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Demonetization Dos and Don’ts

CAMBRIDGE – On November 8, at 8:15 in the evening, Indian Prime Minister Narendra Modi’s government announced that, at the stroke of midnight, all 500- and 1,000-rupee notes in circulation would no longer be considered legal tender, and would need to be exchanged for new 500- and 2,000-rupee notes. Modi’s “demonetization” intervention affected 85% of the money in circulation in India. It was an unprecedented move, whether in India or almost anywhere else, and it is by far Modi’s boldest policy intervention to date.

The Modi government is targeting the “black money” associated with tax evasion, corruption, and counterfeiting, and thus the drug traffickers, smugglers, and terrorists who engage in those activities. India’s tax-paying salaried classes and even the poor initially welcomed the policy enthusiastically, viewing it as sweet revenge against tax evaders who had stowed away their ill-gotten gains; they reveled in anecdotes of corrupt officials burning bags of cash or throwing money into India’s rivers.

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But with each passing day, that initial cheer diminishes. Public frustration is now mounting, because the government has failed to meet the demand for new printed notes. Commerce in India – where the cash-to-GDP ratio is 10% – relies heavily on cash transactions, and informal-economy and small-business operations have now ground to a halt, owing to long lines and tight cash-withdrawal limits at banks and shortages at ATMs.

The near-term impact will be the equivalent of an “anti-stimulus” policy intervention, and the consequent drag on demand will be significant. Moreover, as real-estate prices decline, so, too, will household wealth. Although lower house prices will make new homes more affordable, the stock of occupied homes will far exceed new purchases in the near term, so the negative-wealth effect will overwhelm the gains.

Given these large upfront costs, it is reasonable to ask how effective demonetization is in fighting tax evasion and corruption, and if there is a less costly approach to demonetization.

Back in 1976, in an article entitled “How to Make the Mob Miserable,” the American economist James S. Henry addressed the question of effectiveness, prescribing demonetization as a measure to undermine mafia operations. But policymakers did not take his proposal seriously. Henry’s proposal was, in his own words, “dismissed as either administratively impractical or as a one-shot action that would have no long-run impact on criminal behavior.”

In a new book, The Curse of Cash, Kenneth Rogoff champions the elimination of high-denomination notes in order to fight tax evasion and criminal activity. Rogoff furnishes extensive evidence that making it costly to hoard cash would deter illegal activities. While tax evaders also store their wealth in non-monetary forms, such as land, art, and jewelry, cash remains a leading vehicle for ill-gotten gains, owing to its inherent liquidity. In other words, questions posed by Modi’s critics about the role of cash in feeding stockpiles of black money are misplaced.

That said, Rogoff proposes a different strategy to address the menace of black money – one that would be minimally disruptive and arguably more effective, at least in the long run. That strategy would depart from the Modi government’s intervention in two fundamental ways. First, it would be gradualist, implemented over several years. Second, it would permanently eliminate high-denomination notes.

While this gradualist strategy would not punish existing hoarders, who would find creative ways to recycle their cash in the interim, it is more likely to improve tax compliance and reduce corruption over time, as large-denomination notes are permanently taken out of circulation. India’s current policy of replacing 1,000-rupee notes with 2,000-rupee notes undermines the long-term effectiveness of its policy.

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Moreover, the gradualist approach is administratively practical, minimizes the collateral damage to the real economy and ensures that there is enough time to extend financial services and financial literacy to larger parts of India. Over the last two years, the Modi government has made an impressive push for financial inclusion with its Jan Dhan program, which has facilitated the creation of 220 million new bank accounts. But many people who create accounts do not necessarily use them. A 2015 World Bank study of bank-account usage and dormancy rates across different regions found that only 15% of Indian adults reported using an account to make or receive payments. In this environment, a cash scarcity is economically crippling.

Modi’s policy intervention is bold, and the economic principles motivating it are beyond reproach. But a gradualist approach that includes the permanent withdrawal of large notes would have served the cause better, even if it did not generate the same “shock and awe” as the current policy. This will become more apparent as the large costs to the economy emerge over the next several months.