Turning more than 80 percent of your currency into ‘coupons with an expiry date’, overnight, is a huge policy experiment. The idea itself is not new. India tried something similar in 1978, but with bills of much higher value that accounted for a smaller share of total currency in circulation. Ken Rogoff, an economist at Harvard and a chess Grandmaster, has also recommended something similar for the US in his new book: The Curse of Cash. As in India, nearly 80 percent of the cash in circulation in the US is in 100-dollar bills. However, unlike India, hardly anyone uses $100 bills for legal transactions and the US economy is much less cash driven. Even then, Ken recommends not an overnight demonitization, but a slow phasing out of currency bills of high value.
The Indian experiment, therefore, is much bigger and more complex than what has been done in the past and what some economists are recommending for developed countries.
How should we think about the economics of this experiment?
I understand this demonitization as a one time tax or penalty on black money stored in high value bills. Unlike Ken Rogoff, our government does not consider high value bills a curse. It has already introduced new bills of even higher value.
What are the likely effects of retiring old 500 and 1000 rupee bills?
First, the rich, the corrupt, the criminals and the terrorists who have money stored in high value bills will suffer some losses. This gives us all great delight. The positive popular response to this action is driven mainly by the potential losses and inconvenience to the corrupt.
Second, our banks need capital infusion. A lot of idle money–black and white–will be back in circulation and Banks will benefit from it.
Third, tax authorities will have more information on people who have unaccounted incomes. This information can help increase tax collections in years to come.
Fourth, those running fake currency rackets, including terrorist organizations, will lose money. However, their losses may be temporary. They will figure out ways to copy the new 500/1000/2000 rupee bills too. The new bills use technology to make it harder to fake them, but Raj buddhi par chor buddhi bhaari. The chors will find a way again. They always do.
Now, the limitations of this policy and its downsides.
First, it is a attack on the corrupt, but not on corruption itself. People are driven more by expectations of the future than experience from the past. If so, they will not become more diligent in paying taxes or more hesitant in accepting bribes because of this one time tax. Gold, silver, bitcoins and other stores of value will replace 500 and 1000 rupee notes. The mode of corruption will change; the extent of it will not. If the government and the opposition are serious about corruption, they should begin by making it essential for political parties to declare their sources of income. AAP has done it. Other parties should do it too.
Second, turning old bills into coupons may be targeted at the rich and the corrupt, but the collateral loss of savings and income to the poor is likely to be high. 3 out of 4 villages do not have bank branches within 5 km radius. 90 percent of women do not have bank accounts. More than half of our adult population does not even know how to read or write. They have not been equipped to operate bank accounts. It will not be easy for the old, the women, the immobile, the residents of the remote areas and many others living on the margins of the society to exchange old bills with the new. All cash-intensive businesses–small and large–will also suffer at least temporary losses. There is a lot of research that shows that for many, a temporary loss of income may have long-term consequences. It is therefore, absolutely important that our government works hard to ensure that this disruption is short-lived. It will require special efforts.
On addressing the impact of phasing out high value bills on the poor people and people who do not have bank accounts, Ken Rogoff has this to say:
That’s one of the most important things to take into account. And so my proposal not only calls for leaving around the $10 bills, but in providing for financial inclusion by giving free debit accounts to low-income individuals. The Nordic countries have done this. A lot of countries have. It doesn’t cost much, but that’s something absolutely you have to pay attention to.
Remember: he is talking about a country where the unbanked are a small minority. In India, they are the overwhelming majority. If thinking of this disadvantaged group while demonitizing is important in the US, it should be the most important consideration, when doing so in India.
My friends and my government do not agree. They believe that the homilies to bearing the pain for greater good of the country can substitute for real provisions for the poor, the women and other disadvantaged groups. My facebook wall may even convince you that it is OK to leave more than 700 million people of India dependent on the charity and the benevolence of the 100 million privileged ones. When was the last time it worked in India–the elite minority being nice and kind and considerate to the vast majority? I have heard of interest free loans, but I have not heard of free favor. There is always a cost to a favor even when it is not denominated in rupees and percentages. Leaving the underclass to the mercies of the elites is not a progressive or smart policy, not anywhere and certainly not in India.
Every experiment offers useful lessons. One lesson I draw from this big policy experiment is that we should work much harder to ensure universal access to formal financial channels in India. Jan Dhan Yojana (JDY) was a good start, but much more needs to be done. Most JD accounts are non-functioning right now. Some of them may even get used by the local leaders to channel their unaccounted money this time. We need institutions, incentives and technologies to achieve universal financial inclusion, lower cash-dependence and faster growth of the formal sector in our economy.