Till the 17th century, money was mostly commodity money such as gold or silver, which was prized by most people and, hence, had a known ascribable value. This became the basis of exchanges of goods and services among people. Since metal coins were not always easy to carry and as transactions became bigger and many, the merchants started issuing promissory notes against them. To bring order into this system, the states evolved central banks to regulate and monitor the system.
Soon, central or designated banks became the sole issuers of such paper or notes. Even though valued commodities like gold and silver were the physical collateral on the basis of which these notes were issued, the credibility of the note issuer was central to its success. It soon evolved that more than the collateral, the credibility of the central bank was crucial to ensure that it could issue notes way beyond the value of the gold and silver held in its vaults. This system became so enshrined and as the credibility of central banks kept rising, it was inevitable that the direct linkage to gold and silver ended.
Even the residual linkage ended one day in 1974 when United States President Richard Nixon delinked the dollar from bullion. Soon, other central banks followed suit and the value promised was mostly related to the dollar, and trust and credibility were the only collateral against which people and associations transacted with their notes – money. In this way, the trust in the words on every multi-denomination rupee, “I promise to pay the bearer the sum of...”, is it’s only worth.
The original objective of central banking was monetary and financial stability. Following the Great Depression, a severe economic crisis that started in the United States and spread across the world in the 1930s, and the post-war Keynesian revolution, macroeconomic stability became the main objective. Even more so when gold was not the anchor to prevent value from drifting. Thus, credibility mattered even more.
The great fall
India’s central bank, the Reserve Bank of India, came into being on April 1, 1935. The general superintendence and direction of the Reserve Bank is entrusted with a 21-member Central Board of Directors: the governor, four deputy governors, two Finance Ministry representatives, 10 government-nominated directors to represent important elements from India’s economy, and four directors to represent local boards headquartered at Mumbai, Kolkata, Chennai and New Delhi. This spread of representation is meant to ensure that all sectoral and regional interests are considered in its policy making.
Inevitably, a degree of political patronage soon began emerging in the choice of persons on the Reserve Bank’s board. Some clear undesirables managed to get in due to political patronage, but the professional stature of the governors ensured that extraneous considerations were filtered out and even the government was kept at an arms length from the institution. This kept intact the vestment of professional credibility that is so integral to its everyday stewardship of the nation’s macroeconomic situation and control over the banking sector.
But it seems to have slipped somewhat from that lofty perch after the departure in 2016 of former governor Raghuram Rajan, who returned to his tenured faculty position at the University of Chicago’s vaunted economics department. I personally think Rajan preferred to keep the Reserve Bank’s and his own credibility intact rather than bow down to political directions.
To be sure, Rajan’s successor and current Reserve Bank governor Urjit Patel has the professional qualifications, but the stature and competence needed to ensure the nation’s continued trust and to stave off unwanted and even incompetent pressures mostly comes only with time, and often never at all. Consider this. A secretary-level official of the government of India headed the selection committee that chose him to this exalted position. It is important not to forget that while the Reserve Bank is a part of government, it must not be seen as a creature of the government that does as told.
Prime Minister Narendra Modi is not only a social radical but somewhat of an economic radical also. He has a well-known propensity to impose his will on others, and as long as it works, it seems good. Even the gods are known to be fallible. Hence, in an open political and market-driven economic system government by fiat is undesirable and near impossible. But in this case, it has clearly boomeranged. Instead of being a swift surgical strike, it turned into a carpet-bombing of many vital sectors of the economy.
This clearly begs the question as to what the custodian of our financial integrity and macroeconomic stability, the Reserve Bank of India, was doing when the axe descended on the nation? Clearly, it was not a part of the decision. It was peremptorily ordered to do what was done in its name. The pretence of the Reserve Bank deciding this step was clearly abandoned when the prime minister personally made his dramatic announcement on November 8 last year.
Demonetisation is an extreme step. It usually happens when an economy has become chaotic and is on the verge of financial anarchy, and/or when values of currency plummet. Runaway hyperinflation is a typical condition when the bitter medicine of demonetisation is administered. By demonetisation, you strip a currency of its utility as legal tender. As we saw not very long ago in countries like Russia, where multiples of the old ruble were reissued as new rubles.
Demonetisation when inflicted on an economy that is relatively orderly and growing, as it was in India, becomes an act of vandalism to disrupt it. Even if the pile-up of high-denomination notes with some people and their integrity was a cause for concern, less disruptive means were available. For a start, the exchange of old Rs 500 and Rs 1,000 notes could have been more orderly by giving people a comfortable period of time for this.
Suppose we had fixed May 30, 2017 as the cut-off date for the exchange of old notes with new notes, most if not all the cash in the parallel economy would have still come to the banks with the required details of the depositor. This would have ensured the orderly withdrawal of old notes and their replacement with new ones without the collapse of economic order that we have recently seen. Of course, we will get out of it. But what is lost is lost forever.
And the problem is that much more has been lost. The Reserve Bank of India has lost a good deal of its most prized asset – credibility. What is a holder of a rupee supposed to think of the worth of the Reserve Bank governor’s promise to pay the bearer a promised sum on presentation at any place where such notes are meant to be exchanged? Clearly, the Reserve Bank governor has lost face and the institution has had its credibility whittled down.
Mohan Guruswamy heads the Centre for Policy Alternatives, New Delhi, an independent and privately funded think-tank. He is also a Distinguished Fellow at the Observer Research Foundation, New Delhi