Edit: as of June 30, 2017, about 6 months later, it’s becoming increasingly clear that demonetization is having some of the predicted effects: lower GDP growth by about 1–1.5%, lower prices, very little effect on actual black money. The distributional effects are more complex, as the burden has fallen most heavily on farmers. This is not surprising in hindsight, though, since we have seen farmers throughout history be in favor of inflation, and hurt by deflation.

On November 8, 2016, while the United States held a…how do I say this politely?…surprising election, the Prime Minister of India, Narendra Modi, delivered another bit of shock therapy to the world, & to India in particular. Overnight, all ₹500 and ₹1000 banknotes, comprising 86% of the cash in circulation, were declared invalid.

Demonetization, as it’s now called, has been receiving widespread media coverage, but everything I’ve read has been piecemeal, missing the forest for the trees. This is my attempt at sketching out the big picture, putting things in context, and if my opening sentences are any indication, mixing metaphors with alacrity.

Since ₹500 and ₹1000 are equivalent to about US$7 and $14 respectively at today’s exchange rates, these now-obsolete notes were very widely used. And because India is a developing country where 47% of the population does not even have a bank account, an estimated 78% of transactions are conducted in cash.

Wow, that sounds like a lot. Is it?

Yes. M1 (the narrow measure of money supply, comprising cash and checkable deposits) in India is about ₹27 trillion. Of that, about ₹16.42 trillion is cash in circulation. A quick calculation shows that Indians woke up on the morning of November 9 with over 52% of their narrow money supply worth less than the colorful paper it was printed on.

The now-obsolete 500- and 1000-rupee bills

Wait — do you mean worthless?

No, not worthless — just invalid. These notes can be deposited in a bank or post office savings account, or exchanged for smaller denomination bills at any bank counter or post office through December 30, 2016. Any amount can be deposited, but ATM withdrawals were initially limited to ₹2000 per day (the limit has now been raised to ₹4500/day). Bank counter withdrawals were initially limited to ₹10,000/day with a weekly limit of ₹20,000 (now raised to ₹24,000) with valid ID. Currency exchanges were initially limited to ₹4000/day (now dropped to ₹2000). New 500- and 1000-rupee notes will be phased in early next year. A new 2000-rupee note is also available now. But it took a while to recalibrate ATMs for such a drastic change, and it was about 3 weeks till they were functioning again. In the meantime, this has meant 12-hour queues at banks, daily laborers unable to get paid or buy food, banks in rural areas running out of cash altogether, and what may well be a 70% drop in retail sales. Exemptions have been made for government hospitals, school tuition, crematoriums, wedding expenses, farmers’ seed purchases, temple donation boxes, and a few other scattered categories, but it has still been highly unpleasant.

No, really, 12 hours. (Image credit: BBC)

Why would the government do such a thing?

It’s a pretty drastic move, alright. The stated reason was to crack down on so-called “black money” and counterfeiting. Widespread tax evasion has, over the years, given rise to a parallel economy estimated to range from 20–23% of GDP. This distorts life in sometimes-absurd ways; real estate prices are often lower if the transaction involves no black money. In a country with over a billion people, in 2012 fewer than 29 million even filed an income tax return, and more than half of those didn’t pay anything. Bringing black money into the light would be transformational — not least because India’s budget deficit is 3.9% of GDP. It’s why the policy, despite the enormous inconvenience, has not been nearly as unpopular as you might imagine. As a matter of fact, the Goods and Services Tax, passed by Parliament earlier this year, is a worthwhile attempt at solving the problem — it replaces the existing labyrinth of value-added taxes and excise duties with a unified value-added tax.

Noble goal! Will it work?

Ah, now there’s the $64,000 question. On the face of it, sure, why not? All bank deposits over ₹50,000 need to be reported to tax authorities. Declare your cash or lose it (or donate it to a temple and, er, wash your sins clean) appears to be the obvious message.

But here is where proponents of the policy often lose sight of the second of the two major uses of money: it’s a medium of exchange, of course, but it’s also a store of value. If you hold a large amount of black money, you need to have a fairly large amount as cash on hand in order to be able to spend it — after all, it’s not like you can write someone a check or swipe a debit card. But if you intend to hold that money for any prolonged period of time, then incentives change.

Since 1969, inflation as measured by producer prices has averaged 7.31%. The wholesale price index consistently underestimates inflation as compared to the consumer price index — since 2012, CPI inflation has averaged 7.48% while wholesale price index inflation has averaged 3.29%. Anyone with the means, opportunity, and ability to accumulate large sums of cash & keep them hidden from tax authorities (bribery is widespread enough in India that this last part is probably the easiest) has a good idea about inflation even if they aren’t checking the official figures as regularly as a professional economist. 7% inflation means prices double about every 10 years; that’s hard not to notice.

If you had to keep a large amount of money saved and hidden for any length of time, would you want inflation to eat away at it till its value had been halved in a decade? Didn’t think so. No, you would buy gold, real estate, US dollars, Swiss francs, bitcoin…anything but leave wads of cash stuffed in the mattress. This is not idle speculation. Experts estimate that barely 5% of black money is actually held in cash. India accounted for 28% of the global demand for gold jewelry in 2015; this share dropped to 24% once the crackdown on black money began.

She is literally wearing her wealth. 5 necklaces, count ‘em.

(At this point it’s also probably worth pointing out that India accounts for 7% of global GDP. Sure, culture plays a role in this ridiculous imbalance — after all, this is the sort of thing Indian brides dream of wearing on their wedding day— but come on!) To add to that, the Swiss National Bank estimates that about CHF1.9 billion (₹129 billion) in the Swiss banking system belongs to Indian account holders.

Bottom line — any black money in the form of real assets or foreign currency is completely immune to this policy. It’s going to be like deep-sea fishing with a butterfly net — you’ll catch a few small fry & a whole lot of krill, but the tuna and the marlins will swim right past you, and the whales will pass 100 feet below, occasionally rising to the surface to sneeze in your general direction.

Oh, sure, it’s beautiful & majestic when *they* do it….

If you know this & Google knows this, doesn’t the Indian government know this?

Of course they do. My numbers are all from official Indian government statistics or publicly available data. Also, they are introducing a new 2000-rupee note, and I have a hard time seeing how that’s going to make hoarding black money more difficult going forward.

So then why go through such a traumatic experience?

This is where the big picture becomes important.

Starting in 2007–2008, Indian banks went on a lending spree, since the Indian economy was one of the few doing well at the time. Money poured into large industrial and infrastructure projects. But today, Indian banks are sitting on ₹6 trillion in bad loans, euphemistically called non-performing assets (NPAs). That’s 8% of total loans, not counting loans that have already been restructured. Just 6819 individuals or firms owe almost ₹75 billion across the banking system. 90% of these bad loans have been made by public-sector banks.

The previous governor of the Reserve Bank of India, noted economist Raghuram Rajan, was forced out of his position — excuse me, discouraged from reapplying for his position when his term ended — in a very public and ugly way this year. At the time, the most commonly cited point of disagreement between Rajan and Modi’s administration was monetary policy — Rajan was in favor of tightening to lower inflation; the administration was concerned about growth rates. The entire episode was terribly depressing if one appreciates the idea of central bank independence.

With the benefit of hindsight, other points of difference become clear, too. Back in 2014, Rajan was asked his opinion of demonetization, and he was not enthused by it. More to the point, he spent a lot of the latter part of his term trying to resolve the problem of NPAs in the banking system, with an emphasis on transparency — forcing banks to recognize bad loans on their books so that they could work towards recovering them or writing them down as needed, rather than tying up capital that could be lent to other worthy enterprises.

Meanwhile, his successor, Urjit Patel, is on the record as favoring more “creative” approaches to resolving the problem. A cash infusion of up to ₹14 trillion into the banking system with strict withdrawal limits is certainly creative, alright. It will repair bank balance sheets and enable credit creation without forcing banks to recognize, recover, &/or write down their bad loans, & without forcing so-called “willful defaulters” to pay up.

Wait, are you saying this entire demonetization business is a bank bailout in disguise?

The evidence is circumstantial, but it certainly points in that direction, yes.

I dislike untestable hypotheses as much as any empirical social scientist, & barring some revealed communication between people who knew about the policy beforehand, this hypothesis is untestable. I’m here because I simply don’t have a plausible alternative hypothesis. But I am willing — eager — to be persuaded otherwise. Consider this my opening statement; I would love to begin a conversation.

H0: The shock-&-awe overnight demonetization was a way to bail out troubled banks without using tax revenues.

H1: ???

Think about it: if the purpose is to bring illegally hoarded and counterfeit currency into the system, why have withdrawal & exchange limits? If the goal is to drag the country kicking & screaming towards a cashless economy (increasing banks’ income from transaction fees, by the way) why not increase access & incentives and let it happen as an inevitable consequence of development, as it has everywhere in the developed world? Most people without bank accounts are not avoiding the financial system by choice — they are either too poor, or they don’t have convenient access. Right now, India is trying to move to a cashless society when fewer than 10% of retail outlets even have point-of-sale terminals, 300 million people have no electricity at all, and another 250 million or so do not have it for 24 hours a day.

As a final cherry on top of this banana split sundae of absurdity, the RBI just announced that it was temporarily raising the cash reserve ratio to 100% for all deposits made between September 16 & November 11. The ostensible reason is to manage ₹3 trillion of excess liquidity in the system from all these cash deposits. To be brutally frank, this is laughable. Firstly, central banks rarely alter reserve ratios; if they want to tinker with money supply they have far more effective tools at their disposal which cause much less disruption to banks’ portfolios. Secondly, if excess liquidity in the banking system is a problem and people are desperate for cash, why not just let them withdraw it? Why continue the strict withdrawal limits?

(Oh, that’s right — the need for secrecy meant that not enough new currency was printed in time for this.)

As it turns out, the total deposits from November 10–27, less cash withdrawals and exchanges, ergo the total increase in bank reserves is about ₹5.9 trillion.

An interesting aside: remember that the BJP & RSS receive a lot of their funding from overseas, often electronically, while Congress and other regional parties continue to fund election campaigns largely in cash, raised domestically. As a matter of fact, this March, legislation was amended to formally allow Indian political parties to accept donations from foreign firms.

So in sum, I call bullshit on the administration’s reasons, & not the kind that was used last year to make GDP look larger.

Why should I believe you? You’re a labor economist.

True. I haven’t studied this stuff since graduate school. But don’t take my word for it; listen to another ex-RBI governor, who also happens to be an ex-Prime Minister, & has an Oxford PhD in economics with a macro specialization. “Organized loot & legalized plunder,” he called it.

But he’s now an opposition politician, why should I believe him?

Never mind the messenger, then. Focus on the facts. Manmohan Singh projected a 2% drop in GDP — if the 70% fall in retail sales alleged by an ally of the government is real, that’s probably the lower bound. He also referred to gross mismanagement: on top of tremendous hardship for the poor and unbanked, the rushed printing has resulted in new currency with all sorts of printing errors — a numismatist’s dream, but also a counterfeiter’s.

You sound like a conspiracy theorist.

It’s an uncomfortable feeling, but logic & facts have forced me into this corner.

It isn’t even all bad, really. For a large public-sector bank to fail would be truly catastrophic. India does not need a decade of zombie banks, insolvent in all but name, stunting growth the way they did in Japan. A sub-optimal but politically feasible solution is better than no solution (though the fairness concerns of burdening a billion people to avoid cracking down on loan defaulters are…not trivial). The deceit is troubling, but what are a few white lies between friends? And if you can convince people of the rectitude of their actions and their sacrifice while you’re at it, why, that’s not a bad deal at all.