What sort of monetary experiment did India undertake?

Pat Horan directed me to this FT piece on India’s recent demonetization of “large denomination bills” (worth about $8 and $16 each.)

When Narendra Modi, India’s prime minister, announced in November that Rs1,000 ($16) and Rs500 notes would no longer be legal tender, he suggested that corrupt officials, businessmen and criminals — popularly believed to hoard large amounts of illicit cash — would be stuck with “worthless pieces of paper”.

At the time, government officials had suggested that as much as one-third of India’s outstanding currency would be purged from the economy — as the wealthy abandoned or destroyed it, rather than admit to their hoardings — reducing central bank liabilities and creating a government windfall.

But the Reserve Bank of India’s annual report on Wednesday suggested that most holders of the old currency managed to dispose of it, estimating that banned notes worth Rs15.28tn ($239bn) were returned to the bank. That amounts to 99 per cent of the Rs15.44tn of the old high-value notes that were in circulation when Mr Modi made his announcement, according to the finance ministry.

The bank’s estimate follows media reports that complex money-laundering networks sprang up in the wake of the demonetisation to help wealthy Indians deposit huge volumes of previously undeclared currency without exposing themselves to tax authorities. Such people allegedly sold the old notes, at a discount, to brokers who then dispatched low-income Indians to deposit or exchange them at banks.

Some of my market monetarist colleagues suggest that tight money policies create a “shortage” of the medium of exchange, and that this can cause a recession.  I argue that the real problem with tight money is that it raises the value of money, by reducing equilibrium NGDP.  Each dollar nows buys a larger share of NGDP. Because nominal wages are sticky, falling NGDP leads to more unemployment.  In my view, tight money does not create a true “shortage”, as anyone who wants more cash can always go to the ATM and get some.  On the other hand, people who want a rent controlled apartment in NYC often cannot get one— as rent control creates a true shortage.  Ditto for people who need a kidney transplant.  Those shortages are caused by price controls.

The Indian policy of denationalization of large bills really did create a money shortage.  On that point I don’t think there is any dispute.  And since the vast majority of transactions in India (98% by volume, 63% by value) involve cash, then this really was a policy than might be expected to sharply reduce transactions, and hence NGDP.   Instead, the slowdown was quite mild, and in my view ought to be regarded as more of a real (supply-side) shock.

It appears the cash experiment did lead to a slowdown in GDP, but much milder than what one might have expected from such a dramatic monetary contraction. For people like me, who focus on the role of money as a medium of account, this is no big surprise.  The silver coin shortage of 1964 also failed to significantly slow the US economy.  That’s because these shortages were widely viewed as temporary, and what matters is not the current stance of monetary policy, but rather the expected path of policy over the next few years.  As long as one-year forward NGDP expectations are not greatly affected, the current condition of the economy should hold up pretty well, even if there is a severe shortage of transactions media. The damage to India that did occur ought to be regarded as more of a real (supply-side) shock, sort of like a breakdown of cash registers.

On the other hand, economists who focus on the role of money as a medium of exchange also tend to think that it’s the future path of policy that is crucial, so I’m not sure whether the Indian experiment actually tested any specific model, although I’d be interested in what other people think.

PS.  Here’s a post I did last year, at the beginning of the Indian experiment.

PPS.  This experiment did confirm a point I often make—that data on cash in circulation are highly accurate.  The ratio of global cash to global GDP (and also American cash to American GDP) is very high, which suggests that cash is primarily used as a store of value.

PPPS.  India’s GDP grew at 5.7% over the past 12 months.  That’s modestly lower than in recent years, but experts also attributed the weak second quarter to de-stocking by manufacturers in anticipation of the new GST, which took effect July 1st.

 


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15 Responses to “What sort of monetary experiment did India undertake?”

  1. Gravatar of AlecFahrin AlecFahrin
    31. August 2017 at 15:18

    Scott,

    First, Indian statistics are extremely questionable. Their monthly data the last three years (ever since they revised their GDP calculation formula and changed the base year to 2011) has not at all reflected the annual growth rate reported.
    Second, the first quarter was 6.1% growth, down from the 7.9% average of 2016.
    Third, with the imposition of the GST on July 1st, wouldn’t it make sense that consumer demand was boosted in Q2 because the companies were desperately trying to sell of their stocks before Q3? Private Indian demand grew 6%. GST likely boosted consumer demand in Q2.

    What caused growth then? 20% growth in public demand.
    India’s budget deficit rose dramatically over the last year. No wonder real 10y bond yields remain at 4.5%.

    I’d argue that India’s economy was hurt more than you think by demonetization.

  2. Gravatar of Benjamin Cole Benjamin Cole
    31. August 2017 at 16:08

    Nice post, but…

    “On the other hand, people who want a rent controlled apartment in NYC often cannot get one— as rent control creates a true shortage.”

    Silly me. And I have been thinking property zoning created housing shortages.

  3. Gravatar of Benjamin Cole Benjamin Cole
    31. August 2017 at 16:16

    The ratio of global cash to global GDP (and also American cash to American GDP) is very high, which suggests that cash is primarily used as a store of value.–Sumner.

    Probably true. There is nearly $5000 in circulation for every US resident. One of the features of a low-inflation economy is rising piles of paper cash in circulation.

    But if the cash is used as a store of value, where is it?

    One guess is that paper cash is used to open a Cayman Islands style bank account. Opening such a bank account would leave a digital trace, if done conventionally.

    Once the bank account is opened by paper cash deposit, the paper cash returns to the US, so as to be cycled again.

  4. Gravatar of major.freedom major.freedom
    31. August 2017 at 16:43

    Remember all the fake news prattle about Trump obstructing justice?

    https://townhall.com/tipsheet/katiepavlich/2017/08/31/confirmed-comey-decided-he-wasnt-going-to-refer-hillary-for-prosecution-before-interviewing-key-witnesses-n2375767

    According to new transcripts released by the Senate Judiciary Committee Thursday afternoon, former FBI Director James Comey made the decision not to refer then Democrat presidential candidate Hillary Clinton for prosecution long before ever interviewing key witnesses.

    Why was he drafting this letter exonerating her if it was supposedly Lynch’s decision? It wasn’t his job until after tarmac meeting with rapist Bill Clinton was leaked and she half-recused herself.

    This is the most textbook case of obstruction of justice you will see, and guaranteed Sumner will meh, because he actually doesn’t care about obstruction of justice, they’re democrats in the face of stopping Hitler 2.0 from throwing gays off of building rooftops. Wait, sorry, the people who do that financed Clinton’s campaign, my bad. I have no issues with calling the GOP and the Democrats a bunch of swamp dwelling immoral sell outs. This blog only talks ill of republicans. What a joke

  5. Gravatar of ssumner ssumner
    31. August 2017 at 20:11

    Alec, I used second quarter figures, which are more recent. In any case, your data support my claim of a modest slowdown in GDP growth. So I’m not sure what point you are trying to make. I’m no expert on India, so I defer to the experts on the GST. Let’s see what happens to growth over the next few quarters.

    Just to be clear, I think India’s economy was hurt, and I opposed the policy. But it certainly didn’t cause a recession, which is rather surprising given that it was a pretty severe monetary shock from a “medium of exchange” perspective. The Indian stock market is doing well.

    Ben, Yes, that is pretty “silly”. There are no housing shortages in Massachusetts despite severe zoning restrictions, because Massachusetts lacks rent controls.

    Zoning reduces supply. Supply reductions don’t cause shortages, price controls do.

  6. Gravatar of Benjamin Cole Benjamin Cole
    1. September 2017 at 03:55

    Ben, Yes, that is pretty “silly”. There are no housing shortages in Massachusetts despite severe zoning restrictions, because Massachusetts lacks rent controls.

    Zoning reduces supply. Supply reductions don’t cause shortages, price controls do.==Sumner

    Well, I guess it depends on the definition of “shortage.” True, supply will always equal demand, without price controls.

    But housing prices will explode if the supply is limited, as we see along the West Coast or in Boston, and parts of NYC. I would call that a housing storage. Current account trade deficits evidently exacerbate the problem.

    If Boston granted work permits to work inside Boston city limits, and the number of permits was limited at X00,000, then we could expect labor prices to rise.

    There would be a “shortage” of workers, although supply and demand would be equal.

  7. Gravatar of Benjamin Cole Benjamin Cole
    1. September 2017 at 16:14

    Add on, on the use of the word “shortage,” in macroeconomic contacts.

    The Federal Reserve, in official policy statements, has stated there are “spreading labor shortages” in the United States, despite there being rather fluid labor markets nationally—freedom of movement and entry into any tight labor market—and, if anything, situational leverage tends to rest in the hands of employers, rather than employees.

    Nevertheless, we have “labor shortages” as defined by official statement, in the United States. No wage spikes however, which might be an objective indicator of a “shortage.”

    The Fed has never said there are “housing shortages,” despite residential markets in the United States being ubiquitously defined by restrictive property zoning. And sharply rising housing prices in many markets since 2007.

    I suspect the use of the word “shortage” in macroeconomics is not uniform, but rather reflects institutional, class and political biases.

    The US commercial banking system is heavily exposed to real estate, and in the US that means zoned real estate. The Fed, as a regulatory agency, is closely aligned with commercial bankers.

    Ergo, we have “labor shortages” but never “housing shortages.”

    Can rent controls create housing shortages? Yes, and rent control is bad idea.

    But the City of Los Angeles has no rent controls on new apartments built since the 1990s, and decontrol between tenants. The supply is not limited by rent control, but property zoning.

    Maybe Los Angeles has no “housing shortages.” But the city has “labor shortages”?

    A word means what I say, and no more or no less.

  8. Gravatar of Christian List Christian List
    1. September 2017 at 17:44

    Scott Sumner should write an economic textbook. When I read those kind of books all the relevant information seems to be missing (not to say they are flat out wrong). The correct information seems to be in your blog posts only. How is this even possible, I don’t get it. With just three sentences you make a valid case for NGDP targeting and all those NeoFisherians, Keynesians, and Austrians look bad.

  9. Gravatar of mbka mbka
    1. September 2017 at 19:23

    Christian List,
    Scott,

    “Scott Sumner should write an economic textbook. When I read those kind of books all the relevant information seems to be missing.”

    +1

    e.g., just by framing the concept or monetary stance in this way, that it can be normalized to the amount of GDP one dollar can buy – you’ll never look at the (monetary) world the same way again, the whole abstract mess suddenly makes sense, and I have never seen it expressed that way anywhere else.

    Please do write a textbook, Scott!

  10. Gravatar of ssumner ssumner
    2. September 2017 at 09:44

    Ben, You said:

    “But housing prices will explode if the supply is limited, as we see along the West Coast or in Boston, and parts of NYC. I would call that a housing storage.”

    That’s not what shortage means. It means demand exceeds supply at current price.

    mbka, I’m actually writing two books–but it’s a slow process.

  11. Gravatar of Benjamin Cole Benjamin Cole
    2. September 2017 at 20:31

    That’s not what shortage means. It means demand exceeds supply at current price.–Sumner

    Well, perhaps this gets too deep into semantics, but since prices continuously fluctuate, I guess there are continuously surpluses and shortages in every market, corrected by price after some small delay or friction. (In the case of the modern stock market, nearly instantaneously).

    The real price of labor has been flat to falling since the 1970s in the US, indicating near-continual surplus, while real house prices have almost continuously risen, indicating constant shortages rationed by upward moving prices.

    Yet US policy (or an agglomeration of many local policies, when it comes to housing) effectively operate as if there are labor shortages, but no housing shortages.

  12. Gravatar of Dots Dots
    4. September 2017 at 21:16

    Indian central bank did some pretty serious inflation fighting the last few years, no?

    Indian farmers seemed very bummed about crop prices earlier this year. given a large rural population, I wonder if tight money can be said to have slowed GDP growth by lowering farm investment

  13. Gravatar of Gregory Gregory
    5. September 2017 at 06:45

    The Indian demonetization and resulting bank return schemes could be seen as a one-time wealth tax, transferring a modest amount from the cash-rich to the poorer, with a deadweight loss for opportunity cost of arranging the transactions.

  14. Gravatar of Plucky Plucky
    7. September 2017 at 11:28

    The main objection I’d have to this line of argument is that the denationalization was aimed at the third use of money- store of value. The theory of the Indian government was that there was vastly more currency outstanding than was actually demanded for purposes of transactions, and that they could affect a seizure of the excess amount of it by this policy

    A related problem of tight money is that rewards holders of currency (as opposed to bank deposits) as a value store with a positive (or less negative) return without requiring them to take any investment risk. To the extent money represents claims to real resources in the economy, money held as currency to store value represents idle capital

  15. Gravatar of Shaun Shaun
    25. November 2017 at 12:49

    Just wanted to post an update on this situation Scott.

    One year on, it doesn’t look like India’s unemployment rate has gone back to normal.

    In fact, this piece here shows that the labor force participation rate has fallen (in a country with a burgeoning youth population) and that 2 million jobs were lost between January-June 2017 thanks to the note-ban exercise.

    http://www.livemint.com/Opinion/GWagxJq3AzHyM0w8RnUC0O/Demonetisation-has-hit-employment-hard.html

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