Demonetisation Shock Gives Reasonable Chance Of Changing Economic Behaviour In Right Direction 

With the end of the first week of the announcement of Prime Minister Narendra Modi on the demonetisation of old Rs 500 and Rs 1,000 notes approaching, it is clear that the logistics of the announcement are not going as well as they should have. That is putting it mildly, perhaps.

As for the underlying need for the measure that the Prime Minister had announced a week ago, I am not in doubt. Some have expressed scepticism whether the Rs 500 note should have been demonetised at all. It might be mostly for transactional purposes rather than being used as a store of wealth. Hence, banning it too has been a source of great inconvenience without being a great source of benefit. The rich will find a way to convert their currency notes even if not through the banking channel, etc. etc.

I will share links to some comments by people whose views I do not disregard:

MINT wrote a good editorial on this:

The Edit also made an important point for the future:

The speech by the Prime Minister contained a reference to that and that is the direction in which RBI and the government would go.

I would like to reserve Monika Halan’s piece for the end for it touches upon a very important aspect of this decision – the Prime Minister’s risk-taking.

There was a good piece by Shankkar Aiyar in ‘New Indpress’:

He understands and states that there is lot more to be done:

He concedes the exhilaration of victory but a lot more remains to be done. In our joint piece for MINT today, Gulzar Natarajan and I agree with that and even list out the things that need to be done. We have gone into specifics. It is from our joint work, ‘Can India grow?’ which will be published online by Carnegie India tomorrow.

So, the case for the action taken is established and the action is to be applauded. But, the action’s positive impact will be felt over the long-term provided follow-up actions and steps are also announced. However, in the near-term, the logistics of implementation are creating a big economic dislocation risk, or so it appears.

Given the ‘surprise’ nature of the announcement, the scale of the country (huge) and State capability (very low), some amount of dislocation was to be expected. The public was prepared for it. But, has the actual dislocation exceeded even the worst expectations?

Pronob Sen seems to think so. He points to the dislocation in the informal financial sector:

He calls this exercise the equivalent of cutting the nose to spite the face. That is perhaps too harsh. The government has been taking a sequence of steps. This has to be seen as part of it and more must be coming. There has been a method to the issue of tackling the issue of corruption. Sen is very right to highlight the area where the move would hurt.

Indeed, economic growth is being driven by private consumption in India, in recent times. If parts of it are choked too hard, the negative demand shock on the economy could be significant. Already, there is the negative wealth shock to those who are spending their black money. Third, there is the impending introduction of goods and services tax (GST). So, I think the government might have bitten off more than it could chew, from a macro-economic perspective. That strikes me as a more appropriate idiom than ‘cutting the nose to spite the face’.

A friend with whom I had shared this article sent me the following response:

Perhaps, he is and perhaps he is not. But, the risk is no longer trivial or so, it appears. MINT has three charts on why the exercise is turning out to be painful. The government must start its prayers now!

That brings up a question that another friend asked:

“Can you help think through this standard argument that his could have ONLY been done in a shock and awe manner? What if it had been announced that by 31 December all Rs 1,000 notes will be retired? Anyone that is bringing a note to deposit or exchange to the bank will need to account for it.”

A former bureaucrat gave a very thoughtful response (paraphrased):

1. Have extensive stakeholder consultations, prepare a comprehensive plan covering all dimensions, elaborate to the last detail, and then roll-out the reforms in a predictable environment.

2. Identify an important element of the reform process (based on political and administrative expediencies) and bite the bullet. Hope that it would generate the momentum for change (create conditions, ripen the moment for wholesale change). Intervene strategically and opportunistically with all the other elements of the comprehensive plan in due course.

The first is a linear and logical approach, whereas the second is by definition non-linear and iterative. On deep-seated changes, the former would most likely overwhelm the political and bureaucratic systems (albeit for different but very compelling reasons) and lead to a decision paralysis. It’s just that there are too many bells and whistles associated with such comprehensive plans that they are most likely to run into the constraints of political acceptability, financial and other resources, administrative capacity, and mobilisation of entrenched interests.

In the circumstances, I feel that a more prudent approach would be to identify a totemic element of the implementation plan that can rally the troops, wait for an opportunistic political moment, intervene in a manner that it creates a momentum, and then chip in with all the other elements of the plan. The risk with the latter approach is that the government identifies the wrong elements, intervenes at the wrong time, and fails to follow up with other elements.

The demonetisation may have done all the first three elements of this second approach, and now awaits the other parts of the comprehensive plan. Given the rising discontent, it may be necessary to unveil all the other elements without waiting too long.

I would add more element to the response. If the secrecy were to be abandoned and people given sufficient time to do so, the change of behaviour from cash-reliance to banking channels might not happen. The public would find a way to exchange their old currency notes and continue with the cash economy. In this ‘shock’ therapy, there is a reasonable chance of changing behaviour in the right direction. That is the ‘signalling’ value of this the ‘shock’. Of course, the evidence has to come from the future.

Also, see Tamal’s defence of the ‘secrecy’, ‘shock and awe’ in his superb piece in MINT:

As we have come to expect of Tamal Bandyopadhyay, his is a stellar piece. I conclude this blog post with that.

That brings us to the final element of this blog post. There is both an upside and a downside to the concentration of this initiative in the Prime Minister’s Office (PMO) and with the Prime Minister. “The risk of the discontent – when things go wrong – being concentrated at the top is very high” (quote unattributed).

In this particular demonetisation exercise, may be, there was a case for secrecy and for concentration of decision in few hands. But, if all decisions pertaining to all ministries are seen as being made only in the PMO, the risk is very high. It is also undesirable at many levels. Sharing responsibility and credit are as important as making decisions, taking risk and taking credit for them.

As Monika Halan writes, the Prime Minister has taken a personal and political risk here. Indeed, given the plausible economic growth shock, the risk is enormous:

Her conclusion is something which this blogger very wholeheartedly and enthusiastically endorses:

Back to Tamal:

This is the signalling value of the shock that I had mentioned earlier.

Yes, if handled properly and followed up, it could be a lasting legacy of the government. Indeed, the issue has thrown up the stark challenges that India faces on the State capability front. The implementation of GST lurks from the next financial year. In an indirect way, it has become a curtain raiser or trial run for it. So far, the State has come up short. If it leads to some material changes in the State capability, its organisation and the incentives for performance, so much the better. The collateral benefit of improved State capability could be far more substantial than even the benefits on the corruption front.

This and the GST implementation can become seminal case studies on many aspects of governance: changing culture, behaviour, nudge, implementation, project management, State capability improvement and indeed, refashioning the economy, the government and much else.

This piece was first published on the writer’s blog, The Gold Standard, and has been republished here with permission.