On Demonetisation: Nobody Knows Shit

Posted on November 23, 2016 in Business and Economy

By Yogesh Upadhyaya:

Note: All assumptions and predictions are at best, educated guesses.

Are you totally confused after reading tons of articles, Facebook posts and Whatsapp forwards on demonetisation? You are not the only one. The issue is really complex, and even experts making predictions are guessing when they say what will happen in the future. Underlying their guesses are explicit and sometimes not so explicit assumptions. Big assumptions.

Let me explain this to you with an example. It is a slightly complex example but bear with me.

1. Rajesh is a salaried employee, and his employer deposits his monthly income in the bank. So of course, this income is white. He withdraws some of the money from an ATM and buys a few packs of gutkha from the local paan wallah.

2. The paan wallah passes on most of the money through a wholesaler to the manufacturer. The net income of the paan wallah is small, and he is not liable to pay tax.

3. Unknown to the paan wallah, the manufacturer might not be accounting for this money in his books to evade paying a considerable amount of tax on gutkha. Thus, the white money that Rajesh had has now become black.

4. The manufacturer has to share a part of this black income with his distributors and retailers. He also keeps a small amount of cash for day to day business expenses.

5. With the remaining black money, the manufacturer bribes a government tax official, buys land (partly paid for, by cheque) and also buys tobacco from a farmer.

6. The cash in the hand of the tax officer and the land seller is black and in the hands of the farmer, white.

7. The tax officer buys a fancy watch and keeps the remaining amount in cash. The land seller buys jewellery for his daughter’s wedding with some part of the money and keeps the remaining money in cash. The farmer uses some part of the money to see a doctor.

8. The Swiss watch showroom and the jeweller declare the cash sale turning the money white again. The doctor does not declare a portion of the income, thus making that portion black.

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The main point of this example is the fact that cash moves through the economy in a very complex ways and black and white money economies are strongly intertwined. When you affect the black economy, you are affecting the white economy too.

Also, note that this contrived example is a minuscule part of reality! There would be millions of Rajesh and hundreds of distributors. The manufacturer would have thousands of income and expense entries. And of course, across this vast country, there are many different types of businesses and even more number of individuals with great differences in incomes. Reality = 1 billion people x this example or maybe more.

When columnists give their opinions on the impact of demonetisation, it is a guess. An educated guess at best, and personal bias at worst.

Let us try and answer a few important questions.

Will this measure reduce the generation of black money in the future?

In our example, it depends on how much money the manufacturer, the tax officer, the doctor and the land seller had in cash on the day of demonetisation and how much they will be able to convert/exchange that money for new notes using both official and unofficial channels. Their tax liability and penalty in case of official channels and the commission they end up paying if they use unofficial channels will be a factor in their future decisions.

How much will be the impact on the future of black money? It depends on your assumptions.

How much would be the drop in demand and how long will it last? It depends again on the assumptions you make.

Will this measure reduce GDP growth in the short term?

Definitely. The paan wallah will see a drop in sales because people do not have cash. He may make temporary arrangements to get gutkha on credit and sell it to his known customers on credit but he will still see a drop in sales and would reduce his own purchases as much as he can. So would everyone in our example. There is no way of accurately knowing how much this reduction would be.

Will this measure the impact on GDP growth in the long term?

Yes, but this impact is even harder to assess. On the one hand, the demand shortage and liquidity crunch could force small entrepreneurs to go out of business. The government could use the extra tax collection to build social and physical infrastructure, which spurs the economy. There is also a likelihood of organised businesses growing to take the place of the dying unorganised business. Additionally, the future is not static and individuals, firms and governments will react to the given situation and make the situation worse or better.

To sum it up – Demonetisation is a colossal move in a very complex system viz. the Indian economy. Any predictions about the outcome, whether positive or negative, is at best, an educated guess. I would think that even the government of India was guessing the benefits and the costs when it made the move.

I have not spoken about the social costs of this move, for example –  people are going hungry because they are not being employed on a daily basis or are not being paid for their work. I haven’t spoken about the social costs because I have no way of knowing about these except for anecdotes that I hear and read in media. This does not mean that the social costs are not real.

There is nothing inherently wrong with columnists guessing. It is just that we shouldn’t take any one’s view as absolute truth.

The article was first published here.

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Image source: Hindustan Times/Getty  Images

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