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India’s demonetization initiative was a bad idea and badly executed, says “The Economist”

The prestigious  British  weekly, “The Economist” which has the last say on economic reforms around the world has condemned the ruling government’s demonetization move on November 8th and called it  a cautionary tale of the reckless misuse of one of the most potent of policy tools: control over an economy’s money.

Following are the main excerpts of the article which appeared in “The Economist” under the name “Paper Pains.”

“On November 8th India’s Prime Minister, Narendra Modi, declared that all 500- and 1,000-rupee notes—making up 86% of the cash in circulation in India—could no longer be used in shops. More financially mature economies than India would struggle to cope with such a scheme, but this one floundered at once. Though Indians have until the end of the year to swap their defunct bills, the roll-out of new ones has been bungled. A broad cash crunch and broken supply chains threaten a sharp economic slowdown—albeit one that will abate, at least in part, as the cash squeeze is alleviated. India’s “demonetisation” is a cautionary tale of the reckless misuse of one of the most potent of policy tools: control over an economy’s money.

Unlike most currency reforms, designed to boost confidence in the currency, Mr Modi’s motivation is different. The primary aim of demonetization,the government hopes to improve the functioning of the economy and boost its tax take by cracking down on the shadow economy. The vast majority of transactions in India take place in cash; many escape book-keepers’ notice. Economists reckon that India’s black economy accounts for at least 20% of GDP. Such off-the-books activity shields fortunes from taxation and allows corruption to flourish. Past efforts to attract black money into the light—using tax amnesties, for example—have had little effect.

Demonetisation forces the issue. Indians can swap their hoards of useless bills for useful ones, but those that cannot present paperwork accounting for their cash piles will receive unwanted attention, and tax bills, from the government. Demonetisation also increases use of electronic and bank-based payment systems, which will make record-keeping easier and more common, allowing government better to track and tax the proceeds.

The plan will affect all of India’s 1.3bn citizens, the poorest most of all. 

However clever the plan looked on paper, it is both extraordinarily blunt and risky. Demonetisation will probably make only limited strides in shrinking the black economy while affecting all of India’s 1.3bn citizens, the poorest most of all.

In much of the Indian economy, and especially outside big cities, where cash transactions are most common and financial infrastructure least developed, the sudden invalidation of a vast amount of outstanding currency represents a significant monetary shock. Not all of India’s shadow economy—which provides real employment and income, if not real tax revenues—can migrate quickly and easily above board. Whatever cannot easily be shifted represents a potential loss of economic activity, and a drag on broader Indian economic growth. Similarly, if a cash crunch forces small firms without access to credit to shut down, the eventual alleviation of the cash shortage might not lead to an immediate and complete revival of economic activity.

Clumsy use of monetary instruments comes with high risk.

Managing an economy’s money is among the most important tasks of the government. Clumsy use of monetary instruments comes with high risk. John Maynard Keynes, an economist, wrote in 1919: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.” Trust is fragile, and precious.

Much of the wealth of those enriched by the black economy would be insulated, because lots of their lucre is held not in cash but in property, gold or jewellery. Such heavy-handed measures could undermine the credibility of important government institutions. Fear that they might be used again in future could weaken confidence in the currency as a store of value—paving the way for some broader institutional failure, like hyperinflation. Long-run trust in the judgment of the state might be threatened.”

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