Modi & Monetary Theory: Economic Consequences of the Prime Minister of India (2016)

Modi & Monetary Theory: Economic Consequences of the Prime Minister of India (2016)

by Subroto Roy*


Mr Modi was doing well enough until his catastrophic statement of 8 November 2016 trying to nullify the value of masses of people’s holdings of 500 and 1000 rupee currency notes.

On foreign policy he had flown around important capitals with substantive results.  On economic policy he had ended the ossified process misnamed “planning” and was seeking to bring better rationality to budgeting e.g. by finally integrating the railway budget.  India seemed the envy of the world economy.

What needed to be done next was remove the RBI and nationalised banks from the Finance Ministry’s control completely, into a new Ministry of Money & Banking.  Finance (with Accounts and Planning) then would be tasked to get the budgets right  for both Union *and* the States, for not just railways but the military too.  The Finance Ministry’s full-time year long occupation, not yielding to lobby groups, not allowing anyone get close to them, would be just getting all of India’s Budgets right, for the first time ever.  Money & Banking would run the nationalised banks on commercial lines (being ready to battle their fat cat unions), while the RBI continued with its supervisory, money creating, and balance of payments management roles.  The aim would be to bring a semblance of integrity to India’s currency at home and abroad, for the first time ever.

Instead Mr Modi got into his head there was something bad called “black money”, and that he could remove it by peremptorily declaring the bulk of India’s paper money to be null and void within days or weeks.

Now money is a most peculiar institution. Paper money is intrinsically worthless in and of itself yet all of India’s people (street children onwards)  need to hold it temporarily to expedite their individual transactions of buying and selling real goods and services.  Money acts too as a repository of value over time and a unit of account or measure of economic value.  Money supply consists of hand to hand currency and till-money in the banks (including  ATMs),  and bank deposits of customers.  (“High powered money” or “base money” consists of currency and bank reserves.)

Cash and credit transactions differ obviously in that cash is now, credit is later. Cash needs trust only against inflation devaluing its purchasing power while it is held. Credit needs that too, and in addition has to assess the credit-risk of the debtor for the debt to be encashed.  Hence cash is completely liquid and economizes on trust, credit much less so.

When you accept my cheque you accept my bank’s credit, superior to my own; and banks differ in their  credit-worthiness. As for debit cards, e-wallets or other “plastic money”, there is no relevant difference with cheques except digital signatures being required not handwritten ones.

The crucial task of money, whether hand to hand currency or bank deposits, is to expedite real transactions.  Money is held only temporarily in place of real goods satisfying human needs: shelter, food, clothing.  The labourer accepts Rs 500 as wages believing he/she can dispose of the piece of paper in exchange for rent or food.  The real transactions are labour, shelter, food — the paper money (or bank deposit) merely intervenes temporarily to *allow* these trades to happen.

Money’s paradox is it has no value in itself yet is held universally by all in  belief it can be exchanged.  Why people believe in that universally is because they believe everyone believes the same. Hence the two great divisions of Economics into Theory of Value and Theory of Money, “micro” and “macro”:  what explains the relative values (prices) of things, and why is money – which is not a thing like any other thing – desired to be held at all by people and in what amount.

Hence money represents people’s incomes and, if current consumption needs are met, their savings for future consumption.  Cash or deposits may be held as a store of purchasing power for future consumption, or used to purchase an asset like cattle or gold or land for the same purpose. The cash/deposit ratio, and generally the ratio of money to other assets, has to be voluntary, chosen by people depending on individual circumstances of convenience, wealth, and especially confidence in the banks and financial system.  Liquidity,  a concept introduced  first by JM Keynes himself in *A Treatise on Money*, defined as something being “more certainly realizable at short notice without loss”, applies to all assets, land and human capital too.  “You’ll always find work here”, an employer says to a worker; she immediately realizes her skills are liquid, can always be converted to cash income and hence to food.

Mr Modi on 8 November 2016 suddenly declared the bulk of India’s people’s holdings of hand to hand currency would soon be worthless paper, though it could be exchanged purportedly for bank deposits or new currency.   It is a measure of how obedient India’s people are that they immediately accepted this, at least initially, and started standing in endless often futile queues.

But money’s peculiar nature means its value is ultimately determined by people assessing its liquidity.  If India’s people wish to continue to use their Old 500 or 1000 notes with confidence in trade and employment, Mr Modi cannot stop them.  Government and other banks may be ordered by Mr Modi not to accept them but the “Old Money” can continue to have value as a hand to hand currency as long as it is accepted by masses of people,  either the full face value or a discounted value.

Old Money would become effectively a *private* money, not a fiat government money but a parallel currency to the New Money that Mr Modi and his bankers issue, and there would be an implicit exchange rate defined between Old and New Money.  Who is to say that four Old 500 notes will not have a higher market price than one New 2000 note?  Some evidence has appeared that retail markets where the Old Money is accepted have been doing normal business while others accepting only New Money have been hit badly.

Mr Modi’s sudden nominal shock damaged the normal functions of money and inevitably led to real shocks in trade, transport, employment and hence incomes.  People’s money holdings represent mass nominal incomes and savings, and an arbitrary cutting of these overnight must cut mass consumption, possibly cause mass hunger.  There is a medium term risk a massive contraction will lead to a policy overcorrection, and further erosion in confidence in the currency. Government should try to comprehend the macroeconomic path it has put itself on.

As to the ostensible purpose, India’s masses can see as well as anyone that forcing people to reduce their cash/deposit ratios and then rationing severely their ability to withdraw their own money, is an ill-concealed attempt to help government banks which over decades have been run into the ground financially by political malfeasance. Confidence in the organized banking system cannot be imposed forcibly.  Making banks mere instruments of a tyrannical tax collecting state is a sure way of getting the public to lose further confidence in them, and indeed in the currency they use.

Government like everyone else has two sides to its budget, Revenue and Expenditure. Mr Modi has unleashed a tyranny on individual citizens to raise revenue, while allowing expenditure,  deficits, government accounting and audits to remain a mess.  Instead of attacking government corruption on behalf of India’s masses, he has attacked the masses’ meagre incomes and savings transferring them towards the government class.

The way forward is a Government-Opposition Accord: crackdown on tax evasion, crime, counterfeit currency and terrorism, while allowing Old Money and New Money to continue as parallel currencies for as long as may be needed by the public.

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*Subroto Roy was an adviser to Rajiv Gandhi in 1990-91.

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