‘In a dramatic nationally televised speech on November 8’, the former Chief Economic Advisor Arvind Subramanian recalls, as he watched in his room in North Block, ‘the Prime Minister announced that the top two high-denomination currency notes of ₹500 and ₹1,000 would cease to be legal tender; that is, they would no longer be accepted as a government-certified means of payment.
‘It was an unprecedented move that no country in recent history had made in normal times. The typical pattern had either been gradual demonetisations in normal times (such as the European Central Bank phasing out the €500 note in 2016) or sudden demonetisations in extreme circumstances of war, hyperinflation, currency crises or political turmoil (Venezuela in 2016).’
He called the move Draconian, (which means excessively harsh and severe), and analysts are wondering why the US-based economist had not quit immediately after being party to this decision, and have to second guess the reason for his breaking the silence now, just as his new book is coming out and what might have transpired in between.
Quick to latch on to this Draconian step, Congress President Rahul Gandhi said the former Chief Economic Adviser had distanced himself from the decision to junk high-value currency notes, and he should have resigned on the issue and those guilty of the ‘huge scam’ will be punished.
‘Demo (demonetisation) like Rafale was a crime against India and a huge scam. Parrikar distanced himself from Rafale to save his skin. Subramanian is doing the same with Demo. I wonder why he didn't resign when he disagreed so much? Don't worry India, the guilty will be investigated and punished,’ Gandhi said.
To start with, by all accounts demonetisation seems to have substantially backfired (except in the eyes of its protagonists) and such a big secret would go down in history as much for its dark stealth as for its failed pursuit of black wealth. Even the Finance Minister, Arun Jaitley, was reportedly brought in at the last hour and if Subramanian was not consulted, as it appears, should he be blamed?
This raises the question of what the Chief Economic Advisor did after the demonetisation axe fell. The CEA's post has a quasi-institutional quality and Subramanian excelled in his role as the eloquent author of the annual pre-budget economic survey (especially the second survey with its pink cover) that is supposed to give an objective account of the preceding year's hits and misses. There has been literary flair and some fantastic insights. And Shakespeare never seems out of the radar, as he slams the government even as he seems to praise the ‘honourable men’, though in the spring of 2017, he was in the throes of a Hamletian dilemma.
The economic survey of the demonetisation year is titled ‘To Deify or Demonize’ that seems to offer criticism shaped as doubt. There is one telling paragraph: ‘The public debate on demonetisation has raised three sets of questions. First, broader aspects of management as reflected in the design and implementation of the initiative; Second, its economic impact in the short and medium run’ and, third, its implications for the broader vision.’
It continues, ‘This Survey is not the forum to discuss the first question.’ Thus, the CEA, much before departing his chair had kept the option open to discuss this in future. The survey appeared to defend the demonetisation by calling it a ‘reverse helicopter drop’ to suck out money, but it carefully added that any attempt to guess its future would be ‘hazardous.’
Far away from Ground Zero, of course, Subramanian describes it as a ‘massive, Draconian monetary shock.’ It seems like a helicopter had a built in a vacuum cleaner to suck out not wads of currency notes but poor workers and farm hands were stuck in long queues outside ATM machines. The expert who is supposed to have shown a mirror to the government seems to have had a convex-concave trick, the kind that they charge you for showing funny, mocking faces at village fairs.
Admittedly the CEA ploughed a lonely furrow during his tenure but for some praise from Jaitley. Apart from Subramanian himself, Jaitley was also the target of attacks by Subramanian Swamy, BJP member of the Rajya Sabha, with none left to defend either of them in the ruling party. It was as though the CEA was himself more or less demonetised in design while being honoured for a brief period, much like the high-value notes that vanished amid fanfare and confusion. His book seems like an optical illusion of support for the demonetisation.
Raghuram Rajan, who was consulted on the note ban while he was RBI head and said a firm 'no', while Subramanian was presented with a fait-accompli that he had to justify in flowery language. Ironically with the same flourish he is now hitting at the government, and that is bound to be a good thing for the sales of his book. We can now wait for an I-told-you-so statement from Subramanian Swamy, with whom the former CEA seems to share little apart from half his name.
The initiative was unique and it presupposed an extraordinary amount of resilience in the economy, especially amongst the vulnerable, because it was going to be the first of two major shocks - along with the GST- to affect those in the cash intensive, informal sectors. Two years after, demonetisation still is hotly debated in part because of the mysteries surrounding its origins
Why was the step so popular politically if it imposed such economic costs? And why did it turn out to be an electoral vote winner in the short-term (in the Uttar Pradesh elections of early 2017) if it imposed so much hardship on so many people? Today, the political perception is confounded by developments since November 2016.Many factors influence voters’ perceptions and hence affect outcomes, rendering any attempt to tease out cause and effect as unreliable. It is important not to forget history. In early 2017, the election in UP, the most populous state and the world’s eighth-largest, was widely seen as a verdict on demonetisation.
The experiment speaks to the more pervasive and fascinating global phenomenon of a famous book by American historian Thomas Frank that explores the apparent paradox of citizens voting against their economic self-interest .The poor white males vote for the Republican Party and President Trump when the policy agenda either has no benefits to them (tax cuts for the rich) or is positively harmful (undermining Obamacare and welfare benefits more broadly). That same question seemed relevant after the resounding victory of the NDA in UP.
One answer to the puzzle has been that the poor were willing to overlook their own hardship, knowing that the rich and their ill-begotten wealth were experiencing even greater hardship. ‘I lost a goat but they lost their cows.’ In this view, the costs to the poor were unavoidable collateral damage that had to be incurred for reaching a larger goal.
Understanding the political economy of demonetisation, one needs to confront an overlooked possibility that adversely impacts the many, far from being a bug, could perhaps be a feature of the policy action. In retrospect it appears that impacting the many adversely may have been intrinsic to the success of the policy. First, the breadth of impact could have been a credibility signalling device. American economist Thomas Schelling argued that to convince the public or opponents of the credibility of one’s actions, costs must be incurred. It cannot be done cheaply. Hernan Cortes, the first conquistador, is said to have destroyed all his ships after landing in Mexico to motivate his fellow soldiers to fight boldly because there was no possibility of return.
By imposing near-universal costs, demonetisation could similarly have been a device to signal regime change against black money and the corrupt rich, more broadly. If a regime could incur such enormous costs, it could surely follow up through similar actions against corruption. To demonstrate that the measure was bold and hence more likely to be effective, the felt costs may have had to be high.
Second, the breadth and depth of impact could have served as another purpose. In order to be credible, the masses must somehow be led to believe that the corrupt had been hurt. With demonetisation, this may not have been easy to do, at least in the short-run. How better to convince the masses that the corrupt rich were being hit hard than to hit hard the masses themselves?
Third, the near universality of impact created a sense of solidarity. Sparing some groups would have undermined this spirit and raised questions about the good faith and legitimacy of the policymakers.
Fourth, one legacy of Mahatma Gandhi was to inculcate a spirit of sacrifice as a necessary condition for achieving a larger, loftier objective. Especially if there is a shared recognition that eliminating black money is not an easy task because it has been around for 70 years.
Demonetisation was a truly draconian shock: in one fell swoop 86% of the currency in circulation was withdrawn. Real GDP growth was clearly affected and growth had been slowing even before, but after demonetisation the slide accelerated. In the six quarters before demonetisation growth averaged 8 % and in the seven quarters after, it averaged about 6.8% (with a four-quarter window, the relevant numbers are 8.1% before and 6.2% after). Prior to demonetisation, cash and GDP moved closely together. Then, currency collapsed and recovered, but through all of this, the economy seems to have been chugging along almost unmindful of the currency in circulation.
A few hypotheses have been offered for this apparent resilience. First and foremost, it could simply be an artefact of the way that GDP numbers are created. And especially in India there are no timely measures of informal sector activity, so it is tapped by formal sector indicators. Normally the two move in tandem, but when a shock like demonetisation occurs that primarily affects the informal sector, relying on formal indicators to measure overall activity will overstate GDP. This hypothesis goes somewhat towards explaining the puzzle, since any squeeze in informal sector incomes would depress demand in the formal sector, and this effect should have been sizable.
We need to search for other explanations and one possibility is that people found ways around the note ban, for example by continuing to use the ₹500 note even after it had been formally banned, so the currency shock wasn’t actually as big as conventionally measured. Another possibility is that production was sustained by extending informal credit: people simply agreed to pay their bills as soon as currency became available. Finally, to a certain extent, they may have shifted from using cash to paying by electronic means.
Finally, the weaponisation of economics can cut both ways as the Narendra Modi government had learnt in a matter of hours after preening itself for ‘busting’ the growth story of the Manmohan Singh decade.
Although Subramanian, now part of the visiting faculty at Harvard and a non-resident senior fellow at the Peterson Institute for International Economics, had nuanced his observations in his book, what drew the maximum attention were words like ‘draconian’ and ‘massive’.
In the introduction, Subramanian has taken a balanced view: ‘Honesty on the part of demonetisation’s apologists demands that they confront its significant costs. Equally, honesty on the part of its critics demands that they understand why it turned out to be politically advantageous (first puzzle); and honesty on the part of analytical economists demands that they understand why its economic costs proved much lower than expected (second puzzle).