SUPPOSE that one day the government of a large and fast-growing economy became convinced that its highest priority was to purge the country of black-economy millionaires hoarding piles of illicit cash. Seeking popular approval, it sent the printing presses into overdrive, hoping to inflate away the value of these secret piles of wealth. It worked: rising prices struck a blow against the undeserving rich, and by egging on others to deposit their money in banks (where it could at least earn interest), the shadow economy shrank. The government could plough the newly created money into tax breaks and public-works schemes.
Critics, rightly, would stand aghast. Inflation would affect everyone who held cash, law-abiding or not. Much of the wealth of those enriched by the black economy would be insulated, because lots of their lucre is held not in cash but in property, gold or jewellery. Such heavy-handed measures could undermine the credibility of important government institutions. Fear that they might be used again in future could weaken confidence in the currency as a store of value—paving the way for some broader institutional failure, like hyperinflation. Long-run trust in the judgment of the state might be threatened.
Unlike most currency reforms, designed to boost confidence in the currency, Mr Modi’s motivation is different. The primary aim of demonetisation is reasonable enough: the government hopes to improve the functioning of the economy and boost its tax take by cracking down on the shadow economy. The vast majority of transactions in India take place in cash; many escape book-keepers’ notice. Economists reckon that India’s black economy accounts for at least 20% of GDP. Such off-the-books activity shields fortunes from taxation and allows corruption to flourish. Past efforts to attract black money into the light—using tax amnesties, for example—have had little effect.
Demonetisation forces the issue. Indians can swap their hoards of useless bills for useful ones, but those that cannot present paperwork accounting for their cash piles will receive unwanted attention, and tax bills, from the government. Demonetisation also increases use of electronic and bank-based payment systems, which will make record-keeping easier and more common, allowing government better to track and tax the proceeds.
Yet the government also reckons it can profit from bills that are not turned in. In economic textbooks, money is considered a liability of the central bank—a debt. In most modern economies that debt sits on its balance-sheet, and is offset, on the asset side, by holdings of securities like government bonds. The old and unreturned notes, if they are recognised as cancelled liabilities, would therefore create a huge positive asset position on the central bank’s balance-sheet. The Reserve Bank of India could, if it chose, create new currency liabilities (that is, print money) and transfer that money to the government to spend. Some economists hope the money will be recycled back into the economy through a fiscal stimulus, which might help soothe some of the pain caused by demonetisation.
The status of this would-be windfall is uncertain. If the government allows Indians to redeem dead notes for live ones indefinitely, it is not clear when or if the RBI might recognise cancelled liabilities on its balance-sheet. So far, Indians are depositing their money in the banking system with impressive haste. Of the 14trn rupees ($207bn) invalidated by demonetisation, an estimated 8.5trn has already been deposited. Still, as much as 3trn rupees could remain in the wild as a potential government windfall, reckons a recent analysis by Credit Suisse, a bank.
The other rupee drops
However clever the plan looked on paper, it is both extraordinarily blunt and risky. Demonetisation will probably make only limited strides in shrinking the black economy while affecting all of India’s 1.3bn citizens, the poorest most of all.
In much of the Indian economy, and especially outside big cities, where cash transactions are most common and financial infrastructure least developed, the sudden invalidation of a vast amount of outstanding currency represents a significant monetary shock. Not all of India’s shadow economy—which provides real employment and income, if not real tax revenues—can migrate quickly and easily above board. Whatever cannot easily be shifted represents a potential loss of economic activity, and a drag on broader Indian economic growth. Similarly, if a cash crunch forces small firms without access to credit to shut down, the eventual alleviation of the cash shortage might not lead to an immediate and complete revival of economic activity.
Managing an economy’s money is among the most important tasks of the government. Clumsy use of monetary instruments comes with high risk. John Maynard Keynes, an economist, was echoing Lenin when he wrote in 1919: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.” Trust is fragile, and precious.