Demonetisation and the Question of Inflation

Narendra Modi had asked for 50 days’ time for his demonetisation measure to work: the people were supposed to suffer for 50 days, by the end of which the wonderful results of demonetisation were to become evident. He was even willing to get “hanged” if proved wrong at the end of this period. Well, the 50 days are now over; the cash shortage, and the consequent distress of the people, continues; no wonderful results of demonetisation are evident; but on the contrary, as predicted by most economists, the economy is sliding into a serious recession which afflicts not only the informal sector as expected, but the formal sector as well,through the multiplier effects of the recession in the former.

Yet, in his New Year Eve speech, which came after the end of these 50 days, there was not a hint of contrition, not a whiff of self-criticism, not a reference to the grand offer to get “hanged” if demonetisation failed. Instead there was the usual word-spin, the usual swagger and the usual trotting out of yet another benefit that demonetisation would supposedly bring in its wake. This newly-added item to the list of benefits is inflation-control: demonetisation, it is now being claimed,would have the effect of bringing down the rate of inflation.

Modi gave a bizarre argument for why this should be so. High-value currency notes he suggested were used largely these days by those who are engaged in all sorts of nefarious activities, including hoarding and black marketeering; demonetisation by making these notes worthless had hurt such people; and since they are the ones behind inflation, demonetisation, it followed, made possible a reining in of inflation.

WRONG PERCEPTION

Modi’s perception that high-value notes are used largely by those engaged in the parallel economy, is completely wrong. Cash, including notes of the denominations that have been demonetised, is used primarily in the informal economy, rather than in the “black economy” whose cash-GDP ratio is no higher than that of the “white economy”. By associating cash-use predominantly with the “black economy”, Modi in effect suggested that the 85 percent of the workers who are employed in the informal economy are actually employees of the “black economy”, and that the entire Indian agricultural sector belonged to the “black economy” which is a calumny against the peasantry.

But let us ignore Modi’s reasons, and dispassionately ask the question: might it be the case that demonetisation would actually help to control inflation? To answer this question we must first be clear what inflation-control means, for which we must ask the initial question: why should inflation be controlled? In an economy like India where there is no catastrophic hyper-inflation that is destroying the economy, but rather a steady but low rate of inflation, of around 5-6 percent, the reason for concern over inflation is that it may nonetheless be hurting the poor. If money wages remain constant, then even a 5-6 percent rise in prices, entails an erosion of real wages and hence an increase in the distress of the poor. But if the evil of inflation is seen essentially in terms of its damage to the living standards of the poor, then it follows that inflation-control must be defined in terms of controlling the damage to these living standards.

Consider an example. If with money wages constant, prices rise by 5 percent, then we have inflation hurting the poor. But if with prices remaining constant, the money wages fall by 5 percent then too we have the poor being hurt, even though we have no inflation. Hence if the 5 percent rise in prices is sought to be controlled through a 5 percent reduction in money wages, then we do not really have inflation control, even though price rise has been controlled. The question to ask therefore is: would demonetisation cause a decline in inflation without using some means for doing so that would have the same consequence of squeezing the poor that inflation has? If it can cause a decline in inflation without using for this purpose means that achieve the same squeeze differently then we can indeed say that demonetisation can control inflation.

More specifically, control of inflation must mean controlling the fall in the real incomes of the working poor which inflation causes. Demonetisation can be said to have controlled inflation if it can bring down the rate of growth of prices without squeezing the money incomes of the working poor. Since the working poor in the country are largely concentrated in the informal sector, demonetisation can be applauded for controlling inflation if it does not reduce employment in this sector and if it does not reduce real wages in this sector even while reducing the rate of growth of prices in the economy. Can a reduction in cash supply in the economy achieve this?

I talk of a “reduction in cash supply” since if the cash supply remains the same as it was before demonetisation, ie, if all demonetised notes are replaced by new notes, then we are back to square one and there is no question of any change in the rate of inflation arising from this side. Indeed from Modi’s remark about demonetisation resulting in control over inflation, it is clear that the government has no intention of replacing fully all the demonetised notes. Mukul Rohatgi had already stated this before the Supreme Court, and Jaitley too had said as much. But now we have confirmation of this straight from the horse’s mouth.

Let us continue with the argument.A reduction in currency supply by say 10 percent in the informal sector, it may be thought, can bring down prices and money wages by 10 percent in this sector, in which case the  money wages deflated by prices would have remained unchanged, and in such a case no fall in employment need ensue. Both our conditions, ie, no fall in employment and no fall in real wages would appear to have been satisfied, while prices would have fallen by 10 percent, so that inflation-control would have been achieved through demonetisation. This however cannot happen for the following reason.

The working people in the informal sector also consume some goods from the formal sector. Now, with a 10 percent cut in currency supply there is no reason why the formal sector goods’ prices would fall by 10 percent, or why they should fall at all. Not only is there less currency use in this sector, but, what is more, the oligopoly firms that typically dominate this sector act as “price makers” rather than as “price takers”: they collude to fix prices. When their unit prime costs rise, they jack up their prices to maintain their profit margins; and when their unit prime costs fall, they tend not to lower their prices, at least not to the same extent. Hence even if the informal sector goods prices fall by 10 percent, in the above example, and even if some of these goods are used as inputs in the formal sector, the prices of the latter sector’s goods will not fall by 10 percent; indeed they would most likely not even fall at all. In such a case, the real wages of workers in the informal sector, ie, money wages of workers deflated by what they purchase, from both the formal and informal sectors, would actually fall, if their money wages fall by 10 percent.

In other words, in our hypothetical example, even if employment remains unchanged in the informal sector, the real wages of workers would fall because of demonetisation. And if real wages in this sector are not to fall, then the money wages must fall by less than 10 percent even while the prices of goods in this sector fall by 10 percent, in which case however employment in this sector must fall. This is because many marginal producers, when faced with a 10 percent fall in prices but less than 10 percent fall in money wages, would find their profit margins shrinking to negative levels. This would drive them out of business and cause recession and unemployment in this sector.

NO INFLATION-CONTROL

No matter how we look at it, therefore, demonetisation controlling inflation, in the sense of preventing a fall in both employment and real wages in the informal sector, is a sheer impossibility. The inflation rate may fall because of demonetisation but this would necessarily be accompanied by a fall in the real incomes of the working people of the informal sector, in which case this fall in inflation rate does not amount to inflation-control. It brings down the inflation rate by doing what inflation would have done through other means; and this, as argued above, does not constitute inflation control.

But BJP leaders are now so desperate, because all the claims made about the beneficial effects of demonetisation have turned out to be false, that they are simply clutching at straws. First they talked about a surgical strike against “black money”, but that turned out to be a hollow claim. Then they talked about the “extinguished currency”, ie, demonetised notes that do not get either deposited or exchanged against new ones, boosting the RBI’s profits (by reducing its liability), and hence enabling the government to spend more for the poor; the amount of “extinguished currency” however has turned out to be utterly trivial. They then talked about banks’ lending rates getting reduced because of the huge deposits of demonetised currency that have come into their coffers, but the reduction to date has been paltry, and could have been effected anyway through monetary policy, without any recourse to demonetisation. And now there is talk of inflation control, camouflaging the fact that such inflation control is accompanied by an identical squeeze on the poor through other means.

No doubt we shall soon be having much noise about how demonetisation has defeated inflation. In a regime where unreason reigns supreme, decibels become a necessary accompaniment of such unreason.