"Demonetisation alone will do nothing to end corruption", www.thewire.in, December 16, 2016

Corruption after the demonetisation

It is now over a month since the Government of India announced a partial ‘demonetisation’ of the currency. Perhaps never before in history have so large a number of people been involved in an economic experiment such as this one. The Prime Minister who has led this drive has argued in speeches made to the public that this step was necessary to root out corruption, and any inconvenience in the short run would be compensated for by benefits that are sure to come in the long run. Though the government has not given out a clear idea of what the benefits would be, simple economic principles are sufficient for us to make sense of what the possibilities are.

            It is evident that once the existing Rs. 500 and 1000 rupee notes are no longer legal tender hoarders of unearned income will be sitting on worthless paper. Of course, the government has made it possible for them to hand over all their money at penal rates of tax but it is not clear that many would want to do this as they would have to explain the source of their funds. There are two problems with the approach. First, not all hoards consist of black money. Some, especially in rural areas and among those not in the banking habit, have money balances that are perfectly legal. These are maintained to take care of medical or other emergencies which are quite common in India. The demonetisation would have punished such persons. The government has shown itself to be aware of this and has made arrangements for them to deposit their money into banks, with deposits upto 2.5 lakhs not subject to scrutiny. This may have opened up an opportunity for those with black money to convert it into white. That this has been attempted when we find that Jan Dhan Accounts with almost zero balance have shown a spurt in deposits since the November 8. Secondly, there is some reason to believe that persons holding black money would have converted them into assets such as gold since that date as gold sales have surged. But the idea that those with unearned income keep it in the form of cash is suspect. They usually try to convert it into assets to escape detection and to avoid losing its real value from inflation. So trying to get at black money by demonetisation is not very sound as it can hurt the innocent but, more importantly, may be a case of bolting the stable door after the horse has bolted.

            I have so far argued in terms of its implication for the existing stock of money representing black income but the demonetisation also has an impact on the flow of income in the future. This aspect appears not to have been clearly understood by both the government and its critics, each of whom have ignored one of two flows that are now triggered. The government has pointed out that when money is deposited in banks the banks’ ability to lend is increased. This is indeed so, and we have seen it happen. We have even seen the lending rate of the major banks come down for this very reason. This is good for the economy. But of course a reduction in the rate of interest alone is not sufficient to restore the economy to a better state. This is because there must be a sufficient number of borrowers who will borrow from the bank to invest. Not only can this not be assumed but also it is not likely to happen very quickly for reasons I shall now point to. The second of the flows affected by the demonetisation is the flow of income from consumption activity. Money, it must be remembered, is not only a store of wealth but also the medium of exchange in an economy. Without money there can be no transactions. When approximately 85 percent of the money supply is sucked out, as it was, a large volume of transactions cannot take place as the cash needed is unavailable. Evidence of this mechanism being at work is seen in the empty food markets of India. Commerce has ground a halt. This consequence of the demonetisation appears to have been ignored by the political leadership. In the far flung villages of northern India it will take some time for economic activity to revive, for, when the economy is depressed investment is unlikely to increase even if the rate of interest has been lowered after the demonetisation. We can see that from the point of view of the impact of the demonetisation on the flow of income the question is whether the positive flows resulting from the from larger deposits coming into the banks will exceed the reduction in income due to consumption having been impacted negatively due to the shortage of cash for transactions. When this is lower there will be a reduction in income in the economy. My judgment is that the net flow of income will be negative, or that output will be reduced, due to the demonetisation. This seems to have been ignored by the Prime Minister when he spoke of the inconvenience due to the demonetisation. The loss of income when an economic activity cannot take place is not the same as the inconvenience involved in exchanging the old notes.     

            The Prime Minister has presented the case for demonetisation in terms of rooting out corruption. Of course, to the extent that hoards of black money are affected corrupt activities of the past are punished. But there is nothing in the scheme that can prevent corruption in the future as is claimed. In fact, within days of its announcement Gujarat’s Anti-Corruption Bureau caught up with two officials of the public-sector Kandla Port Trust demanding payment for clearing a consignment of goods. The payment of close to Rs. 3 lakhs was set to be made entirely in the newly-issued 2000 rupee notes. Since then, far far greater stashes have been unearthed in raids in Chennai, Karnataka and Delhi. This points to two things. First, periodically changing the currency in circulation can do little to eliminate corruption at source, for which it is necessary to target the very generation of unaccounted income. For the latter, a re-engineering of the process of interaction between the government machinery and the citizen is necessary, with a public record and independent oversight of each interaction. This is not difficult to achieve. Two suggestions can be made right away. There must be a provision for the citizen to register with the government any demand for gratification made by the bureaucracy. To ensure that frivolous or malicious allegations are not made, anonymous complaints ought not to be entertained and complaints should be made public. Secondly, as the maximum generation of black money is believed to be in the registration of property, details of all transactions in property – including names of the two parties and the value of the sale - must be entered on the concerned public authority’s website even as it they are concluded. In today’s IT environment such transparency is easy to achieve. The possibility of public scrutiny, as opposed to that of the income tax department in private, would make a difference to the generation of black money. It should also provide some relief to citizens who are at otherwise at the mercy of an unaccountable bureaucracy. If the Modi government is serious about ending corruption it must lay out a plan for ending the generation of black money in the interaction of the citizen with the government machinery, including the Income-Tax Department itself. Then there is the issue of election funding. The Prime Minister has mooted public funding. This is contestable. In a democracy, it is not clear that citizens should be asked to pay for political parties often campaigning on sectarian agendas. However there is a strong argument of the reform of present practices. First, the limits on spending should go but so must the practice of allowing anonymous donations to political parties. In fact, political parties must be brought under the RTI. Their argument that they are not a public body does not carry. They are claimants to the government and if they come to power will control every aspect of the economic activity in the country. The citizen is fully entitled to know of their financial transactions. A demonetisation allegedly aimed at ending the generation of unaccounted income that has nothing to say about the funding of political parties is not credible.     

            Demonetisation’s potential in eliminating corruption is limited. Corruption thrives because surveillance and enforcement by public authority is weak. But, we cannot ignore the role of social norms while seeking to end corruption in India. Corruption exists partly because it is tolerated by society. In India there is high socially sanctioned regulation of personal freedoms. This repression is mostly justified by reference to religious sanction and cultural traditions. By comparison there is no shame in amassing illegal wealth or moral injunction against the giving or taking bribes. It is seen as purely transactional and has no moral resonance whatsoever. This leaves a role for civil society in ending corruption. It would be populist to ignore this.

The author is Professor of economics at Ashoka University, Sonepat, Haryana and Senior Fellow-elect at the Indian Institute of Management, Kozhikode.