India’s currency chaos

 

So what’s going on with the Indian government’s crackdown on cash?

Their sudden decision to demonetise 87% of the country’s currency (notes of Rs. 500 and Rs. 1000 all in people’s personal possession) is as historic a decision as it is destructive --- messing up the country’s financial system; denying wages to the millions of day labourers paid in cash; destroying the perishable stocks of farmers and vendors suddenly unable to sell fresh produce – not to mention that close to 50 deaths have been attributed to the sudden demonetisation. This has affected the life of every single person in the country, for whom their wealth in the form of the government’s paper is now under threat of simply disappearing.

Not to mention their confidence in the very medium of exchange that makes their economic system’s division of labour possible (in India, over 90% of all transactions are (or were) conducted in paper currency). In a paper-based system with no commodity backing, then as Milton Friedman once noted

private persons accept these pieces of paper because they are confident that others will. The pieces of green paper have value because everybody thinks they have value. Everybody thinks they have value because in everybody's experience they have had value.

This is not trivial. When that confidence in that value has gone, well, that’s when paper money goes away and dies.

So something this patently destructive must have a reason, particularly when (as even the wreckage’s supporters readily concede) the note cancellation will do little to remedy tax evasion, corruption, or illicit commerce. And there is a very plain reason, as economists Larry White and Shruti Rajagopalan make clear: The demonetisation represents “a massive one-shot transfer of wealth from the private to the public sector."

If there is anything that explains Prime Minister Modi’s sudden and hitherto unconcealed enthusiasm for currency cancellation, then this unprecedented one-off wealth transfer to his government is surely it.

Since every government in the world is desperate to keep their ships of (welfare) state afloat, yet all are evidently running out of the readies, these raids on people’s wealth by the likes of the Indian and Greek government (who simply did an overnight raid on savers’ bank accounts) should be understood as precursors of the destruction to come further afield – so their effects should be fully grasped. White and Rajagopalan list three, all hidden:

1. Effects of transition away from old notes

2. Fiscal impact of transition into new notes

3. Impact of the non-uniform injection of the new notes into the economy

Of the first they point out that Modi’s surprise announcement imposes “a one-time wealth loss on currency holders who are unable or unwilling to convert their entire holdings of old notes.” In that the stated aim is to eliminate “untaxed wealth,” this effect is intentional.

Modi seems to have underappreciated, however, that in so doing his policy creates a serious shortage of currency. This shortage blocks ordinary currency transactions, blocking honest ordinary people from making a living, thus reducing national income. The biggest impact is on the poor, who have few substitutes for cash transactions…
    [So] a policy ostensibly intended to inflict losses on tax evaders and criminals is imposing, at least in the transition, much greater losses on honest users of currency.

Of the second, they note the hidden gain to the government in the imminent issue of new notes.

The most striking implication is that the Indian government enjoys a one-time revenue gain. Suppose that, as the government purports to believe, a large share of the old currency is “black money” held by tax-evaders and professional criminals who will be penalised by the cancellation because they do not want to face the scrutiny that will accompany the exchange of too many old notes for new. They will simply eat their losses.

This on its own could represent nearly half of the value all the invalidated currency notes issued: i.e., Rs. 7.2 trillion, or US$106 billion. So without any new increase in the money stock, the government can now spend into existence US$106 billion on any pet project without any inflationary consequence whatsoever.

It’s easy to imagine any finance minister or adviser hopping with delight when they figured that one out. Little would they have worried that this effectively represents a giant capital levy, “a massive one-shot transfer of wealth from the private to the public sector.”

In blunter words: outright theft.

But this injection of new notes will not be even: as with the injection of all new money, especially in a corrupt commonwealth, the new money is spread unevenly through the economic system. Importantly, it is the cronies who get the new money first.

Those who receive the new currency notes first can buy goods and resources at depressed prices. The terms of trade turn against the unbanked sector, and the relatively wealthy banked population receives a transfer from the relatively poor unbanked population. The skewing of relative prices and incomes will persist until the access to new currency notes flows throughout the economy.

Very nice if you’re a crony.

But that’s not all.

There is also a geographic skewness. Tea vendors in the city of Mumbai, for example, where new currency is appearing relatively promptly, are less hard-hit than tea vendors in the rural villages of Maharashtra.

And,

The currency shortage may also cause structural imbalances in the economy for longer production processes.

Crops need to be paid for and sown (“Close to half of Indian families are engaged in agriculture, and it accounts for 16% of the GDP.”) Commodities need to be bought as inputs. And in construction, (“almost entirely a cash-based industry”)  current projects “are already being postponed until new currency notes become sufficiently available. This postponement will have effects on housing supply and prices for several years ahead.”

So not just an immediate one-off destructive effect, but destruction for some years to come.

What makes it the ideal government project however is that the cause of these long-term destructive effects will be hidden, the gain them in scads of ill-gotten lucre is immediate. For a politician, what could possibly be more motivating.

That the government no doubt understood much of the destruction the project would cause, yet went ahead with it anyway, attests to the desperation that all governments will have when they face their own financial emergencies.

Be warned.

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