The former CEA says he does not think anyone disputes that demonetisation slowed growth.

It’s not convincing to argue that the poor were willing to ignore their own hardship during demonetisation, since the rich and the corrupt were undergoing greater hardship, former Chief Economic Adviser Arvind Subramanian writes in his upcoming book.

Calling the note ban exercise a “massive, draconian, monetary shock,” Mr. Subramanian, in his book titled ‘Of Counsel: The Challenges of the Modi-Jaitley Economy’, says that increasing the hardship on the poor counter-intuitively has been the precise reason why the move yielded political benefits in the U.P. elections soon after.

The former CEA raises two ‘puzzles’ about demonetisation: why was it so popular politically if it imposed such economic costs, and why the removal of 86% of cash did not have a greater impact on economic growth.

“I offer the controversial hypothesis that imposing large costs on a wide cross-section of people [and the fact that the ₹500 and not just the ₹1,000 note was demonetised increased the scope and scale of demonetisation’s impact], unexpected and unintentional though it may have been, could actually have been indispensable to achieve political success,” he says in the book.

“One answer to the demonetisation puzzle has been that the poor were willing to overlook their own hardship, knowing that the rich and their ill-begotten wealth were experiencing even greater hardship. ‘I lost a goat but they lost their cows’,” he adds.

“In this view, the costs to the poor were unavoidable collateral damage that had to be incurred for attaining a larger goal.”

Collateral damage

This is not entirely convincing, Mr. Subramanian writes, since the collateral damage was, in fact, avoidable. Anti-elite populism could have taken the form of other punitive actions such as taxation, appropriation, and raids that were targeted at just the corrupt rich.

“Why entangle the innocent masses and impoverish them in the bargain? As I wrote in the Economic Survey of 2016–17, if subsidies are a highly inefficient way of transferring resources to the poor, demonetisation seemed a highly inefficient way of taking resources away from the rich.”

Some answers to this puzzle, he argues, could lie in the sheer scale and scope of the note ban. One answer could be that such a broad-based move was intended to serve as a signalling device to the corrupt rich that there was a ‘regime change against black money’. “Indeed, to demonstrate that the measure was bold and hence more likely to be effective, the felt costs may have had to be high,” he said.

The other factor could be another signalling device, wherein it could be argued that how better to convince the masses that the corrupt rich were being hurt than by hitting hard at the masses themselves.

Third, he argues, the near-universality of the move created a sense of solidarity that would have been undermined if selected groups were kept out of it.

“Honesty requires admitting that the political response to demonetisation was puzzling, and confounded most economists and political scientists,” Mr. Subramanian said. “So we must be open to the hypothesis that politically speaking, in the case of demonetisation, vice may have been virtue.”

As to the second puzzle of why economic growth was not impacted more by demonetisation, he said one explanation could be that the measures of GDP failed to take into account the informal sector, which felt the brunt of the note ban.

“One possibility is that people found ways around the note ban, for example by continuing to use the ₹500 note even after its use had been formally banned, so the currency shock wasn’t actually as big as conventionally measured,” he said. “Another possibility is that production was sustained by extending informal credit: people simply agreed to pay their bills as soon as currency became available.”