A Tale of Two Shocks

Two shocks rocked the world: Donald Trump’s upset victory in the US presidential elections, and the demonetization of high-denomination currency in India. Both can be expected to have profound repercussions. I will pass commenting on the tears of Hillary Clinton — delicious though they are to yours truly — except to say that to me the result was as unexpected as it was delightful.

The Indian economy experienced a massive shock with the announcement that Rs 500 and Rs 1000 currency notes will no longer be legal tender starting from just a few hours after the announcement. An astounding 86 percent of all currency was rendered worthless for transactions, and only the remaining 14 percent was expected to serve for a short term (hopefully) the myriad purposes that money usually serves in an economy. A monetary shock of that magnitude cannot but have complex intended and unintended consequences.

The intended consequence has to do with “black money.” The belief is that this will remove the unaccounted-for money out of the economy, and that it will hurt those who have heaps of cash stashed away at home. Only time will tell if that intended consequence will materialize.

If say only 70 percent of high currency notes are exchanged by Dec 31st, then we can conclude that at least 30 percent of the high denomination notes represent the amount of black money that was removed from the monetary system. That would be a good outcome. Asset price inflation in the real estate sector will slow down and thus be good for the economy.

If nearly all of the high denomination currency is exchanged for the new Rs 500 and Rs 2000 bills, it would be a clear indication that those with black money figured out a way to launder their cash. We will know the result at the start of Jan 2017. And that is when it will be clear that this “surgical strike” was a very botched operation that did more harm than good.

The unintended consequence is that the shock of withdrawal of 86 percent of the money supply will hurt economic activity. The contraction of the money supply will constrain the real economy — that fewer goods and services will be exchanged, and that means fewer good and services will be produced, and that means fewer goods and services will be consumed, and that means lower overall demand, and lower overall income, etc.

India is mostly a cash economy, unlike say an advanced industrialized economy like the US. I doubt that I have handled more than $20 in cash over the last year; credit cards and online payments suffice. In the last two weeks that I have been in India, I have spent around Rs 10,000 in cash. Except for a relatively small proportion of transactions, most people are paid in cash and spend cash. Remember that only about 7 percent of labor in India is in the formal sector.

I am not a macro economist, and so this is not an expert opinion. I look at the world through microeconomics lenses (the only lenses that makes sense since macroeconomics is a load of worthless just-so made up stories). Money is the medium of exchange, and exchange lies at the very core of an economy. Put even a little bit of sand into the machinery of exchange, and you can be assured that the gains from exchange will be lost.

You can never do only one thing. That’s what I call the First Law of Ecology — and economics too. Maybe this exercise will bury a bit of black money, maybe it won’t. But for sure this exercise will put the brakes on the real economy. Will it result in net benefits or losses? If nearly all the high denomination bills are exchanged, it will be a net loss. If a significant (say 30 percent) are not exchanged, that’s a positive. But that positive has to be weighed against the negative of the contraction of the Indian economy.

My sense it that it will be a net loss.

The problem of black money is a problem that is essentially government created. High unreasonable taxes compel tax avoidance and the generation of “black money.” Black money is the symptom; the disease is taxation. The reasonable solution is to reduce government expenditure, thus reducing the need for high taxes, and thus eliminating the phenomenon of black money.

But it will be a cold day in hell when the government considers reducing taxes. Until then, we have to silently suffer the mess. Breathe deep. This too shall pass.

Author: Atanu Dey


11 thoughts on “A Tale of Two Shocks”

  1. While almost everything you said seems intuitive I never understood the following comment which I have read from some other knowledgeable people too.

    Asset price inflation in the real estate sector will slow down and thus be good for the economy.

    If builders lose money isn’t it like taking away capital which will then slow down the supply of real estate making the prices go up ?

    Or do you mean to say since people will have less cash to spare they wont be buying real estate as investment ? (That does not seem intuitive to me. People might be willing to pay more cash to the builder to reduce risk of keeping cash and might drive up the prices too.)

    Do you care to explain a bit more ?


    1. Akshar,

      Real estate is perhaps the only sector where a person can misrepresent the purchase price. Someone can pay Rs 100 lakhs (Rs 30L by check and Rs 70L by cash), and claim that he bought the apartment for Rs 30L only. You cannot do that for goods such as cars, etc., because the prices are published. So when there is a lot of black money around, the price of real estate gets bid up. In this, the one who has unaccounted money beats others who have “white” money.

      In general, real estate buying and selling will continue to go on but at lower prices. Housing is a critically important sector of the economy and if prices come down, more people will be able to afford housing. In any case, this is a topic that needs greater attention than it gets.


  2. If smashing a Madhya-Pradesh-sized hammer into an appendicitis patient is “surgery”, then this is a “surgical strike”. Otherwise, please use the more accurate description: “carpet bombing”. Indians just give away their ignorance (not of English but ignorance in general) by not using the correct names for things.

    I am surprised no economist has pulled out the blood-as-money analogy:
    As blood circulates through the body, it gets increasingly contaminated with toxins and waste products. Then it passes through the major and critical organs, the liver and the kidneys, that clean it up. Blood is circulated through these organs 24×7, because contamination also happens 24×7. When kidneys begin to fail, intermittent dialysis is performed for reasons of practicality; but dialysis is a far cry from the real continuous thing. Both liver and kidney failure have poor prognosis, because there is no substitute for the continuous circulation and filtering. A “surgeon” may instead choose to puncture a bunch of arteries, flush all blood out of the patient, clean it in a vat somewhere, inject it over a month through one or two canulas back into the blood vessels, and give violent shocks to the heart with a hope to restart the pump and revive the patient. Such a “surgical strike” can perhaps raise Frankenstein’s monster, but not a cured patient. Realistically, the “surgeon” ends up with a cadaver. In the current situation, lots of cadavers. You would call such a “surgeon” a “quack”, or rather a “vampire”.

    Events are on a roll now, there’s no turning back any more. The government should not back down while there is a single Indian still left alive. At least crematoriums are accepting old cash. After that, there’s always the old cash as fuel.


  3. Once again you are amongst the few who make sense. Instinctively this looks like a bad decision. The first thing it does is it creates distrust about the government. Today it is 500/1000 notes tomorrow it could be gold. Even assuming a large percentage of unaccounted money is removed from the system the question still remains as to what the ordinary person gets in return. Will we get lower taxes, better infrastructure, better schools and better services from the government. The important question about stopping new black money generation is still not addressed.
    While I do hope I am wrong I think in five years time the country will be back to the usual unless this action is followed by other important measures to curb generation of black money


  4. I completely agree with you on black money. There is also one more point which I am not able to understand that how bringing the new Rs 2000 note will stop corruption or in-turn black money!


  5. You did not address the counterfeiting. What if a material % of the cash i circulation is counterfeit. Does not this remove that instantly.


    1. The Indian Express reports that out of 10 lakh notes 250 are fake according to a survey of the Indian Statistical Institute. It further reports that at any time about 400 crore rupees worth of money is fake. You ask “if a material % of the cash in circulation is counterfeit”. Do you think this is a material % of the cash in circulation. I don’t.


  6. “The contraction of the money supply will constrain the real economy” – How much of this contraction is absolute/lost and how much will be a deferred one ( like a postponed vacation plan)..


  7. Atanu,

    You clearly got it wrong. The FM made it clear today that the plan all along was to bring all the cash into banks and not to invalidate any black money. Since 99% of cash is returned back the government objective is achieved and demonetisation has succeeded.

    Mere mortals like you will not understand the complex strategies of leader of century. As someone called this is “Pradhanmantri Heads I win, Tails you lose Yojana”.


    1. Mr Jaitley, the Finance Minister, is tragically untrained in anything resembling economics. It’s the great tragedy of India (and democracy is more than a little to blame for this) that certifiable morons get to positions of immense power, and wreak havoc on the nation. It’s all karma, neh?


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