Regular Demonetisation of Paper Money is a Stupid Idea

Thu, 17 Nov 2016
On November 8, 2016, Modi announced the decision of the government to demonetise notes of Rs 500 an Rs 1,000. Several economists have made suggestions since then on what the prime minister Narendra Modi, should be doing next to tackle the huge amount of black money in the country. 

One suggestion has been made by Soumya Kanti Ghosh, the group chief economic adviser of the State Bank of India (SBI), the largest bank in the country. In a column in the Business Standard titled Demonetisation and Note Burning and dated November 15, 2016, Ghosh wrote: "We suggest that this demonetisation may be carried out over periodic intervals with the surprise element and the government makes its intention clear on that. In such an eventuality, people will be discouraged to hold cash." 

What Ghosh is essentially saying here is that the government should carry out regular demonetisation of currency in the years to come. This basically means that the government should regularly make old currency useless and introduce new currency. He also suggests that the government retain the surprise element of the move like it did this time around. 

This means that one fine evening (or morning or afternoon for that matter), the prime minister should suddenly announce to the nation, like he did this time around, that the high-denomination notes are basically useless now and new ones will be introduced. Ghosh hopes that by doing this people will be discouraged from holding on to cash. In the process the economy will move from being an "informal economy to a more formal economy". In simpler terms, it means that the black portion of the economy will come down. 

This I think is a stupid suggestion. Allow me to explain. 

Paper money doesn't have any value on its own, like various other forms of money like gold or silver, have had over the years. The Rs 10 note is not very different from the demonetised Rs 500 note except for the colour of the ink and the amount of paper used, to make it. The difference in the value of the notes is clearly not Rs 490. A Rs 10 note has a purchasing power of Rs 10 because the government deems it so. And so was true for the Rs 500 note, before it was demonetised. 

So what is paper money? It is primarily a token deemed to have a certain value by the government and which everyone accepts and is used to carry out transactions in the everyday economy. 

Without enough paper money in the economy, people can't carry out transactions and the economy comes to a standstill. This is what is happening right now all-across the country. Mobile phone sales have collapsed. People aren't buying two-wheelers. Restaurants are deserted. And normal taxis are not getting enough business. The farming economy has slowed down tremendously. Daily wage workers like plumbers and electricians are not getting enough work. For more examples, you can open any newspaper and there will be enough stories there. Generally, business is slow. 

This isn't surprising given that close to 86 per cent of the currency by value has been rendered useless by the demonetisation move. Of course, this wouldn't have mattered if Indians were used to transacting through debit cards, credit cards, net banking, wallets and so on. The show would have gone on. 

But that has not happened. India is a country where a bulk of transactions are still carried out in cash. An estimate made by the Fletcher School at the Tufts University in the United States, said that in 2012, in India, 86.6 per cent of the transactions by value were carried out in cash. While this figure would have come down since then, it would still be at a very high level. In comparison, card transactions stood at 4.1 per cent of the total transactions. The electronic transactions stood at 6.8 per cent. Another research paper titled The Cost of Cash in India points out that "the ratio of currency to GDP in India (12.2%) is higher than countries such as Russia (11.9%), Brazil (4.1%), and Mexico (5.7%)".We can be prude about the matter and say that people should move away from cash, but societal habits are not easy to change. Given this, high importance of cash in our lives, it isn't surprising that business in all kinds of markets has come down substantially. There isn't enough token or paper money going around for people to carry out these transactions. 

The only way to tackle this is to put out enough new money into the financial system in order to replace the old money. This will ensure that people will go back to carrying out transactions and businesses will go back to being normal again. But this is easier said than done. 

Economist Saumitra Chaudhuri writing in The Economic Times said that "the timeline to replace the existing stock of 1,658 crore pieces of Rs 500 notes will run into May 2017." He arrives at this number taking into account the printing capacity of the existing mints. This basically tells us that the implementation of the demonetisation move wasn't really thought through. As usual we have managed to screw up on the implementation bit. And this has created problems in the everyday economy. 

The basic hope of Ghosh of SBI is that with frequent demonetisation people will get on to other more formal mechanisms of paying than cash. That is likely to take place. But what will also happen is that more amount of black money will now quickly move into gold. There is nothing stopping that from happening. 

And the thing is that India produces almost next to no gold. We import almost all of the gold that we consume. This has its share of repercussions on the balance of payments and the rupee dollar exchange rate. 

But there is a bigger worry. All paper money essentially works on faith. This faith leads people to believe, that a piece of paper with some ink, digits and promises on it, is basically money. It is this faith which leads people to believe that a Rs 10 note has a purchasing power of Rs 10 and a Rs 100 note has a purchasing power of Rs 100, though essentially there isn't much difference between the notes. 

This faith is what basically keeps paper money going as money. I know for sure that when I use rupees to pay for goods or services, they will be accepted by others. And this is what keeps the economy going. If this faith breaks down, paper money breaks down. People move on to other forms of paper money or simply gold. 

Let's look at some evidence of what regular demonetisation does to an economy. One country which has gone through regular demonetisation of a large scale is Myanmar (or Burma as it is more commonly known as in India).

As the Federal Reserve Bank of San Francisco points out in a document titled Burma-Paving the Road to a Modern Banking System: "After the 1962 coup, the government installed a socialist economic system and nationalized all banks, including foreign banks. Subsequently, three major demonetizations occurred in 1964, 1985, and 1987. In the latest 1987 demonetization, the Ne Win military regime effectively declared about 75 percent of the cash in circulation illegal and eliminated three banknote denominations without exchange or compensation. The demonetization eroded most of the populace's savings and resulted in widespread protests and the 1988 coup. Demonetization coupled with rampant inflation in the 1990s has led to the retainment of little faith in the storage value of the kyat. As a result, the economy is partly dollarized." 

While, the Indian demonetisation is nowhere as extreme as the ones in Burma, but the part in italics in the above paragraph is what is important. Regular demonetisation has led to people having little faith in the Burmese currency kyat. Hence, people prefer to deal in dollars rather than the local currency. 

This is something recounted by a writer on the National Public Radio website: "[In 1987]... the country's leader created new bills overnight in denominations that were multiples of nine - his lucky number... So people started to sock away their extra money in U.S. currency. And when your life savings is a few U.S. $100 bills, you want to keep them pristine." 

Regular demonetisation can lead to people losing faith in the country's currency and moving on to dollars. And that is something no Indian government would want. Other than losing control on the monetary policy, it is going to have other repercussions as well. In the Indian case, more and more people will simply move to gold, given our love for the yellow metal. 

Once this is considered, the suggestion from the chief economic adviser of the country's largest bank, seems rather silly. The only possible explanation for it perhaps lies in the fact that he was perhaps trying to please his political bosses.

The above is from Vivek Paul'sDairy, in Equitymaster.