The Demonetisation Mess in India

Here is my understanding of the situation:
The government has said that it has withdrawn the 500/1000 rupee notes for the following reasons:
1. To eradicate black money
2. To eradicate corruption
3. To check the fake currency racket and terror financing
4. To bring more people into the tax net
5. To reduce prices of land

I do not support the move because:
1. It does no significant harm to the black money problem. As per the statistics of the Income Tax department, cash forms less than 6% of total black money holdings. If from this even 75% of the black money is forfeited it still has an impact of only 4.5% of the total black money. That is hardly equal to eradication. Also, the effect would be temporary, since the stocks will be built up again as the liquidity improves. By the way, the government is driving completely blind here. The Finance Ministry has no idea as to the amount of black money or the proportion that is being held in cash form(http://scroll.in/latest/821931/there-is-no-official-estimate-of-the-amount-of-black-money-in-the-country-says-finance-ministry). The only statistics are those available with the Income Tax department.

Some people have said that the cash is the medium for all black money transactions and they will be affected. Agreed, but only for a short time since the government itself is promising that it is hard at work to restore liquidity. This move impacts only the current stock of black money held as cash. It does not do anything for the reasons for which black money is generated. Therefore, the move is not effective.

2. This move does not eradicate corruption. It just postpones bribe seeking and giving by about three months hence till the time liquidity is restored. The bribe seekers are just going to specify to the bribe givers that they will extend sought after favors if bribe is given in new currency. Problem solved through delegation! Eradication of corruption requires removal of discretionary powers of the executive branch of the government. Seeing the arbitrary rules and guidelines for managing the cash withdrawals, I feel we are moving in the opposite direction with more and more discretionary powers being granted. Just check out the guidelines for getting the 2.5 lakh rupees for weddings and you will know what I mean. Modi promised minimum government and maximum governance. This is just the opposite.

3. Fake currency stocks will definitely be rendered useless. However, P. Chidambaram said in a recent interview that the estimated stock of fake currency was Rs. 4,000 crore out of a total outstanding currency of Rs. 13,00,000 crore. That means to weed out a fake currency component of 0.000031% we are replacing 99.999969% of the currency. This hardly seems sensible. And to this a BJP leader (an economist in Rajya Sabha) agreed that while mathematically PC was correct, the lives lost due to terrorism cannot be measured in terms of percentage (logic being that fake currency percentage being trivial does not matter because the lives lost are priceless). What this argument means that if the new currency is also counterfeited and even one priceless life is lost due to terror, then we can again logically demand yet another change of currency. And the new currency is bound to be counterfeited because the government has admitted that it only has a new design and does not have any new security features.

4. The government has done lots of marketing that this move will bring more people in the tax net by increasing the tax base. But we should look at some data before believing that.

An annual income of Rs. 250000 places one in the top 1.98% of the Indian economy. The data source for this information is the Income Tax Return Statistics, AY 2012–13. Here you may argue that lots of people do not report their income so this has no meaning. But let us look at other consumption based surveys which do not depend on declared income data.

The India Human Development Survey, 2011–12 found that the annual income earned by people in India was distributed as below:

Income Quintiles Annual Income Range (in Rs)
Poorest Quintile (Poorest 20%) 1,000–33,000
2nd Quintile 33,001–55,640
3rd Quintile 55,641–88,820
4th Quintile 88,821–1,59,600
Richest Quintile (Richest 20%) 1,59,601+
Note: Quintile represents 20% of a given population

The National Sample Survey Organization (NSSO) which does consumption surveys found that according to the latest data available for 2011–12, if your monthly spend is around Rs. 3,000 in rural areas and Rs. 6,300 in urban areas, you belong to the top 5 per cent. That translates to an annual spend of Rs. 36,000 and Rs. 75,000 for rural and urban areas respectively.

This means as per consumption data at least 95% of Indians are NOT going to come under Income Tax coverage anyways. 4% Indians already file Income Tax returns, although only some 1.5% pay tax.

This leaves less than 1% people who might additionally come under the tax net because of cash transactions going out of vogue.

The PM has said that this will lead to lower taxes. To this I counter that till the time there is a budget deficit in India, all this talk of lower taxes is just JumlaSpeak which is another name for BS. If lower taxes happen, they will happen due to political populism and not due to economics.

5. The prices of land have risen because people use it to hide black money. If black money is generated, land will be used to hide it. Since this step does not do anything to counter the reasons that lead to generation of black money, it follows it will do nothing to reduce prices of land.

Many people have also mentioned that this is just first of many steps, and that there will be follow up steps that will have a greater impact. My question to these people is that what are these steps? No one has yet specified them. It seems more a way to keep people quiet and postpone the problem. And also, I want to ask as to why couldn’t these hypothetical steps have been taken WITHOUT first de-monetising the currency in the way it has been done.

My conclusion:

As far as I can see the only logic that seems to fit is that this has been done to rob BSP and SP from buying votes in the UP elections from their cash stash.

I am all for bold moves that can control corruption, but I am against playing politics and making fool of the public. I am also open to changing my stance if evidence/data is presented.

Update:

I think I am getting the understanding of the reason why the demonetisation was done. The government is hoping that not all of the outstanding currency would be deposited. If say 70% of the 16 Lakh crore is deposited, even then about Rs. 4.8 Lakh crore is left. Earlier I was unable to understand that even if this liability is extinguished, what benefit will it have since the government will have to ultimately issue new notes (new notes are printed because of the demand for liquidity and for some monetary policy measures). I had been thinking that the demand for liquidity will push the liability of the government back towards the current outstanding of Rs. 16 Lakh crore and therefore there can be no lasting benefit.

However, the crucial thing is that now when the government prints the new notes to meet the shortfall of currency in the economy, it has the discretion of releasing the money through its chosen channels. And I am betting that it will release the new money in the form of a one-time payment to poor people holding Jan Dhan accounts. I am also willing to predict that it will be couched in marketing speak that the government is returning the money captured from Black money hoarders to the citizens of India. This will lead to enormous electoral benefits and will more or less ensure that Modi returns to power in 2019.

So this demonetisation scheme is actually a wealth redistribution and vote buying scheme. It will not have an impact on black money in the long- or even the medium-term.