The most radical economic policy decision was made by Narendra Modi on November 8. For a long time, we have known—or at least I have advocated—that the only way to eliminate the cancer of black money was to demonetise the currency in which hoards of cash had been embodied. Money is a piece of paper whose value comes from being acceptable as legal tender, as a means of payment. As a store of value, it is a wasting one. Only the possibility of tax avoidance makes it profitable to hoard currency.
For at least forty years since the mid-1970s, economists have tried to estimate the size of the black economy. Policy-makers have tinkered with the problem. They have demonetised high-value notes as Morarji Desai did. Periodically, they have declared amnesty for tax-evaders or offered them incentives of gold or bonds. To no avail. Black money is profitable to hoard and even more so to invest in other illegal activities. It can be converted into real assets easily by giving it to others who are part of the circuit of black money. It is a dynamic force in the economy and unavoidable in the electoral politics.
For those of us far away from policy levers who were thinking of how to tackle black money, the problem was the modus operandum of demonetisation. The mechanics of replacing one currency by another overnight was a daunting one. I had proposed many years ago that each individual be allowed to convert one for one up to a limit of, say, R200,000. Beyond that, all surplus cash had to be converted into zero coupon bonds which could be sold on the market after a certain interval. This allowed for a market-determined rate of write-off for the value of the old currency.
This was perhaps too kind and forgiving of the criminal hoarder. But it would have been easier on the public. In any case the difficulty has been the conversion of white money from old into new. It is the transaction demand which has been affected by the difficulty of getting the new money in place on time. This is a failure of policy engineering rather than design.
We can stop worrying about the costs of the move already made. Bygones are bygones and the political costs will have to be borne. The issue now is to construct a monetary system which will not regenerate black money. If we could rely on the honesty of all private individuals as well as government officials, not to say politicians, then one bout of drastic demonetisation should be enough. But economists minimise on the assumption of such honesty. We have to assume the worst and proceed.
In printing the new 500- and 2,000-rupee notes, the government has a weapon if subsequent issues can be differentially dated in an identifiable way—serial number or letter. Then, periodically, the government can demonetise the earliest vintage issue of notes. This would give people a warning that cash is not a store of value and hoarding is not profitable.
The government has also been trying to raise the transaction cost of large-value cash transactions by attaching conditions of identity cards, etc. This is helpful as far as it goes. But payment by cards also needs to raise the maximum amount which can be spent on any day by card. The younger generation, at least the more affluent sections, is increasingly adapting to a cashless economy. But until the vegetable seller and the kirana shop owner are equipped to receive payments by card, cash transactions will remain convenient.
Narendra Modi, while campaigning in the 2014 election, had said that he would bring all the kala dhan (black wealth) back. It would mean R15 lakh for each Indian. This was perhaps a way of illustrating the size of the problem. It has been interpreted literally as promising to give that much money to each individual. With a population of 125 crore, R15 lakh per capita works out to just under R20 lakh crore (R20 trillion).
It is difficult to believe this estimate—if by kala dhan, Modi had meant money sent abroad—not all of which can be confiscated by the government even if it could bring it back. Only the unpaid tax plus a fine would be recoverable. But the bulk of black money was at home in any case. By destroying the value of these hoards rather than seizing them, the government has done better. People will never get R15 lakh. The promise should never have been made. What Narendra Modi has done is much more drastic and healthy for the economy.
The author is a prominent economist and Labour peer