More than a month has passed since the 8 November announcement by Prime Minister Narendra Modi that high-denomination currency notes would be scrapped and remonetisation would occur through replacement of new notes and deposits of old notes in bank accounts. Often termed “demonetisation", this policy has created considerable confusion among commentators, some ill-informed, some politically motivated. A number of fallacies continue to persist—concerning the value of “unreturned" versus “returned" money, the existing “stocks" versus future “flows" of black and counterfeit money, the short- versus the long-term impact on black money, and the expansionary versus contractionary effects of the policy reform—allowing opponents of the policy to claim, prematurely, and without evidence, that it is a failure. We clarify in what follows.

First, it is frequently asserted that the return into the formal monetary and banking system of a large percentage, perhaps 80% or more, of the old notes represents a failure of the policy. This is a fallacy which results from the misunderstanding that unaccounted money that is deposited into bank accounts has been converted successfully without penalty from black into white—which, actually, is not the case. The current rules dictate that deposits of unaccounted money will be taxed at 50%—with a further 25% taken by the government (into the Pradhan Mantri Garib Kalyan Yojana) as an interest-free loan for a period of four years.

Thus, the return of money to the formal banking system, when taxed, will generate a fiscal gain to the system. Interestingly, money that is not returned to banks is implicitly taxed at 100% from the perspective of the “owner" of that money, and this too could result in a fiscal gain under certain circumstances, which we clarify below.

The first requirement for any possible fiscal gain from that portion of the old stock of demonetized notes that are not returned is that such notes be de jure denotified, rather than merely de facto demonetised. This would allow the Reserve Bank of India (RBI) to cancel the liabilities associated with the issued currency.

Second, assuming that de jure denotification were to occur, any putative fiscal bonanza for the government would require one specific mechanism through which the resulting mismatch between the assets and liabilities of the central bank are rectified, which would be that the RBI, in effect, creates new money of equivalent value and turns that over to the government to do with as it pleases.

This, however, is not the only mechanism to correct the asset-liability mismatch. Another possibility would be for the RBI to offset the drop in liabilities by, for example, writing off an equivalent value of non-performing assets, thereby squaring its balance sheet. Yet another would be to effect a “helicopter drop" indirectly into the hands of the public, thereby creating new liabilities equivalent in value to the extinguished liabilities. While neither represents a direct fiscal gain for the treasury, it yields an outcome which is similar to what would have happened if the treasury had used its own resources for the same purposes.

What does all this add up to? Since there are gains to be had on black money, when it is returned to banks and also when it is not, the quantum of “unreturned" money is not a good indicator of the success or failure of policy. How then can we assess policy success?

Clearly, at least from the perspective of its effectiveness in dealing with the black money issue, success has to be measured by the sum of tax revenue generated and black money destroyed. Suppose we accept the estimate that one-third of the approximately Rs15 trillion in demonetised notes is black money. Roughly speaking, the revenue that would have been generated had that income been taxed in the first place is 30% of that (so, Rs5 trillion times 0.3 = Rs1.5 trillion). Perfect detection of black money should now yield 50% as tax revenue (so Rs5 trillion times 0.5 = Rs2.5 trillion), if all black money is returned and identified as such.

Of course, perfection is rarely achieved in practice. Allowing for slippages, we should neither expect all the black money to be returned, nor that all the black money that is returned will be perfectly identified and taxed. If we assume that by 30 December, Rs1 trillion is unreturned, as is believed, and we further assume that only half of the remaining Rs4 trillion of black money that is returned falls within the tax net, the net gain works out to Rs1 trillion of black money destroyed and 50% times 2 trillion = Rs1 trillion in tax revenue. When compared with the approximately Rs2.5 trillion in income taxes collected annually, the government could reasonably claim this as a successful outcome.

A second major fallacy concerns another stated goal of the demonetisation drive: counterfeit currency. Will demonetisation penalize those who have introduced counterfeit currency into the system? To address this question, one needs to clarify the distinction between stocks and flows. Thus, the stock of counterfeit money already in circulation, which has changed hands many times and, for better or worse, was already in use in the Indian economy on 8 November, will not be affected by the demonetisation exercise. At best, to the extent that the security features introduced into new notes limit immediate counterfeiting, the policy may minimize the future flows of counterfeit notes for some time. Thus, demonetisation addresses future flows, but not the current stock, of counterfeit money.

A third fallacy relates to the expectation of some that demonetisation will put an end to black money generation. This is because compared to the impact of demonetisation on counterfeit money, exactly the opposite is true for black money: demonetisation, by invalidating existing high denomination notes, deals with the stock of black money—but, in and of itself, does nothing to address future flows of black money (which may accrue in the new currency notes).

Relatedly, note that the demonetisation strategy proposed by Harvard economist Kenneth Rogoff—the slow replacement of high denomination notes by lower denomination ones—is essentially aimed at eliminating flow accumulation of black money in the future (by making the hoarding of high values of cash physically difficult), but does little to address the existing stock of black money, which remains legal tender under his proposal.

Fourth, it is argued by critics that the current exercise will not tackle the underlying roots of corruption, which lie in areas such as election finance, burdensome regulation, high taxes, and so forth. While perfectly true, this criticism misses the centrality of what economists call the “targeting principle"—the idea that, typically, each policy objective requires a specific, targeted policy instrument—a fundamental concept in the theory of economic policy.

In other words, for a policy designed, in effect, as a one-time tax on black money, it is a truism to argue that it cannot by itself tackle future flows of black money. Eliminating such flows will require further reforms. For instance, lowering stamp taxes on property transactions would incentivize the lower levels of evasion associated with such transactions. Further, electronic registration of real estate transactions (and re-registration of existing ownership claims) to match individual identification numbers will go a good distance in minimizing the channelling of corrupt earnings into real estate.

Fifth, it is argued by critics, including some well-known economists, that the short- to medium-run economic impact post 8 November will be contractionary. This is normally assumed to follow from the temporary liquidity shortage induced by an insufficiently fast replacement of old notes with new notes.

Yet, this is not necessarily the only outcome possible. On the one hand, if black money that was actively in circulation (as opposed to being hidden in a mattress) is unreturned to the banking system and is invalidated, the effects, in the first instance, may be contractionary (unless an equivalent sum is printed and spent by the government or delivered as a helicopter drop, as we have previously discussed).

On the other hand, money that has been proverbially hoarded under the mattress, whether white or black, and which has entered the formal financial system via bank deposits, now may grow via the classical money multiplier, assuming a portion of it is loaned out by banks. This could, at the margin, have an expansionary impact, which could be further magnified by standard Keynesian multiplier effects.

Further, ironically, benami deposits by the rich in the names of the poor, may also have an expansionary effect, even in the short run, to the extent that the poor keep a fraction of those deposits for themselves and spend it.

Finally, it has been said that the swap of currency notes has damaged trust in the monetary system. This misses the fact that in a world of fiat paper currency not backed by commodities such as gold, by far the greatest threat to trust in the currency is hyperinflation. It is risible to compare any possible trust deficit in the Indian rupee wrought by the current exercise to the episodes of hyperinflation that have ravaged trust in currencies, leading to their abandonment as a medium of exchange, unit of account, and store of value. In such cases, one typically sees some variation of “dollarisation", as one has seen in other emerging economies. Yet there is no credible evidence that there has been significant dollarisation in the wake of 8 November. Contrary to what doomsayers suggest, the vast majority of Indians still trust the rupee.

Jagdish Bhagwati, Vivek Dehejia and Pravin Krishna are, respectively, university professor and director, Raj Center on Indian Economic Policies at Columbia University; resident senior fellow at the IDFC Institute; and Chung Ju Yung distinguished professor of international economics at Johns Hopkins University and deputy director of the Raj Center on Indian Economic Policies at Columbia University.

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