Demonetisation’s hydra-headed critics

Ill-informed, misguided or (ideologically or politically) motivated criticisms of the swap of old for new currency notes initiated by Prime Minister Narendra Modi on 8 November are akin to the Lernaean Hydra of Greek mythology: As soon as one chops off one of the heads, another replaces it. It might take a demigod of the stature of Heracles to slay the baleful beast of bogus arguments and fact-free opinions.

Economists Jagdish Bhagwati, Pravin Krishna and I made an attempt to chop off at least a few of the hydra’s heads in a long essay in these pages last week (see “Demonetization Fallacies And Demonetization Math”, 27 December). In light of developments since then, it might be worthwhile to revisit and refine a few of our ideas.

First, if unconfirmed news reports at the time of writing, suggesting that even more of the old demonetized notes will come back in by 30 December than officially were extant on 8 November (approximately Rs15 trillion) turn out to be true, one possibility is an accounting error by the Reserve Bank of India (RBI), either post 8 November, or before. In other words, it could be that the RBI under-counted the notes extant on 8 November, or has over-counted what has returned since then. An entirely different possibility is that there is a greater stock of undetected counterfeit currency than has been widely believed.

If it turns out that notes extant on 8 November were somehow under-counted, it would mean that the RBI had greater liabilities than its books showed. This scenario seems unlikely, as such money would have found its way into the hands of the public through classical open market operations or other mechanisms which would require entries on both the asset and liability side of the balance sheet.

If this type of error indeed occurred, the resulting excess liabilities after 30 December would need to be rectified by the RBI extinguishing an equivalent amount of exiting liabilities or marking up an equivalent value of assets.

Likewise, if it turns out that the discrepancy is due to a larger than expected stock of counterfeit notes, which heretofore have been undetected and which remain undetectable after 30 December, the RBI might again be in the position of extinguishing other liabilities or marking up some of its assets. Both of these scenarios appear unlikely, but are theoretically possible.

If it turns out, as is much more likely, that notes returned have been over-counted, the possible fiscal gain could be larger than anticipated when a correct recount is arrived at.

As Bhagwati, Krishna and I clarified, any putative fiscal gain would require, in the first instance, that the old notes be de jure denotified, not merely de facto demonetised. That has now happened through a government ordinance. The second step is that the RBI should choose to rectify the resulting asset-liability mismatch on its balance sheet created by extinguishing liabilities on the old notes by creating new liabilities in the form of new money, transferred to the government or to the public via helicopter drop. If, instead, it chooses to mark down an equivalent value in assets, the gain will be indirect. In any case, as we argued in some detail, there is likely to be a fiscal gain irrespective of whether all of the old notes re-enter the formal financial system or not, but the mechanism for the fiscal gain could differ.

Consider now one of the hydra heads that Bhagwati, Krishna, and I did not find the occasion to take on: the meretricious argument that, since some of those currently defending the currency exchange exercise as being potentially gainful, including this author, did not explicitly advocate it earlier, there is some inconsistency involved. This is to make the elementary error of conflating falsely ex post facto analysis of the effects of the currency exchange with an ex ante judgement on its effects.

In other words, before 8 November, an economist who might have been asked about the merits of the currency exchange would have weighed the likely short-run costs against the medium- to long-run gains, and determined if the policy passed the test of this cost-benefit analysis.

However, post 8 November, as both the magnitude and nature of both short-run costs and long-run benefits is becoming somewhat clearer, it would behove any sensible economist to revisit and revise her ex-ante judgement, if any had been made.

It is clear to this economist, post 8 November, that the most important long-run economic effects will revolve around the increasing digitization and formalization of the economy, wrought by Prime Minister Modi’s attack on black money, of which the currency exchange is but one piece of the puzzle.

As I put it at a meeting of outside experts convened by vice-chairman Arvind Panagariya on 27 December at Niti Aayog and chaired by Prime Minister Modi, it is as if, post 8 November, the tide has receded, revealing rocks in the harbour. That is, the jump-start to formalization since then—most notably, pulling workers and firms out of the darkness of the black economy and bringing them into the light of the formal economy—has highlighted the need, indeed, the urgency, for follow-on reforms which simplify the tax and regulatory burden on ordinary citizens.

We await such further reforms with anticipation.

Every fortnight, In The Margins explores the intersection of economics, politics and public policy to help cast light on current affairs.