On November 8, at 8.15pm (6.45pm UAE time), Indian Prime Minister Narendra Modi announced that at the stroke of midnight, all 500 and 1,000-rupee currency notes in circulation would no longer be considered legal tender and would need to be exchanged for new 500 and 2,000-rupee notes. Modi’s “demonetisation” has affected 86 per cent of the money in circulation in India. It was an unprecedented move, whether in India or almost anywhere else in the world, and it is Modi’s boldest policy intervention to date.
The Modi government is targeting “black money”, or unaccounted income, associated with tax evasion, corruption and counterfeiting and thus the drug traffickers, smugglers and terrorists who engage in those activities. India’s tax-paying salaried classes and even the poor initially welcomed the policy enthusiastically, viewing it as sweet revenge against tax evaders who had stowed away their ill-gotten gains; they revelled in anecdotes of corrupt officials burning bags of cash or throwing money into the rivers.
But with each passing day, that initial cheer has diminished. Public frustration is now mounting, because the government has failed to meet the demand for new printed notes. Commerce in India — where the cash-to-gross domestic product ratio is 10 per cent — relies heavily on cash transactions and informal-economy and small-business operations have now ground to a halt, owing to long queues outside banks and automated teller machines and tight cash-withdrawal limits from bank accounts.
The near-term impact will be the equivalent of an “anti-stimulus” policy intervention and the consequent drag on demand will be significant. Moreover, as real-estate prices decline, so, too, will household wealth. Although lower house prices will make new homes more affordable, the stock of occupied homes will far exceed new purchases in the near term, so the negative-wealth effect will overwhelm the gains.
Given these large upfront costs, it is reasonable to ask how effective demonetisation is in fighting tax evasion and corruption, and if there is a less-costly approach to demonetisation.
Back in 1976, in an article titled ‘How to make the mob miserable’, American economist James S. Henry addressed the question of effectiveness, prescribing demonetisation as a measure to undermine mafia operations. But policymakers did not take his proposal seriously. Henry’s proposal was, in his own words, “dismissed as either administratively impractical or as a one-shot action that would have no long-run impact on criminal behaviour”.
In a new book, The Curse of Cash, Kenneth Rogoff champions the elimination of high-denomination notes in order to fight tax evasion and criminal activity. Rogoff furnishes extensive evidence that making it costly to hoard cash would deter illegal activities. While tax evaders also store their wealth in non-monetary forms, such as land, art and jewellery, cash remains a leading vehicle for ill-gotten gains, owing to its inherent liquidity.
In other words, questions posed by Modi’s critics about the role of cash in feeding stockpiles of black money are misplaced.
That said, Rogoff proposes a different strategy to address the menace of black money — one that would be minimally disruptive and arguably more effective, at least in the long run. That strategy would depart from the Modi government’s intervention in two fundamental ways. First, it would be gradualist, implemented over several years. Second, it would permanently eliminate high-denomination notes.
While this gradualist strategy would not punish existing hoarders, who would find creative ways to recycle their cash in the interim, it is more likely to improve tax compliance and reduce corruption over time, as large-denomination notes are permanently taken out of circulation. India’s current policy of replacing 1,000-rupee notes with 2,000-rupee notes undermines the long-term effectiveness of its policy.
Moreover, the gradualist approach is administratively practical, minimises the collateral damage to the real economy and ensures that there is enough time to extend financial services and financial literacy to larger parts of India. Over the last two years, the Modi government has made an impressive push for financial inclusion with its Jan Dhan Yojana (public wealth scheme), which has facilitated the creation of 220 million new bank accounts. But many people who create accounts do not necessarily use them. A 2015 World Bank study of bank-account usage and dormancy rates across different regions found that only 15 per cent of Indian adults reported using an account to make or receive payments. In this environment, a cash scarcity is economically crippling.
Modi’s policy intervention is bold, and the economic principles motivating it are beyond reproach, but a gradualist approach that includes the permanent withdrawal of large currency notes would have served the cause better — even if it does not generate the same “shock and awe” as the current policy. This will become more apparent as the large costs to the economy emerge over the next several months.
— Project Syndicate, 2016
Gita Gopinath is professor of Economics at Harvard University. She is a visiting scholar at the Federal Reserve Bank of Boston, a research associate with the National Bureau of Economic Research and a World Economic Forum Young Global Leader.