India -- currency changes and the barter economy

A regular reader -- a person of remarkably persistent inquisitiveness -- inquired recently about India's current program of recalling and replacing the two most commonly-used denominations of its currency.  The reader then asked that I publish our conversation.  And with that, here it is.

The conversation began with this question:

Could this give bartering behavior a boost?

Eliminating Cash – The NEW AGE of Economics | Armstrong Economics

Which prompted this answer:

Interesting question.  I think that in the short run the answer is "yes."

However, the full story behind the Indian government actions is much more complicated than what is described in the article, so I think that the long-run answer to your question is probably "no."

India has a problem with taxes -- as the Armstrong article says -- but what the article does NOT say is that the problem is tax evasion (an illegal act) and not tax avoidance (which is legal).

At the risk of over-simplification:  India's economy has grown enormously over the last 20 years, but an unusually large amount of that growth has been due to the country simply printing cash instead of developing a more mature banking system.  Naturally, a bunch of wealthy people have taken advantage of that situation by doing business outside of a banking system. . .what we in the USA might call "under the table" sorts of transactions.  (I don't know what they would call it in India.)

And so, the government(s) in India is/are not collecting taxes that Indian law says it/they ought to collect.

Unfortunately, from what I have been reading, the process of replacing the physical bank notes seems to be somewhat botched, at least from the perspective of most people in India, so that bartering is being used in some cases where cash is no longer available.  That's not helpful for anybody, whether it's the individual or the government.  It'll be interesting to see how this develops over the next few days.

Since rupee replacement was apparently totally unexpected throughout India, this has to qualify as an extraordinary event.  Now that it has had a couple of month to roll out, the results have to make us wonder how well this was planned by the people in charge, and what else might there be yet to come?

The Indian government's announced plan was to complete the conversion by December 30.  That has not happened.  The "old rupee" is still accepted for payments at hospitals, pharmacies and gas stations.  As part of the government's program of "demonetization," use of digital payment services is being encouraged.  There have been some reports of tremendous growth in their numbers of users.  If there is a great deal of bartering, it is not mentioned in the news reporting. 

As of the date of this writing, the program of replacing the "old" with the "new" remains incomplete, with more success in the biggest cities and much less success in the smaller towns and villages of rural India. There is very little current reporting on how this is affecting the lives of the people who had previously relied on the use of cash for daily necessities and activities.  What little has been reported has focused on significant hardship.

That there would be hardship should not be a surprise, since Bloomberg has reported that 98% of the volume of consumer transactions in India are conducted in cash.  For comparison, that figure is 55% in the U.S., and 48% in the U.K.  (Volume, being different from value, implies that the hardships fall with much greater force on those of poor and modest means since they conduct a larger number of their transactions in cash than do the wealthier citizens who are more likely to have, and to use, credit cards and other forms of "cashless" payments.)

Whatever is the end result of this demonetization event, it has to be looked at as self-induced chaos.  I wouldn't rule out an increased use of bartering for consumer transactions that could persist for some time, but there are probably bigger issues that the Indian government will have to manage.  With the persistent shortage of cash, it seems likely that India's GDP (the measure of its total annual economy) will take a meaningful hit.  If so, it will show up as a decline in the annual GDP growth rate which has been reported as likely to be in the vicinity of one-half of one percent.

Since India's GDP growth rate has been around 7% per year we could guess that the government feels that it can sustain a decline to the 6% to 6.5% range without too much difficulty.    But does the sanitized computation of GDP growth accurately and fully reflect the social and human costs of self-induced chaos?

An answer to that question will come only with the passage of more time.