Chief Economic Adviser Arvind Subramanian at a press conference in New Delhi after the Economic Survey 2016-17 was tabled in Parliament on Tuesday (Photographer: Subhav Shukla/PTI)

The Two Puzzles Of Demonetisation - An Excerpt From Arvind Subramanian’s Book ‘Of Counsel’ 

The Chief Economic Adviser has no clear job description, says Arvind Subramanian, India’s former CEA, in his soon-to-be-released book ‘Of Counsel’.

Subramanian was appointed CEA in 2014 and in his four years on the job the Indian economy witnessed the unprecedented events of demonetisation and the implementation of a Goods and Services Tax among other important economic developments. The book analyses both these events and other significant ones such as JAM (Jan Dhan-Aadhaar-Mobile), the twin balance sheet challenge, fiscal federalism and climate change.

As Subramanian puts it, Of Counsel is “a retrospective assessment of key events and policies”.

Transitioning to Indian public life and specifically to North Block, the seat of the Ministry of Finance, with politicians as bosses and entrenched government bureaucrats as colleagues,with my every move being watched and every utterance reported,was a radical leap that, at the time, I was not even aware I was making.
Of Counsel - Arvind Subramanian
Cover image of Of Counsel, a book authored by Arvind Subramanian - India’s former CEA. (Image: Penguin)

The Two Puzzles Of Demonetization

Subramanian devotes a chapter to the 2016 demonetisation exercise undertaken by Prime Minister Modi, where 86 percent of the currency in circulation was extinguished overnight with the cancellation of high-value currency notes.

“I do have some new thoughts, or rather hypotheses, on two demonetization puzzles, political and economic.” 

Puzzle 1: Why was demonetization so popular politically if it imposed economic costs? Specifically, why did demonetization turn out to be an electoral vote winner in the short-term (in the Uttar Pradesh elections of early 2017) if it imposed so much hardship on so many people?

I offer the controversial hypothesis that imposing large costs on a wide cross-section of people (and the fact that the Rs 500 and not just the Rs 1,000 note was demonetized increased the scope and scale of demonetization’s impact), unexpected and unintentional though it may have been, could actually have been indispensable to achieve political success.
Of Counsel – Arvind Subramanian

Subramanian expands on that to suggest that

...the breadth of impact could have been a credibility signalling device. The American economist Thomas Schelling famously argued that to convince the public or opponents of the credibility of one’s actions, costs must be incurred.

...the breadth and depth of impact could have served as another signalling purpose. In order to be credible, the masses must somehow be led to believe that the corrupt had been hurt.

...the near universality of impact created a sense of solidarity. If only a few had been adversely affected in the demonetization process, they would have mobilized and from trade theory we know that their incentives to do so would have been great.

...and a related point, is cultural. One legacy of Mahatma Gandhi was to inculcate a spirit of sacrifice as a necessary condition for achieving a larger, loftier objective.

Puzzle 2: Why didn’t the draconian 86 per cent reduction in the cash supply have bigger effects on overall economic growth? To put this more provocatively, the question was not whether demonetization imposed costs—it clearly did—but why did it not impose much greater costs?

“Demonetization was a massive, draconian, monetary shock: in one fell swoop 86 per cent of the currency in circulation was withdrawn.”

Growth was slowing even before demonetisation, Subramanian notes, as others have. Data indicates the impact on GDP growth was between 1.2 to 2 percent.

“As a monetary economist, though, what is striking is how small the effect was compared to the magnitude of the shock.”

More striking is the how cash and nominal GDP moved before and after demonetisation, as illustrated by Subramanian with a striking chart in the book.

“Prior to demonetization, cash and GDP move closely together. Then, currency collapses and recovers, but through all of this, the economy seems to have been chugging along almost unmindful of the currency in circulation.”

What could possibly explain this apparent resilience? A number of hypotheses need to be considered. First and foremost, it could simply be an artefact of the way that GDP numbers are created.

In India, there are no timely measures of informal sector activity, so it is proxied by formal sector indicators. Normally, this is not a problem, since the two move in tandem. But when a shock like demonetization occurs that primarily affects the informal sector, relying on formal indicators to measure overall activity will overstate GDP.

This hypothesis goes only a small way towards explaining the puzzle, since any squeeze in informal sector incomes would depress demand in the formal sector, and this effect should have been sizable.

As a result, we need to search for other explanations. One possibility is that people found ways around the note ban, for example by continuing to use the Rs 500 note even after its use had been formally banned, so the currency shock wasn’t actually as big as conventionally measured. Another possibility is that production was sustained by extending informal credit: people simply agreed to pay their bills as soon as currency became available. Finally, to a certain extent, people may have shifted from using cash to paying by electronic means, such as debit cards and electronic wallets.

Is RBI Over-Capitalised?

It was in 2016 that Arvind Subramanian, in the Economic Survey of the year argued that the RBI was over-capitalised. That issue has returned to the headlines in the past months, as the central piece of a debate on regulatory autonomy.

In the book Subramanian explains his views and ends the chapter with a dramatic visualisation.

I have a dream. Perhaps it is a nightmare. There is a public event and on one side of the stage are lined up Messrs Bimal Jalan, C. Rangarajan, Y.V. Reddy, D. Subbarao, Rakesh Mohan, Raghuram Rajan, Urjit Patel and Viral Acharya. I am alone on the other side. I am being lectured on the RBI’s balance sheet by this eminent group of current and former RBI officials, and the hordes—especially the fawning elites in journalism, TV, financial community, etc.—are cheering them on. One of the group lectures me that I don’t understand monetary economics because transferring excess capital would increase inflation, forgetting that he too made my case when he was in my job. Another asks how I dare raise such a proposal to raid the RBI and destroy a great public institution. Yet another harangues that I am just another Ministry of Finance lackey. I respond with my arguments. The eminences are dismissive.

Suddenly Ben Bernanke and Mario Draghi appear. They had been bold in deploying their balance sheets during their respective financial crises, taking risks that eventually paid off. I appeal to them. They examine the case and pronounce their verdict. ‘This is such a no-brainer,’ they say. ‘Obviously, you should do whatever it takes.’

Deficit Down, Debt-GDP Ratio Up?

In addition, over the last few years, I have become less enamoured of the tremendous emphasis placed on targets, especially the fiscal deficit. Targets are indeed important. But process integrity is no less important. In fact, it is arguably more important.

I think the government made a commendable effort to bring back fiscal discipline after the profligate years following the global financial crisis. What is striking though is that while headline deficits have come down, debt–GDP ratios have been stubbornly high and rising. This is striking because deficit and debt ratios normally follow similar paths. If deficits are brought down to low levels, borrowing will be low, and nominal debt will rise by only a small amount. And if nominal GDP grows rapidly, the debt–GDP ratio should fall. The fact of rising debt despite healthy GDP growth warrants more attention.

Why didn’t debt–GDP ratio decline? One reason is straightforward: the government has had to issue additional debt to finance bank recapitalization. But the deeper issue has to do with activities that aren’t reflected in the budget deficit.

To take one example, the LIC and the SBI are playing a quasi government role in helping distressed public-sector and private sector enterprises such as IL&FS. For the moment, these activities will not show up in the government accounts. But ultimately they may do so, for if the bailouts lead to losses, the government may need to step in to assume some of the debt that LIC and SBI have thereby incurred.

Another reason is that financing of budgetary expenditures by the National Small Savings Fund (NSSF) or by the issuance of special bonds are not always reflected in real-time deficit numbers.

Firms must report their results according to established accounting principles. But things are different when it comes to government. Singer–songwriter Paul Simon once told us that there are fifty ways to leave a lover. Similarly, governments have more than fifty ways—policies and accounting—to meet a deficit target. The narrower the definition of government, the greater the scope for shifting things off-budget. And the more complicated the fiscal arrangements—as they are in India because of different layers of ‘off-budget’ activities and incurring of contingent liabilities—the more the scope for creative accounting.


Of Counsel
will be available starting next week. Arvind Subramanian will also be formally launching the book in events in Mumbai, Delhi, Hyderabad Bengaluru and Chennai.