Money & Finance

Demonetisation: Some very counterintuitive effects in practice

  • Blog Post Date18 December, 2016
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Gurbachan Singh

ISI, Delhi Centre; Ashoka University

gurbachan.arti@gmail.com

Due to demonetisation, holders of black money lose if they cannot exchange their notes or sell these in the black market. It is widely reasoned that this implies an equal financial gain for the public authorities. In this article, Gurbachan Singh shows that this logic is flawed.

Suppose that the effect of demonetisation announced on 8 November 2016 in India is that 10% of the old high-denomination notes (HDNs), which is about Rs 1.5 trillion, become valueless; this is after exhausting all possibilities for selling the HDNs in the black market. Clearly, the holders of such notes lose. But who gains? In fact, is there a financial gain at all to anybody? In answering the question, the focus has typically been on the sharing arrangement between the Government of India (GOI) and the Reserve Bank of India (RBI). It is presumed that the public authorities (the GOI and the RBI together) will gain financially (Rangarajan and Thorat 2016). In this article, I question this presumption.

If currency is a liability of the public authorities, as is usually assumed, obviously the public authorities will gain Rs. 1.5 trillion if black money holders lose this amount as a result of demonetisation. But what if currency is not a liability of the public authorities?

Currency notes are irredeemable

At this stage, we need to go back in history. Under Gold Standard, a currency note was redeemable into gold. This is why the head of the bank issuing, say, a Rs. 1,000 currency note stated, “I promise to pay the bearer the sum of one thousand rupees”. However, gradually, since at least the 1930s, Gold Standard had been abandoned in much of the world. The final abandoning was on 15 August 1971 when even the US Dollar became irredeemable. Since then, the world is off the Gold Standard (Bordo and Schwartz 1999). The Rupee is irredeemable. It is another matter that the RBI, like other central banks, has continued to state on the currency note that it promises to pay the bearer (in a form other than the trivial form of exchanging one note for another note). Given that a currency note is irredeemable, it is no longer effectively a liability or debt for the public authorities1. This has interesting implications.

Scenario I: Demonetisation succeeds in eradicating black economy

As a result of demonetisation per se, although the holders of non-exchangeable old HDNs will lose, the public authorities are - ignoring for simplicity the costs related to printing of new notes - financially unaffected (they may gain for different reasons and do so in future but that is another matter). It may seem strange that somebody loses but nobody gains financially. But it is true in this case. Let us elaborate.

Before demonetisation, some of the old HDNs were being used as black money. If demonetisation brings this to an end, then the supply of such currency is out of circulation. This has been the focus in the media. But the demand for such currency also disappears as a result of, what is assumed for the time being, the removal of the black economy. This fall in demand leads to a loss, which is borne by the holders of ‘unaccounted for’ notes but no one else gains financially. In particular, the public authorities do not gain financially, given that demonetisation succeeds in removing the black economy! This is the first counterintuitive effect of demonetisation. This is not to say that there will be no change in social welfare; in fact, welfare can go up if the black economy is finished.

Scenario II: Demonetisation fails to eradicate black economy

Above, it was assumed that demonetisation is successful in eradicating the black economy and not just the black money. Let us relax that assumption. Given that post 8 November, the laws, regulations and procedures (other than those related to demonetisation) have remained unchanged, it is plausible that bribes will resurface. Suppose somebody needs an electricity connection, an approval for getting construction started, and so on; the person will withdraw new currency notes from his or her bank account in order to pay a bribe. The receiver now has new black money! This simple example is used for illustration. But the whole black economy of the kind that prevailed before 8 November can resurface, if it has not resurfaced already.

Suppose now that due to the resurfacing of the black economy, the demand for black money (currency) too re-emerges. Suppose it goes up by a third of Rs. 1.5 trillion, which is Rs. 0.50 trillion. Note that this increases the total demand for currency in the economy by Rs. 0.50 trillion. It is interesting that the RBI will need to issue new currency to meet this additional demand, given its mandate to maintain macroeconomic stability and given that currency is, in itself, neither white nor black. What do the public authorities do with this new currency? They can buy goods and services or redeem their debt to the extent of Rs. 0.50 trillion. The public authorities gain financially, given that demonetisation fails to curb black economy! This is the second counterintuitive effect of demonetisation.

We can generalise and substitute Rs. 0.50 trillion by some other number all the way up to Rs. 1.5 trillion. The higher the number, the more the public authorities gain financially. In the extreme case of Rs. 1.5 trillion, which is the assumed loss to the black money holders, the public authorities gain an equal amount.

Summing up

Demonetisation can always succeed in causing some losses to black money holders. But it may or may not succeed in curbing the black economy. If it succeeds, the public authorities will not gain financially. If it fails, the public authorities will gain; the quantum of gain rises with the degree of failure in curbing the black economy.

Notes:

  1. Despite being irredeemable, a currency note has value because it is acceptable in the market by convention or by fiat. But the HDNs ceased to be legal tender on 8 November 2016. See Patinkin (1969) for related issues on money and wealth. The latter includes not just capital (machinery, equipment, etc.) but also assets like money and gold.

Further Reading

  • Bordo, M and A Schwartz (1999), ‘Monetary policy regimes and economic performance: The historical record’, in JB Taylor and M Woodford (eds.), Handbook of Macroeconomics, Volume 1A, Elsevier.
  • Patinkin, Don (1969), “Money and Wealth: A Review Article”, Journal of Economic Literature, 7(4):1140-1160, December.
  • Rangarajan, C and U Thorat (2016), ‘Demonetisation: How to account for extinguished notes’, Mint, 5 December 2016.
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