The Lessons of Demonetization | Livemint

Prime Minister Modi in his televised address to the nation his Government’s decision to demonetise the higher denomination currency notes. There is now ample proof that the grand demonetisation gamble has failed to meet its primary objective.

Signals of failure –

  • The Reserve Bank of India (RBI) has finally released numbers that show how most of the currency notes that were cancelled were deposited in banks.
  • The airy hopes that the Indian central bank would be able to extinguish a substantial chunk of its liabilities—and some mistakenly also argued that this would provide a fiscal bonanza that the government could use to recapitalize the banking system—have been belied.

What next?

  • Finance minister Arun Jaitley said that the money is now in the system, where the use of Big Data analytics could help the government identify who deposited black money.
  • The challenge now is to ensure that the creation of new black money is minimized. GST, which creates incentives for producers to seek bills from their input providers—will be part of the solution.

Positive consequences–

Every policy has a stated goal as well as secondary consequences, some of which are unintended. It is still quite possible that demonetisation will have positive consequences over a longer period—

  • the growth in the direct tax base,
  • the switch in the financial holdings of households from cash to bank deposits,
  • the increased use of digital payments.

The question to be asked is whether the potential long-term benefits will be greater than the short-term costs that the Indian economy had to bear.

Negative consequences –

The main negative economic consequence of demonetisation has been the disruption of unorganized supply chains that are dependent on cash transactions. However, it is also true that the Indian economy did not collapse because of the disruption of the monetary base, as some economists had predicted.

Lessons to be learnt from demonetisation –

  • The main lesson is that the Modi government did not seek the advice of experts before going ahead. The strategic decision to surprise holders of illegal wealth would anyway have restricted the circle of those who could be informed, but it seems that the idea came from outsiders with a penchant for impractical ideas rather than experienced policy advisers.
  • A good policy design should take into account how people will respond to any change in the rules of the game. In other words, incentives matter. Most rational human beings will adjust their behaviour to further their self-interest. Those who had illegal wealth held in cash obviously gamed the cash exchange process. Good incentive-compatible policy design is thus as important as good policy intent.

Conclusion –

The implementation of such a behemoth decision requires capacity building of those who would implement it on ground. A surprise invasion to the comforts of bureaucracy may seem desirable to check their readiness but it cannot be performed at the cost of common people and the economy as a whole. Government has derived the lessons and it is possible that the database of doubtful transactions, people and entities (formed post-demonetisation) would be fruitful for the Government to take the necessary legal action against such illicit wealth.