8

Demonetization on Five Continents

CAMBRIDGE – Around the world, several countries are currently undergoing “demonetization,” or currency reforms in which the government removes banknotes of a certain denomination from circulation and replaces them with new notes. Governments pursue demonetization for a variety of reasons, and some of the recent initiatives are going better than others.

When demonetization is particularly dramatic and disruptive, it is often a signpost on the road to hyperinflation. This seems to be the case in Venezuela, where President Nicolás Maduro recently recalled the 100-bolivar note, and will replace it with new notes denominated at 500-20,000 bolivars.

Economists define hyperinflation as a pattern of monthly price increases that exceed 50%, which may happen in Venezuela in the next few months. Hyperinflation has been much rarer this century than in the twentieth century, and Venezuela will be the first country to experience it since Zimbabwe in 2008-09.

The current Venezuelan episode continues a long tradition of gross currency mismanagement in Latin American and former Soviet-bloc countries, where past governments used demonetization to transfer wealth from the public to themselves. In each case, the fundamental problem is that the government cannot finance its unsustainable spending through taxation or borrowing, so it resorts to debasing the currency.

The Venezuelan government’s latest “currency reform” may ostensibly be aimed at curbing high inflation. But fundamental macroeconomic reform requires that the government rein in its excessive primary budget deficits, so that it does not have to keep printing money. Barring that, each new demonetization scheme only furnishes more evidence of mismanagement.

But governments also decommission and replace bills for more benign, technical reasons, such as to remove unpopular notes; introduce new counterfeit-proof bills; switch national currencies, such as when a country enters the eurozone; or honor a national hero. For example, in April, United States Treasury Secretary Jack Lew announced that the $5, $10, and $20 bills will be replaced with new designs that include women and civil-rights leaders.

With this form of demonetization, citizens are given enough time to trade in the old bills for the new, and the monetary authorities plan ahead, so that they have plenty of the new currency available. In these scenarios, there is minimal economic and social disruption. When Lithuania left the litas and adopted the euro in 2015, its currency transition went smoothly, as did Germany and France’s adoption of the euro in cash form in 2002, and so on with all 19 countries that have joined the eurozone.

A third form of demonetization is embodied in Indian Prime Minister Narendra Modi’s November 8 announcement that 500- and 1,000-rupee bills – constituting 86% of the cash in circulation in India – would no longer be considered legal tender and should be exchanged for newly issued bills by the end of the year. Since then, the country has been reeling. Indians have been waiting in long lines at banks, only to discover that the banks had not received enough new bills. Some businesses are unable to operate.

India’s demonetization plan was intended as a way to crack down on illegal activities. But its abrupt implementation has inflicted unnecessarily high costs on the Indian economy. The US had similar motives when it phased out bills denominated at $500 and above, in 1969. So, too, did the European Central Bank, when it commendably decided in May to phase out the €500 note. High-denomination notes are often used for tax evasion, bribery, drug trafficking, and even terrorism, so governments use demonetization to frustrate criminal enterprise. As it happens, such prominent observers as Kenneth Rogoff, Larry Summers, and Peter Sands think the US should even phase out $100 bills, too.

This form of demonetization is typically carried out gradually, and in some cases, indefinitely, by simply letting targeted notes wear out on their own. If leaders are brave and want to invalidate a high-denomination note in less than one year, they can ask tough questions of anyone who tries to exchange a large quantity of them. Rather than just making future illegal activities more difficult, they can also strike a blow against people who stockpiled cash from past illegal activities. But imposing a short timeframe requires political will. It will be resisted by non-criminals – everyone from survivalists to grandparents who want to give a crisp new $100 bill to a grandchild for a special occasion.

India’s strategy of rapid demonetization has obviously fallen short, because it was unnecessarily abrupt and secretive. What’s more, the Modi government is targeting relatively small notes (worth approximately $7 and $15, respectively) that all Indians use for all purposes. It should have allowed for more time to print an ample supply of new notes, and to help businesses switch over to non-cash payment methods, such as electronic funds transfers.

Even with more warning, people who had stockpiled the targeted bills for illegitimate purposes would have suffered a loss, if they had been unable to demonstrate to a bank the provenance of their currency. Their other option would have been to offload the bills at a discount in an unofficial market. Most important, by allowing more time, the government could have avoided inconveniencing ordinary people and disrupting the economy.

One possible explanation for Modi’s urgency is that, eyeing the 2017 election in Uttar Pradesh, he was trying to disrupt rival political parties that use cash in their campaigns. If true, that would be a rather cynical justification for what is supposed to be a good-government reform.

Western leaders could probably be bolder when they phase out big bills as slowly as they do. But Modi has been too bold.