David R. Henderson  

India's Assault on Money

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In our 5-minute discussion in class on Wednesday, a student asked me about the implications of the Indian government's crackdown on people holding high-denomination currency. I didn't know much about it and gave a so-so answer. Now I know more.

This piece lays out some facts and some of the ominous implications.

Some highlights:

About 85% of all currency in circulation has just been turned into coupons that can only be exchanged in specific places. These notes can be converted into currency again only with identity proofs (which hundreds of millions don't have) and the additional hardship of standing in many queues for many hours.

Over half of India's population doesn't have any sort of bank account at the moment and about 300 million don't have basic ID such as Aadhaar either and hence, cannot access the banking system at all. About 130 million Indians have mobile wallets (about 25 million have credit cards) and there are maybe 550-600 million debit cards in circulation. So access to cash is very, very important for average Indians.

One possible implication:
The move to demonetise will hurt the very rich in absolute terms but it will mean marginal damage to their assets. It will impact the middle class in terms of inconvenience for several months. It will gut the very poor and the lower income groups. These are people with little in the way of ID proof and they often keep cash stashed under the bed because they have no bank accounts.

Your domestic worker, whose ID (if she has one) says she lives in a village a 1000 km away. Your driver, who saves a chunk of his salary and sends it home to his family. The disabled flower seller/beggar at the traffic lights. The 12-year-old selling pirated books who ran away from an abusive home. The waiter--cum-delivery boy at the local dhaba. The massage parlour therapist. These are the people who will get really badly hurt. They all have high proportions of their income stashed in cash and they will have to pay large sums under the table to legitimise it.

Here's what I wonder. If Kenneth Rogoff, the U.S. economist who would like to get rid of cash and, indeed, thinks it's a curse, could push a button affirming this particular Indian government move, would he push it?

HT2 Shikha Sood Dalmia.

Comments and Sharing

CATEGORIES: Monetary Policy , Money

COMMENTS (10 to date)
David writes:

Interesting. Most of the discussion I have seen on this topic from Indians has been widely positive, so it is nice to see a piece from the other side.

I think the assumptions in going forward with this action were that the poor and undocumented didn't hold significant amounts of high denomination bills. On the face of it this assumption makes sense to me, from what I know of India, I don't think the '12-year-old selling pirated books' has a stash of cash under his mattress, in fact he probably doesn't have a mattress of his own, and rents one from his earnings that day. The question is if there is a population on the margin of the transition from poor to lower middle class, who may be making an effort to move up in status though saving (cash), but do not have a bank account, and can't easily obtain one. When described that way, you would say yes, there must certainly be some of those, the question is how many.

I guess we will see over the next months how many; in the strain placed on banks and the government to document and provide banking for these people. Knowing the painful functioning of indian bureaucracy, I am sure there will be a mess, but hopefully we can see if there seems to be more people demanding documentation then are able to be provided in the timeframe allowed, and try to determine what that means. (I would point out that there will be a massive effort to launder the black cash in the system, and the poor, being numerous, will be the mules of this laundering, so people looking to make a profit in this opportunity will also be asking for accounts for this reason . . .)

EB writes:

David, thanks for the link to the Scroll's article by D. Datta. Indeed, it's very difficult for outsiders to understand how the various systems of payments of any economy work, particularly a very large country's economy (in January 1994, I moved to Beijing and for my own work I needed to understand China's systems of payments). Unfortunately, systems of payments are ignored in monetary economics, as any one that has written lectures notes know. Thus the consequences of any disruption in systems of payments are difficult to analyze but we know from experience that the short-run effects are large enough for governments to take immediately preventive or corrective actions (for example, look at what happened both in New York the day after 9-11-01 and in Argentina three months later under the infamous "corralito").

In the history of systems of payments we can find some instances in which governments attempted to collect seignorage by replacing part or all the stock of currency in circulation (this "stock tax" is different from "the inflation tax" to finance the deficit). Although there is always a "good" excuse to do it ("to get rid of bad people" is as good as "to finance the revolution"), that replacement is hardly effective to achieve it and actual seignorage is likely to be much lower than anticipated.

In India, the government's attempt to get rid of bad people by collecting seignorage from them will disrupt the economy's systems of payments. The disruption may be large enough to force the government to restore the old system quickly.

David R. Henderson writes:

I hope your last sentence is correct.
Re your point about systems of payments being ignored in monetary economics, I have sat in on some of Professor Jeffrey R. Hummel’s classes at San Jose State University, and he talks a great deal about such systems in U.S. monetary history.

Thomas Sewell writes:

Talking to coworkers in India, it's seen as a disaster by those on the street. 1000rs bills are exchanging for 500-600rs in smaller denominations, so it's a huge transfer of wealth from the unbanked and black market participants to those who can justify and turn in the bills.

One interesting point has been the timing, coinciding with the U.S. election, which is apparently very popular to bet on in India, but illegal. Many more people than usual were holding cash as a result of the election betting.

If at most you are legally allowed to turn in 4K rs to the bank in a day (or face a 20% tax), or about $60, then anyone dealing in large quantities of higher denomination cash is currently hard-pressed to find an outlet for it. Also, when you turn it in, you must justify where it came from, which is going to be difficult to do for many.

Will make for a lot of future economics papers, but not so great for the population of India.

Shreyas Bharadwaj writes:

The 'aadhar' card coverage in India is quite wide. D. Dutta is exaggerating when he says millions will be inconvenienced. Not more than a few hundred thousand will be inconvenienced even if they dont have bank accounts.

More than anything, it is a political move. The elections for a few important states are nearing and the opposition parties would have soon started spending their illegally earned money to buy votes. Demonetization has made that difficult and bankrupted many politicians in the opposition.

The Indian left wont be a credible political force for another few decades. Given how we've suffered due to them for over 60 years, I'm glad Modi did this.

Roger Sweeny writes:

The affected bills may be "high denomination" in that there are no higher denominations but a 500 rupee bill is only worth $7.50 and a 1,000 rupee bill is only worth $15.00.

karimpootam writes:

> I think the assumptions in going forward with this action were that the poor and undocumented didn't hold significant amounts of high denomination bills.

You're mistaken. These are not *that* high denomination bills. A lot of labourers get their weekly/ monthly pays the 500 notes. The daily wage rates vary in different regions of the country, but going by this report, the all India average daily wage rate in rural India was around Rs. 260. In certain parts of the country, the wage rate is much higher, and a lot of the people earning at these rates are undocumented migrant labourers with almost no experience of the banking system.

The issues with this move for a lot of these folks is not in converting a hoard of savings into deposits. It's to convert their cash in hand (in the organized sector a lot of these contract labourers get paid around 7th/8th of the month, and would have just received their salaries when the government announcement aired) into usable currency notes. There's a thriving trade in conversion, you can get Rs.300 or Rs.400 in valid currency when you exchange your invalid Rs. 500, so a lot of these people are probably currently paying a one-time tax of >20% on their spending money.

Also a lot of the not-desperately poor do keep their savings at home. A lady in my maid's neighbourhood has been scrimping and saving for years for her son's education and wedding. She has no paper trail to prove where this money comes from of course, but it *is* higher than the amount that's allowed to be deposited without attracting a tax penalty. She too will probably find a way around this move by paying a certain % commission on her savings, but as of now, she's quite upset about the whole thing.

It's true nobody knows how many such people there are.

Ethan writes:

The 1000 and 500 notes are no longer legal tender, but I wonder if they will still trade? I'd love to hear from someone in India if these notes are still being accepted for exchange, or not. The chance of the notes continuing to circulate is slim, I'd guess, but not a zero chance.

karimpootam writes:

I guess the answer will be different in different parts of India.

In my area, only some pharmacies and fuel stations are accepting the currencies. Pharmacies, petrol pumps, railway stations etc. are supposed to accept these notes till 24th November (this deadline has been extended by the central government twice already). However, they too only accept these notes if you make big enough purchases since they're running out of change. A nearby pharmacy refused to take 500 rupees for any transaction less than Rs. 400 in value. Petrol pumps expect you to fill up for the entire value of these notes. Electricity bills are also supposed to be payable in the old notes, but a neighbour reported that she was asked for id papers before she could pay - this was certainly never a requirement before.

The situation is much the same in a neighbouring state where my parents and extended family live - all of these are largely middle-class localities.

Some transactions are being done on credit at the neighbourhood level. This report rings true: http://indianexpress.com/article/explained/demonetisation-utility-bills-household-bill-4375665/

Garvit Sharma writes:

The present situation of providing new money is heavily skewed towards cities as usual. The government had ordered post offices,police stations to start exchanging notes but how can they when there is no supply at hand. Rumour mongering is rampant because of social media and rs 10 coins are not being accepted. Situation in cities is bearable but villages are sitting on harvested crops to sell in the markets and returning empty handed.wholesale markets of delhi have started seeing flight of migrant labourers to their homes for loss of trade and various reasons linked to demonetisation. Worst part is the poor's loss of wealth as stated above in the comments as well as them falling on credit at ostentatious rates to local lenders who themselves are feeling a lot of heat. Banks as of today have been running out of money in two-three hours in my city meerut. Government banks today outrightly have been refusing service to people who dont have accounts in their banks.

I am not a good enough seer to look into the future to predict any long term improvements in productivity of the economy which has been cited in various places but right now the damage to human capital has been huge. At least 20 people have already died because of this move to wipe out unaccounted wealth from the system.

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