A conservative criticism of the Great Currency Transfusion

On making big bold moves in uncharted territory

Over the past few weeks, many people have asked me (just as they’ve asked each other) what I think of the Modi government’s currency reform (popularly known as ‘demonetisation’).

To this day, my response has been that PM Modi has taken a very risky bet, and it’s too early to tell how things will turn out. It is unclear what the fundamental purpose of the exercise was—there are at least half-dozen of them—and hence it’s hard to say whether it met the policymakers’ objectives. I am not persuaded by the initial defence that it is a good policy, terribly implemented, because a policy is only as good as its implementation. I am not persuaded by the current short-term pain, long-term gain rationalisation, because it’s important to know what exactly the intended long-term gain is, before we can answer how much short-term pain is worth suffering for it.

What we do know is that the most damaging unintended consequences can be minimised by a combination of rapid take-up of electronic transactions by those who can, and a rapid re-injection of currency notes into the economy for the rest. To the extent that electronic transactions are substitutes for cash transactions, the re-injected cash can reach more of the people who lack bank accounts, smartphones and identity documents. If you use less cash, then at the margin, you ease the difficulties of cash-dependent persons. Even so, we do not know how long it’ll take to reflate the tyres of our complex economy. In the meantime, the economy will suffer losses, and these can be quite painful to ordinary citizens.

We should now hope that the long-term benefits will be worth all this pain. But hope, as George Shultz famously said, is not a policy.

Therein lies my principal criticism of Mr Modi’s big currency reform initiative: as an advocate of conservative policymaking, I believe that it is unwise to introduce sudden, big, pervasive, irreversible changes to large, diverse, complex, perhaps semi-chaotic systems like national economies. (If I’ve used too many adjectives in the previous sentence, it is because they are necessary.) I use the word “conservative” in the sense that it means cautiousness, tentativeness, lack of certitude; like how medical practitioners use it to denote their approach to treatment. I do not use it in the big-“C” Conservative ideological sense.

Prudence suggests that the greater the number of people affected, the costs involved, the irreversibility or the complexity of the system, the better it is to be cautious, tentative and have the ability to tune up or tune down the policy dials. Because we cannot predict the consequences to any degree of accuracy before-hand, it’s better to follow a trial-and-error method. The Modi government’s currency reform, unfortunately, leaves its policymakers with few policy dials that they can tune up or down. It is a big bang reform.

This was also my criticism when the UPA government decided to extend the rural employment guarantee scheme nationwide without waiting to see how the pilot projects turned out. What benefited some people in some districts, hurt other people in other districts. A conservative approach would have extended the rural employment guarantee to districts where it was necessary, and not to areas where it worsened labour shortages, hurt agricultural productivity and raised prices. The currency reform project is similar in this respect, but touches almost every citizen and in a much smaller amount of time.

Whatever we might think about the effectiveness of such ‘bold’ policies, we should prefer a conservative approach to policymaking. No, this is not a recipe for status quoism. There are lot of areas where there is plenty of empirical evidence to implement big changes. For instance, we know that sectoral deregulation and liberalisation has yielded positive results since 1992, so we can do more, even a whole lot more, of the same.

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.

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.

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.”