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DemonetisationfallaciesanddemonetisationmathLivemint

Demonetisationfallaciesanddemonetisationmath
Forapolicydesigned,ineffect,asaonetimetaxonblackmoney,itisatruismtoarguethatitcannotby
itselftacklefutureflowsofblackmoney

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JagdishBhagwatiVivekDehejiaPravinKrishna

Inaworldoffiatpapercurrencynotbackedbycommoditiessuchasgold,byfarthegreatestthreattotrustinthecurrency
ishyperinflation.Photo:IndranilBhoumik/Mint

Morethanamonthhaspassedsincethe8NovemberannouncementbyPrimeMinisterNarendraModithat
highdenominationcurrencynoteswouldbescrappedandremonetisationwouldoccurthroughreplacement
ofnewnotesanddepositsofoldnotesinbankaccounts.Oftentermeddemonetisation,thispolicyhas
createdconsiderableconfusionamongcommentators,someillinformed,somepoliticallymotivated.A
numberoffallaciescontinuetopersistconcerningthevalueofunreturnedversusreturnedmoney,the
existingstocksversusfutureflowsofblackandcounterfeitmoney,theshortversusthelongterm
impactonblackmoney,andtheexpansionaryversuscontractionaryeffectsofthepolicyreformallowing
opponentsofthepolicytoclaim,prematurely,andwithoutevidence,thatitisafailure.Weclarifyinwhat
follows.

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First,itisfrequentlyassertedthatthereturnintotheformalmonetaryandbankingsystemofalarge
percentage,perhaps80%ormore,oftheoldnotesrepresentsafailureofthepolicy.Thisisafallacywhich
resultsfromthemisunderstandingthatunaccountedmoneythatisdepositedintobankaccountshasbeen
convertedsuccessfullywithoutpenaltyfromblackintowhitewhich,actually,isnotthecase.Thecurrent
rulesdictatethatdepositsofunaccountedmoneywillbetaxedat50%withafurther25%takenbythe
government(intothePradhanMantriGaribKalyanYojana)asaninterestfreeloanforaperiodoffouryears.
Thus,thereturnofmoneytotheformalbankingsystem,whentaxed,willgenerateafiscalgaintothe
system.Interestingly,moneythatisnotreturnedtobanksisimplicitlytaxedat100%fromtheperspectiveof
theownerofthatmoney,andthistoocouldresultinafiscalgainundercertaincircumstances,whichwe
clarifybelow.
Thefirstrequirementforanypossiblefiscalgainfromthatportionoftheoldstockofdemonetizednotesthat
arenotreturnedisthatsuchnotesbedejuredenotified,ratherthanmerelydefactodemonetised.Thiswould
allowtheReserveBankofIndia(RBI)tocanceltheliabilitiesassociatedwiththeissuedcurrency.
Second,assumingthatdejuredenotificationweretooccur,anyputativefiscalbonanzaforthegovernment
wouldrequireonespecificmechanismthroughwhichtheresultingmismatchbetweentheassetsand
liabilitiesofthecentralbankarerectified,whichwouldbethattheRBI,ineffect,createsnewmoneyof
equivalentvalueandturnsthatovertothegovernmenttodowithasitpleases.
This,however,isnottheonlymechanismtocorrecttheassetliabilitymismatch.Anotherpossibilitywould
befortheRBItooffsetthedropinliabilitiesby,forexample,writingoffanequivalentvalueofnon
performingassets,therebysquaringitsbalancesheet.Yetanotherwouldbetoeffectahelicopterdrop
indirectlyintothehandsofthepublic,therebycreatingnewliabilitiesequivalentinvaluetotheextinguished
liabilities.Whileneitherrepresentsadirectfiscalgainforthetreasury,ityieldsanoutcomewhichissimilar
towhatwouldhavehappenedifthetreasuryhaduseditsownresourcesforthesamepurposes.
Whatdoesallthisaddupto?Sincetherearegainstobehadonblackmoney,whenitisreturnedtobanks
andalsowhenitisnot,thequantumofunreturnedmoneyisnotagoodindicatorofthesuccessorfailure
ofpolicy.Howthencanweassesspolicysuccess?
Clearly,atleastfromtheperspectiveofitseffectivenessindealingwiththeblackmoneyissue,successhas
tobemeasuredbythesumoftaxrevenuegeneratedandblackmoneydestroyed.Supposeweacceptthe
estimatethatonethirdoftheapproximatelyRs15trillionindemonetisednotesisblackmoney.Roughly
speaking,therevenuethatwouldhavebeengeneratedhadthatincomebeentaxedinthefirstplaceis30%of
that(so,Rs5trilliontimes0.3=Rs1.5trillion).Perfectdetectionofblackmoneyshouldnowyield50%as
taxrevenue(soRs5trilliontimes0.5=Rs2.5trillion),ifallblackmoneyisreturnedandidentifiedassuch.
Ofcourse,perfectionisrarelyachievedinpractice.Allowingforslippages,weshouldneitherexpectallthe
blackmoneytobereturned,northatalltheblackmoneythatisreturnedwillbeperfectlyidentifiedand
taxed.Ifweassumethatby30December,Rs1trillionisunreturned,asisbelieved,andwefurtherassume
thatonlyhalfoftheremainingRs4trillionofblackmoneythatisreturnedfallswithinthetaxnet,thenet
gainworksouttoRs1trillionofblackmoneydestroyedand50%times2trillion=Rs1trillionintax
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revenue.WhencomparedwiththeapproximatelyRs2.5trillioninincometaxescollectedannually,the
governmentcouldreasonablyclaimthisasasuccessfuloutcome.
Asecondmajorfallacyconcernsanotherstatedgoalofthedemonetisationdrive:counterfeitcurrency.Will
demonetisationpenalizethosewhohaveintroducedcounterfeitcurrencyintothesystem?Toaddressthis
question,oneneedstoclarifythedistinctionbetweenstocksandflows.Thus,thestockofcounterfeitmoney
alreadyincirculation,whichhaschangedhandsmanytimesand,forbetterorworse,wasalreadyinusein
theIndianeconomyon8November,willnotbeaffectedbythedemonetisationexercise.Atbest,tothe
extentthatthesecurityfeaturesintroducedintonewnoteslimitimmediatecounterfeiting,thepolicymay
minimizethefutureflowsofcounterfeitnotesforsometime.Thus,demonetisationaddressesfutureflows,
butnotthecurrentstock,ofcounterfeitmoney.
Athirdfallacyrelatestotheexpectationofsomethatdemonetisationwillputanendtoblackmoney
generation.Thisisbecausecomparedtotheimpactofdemonetisationoncounterfeitmoney,exactlythe
oppositeistrueforblackmoney:demonetisation,byinvalidatingexistinghighdenominationnotes,deals
withthestockofblackmoneybut,inandofitself,doesnothingtoaddressfutureflowsofblackmoney
(whichmayaccrueinthenewcurrencynotes).
Relatedly,notethatthedemonetisationstrategyproposedbyHarvardeconomistKennethRogofftheslow
replacementofhighdenominationnotesbylowerdenominationonesisessentiallyaimedateliminating
flowaccumulationofblackmoneyinthefuture(bymakingthehoardingofhighvaluesofcashphysically
difficult),butdoeslittletoaddresstheexistingstockofblackmoney,whichremainslegaltenderunderhis
proposal.
Fourth,itisarguedbycriticsthatthecurrentexercisewillnottackletheunderlyingrootsofcorruption,
whichlieinareassuchaselectionfinance,burdensomeregulation,hightaxes,andsoforth.Whileperfectly
true,thiscriticismmissesthecentralityofwhateconomistscallthetargetingprincipletheideathat,
typically,eachpolicyobjectiverequiresaspecific,targetedpolicyinstrumentafundamentalconceptinthe
theoryofeconomicpolicy.
Inotherwords,forapolicydesigned,ineffect,asaonetimetaxonblackmoney,itisatruismtoarguethat
itcannotbyitselftacklefutureflowsofblackmoney.Eliminatingsuchflowswillrequirefurtherreforms.
Forinstance,loweringstamptaxesonpropertytransactionswouldincentivizethelowerlevelsofevasion
associatedwithsuchtransactions.Further,electronicregistrationofrealestatetransactions(andre
registrationofexistingownershipclaims)tomatchindividualidentificationnumberswillgoagooddistance
inminimizingthechannellingofcorruptearningsintorealestate.
Fifth,itisarguedbycritics,includingsomewellknowneconomists,thattheshorttomediumruneconomic
impactpost8Novemberwillbecontractionary.Thisisnormallyassumedtofollowfromthetemporary
liquidityshortageinducedbyaninsufficientlyfastreplacementofoldnoteswithnewnotes.
Yet,thisisnotnecessarilytheonlyoutcomepossible.Ontheonehand,ifblackmoneythatwasactivelyin
circulation(asopposedtobeinghiddeninamattress)isunreturnedtothebankingsystemandisinvalidated,

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theeffects,inthefirstinstance,maybecontractionary(unlessanequivalentsumisprintedandspentbythe
governmentordeliveredasahelicopterdrop,aswehavepreviouslydiscussed).
Ontheotherhand,moneythathasbeenproverbiallyhoardedunderthemattress,whetherwhiteorblack,and
whichhasenteredtheformalfinancialsystemviabankdeposits,nowmaygrowviatheclassicalmoney
multiplier,assumingaportionofitisloanedoutbybanks.Thiscould,atthemargin,haveanexpansionary
impact,whichcouldbefurthermagnifiedbystandardKeynesianmultipliereffects.
Further,ironically,benamidepositsbytherichinthenamesofthepoor,mayalsohaveanexpansionary
effect,evenintheshortrun,totheextentthatthepoorkeepafractionofthosedepositsforthemselvesand
spendit.
Finally,ithasbeensaidthattheswapofcurrencynoteshasdamagedtrustinthemonetarysystem.This
missesthefactthatinaworldoffiatpapercurrencynotbackedbycommoditiessuchasgold,byfarthe
greatestthreattotrustinthecurrencyishyperinflation.Itisrisibletocompareanypossibletrustdeficitin
theIndianrupeewroughtbythecurrentexercisetotheepisodesofhyperinflationthathaveravagedtrustin
currencies,leadingtotheirabandonmentasamediumofexchange,unitofaccount,andstoreofvalue.In
suchcases,onetypicallyseessomevariationofdollarisation,asonehasseeninotheremerging
economies.Yetthereisnocredibleevidencethattherehasbeensignificantdollarisationinthewakeof8
November.Contrarytowhatdoomsayerssuggest,thevastmajorityofIndiansstilltrusttherupee.
JagdishBhagwati,VivekDehejiaandPravinKrishnaare,respectively,universityprofessoranddirector,Raj
CenteronIndianEconomicPoliciesatColumbiaUniversityresidentseniorfellowattheIDFCInstitute
andChungJuYungdistinguishedprofessorofinternationaleconomicsatJohnsHopkinsUniversityand
deputydirectoroftheRajCenteronIndianEconomicPoliciesatColumbiaUniversity

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