Macroeconomic effects of demonetisation are unknown - Tim Worstal

By Vijay Kumar

THE same Adam Smith Institute Fellow, Tim has commented on Dr. Manmohan Singh's speech in Parliament yesterday:

Manmohan Singh, the former PM, has said that India's demonetisation program will cut 2% from GDP. This is of course entirely possible-but it's very far from certain. Yes, of course, there will be disruption from the change in the Rs 500 and Rs 1,000 notes. We can all see that with our own eyes just by looking at the queues at the banks. We can also have the most lovely arguments about whether it is worth it or not, in the sense that very large numbers of Indians think the economic system is weighted against them and therefore they welcome the move. And that would have beneficial effects in the future as trust in the fairness of the system is a vital part of it being a successful economic system.

However, the macroeconomics of this are difficult. More than difficult in fact-we have uncertainty here. Economists distinguish between possibility and uncertainty. Possibility is, well, we think this will happen with about those odds. Uncertainty is, sorry, we don't know and cannot know. And the macroeconomic effects of demonetisation are unknown.

Dr. Singh is a noted economist himself and if he were pressed, as an economist, he would agree that there is this uncertainty.

We know very well that there are processes going on here which will indeed shrink the economy. That chaos at the banks for example. But there are, as there always are, other processes going on too. And some of those will tend to grow the economy-that greater belief in fairness in the future perhaps. We don't know what the balance between the two sets of processes will be.

For example, the flood of money into the banks will lower interest rates and inflation, both of which should spur real GDP growth. We even have an effect here which no one, absolutely no one at all, even knows the sign of, positive or negative. That's the effect upon the money supply.

We just don't know what the effect on the broad money supply of demonetisation is. It could be to shrink it, which will, other things being equal, shrink the economy. It could increase it (if black money changes hands much less often than white) and thus boost economic growth.

We really, really, just don't know.