Currency transfusion and political cyni-, er, realism

Have Indians proved the cynics among them wrong?

A few years ago, a cynic postulated two laws of policy realism in India.

The first law of policy realism
A policy that relies on the Indian citizen to act in selfless public interest will not work. In fact, a policy that expects an Indian citizen to act in anything but self-interest and relative gain will not work.

The second law of policy realism
A policy that expects Indian citizens to adhere to a process—any process—will not work as intended, because people will ignore, work around or actively undermine the process. [Two laws of policy realism]

While these statements hold up almost in all cases, the Modi government’s currency transfusion (‘demonetisation’) appears to be different. Even considering that most people are conflating their personal opinion of Prime Minister Modi and of his currency policy, and despite almost every person undergoing inconvenience and hardship (to various extents), the policy is largely popular. So isn’t this a violation of the first law? Aren’t people acting in selfless public interest?

Not quite. First, the actions of the citizens are not voluntary, but enforced. They have no choice but to act in a manner prescribed by the government. Second, as I wrote in the explanation of the first law, “the citizen must feel s/he will get more out of it compared to others”. In this case, most citizens feel the cost they are incurring is a lot less than the cost others—those with unaccounted money—will incur. For the moment at least, intangible schadenfreude is outweighing tangible personal losses. The emotional support for the policy derives from the relatively higher value people are currently attaching to schadenfreude. This is consistent with the first law. If the inconvenience persists for longer than people’s endurance (which is different for different people), then it might begin to outweigh schadenfreude.

What of the second law? From the numerous announcements the Finance Ministry and the Reserve Bank of India are making with respect to the acceptance of old currency, conditions for exchange and withdrawal limits, it is clear that there is a cat-and-mouse game going one between those making rules and those finding loopholes. The second law holds too.

Why PM Modi should push economic liberalisation now

The best use of his store of political capital is to undertake big ticket economic reforms.

When a small Takshashila team walked around Bangalore’s wholesale markets, Dobbspet town and a few tiny village in the latter’s vicinity as part of our #FootNote initiative, we noticed many people reporting that they were not only inconvenienced but suffered monetary losses, yet supported Narendra Modi’s currency reform (‘demonetisation’) initiative. This is counter-intuitive, except perhaps in the context of religious faith.

To better understand this phenomenon, I conducted a twitter poll earlier this week that sought to investigate to what extent have people conflated their opinion of Prime Minister Modi and his currency reform initiative.

The results, after just over 1800 responses, were as follows:

Obviously, there is no claim that this poll is representative of the entire population of India. It is more likely representative of the forty thousand or so people who follow my twitter handle. Even so, the responses are interesting, and support what we noticed on the #FootNote tour.

Modi-Demonetisation-Poll

What does this mean? As Karthik Shashidhar, our resident quant, remarked, in 87% of the respondents there is an overlap between their opinion of Mr Modi and his policy. In other words, people’s attitude towards him overshadows their opinion of his policy. My colleague Nidhi Gupta, who recently reviewed Christopher Achen and Larry Bartels’ Democracy for Realists (Princeton University Press), that exposes the flaws of democratic systems, noted that in this case too, the notion that people vote on issues does not seem to hold up.

We’ll repeat the poll again in January to see how much the responses change.

In any event, the upshot is that the demonetisation episode shows that Mr Modi enjoys tremendous political capital that he can use to implement the type of structural reforms that would be extremely difficult for other leaders to pull off.

He should not lose the opportunity.

Postscript: Mr Modi’s team conducted their own poll using his smartphone app. Both the framing of the questions and the type of sample suggest that the poll is essentially a device to rally his supporters rather than obtain an objective estimate of public opinion. It would be wrong to assume it reflects what Indians think, just as it would be wrong to use my twitter poll for the same purpose.

What did the currency reform intend to do?

Countering terrorism, counterfeit currency, unaccounted wealth, unaccounted income…?

Anupam Manur and I have a brief analysis of what the currency reform (popularly, and inaccurately, known as demonetisation) might have been intended to do, in the eight following slides.

India's Currency Reform 2016 from The Takshashila Institution Click on the slide to enlarge.

Cash crisis, reform and pain

Structural reform does not have to be painful.

It is clear by now that the Modi government’s currency reform, involving replacement of old high-denomination notes with new ones, is inconveniencing people across the country to various extents. The expectation that the inconvenience will last only a few days has given way to fears that it will take longer: weeks, a couple of months, or more. Many economists estimate that the cash shock will cause an economic slowdown and hurt economic growth in the short term. [Mint has a very good economic analysis of the currency reform]

So question obviously is: was the move worth the pain? Are the benefits of a one-time cleanup of unaccounted cash worth the disruption of almost everyone’s daily life and the short-term—albeit irreversible to some innocent businesses and individuals—damage to the economy? It’s too early to tell.*

In the meantime some defenders of the move argue that inconvenience and pain is an essential part of structural reform. This is both inaccurate and disingenuous. This month’s currency exchange is not a structural reform. And structural reforms do not have to come with so much pain for so many people.

Those old enough to recall 1992 will hardly recall any pain or inconvenience. Similarly, it is hard to envisage the people of the country undergoing pain if say, schools no longer required licenses, businesses could be set up and closed down without hassle, tax laws became simpler, or even labour reform allowed easier hiring and firing of people.

Those linking structural reform to pain are doing a disservice to the cause of liberalisation. There is no reason why structural reforms must be painful. If anything, by removing red tape, preventing official harassment and lowering friction, structural reforms will make life a lot less painful—both in the short term and in the long term. Baby, bathwater and so on.

* Postscript: Many have asked me whether this currency reform will be successful. The honest answer is that it is too early to tell.

In fact it is hard to even analyse its impact had everything gone smoothly. The Indian economy is very complex, and we know less about the ‘unorganised’, ‘informal’ economy. Like blood that runs through the body’s veins, money supply affects every sector and over a billion people. It would be flippant and arrogant to claim to be able predict how it will pan out. Further, given that the transition is not going smoothly, what was complex has become even more so.

Complexity, the lack of required level of knowledge and inability to predict outcomes is one reason for governments to be tentative and parsimonious in their actions. This forms the basis of the argument for “small government”, or “minimum government”. The Modi government has wagered against this wisdom.

Only time will tell. Take expert predictions with a pinch of salt.

Dr Reddy’s life-saving medicines

Independent institutions under independent individuals

Joe Nocera’s piece in the New York Times crediting Y V Reddy, former governor of the Reserve Bank of India, for pursuing policies that (relatively) insulated the Indian banking system from the global financial crisis, has some of India’s top bankers sounding like people looking back at their adolescence and thanking their strict parents or school principals for, well, being strict parents or school principals.

Now that those risks have been made painfully clear, every banker in India realizes that Mr Reddy did the right thing by limiting securitizations. “At times like this, you tend to appreciate what he did more than we did at the time,” said (Yes Bank founder Rana) Kapoor. “He saved us,” added (HDFC chief Deepak) Parekh. [NYT]

Now, a few experts, like V Anantha Nageswaran, have been arguing that Dr Reddy’s exemplary stewardship of the RBI was among the few bright spots in India’s economic management in the last five years. And as events proved, they were right.

Beyond individuals though, the underlying point is that independent institutions can deliver competent governance in their mandated areas even under bad governments. Of course, even independent institutions can be undermined over time, by packing them with less than independent-minded individuals. And that, unfortunately, might well be on the cards. The tenacious Dr Reddy is no more at the crease. The Election Commission could fall into the hands of Naveen Chawla, who the Shah Commission declared “unfit to hold any public office which demands an attitude of fair play and consideration for others.”

By Invitation: Buy lots of mattresses

Wall Street woes

By V Anantha Nageswaran

In the last few months, financial markets had got used to the idea of the authorities conjuring up some solutions to problems in the US financial industry over the weekend and announcing it on Monday morning (Asian time) in time for the Asian stocks to open higher. This routine worked initially but when problems did not go away, the impact became rather muted.

Unfortunately for Lehman Brothers such a weekend solution did not arrive. Late on Sunday evening in the US it announced that it was going to declare bankruptcy. Wanting to avoid that fate, Merrill Lynch sold itself to Bank of America. Some called it tectonic shifts on Wall Street. Alan Greenspan, former chairman of the Federal Reserve said that America was facing once-in-a-century financial crisis. He should know better because he played no small role in creating it. Continue reading “By Invitation: Buy lots of mattresses”

A debtor’s capacity to project military power

…hinges on the support of its creditors

Lending money to governments to fight wars has a very long history, giving creditors a degree of influence over debtor monarchs or governments. But at least four factors make the situation in the early twenty-first century different. First, the global economy—and not least global financial markets—are connected in an intricate sense. Second, the creditors are not only sovereign but in several instances also from countries where the state-owned companies are entrenched economic players in their own right. Third, the individual and combined size of the sovereign wealth holdings is unprecedented. And finally, the geopolitical relationships between the principal debtors and creditors is competitive and adversarial, if not antagonistic.

In this light, the Council on Foreign Relations has published a special report by Brad Setser on the sovereign wealth and sovereign power. It argues “that the United States’ current reliance on other governments for financing represents an underappreciated strategic vulnerability.”

The willingness of foreign central banks—which remain a far more important source of financing for the United States than sovereign wealth funds (SWFs)—to build up dollar reserves has long provided a stable, but limited, source of external financing. But the United States increasingly relies on financing from central banks that already hold far more reserves than are needed to assure their own financial stability. It is true that foreign central banks have an interest in keeping the dollar strong. But the United States might have more to lose from a disruption of this relationship: financial flows create mutual interdependence, but the interdependence is asymmetric. The longer the United States relies on central banks and sovereign funds to support large external deficits, the greater the risk that the United States’ need for external credit will constrain its policy options. [CFR]

While much of the recent analysis on sovereign wealth has been from an economic standpoint, Dr Setser’s report provides directions for a realist appreciation of the issue. To the extent that they give rise to a balance of terror, it is possible to see excess foreign reserves holdings of central banks and large sovereign wealth funds as strategic weapons. How these ‘weapons’ work, how they might be employed and how they might be deterred or defeated are all questions that should concern geopolitical strategists.