Demonetization, Modi's Biggest Move, Is Total Bust: Mihir Sharma

When India's prime minister announced last November that 86 percent of India's currency would be worthless in hours, he presented the decree as a well-thought-out measure to attack cash "hoarded by anti-national and anti-social elements." We were led to believe that honest taxpayers would line up to return their high-value currency notes, but these "anti-national and anti-social elements" would be unable to do so without raising suspicion. In the words of Finance Minister Arun Jaitley: "Obviously people who have used cash for crime purposes are not foolhardy enough to try and risk and bring the cash back into the system because there will be questions asked."

Well, if that's true, then apparently nobody in India is dishonest -- because, according to the Reserve Bank of India's long-delayed accounting, more than 99 percent of the cash in circulation has been returned. This isn't surprising. Indians are not the idiots their government seemed to imagine. Within days of the "demonetization," a dozen methods to launder piles of cash had been pioneered. Instead of the world's best-planned attack on black money, India's government had launched the world's biggest legal money laundering scheme.

Eight months on, no argument advanced by the government or its backers in favor of demonetization has been validated. Some officials argued that the piles of cash the prime minister spoke of would be "extinguished," representing a transfer from black money hoarders to the Reserve Bank's balance sheet which the government could use, say, to recapitalize India's struggling banks. That hasn't materialized, and in fact the RBI has given far less than usual to the government this year.

Some said that counterfeit currency would be exposed; in fact, it's less than 0.0007 percent of the cash taken in. The prime minister himself argued that demonetization would "break the back of terrorism" by cutting off sources of funding. Instead, this has been among the bloodiest summers for Indian security forces in Kashmir. This week, Jaitley argued that the move would change Indians' behavior, encouraging them to use digital payments instead of cash; but as I've pointed out in the past, demonetization is the exact opposite of what Cass Sunstein would call a "nudge."

The government has been reduced to boasting that the fact that almost all the cash was returned shows how efficiently the government can collect money. That's like throwing yourself off a building while praising how hard the ground is.

The only real, if weak, defense left is that demonetization pushed the Indian economy toward more formal ways of operating and saving and expanded the tax base. But neither of these requires a policy as incredibly destructive as demonetization. Nor is it clear that the government's claims are valid. Officials, including Modi and Jaitley, keep on arguing that the direct tax base has vastly increased. But the numbers they've released have been contradictory and deceptive. And even if the figures are correct, we've seen increases of comparable proportions several times in the past, without the trauma of demonetization. India's new goods-and-services tax is going to expand the formal economy and the tax base anyway. There was simply no need for an additional, untested and hugely disruptive policy to achieve the same end.

Exactly how disruptive was demonetization? Well, it may have eliminated over 5 million jobs; it's certainly ensured that growth slowed. For weeks, hundreds of thousands of small businesses struggled to find working capital; many of them may have gone out of business permanently. There was so little cash that agricultural prices crashed -- and, as a result, protesting farmers began to demand that their debts be written off. The government may give in, with dreadful consequences for India's fiscal position.

Most of this could have been foreseen by any half-decent economist. But the demonetization decision was taken in secret by less than half a dozen people, none of them an economist. Few governments in history have introduced something as disruptive as this with as little thought, preparation or study.

Unfortunately, the paucity of benefits from its sole big policy innovation may lead the government do more harm. Both Modi and Jaitley have turned to arguing that "excess" deposits in the months after demonetization will have to be investigated. In essence, this means that India's notoriously corrupt tax administration -- already being used by the government as a tool to attack the political opposition -- will be given a free hand. A "raid raj" isn't just illiberal, it will further depress already weak business sentiment.

India's government has learned no lessons from this fiasco. Why should it? It hasn't suffered at the ballot box. Enough voters bought the idea that demonetization may not have worked "perfectly," but at least Modi tried. As long as that remains true, the government will surely be tempted to launch some other scheme soon that is equally unusual, unnecessary and counterproductive.

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