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Broken Window Fallacy: What Falling Vegetable Prices Tell Us About Notebandi

Feb 28, 2017

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The negative effects of demonetisation have now reached a stage wherein there is enough data available to discuss the concept of the broken window fallacy. This fallacy explains beautifully the ill-effects of demonetisation or notebandi in a very simple and straightforward way.

The French economist Frédéric Bastiat discusses this fallacy in his 1874 book That Which is Seen, and That Which is Not Seen. He talks about the anger of a good shopkeeper whose careless son has happened to break a pane of a glass window.

As Basitat writes: "If you have been present at such a scene, you will most assuredly bear witness to the fact, that every one of the spectators, were there even thirty of them, by common consent apparently, offered the unfortunate owner this invariable consolation-"It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?"

The point being if window glasses were never broken what would glaziers ever do? A glazier is essentially person who fits glass into windows and doors. Without broken window glasses, there would be almost no work for glaziers.

As Basitat writes: "Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier's trade-that it encourages that trade to the amount of six francs-I grant it, I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen."

But what about that which is not seen? "It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way which this accident has prevented," writes Bastiat.

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So how does all this apply to demonetisation? The phrases to mark in the above paragraphs are that which is seen and that which is not seen. As economist Jim Walker of Asianomics put it in a recent research note: "It is likely that the demonetisation exercise will throw up very little, and certainly transient, weaknesses in measurements of the formal economy. It will be claimed, because it can be seen, that the pain was small and transient."

This is clearly seen in the post demonetisation revised GDP estimates (or to put it simply economic growth estimates). Most economists have cut their economic growth estimates by less than 100 basis points. One basis point is one hundredth of a percentage.

Take the case of the National Council of Applied Economic Research. It recently cut the Indian economic growth forecast by 70 basis points to 6.9 per cent. Earlier it had forecast an economic growth of 7.6 per cent for 2016-2017.

Or take the case of Moody's Investors Service. It recently cut the Indian economic growth forecast by 40 basis points to 7.1 per cent, from the earlier 7.5 per cent. The Reserve Bank of India has cut the growth forecast by 70 basis points to 6.9 per cent, from the earlier 7.6 per cent.

Hence, India is widely expected to grow by around 7 per cent in the current financial year. Before demonetisation was announced, it was expected to grow by around 7.6 per cent. Hence, that is a drop of around 60 basis points. Given this small fall, those in favour of demonetisation will claim that the negative impact of demonetisation hasn't been much.

But this is what Bastiat called that which can be seen. The problem is with the unseen part, which is India's huge informal economy. As Walker puts it: "Since by definition it is not measured, the detrimental and potentially lasting effects on the informal economy are impossible to observe, precisely because it is not measured."

This is a point I have made in few of my recent columns. (You can read them here and here). This point is made in the latest Economic Survey as well, a document published by the ministry of finance. As the Survey pointed out: "It is clear that recorded GDP growth in the second half of FY2017 [October 2016 to March 2017] will understate the overall impact because the most affected parts of the economy-informal and cash based-are either not captured in the national income accounts [basically the gross domestic product]."

Hence, a large part of the damage because of demonetisation will remain unseen. This will happen because of two reasons, one because a lot of it will remain unmeasured and two, because a lot of it won't make it to the national media, which primarily operates out of New Delhi.

Take the case of vegetable prices. Take a look at Figure 1. It shows the vegetable price inflation since November 2015, using the wholesale price index (WPI) data.

Figure 1:

As is clear from Figure 1, the vegetable price inflation was at around 28.5 per cent in July 2016. Since then it has been falling and has been in negative territory since September 2016, with a major fall coming in after demonetisation in November 2016. In December 2016, wholesale vegetable prices fell by a third in comparison to a year earlier. In January 2017, the situation continued.

This damage has primarily happened because the vegetable supply chain in the country works primarily on cash. As analysts Ritika Mankar Mukherjee and Sumit Shekhar of Ambit Capital write in a research note: "The core theme which was discernible across India was that the prices of perishables, such as vegetable, have crashed as farmers are unable to sell their produce as their supply chains are entirely cash driven. For instance, cauliflower and pea farmers in a village in Haryana (near Panipat) told us that they had to trash their produce entirely as there were no buyers."

With not enough cash going around, transactions for buying and selling of vegetables could not be carried out in the same volume as was the case before notebandi. This has led to a situation where the farmers have had to trash their produce. This is the unseen damage of demonetisation that will never be talked about.

Also, this damage will have a multiplier effect. Given that farmers producing vegetables are ending up with a lot of waste despite a bumper crop, it means that they will not earn as much money as they were hoping to. This will have an impact on their consumption as well. As I had written sometime back, two-wheeler sales have already crashed big time.

The analysts also add: "Whilst farmers were confident that as the cash comes back into the system the situation will improve, they lamented about the fact that the bumper vegetable season was destroyed because of demonetisation."

How soon the situation improves is not unseen, but it remains to be seen.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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15 Responses to "Broken Window Fallacy: What Falling Vegetable Prices Tell Us About Notebandi"

Ramana Kumar

Mar 4, 2017

I have read reports of the vegetables getting trashed, in many places, in Karnataka as well. But the impact on inflation is a mystery. If indeed agricultural produce could not be transported, what happened to the consumers ? why did the prices in urban consumption centres not shoot up because the supplies have not come into markets ? Maybe such trashing of produce was on a small scale ??

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DINESH NAYAK

Mar 1, 2017

The analogy of the glazier not getting work if glass panes do not break is not correct. All artisans connected with construction sector get most of their work from new construction work. Replacing broken glass pane is 'maintenance & repairs' which forms a small part of their earnings.

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Bhalender Singh Nayyar

Mar 1, 2017

Is it not ironic that when the agricultural prices go up too much we stop talking about the dramatic rural demand increase and when the prices go down we start blaming the government for the farmer's plight and the impact on rural demand.
The wholesalers in the agricultural sector have been fleecing the farmer on one side and the consumer or the retailer on the other. When they get hit we want to take their side rather than blaming them for all their misdeeds. The country desperately needs severe action on people who have been fleecing the economy at the honest taxpayer's cost.
The poor farmer has been manipulated by the weather, the corruption in the system and many other factors, Let us see how we can uplift them rather than strengthening the hands of the middlemen.

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D p sahu

Mar 1, 2017

The falling of veg. Prices are not due to notebandi but due to poor infrastructure like lack of poor cold storage chains in the country.Hope you give a constructive suggestions to the government in your future article.
Thanks.

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krishnan

Feb 28, 2017

Yes, pain was felt everywhere and in some cases more than others. In villages, banks and the FBCs worked real hard 24X7 to ensure farmers had enough cash to move thing across the channel. In fact, the survey done by me in 10 villages showed not much impact the farmers felt.

Like (1)

Rajendra

Feb 28, 2017

If vegetables are trashed by farmers due to shortage of supply chain, the prices should soar up as supply is matching demand. I think you missed this point due to your biased and ill intentions to prove demonization is wrong. You can keep trying , but as per any tax payer and honest earning people, any unorganized sector should be converted to organised sectors .. unorganised is not good..

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Babo Shah

Feb 28, 2017

I will 50% agree with you. Each action or reaction always have seen and unseen side whether it done by human being or nature. Good side of demonetisation was that people savings increase as wasteful expenditure decrease and people have spent on necessaries items only. Its also cool down the economic activities whether good or bad. Development only can't be regarded as country's progress. Demonetisation has bring the idle hidden cash laying in the country to the forefront in banking system.

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avinash b ketkar

Feb 28, 2017

historically agriculture was local based and carried as a way of life and not on business lines. therefore traders earn on vegetables and farmers suffer loss. in changing economy old pattern farming must change according to time. we deal in cash only this tendency has tobe discourage at any cost. previous leaders their self interests dominates over public welfare. rational distribution optimum production has tobe thought by now. bumper crop or no crop was the fate of farmers because no economic planing was there. profit to us and loss transfer it to govt. was very attractive slogan to public at large. therefore loan weaver schemes were experienced at the cost of bank profitability. now bank advances nearly rs. 18 lac cror are non performing and 125 crore entire population is suffering due to handful of political criminals turn politicions , present prime minister is cleaning india in every respect without any personal selfish motive. people are supporting him ignoring vested publicity on news channels on tv.

Like (2)

Venkat R

Feb 28, 2017

No offense, but your articles are getting quite ridiculous. One writer says that prices have crashed. And, you an analyst base an article on one data point. Please! I am a farmer, and prices crash so often. No one helps us. At the time of this notebandi, we were told that prices would skyrocket because no one had notes to buy our produce. When that did not happen, now the story is changed. The prices have been coming down for months, and the December drop was as big as those for some other months, nothing more. As for us, with lowering inflation, the cost of several of our inputs are less now, so profits remain the same. I see you are determined to show notebandi as a bad policy. It may well be. But, please dont fly kites, talk some sense. Using high sounding words and apparently great logic defeats the purpose. People will begin to stop taking you seriously. And, then there will be no way to get back your fairly good name.

Like (3)

sivaraman

Feb 28, 2017

Small businesses are no longer viable as several departments keep peeping the small business owners and they are very much ha razzed and gradually they started retrenching employees and packing up.

Like (3)
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