We need a cash economy for stability
Demonetisation failed to achieve any of its stated objectives. Instead, it severely hit the poor
If there is one defining economic policy that the NDA government has come to be uniquely associated with, it is the demonetisation that was announced on November 8, 2016. Prime Minister Narenda Modi addressed the nation in a televised speech that evening to announce that at midnight, all currency of ₹500 and 1000 denomination would cease to be legal tender.
His tone underlined a degree of financial emergency. The explicit purpose of the measure was to rid the country of “kala dhan” or black wealth. But there were some other objectives as well. The move was a strategy to curb terrorist activity and to put a check on counterfeit currency notes. But the main purpose of this measure was declared to be to strengthen the hands of the common man in the fight against corruption.
The moot point is whether any of the objectives stated above have been realised to any appreciable degree. The answer is in the negative. Holders of these notes were given a certain amount of time to deposit the money in banks and obtain cash in other denominations, and a new ₹2000 note was soon circulated.
There was a deep conceptual error behind the move which held that individuals with “kala dhan” would not return to banks to deposit the 500 and 1000 rupee notes in their possession. The amount of currency not deposited back would constitute a net gain to the banking system.
The reality was otherwise. Barring a tiny fraction of these currency notes, virtually all of it has returned to the banking system. This is proof enough that the strategy of trying to identify black wealth with high-value currency notes was a failure.
It would be erroneous to think of “kala dhan” as a stack of currency notes. It may be more useful to think of the flow concept which suggests that an activity may be regarded illegal or ‘black’ if it evades taxes.
The real difficulty with the move was the sheer scale of the misadventure. It hit 86% of the value of currency in circulation and, therefore, instantly crippled the economy. The entire range of farming, construction and informal sector, for example, run on a cash basis, and they affect the vast bulk of the population. This particularly hit the poor and the vulnerable. Across India there was a sharp fall in the prices of agricultural goods in all the major mandis, which hit farm incomes in an unprecedented manner.
The only other experience of demonetisation in independent India was in 1978 when ₹1000, 5000 and 10,000 denomination currency notes were flushed out. Morarji Desai was prime minister and HM Patel was finance minister, while IG Patel was governor of the Reserve Bank of India. The latter was known to be against the move. In total, the demonetised notes constituted barely 1.78% of the total value of notes in circulation. It was hardly noticed by the general public.
The contrast with 2016 is obvious. Both ₹500 and ₹1000 currency notes, especially the former, were in common use. The impact of demonetisation was too abrupt and arbitrary. It crippled the vast range of economic activities in the informal sector, leading to huge job losses.
The slowdown in the GDP growth rate is proof enough. The GDP growth rate in the past quarter has been down to a low of 5.7%, from the high of more than 7%, which had put India among the fastest growing major economies of the world.
When the demonetisation strategy was found to lead to a dead end, the government changed the narrative to the desirability of a cashless, digital economy. There is nothing in economic theory that suggests that one should eschew cash. There is a substantial body of economic theorising that provides a clear rationale for the use of paper currency. A cash economy is desirable because it facilitates exchange and encourages economic activity. Cash can be used as a store of value and it also enables agents to conduct their economic activities with greater stability.
While the declared purpose of demonetisation was to penalise those among the rich who evade taxes, in reality it hit the poor in the informal sector, many of whom lost their source of livelihood. The political narrative however was presented with such consummate skill that the strategy became a major political weapon in the hands of the government. The result of the UP election goes to show how Modi was able to convince the common voter that the measure was ultimately for her good even while jobs were being lost and GDP growth rate was shrinking.
One final point: There was hardly any transparent consultation of this rather momentous decision. From all accounts, the top most functionaries in the ministry of finance and the RBI were not kept in the loop. This raises serious and disturbing questions regarding the nature of decision-making in our parliamentary democratic system.