Mystery of capital and demonetisation of currency

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Picture credit: Business Standard, Nov 10, 2016

If you follow Stuart Rutherford or Jonathan Morduch’s work, it is quite apparent that the poor lead complex lives and constantly deal with financial decisions. Most people associate poverty with the absence of savings, which is a flawed assumption. The poor do save, but they do so in assets that are illiquid, or cannot be transformed easily into capital. For instance, a house is an asset, but not when it does not have property documents that are recognised in formal markets. This restricts the ability of the house to be traded outside of known circles, and limits their ability to transact in formal financial systems.

This illiquidity is not unknown to the poor and to overcome it,they do one of two things. “Farm out their liquidity” to neighbours i.e. give their money to a neighbour in need so they would respond appropriately in their own time of need. And they bury cash in a pot in their homes, or store it in a hole in the wall or under a mattress. For a long time, this behaviour appeared to be caused by a lack of access to formal institutions. Research now shows that people tend not to use formal financial services for savings, although they may borrow from these institutions <http://www.economist.com/blogs/feastandfamine/2012/04/banking-developing-world&gt;. Underlying this low usage of accounts is the lack of trust in formal financial institutions. They would much rather trust the local savings groups, or dig up that pot in their house when they needed money for emergency.

As much as this is true for poor households, this holds water for the large set of enterprises that are classified as “informal” or “unorganised”. While statistics for the sector are far from accurate, surveys suggest that about 86-92.4% of the work force is engaged in the informal sector. Most of these institutions lack access to formal credit and operate in largely a cash based economy. Schneider and Buehn, in their article titled “Corruption and shadow economy: like oil and vinegar, like water and fire?” state that in country contexts where corruption is rife, institutions may choose to remain informal. This informality brings with it the ability to escape bureaucracy and avoid paying a fine to a corrupt official, but it also means undercapitalisation and lower benefits to the economy in the long run.

How does all of this link with the recent demonetisation conducted by the Indian government? There are two ways to ensure that the shadow economy does not exist. One, is to nudge informal enterprises to formalise, to ensure that property titles are clear, etc. The second is to reduce corruption. Tackling one of these without addressing the other does not solve the problem since they both are part of a vicious cycle that feed off each other. In what causes inconvenience to many, but breaks this vicious cycle in the long run, the Indian government’s move to demonetise currency tackles both challenges with one stroke. The benefits can be explained by examining some of the mysteries, which make it harder for poorer and informal economies to compete with more formal ones that Hernando Soto outlines in his book “The Mystery of Capitalism”.

  1. The mystery of missing information: We don’t know the extent of the cash economy. One can have estimates, but it is hard to know accurately. Until people declare this so we are able to capture the number accurately. Until September 30, the government had a scheme for voluntary disclosure of their income. Assuming that there would still be people that did not declare their incomes, demonetising currency leads to a state where people could either forego the value of their currency or exchange existing notes for new ones that are recognised. The latter solves the problem of missing information.
  2. The mystery of capital: In order to unlock the value of assets, one needs to “go beyond physics to touch the hen that lays the golden eggs”. Revealing one’s earnings in the process of exchanging notes that are defunct, one ends up revealing the sources of income and where the capital is generated
  3. The mystery of political awareness: We have known that there is a lot of value in the informal sector, but have not known how to benefit at a macro level from this wealth. If we assume that there is benefit in dealing with a closed circle to meet one’s financial needs, Metcalfe’s law dictates that a larger network would yield higher benefits to the actors involved. (For e.g. one telephone is useless, two is better, but when everyone in the world has a telephone, you change society)

None of these, however, ensure that what caused the problem in the first place does not re-occur.

What does the government need to do to ensure demonetization is successful?

  1. Ensure that the poor are not inconvenienced in the transition to new currency
  2. Solve the problem of corruption in the long run: there is nothing currently that prevents small enterprises and households from being targeted by corrupt officials in the aftermath of the demonetisation to ensure they continue to fill their pockets
  3. Ensure banks are accessible and use the interaction to build trust with customers
  4. Make it easier and cheaper to transact without cash

We must remember the words of Ronald Coase in his speech titled, The task of the society:

Economics, over the years, has become more and more abstract and divorced from events in the real world. Economists, by and large, do not study the workings of the actual economic system. They theorize about it. As Ely Devons, an English economist, once said at a meeting, “If economists wished to study the horse, they wouldn’t go and look at horses. They’d sit in their studies and say to themselves, ‘What would I do if I were a horse?’”

Let’s actually go and study horses before we scream success (or failure) from rooftops.

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