Sunday, November 13, 2016

Modi's demonetization: chaos is a feature, not a bug


Prime Minister Narendra Modi's aggressive demonetization of the 500 and 1000 rupee note is causing plenty of chaos in India. A general shortage of money has emerged, massive lineups have formed at banks, and cash-based business has come to a standstill. All this would seem to indicate that the process has been ineptly carried out. But I'd argue that the problems listed above are exactly what one should expect of a well-designed aggressive demonetization. Chaos is a feature, not a bug.

As I mentioned in my previous post, a regular demonetization isn't meant to harm anyone. To ensure that no one is left behind, legacy note are gradually replaced with new ones, a process that often takes decades to carry out. See for instance the below pamphlet published by the Bangko Sentral ng Pilipinas (BSP), the Philippines central bank. It shows a slow and staged approach to replacing old peso notes with new ones. The goal of an aggressive demonetization like Modi's is exactly opposite: to leave people behind. To get this effect, the demonetization has to begin suddenly and end quickly.



Why didn't Modi make more preparations for the retirement of the Rs 500 and 1000 note? For instance, to reduce lineups at banks and ATMs the Reserve Bank of India could have begun supplying banks with extra 100 rupee notes several weeks ago in order to ensure that there was sufficient supply come November 8. And maybe the RBI could have nudged banks to purchase more safety deposit boxes to hold cash and hire extra staff to handle the rush.

Or take ATMs. One reason for lineups is that with the demise of the 500 and 1000 note, ATMs are running at a fraction of their capacity.  Indian ATMs have four "cassettes", each holding around 2000 notes. Two cassettes are typically configured for the old 500 rupee note, one for the legacy 1000, and one for the still-existing 100. They typically do not dispense 50s. Thus the maximum an Indian ATM can provide in a post-demonetized India is one cassette worth of 100s, or 200,000 rupees (US$3,000). If everyone in the lineup removes 2000 rupees, the daily limit, that means just 100 people can be served. That's peanuts.

To get ATMs up to full capacity, all four cassettes need to be dispensing some combination of new 500 notes, 2000 notes, and/or existing 50 and 100 notes. The problem is that each ATM cassette need to be re-calibrated to hold a certain denomination since notes are not uniformly shaped. With every single ATM in the country needing to be modified, and only so much staff trained to do so, it's taking a lot of time.

So why didn't the government begin working with ATM companies a few months ago to make all the modifications in time for November 8? This would have surely reduced the awful indignities that regular Indians must undergo as they wait for hours to withdraw cash.

Unfortunately, any attempt to modify ATMs ahead of time would have caused Modi's aggressive demonetization to fail. In order to inflict maximum damage on those who depend on "black money" (i.e. income obtained illegally or not declared for tax purposes),  an aggressive demonetization needs to be executed suddenly. If rumour gets out that a demonetization is about to occur, the element of surprise will be lost. Those working in the underground economy will simply switch their high value banknotes into low ones ahead of the demonetization, thereby avoiding being damaged. And of course it is the rich, not the poor, who have the best networks for gleaning information. To reduce the potential for information leaks, the number of people 'in the know' needs to be kept to a minimum, and this means that all large-scale preparation—including a huge reconfiguration of the ATM network—must be avoided.

So if you support the idea of a demonetization—specifically one that is designed to hurt the underground economy and, in so doing, draw people into the taxed economy--then you should just accept that this was always going to be a messy affair. If it had been a smooth one, then that would have been a sign that it wasn't being effective.
  
Once the dust is settled, India will be made better off by the demonetization. While many Indians in the underground sector will grudgingly comply and deposit their funds in an account only to withdraw that same amount in new notes later, others will keep their funds in the banking system. To change, people sometimes need to be prodded. This should be a shift in the right direction given that a banked economy is stronger than an unbanked one.

My back of the envelope calculation tells me that the demonetization will generate real pain on the underground economy. Consider that there are Rs 12.2 trillion worth of 1000 and 500 notes in circulation, or US$181 billion (source). Assume that 40% of these notes, or Rs 4.9 trillion (US$72.7 billion) circulate in the dark economy and lack a paper trail. Further assume that thanks to Indian ingenuity, or jugaad, half of the black money will sneak through the demonetization. That still leaves the remaining Rs 2.4 trillion, or US$36 billion, stranded. That's a painful writeoff!

To build and effectively run a nation, a government needs to be able to efficiently collect taxes. Many will shrug off the immense losses caused by the demonetization and go back to using cash as a way to evade to avoid the tax man, especially now that the government has (somewhat puzzlingly) introduced a new 2000 rupee banknote. But a large enough contingent will migrate to the tax-paying economy for good. Once bitten, twice shy.

19 comments:

  1. Dear J P koning, i love and read your work on a regular basis. If a sick patient is suddenly put through a surgical strike, the chances of revival are not always good. I don't disagree with your broader argument but don't you think that fate of imminent negative GDP growth is something that i don't feel India can bear easily. India is already passing through serious loss of jobs and deskilling. Haryana, Gujarat, Andhrapradesh and Kashmir have already seen series of social and political unrest. Only 20% of the population is actually using internet. In this context, don't you feel that this move can be more damaging than benefitting.

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    1. Hi Sunil,

      Thanks for your comment. I don't doubt there will be a hit to business activity. However, the RBI has the tools to offset this by reducing interest rates. Whether it will do so will be tempered by the fact that the hit will only affect two weeks of spending (and output lost in lineups). As ATMs are reconfigured and new 500 and 2000 notes enter circulation, the cash shortage will go away. In the two weeks that follow the end to cash lineups, Indians may even embark on a period of catch-up spending (and extra work) so as to make up for the two weeks of under-spending (and lost output).

      In the meantime, the policy will have taxed the underground economy for up to US$36 billion and brought many people into the banked/taxed sector who otherwise wouldn't be there. I think it's a win.

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  2. Hi JP, I also read you regularly and enjoy many of the high quality thoughts you share. However, your sometimes over friendly attitute towards the estbablishment and its practices are confusing. The black economy will continue in India and the rest of the world as long as there is demand and often also created by the governments themselves to criminalize everyone in pseudo democracies.

    Kind regards,
    AP

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    1. Thanks.

      "The black economy will continue in India and the rest of the world as long as there is demand and often also created by the governments themselves to criminalize everyone in pseudo democracies."

      Yes, the black market will continue. But will it be smaller than it might otherwise be? Certainly yes.

      Will its rate of growth be reduced? I like to think so. If enough damage is caused by the demonetization, it might create a one-time alteration to people's behaviour.

      The demonetization isn't criminalizing anything; it is only forcing large actors who haven't paid taxes to endure a one-time hit to their wealth. Think of it as a scheme to make tax evaders pay their due so that they catch up to everyone who has already paid their taxes. Isn't tax payment an important rule to enforce?

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    2. JP, tax payment is important when you are beeing provided quality services and trust your system, maybe that is your case in Canada (I assume you live there), but it is not the case for most of the rest of the world. Actually the opressive tax regimes of many countries creates the need for a black market.

      I doubt that the black market will shrink and that its rate of growth will be reduced. It exists for a reason and the natural growth it has will only be reduced if the quality of services is improved.

      http://www.bloomberg.com/news/articles/2016-11-14/cash-shortage-hits-goods-movement-in-india-as-atms-remain-dry

      AP

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    3. AP, fair enough.

      Even in a country like Canada (you're right, that's where I live) where services are good and corruption low, tax evasion is endemic. We trust the system, yet we cheat.

      In a perfectly efficient system run by an omniscient incorruptible bureaucracy, black money would still exist. Citizens aren't angels; given the means to take a shortcut, they will. Cash is a natural tool for tax avoidance, and it is everywhere. In order to combat the natural human proclivity to take tax shortcuts, having the authorities do something to cash makes a lot of sense, whether that be a "Modi switch" or a Rogoff high denomination note ban.

      As you point out, India's quality of services is bad. So maybe a large chunk of India's black money exists for good reason. But I'd argue that much of it also exists because of people's natural proclivity to take tax shortcuts when the tool, cash, is right in their noses. One hopes that it is this proclivity that the demonetization damages. Shame is a powerful way to modify people's behavior.

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    4. JP, we are in agreement then and there seem to be countries like Denmark that manage to create a system of good welfare services, education, etc with good tools of control that are fair to everyone. From my point of view the order of things is to create provide good services followed by fair control tools with everyone. Of course the road to achieve that will be bumpy.
      AP

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  3. I don't see how the demonetisation can bring in more taxes. Rather, the extra income to the government will come from the Cantillon effect.

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    1. Not sure what you mean when you say the extra income will come from Cantillon effects.

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    2. To translate it into a different terminology, it's a redistribution that will occur as the liquidity premium of the old notes decreases and the liquidity premium of the new notes increases. Those that print the new notes and those who receive them earlier will benefit, those who receive them late or who have to get rid of the old ones at a discount or are left stuck with them will suffer.

      A black market entrepreneur who doesn't pay taxes isn't going to pay taxes if you demonetise his stash. Indeed, he has nothing left to pay the taxes with.

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    3. Yes, it's a tax on one section of the economy to subsidize another. I don't understand why those who get new notes later will suffer relative to those who get them earlier. As long as Indians exchange notes at a bank before the final demonetization date, they'll get full value. After that, as you say they'll be valueless.

      "A black market entrepreneur who doesn't pay taxes isn't going to pay taxes if you demonetise his stash. Indeed, he has nothing left to pay the taxes with."

      The demonetization of his stash is the tax. The central bank suddenly owns a free asset (one without a corresponding liability), and since citizens in turn own the central bank, everyone shares that free asset.

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    4. So it's not a literal tax, but a metaphoric tax.

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  4. I'll rip into your position because I think you need to be educated on the function of black markets. Even if you think that tax collection is a good idea, there's still the issue of corruption.

    If you have insufficient governmental (or on a smaller scale, municipal) service, corruption is the only way to get what you need. In many cases, it is a matter of survival. If you google for a while, you'll find out that India, for example, has problems with water supply, and a large part of it is provided by the black market. There is also a large proportion of so called "counterfeit" electronics and cosmetics (i.e. for an economist, cheaper lower quality competition).

    But the state doesn't get its tax "revenue" from unlicensed and black market trade, so it fights against it under the pretense that this is good. In other words, the statist fanatic would prefer to let people suffer or even die and punish those that try to help them, just because of egoism. The plebs can't drink and buy phones? Well, fuck them, they should pay the taxes first. The kleptocrat gets thirsty too. While the authors of the excellent "The Dictator's Handbook" explain that this is characteristic of autocratic regimes, I think they underestimate the negative effect of statist ideology even in democracies.

    Even though I don't condone it, at least I can understand the state oppressing its own citizens (as I said, the state employees need to eat too). But I don't understand citizens from other countries promoting such actions. I'm afraid you've been scammed.

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  5. Hi

    Thanks for the great article!!

    What's your opinion on below?
    http://blogs.timesofindia.indiatimes.com/Swaminomics/less-black-in-cash-means-more-in-gold/

    Thanks
    Mehul S.

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  6. You are ignoring the unintended consequences. For details, see here:
    http://www.acting-man.com/?p=47966

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  7. Definitely what happened to India is going to INCREASE not to decrease the size of the black economy. The way to fight black money is to introduce efficient tax audit teams (like the IRS) with tight procedures , to give them targets and incentives to scrutinise black money and tax it. What Modi achieved is a one-off hit to black economy which , in any case, will create something like a tax effect to the holders of black money. Nobody is going to trust again the Indian gonverment on issues related to fiscal control.

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  8. Fine, thoughtful article. Incredible though to see the negative comments- people are a bit 'crack'. Mr Koning should remember that, often when people criticise Modi and his policies, behind the smokescreen of their arguments, lies hidden biases and hatred for a 'tea-seller' who dared to become the PM.
    The arguments that black money will continue otherwise is patently absurd. If you don't tk steps, you're massacred. If you do, you're well again massacred.
    This demonetisation 'nuclear bomb' was just one in a series of steps ushered in by the government over the last two yrs. To view it as be all and cure all is to miss the whole.

    Also, there is a diff dimension to the whole arguments, which you nailed in your sentence: " Chaos is a feature". It's what Naseem Taleb refers to as "trial and error, learning by doing". In real world, you iterate to perfection. Just ask the software and tech companies guys. For the rest of the armchair intellectuals, who theorise and pontificate, and hv never done a real job in their life, every action is flawed.
    Well it is, but then you keep learning and adapting with a rough gameplan in your head.

    Excellent piece.

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  9. Its been a while you wrote this op-ed. Things aren't panning out so smoothly and we have passed the window.Just wondering if you have changed your thoughts now? (I am on the critical side of this move because I know the abysmal state of digital infra in India and the costs involved compounded by less than efficient regulatory bureaucracy to my minnd outweigh the potential benefits. (Better ways of getting there aka getting the informal businesses in to the formal fold)). Do let me know whenever if you get a chance.

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    1. Mandar, you can see my updates at this link:

      http://jpkoning.blogspot.ca/search/label/demonetization

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