Dormant for a while, the debate over India’s demonetization program of last fall has been revived by new evidence. The new evidence on note returns and GDP vindicates the critics and has the defenders in strategic retreat.
What Happened
To recap: On November 8, 2016, India’s Prime Minister Narendra Modi shocked the nation by announcing the immediate “demonetization” of the two largest rupee currency notes (Rs 500, worth about $7.50, and Rs 1000, worth about $15). Noteholders would have only 50 days to turn them in for new Rs 500 and Rs 2000 notes. The move, Modi promised, would sharply penalize holders of unaccounted “black money,” namely tax evaders, bribe-takers, professional criminals, and terrorists. Their currency hoards would become worthless — a welcome one-time wealth loss — or they would expose themselves to detection by trying to swap or deposit large batches. Anyone depositing a large sum in old notes would face scrutiny by tax authorities.
In order to keep the move a surprise (the better to catch the black money holders), new notes to replace all the discontinued notes had not been printed in advance. The canceled notes represented 86% of the currency in circulation, and more than half of M1 (currency plus checking deposits), India having a highly cash-intensive economy with half the population unbanked. As criminals were far from the main users of currency, the impact was unavoidably felt well beyond the black-money set. A serious currency shortage immediately arose, with predictable consequences. Honest wage laborers in the huge cash economy went unpaid, honest construction projects came to a standstill, honest shopkeepers saw sales dry up, and honest businesses failed. Honest people wasted billions of hours waiting in queues to exchange old notes for the trickle of new notes.
As Shruti Rajagopalan and I noted in November last year, there was also a fiscal angle: for every billion of old rupee notes not turned in (for fear of being scrutinized), the government could issue a replacement billion and pocket it as one-time seigniorage revenue. For example:
If 20% of the old notes are never turned in, the government’s revenue windfall is up to Rs 2.9 trillion ($42.5 billion).
The destruction of the private wealth of non-redeeming old-note holders, combined with the revenue windfall to the government, makes the currency policy effectively a large capital levy, a massive one-shot transfer of wealth from the private to the public sector.
We speculated: “The wealth transfer to government may help to explain Prime Minister Modi’s enthusiasm for the currency cancellation and re-issue, despite its likely ineffectuality against black money.”
Economically literate defenders of demonetization have been fewer than critics. The most prominent defenders have been the well-known trade economist Jagdish Bhagwati of Columbia University together with his former students Vivek Dehejia and Pravin Krishna, and with his Columbia colleague Suresh Sundaresan.
The Defense
In a December 2016 piece in the prominent Times of India, Bhagwati, Krishna, and Sundaresan (hereafter BKS) praised the demonetization program as “a courageous and substantive economic reform that, despite the significant transition costs, has the potential to generate large future benefits.” BKS recognized that “the process is inconvenient, and subjects many households to hardships,” but thought it worthwhile for “potentially increasing transparency and expanding the tax base and revenues to the government from taxes and surcharges.” The fiscal angle was foremost: since “unaccounted deposits will be taxed, this will yield a windfall for the government permitting large increases in social expenditures.” In addition, it would promote a “switch into digital transactions” and “put a major dent in counterfeiting.”
