of the Reserve Bank of India Raghuram Rajan, now returned to the University of Chicago,\u00a0links the drop to demonetization<\/a>: \u201cLet us not mince words about it \u2014 GDP has suffered. The estimates I have seen range from 1 to 2 percentage points, and that’s a lot of money \u2014 over Rs2 lakh crore [i.e. trillion] and maybe approaching Rs2.5 lakh crore.” Kaul adds that GDP does not well capture the size of the informal cash sector, where the losses from demonetization were greatest.<\/p>\n

In response to the RBI report and GDP data, and to their credit, BDK have substantially retreated from claims of success to what can be regarded as the claim that there is still a chance to break even. They have\u00a0recently written<\/a>:<\/p>\n

First off, it must be conceded that if demonetisation is to be judged narrowly on the basis of the triple rationale originally advanced \u2026 , it would at best be unclear if it could be accounted a success. For, little black money was literally \u201cdestroyed\u201d and there is scant evidence that the policy had much if any impact on counterfeiting or terror finance.<\/p><\/blockquote>\n

Although they acknowledge that they \u201coverestimated the quantum of black money that would ultimately be unreturned\u201d and thus overestimated the seigniorage gain, they still contend that the \u201cmoney deposited into bank accounts can also generate fiscal gain, as these will invite the scrutiny of tax officials.\u201d\u00a0For about two-thirds of the deposits of old currency by value, even though no admission was made and thus no 50% tax was paid, the sums deposited were large and \u201care mostly open to scrutiny by tax officials.\u201d Thus it is conceivable that tax investigators may eventually squeeze taxes and fines out of them, and it is premature to rule this out.<\/p>\n

Conceivable, but unlikely. The investigatory capacity of the tax authority is finite and it already has its hands full, as\u00a0Vivek Kaul spells out in detail<\/a>.<\/p>\n

BDK concede: \u201cShould, however, the government fail in identifying and taxing black money deposits in any significant quantity, we can all conclude that demonetisation will have failed in achieving its primary goal.\u201d Welcome as this reasonable concession is, the converse does not follow: whether even significant eventual revenue counts as success depends on how it compares to the sizable costs of demonetization. A deadweight burden of less than 100% seems highly unlikely.<\/p>\n

BDK add an odd coda. They acknowledge transition costs in the program actually followed, but suggest that it could have been otherwise:<\/p>\n

in principle, had demonetisation occurred without transition costs \u2014 for instance, if old notes could have been seamlessly converted or deposited within a few days after 8 November, or if demonetisation had been pre-announced to occur with a lag, allowing time for an orderly remonetisation \u2014 there could only have been largely upside gain without any downside cost.<\/p><\/blockquote>\n

It is hard to square this with BDK\u2019s earlier statements that demonetization without secrecy would have been pointless because it would not have caught out the black money holders. Are BDK saying that if the aim had been merely to introduce new notes with better anti-counterfeiting features, the Modi government\u2019s demonetization program was an unnecessarily costly way of doing it? Well yes, the critics have said that all along. High transition costs were a feature and not a bug of the dramatic scheme to penalize black money by surprise.<\/p>\n

Reprinted from Alt-M<\/a><\/em><\/p>\n


\nLawrence H. White
\n<\/a><\/p>\n

Lawrence H. White<\/strong>\u00a0is Professor of Economics at George Mason University and\u00a0The Freeman<\/em>\u00a0contributor.\u00a0 He previously taught at New York University, the University of Georgia, and the University of Missouri \u2013 St. Louis.\u00a0He is a member of the FEE\u00a0Faculty Network<\/a>.<\/p>\n

This article was originally published on FEE.org. Read the original article<\/a>.<\/p>\n

\"\"<\/p>\n","protected":false},"excerpt":{"rendered":"

Dormant for a while, the debate over India\u2019s demonetization program of last fall has been revived by new evidence. The new evidence on note returns and GDP vindicates the critics and has the defenders in strategic retreat. What Happened To recap: On November 8, 2016, India\u2019s Prime Minister Narendra Modi shocked the nation by announcing the immediate \u201cdemonetization\u201d of the two largest rupee currency notes (Rs 500, worth about $7.50, and Rs 1000, worth about $15). Noteholders would have only 50 days to turn them in for new Rs 500 and Rs 2000 notes. The move, Modi promised, would sharply penalize holders of unaccounted \u201cblack money,\u201d namely tax evaders, bribe-takers, professional criminals, and terrorists. Their currency hoards would become worthless \u2014 a welcome one-time wealth loss \u2014 or they would expose themselves to detection by trying to swap or deposit large batches. Anyone depositing a large sum in old notes would face scrutiny by tax authorities. In order to keep the move a surprise (the better to catch the black money holders), new notes to replace all the discontinued notes had not been printed in advance. The canceled notes represented 86% of the currency in circulation, and more than half […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[15],"tags":[2991,893,1176,2992],"class_list":["post-18568","post","type-post","status-publish","format-standard","hentry","category-news-and-politics","tag-demonetization","tag-india","tag-money","tag-war-on-cash"],"_links":{"self":[{"href":"https:\/\/www.megalextoria.com\/wordpress\/index.php\/wp-json\/wp\/v2\/posts\/18568","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.megalextoria.com\/wordpress\/index.php\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.megalextoria.com\/wordpress\/index.php\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.megalextoria.com\/wordpress\/index.php\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.megalextoria.com\/wordpress\/index.php\/wp-json\/wp\/v2\/comments?post=18568"}],"version-history":[{"count":0,"href":"https:\/\/www.megalextoria.com\/wordpress\/index.php\/wp-json\/wp\/v2\/posts\/18568\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.megalextoria.com\/wordpress\/index.php\/wp-json\/wp\/v2\/media?parent=18568"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.megalextoria.com\/wordpress\/index.php\/wp-json\/wp\/v2\/categories?post=18568"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.megalextoria.com\/wordpress\/index.php\/wp-json\/wp\/v2\/tags?post=18568"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}