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Regular Demonetisation of Paper Money is a Stupid Idea

Nov 17, 2016

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On November 8, 2016, Modi announced the decision of the government to demonetise notes of Rs 500 an Rs 1,000. Several economists have made suggestions since then on what the prime minister Narendra Modi, should be doing next to tackle the huge amount of black money in the country.

One suggestion has been made by Soumya Kanti Ghosh, the group chief economic adviser of the State Bank of India (SBI), the largest bank in the country. In a column in the Business Standard titled Demonetisation and Note Burning and dated November 15, 2016, Ghosh wrote: "We suggest that this demonetisation may be carried out over periodic intervals with the surprise element and the government makes its intention clear on that. In such an eventuality, people will be discouraged to hold cash."

What Ghosh is essentially saying here is that the government should carry out regular demonetisation of currency in the years to come. This basically means that the government should regularly make old currency useless and introduce new currency. He also suggests that the government retain the surprise element of the move like it did this time around.

This means that one fine evening (or morning or afternoon for that matter), the prime minister should suddenly announce to the nation, like he did this time around, that the high-denomination notes are basically useless now and new ones will be introduced. Ghosh hopes that by doing this people will be discouraged from holding on to cash. In the process the economy will move from being an "informal economy to a more formal economy". In simpler terms, it means that the black portion of the economy will come down.

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This I think is a stupid suggestion. Allow me to explain.

Paper money doesn't have any value on its own, like various other forms of money like gold or silver, have had over the years. The Rs 10 note is not very different from the demonetised Rs 500 note except for the colour of the ink and the amount of paper used, to make it. The difference in the value of the notes is clearly not Rs 490. A Rs 10 note has a purchasing power of Rs 10 because the government deems it so. And so was true for the Rs 500 note, before it was demonetised.

So what is paper money? It is primarily a token deemed to have a certain value by the government and which everyone accepts and is used to carry out transactions in the everyday economy.

Without enough paper money in the economy, people can't carry out transactions and the economy comes to a standstill. This is what is happening right now all-across the country. Mobile phone sales have collapsed. People aren't buying two-wheelers. Restaurants are deserted. And normal taxis are not getting enough business. The farming economy has slowed down tremendously. Daily wage workers like plumbers and electricians are not getting enough work. For more examples, you can open any newspaper and there will be enough stories there. Generally, business is slow.

This isn't surprising given that close to 86 per cent of the currency by value has been rendered useless by the demonetisation move. Of course, this wouldn't have mattered if Indians were used to transacting through debit cards, credit cards, net banking, wallets and so on. The show would have gone on.

But that has not happened. India is a country where a bulk of transactions are still carried out in cash. An estimate made by the Fletcher School at the Tufts University in the United States, said that in 2012, in India, 86.6 per cent of the transactions by value were carried out in cash. While this figure would have come down since then, it would still be at a very high level. In comparison, card transactions stood at 4.1 per cent of the total transactions. The electronic transactions stood at 6.8 per cent. Another research paper titled The Cost of Cash in India points out that "the ratio of currency to GDP in India (12.2%) is higher than countries such as Russia (11.9%), Brazil (4.1%), and Mexico (5.7%)".We can be prude about the matter and say that people should move away from cash, but societal habits are not easy to change. Given this, high importance of cash in our lives, it isn't surprising that business in all kinds of markets has come down substantially. There isn't enough token or paper money going around for people to carry out these transactions.

The only way to tackle this is to put out enough new money into the financial system in order to replace the old money. This will ensure that people will go back to carrying out transactions and businesses will go back to being normal again. But this is easier said than done.

Economist Saumitra Chaudhuri writing in The Economic Times said that "the timeline to replace the existing stock of 1,658 crore pieces of Rs 500 notes will run into May 2017." He arrives at this number taking into account the printing capacity of the existing mints. This basically tells us that the implementation of the demonetisation move wasn't really thought through. As usual we have managed to screw up on the implementation bit. And this has created problems in the everyday economy.

The basic hope of Ghosh of SBI is that with frequent demonetisation people will get on to other more formal mechanisms of paying than cash. That is likely to take place. But what will also happen is that more amount of black money will now quickly move into gold. There is nothing stopping that from happening.

And the thing is that India produces almost next to no gold. We import almost all of the gold that we consume. This has its share of repercussions on the balance of payments and the rupee dollar exchange rate.

But there is a bigger worry. All paper money essentially works on faith. This faith leads people to believe, that a piece of paper with some ink, digits and promises on it, is basically money. It is this faith which leads people to believe that a Rs 10 note has a purchasing power of Rs 10 and a Rs 100 note has a purchasing power of Rs 100, though essentially there isn't much difference between the notes.

This faith is what basically keeps paper money going as money. I know for sure that when I use rupees to pay for goods or services, they will be accepted by others. And this is what keeps the economy going. If this faith breaks down, paper money breaks down. People move on to other forms of paper money or simply gold.

Let's look at some evidence of what regular demonetisation does to an economy. One country which has gone through regular demonetisation of a large scale is Myanmar (or Burma as it is more commonly known as in India).

As the Federal Reserve Bank of San Francisco points out in a document titled Burma-Paving the Road to a Modern Banking System: "After the 1962 coup, the government installed a socialist economic system and nationalized all banks, including foreign banks. Subsequently, three major demonetizations occurred in 1964, 1985, and 1987. In the latest 1987 demonetization, the Ne Win military regime effectively declared about 75 percent of the cash in circulation illegal and eliminated three banknote denominations without exchange or compensation. The demonetization eroded most of the populace's savings and resulted in widespread protests and the 1988 coup. Demonetization coupled with rampant inflation in the 1990s has led to the retainment of little faith in the storage value of the kyat. As a result, the economy is partly dollarized."

While, the Indian demonetisation is nowhere as extreme as the ones in Burma, but the part in italics in the above paragraph is what is important. Regular demonetisation has led to people having little faith in the Burmese currency kyat. Hence, people prefer to deal in dollars rather than the local currency.

This is something recounted by a writer on the National Public Radio website: "[In 1987]... the country's leader created new bills overnight in denominations that were multiples of nine - his lucky number... So people started to sock away their extra money in U.S. currency. And when your life savings is a few U.S. $100 bills, you want to keep them pristine."

Regular demonetisation can lead to people losing faith in the country's currency and moving on to dollars. And that is something no Indian government would want. Other than losing control on the monetary policy, it is going to have other repercussions as well. In the Indian case, more and more people will simply move to gold, given our love for the yellow metal.

Once this is considered, the suggestion from the chief economic adviser of the country's largest bank, seems rather silly. The only possible explanation for it perhaps lies in the fact that he was perhaps trying to please his political bosses.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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26 Responses to "Regular Demonetisation of Paper Money is a Stupid Idea"

Ram

Dec 6, 2016

This is one stupid banker who does not know the difference between banking & economic policy. They should stick to banking.

Like 

raghavendra bhat

Dec 6, 2016

Sir, Regular demonetisation is a stupid idea I agree, but I am also disappointed with your views regarding comparing india with much below rated country like burma. Another important thing you have not mentioned is fake currency used by terrorist group has come down drastically. One thing is sure that Modi has taken what is best at present, and thinking best future also. This is my point view regarding u.r. readable good article

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Shubha shukla

Nov 22, 2016

Regular demonetisation is a stupid idea I agree, but I am also disappointed with your views that people are facing lot of problems .l am surprised that you write an article based upon news paper reports .people from all strata and economic Background are managing well.my three domestic helps have have no grudge .i have been following you since your DNA days , and this is most absurd article from you .reach out to people to find out how wellbthings are going

Like (1)

suhas doshi

Nov 20, 2016

Remarks on the article are not visible yet post closure for maintenance.

Like (1)

subramani

Nov 18, 2016

This The demonetization eroded most of the populace's savings and resulted to heavy protests, this act seems to be a foolish act that, one man like to eradicate bedbugs may act to fired his full house, like this mr. modi, do this to eradicate forfeited money of 0.001% and about 400 crores of black money he simiply do this idea tic action, to prevent,and curb black and forfeited currencies in india, this resulted into heavy casualties to common man of india, whose suffering un affordabale loss to run his day today life, even to a bread, this will resulted in the coming by-elections and U.P. and Punjab elections where modi and his BJP will be eradicated from politics.

Like (2)

sshri

Nov 18, 2016

Mr Kaul, please give your article a second thought.
- Consider, that the security features of every currency will not last more than 6-7 years.
- By that time, there will be some fake currency who would have caught up with most security features.
- RBI should introduce a new design in the timeframe, even if they are 500, 1000, 2000 or some other denomination.
- In such a case, the new note may be introduces, and the OLD withdrawn, demonitized whatever you want to do.
SO WHAT has been suggested is PLAN FOR IT...

Now about cash entering into Property and GOLD there are various suggestions I can give... but will restrict myself to simple ones...
- Housing Finance companies be allowed by LAW to open Mutual Funds, that can purchase property at 5% higher than the price at which it is REGISTERED, within 1 week of any registration. Seller cannot complain (getting higher price) and buyer will hesitate to part with BLACK money before registration.
- Of course it will require some infrastructure in terms of PUBLICATION of some part of registration information say on the WEB, but these should be public anyway.
- The purpose of Mutual Fund is that general people can invest, and the investors can keep an eye. The Fund has to get rid of the property in say 1 month. THIS WILL CLEAN UP REAL ESTATE...

Detailed proposals have been forwarded, but the essential principle is
- if a behaviour is beneficial to the involved parties (such as BM is to buyer and seller) then it will happen. Here we have introduced another INVOLVED party who is the Mutual Fund, who will profit at the expense of the earlier parties, in case the transaction involves a lot of BM.

Similar approached can be used for other asset classes... let me see if you can work it out...

regards
BTW: what happened to the triology, I enjoyed Part 1.

Like (2)

SK Gupta

Nov 17, 2016

First of all, you say that the idea put forth by Ghosh is stupid. This is not in good taste. He has put forward his thoughts and we are free to agree or disagree depending on our own experience and views.

Secondly, you are comparing demonetisation in Burma with what we are having in India. The action in Burma was taken by their Govt and the lack of faith for currency is in fact the lack of faith on Govt. In India, people, all across different sections of our society, have expressed faith in present Govt and have said that demonetisation was good and necessary. There difficulties in implementation which people are trying to cope with. There has been no expression of lack of faith in our Govt except by few political leaders with self interest.

More than any thing else, I want to say that it is role of leadership that they should guide the society in correct path. To my mind, by this time farmers should have been buying agri inputs or selling their crops through banking system instead of cash (atleast majority of farmers). Farmers are now enough educated to adapt to modern ways, including computers. It is saddening that even after so many years, our economy is dependant on cash transactions and not through banking systems, inspite of the fact that banks have increased their reach so much. All because of self interest by politicians, and others who gain by generation of black money.

In my view, leadership, which include all politicians, experts, opinion makers, has miserably failed in this task.

Like (2)

Well Wisher

Nov 17, 2016

Best article I read so far on this issue is this one...

"Stunning Scenes Of Panic As Gold Price Skyrockets to $2800/oz In India After Currency Ban"
by Silverdoctors.

You will have to search it on Google as I don't think I am allowed to post a URL.

Like (2)

Vin

Nov 17, 2016

Hi

I do not agree that it is a stupid idea. Be real. I have seen politicians and people of their ilk at close quarters and seen the un imaginable amount of black money they are having. Today all that money has turned to dust. Let us wait till 31 st December 2016 and let the figures of total value of demonitized currency as per RBI and the percent Of money not returned to banks be out , then that will decide who is stupid. Also one should answer questions about terror funding through fake money.

Vin

Like (2)

ravi

Nov 17, 2016

Government should have channeled black money after paying highest tax rate and penalty into buying psu stock.

Like (2)
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