Introduction
It has been
almost a year since Prime Minister Modi surprised the country with the
announcement of demonetisation. Numerous commentators had criticized the move
for a variety of reasons, the most prominent among these being:
(1) Demonetisation was the wrong
instrument for the intended objective of eliminating black money from the
Indian economy.
(2) The economy would suffer a severe
adverse shock as a result of the draining of 86% of the currency from the
system.
This blog had
written about these criticisms and added some of its own.[1] At that time, much of the
criticism was on conceptual grounds, given the importance of cash in the Indian
economy. The government itself realized that the original objective of
eradicating black was unlikely to succeed and kept changing the narrative.
After mentioning “black money” eighteen times in his fateful November 8 2016
speech, the Prime Minister and his colleagues gradually changed the narrative
to include the objectives of cashless economy, curbing of terrorism, long term
growth and so on. In a revealing content analysis of the Prime Minister’s
speeches, IndiaSpend.com reported that, by the end of November 2016, references to
black money had fallen substantially, references to fake currency had all but
disappeared and cashless economy, which was not mentioned at all in his
November 8 speech, had risen high enough to become the primary objective of demonetisation.[2]
As time has
passed since the withdrawal of currency from the Indian economy, evaluation of
the move is no more based on only a theoretical understanding of the Indian
economy; this is now being supplemented by hard data. I had written about this
in June 2017 as I tried to explain the agitation of farmers.[3] Much of the recent
analyses have validated the fears that had been expressed in the immediate
aftermath of demonetisation. It is important to bear in mind that reports from even
respectable Indian institutions have started to point towards the adverse
consequences of demonetisation. A recent RBI report pointed out that almost all
the currency notes that had been extinguished, had made their way back to the
banks. Of the currency worth Rs. 15.45 trillion withdrawn from the economy, “the
estimated value of SBNs [specified bank notes i.e. currency notes] received as
on June 30, 2017 is Rs. 15.28 trillion”.[4] This has belied the
expectation that almost 30% of the banned notes would not be returned[5] and would, in effect,
represent black money that had been “burned” by holders of such monies.
Among the
commentators who have strenuously defended demonetisation Bhagwati, Dehejia and
Krishna are the most high profile with rather exalted academic standing.
Bhagwati et al have been at pains to point out that demonetisation did have
some beneficial effects on the Indian economy although their list of benefits seems
to depend on a number of assumptions, most notably, how much may be collected
in the form of taxes from the monies deposited into bank account.[6] As an aside, I must
mention that the title of their paper (“It’s premature to argue if
demonetisation was a success or failure”) reminds me of the interesting but,
possibly, apocryphal story of Zhou Enlai, the Chinese Premier from 1949-1976.[7] When asked about the
impact of the French Revolution, Zhou apparently said “It’s too early to tell”.[8]
The most specious
claim made in aforementioned article of Bhagwati et al is in its last sentence.
Referring to the apparent boost to digital banking and digital transactions due
to demonetisation, they write: “We would note that while this was not the
original intended goal of demonetisation, it may yet prove the most important
long-lasting benefit”. If something was not intended, then its occurrence is
serendipitous and serendipity cannot be used to bolster one’s support for a policy.
Also, if unintended benefits are to be claimed as positives for demonetisation,
then unintended costs should also be included on the negative side: who had,
for instance, anticipated that 40 persons would die while standing in the long queues
that had formed for the purpose of depositing defunct notes into the banks? This
was a tragic occurrence in the aftermath of demonetisation which needs to be
taken into account unless, of course, such deaths are seen as minor collateral
damage. And there is no estimate of how much productive time was lost by
employed individuals while standing in these queues.[9] The sheer one-sided evaluation
of demonetisation by Bhagwati et al is neatly exposed by Shruti Rajgopalan and
Lawrence White[10]
in their comments on an earlier article by the trio.[11] Rajgopalan and Lawrence
point out that Bhagwati et al, instead of carrying out a cost-benefit analysis of demonetisation,
carry out only a simplistic benefit analysis of it.
Employment and Demonetisation
It has been pointed
out that demonetisation has resulted in the extinguishing of jobs, especially
in the informal sector.[12] The CMIE has estimated
that 1.5 million jobs were lost during the period January-April 2017.[13] Alongside this reported
loss of jobs there has been a decline in the labour force participation rate (LPR).[14] However, the unemployment
rate (UR)[15]
and the LPR show divergent trends in the post-demonetisation time period.
Mahesh Vyas of CMIE does try to explain this but his explanation does not seem
convincing to me.[16]
Figure 1 shows the trends in Total (All India) UR and Total LPR.[17]
The reported
job losses are not reflected in the unemployment rate but the declining LPR
shows that persons are dropping out of the labour force. This is a phenomenon
that was witnessed in the USA also during the recent recession: the dismal jobs
situation led many to drop out of the labour force i.e. they stopped searching
for jobs. As per the FRED database, LPR in the USA fell from 66% in September
2008 to a low of 62.4% in September 2015 before beginning to recover.[18] A mere visual examination
of the data for India does not seem to suggest that LPR began to fall only
after demonetisation in November 2016 since it shows a fall in October 2016 as
well. Could the fall have accelerated after demonetisation? I examine this in a later section.
Figures 2 and
3 show LPR and UR for Urban and Rural sectors. The trends in LPR and UR for urban and rural areas are no different from those for Total LPR and Total UR.
LPR and Demonetisation
It has often
been stated that India has a young population. Many countries in Asia seem to
be moving in the other direction i.e. their population is aging but, in India, approximately
half the population is under the age of 26, “and by 2020, it is forecast to be
the youngest country in the world, with a median age of 29”.[19] IndiaSpend.com reports that 64.4% of India’s
population is in the 15-59 years age group. This number is 67.7% for urban
India and 62.9% for rural India.[20] With this distribution of
population it seems inconceivable that LPR can show a declining trend unless
something dramatically unusual is happening in the Indian economy. World Bank
data tells us that from 2012 to 2016, the Indian labour force has increased by
34.5 million, that is, an average yearly increase of 8.6 million[21] and yet, unexpectedly,
the LPR ratio shows a sudden fall.
For the USA,
which has also faced the problem of declining LPR, FRED (Federal Reserve Bank
of St. Louis)[22]
has put forward two reasons for this phenomenon (See also James Bullard[23] and Maria A. Arias and Paulina
Restrepo-Echavarria[24])
(1) The
“demographics” view, which states that the changes in the rate are a reflection
of changes in the demographics of the labor force
(2) The
“bad omen” view, which says that the declines in the LPR rate are due to people
leaving the labor force because of the poor state of the economy
Bullard,
after evaluating all the evidence, comes to the conclusion that the
demographics view best explains the declining LPR in the USA: “The nation’s
workforce had a younger profile as the Baby Boom generation came of age, and it
will have an older profile as the Baby Boom generation continues to retire.
Since different age groups have different propensities to participate, this
suggests a promising avenue to explain the labor force participation data”.
Clearly,
India’s demographic history is completely different from that of the USA. India
does not have the equivalent of the baby-boomers generation which might be
retiring now. In fact, as stated above, India’s demographic profile suggests
that more and more individuals should be entering the job market. That apart,
the LPR in the USA has declined over a few years which is to be expected since
demographic variables change slowly. In India, the LPR has declined within a
span of a couple of months thereby rejecting the demographic explanation of a
declining LPR. Consequently, the only explanation that holds some credibility
is the “bad omen” view. The state of the economy, already fragile before the
shock of demonetisation, nosedived after November 2016 causing the unexpected decline in LPR.
Declining LPR: Empirical Verification
I carry out some
exercises to show the link between LPR and demonetisation. A simplistic
exercise would be to run a regression of Total LPR on a binary variable
representing demonetisation. The results of such as an exercise would reveal a
picture like Figure 4.
The vertical
line at November 2016 divides the plot area into two segments: before and after
demonetisation. Even though I don’t show it here, but similar graphs for Urban
LPR and Rural LPR can be created.
I extend the
above analysis by linking LPR to the amount of currency with the public (CURR)
which in turn was affected by demonetisation. In the language of econometrics,
I endogenise CURR and use demonetisation (which I believe to be an exogenous, unanticipated
event) as an instrument. My reasoning for linking LPR to CURR is that almost the entire informal sector depends on cash for its transactions. The withdrawal of 86% of the currency from the economy dealt a blow to production of this sector rendering millions jobless. The "bad omen" effect of loss of jobs led to an adverse effect on LPR. Nakamura and Steinsson have cautioned that exogenous monetary
policy shocks should be identified carefully since many apparent shocks seem to
have been triggered for identifiable economic events and are, hence, not truly
exogenous.[25]
There is reason to believe that demonetisation was not triggered by any prior identifiable
economic events.[26]
I now report
the results of my empirical exercises. For those interested, the Appendix gives
details of the econometrics. Using the results of the equation reported in the
Appendix, I chart out the estimated path of LPR and compare it with a
counter-factual path, namely, a path that LPR would have taken if demonetisation
had not taken place (Figure 5). I show this only for Total LPR since the charts for Urban
LPR and Rural LPR are almost identical.
The
blue line shows what did happen in the Indian economy with Total LPR collapsing
after November 2016. In contrast, the maroon counterfactual line shows the path
LPR would have taken had demonetisation not taken place. The contrast between
the two lines clearly shows that demonetisation was responsible for the sudden
fall in Total LPR.
Summing Up
The
decline in the LPR should be matter of deep concern for the Indian economy.
Persons may drop out of the labour force due to discouragement, the inability
to find a job.[27]
They may not permanently stay out of the labour force and would possibly return
when job prospects improve. In the meantime, they may take up part-time jobs to
make ends meet or maybe compelled to start a small business as a desperate move
for their very survival. A remedy for this dismal state of affairs will not be
forthcoming until the government recognizes the reasons behind this phenomenon.
Unfortunately, there seems to be little hope of that with the government and
its ministers continuing to aggressively defend demonetisation and denying that
the economy is in deep trouble. An indication of how poor the government’s
understanding of the economic situation is can be gleaned from the callous comment
of Railway Minister Piyush Goyal who said that loss of jobs is a good sign
since the youth of today would like to be entrepreneurs.[28] Goyal, obviously, does
not recognize the difference between the “forced entrepreneurship” of the
jobless and those who voluntarily choose to be entrepreneurs.
APPENDIX
I use 2SLS estimation to model
Total LPR as a function of Currency with the Public (CURR). However, there are
strong reasons to believe that CURR is not truly exogenous and I use a dummy
variable (DEMON) to represent pre- and post-Demonetisation periods as an
instrument for CURR. The estimated main equation and the first stage regression
are given below. The numbers in brackets are p-values.
The endogeneity test confirms
that CURR is, indeed, endogenous. The RMSPE tells us that the prediction
performance of this equation is very good.
The first-stage regression shows
the importance of demonetisation for CURR.
Even though I do not report it
here, I get very similar results for Urban LPR and Rural LPR using the same
methodology as for Total LPR.
[1] http://ajitkarnik.blogspot.ae/2016/12/demonetisation-thunderbolt-in-search-of.html
[2] http://www.indiaspend.com/cover-story/how-modi-changed-and-changed-the-demonetisation-narrative-54391
[3] http://ajitkarnik.blogspot.ae/2017/06/what-is-agitating-farmers.html
[4]
RBI Annual Report, 2016-17, p. 195; https://rbidocs.rbi.org.in/rdocs/AnnualReport/PDFs/RBIAR201617_FE1DA2F97D61249B1B21C4EA66250841F.PDF
[5] https://www.bloomberg.com/news/articles/2017-08-30/india-central-bank-spends-record-amount-to-replace-void-notes
[6] https://theprint.in/2017/09/05/premature-argue-demonetisation-success-failure/
[7] http://www.historytoday.com/blog/news-blog/dean-nicholas/zhou-enlais-famous-saying-debunked
[8]
This perfectly good story has been debunked by spoilsports who claim that Zhou
was actually referring to the 1968 protests in France. See: https://mediamythalert.wordpress.com/2011/06/14/too-early-to-say-zhou-was-speaking-about-1968-not-1789/
[9] My
back-of-the-envelope calculation suggests the following: India’s population is
1.2 billion. Assume that average household size is 5. Hence, there are 240
million households in the country. Assume that only one member for only half of
these households had to stand in a queue to exchange defunct bank notes (the
remaining household, being better off could get someone to stand in the queues
for them). Hence, 120 million individuals stood in queues. Further, assume that
each person stood in the queue for only 2 hours (possibly a gross
under-estimate): 240 million hours were spent in queues. Assuming a working day
of 10 hours, I get an estimate of 24 million person-days were lost in queues.
[10] http://www.livemint.com/Opinion/0RUMX1LvfO8VtMdC4Acd5L/Demonetisation-and-welfare.html
[11] http://www.livemint.com/Opinion/niFH9uM377oUSHEQcRuUWP/Demonetisation-fallacies-and-demonetisation-math.html
[12] https://economictimes.indiatimes.com/markets/stocks/news/deep-impact-of-demonetisation-analysts-count-cost-in-terms-of-job-business-losses/articleshow/56370617.cms
[13] https://www.cmie.com/kommon/bin/sr.php?kall=warticle&dt=2017-07-11%2011:07:31&msec=463
[14] LPR
is defined as the ratio of the labour force to the population greater than 15
years of age. Please see: https://unemploymentinindia.cmie.com/kommon/bin/sr.php?kall=wtabnav&tab=4000§code=200150000000000000000000000000000000000000000
[15]
Unemployment rate is defined as those who are willing to work and are actively
looking for a job expressed as a per cent of the labour force. The source for
this is CMIE in the previous endnote.
[16] https://www.cmie.com/kommon/bin/sr.php?kall=warticle&dt=2017-07-11%2011:07:31&msec=463
[17]
The source for my data is: (1) https://unemploymentinindia.cmie.com/kommon/bin/sr.php?kall=wtabnav&tab=4020
and (2) CMIE’s Unemployment in India: A
Statistical Profile (various issues) (https://unemploymentinindia.cmie.com/)
[18] https://fred.stlouisfed.org/series/CIVPART
[19] https://blogs.thomsonreuters.com/answerson/indias-demographic-dividend/
[20] http://www.indiaspend.com/viznomics/indias-demographic-dividend-64-4-youth-27-3-children-in-2015-2015
[21] https://data.worldbank.org/indicator/SL.TLF.TOTL.IN
[22] https://www.stlouisfed.org/on-the-economy/2017/january/dissecting-falling-labor-force-participation-rate
[23] https://research.stlouisfed.org/publications/review/2014/03/13/the-rise-and-fall-of-labor-force-participation-in-the-united-states/
[24] https://www.stlouisfed.org/publications/regional-economist/october-2016/demographics-help-explain-the-fall-in-the-labor-force-participation-rate
[25] http://www.columbia.edu/~js3204/papers/macroempirics.pdf I would like to thank Jeremy Edwards for drawing
my attention to this article to me though I am not sure if he will agree with
my claim that demonetisation was genuinely exogenous.
[26]
This can, of course, be contested if one accepts the Prime Minister’s
contention that demonetisation was designed to remove black money from the
economy. Given how inappropriate the instrument was to curb black money, I find
it difficult to accept the Prime Minister’s contention.
[27] https://www.federalreserve.gov/newsevents/speech/yellen20140822a.htm
[28] http://indiatoday.intoday.in/video/piyush-goyal-job-loss-congress-rahul-gandhi/1/1063788.html
