Keep the hands off the stash

They say that we live in a cashless society. The same cannot be said for India. On 8 November, the prime minister gave just four hours’ notice that 500 and 1,000 rupee notes would no longer be legal tender. People were told they could deposit or exchange their old notes at banks until 30 December, and new 500 and 2,000 rupee notes would be issued. This dramatic move was designed to flush shadow economy transactions out into the open in a bid to curb tax evasion. Given that these notes made up 86% of all cash in circulation, this has clearly led to more short-term disruption than necessary.

Official figures from the Reserve Bank of India suggest that as of January, currency in circulation with the public was almost 43% below year-ago levels. This does not bode well for overall economic growth: The IMF has lopped one percentage point off its 2017 growth projection, with the October forecast of 7.6% having been recently downgraded to 6.6%. According to the IMF, the disruptions which forced people to queue outside banks to exchange their notes and the simple shortage of cash resulting from the switchover, will curb consumption in the early part of 2017. It is fairly certain that activity will subsequently recover and before too long India will be able to regain its crown as the “fastest growing major economy” (it might still hold onto this position, depending on what happens in China in 2017). Nonetheless, the episode highlights how an apparently capricious decision of this nature can have far reaching consequences.

One of the prerequisites of money in a modern economy is that it acts as a stable source of value and medium of exchange. At a stroke the Indian government wiped out the cash holdings of those citizens who had not deposited their money in the bank, and in the process has done nothing to win the trust of those who have been disadvantaged. A bigger issue is that if we erode trust in money, we potentially erode wider trust in institutions.

In Europe, for example, the ECB has faced a battle to establish its credibility, particularly in Germany where it replaced the much-revered Bundesbank. As former European Commission president Jacques Delors pithily remarked in 1992: “Not all Germans believe in God, but they all believe in the Bundesbank.” Many people in Germany today have a problem with the monetary policy which the ECB is conducting because they see a huge explosion in the stock of money created by the central bank which they fear will ultimately lead to higher inflation. Whether they are right or wrong, only time will tell. But it is important for the ECB to win the credibility battle today or it may not survive long enough to say ‘we told you so’.

As it happens, there is a strong case for suggesting that if governments are serious about reducing the scope of the shadow economy, maybe they should withdraw all high value notes from circulation. To the extent that it is pretty easy to transport large quantities of cash in 1,000 Swiss franc notes or the 500 euro note without carrying a huge volume, the authorities are concerned about their use in illegal transactions. As a neat little paper by Peter Sands points out (here), the equivalent of one million dollars  in cash weighs just 2.2 kg in the highest denomination euro note whereas it weighs 10kg in the highest denomination  US dollar bills. Precisely for this reason, the ECB is to stop issuing the 500 euro note next year.

But in contrast to the ECB, which has given plenty of warning, the Indian authorities gave virtually none. As a way to crack down on the shadow economy and other avoiders of tax, it may well be highly effective. But if it leads to a sharp decline in economic activity with consequences for tax revenue, it may turn out to be counterproductive. Moreover, the government rather strangely decided to phase out the 1,000 rupee note and replace it with a 2,000 rupee note. It is not exactly what the authorities elsewhere would advocate in the fight against shadow activity. But given recent experience, those who might be tempted to hold any of their untaxed income in rupees in future may think again. It will thus be interesting to see whether it ultimately boosts demand for gold – the ultimate safe haven during times of uncertainty.