Road map for Mr Modi: Here's how note ban can be made a success
Nearly three weeks after it was rolled out, demonetisation has brought many angry people to the streets even as long queues at banks and ATMs show no signs of disappearing.
It's essential, however, to separate rhetoric from economic arguments. It is also necessary to clear some misunderstood issues.
First, demonetisation refers to a reduction in the value of currency. So, for example, a new Rs 100 note can be exchanged for an old Rs 1,000 one. But this is normally done in cases of "hyper inflation" - inflation rates of 500% or above - where the old currency has lost all value. This was done in some Latin American countries in the 1970s and, more recently, in Russia after the break-up of the Soviet Union in the early 1990s.
So, what the Narendra Modi government announced on 8 November is not demonetisation but " currency replacement". Let's call it CR. Now, let's sift through its economic logic:
CR reduces black money
Actually, it does. There's some confusion about the difference between black money and black income. Opponents of CR argue that the amount of black money held in hard currency is only about 6-10% of total stock of currency; the bulk of illegal wealth is held in assets like gold, land, real estate, foreign exchange, which aren't affected by this move.
It must be understood, however, that transactions for "black assets" are financed by movements of black currency. Economists talk of the "velocity of circulation" of money. This is easily understood. If someone gives you a one rupee note, your income increases by that amount, but that same rupee note generates multiple incomes as more transactions take place. In India, a single unit of currency can generate about six times its value in terms of income.
So, taking the black currency out of circulation reduces black incomes by reducing transactions in black assets. This is already visible in the 20-25% decline in prices in the secondary market for real estate, and will be followed soon by a decline in the prices of gold. The withdrawal of black currency, thus, removes the method of circulating black income.
Does this mean currency replacement should be welcomed? Not necessarily. From an economist's perspective, black income finances economic activity as any other income. For example, the reported 40% black component of a real estate transaction pays for labour, construction material etc. just like the other 60%. However, the former component escapes the banking channels and thus taxation.
The lowest estimate of black income in India is 20% of the GDP. If CR completely eradicate black income, 20% of our GDP will disappear. The impact on GDP growth has been commented on by former prime minister Manmohan Singh although the exact impact needs to be worked out more carefully. Still, one has to be prepared for a short-term fall in the GDP and, hence, in growth rates. Paradoxically, this negative impact of CR will be lesser the less successful it is in unearthing black money.
CR causes only short-term pain
This is incorrect. Alfred Marshall is reported to have remarked, "You can train a parrot to be an economist. Just teach it the words demand and supply." CR only impacts the supply - stock - of black money. The demand for black money remains, and it mostly comes from the government. For permanent impact, CR must immediately be followed by measures to reduce demand.