note demonetisation

Is Modi’s move to scrap high-denomination notes more about politics than economics?

Economic theory offers little or no guidance as to the impact such an action would have.

The government of India’s decision to abolish high-denomination notes of Rs 500 and Rs 1,000 has been given two primary rationales. The first is to address a problem of counterfeiting, suggested to emanate from across the border, and the second is to address the problem of ill-gotten gains resulting from corruption or tax evasion. The dramatic nature of the announcement of the move, giving rise to an appearance of determination and decisiveness in government, and the claim that popular social goals were being pursued, appear to have generated initial support for the action (such as on social media). However, how wise an approach to addressing these problems is it?

Fundamentally, the abolition of high-value notes involves the application of a blunt instrument of uncertain value. Economic theory offers little or no guidance as to the impact such an action would have, and effects on the proclaimed goals could be counter-productive, with some groups being harmed for no fault of theirs, while undermining the ultimate promise of governmentally issued money that it is a reliable medium of transactions and source of value. It is far from clear to what extent the government’s decision was based on a careful study weighing the consequences.

Consider the idea that foreign terrorists use counterfeit cash to finance their operations. If they can bring in counterfeit cash, then do they not also have access to foreign currency abroad which they can transmit with hawala methods, or indeed can they not smuggle them outright and exchange these in the black market within the country? What about the idea that counterfeit notes are being systematically and intentionally used to destabilise the national economy? There is nothing to stop currency notes in circulation being instead gradually, or indeed rapidly, replaced through central bank operations, as routinely and continually done in all countries to substitute for ageing banknotes.

What of the idea that the elimination of high-value notes will make it harder for officials and politicians to engage in corrupt acts, or for citizens to engage in tax evasion? Corrupt acts are of innumerable types and the quid-pro-quo can take the form, depending on the size and nature of the corruption involved, of delivery of in-kind benefits, transfers of title, or indeed payment in precious metals, larger numbers of small-denomination notes, the new high-denomination notes to be introduced, foreign currency or crypto-currencies, especially if willing intermediaries can be found.

No one who has experienced or studied the creative character of corruption in India and worldwide should doubt the ability of the interested parties to find such workarounds. A supposed technical fix is no substitute for multi-pronged solutions to complex institutional and social problems.

Although there has been a move elsewhere in the world to eliminate high-value notes because of their use in criminal activities, notably in Europe where the European Central Bank has prominently pushed for such a measure, it has been resisted in Germany and in other eurozone countries, where cash plays a very large role in legitimate transactions because the public is credit-shy and values anonymity.

By introducing a new Rs 2,000 note the government has in any case muddled its message. Will the move either punish previous wrongdoers or prevent future wrongdoing? It is unlikely to punish previous wrongdoers because cash proceeds of corruption are likely for the most part to have been redirected into other assets of one kind or another, perhaps abroad. If they are still in the form of cash, it is plausible that intermediaries will be found to funnel the resources into new banknotes, for a fee. The move is unlikely to prevent future wrongdoing both because other routes will be found for transactions and because, to the extent it reduces the wealth of the corrupt, it may even provide a spur to further corrupt activity to make up the losses.

Distributive consequences

What of the distributive consequences? In a country as diverse, complex and uneven as India (features readily forgotten in today’s media-driven universe) it is wholly probable that some will hear the message too late, not know how to go about making exchanges, or not have the required forms of identification or bank accounts for exchanging more than the still-modest maximum of Rs 4,000. If they must rely on intermediaries, they will pay direct and indirect costs, and even risk losing all of their cash.

Such difficulties are likely to be faced especially in the rural sector, among the socially vulnerable, and the illiterate. The effect on the holdings of the elderly and women who are less likely to be able to engage in direct transactions with banks, may be sizable, but there is little basis to know what it will be. One wonders if the RBI made the requisite studies and what role they played in the decision to proceed. The costs of the exercise in terms of the time of bankers and citizens are likely moreover to be enormous. Is a cavalier attitude toward their time that of an India “open for business”?The likely impact on aggregate demand of the destruction of wealth may have been judged small, but is in fact unknowable.

To summarise, those who have means and determination to evade taxation, hide ill gotten gains of corruption, or finance terrorist activities, have had and will have other routes. The one objective that the move might possibly help with more substantially is to reduce the general impact of counterfeiting, but that goal could have been better handled through a progressive replacement combined with a call for greater public and institutional scrutiny of older high value notes.

The draconian move will generate huge disruptions and possible adverse economic consequences despite its presentation as a “surgical strike”. Moreover, whether this step has furthered the government’s purported goals is unverifiable, which will make it easy for it to claim success regardless of the disruptions entailed, and to sustain the notion that the government is bold and decisive.

One is left with the feeling that this action may be, quite apart from any sectional political calculations which might be involved, motivated by the desire to create a high level of political mobilisation – the enactment of the idea of the nation as a daily plebiscite – in which all who exchange cash will participate. In doing so they will indirectly bow down before, and affirm, the narrative of the government. One can only hope that enough of them will, despite the initial unthinking plaudits, maintain the independence of thought needed to raise essential questions.

Sanjay G Reddy is an Associate Professor of Economics at The New School for Social Research.

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The Amazon Fire Stick
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This article was produced by the Scroll marketing team on behalf of Amazon.in and not by the Scroll editorial team.