Economics for Non Economists 7: Demonetisation and Indian Economy

 by Girish Menon

 

My friend Shekar has asked the following questions which I will attempt to simplify and answer:

Why do these people keep blaming demonetization? What’s the link to economic prosperity? With such a high saving ability in the middle class, why do they talk about suspensions over moratorium? Is giving handouts the only solution? 

Please explain me how spending on a car, tv, consumer goods etc is going to save the planet? How many TVs would one require so that economist feel there economic prosperity on a nation? 

Me changing my iPhone every year benefits whom; Apple or India?

What about the fake currencies that were bought into our country that vastly created this economic imbalance and parallel economy in our country. If it’s that bad why aren’t people on the streets?

 

Let me start by explaining how one man’s spending is another man’s income and how demonetisation undermined the recycling of money within the Indian economy.

 

In economics there is a term called the Multiplier Effect. A simple definition is “a phenomenon whereby a given change in a particular input, such as government spending, causes a larger change in an output, such as gross domestic product”.

 

To give you an example, suppose say the Modi government actually spent the Rs. 20,000 crores in the economy which it promised to do earlier this year. This money would go to other businesses who will have new business orders. They will in turn employ more workers, buy more machinery which will create additional demand in the economy. These workers and machinery sellers will further spend their income buying goods and services creating even more demand in the economy. In this process of recycling money between the government, businesses and consumers the overall effect of additional government spending of Rs. 20,000 crores may be Rs. 40, 000 crores etc giving a much higher boost to growth and employment within the Indian economy. Now, this is an example of a positive multiplier and is recommended when an economy is in recession. Media reports seem to indicate that the Modi government did not actually give this additional boost to the economy.

 

Now, you can visualise what would happen when you decide to demonetise* some currency. You are reducing the money available to circulate between governments, firms and consumers within the economy. And the immediate effect of demonetisation was that many cash based industries folded starting a negative cycle of less demand therefore less employment leading to even less demand…in a downward cycle.

 

Demonetisation, as per the Modi government, may have been used to combat immediate political threats. However the economic fall out is inescapable in terms of fall in the rate of economic growth and hardships to ordinary people.

 

The timing of the decision may have been politically apt but for an economy that had already declining rates of growth this decision worsened the conditions within the economy. Covid and the lockdown completed the disaster with a 24% fall in GDP that was explained away as an ‘Act of God’.

 

The link to economic prosperity is the belief that as the GDP of an economy rises the people become materially well off and therefore more prosperous. I have explained this in an earlier piece here.

 

As far as the savings of the middle class is concerned these may have been affected by liquidity issues along with unemployment. They may have invested in property and other illiquid ‘assets’ which may be affected by lack of demand and lower prices. Hence they may not be able to repay their debts, mortgages…and hence the call for suspensions/moratoriums.

 

Is giving handouts the only solution? The objective of most governments is to generate a positive multiplier effect. In the western world, governments have given cheap loans and subsidies to firms but it has not resulted in a satisfactory positive multiplier. So, one of the possible solutions is called helicopter money or what you call handouts. The logic is that if you give money to those who need it most i.e. the poor, they will use it to buy goods and create demand in the economy which may kickstart a positive multiplier effect.

 

Your comments on buying iPhones and TVs should be understood with the need for economic growth and recycling of money within an economy. If the money is with you then it becomes your patriotic duty to consume and not save. The environmental damage is well documented and yet only paid lip-service to currently. GDP and economic growth are the unquestioned Ram Janambhoomis of the economic world. Remember, Modi and his 5 trillion economy boast. So, in this model which we have accepted, one way of sustaining growth is for consumers to keep on buying goods because if she stops then the process of recycling slows down and the economy will go into a downward spiral.

 

As for the fake currencies brought into the country; the one positive thing is that such currencies gave the economy a positive boost as it circulated between the people and businesses. It may at the same time have helped Modi's/India’s political enemies in the process. So the right question to ask would be, ‘who has demonetisation damaged more: Indians many of who were Modi's supporters or Modi/India's political enemies more?’

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*Demonetisation is not always a bad tactic. Keynesian economists will argue that when the rate of economic growth is rising and there is a fear that a crash is imminent then at such a time reducing the money supply could be a reasonable decision to temper the high rate of growth.