The Demonetization Screw-up Explained.

Any decision is generally judged by the result it generates. However, this method must be considered wrong, especially since events could have occurred after that decision was made- that generated the wrong or right result. One must judge a decision based on it’s principles and logic, and on the information that was available just when that decision was made.

Which is why I’m not going to mention the negatives of Demonetization based on GDP numbers or the amount of money returned or black money seized- these are results. Instead let’s judge the decision on ‘how and why’ it was made- and what was wrong with that.

1. When Arun Jaitley(the Finance Minister) said that the govt. had no estimation of black money before the demonetization. This is enough to discredit the whole move.
   Let me explain this to you in a better way- this was like trading your entire fund in e̶q̶u̶i̶t̶y̶ ̶s̶h̶a̶r̶e̶s̶ futures without having any idea about how high/low the value of it’s underlying asset could go in the future, let alone the probability of whether it will rise or fall. This was a huge economic risk and the government didn’t even have an estimate of the expected return. Extremely foolish risk-taking. Which brings us to-
2. Unethical Risk-taking. I believe that if huge risks are to be taken- they must be taken by people who would proportionately suffer/benefit from the consequences of the risk. Basically, the equity holder must be allowed to vote yes on letting the business take a huge risk- not the secured lender.
   This is why demonetization was inherently unethical even if it had succeeded, because this huge economic risk- it’s consequences severely affecting millions of small businessmen, daily wage laborers and farmers- was taken by a politician.
   Politicians in power are immune from such risks because:
   i) they get fixed salaries from the accounts of the Government,
   ii) they have fixed terms in the Government.
   They can’t be fired. They cannot be made to suffer an economic loss.
3. The Government didn’t print enough currency notes prior to taking the decision. This was something that the former RBI governor, Mr. Raghuram Rajan, recently pointed out in a recent interview. Had the Government printed enough currency notes(of smaller denomination than 2,000 rupees) beforehand, it would have lowered the negative impact on productivity and the waiting times in lines outside banks and ATMs, as cash would have been injected faster into the system. The period given for exchange of currency could have also been made smaller, which would have meant lesser time for people to arrange means for converting their black money to white.
4. No prior push to Digital Transactions. The government first mentioned about the push for digital transactions on November 27th, 19 days after announcing demonetization. Then came the problems of internet connectivity in some places and RuPay cards not working. Even the BHIM UPI(Unified Payment Interface) app was launched by the Government on December 30, 2016. If the Government knew that it was going to demonetize 86% of India’s cash in the near future, it should have actually pushed for digital transactions, set up digital infrastructure, and created the UPI months before November 8.
5. Demonetization targeted the small fishes- not the big ones. The big fishes don’t have black money stored in the form of cash- only people from lower levels and small businesses might. This basically means more work and pressure on the Income Tax Department- as they’ll have to take many small fish cases instead of one big fish case to recover the same amount of black money- and only for investigating the deposited demonetized currency in bank accounts. Does the Income Tax Department have the capacity to conduct such investigations? This twitter thread from James Wilson answers in the negative.
6. The loss of jobs and already slowing growth. It was obvious that demonetization would lead to a loss of employment and jobs- especially in the informal sector, which employs more people than the formal sector. At a time when the job creation for the past few years is already too low(look at the latest figures), NPAs in the books of banks already rising, introduction of GST set to disrupt industry growth from July 2017, and a huge demographic dividend (along with rise of automation and AI) set to peak in 2021, demonetization simply wasn’t the need of the hour. It was the exact opposite.

Now we see the effects. GDP growth estimates declining, CMIE estimating that 15 Lakh jobs were lost in the first four months of 2017, increase in the current account deficit and exports falling. However, the situation might not be as negative as the numbers suggest. It might actually be worse:

Arjun Ram Meghwal (Minister of State for Finance) said in February 2017, that demonetization would boost GDP growth as transactions and businesses which were informal before, would become formal, and their activities would now be recorded in the GDP.

This was an echo of what was said by Piyush Goyal(currently Minister of Railways and Coal, then the Minister of Power and Coal) in December 2016.

The problem with this analysis is that it says that the increased GDP (in absolute terms) we now see not only represents an increase in productive economic activity, but a good part of it now includes activities that were already happening before but were not being counted while calculating GDP. Which means that the GDP growth rates could be inflated due to increased formalization of the economy- both transactions and businesses. This suggests that the situation could be even bleaker than what the already falling growth rates represent.

And with GST coming in, you can expect more formalization and higher inflation in GDP growth figures, without any actual boom that represents those figures. I guess the more the Government boasts about it’s success in formalization of the economy, the more it will have to defend itself on the problem of decline in growth of productivity.