Demonetisation debates, redux

Amid the cacophony of arguments as the debate over the government’s decision to swap old for new high-denomination currency notes (HDNs) continues, it is imperative to distil and differentiate both ex ante rationales and ex post facto analyses.

Thus, according to news reports, the Union government suggested to the Reserve Bank of India (RBI), on 7 November 2016, that it ought to consider demonetising HDNs, citing as a rationale that this would work against the “triple problems of counterfeiting, terrorist financing and black money”.

In support, the government’s note pointed to the fact that “in the last five years, there has been a significant increase in circulation of Rs500 and Rs1,000 notes”. According to reports, the RBI accepted this rationale, and, upon communicating this to the government, Prime Minister Narendra Modi announced demonetisation of HDNs to the nation on the evening of the following day, 8 November.

As economists Jagdish Bhagwati, Pravin Krishna and I argued recently in this newspaper, it is indeed true that the exchange of old for new HDNs will have an impact on the stock of existing black money and on the flow of future counterfeit notes, although the magnitude of the effects can be debated. However, it is unfortunate that, in its defence of the proposed policy, the government’s note should cite increased circulation of HDNs in the period preceding the decision.

As any credible economist will tell you, it is fully to be expected that the stock of HDNs should rise approximately in proportion to nominal gross domestic product (GDP). Indeed, this follows directly from the equation—MV=PY—where M is the money stock, V is the velocity of circulation, P is the price level, and Y is real GDP, assuming, as seems a reasonable first-order approximation, that V is constant in steady state and that the ratio of HDNs to M is approximately constant in steady state.

Data analysis by my IDFC Institute colleague Praveen Chakravarty, published in a column in Bloomberg Quint, shows that, exactly as one would expect, HDNs grew approximately in proportion to nominal GDP—barring an initial and entirely to-be-expected transition towards steady state after the old HDNs were initially introduced.

To reiterate, these facts do not negate the stated ex ante rationale for demonetization, which is theoretically valid, but do call into question the empirical basis on which this rationale was apparently buttressed. Things are no less confusing when it comes to ex post facto analyses, with motivated critics of the policy emphasizing short-run costs and downplaying medium- to long-term gains.

As a matter of economics, the smaller the short-run costs caused by the temporary liquidity shortage induced by demonetisation followed by insufficiently rapid remonetisation, the smaller, too, would be the expected medium- to long-term gains in terms of a move towards less cash and towards greater formalization of the economy.

In other words, had the old notes been swapped for new ones within (say) the first week or two after 8 November, the cash crunch would have been short-lived, and consequently there would have been less of an impetus to move towards non-cash means of payment and towards moving out of the black and grey economies into the white economy.

Strikingly, a sharper temporary liquidity crunch, inflicting higher short-term costs, will likely induce, in the end, greater medium- to long-term gains in the form of digitization and formalization. However, adding up these costs and benefits is a tricky problem, as the short-run costs are immediately apparent and relatively easy to quantify, whereas the opposite is true for the medium- to long-term gains.

This makes it difficult to apply the economist’s standard toolbox of cost/benefit analysis, which would involve computing the present discounted value of benefits net of costs, and determining if this is, indeed, positive, as the government and proponents of the policy hope would be the case. In such situations, an economist must rely on intuition and judgement.

Lastly, there is the vexed question of a putative fiscal gain associated with cancelled liabilities relating to those old HDNs which were not returned as of 30 December. As Bhagwati, Krishna and I argued, the resulting mismatch between assets and liabilities could be rectified, if the RBI so wishes, either by creating new liabilities of a value equivalent to those that are extinguished—such as via a helicopter drop of new money—or by marking down or reducing in some other way a corresponding value of assets.

Economist Gita Gopinath, writing in these pages, has cautioned against the RBI reaping such a putative fiscal bonanza, suggesting that it may “conflict with the goals of monetary policy” —by which she means the inflation-targeting mandate administered by the monetary policy committee (MPC).

But this could only be the case were the MPC to ignore the possible macroeconomic consequences of any correction to the asset-liability mismatch, which is a problematic assumption.

Thus, if (say) a helicopter drop is expected to have an inflationary impact, the MPC would account for this when it sets the policy rate, by adopting a tighter stance, other things being equal. In other words, the existence of a credible MPC should allay any such concerns.

Every fortnight, In The Margins explores the intersection of economics, politics and public policy to help cast light on current affairs. Read Vivek’s Mint columns at www.livemint.com/vivekdehejia