The distribution of political and economic powers is an important factor in driving the development trajectory of a nation. Daron Acemoglu and James A Robinson wrote a book, “Why Nations Fail: The Origins of Power, Prosperity, and Poverty” in 2012 to find the development and prosperity trajectory of a nation through its institutions. They deviated from the traditional approaches that stressed on the role of geographical factors for finding prosperity. They argued that political and economic institutions have a critical role to play in the prosperity and poverty of a nation.
The authors talked about critical junctures where there is a sudden change in the working of the system and the power is shifted or gets transformed. The authors had little to say about India in their book. The decision concerning demonetization in India in 2016 was such a critical juncture where the political and economic institutions saw a sudden change. There was a seismic shock in the market as a tremendous amount of money in circulation was wiped out. It led to severe consequences, both politically and economically. This hurt the political institutions of the country where the rule of law was not respected. Further, the interests of marginalized and informal sectors were affected economically as they faced hardships due to a lack of liquidity in the market. This was detrimental to the level playing field in the market sphere.
In this post, I aim to look at demonetization from the lens of political and economic institutions theory developed by Acemoglu and Robinson in their book and argue as to how the decision concerning demonetization was detrimental to the pluralistic character of inclusive political and economic institutions of India. Firstly, I explain the broad argument of the book and, particularly, the arguments contained in Chapter 11 of the book, The Virtuous Circle, which is the most relevant chapter for the discussion surrounding demonetization. Secondly, I analyze the effect of demonetization on the inclusive political and economic institutions of the country. I conclude that demonetization failed to satisfy its purported benefits and had detrimental effects on the pluralistic character of the inclusive institutions of the country.
Why Nations Fail: An Indian Context
“Why Nations Fail”: Synopsis of the Book
Acemoglu and Robinson wrote the book, “Why Nations Fail: The Origins of Power, Prosperity, and Poverty” in the year 2012. The two of the world’s leading experts on growth and development revealed reasons behind the success and failure of nations in the world. Acemoglu and Robinson deviated from the traditional theories that have considered geography and locations as the determinant factors. The authors, throughout the book, argued that it is the nature of the institutions instead that decides prosperity and poverty. They argued that any country has either inclusive or extractive economic and political institutions.
Inclusive economic institutions pave the way for success as they encourage citizens to engage in economic activities by having strong economic freedom. These institutions ensure that their efforts will result in wealth creation. On the other hand, extractive economic institutions primarily result in wealth creation for some particular groups in society at the cost of other groups. An example of the same could be the institutions in North Korea. Similarly, there are inclusive and extractive political institutions. An essential characteristic to differentiate between these is the presence of ‘pluralism’. Pluralism ensures that every group in the society gets a representation in policy-making. This is ensured by the presence of the rule of law in society. Extractive political institutions are those institutions which do not provide pluralism or the rule of law. An example of the same could be the institutions in China.
- The Virtuous Circle: Inclusivity in one aids Inclusivity in another
Remarkably, in chapter 11 of the book, Acemoglu and Robinson argued about the virtuous circle. Through the example of the Glorious Revolution of 1688, the authors argued how the rule of law was implemented in England. Glorious Revolution ensured the representation of the new mercantile and economic interests of different groups. This was directed to empower different groups, prevent exploitation and make institutions more pluralistic in nature. The authors argued that as institutions become more pluralistic and inclusive in nature, society tends to have more political and economic equality. It also helps in preventing abuses of power, misuse of media, and concentration of wealth in a few hands. Acemoglu and Robinson termed this as the virtuous circle, where inclusive economic institutions build a foundation upon which inclusive political institutions are constructed, and inclusive political institutions help in restricting deviations from inclusive economic institutions.
- Demonetization: A Critical Juncture
Similarly, a recent critical juncture in India was the decision concerning demonetization announced by the Government of India in 2016. Through this decision, the Government demonetized 500 and 1000 rupees notes, valued at Rs. 15.4 trillion. This constituted approximately 86.9% of the total currency that was in circulation at that time. The purpose, as cited by the Government of India, behind the action was to undertake “transformational economic policy steps” to forward objectives such as: truncate fake currency, increase taxpayers and growth in digital transactions. It is not being denied that the presence of black money in the economy hinders public prosperity and development as the Government is unable to utilize the revenues to further social welfare. This is an essential cause of poverty.
Importantly, the Government cited that the objective of demonetization was to enhance the formalization of the economy, and it was aimed to expand opportunities for millions of people living on the periphery of the economy in India. However, a pertinent question arises here: Whether that class was able to reap the benefits of demonetization or not? Different economists make different arguments, some supporting the decision and some citing its harmful effects. However, let us consider the effects of the same through the lens of Acemoglu and Robinson.
Demonetization in India: A Smack to Pluralism
The decision concerning demonetization hits inclusive institutions prejudicially. If looked at from the perspective of Acemoglu and Robinson, the Government just manifestly aimed at making the economic institutions of the country more inclusive. Instead, the decision ended up hitting the pluralistic character of these institutions. India is a cash-driven economy and when approximately 87% of the money is swept away from the market, it necessarily has detrimental effects on the poor. The impacts due to limited access to currency during demonetization could be seen in two ways: firstly, due to the unavailability of liquidity in the market, there was a huge decline in demand, and secondly, the long ques for exchanging the currency mainly affected workers and laborers in the unorganized sector. The loss in income of the daily wage workers also affected consumption and eventually demands in the market.
- Effects of Demonetization on Inclusive Economic Institutions
There are various reports specifying that sweeping of the currency from markets affected domestic and household sectors the most. This further affected different industries where liquidity and cash flow is necessary. The Government justified some level of suffering to the poor by arguing that the return of black money in the economy would be beneficial for poor. However, the purported claim of the Government to recover black money was also unsatisfactory.
This is because a very less portion of black money is stored in the form of cash. Mostly, black money is stored in durable and physical assets like land, property, and gold. Further, as per the RBI reports, almost Rs 15.28 trillion was recovered to the banking system, which accounts for 99.3% of the total currency that was being circulated in the denominations of Rs. 500 and 1000 notes. Almost all the money circulating had been deposited in the banks and was easily converted into white money. There are reports stating that there was no efficient follow-up by the income tax authorities to keep an eye on the black money deposited in the banking system.
According to Acemoglu and Robinson, one of the most important characteristics of inclusive economic institutions is that they accommodate the interests of all groups and provide a level playing field. We have already discussed how the marginalized and unorganized sector was affected the most due to demonetization.
Further, a significant percentage of the Indian population does not possess debit cards. The Government wiped out huge amounts of money from the market, without accommodating the interests of marginalized and unorganized sectors. This did not give a reasonable opportunity to people to make financial arrangements or any other alternative to avoid mayhem and chaos. This indicates that the action of the Government demonetizing the currency was detrimental to the inclusive economic institutions of the country. This is because the policy of demonetization was not economically beneficial for the marginalized and poor class. The Government failed to actualize the economic promises it made to the poor and needy class. It contradicts to the characteristics of inclusive economic institutions discussed by Acemoglu and Robinson in their book.
Closely related to the last point, North, Wallis and Weingast define the terms ‘limited access orders’ and ‘open access orders’. In limited access orders, the access to resources is limited to some groups of the society. This furthers crony capitalism where bureaucrats take such a decision. On the other hand, in open access orders, the access to resources is made public in general, and there is free and fair competition in the market and the resources are impersonalized. However, when the Indian Government made a decision of demonetization, it limited citizens’ access to resources and discriminately affected their rights. The decision of demonetization limits the financial access to the marginalized and poor class. On the other hand, it did not concern much to the elite and wealthy class of India. It was the financial incentives of poor which were affected, and it also led to the loss of jobs in the small and medium manufacturing enterprises.
- Effects of Demonetization on Inclusive Political Institutions
The decision of demonetization was taken by the Executive expeditiously and not in a phased manner. The citizens of India have certain rights ingrained in the Constitution of India and various other democratic rights, which cannot be taken away by hasty decisions. The rule of law cannot be sustained if political institutions start making decisions without accommodating interests of all. It must lead to pluralism, where different individuals and groups have a say in the decision-making process.
Section 26(2) of the Reserve Bank of India Act, 1934, authorizes the Central Government to demonetize and declare any denomination of notes as illegal tender. The Central Government did the same on two previous occasions, i.e. in 1946 and 1978. In 1946 and 1978, there were ordinances passed by the Central Government and the same were later passed by the legislature. Unlike the decisions in 1946 and 1978, there was a clear failure on the part of the Government to issue an Ordinance allowing demonetization in 2016. Apart from the lack of an Ordinance, the Government also put a restriction on the withdrawal of the sum from the bank accounts. This restricted people’s right to access their cash and bank accounts. This, in the author’s opinion, was a gross violation of the rule of law.
A similar contention was raised in the writ petition filed in the case of Vivek Narayan Sharma v Union of India. It was argued that the decision of demonetization ought to have been made in a well-planned manner, accommodating the interests of the most affected ones. Various rights of citizens, including the right to life and the right to trade, were violated. The Government failed to ensure that the rule of law and principles of natural justice are followed. This affected the lives, livelihoods, businesses, trade and commerce of millions of citizens in uncountable ways. The “horrendous consequences” of demonetization were not assessed and appropriately calculated before implementing the decision.
Similarly, in 2009, the North Korean Government brought currency reforms within their nation with the objective of wiping out corruption from the market. The said action of the North Korean Government, as also argued by Acemoglu and Robinson, resulted in wiping out of a huge fraction of citizen’s private wealth. The Government of North Korea is based on dictatorship, and hence, the political institutions evidently do not reflect pluralism and are, therefore, extractive.
The currency reforms in North Korea were motivated to stabilize the position of people in power. This also holds true when the Government in power wants to show that it is doing something it promised in its manifesto. Political power and interests, particularly through institutions, drive policy decisions. Inclusive political institutions must ensure that their policies are empowering broad sections of the population and they should be able to participate in the growth and development of the country. Inclusive policies cannot be made when they are not benefiting a huge section of society, particularly the poor.
In this paper, I have analyzed the mode, implementation and impacts of demonetization on the inclusive political and economic institutions of the country. It is my opinion that the decision concerning demonetization hurt the pluralistic character of these institutions. The same was analyzed through the theories developed by the famous authors Acemoglu and Robinson.
It is nowhere argued that the scheme of demonetization was bad but that the manner in which it was implemented was detrimental to the inclusive institutions of the country. The decision was not politically inclusive as it did not provide a say to all the groups equally. This violates the rule of law, an essential characteristic of inclusive political institutions. Additionally, the decision failed to achieve its purported economic goals. The interests of the marginalized and informal sector were primarily affected as they had to bear the burden of economic hardships in the market. This hurts the inclusive economic institution of the country.
(This post has been authored by Sahil Mehta, a Third Year student at the National Law School of India University, Bangalore.)
CITE AS: Sahil Mehta, ‘Demonetization in India: A Critical Juncture Affecting Pluralism’ (The Contemporary Law Forum, 07 February 2023) <https://tclf.in/2023/02/08/strongdemonetization-in-india-a-critical-juncture-affecting-pluralism-strong/> date of access