The Indian commentary scene, whatever else may be right or wrong with it, is replete with unselfconscious irony. For two and a half years, a chorus of well-known observers in the domestic and foreign media has cried hoarse that Prime Minister Narendra Modi and the Bharatiya Janata Party- (BJP-) led government have failed to seize the nettle of politically difficult economic reforms. They have been timid gradualists, tinkering incrementalists at best, and not bold, visionary reformers, of the likes of Margaret Thatcher or Ronald Reagan: so went the refrain.
Now, however, that the Narendra Modi government has unleashed its biggest and boldest move yet, fraught with great political risk for the BJP while holding out the possibility of fundamentally transforming the Indian economy for the better, these same voices have pivoted to decry the reform. They claim that it has caused undue hardship, will be detrimental to the growth rate of gross domestic product (GDP) for the next couple of quarters and therefore, more broadly, represents a major economic and political blunder.
The naysayers evidently have forgotten, if they ever knew to begin with, that the essence of politically difficult economic reform involves managing distributional conflict: between gainers and losers today, between losses today and gains tomorrow, or some combination of intra-temporal and inter-temporal distributional impacts. This is the first law of political economy.
On this score, the Modi government’s currency swap (let us henceforth banish the misnomer, demonetization) represents a classic political economy trade-off: costs today as a temporary liquidity crunch squeezes cash-based transactions and dents GDP growth in the short run as a consequence must be weighed against medium- and long-term gains as unaccounted cash is flushed out of the economy and as the formalization and digitization of India’s economy is jump-started.
While it has been widely argued, including by this author, that without allied reforms, for instance, of electoral finance and regulatory and tax reform more broadly, the tax on unaccounted wealth and income is a one-shot affair, I am increasingly of the view that the long-term changes wrought by the shock of the currency swap may be far deeper and more fundamental than this conventional logic suggests.
Thus, the movement of some or many of the unbanked into the formal financial sector and the movement of firms from the informal to the formal economy (or, equivalently, the process of “creative destruction” whereby new formal sector firms replace defunct informal sector firms) has a permanent and positive impact on the economy, even though the gains from taxing black money via the currency swap is putatively one time only.
Economists, borrowing from physics, call these “hysteresis” effects. In simpler terms, once someone is banked, or a firm enters the formal economy and its activity falls within the net of tax authorities, there is no going back to the old way of operating, even when the cash crunch eases, as it will shortly.
The astute observer will also notice an arc in the Modi government’s reforms initiatives, which have all involved a progressive ratcheting up of steps to modernize the Indian economy and governance of the Indian state.
In that sense, then, the currency swap and what it entails is a logical follow-on from the “JAM trinity” (Jan-Dhan Yojana-Aadhaar-Mobile), which aims to link entitlement claims to a unique identification number, a bank account, and a mobile phone, and eliminate leaky and corruption-prone physical distributional channels. Such reforms are all of a piece. Expect more to come.
Misguided critics who failed to see the ghost of Thatcher or Reagan lurking over Modi’s shoulder and saw only Congress-style policies dressed up in new garb remained trapped in a dated left/right binary which falsely pitted Congress-style socialism against a putatively libertarian party of economic reform, something like the short-lived Swatantra Party. What they have failed to see is that Modi’s BJP is the party of modernization and empowerment, a credo which transcends conventional ideological dividing lines.
What, after all, is either left or right in making government function better and better serve its people? What is left or right in ensuring that all Indians, including the poorest, have bank accounts and that every business firm must be registered, pay taxes, and observe the law of the land? What is left or right in making sure that everyone, whether rich or poor, who owns a piece of land holds a legitimate title to it, allowing them to use it as collateral when they go to take out a loan?
Fixing the plumbing and ensuring that the foundation is secure may seem an unglamorous job, but it is a necessary first step before erecting new stories. Fail to do it properly and the whole structure may collapse.
This is true of the economics and of the politics, and crucially when the two are intertwined: in other words, the political economy of governance and development. Modi understands this; many of his critics don’t.
The biggest blunder may well be by the ill-informed critics, who assume that with the currency swap, the Modi government has committed a self-goal. It might turn out, instead, to be the golden goal that catapults Modi and the BJP to a thundering re-election victory in 2019.