India's withdrawal of bank notes

At what was in effect no notice, on 8th November, India announced that all 500 and 1000 rupee notes would cease to be legal tender. That is 86% of the cash in the Indian economy.

This is quite a shock to the system, after all 90% of India's transactions take place in cash. Yet the bulk of the Indian population apparently support the move, despite having to queue for hours to deposit their now otherwise worthless notes into bank accounts.

The reason the government took this radical step is to reduce tax evasion. India has a massive corruption problem where only 1% of people pay income tax, largely because transactions go unrecorded because they take place in cash.

The move is designed to make people deposit their cash in banks and to make more future transactions through the banking system.

Those who deposit large amounts will be asked to prove they paid tax, or be taxed on it. From then on transactions will largely have to be transparent through the banking system as people can only obtain a limited amount of cash in new notes. Therefore in the future they can be taxed fairly.

This is a bold attempt to deal with the informal or black economy. Developing countries lack the tax base to raise the money governments need to fund infrastructure and other development projects. Of course it is unclear whether the Indian governments bold (reckless?) plan will work.

The BBC explain the motives here

This is an article that is relevant to Development Economics, the last topic in the IB syllabus. However it is well worth looking at now for use later. 

"Monetary policy is not enough."

The Governor of the Reserve Bank of Australia (RBA) has told a New York conference that monetary policy is not enough to allow faster growth. he suspects that the world has entered a period of much lower 'trend growth'.

Stevens has made a number of points and this is a quick summary of what I think he means:

1. With nine years of low interest rates there is no longer any room to boost Aggregate Demand (AD) with lower rates.
2. Simply 'printing money' ('Quantitative easing' or 'helicopter money) will also be ineffective.

Low confidence among both consumers and firms contribute to these first two points, but simply that the incentive provided by these measures is now too small. He therefore thinks the use of negative interest rates (as in Japan and the EU) will fail to raise economic growth.

3. More than monetary policy is needed to promote growth and that should be provided by increased government infrastructure spending.

He makes the point that this can be funded very cheaply by issuing bonds (government debt) at record low interest rates and that the return on this investment will far exceed the borrowing cost.

Stevens is not calling for a naive Keynesian fiscal boost. However he is calling for an end to 'austerity' and a blind adherence to the idea that any government Budget deficit is bad. (Some are, some are not.) What Stevens is calling for are projects that will assist the private sector to grow through active supply side policies which have the advantage of adding to AD as well.

Finally Stevens talks about the wider implications of monetary policy. He pointed out that the low interest rates are destroying retirement plans. Pension (superannuation) funds rely on investing in safe assets such as bonds. The interest rates earned on these assets are so low many find their retirement plans are being ruined. A short period of low interest rates will not affect pensions too badly, they can catch up, but we are now nearly a decade into low rates and that has serious implications.

Business Insider covers his comments here

This article is applicable to VCE and IB students. Australia has record low interest rates and the 'policy mix' between monetary and budgetary policy in Australia is a crucially important area of study. For IB students the limitations of monetary policy and the interaction between fiscal and monetary policy and the operation of supply side policy in the policy mix is directly relevant to Paper 1.

Rare sense from the Coalition on borrowing

The Coalition made a great show of claiming the budget was in crisis for the last five years. While this was simply (bad) politics it has clouded the issue to a dangerous degree as people believed the propaganda.

Now the Government are considering the very sensible move of distinguishing between borrowing to fund investment and borrowing to pay everyday bills. This is quite normal in other countries.

The argument works like this. If you borrow money and buy ice cream then you are simply funding consumption today and will have to pay back later. But you have nothing to show for your borrowing except a bigger waistline.

If you borrow to buy a business then you are borrowing to fund future consumption. While you have to pay back the loan you have bought an income stream to do that and make a profit.

For the government it is a similar story. If they borrow to pay the wages of government employees and to subsidise prescription drugs then they are buying ice cream. It does somebody some good now but you have to pay it back later which means higher taxes.

When the government funds infrastructure spending through borrowing they are adding to the capital stock of the nation. It allows businesses to operate more efficiently and competitively. The government has given the economy the chance to grow more quickly than it otherwise would. The higher taxes paid by individuals and firms in the future pays back the borrowing.

The NBN, new railways and ports are all good examples of infrastructure spending, while higher spending on schools and universities adds to human capital. They all add to Australia's ability to produce goods and services at competitive prices.

From this it follows that borrowing for infrastructure is good, providing the benefits outweigh the costs. In a modern economy the government should always be in debt to fund infrastructure projects as part of a long term supply side policy.

Therefore the stupid contest between political parties to return to an overall surplus faster than the other is fundamentally flawed. The change to distinguishing between a deficit to fund current spending and capital spending needs to be done and Joe Hockey will have to explain this to the idiot Abbot in words of a few syllables.

The Financial review has the story here