Home / Opinion / The lessons of demonetisation

There is now ample proof that the grand demonetisation gamble has failed to meet its primary objective.

The Reserve Bank of India (RBI) has finally released numbers that show how most of the currency notes that were cancelled were deposited in banks. The airy hopes that the Indian central bank would be able to extinguish a substantial chunk of its liabilities—and some mistakenly also argued that this would provide a fiscal bonanza that the government could use to recapitalize the banking system—have been belied. The minor relief is that the value of notes returned was not greater than the value of currency printed by the Indian central bank. That would have created a huge accounting mess.

Prime Minister Narendra Modi had said in his address to the nation on 8 November that the decision was an attack on the scourge of black money. It was only later that other potential advantages of demonetisation were introduced into the public discourse. The press release by the Union finance ministry after the new currency data was made public similarly tries to broaden the set of benefits from demonetisation. Finance minister Arun Jaitley said on Wednesday that the money is now in the system, where the use of Big Data analytics could help the government identify who deposited black money.

This newspaper had welcomed the move when it was announced. In an editorial published on 11 November, we had described demonetisation as a war on the stock of illegal wealth: “The Modi government has clearly signalled its intention to move against illegal wealth. The currency swap deals with the stock of black money held by tax evaders. The challenge now is to ensure that the creation of new black money is minimized. There is no magic wand to solve what is a deep problem in India, but a committed government plus tax reforms such as the new goods and services tax (GST)—which creates incentives for producers to seek bills from their input providers—will be part of the solution." The editorial overestimated the amount of illegal wealth that would be extinguished while paying little attention to the immediate negative impact it would have on economic activity.

Every policy has a stated goal as well as secondary consequences, some of which are unintended. It is still quite possible that demonetisation will have positive consequences over a longer period—the growth in the direct tax base, the switch in the financial holdings of households from cash to bank deposits, the increased use of digital payments. That is what its supporters are now banking on. The question to be asked is whether the potential long-term benefits will be greater than the short-term costs that the Indian economy had to bear.

The main negative economic consequence of demonetisation has been the disruption of unorganized supply chains that are dependent on cash transactions; it is still not clear how smoothly they were being rebuilt as the economy was remonetized. However, it is also true that the Indian economy did not collapse because of the disruption of the monetary base, as some economists had predicted. There are two possible reasons for this. First, the impact on broad money was far less severe than the effect on base money thanks to the growth in bank deposits. Second, informal contracts to settle financial transactions could have kept economic exchange going during the worst weeks of the cash crunch. The reasons will be debated for many years to come.

There are a few salient lessons to be learnt from this episode. One, the main lesson, is that the Modi government did not seek the advice of experts before going ahead. The strategic decision to surprise holders of illegal wealth would anyway have restricted the circle of those who could be informed, but it seems that the idea came from outsiders with a penchant for quixotic ideas rather than experienced policy advisers.

Two, good policy design should take into account how people will respond to any change in the rules of the game. In other words, incentives matter. Most rational human beings will adjust their behaviour to further their self-interest. Those who had illegal wealth held in cash obviously gamed the cash exchange process. Good incentive-compatible policy design is thus as important as good policy intent. This is a lesson that is relevant in several contexts, but is one of the clear lessons from the demonetisation experience.

Three, political dynamics can be quite different from economic dynamics. That voters have continued to back the Bharatiya Janata Party (BJP) despite the pain imposed by demonetisation shows that the ruling party has gradually redefined its typical voter from the traditional trading base that supported the Bharatiya Jana Sangh to the aspirational middle class that has a lower tolerance for corruption.

Did the government overestimate the benefits of demonetisation? Tell us at

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