India’s Assault on Cash

Link to Amy Kazmin’s article “India’s cash chaos sparks growing backlash” on (the Financial Times website)

Link to Wikipedia article “Indian 500 and 1000 rupee note demonetisation”

Link to Raymond Zhong’s Wall Street Journal article “India’s Money Launderers Soil Modi’s ‘Spring Cleaning’ of Cash”

India’s sudden declaration that its existing 500- and 1000-rupee notes were invalid and needed to be replaced by new notes, with severe restrictions on that conversion is so far afield from my proposals for taming paper currency that I have been slow to write about it. Nevertheless, there are some interesting lessons to be learned. In this post, I will assume you know the basics. For that, the Wikipedia article flagged above is actually much better than the news accounts. Here are some of the lessons to draw and theoretical insights sparked by thinking about this episode:

First, the details of any modification in paper currency policy matter a lot. Getting the details wrong can make a big mess. 

Second, central banks and governments do big unexpected things. With a bit of care, there is no reason they can’t do big things that are well-designed and have much smaller side-effects instead of big things that are badly designed and cause a great deal of trouble.

Third, a policy that doesn’t depend on surprising people is likely to be better implemented, since policies can be planned and executed better if the depth of secrecy required is less and therefore more people can be brought in on the planning.  

Fourth, keeping large cash hoards is inherently risky, since almost all of the reasons one might want to keep a large cash hoard are reasons the government is likely to frown upon. In practice, governments are unlikely to tolerate the equivalent of what in the US would be the trillions and trillions of dollars of hoarded cash needed to enforce a lower bound on interest rates. (See “How Negative Interest Rates Prevail in Market Equilibrium.”)

Fifth, reducing the expected rate of return on paper currency relative to the rate of return on bank money causes a flight away from paper currency, not a flight toward paper currency. People in India are not saying “If we can’t freely turn in paper currency without restrictions and without documentation at the bank, let’s just quit dealing with the banks and instead use the cash the government is trying to invalidate for transactions instead.”

Sixth, it is important to think through all of the ways that people might try to get around something. Approaches that leave no way around (such as a gradually changing effective exchange rate for paper currency that makes the return on paper currency equal to the return on safe, short-term electronic rates) have a real advantage.