"Demonetization was a massive and draconian monetary shock," says Arvind Subramanian in his new book

On November 8, in a televised drama speech about the country I saw in my northern building room, the Prime Minister announced that the two bills having a very high face value, £ 500 and £ 1,000, would cease to be legal tender. that is, they would no longer be accepted as a means of payment certified by the government. It was an unprecedented initiative that no country in recent history had taken in normal times. Progressive demonetizations in normal times (such as the gradual deletion of the € 500 banknote in 2016 by the European Central Bank) or sudden demonetizations in extreme situations of war, hyperinflation, currency crises or political unrest ( Venezuela in 2016) [en général] 19659002] The Indian initiative was singular to say the least. This presupposed extraordinary resistance from the economy, especially the most vulnerable, as it would be the first of two major shocks – along with the GST – to affect informal sector players in the cash-intensive economy. . Two years later, the demonetization still absorbs the attention of the commentary, partly because of the mysteries surrounding it. I have little to add to the economics of the D decision beyond what has been said in three economic surveys that I supervised. I have new ideas, or rather badumptions, about two enigmas of demonetization, political and economic.

Puzzle One

Why was demonetization so popular politically if it imposed economic costs? More specifically, why did the demonetization take place in the short term (in the Uttar Pradesh elections in early 2017) if it imposed so many difficulties on many people?

Today, the political perception of demonetization is: confused by a whole series of economic and political developments since November 2016. It is clear that many factors influence voters' perceptions and, hence, the results, making any attempt to determine the cause and effect unreliable. However, it is important not to forget the story as it happened. At the time (early 2017), elections in Uttar Pradesh – the most populous state of India and the eighth largest "country in the world" – were widely considered a verdict on demonetization , arguably the most prominent political action of the government. , personally and with force expressed by the Prime Minister.

The demonetization experiment speaks of the more pervasive and fascinating global phenomenon from What's wrong with Kansas? title of a famous book by the American historian Thomas Frank This book explores the apparent paradox of citizens voting against their own economic interest. For example, why do poor white men vote for the Republican Party and President Trump while the political agenda does not bring them any benefit (tax cuts for the rich) or is positively damaging (weakening Obamacare and the benefits? social more generally)? This same question seemed relevant after the resounding victory of the NDA government in the UP elections. This article in particular attempts to understand this result as a disinterested observer, armed only with facts known to the public. This is not an explanation of the motives for demonetization, but simply a post facto badysis of a seemingly fascinating political result badociated with it.

How a demonetization that is supposed to have affected so negatively a considerable number of Indians – tens of millions Monetary economy: so strongly supported by the (very many) victims of politics? I emit the controversial hypothesis that imposing significant costs on a wide range of people (and the fact that the $ 500 and not only the $ 1,000 bill was demonetized increased magnitude and impact of demonetization), however unexpected it may have been, might have been indispensable to political success.

The business model of canonical political economy explains the persistence of protectionism in terms of imbalance between winners and losers. Protection, which raises domestic prices, helps a lot of domestic producers while spreading the damage to many consumers, who are each losing little. Producers therefore have both an incentive and an ability to lobby for protection, while individual consumers have little incentive to lobby against it. The case of demonetization has been very different: difficulties have been imposed on many people, perhaps even to a large extent, and yet they seem to have been its biggest cheerleader.

One of the answers to the enigma of demonetization is that the poor were willing to neglect their own difficulties, knowing that the rich and their poorly-begotten wealth faced even greater difficulties: "J & rsquo; I lost a goat, but they lost their cows. "From this point of view, the costs to the poor were inevitable collateral damage that had to be suffered to achieve a broader goal.

This is not totally convincing. After all, the collateral damage was in fact preventable. Anti-elite populism, or "disparagement of the rich," as the economist put it, could have taken the form of other punitive actions – imposition, appropriation, raids – targeting only the corrupt rich. Why entangle the innocent mbades and impoverish them? As I wrote in the 2016-17 Economic Survey, while subsidies are an extremely inefficient means of transferring resources to the poor, demonetization appears to be an extremely ineffective way of removing resources from the rich.

Understanding the political economy of demonetization can force us to deal with a neglected possibility, namely that the negative impact on the greatest number, far from being a bug, might have been a characteristic of political action. Not necessarily on purpose or in real time, but in retrospect it seems that the negative impact on the many people might have been intrinsic to the success of the policy. Consider why. First, the magnitude of the impact could have been a credibility signaling device. The American economist Thomas Schelling has argued that to convince the public or opponents of the credibility of its actions, it was necessary to incur costs. It can not be done cheaply. Hernan Cortes, the first conquistador, reportedly destroyed all his ships after landing in Mexico to urge his fellow soldiers to fight boldly, as there was no possibility of return.

By imposing quasi-universal costs, demonetization could also have been a demonetization. a device to signal a regime change against black money in particular and corrupt rich, more widely. If a scheme could bear such huge costs, it could certainly follow similar actions against corruption. In fact, to demonstrate that the measure was audacious and therefore more likely to be effective, the estimated costs may have had to be high.

Second, the magnitude and depth of the impact could have served as an additional goal. To be credible, the mbades must somehow be led to believe that the corrupt have been hurt. With demonetization, it may not have been easy to do, at least in the short term. How better to convince the mbades that the corrupt rich were hit hard than to hit hard the mbades themselves? "If it hurts so much, it must do a lot more harm to the rich" could have been the thought process of the typical victim.

Third, the quasi-universality of impact has created a sense of solidarity. By sparing some groups, it would have undermined this spirit and raised questions about the good faith and legitimacy of decision-makers, who could have been seen as favoring some while hurting others. If only a few had been negatively affected in the demonetization process, they would have mobilized and the theory of trade taught us that their incentives to do so would have been great.

Moreover, if only a few had been affected, suspicion would have arisen about those who were spared: were they connected? Were they even "involved" in the decision? Did they contribute as a counterpart to be spared? By impacting the greatest number, these difficult decisions were avoided. In the light of the zeitgeist of stigmatized capitalism, such questions would have invariably been raised and would have been politically sensitive.

The fourth aspect (and the related point) is cultural. One of Mahatma Gandhi's legacies was to inculcate the spirit of sacrifice as a necessary condition for achieving a greater and nobler purpose. Especially since it is acknowledged that the elimination of black money is not an easy task because it has existed for 70 years, the need for sacrifice – and shared sacrifice – could only be strengthened. One of the points I have raised here is a normative badessment of the economy and the politics of demonetization. But to be honest, it must be admitted that the political response to demonetization was disconcerting and confused most economists and political scientists. We must therefore remain open to the hypothesis that politically, in the case of demonetization, vice could have been a virtue.

Puzzle Two

Why did the drastic 86% reduction in the cash offer not have greater effects on overall economic growth? To put it more provocatively, the question was not whether demonetisation generated costs, but why it did not impose much higher costs.

Demonetization was a drastic and draconian monetary shock: 86% of the money in circulation was withdrawn. Demonetization has clearly affected real GDP growth. Growth had already slowed down, but after demonetization, the slippage accelerated. In the six quarters preceding demonetization, the average growth was 8% and in the following seven quarters it was about 6.8% on average (with an interval of four quarters, the relevant figures are 8%). , 1% before and 6.2% after).

I do not know think anyone is arguing that demonetization has slowed growth. The debate instead focused on the magnitude of the effect, that it is 2 percentage points or much less. After all, many other factors have influenced growth over this period, including rising real interest rates, implementing the GST, and rising oil prices. I do not have a strong empirical view, apart from the fact that the costs of social welfare, particularly in the informal sector, have been substantial.

However, as a monetary economist, what is striking is the magnitude of the effect compared to its magnitude. shock. There are many ways to see this. Compare what happened to cash with what happened to nominal GDP. It's a beautiful photo. Before demonetization, liquidity and GDP are evolving closely. Then, the currency collapses and picks up (the dotted line), but through all of this, the economy seems to have grown almost unconsciously from the currency in circulation. We must look head on to see any downward movement in nominal GDP after demonetization: in fact, there is none, and all downward declines reflect the seasonality, which leads to a level of Lower activity in the first quarter (April-June) each year.

What could explain this apparent resilience? A number of badumptions must be considered. First and foremost, it could simply be an artifact of how GDP figures are created. In India, there are no one-off measures of informal sector activity, so it is represented by indicators of the formal sector. Normally, this is not a problem because both are moving in tandem. However, when a shock such as demonetization occurs and mainly affects the informal sector, the use of formal indicators to measure overall activity overestimates GDP. This badumption provides little explanation, as any compression of informal sector revenues would reduce demand in the formal sector and this effect should have been substantial.

As a result, we must look for other explanations. One possibility is that people find a way to circumvent the ban on banknotes, for example by continuing to use the $ 500 bill even after the formal ban on its use. The monetary shock was not as important as was usually expected. Another possibility is that production was supported by informal credit: people simply agreed to pay their bills as soon as the currency became available. Finally, to some extent, people may have abandoned cash to pay by electronic means, such as debit cards and electronic wallets.

Or, other completely different explanations have eluded my understanding of demonetization, the least similar economic experiences in the history of modern India.

Excerpted with permission from Penguin Random House India

Until recently, Arvind Subramanian was the chief economic adviser of the Narendra Modi-led government

First published: Thu, November 29, 2018. 07:59 am IST