Thursday, December 15, 2016

Small steps, not a large leap, towards less black money & more digital money

 We are more than thirty days into Narendra Modi's demonetization campaign, and while many of the commentators I follow say that it is admirable of Modi to try to reduce the role of black money (wealth held by tax-evaders and criminals) and increase digital money adoption, most say that demonetization is not the way to go about it.

In short, the idea behind Modi's demonetization is to require everyone who owns old 1000 and 500 rupee notes to bring them to a bank before year-end for conversion into new banknotes or to be deposited into an account. By forcing Indians to re-familiarize themselves with dormant accounts, or open new ones, the architects of the plan hope that India's reliance on cash as a medium of exchange will be reduced. Any amounts above the ceiling require proper documentation. Those who own large amounts of cash for undocumented reasons, either because they are evading taxes or engaging in criminal behaviour, will therefore be unable to make the switch, their money expiring worthless by year's end. Having been taught a lesson, they may choose to permanently move some of their operations into the official sector.

Kaushik Basu, World Bank chief economist from 2012-2016, is particularly pessimistic about the policy, noting that while he agrees with the Reserve Bank of India's estimate that the economy will probably grow at 7.1% in 2016-17, from 7.6% estimated earlier, he expects a "huge drop" in the economy next year. "Money works like blood," says Basu, invoking one of the Physiocrat's classic analogies of the economy to the human body.

I certainly agree with Basu's use of the money-as-blood analogy, but my hunch is that temporary media of exchange will spring up to take the at least some of the space heretofore occupied by Modi's demonetized banknotes. My mental model for understanding demonetization is the Irish bank strike of 1970. For six months banks were shuttered, Irish citizens entirely cut off from their bank accounts. Cheques could not be deposited, nor could the central bank use the branch banking system as a means to get paper money into the economy.

Rather than suffering a huge blow, the Irish economy continued to function as it did before. Into the void vacated by banks and cash, post-dated cheques emerged as a the economy's blood, its circulating medium of exchange, with pub owners acting as informal credit evaluators.

Like Ireland in 1970, India suddenly finds itself deprived of a large portion of its money. In the place of 1000 and 500 rupee notes I expect informal credit to take some of its place, the effects on the economy therefore not being as devastating as Basu hints. See for instance this:

While many commentators are already declaring the demonetization to be a success or a failure, we won't have a good sense of this for several years. What sort of data should we be evaluating along the way? One of the effects we'd expect to see in a successful policy is a long-term reduction in the usage of cash, both as licit users of banknotes are diverted into the banking system and illicit users, burned by the forced switch out of old 1000 and 500 rupee notes, migrate out of the underground economy into the official economy. This should be reflected in data on India's currency in circulation, an attractive indicator in that is simple, accurate, not subject to revision, and comes out on a weekly basis. You can download the data here under the section 'Reserve money'.

The chart below shows the number of rupee banknotes outstanding going back to 2001. Prior to the demonetization, cash had been growing at a rate of 14-15% per year, as illustrated by the blue trend line. Since then you can see that there has been a huge collapse in quantity outstanding as Indians queue to deposit their cash in the banking system. At the same time, the Reserve Bank of India (RBI) hasn't printed enough new 500 and 2000 rupee notes to meet demand.

Cash in circulation will inevitably rebound in 2017 as the RBI catches up to demand by printing new rupees. If cash in circulation jumps back to the pre-demonetization level of ~18 trillion rupees and proceeds to readopt its growth path of 14-15%, than the demonetization will have failed to generate the desired effect. Despite suffering through queues and a relatively sluggish period of aggregate demand, Indians will have returned to their old habits, the whole demonetization campaign being a waste of time and effort.

But if cash in circulation only retraces part of the rebound, say rising to 16 trillion rupees by mid- 2017 (it is currently at ~10 trillion), and then sets out on a new and lower growth path (say 12-13%), then it will have achieved at least some of the desired effect. A new growth path starting from a lower level would imply that the demonetization has been successful in modifying the behaviour of licit cash users (i.e. converted them into digital money users) while driving illicit users of cash into the official economy.

My hunch is that of these two possibilities, the second is more likely: India will see a reduction in the growth path of rupee banknotes starting from a lower plateau. That being said, I find myself sharing many of the worries that Basu and other commentators have. Such a large and aggressive demonetization is a risky way to achieve the twin goals of broadening India's official economy and increase electronic money use. In order to catch people by surprise, much collateral damage must be inflicted, including time wasted in lineups and trades that go unconsummated due to a lack of cash (informal credit as in the case of Ireland not being able to completely fill the void). Suyash Rai makes a convincing argument that a demonetization of this size intrudes on property rights and rule of law.

Despite the chaos it has created, I still feel that the demonetization will make India at least a bit better off than before. However, other nations with large underground economies and low digital money uptake should be wary of copying India's example, waiting at least three or four years to gauge the final outcome. Rather than Modi's risky shock-and-awe approach, a better way to solve the problem is through a series of small and gradual measures. One of these steps might include implementing the approach Kaushik Basu writes about in his 2011 paper Why, for a Class of Bribes, the Act of Giving a Bribe should be Treated as Legal. See my post here for a full explanation.

Here's another incremental maneuver. Instead of imposing a short period of time for switching out of a limited quantity of 1000 and 500 rupee notes, why not allow three or four years for unlimited amounts of notes to be converted—but design the new notes to be 40% larger than the demonetized ones, as Peter Garber suggests, thus making it harder for Indians to store and handle cash?

Another step would be to copy Sweden which, thanks to several policies enacted over the last decade or so, is the only nation in the world with declining cash in circulation. One reason: retailers are required to use certified cash registers that prevent cash-induced tax gas. The Swedes have also adopted tax policies that encourage reporting of activities that typically remain in the unofficial economy, as I explain here. I also recently learnt from Miles Kimball that the Riksbank, Sweden's central bank, privatized the banknote distribution system in the 2000s, the effect being to end the subsidization of note transportation. If banks must bear the true (and higher) cost of moving notes around India, then this will be passed onto their customers, who in turn will react by switching into cheaper digital alternatives. I plan to write about this next week.

The advantage of many incremental steps towards increased digital money usage and a smaller underground economy is that should one step go bad, the blast radius will be small. One large Modi-style step might get you there faster, but if it goes awry, it risks upending the entire effort.


  1. Good piece, JP. But restricting cash does not change the positive incentive to cheat. The incentives to cheat in India include high taxes, tax complexity, bureaucratic corruption, weak property rights, and arbitrary justice.

    Restricting cash changes none of this positive incentive to cheat. Cash bans only raise the negative price of cheating. So, please consider that India's *high taxes, tax complexity, bureaucratic corruption, weak property rights, and arbitrary justice* could be an immoral system.

    Why is is moral to war against cash usage by poor Indians? Aren't they are simply trying to protecting themselves against immoral taxes and laws? Reforming the laws and lowering incentives to cheat would be a more humane, effective, and moral approach than cash bans.

    Also, consider unintended consequences. Bans can actually deepen and broaden corruption networks. These *temporary work-arounds* that you favor don't automatically disappear when the banks reopen and the cash disappears.

    The criminal "gateway drug" is the network. When people get plugged into a dark market network, even temporarily, it adds sticky demand for dark activities. India may find itself with a larger black market after all this -- because people will adapt, the incentives will still be there, and their adaptation will be durable.

    JP, you might even discover that the ban-cash-because-criminals-and-tax-evaders argument is bogus.

    FYI, banning booze in the US created criminal networks from the neighborhood speakeasy to al capone to meth labs now.

    What sort of criminal networks will thrive under cash bans?

    1. "...than cash bans."

      You use the phrase cash ban several times. Where in my post did a say anything about banning cash? Not even Modi is banning cash, he's implementing a note switch along with introducing a new higher note.

    2. Well, banning specific denominations all the way to a full cash ban, which is the goal in India, no?

      Please address the issue. The piece on dry/wet counties and criminal networks was an eye opener to me. Being pushed into criminal networks has long lived consequences.

      BTW, Rogoff cash curse was not an eye opener. His stuff is not scientific. It's closer to a polemic. Not persuasive. More an article of faith than compelling evidence. His "this time is different at least had evidence, though that was also incredibly flawed.

      Mao and Stalin also had their baseless economic theories, and academics who backed them. Modi appears cut from the same cloth.

    3. "Well, banning specific denominations all the way to a full cash ban, which is the goal in India, no? "

      The goal of Modi's demonetization is to cancel and then reintroduce the same banknote, the door between the old and new being used as filter for catching those with black money, and as a way to nudge licit users of cash to use bank money. The idea is not to ban money, not like Rogoff's abolition of high denomination notes.

      "The piece on dry/wet counties and criminal networks was an eye opener to me. Being pushed into criminal networks has long lived consequences."

      In this post I've suggested: 1) Basu's legalization of bribe giving; 2) larger size banknotes; and 3) privatized note distribution. While you provide an interesting link, how does the analogy to alcohol prohibition apply to my three points, or to Modi's cancellation/reintroduction?

    4. Look, Modi banned some 80% of cash value in circulation. As you point out, some of that may be swapped into small bills. And oh my goodness, middle class and wealthy Indians are plugging into the black mafia-run currency market like never before.

      New criminal networks are being formed, JP, with lots of secrets and blackmailable crimes that bind people together for the long term. The black market and number of criminals has likely never been higher in India, all thanks to Modi.

      I see no evidence of the three bribe legalization, larger notes, or private notes happening. All cloud cookoo land. What I do see is an explosion in the profitability of criminal black markets in India. Criminal networks become very profitable in prohibition - whether alcohol or currency - and so you get more of it. And, ultimately, more violence and criminal diversification into new lines of criminal business, whether meth or heroin or protection rackets

      Modi just made millions of Indians into law-breakers who have to pay black market criminals for financial protection. This is a massive subsidy for criminals that will sustain criminality for decades to come. That's the legacy, not some technocratic half backed cashless society dream. Just like al Capone, just like meth labs.

      Bans make criminals. Just where do you think you are? Scandinavia?

    5. Couldn't taking peoples currency and ruing a significant part of the economy be considered criminal? If not the same result of a large crime?

      It seems so counter productive.

  2. I am confused.
    Did not you argue that chaos is a feature, not a bug?
    But now you advocate small steps and chaos seems to be a bug again?
    Have you changed your mind?

    1. Chaos is a feature of any aggressive demonetization. You can't design one that doesn't have a wide blast radius, because the more preparation you do, the more information leaks out, and the less successful it will be in its aggression.

      My feeling is that Modi's demonetization will have some degree of long-term success in driving Indians into digital money and flushing them out of the underground economy, and the money supply data will show this.

      But small steps are preferable to a big leap.

  3. I believe removing currency from the economy will reduce the amount of transactions and thus taxes.

    1. This will reduce the white money taxes collected. Because it reduces transactions an will hurt or ruin businesses. Ruined businesses will reduce the future economic output.

    2. Marginal businesses that help the economy along may not be able to pay tax any way. The answer their would to be some way to get them profitable enough to pay tax.

    3. I don't understand why an experienced tea merchant would not see such action damaging the economy.

    4. This punishes the innocent (every one). So is unfair. And would be against the spirit of the constitutions of the united states and possibly many other countries.

    5. I read that the receipts of high denomination notes were so high that the remaining money was much lower than the black money estimate. That alone might be good reason to end this experiment. I think the common practice is to convert illegal money or (depreciating money) to some thing else (or to some thing that depreciates slower.)

    6. I think this reduces the liquidity of the whole economy and banking system. In modern banking systems currency held by banks and deposited in the central bank or clearing banks are reserves. Reserves are required to support credit money. As if reserves are imprudently too low check clearing cannot be done efficiently or fairly. If reserves are reduced the credit money or bank money is at risk. Since the credit money is often >= than 10 times the currency it is the most significant amount of money used. Take for examples, Greece's financial problems or the depression in the United States caused by President Andrew Jackson by his policy that removed gold money (paper money was credit money redeemable for gold money) from the economy and caused bank failures and loss of deposits.

    So, if I were India or her leaders, I would consider this a failed experiment or mistake and reintroduce the money.

  4. Also, if other notes were promised in return for the old notes but not delivered that could be considered fraud.

  5. On President Andrew Jackson's policies causing an economic Depression:

    p. 297-298
    "Making America: A History of the United States"