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India’s demonetization: Black money a symptom, not the disease

By Derek Scissors

Opinion: The government’s priorities are flawed, and demonetization is not likely to strike a lasting blow against corruption.
Derek ScissorsI do not live in India and cannot speak to the pain felt by ordinary people due to demonetization. It is possible, though, that distance offers useful perspective about the larger questions of “black money” and corruption. From that perspective, it is likely that demonetization came too soon. Because the war on corruption is far from won, gains from demonetization will soon be eroded.

Before moving to genuine concerns, there is a false one: GDP. GDP measures the value of transactions. It has been extensively documented that demonetization has curbed transactions  from agriculture to tourism. Thus, GDP growth will slow, perhaps considerably depending on the quality of India’s official statistics.

Indian elites have been obsessed with GDP growth for years, but GDP is just an accounting tool. It does not make people’s lives better. The government and the World Bank may report GDP per person, but no one can spend this hypothetical amount – they spend and save from their real-world income.

The disruptions now being suffered are what matter to people’s welfare. Lower GDP growth for this quarter and next, even if surprisingly bad, is merely accounting and does not matter. When future GDP growth figures receive an arithmetic boost due to the effect of a smaller base in October-December, this also will not matter.

Nor should the government of Prime Minister Narendra Modi be criticized for the sudden, unannounced action. Economic theory and evidence indicates that, to be effective, monetary policy must be a surprise. Otherwise, money-holders just change their behavior in advance and there is no impact. If it had been made public in advance, demonetization would have just turned into a bill swap.

This certainly does not mean the central government is off the hook. Demonetization is a means to an end, with the major goal being reducing the incentive for corruption by making it harder to store the payoffs in cash. But if graft itself is not reduced, those who are corrupt will just find other ways to pocket their gains and the current turmoil will have accomplished little.

It is highly unfortunate, then, that opportunities to cut into graft have been missed. Perhaps its single biggest source is unclear land ownership, which encourages disputed land to be given to those most willing to bribe or for land to be stolen outright by local officials. Yet the Modi government offered a land bill that did not emphasize clear ownership rights. Corruption linked to land is unchecked.

That was a failure of omission, the proposed multi-tier structure of the goods and services tax (GST) is a failure of commission. In addition to the bribes that will ensue as groups lobby the national government to shift specific rates, businesses will falsely represent themselves in order to qualify for lower taxes. The result: much more black money will be generated.

The GST flaw reflects a larger issue: while the government has taken action to fight corruption, it remains tolerant of conditions that breed it. For example, even if one has no reasonable grounds to break contracts, one can still politicize them. Working to take politics, and thus the opportunity for graft, out of contracts would be far more valuable than demonetization.

The Modi government deserves credit for trying hard to ease a horrible problem. But its priorities are flawed, and the sad outcome is that demonetization is not likely to strike a lasting blow against corruption.

(Derek Scissors is a Resident Scholar at the American Enterprise Institute in Washington, DC.)

More from Derek Scissors:

India’s budget this week: What we need to see (February 23, 2015)