Note ban effect over?

As the fiscal year 2017-18 has ended, we will soon be talking about full-year gross domestic product (GDP) growth and how India’s economy has put demonetisation and goods and services tax (GST) troubles behind it. The Economic Survey 2016-17 appeared to take that line and many commentators have done the same. With currency in circulation now back at predemonetisation levels and growth in the third quarter of 2017-18 at 7.2 per cent, the narrative of “all is well” is taking shape. The message seems to be that economic growth slowed after demonetisation and that the economy is now growing again and India is back on its original growth path — a V-shaped recovery has taken hold. This narrative is misguided and could lead to policy complacency and mistakes. A global study by two International Monetary Fund (IMF) economists, while not directly linked to demonetisation, could help focus attention on understanding the true, long-term impact of demonetisation. Given demonetisation’s impact on the cash-based informal economy and our limited data capacity, I have for a while felt that reports of a V-shaped recovery are premature. I have quietly fretted that India’s economy may settle below the pre-demonetisation trend growth. After reviewing the IMF study, I am convinced that we urgently need to figure out a reliable method for a fuller and deeper understanding of the impact of demonetisation.

Let’s get to what the IMF economists found in 2008 and what their latest update may mean for India in 2018. In 2008, before the global financial crisis hit, two IMF economists, Valerie Cerra and Sweta Chaman Saxena, published a paper “Growth Dynamics: The Myth of Economic Recovery” in the American Economic Review. In a recent blog that details a update of the original paper, Ms Cerra and Ms Saxena argue against the traditional business cycle view of recessions as “short-term periods of negative economic growth”. Basically, an economy grows along a certain trend line, moving up or down around that line. However, when an economic shock strikes, the economic output falls. But, after some time, the economy recovers to its original path. The Indian government and many policy experts are taking a similar view as far as demonetisation is concerned.

However, this new study of 190 economies does not agree with the traditional business cycle view. The study shows that “all types of recessions —including those arising from external shocks and small domestic macroeconomic policy mistakes — lead to permanent losses in output and welfare”. This is as unequivocal as it gets when you ask IMF economists for their views on global economic matters. Even though India did not technically suffer a recession, the economy did suffer a sharp postdemonetisation growth slowdown. Even though the IMF study does not specifically talk about demonetisation, policymakers in India must pay attention to its findings because I believe these have great relevance for India.

Beyond the finding on permanent loss of output (see second chart), the study finds that economic scars from recessions and crises can have “dramatic long-term consequences”. There is a longheld belief that poorer countries will eventually catch up to the developed world because of higher growth rates, more access to technology and greater investment opportunities. However, historical data indicates that on average, poor countries’ incomes have fallen behind and convergence is not happening. The IMF economists found that poor countries suffer more frequent and deeper recessions and crises. Each time, they lose some part of the economic output permanently and, as a result, fall further behind.

The study recommends that we should be more conservative in forecasting growth after recessions and that policymakers avoid crises and severe recessions. While India did not suffer a recession, its sharp slowdown was a result of a crisis that resulted from demonetisation, which is widely considered a macroeconomic policy blunder. I don’t believe Prime Minister Narendra Modi had any idea of what demonetisation could do to the Indian economy. Along with many others, I have argued that the PM neither thought through the implications of demonetisation nor cared to consult experts who could have persuaded him to drop the idea. We must now focus on minimising the damage from demonetisation and the only way to do that is to not give in to a narrative that lulls us into complacency. Demonetisations adverse impact is likely not over. It may have scarred the Indian economy permanently. It was self-inflicted and that is the greatest tragedies of all.