2 Puzzles of Note Ban: Arvind Subramanian Reviews ‘Draconian’ Move

Former CEA Subramanian writes on two puzzles of demonetisation in his upcoming book ‘Of Counsel’.

Former chief economic adviser Dr Arvind Subramanian. 

(File Photo: IANS)

In his new book Of Counsel, Arvind Subramanian, the former chief economic adviser to the Indian government, attempts to decode two puzzles surrounding demonetisation – political and economic.

Of Counsel is a repository of Subramanian’s writings and reflections and “a retrospective assessment of key events and policies”.

Subramanian was appointed CEA in 2014 and in his four years on the job the Indian economy witnessed the unprecedented events of demonetisation and the implementation of a Goods and Services Tax among other important economic developments. The book analyses both these events and other significant ones such as JAM (Jan Dhan-Aadhaar-Mobile), the twin balance sheet challenge, fiscal federalism and climate change.

Subramanian devotes a chapter to the 2016 demonetisation exercise undertaken by Prime Minister Modi, where 86 percent of the currency in circulation was extinguished overnight with the cancellation of high value currency notes.

“I do have some new thoughts, or rather hypotheses, on two demonetisation puzzles, political and economic.”

Puzzle 1: Why was demonetisation so popular politically if it imposed economic costs? Specifically, why did demonetisation 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?

“I offer the controversial hypothesis that imposing large costs on a wide cross-section of people (and the fact that the Rs 500 and not just the Rs 1,000 note was demonetised increased the scope and scale of demonetisation’s impact), unexpected and unintentional though it may have been, could actually have been indispensable to achieve political success.”

Former CEA Arvind Subramanian, in his upcoming book <i>Of Counsel</i>

Subramanian expands on that to suggest that:

...the breadth of impact could have been a credibility signalling device. The American economist Thomas Schelling famously argued that to convince the public or opponents of the credibility of one’s actions, costs must be incurred.

...the breadth and depth of impact could have served as another signalling purpose. In order to be credible, the masses must somehow be led to believe that the corrupt had been hurt.

...the near universality of impact created a sense of solidarity. If only a few had been adversely affected in the demonetisation process, they would have mobilised and from trade theory we know that their incentives to do so would have been great.

...and a related point, is cultural. One legacy of Mahatma Gandhi was to inculcate a spirit of sacrifice as a necessary condition for achieving a larger, loftier objective.

Puzzle 2: Why didn’t the draconian 86 percent reduction in the cash supply have bigger effects on overall economic growth?

To put this more provocatively, the question was not whether demonetisation imposed costs – it clearly did – but why did it not impose much greater costs?

Demonetisation was a massive, draconian, monetary shock: In one fell swoop 86 percent of the currency in circulation was withdrawn.

Figure 1 shows that real GDP growth was clearly affected by demonetisation. Growth had been slowing even before, but after demonetisation the slide accelerated. In the six quarters before demonetisation growth averaged 8 percent and in the seven quarters after, it averaged about 6.8 percent (with a four-quarter window, the relevant numbers are 8.1 percent before and 6.2 percent after).

Trend of real GDP growth rate over 3 years.(Photo courtesy: Of counsel, Arvind Subramanian, Penguin Random House)

I don’t think anyone disputes that demonetisation slowed growth. Rather, the debate has been about the size of the effect, whether it was 2 percentage points, or much less. After all, many other factors affected growth in this period, especially higher real interest rates, GST implementation and rising oil prices.

I do not have a strongly backed empirical view apart from the fact that the welfare costs especially on the informal sector were substantial.

As a monetary economist, though, what is striking is how small the effect was compared to the magnitude of the shock. There are many ways of seeing this.

Figure 2 compares what happened to cash with what happened to nominal GDP. It is a stunning picture. Prior to demonetization, cash and GDP move closely together. Then, currency collapses and recovers (the dotted line), but through all of this, the economy seems to have been chugging along almost unmindful of the currency in circulation. You have to squint to see any downward movement of the solid line (for nominal GDP) after demonetisation: In fact, there isn’t, and all the downward blips reflect seasonality, which leads to a lower level of activity in the first (April–June) quarter every year.

(Level of cash and Nominal GDP trends over three years)(Photo courtesy: Of counsel, Arvind Subramanian, Penguin Random House)

What could possibly explain this apparent resilience? A number of hypotheses need to be considered. First and foremost, it could simply be an artefact of the way that GDP numbers are created.

In India, there are no timely measures of informal sector activity, so it is proxied by formal sector indicators. Normally, this is not a problem, since 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 only a small way towards explaining the puzzle, since any squeeze in informal sector incomes would depress demand in the formal sector, and this effect should have been sizeable.

As a result, we need to search for other explanations. One possibility is that people found ways around the note ban, for example by continuing to use the Rs 500 note even after its use 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, people may have shifted from using cash to paying by electronic means, such as debit cards and electronic wallets.

Or, there may be other, completely different explanations that have eluded my understanding of demonetisation, one of the unlikeliest economic experiments in modern Indian history.

(The article was originally published in the BloombergQuint)