Demonetisation: Foolhardy Notion of Linking Corruption and Growth

It’s a foolhardy notion that demonetisation will reduce corruption and boost economic growth, writes Devashish Mitra

In 1923, Lord John Maynard Keynes wrote in one of his famous early works, The Tract on Monetary Reform, “The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past, the ocean is flat again.”

During the “tempestuous” months, immediately following the announcement of the demonetisation initiative in India, its citizens were told by Prime Minister Modi and his advisors and supporters that the resulting short-term pains were necessary for the huge long-run gains that demonetisation is certain to bring.

There have been about a hundred people so far, who, as a result of demonetisation, have not lived to see the medium run or even part of the short run. Keeping this caveat in mind, let me try to discuss whether we should expect any long-run gains from the demonetisation initiative.

Also Read: Unlike 1978, Demonetisation in 2016 Violates Fundamental Rights

No Link Between Corruption and Growth

Some expectations have been created about the long-term benefits of demonetisation, on the basis of which the initiative has been sold to the public. One is the cleansing of the economy of the scourges of corruption, black money and fake currency. The desirability of achieving this goal is unquestionable.

In addition, it has been argued that a reduction in corruption will lead to higher GDP growth, an expectation based on some well-known cross-country studies.

In this context, it needs to be noted that some of the more recent studies on corruption and growth do not show this clear positive relation between the control of corruption and growth. In fact, they show that some amount of corruption can “grease the wheels” of an economy that is over-regulated (i.e., where there are too many regulations in place that act as barriers to progress).

Some rapidly growing Asian economies, with moderate amounts of corruption, have actually been responsible for this unexpected relationship between corruption and growth.

Also Read: Govt Took Demonetisation Decision Hurriedly, Says Amartya Sen

Myths About Cashless Economy

The second long-term benefit of demonetisation that has been sold by the government, is the conversion of the primarily cash-based Indian economy into a “cashless” one. Such digitisation of the economy speeds up transactions or, in economics jargon, increases the velocity of money.

A higher velocity, in turn, should lead to an increase in real GDP, unless it gets fully converted into a higher price level. Moreover, moving over to digital transactions reduces corruption, as all such transactions are automatically recorded.

With a very small proportion of India’s black wealth held as cash, and almost all the demonetised cash being returned to the banks, it is difficult to imagine how the demonetisation initiative will have any long-term impact on corruption.

Some analysts, who have come out in support of this initiative, have argued that demonetisation has had a strong positive signaling value.

According to them, a bold move of this sort, signals to everyone the government’s seriousness about tackling corruption, and then this signal and the fear created, are expected to reduce corruption. However, as mentioned above, almost the entire stock of demonetised currency notes has been returned to banks.

Also Read: RBI Didn’t Want Demonetisation, But Modi Govt’s Bullying Worked

Is the Govt Serious About Money Launderers?

Obviously then, a huge amount of black money has been laundered successfully. It is difficult to imagine how this kind of success, on the part of black money holders and launderers, would actually not embolden them (and not create greater confidence in their own skills), but make them fearful of future courageous moves by the Prime Minister.

The fact that such an indirect and badly targeted policy was used in place of policies (such as reducing the stamp duty on real estate transactions or bringing about serious election finance reforms) that would directly attack black money and corruption, should strongly signal to the black money holders that the government is actually not serious about controlling corruption.

It is an exhibitionist political stunt that conveys (and probably quite successfully) to the average poor citizen that the government is pursuing the noble goal of combating corruption, with the actual holders of black money remaining and feeling quite safe.

Also Read: Idea of Demonetisation Wrong, Don’t Blame Execution: Rajiv Bajaj

Short-Term Pain, No Gain

As I have written previously with Amartya Lahiri of the University of British Columbia, a single policy cannot attack many different targets all at the same time. Therefore, this policy cannot directly attack black money and corruption, and also bring about digitisation at the same time, especially in the absence of the needed infrastructure and literacy. There are no shortcuts here.

An inclusive digital infrastructure will have to be built along with the provision of adequate power supply throughout the country. The problem of illiteracy will have to be tackled. Let us not try to fool ourselves into believing that complete digitisation (a “cashless” economy) is possible with 300 million people who are completely illiterate.

The best case scenario for the long-term effects of demonetisation, therefore, is that there is no effect at all. It is clear that there have been short-term pains felt by many, especially those in the informal sector, which represents 90 percent of India’s employment and 45 percent of its GDP.

(Devashish Mitra is Professor of Economics and Gerald B and Daphna Cramer Professor of Global Affairs at Syracuse University, New York, USA. This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)

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