The sudden move by the government to ‘demonetise’ needs to be understood in the right perspective. The term ‘demonetisation’ itself is a misnomer. The move is not a demonetisation. The latter refers to the act of stripping a currency of its status as legal tender, when a national currency is retired and a new currency unit replaces it. As history provides a record, such an act had been tried in India in the past as well, with currencies such as the Rs. 1000, 5000 and the higher denomination Rs. 10,000, which existed then being taken out of circulation. In post–Independence India, this was attempted in 1978. In fact, it was under the A BVajpayee government in the year 2000 that the Rs. 1000 note was reintroduced. That a new set of notes of Rs. 500 and Rs. 2000 is being reintroduced, even as you read this article, is evidence enough that there is no demonetisation of the sort pure economics would have us understand.
More importantly, how does the government’s latest move impact the economy — especially growth, the common man and most importantly the two prime targets: purveyors of black money and those of fake currency? As regards the economy, we can experience a short-term impact on consumption. Much of consumption in India is cash-based, in fact quoted as one of the reasons to implement this move, and to nudge people to move on to a cashless economy. Restricting such consumption, through restricting the off-take of cash from banks, ATMs etc on a daily/weekly basis will have some short-term impact on consumption, and through that growth. This is pertinent, since consumption accounts for about 55 per cent of GDP. We may also expect the velocity of circulation of money — i.e. the number of times a unit of currency changes hands to facilitate transactions of various kinds — which is considered fixed in the short run, to increase tremendously in the short run. In a scenario where such velocity is not constant, the relationship between money supply and GDP becomes difficult to predict.
The common man may experience some woes, more psychological than real — on account of lack of understanding of the modalities of the process. As the news got out last evening, there were educated people who felt that they were about to lose their money, unless they took steps to convert to lower denomination currencies on a war-footing. However, once information asymmetries are addressed, the common man may not be bothered much about whether he gets paid in lower or higher denominations. Having said that, as behavioural economists would testify, the tendency to break larger denomination notes leads to a sense of loss aversion, and thereby prevents lesser consumption, all other things remaining the same.
What of black money? A casual conversation with some of the owners of family businesses reveals that only about 2 per cent of the total unaccounted money (which by several estimates accounts for about 30 to 50 percent of our 2 trillion economy) is in the form of currency. The remaining is in the form of gold and real estate. The large unorganised sector will definitely, over time, come up with ways and means of converting this miniscule portion of their wealth into more acceptable forms. What it does in the short run, however, is create a fear psychosis of further retaliatory measures. For instance, a Whatsapp message doing the rounds, which several people sought clarification from each other, was that of a smart chip embedded in the Rs. 2000 notes, useful in identifying tax offenders. Such a change in the mindset may work at multiple levels — it may trigger more complex and stylised versions of holding unaccounted money; may further push money into gold and real estate, thereby diverting savings away from financial savings and thereby affecting investment; it may also, partially, get businesses to systematise at least part of their operations.The one group, which will definitely be impacted, is that of the counterfeiters. The withdrawal of the old series will put fake currency notes out of circulation, at least temporarily. The success of the move would depend on the administrative measures undertaken to prevent such counterfeiting. Thus, while the current story is one of the Emperor’s new clothes, none willing to completely slam the ‘honest’ moves of the government, it is an experiment worth watching for its results. At the end of the day, it may simply be a case of the market forces working to restore ‘equilibrium’.
Author is a Professor of Economics at SPJIMR, Mumbai. Views are personal.