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Narendra Modi

Indian Prime Minister's Shake Down of Private Wealth

Modi restores a command economy, ends liberalization.

Shikha Dalmia | 12.3.2016 10:00 AM

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Indian Prime Minister Narendra Modi stunned his country earlier this month when, out of the blue, he declared 85 percent of the nation's currency notes null and

Indian Change
ironypoisoning via Foter.com / CC BY-SA

void.

India's two highest rupee notes — Rs. 500 ($7.50) and Rs. 1,000 ($15) — will no longer be legal tender, and will be replaced with redesigned Rs. 500 notes and new Rs. 2,000 bills. Indians can swap a relatively small number of old bills for new ones by the end of the year, but only at designated banks and with proof of ID. Anyone trying to swap large sums of cash that they can't legally account for will be subject to investigation and legal action. And all the unswapped currency will stay with the government, a massive transfer of wealth from private citizens to the state/

Modi's fans see this as an audacious move to smoke out untaxed "black money" from India's informal economy, which constitutes anywhere from 25 to 40 percent of the nation's GDP. But in reality, this demonetization scheme is the equivalent of killing the patient to cure a headache. And it marks an end to India's three-decade flirtation with market liberalization.

Modi was elected in a landslide on the slogan of "Minimum Government, Maximum Governance." He promised to end babu raj — the rule of corrupt, petty bureaucrats who torment ordinary citizens for bribes — and radically transform India's economy. But rather than tackling government corruption, he has declared war on private citizens holding black money in the name of making all Indians pay their fair share.

Tax scofflaw behavior is indeed a problem in India. But it is almost always a result of tax rates that are way higher than what people think their government is worth. The enlightened response would be to lower these rates and improve governance. Instead, Modi is taking his country down what Nobel-winning political economist F.A. Hayek called the road to serfdom, where every failed round of coercive government intervention simply becomes an excuse for even more draconian rounds — exactly what was happening in pre-liberalized India.

Last year, Modi went after black money stashed in Swiss banks, demanding that Indians with such accounts pay a 30 percent penalty and bring their money home or face a lengthy jail sentence. This scheme was a flop.

Next Modi offered Indians hoarding illegal assets amnesty from prosecution in exchange for paying a 45 percent penalty. But this flushed out only a small fraction of the expected haul, for the simple reason that the penalty was higher than the taxes people were trying to avoid.

So now Modi has ripped a dusty page from the playbook of communist dictatorships (Soviet Union, North Korea, Cuba), military juntas (Myanmar, Pakistan), various other kleptocratic banana republics, and India circa 1978 — all of whom tried demonetization and failed.

The theory with Modi's new scheme is that rich hoarders of illicit cash would simply forfeit their money rather than risk jail. Meanwhile, middle-class folks who work for legitimate businesses and poor laborers who have small cash savings would be free to legally swap old bills for new.

The reality is different. Yes, the rich have indeed gotten poorer. But the poor have been decimated. Call it trickle-down poverty.

About 600 million Indians don't have bank accounts, many because they are poor and uneducated. Roughly 300 million don't have official identification. It's not easy to swap their soon-to-be worthless cash, which is a catastrophe given that they live hand to mouth. It is heartbreaking to see these people lined up in long queues outside post offices and banks, missing days and days of work, pleading for funds from the very bureaucrats from whose clutches Modi had promised to release them.

Modi hatched his scheme in complete secrecy, without consulting his own economic advisers or the Parliament, lest rich hoarders catch wind and ditch their cash holdings for gold and other assets. Hence, he could not order enough new money printed in advance. This is a massive problem given that about 90 percent of India's economic transactions are in cash. People need to be able to get money from their banks to meet basic needs. But the government has imposed strict limits on how much of their own money people can withdraw from their own accounts.

Patients needing critical care are being turned away because they don't have new bills, and hospitals won't accept the old denominations. Old people are being forced to choose between food and medicine. Some farmers, living on the brink of financial catastrophe given their meager savings, have committed suicide as produce sales plummet. Industries dominated by small businesses that rely on private, off-the-grid financing from local money lenders and have no access to India's meager official credit institutions are getting wiped out.

Modi insists the trauma is temporary and worth it because more Indians will be forced into the formal economy that can be tracked and taxed to fund vital infrastructure and boost growth. But that assumes that India's bloated, corrupt, and inefficient government can spend other people's money better than they can. In truth, the government will waste the new funds while rich people, whose wealth has been confiscated, will cut back consumption and lay off their employees.

But the biggest tragedy of Modi's demonetization scheme is that because it does nothing to eliminate the underlying causes of black money — India's tax burden that includes hidden levies such as bribes to bureaucrats — won't disappear. People will simply park less of it in cash and more in harder-to-trace, non-cash assets such as gold and real estate, which already account for almost 60 percent of household savings. (Poor households have taken to buying jars of Tide to barter for goods and services, giving new meaning to the term money laundering.)

And you can be sure that Modi, who has already warned of further action before the end of the year, will go after gold and other assets next. He's already raised excise duties on gold and requires jewelers to check the tax identification card of anyone purchasing gold worth over $3,000, echoing India's notorious 1968 Gold Control Act that criminalized gold holdings by private citizens.

As for real estate, it's possible that Modi might try a demonetization equivalent for illicit property called the E-Property Pass Book scheme. Essentially, all property ownership would be declared invalid for one year, with property sales banned. During that time, owners would be required to re-register their property in an electronic passbook linked to the equivalent of India's Social Security numbers, by personally appearing before authorities and showing proof of ownership. Properties that are not re-registered would default to the government, just like unswapped black money holdings.

This is not boldness, but sheer conceit based on the misguided notion that people have to be accountable to the government, rather than vice versa. Over time, it will undermine the already low confidence of Indians in their institutions. If Modi could unilaterally and so suddenly re-engineer the currency used by 1.1 billion people, what will he do next? This is a recipe for capital flight and economic retrenchment.

The fear and uncertainty that Modi's move will breed will turn India's economic clock back to the dark times of pre-liberalized India — not usher in the good times (aache din) that Modi had promised.

This column originally appeared in The Week.

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NEXT: My Kid Packs Heat

Shikha Dalmia was a senior analyst at Reason Foundation.

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