Money is important. The real economy cannot function without a stable and predictable currency. Money serves as a numéraire, which the wiki defines as “a basic standard by which value is computed . . . the numéraire is one of the functions of money, to serve as a unit of account: to provide a common benchmark relative to which the worth of various goods and services are measured.”
These days, nearly all money is fiat money issued by the central bank of an economy which is controlled (indirectly perhaps) by the government. The quantity, and therefore the “price” of money (which is the interest rate), is controlled by the central bank.
Money is also a medium of exchange. Without money, all exchanges would be reduced to barter. Barter suffers from the problem of a “double coincidence of want” which basically means that you have to find someone who has precisely what you want and who also wants what you have in exchange — an almost impossible task in a world where there are literally billions of people and millions of distinct goods and services.
Finally, money is also a store of value. People borrow and lend in money terms.
Of the three functions of money–unit of account, store value, and medium of exchange–the fact that it facilitates exchange is the most critical. Disruptions in the money supply is akin to the disruption in the air supply for a human being. Remember the rule of three: you can survive for three weeks without food, three days without water, and three minutes without air. The economy can survive a disruption in the money supply for a few weeks but not without suffering some damage.
Deliberately inducing a critical shortage of money should not be a matter of whim. The costs are immense and such a move can only be justified in the fact of clear and present danger. To use a medical analogy, it is like chemo or radiation therapy: the side-effects are nearly as damaging as the targeted malignancy.
On Nov 14th, just a few days after Nov 8th (what I call India’s 8/11), I wrote a blog post that was republished on The Quint. Yesterday I wrote another piece on the matter. Here it is, for the record. (Link to The Quint article. I should clarify that the title of the piece is not mine.)
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Note Ban: A Blunt Instrument That May Spark Greater Economic Evils
In his 1848 essay ‘What is Seen and What is not Seen’, celebrated French economist Frédéric Bastiat enunciated an important truth that any action in the economic sphere produces not just one effect but a series of effects. Some of these effects, he wrote, are intended and foreseen, others are unintended, unseen and unforeseen. Furthermore, only some of the consequences are immediate while others unravel over time.
He went on to observe that “it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”
The best laid schemes of mice and men often go awry, as the poet lamented, because we are not given unbounded rationality and foresight. Therefore, it is best to exercise extreme caution when making bold moves in our personal lives.
That caution has to be multiplied a thousand-fold when an action is sure to affect untold millions of people, as when governments make potentially game-altering policies.
The Indian government’s 8 November decision to demonetize Rs 500 and Rs 1,000 notes is one such bold policy. The motivation for that action was, no doubt, benevolent. The expressed goals changed with time, from the high-minded elimination of “black money” and counterfeit currency, to the rather questionable goal of moving India towards a “cashless” digital economy.
Removing an estimated over 80 percent of cash in hand has to have dire consequences for any economy, especially one in which a vast majority of transactions involve cash.
We must remember that the act of exchange and trade, buying and selling, lies at the heart of both production and consumption, and that money is what keeps the whole system functioning. Without some form of money, most non-barter exchanges will come to a halt or at least slow down and so would the economy.
It is like when you forget your wallet at home and cannot buy what you need from the market, and it causes some inconvenience to you. Your money is still there, but you don’t have access to it. But if a few hundred million people suddenly don’t have access to money – even temporarily – the impact can not but be staggeringly negative.
Demonetisation of that scale is a blunt instrument for attempting to eliminate black money. Black money itself is only a symptom of a structural problem in the economy. Without a structural change in the system, even if the stock of black money is entirely eliminated, the flow will resume and soon enough the stock will recover.
What’s worse is the likelihood that much of the existing stock of black money will not be eliminated because people are endlessly inventive and if they have had the smarts to accumulate black money, they can be trusted to figure out ways and means to launder much of their stockpile.
The benefits of the demonetization have to be considered in relation to its costs. Only a small segment of the population are people who have black money because crooked politicians, judges, and bureaucrats, and business people with undeclared incomes are a minority in any population. Most people in India have neither the capability nor the opportunity to generate black money. Making the innocent majority pay for the sins of the culpable minority is morally wrong and economically inefficient.
The benefits are dubious at best and the costs in terms of loss of income and economic output are massive. If the government is serious about removing black money, it needs to address the root of the problem: needless heavy-handed political and bureaucratic control of the economy. That control has been in place since colonial times and the system created the incentives for people to cheat. Only by changing those incentives will people respond by not cheating. Symbolic actions, however sincerely felt and however dramatically executed, cannot begin to address deep rooted problems.
The sad fact remains that those who have the power to make those needed structural changes have the least incentive to make them since the present system is what gives them the power.
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So there we are. This is our “Ask me anything” for December. What’s on your mind?