How I Knew Demonetisation Was Going To Be A Disaster Right From Day 2


The recent past has seen even the biggest supporters of prime minister Narendra Modi concede that demonetisation was a disaster that the country could have done without. A major reason for this has been the gross domestic product (GDP) data for the year 2016-2017, which was published on May 31, 2017.

As per this data, the growth for the non-government part of the economy crashed to 5.6 per cent in 2016-2017, after having grown by 8.5 per cent in 2015-2016. In fact, even the 5.6 per cent growth might be an overstatement given that the GDP data does not capture informal sector data well enough. And the informal sector has been in a large mess post demonetisation.

The trouble is that anyone who had any basic understanding of economics or had read up on some economic history, would have known this from day one. And if not from day one, at least from day two.

I wrote my first piece on demonetisation within hours of the announcement to demonetise the Rs 500 and Rs 1,000 notes. As a freelance writer, I am expected to react to things as soon as they happen. The first piece I wrote had a neutral tone to it, where I tried to explain as to why the government had done what it had done.

With the benefit of hindsight, I can say that the first piece was written too quickly and at the same time was highly influenced by the government’s press release explaining the decision. But from Day 2 onwards, I went back to basic economics to essentially say that demonetisation would turn out to be bad for the Indian economy as it eventually has.

After the first piece was published I happened to remember a story that was a part of my first book Easy Money–Evolution of Money from Robinson Crusoe to the First World War.
The story was about cigarettes being used as money in the prisoner-of-war camps that cropped up all over Europe during the Second World War. The prisoners used to receive standard food parcels from the Red Cross during the war. The parcels included biscuits, butter, cigarettes, canned beef, chocolate, jam, milk, sugar, etc.[i]

As soon as the rations arrived, prisoners used to start exchanging them. One of the earliest transactions used to be nonsmokers exchanging their cigarettes for chocolates that the smokers had got. Sikhs, who had been fighting for the British Army, used to exchange their allocation of beef for other goods like butter, jam, and margarine. But gradually cigarettes went way beyond the status of a normal commodity and became the standardized medium of exchange. A prisoner of war even recalls exchanges like “cheese for seven cigarettes” happening in the camps. He also recalls an individual who sold coffee, tea, or hot chocolate at the rate of two cigarettes a cup. This individual eventually scaled up his business but failed, making losses of a few hundred cigarettes.[ii]

Sometimes, the weekly Red Cross parcels which had cigarettes in them, did not arrive. At other times, the stress of heavy air raids near the camps made peo­ple smoke away their money, that is, cigarettes.[iii]

In such situations, there was not enough money (i.e., cigarettes) going around in the prison economy and led to a situation where prices fell. Since people did not have cigarettes to buy goods, those who were hoarding food, toiletries, and so on, had to cut prices in the hope that they are able to make a sale.

This story tells us a lot about how demonetisation has played out.

Money basically has three functions. It is a medium of exchange, a unit of account and a store of value. It’s function as a medium of exchange is its most important function. People use money to buy and sell things i.e. to carry out economic transactions, with the buyer paying money to the seller every time he sells a product or a service.

In the above example cigarettes were used as money. And when a war camp ran out of cigarettes, or there was a shortage, the economy inside the camp collapsed or slowed down considerably.

How is this relevant to demonetisation? Any economy needs a certain amount of money to function properly. Demonetisation at one go rendered 86.4 per cent of the currency useless. While currency is not the only form of money in India, it is the major form.
Like with cigarettes at prisoner-of-war camps, suddenly there wasn’t enough currency going around post demonetisation. Hence, the rupee’s function as a medium of exchange came to a standstill.

The Reserve Bank of India (RBI) has replaced this money at a very gradual pace. In fact, even now the currency in circulation is at 84 per cent of the currency in circulation that prevailed before demonetisation. This shortage of currency over the last seven months has led to a slowdown in the buying and selling of things i.e. people haven’t been able to carry out economic transactions.

The slowdown in economic transactions has ultimately led to a slowdown in economic growth. In fact, when there weren’t enough cigarettes going around, prices collapsed in the prison economy. Along, similar lines prices of agriculture produce, have collapsed since demonetisation, as cash in agriculture trade has dried up. This has led to the farmers protesting across the length and breadth of the country.

Anyone who had studied some economic history would have known from the beginning that demonetisation would turn out to be a disaster that it has. Anyone who understood the functions of money, would have argued along similar lines.

But that is not how it has turned out to be. Economists have gone on and on, about how demonetisation will prove beneficial to the nation, especially in the long run. Some have even built models to show the success of demonetisation.

But the fact of the matter is that you can keep building models to justify demonetisation but that doesn’t change the basic fact that with less money going around an economy contracts or grows at a slower pace.

Because with less money people cannot carry out economic transactions of buying and selling things. And without that economy grows slower or contracts.

Yes people can move onto digital payments. But digital payments haven’t grown fast enough to be able to bring down the influence of cash in the Indian economy. This means people still prefer cash or they are simply not confident about spending money in any form at this point of time.

[i]  C. Desan. Coins Reconsidered: The Political Alchemy of Commodity Money (The Berkeley Electronic Press, 2010).

[ii] R.A. Radford, “The Economic Organisation of a P.O.W. Camp,Economica 12 (1945): 189–201.

[iii]  Desan 2010

The column originally appeared in the Huffington Post on June 17, 2017.

Beedis are fine, but smoking cigarettes stick by stick is injurious to health

beedisNews-reports suggest that the government is planning to ban the sale of loose cigarettes. Sagarika Mukherjee an analyst with SBI Caps points out that 70% of the cigarettes sold in India are sold loose.
Further, a November 26
news-eport in the Mumbai Mirror says “The union health ministry on Tuesday recommended a ban on the sale of unpackaged cigarettes to deter smokers from graduating to buying full packs.”
The health minister JP Nadda said in the Rajya Sabha on November 25 that the ministry had accepted the recommendations of a seven member committee on the “prohibition on sale of loose or single stick of cigarette, increasing the minimum legal age for sale of tobacco products, increasing the fine or penalty amounts for violation of certain provisions of the Act as well as making such offences cognizable”.
On the face of it this seems to be a good decision. We all know that cigarette smoking is injurious to health. Nevertheless, before the sale of loose cigarettes is actually banned there are several other points that need to be taken into account.
Governments normally tend to see what is only immediately obvious and ignore the secondary consequences. The economist Henry Hazlitt calls this the broken window fallacy. He explains this through an example in his book
Economics in One Lesson.
A young hoodlum throws a stone at a shop’s window and breaks it. By the time the shopkeeper realises what has happened and comes out of the shop, the boy has already escaped. As often happens in these cases, a crowd gathers around, first trying to figure out what has happened and then offers its own analysis on the scenario. In sometime, the crowd decides rather philosophically that what happened was for the good.
As Hazlitt writes “After a while the crowd feels the need for philosophic reflection…It will make business for some glazier….After all, if windows were never broken, what would happen to the glass business?”
With the shopkeeper now having to repair the window, the glazier would earn more money. He would thus have more money to spend and would spend it in the days to come. And this would benefit other businessmen. “The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be…that the little hoodlum who threw the stone, far from being a public menace, was a public benefactor,” writes Hazlitt.
All this sounds very straightforward. But what it does not take into account is the fact that the shopkeeper would have to spend money in order to get the window repaired. And he may have earmarked to spend the money on something else.
In Hazlitt’s example, the shopkeeper wanted to buy a suit. Now that he has to spend money on getting the window repaired, he would have no money to buy a suit. As Hazlitt writes “The people in the crowd were thinking only of two parties to the transaction, [the shopkeeper] and the glazer. They had forgotten the potential third party involved, the tailor [who would have made the suit]. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye…It is the fallacy of overlooking secondary consequences.”
Many government decisions are plagued with the fallacy of overlooking secondary consequences. The recommendation to ban the sale of loose cigarettes also overlooks several secondary consequences. Also, it stinks of hypocrisy and is the kind of micromanaging which governments should be avoiding.
Typically, most people who buy loose cigarettes are ones who cannot afford to buy a packet at one go. If loose cigarettes are banned will these people stop smoking? Most likely not. They will either save up and buy a packet every few days.
Or they will simply move on to a cheaper substitute, which in this case would be
beedis. Beedis because they do not have a filter are a bigger health hazard than cigarettes with filters are. And chances are the government will end up spending more money in trying to cure tobacco related illnesses, in the years to come.
Further, the question is how will the government implement such a ban? Cigarettes aren’t exactly sold through a few big stores around the country which can be monitored. They are sold by millions of
paan wallahs through the length and the breadth of the country. Mukherjee of SBI Caps puts the number of shops selling cigarettes from anywhere between seven to eight million.
I used to live in Hyderabad in the early 2000s, when the erstwhile Andhra Pradesh government decided to ban
gutka. All that happened was that the paan wallahs stopped displaying gutka packets in the open and started keeping them in their pockets.
Further, they even demanded a premium to the maximum retail price. The police was suitably bribed to look the other way.
Gutka which was freely available in states around Andhra Pradesh continued to be smuggled in.
Another logic offered in support of not allowing the sale of single sticks is that when a packet is sold, it contains graphic images showing the ill-effects of smoking. When loose cigarettes are sold, individuals buying those cigarettes don’t see those graphic images. Hence, sale of loose cigarettes should not be allowed.
Other countries in Asia have banned the sale of loose cigarettes using the logic explained above. So, the cigarette companies there simply moved to producing smaller packets. The committee whose recommendations the health ministry has accepted has already recommended that smaller packets should not be allowed. But this is where you start to discriminate between those who can afford to buy a cigarette pack and those who can’t.
Mukherjee of SBI Caps points out that only 12% of the tobacco consumption in the country happens through cigarettes. And cigarette companies contribute a major portion of the excise duty and other taxes collected from the tobacco industry. So, if the government is serious about tackling tobacco consumption why not look where the real problem is? Attacking the beedi sector will be a difficult thing to do, given that the beedi barons are politically very well connected.
Another thing that needs to be pointed out here is that the government of India owns around one third of ITC, a company which controls 80% of the Indian tobacco market. The Life Insurance Corporation of India owns 14.5% stake, followed by the Specified Undertaking of the Unit Trust of India (SU-UTII) which owns 11.25% and the four general insurance companies together own 6.78% in the tobacco major.
This stake of LIC, SU-UTI and the four general insurance companies, in ITC, as on November 26, 2014, was worth a whopping Rs 94,241 crore. The actual stake of the government will be worth much more once one takes into account the holdings of government owned mutual funds as well.
If the government is serious about discouraging tobacco consumption, the first thing it needs to do is sell its stake in ITC and then take it on from there. This money could be put to good use by helping specialized cancer hospitals in the country to expand their infrastructure or to even set up new ones. Then there is also the case of the government subsidizing fertilizers, a portion of which goes into tobacco farming as well.
beedi industry does not face the same kind of taxes that the cigarette industry does. Why not do away with that anomaly? In a recent column Swaminathan Aiyar talks about a column he wrote in 2009. At that point time Indians consumed around one trillion beedis per year against 106 billion cigarettes. If the taxes on beedis and nonfilter cigarettes were equalized it would have yielded an additional revenue of Rs 15,000 crore per year, back then. If taxes on beedis were equalised to the level of tax on a standard filter cigarette, it would have yielded an additional tax of Rs 80,000 crore per year. If such a tax is implemented now, the numbers will be higher.
What all this clearly tells us is that targeting just loose cigarettes doesn’t make any sense. If tobacco consumption is to be brought down, it needs a more holistic solution than what is being currently offered. The current government like most governments before it has fallen victim to the broken window fallacy.

Disclosure: I do not smoke. And I would like to thank PV Subramanyan for explaining several points that I made in this piece.

The article appeared originally on on Nov 27, 2014