We humans are very addicted to fairy tales and stories where the knight in shining armour kills the evil giants and rescues the people of the town. Modi's demonetisation move has evoked gleeful reactions from the general population. They are imagining that the blackmarketeers and the corrupt have hoards of cash in 500 and 1000 rupee notes stored under their beds, which now is not worth the paper it is printed on; and overnight a lesson has been taught to them. Justice! Retribution! The rich (and by extension, the corrupt) have been brought to their knees!
All this makes for good politics. But whether it is good economics is debatable.
To understand why demonetisaion will not solve the "black" money problem we need to understand the nature of money first. Money is primarily a medium of exchange and secondarily, a store of value. Human beings started with barter, and soon realized that you needed a common currency that has the following characteristics:
· It is acceptable by everyone
· It is not too easy to procure (e.g. sand cannot be money)
· It is not too difficult to procure (e.g. rare earths cannot be money)
· It needs some effort to procure (e.g. gold needs to be mined, and so do bitcoins) – the guy who makes the money cannot produce it out of thin air (nowadays they do, but more about that later)
· It should be:
o A non-life form (e.g. people have used livestock as money but they could die on them),
o easily transportable (e.g. real estate can't be money),
o divisible, i.e. one should be able to cut it into smaller pieces
o exchangeable and transactable (can't be poisonous for example),
o non-reactive with most other elements and things on earth (e.g. salt was used as money in the Roman army, which by the way is the origin of the word 'salary', but it could just dissolve in water and be lost),
o hold a lot of value in a small volume,
o cannot be liquid or gas, for obvious reasons
Of all the elements in the periodic table, most get eliminated due to the above reasons. What remains as ideal for money are gold, silver and copper.
Kings and governments started minting coins of the realm using these metals. This had a problem. The moment the currency was debased, which invariably happened, people would melt the coins for the value of the metal contained in them.
But then using gold as money is also a problem. It is not strictly divisible. So someone, initially the local banker, and later the Central Banks, offered to hold gold, and issue "notes" in their stead which people could easily use as money. The bank issued you a 'promissory note' saying 'I promise to pay the bearer x grams of gold', i.e. you could go back anytime and get gold by surrendering the promissory note. Slowly, an interesting thing happened. The banker realized that while the money was circulating in the economy, it was not possible that all the people would come and demand their money at the same time. So the banker issued more promissory notes than the stocks of gold he had! A scam of the highest proportions, which in modern economic parlance, is called deficit financing.
Exchange rates around the world were fixed with respect to the dollar, and the dollar was fixed to a particular exchange rate with gold. This was the gold standard. But every bank in the world, including the US, started printing more currency than the gold they had, and soon it was obvious that this promise could not be sustained.
So one fine day the United States unilaterally reneged from its commitment and withdrew its promise to pay gold in exchange for dollars. All the other countries followed. The currency note is essentially a promissory note to give you 'value' in exchange. Gold is one of the few things which have value across the world, and the promise to pay gold was acceptable. Once gold would not be paid in exchange for your currency, the promise becomes an empty one. They sanctified this emptiness by modifying the promise on the note. If you take your 100 rupee note and have a look it says: "I promise to pay the bearer the sum of hundred rupees"! Circular logic. The world's biggest empty promise. And who is the one who promises to pay? The Central Bank. What do they promise to pay you with? The same piece of paper!
So the currency note is essentially a piece of paper which is a promissory note signed by the Central Bank of the country; a note which promises to pay you nothing. It is also essentially a zero-coupon perpetual bond, one which bears no interest, and has no expiry date. So then how does this money become valuable? It is valuable only because we all say so. It is a delusion held by all by common acceptance that provides it its value; a faith that we place in each other to honour it and accept it as currency, a faith that is backed by law; all of these are man-made constructs.
So money now is merely a medium of exchange. It is no longer a store of value except for the limited period that the government says it is so. This is a very important point. In the public imagination, demonetizing notes is like killing a dragon; once it is killed, the problem is solved. There is no dragon here waiting to be killed, it is all a figment of our collective imagination.
So let us come to this whole black money issue now. What is black money? It is not a dragon which is waiting to be killed. It is merely the generation (flow) and the accumulation (stock) of money on which tax has not been paid. Where does black money sit? In assets of course. Are currency notes an asset? Of course not, not in the sense we are discussing it. Currency notes are at best temporary assets, exposed to the whimsical actions of the government of the day, held in order to exchange it for hard assets. So where is black money held? It is held in the form of gold, real estate, foreign exchange, money stashed abroad, etc. How much of the black money stock is then held in currency notes? No one knows for sure, but let us say, less than five percent, maybe much less.
How much money is in circulation in India today, before the withdrawal of these notes? About Rupees Eighteen Lakh Crores, of which about Rs. 15 lakh crores are in notes of 500 and 1000 denominations. ( I am rounding these numbers; they are close enough; and I have seen many numbers in this range being bandied about).
This money of 18 lakh crores is what lubricates the economy. Of and by itself it has no value. Its value arises from being something people can use as currency for exchanging with stuff of economic value. What happens when you suddenly demonetise 15 lakh crores out of this.
The economy contracts in the short term. People are put to great hardship. We are already seeing this happening.
There are some attendant consequences like banks becoming flush with funds, interest rates coming down as a consequence, ailing and tottering banks being propped up due to the sudden inflow in deposits, sudden upsurge of 'white' money due to money coming into banks, etc. but these are merely side effects that are worth noting, but not significant in the sense they are not responsible for making the decision in the first place, and their effects may wear off over time.
How did our beloved Prime Minister justify the demonetisation to the nation? Primarily on the twin planks of terrorist-funding through fake notes, and control of black money. The Prime Minister either has a profound lack of understanding of the nature of money, or it is as much a political step as anything else (watch how the entire nation's consciousness is centred around him). I suspect the former is only partly true, since he is a smart cookie, and the latter is definitely true.
Let us examine these two reasons.
First the terrorist funding through fake notes: The amount of fake notes in the economy is estimated at 250 per 1 million notes. Hardly significant. Also, who holds these notes? Not the terrorists, but the common citizens since they are already in circulation. So what do you achieve by demonetising? Stop fresh notes from coming in. For a while. We are entirely glossing over the fact that they will soon start counterfeiting the new notes anyway. Also, it is an admission on the part of the government that they are unable to stem the supply chain. Ask the BSF jawans on the Bangladesh border. They know how the whole chain works, but it is impossible to stop, due to sheer logistical issues. So what changes with this step? Nothing. In any case, the scale of the problem in terms of materiality is insignificant for a step of this nature. So the argument of terrorist funding is a red herring – in recent times it has become fashionable to appeal to patriotism; goes down well with the public, and no one dares say anything against it.
Ok, let us now come to the black money issue.
How much black money are we targeting? Less than five percent (just a guesstimate, but you get the idea).
How much of this money will be impounded? Of the 15 lakh crores, very little. Assume about half of it is with the general public, and the balance with the desh-drohi scamsters. That makes it about 7.5 lakh crore so-called black money. Of these, part of it has been already converted to gold. Part of it has already been laundered by over-invoicing festival season sales in various businesses by raising back-dated invoices. The major part of it is being distributed to people who don't have cash to deposit in their bank accounts, to be returned later after retaining a slight premium. How much of this is going to happen? One clue is the 'premium' in the market as on date (today, 18th November) for exchanging old notes. The people who take it from you in turn have their channels. The premiums shot up initially but reports are that currently you can get them exchanged for 20 to 30 percent premium. Now why would someone give you 70 percent of the value of the worthless notes, unless he has ways of laundering it?
So how much of money is going to get extinguished? About two to three lakh crores, maybe even upto five lakh crores. Part of this will be genuine hard-earned money of honest people who are either unable or unwilling (a large part of the poor still don't trust the system) to exchange the old notes, a part that is put off by the effort involved, NRI's who just will not bother, and a large part of it just because someone forgot.
What happens when this money gets extinguished? The RBI makes a profit. Since its liabilities have just reduced by five lakh crores. The government can use it to reduce the fiscal deficit for the year, or use it on fresh spending.
Does black money generation stop? As result of demonetisation, not at all.
Other steps need to be taken for that, which are anyway not linked, like:
· Make people declare the value of their assets with their tax returns (already begun in a small way with real estate holdings being declared along with returns in excess of fifty lakhs)
· Have a public database of transacted prices especially for real estate and punitive measures for under-reporting; there are many ways to bell this cat
· Attack agricultural income which is non-taxable and a source of much laundering. In India, the total "sales" of agricultural commodities are far in excess of actual production. People with unaccounted money simply show it as income earned from farming activities. This is the holiest of holy cows, and difficult to tackle due to political reasons
· Introduce single-point taxation with full traceability like GST and slowly strengthen the systems (already started)
· Control election funding (Modi is making some noise about it; but that is just noise, nothing will come of it)
· Control laundering through religious trusts and temples (can be done with some effort)
Do the above measures have any connection with demonetisation? There is a school of thought that says demonetisation will put the fear of God in people, and that other steps will follow. Fear of God is like the mother telling the child in Sholay "So ja beta, nahi to Gabbar Singh aa jaayega". The child is scared, but not the village sahukar. It is a specious argument if ever there was one. As to "other steps will follow", they anyway should – they are an ongoing process, but what connection does demonetisation have with that?
Are we stopping issue of large denomination notes, since it is supposedly the favourite staple of the ungodly corrupt to stash their ill-gotten lucre? On the contrary. We are now talking about keeping note-disgorging machines which will disgorge 2000 rupee notes at petrol pumps!
Will black money generation stop as a result of demonetisation? As we already discussed, we have only attacked the stock, and that too not of the asset but of the lubricant. The activities that generate black money will continue; and the assets that hold black money still exist.
You cannot kill the dragon by confiscating its droppings. The dragon will continue to shit.
What are the attendant consequences? Any person with even a rudimentary knowledge of economics always knew that currency has no value on its own, it runs on faith alone. The person who wants to store unaccounted income will now store it in the form of gold, bitcoins or bitcoin equivalents, and foreign currency. And what prevents any of these from being converted from a store of value to a medium of exchange? Nothing. If a section of people decides to do that, there is nothing the government can do about it, except passed toothless laws outlawing the practice.
Meanwhile, what of the establishment? The establishment is supporting the move. Witness the interview published yesterday of Deepak Parekh. He skirts over the real issues, and talks as if he is unschooled in the basics of economics. He of course knows his stuff, but he is just toeing the establishment line. There is also a large mass of people who are equating this with patriotism and any move to oppose demonetisation as anti-national. This kind of mass psychology that is taking hold is insidious and diabolical. I have not seen any arguments from any of these desh-bhakts rebutting any of the points that have been outlined above, and few will be forthcoming, since religion and patriotism don't operate based on logic.
And, finally, what about the common man? Are you joking, my friend? The common man is only a pawn in this game!