Demonetisation is the classic example of a policy whose oppressive costs are to be digested to ‘punish the thieves’ or ‘in service of the nation’ by the poorest daily-wage labourer standing in the longest queue. She cannot complain that she doesn’t have money to feed her children dinner, or that she has been laid off because there is no liquid money to pay. She cannot talk about how long she had to walk to get to the bank, only to be told that the ATM has no cash. These are just minor inefficiencies.
It must be noted, however, that the threats posed by the reasoning that has gone into the making of this policy have the capability to haunt long after enough cash has been printed and the industries have revived. Those who thought out demonetisation tested the trust that people invest in the economic institutions of our State and never saw any problem with that. It is absolutely essential that such reasoning must not be employed by governments in matters of public policy.
Free markets imply the exit of the government from economic activity. However, this does not mean that governments have no role to play. Governments have certain responsibilities that cannot be dispensed adequately by the private sector. Few of these derive from the credibility associated with the state. The supply of bank notes, the maintenance of law and order, etc., and institutions associated with these and other functions are examples. Thus, the government facilitates the functioning of the free market by maintaining institutions that are essential for the forces of supply and demand to interact freely.
For such a system to function, it is essential that the trust that participants invest in these institutions must be maintained. An important end that transparency in government serves is the generation of confidence. For instance, floating exchange rates are preferred in free market economies so that the true underlying value of the currency is known. One reason why the Chinese Renminbi doesn’t become the international reserve currency is that people are more confident about the dollar. This confidence partly derives from the openness with which American economic institutions function.
Similarly, the reason the Indian population agrees to embrace the Indian rupee (and not pieces of rock) as a medium of exchange has more to it than the efficiency associated with a homogenous currency. People associate the currency with credibility because of the confidence that they have in the Indian government and the RBI. The promise that features on the bank notes is taken seriously because people agree that the word of the RBI Governor can be trusted. If people lose their faith in the bank note, what remains is a piece of paper worth nothing. The value of the bank note is not a physical attribute. It arises from the perception of the people.
Demonetisation sent out a message that the promise is not eternal. That the government can refuse to keep it if it so desires. Demonetisation happened thrice before: the difference now is the magnitude and the depth. Eighty six percent of the currency lost its legal tender overnight in a move that rattled the informal sector and the poorest and most vulnerable associated with it.
The confidence of the people was jeopardised on a regular basis, as the errors in the policy and its botched implementation started becoming clearer to its progenitors. Rules were changed around 74 times (through 74 notifications), as the Indian Express reported on Saturday, December 31. The banking sector, scarce and weak in rural India, buckled under the stress. Till December end, only 40% of all ATMs were dispensing bank notes.
Changing rules 74 times in 50 days generates uncertainty to exponential levels. The uncertainty is only magnified in rural India, as the penetration of news is not as quick and efficient as in urban regions. The ability of people to understand diminishes due to inadequate education. The result of these is twofold: there is a state of panic and confusion and there is an erosion of the confidence that people invest in the system. The short term and medium term problems are the consumption demand shock and breakdown of the informal sector. The long term problem arises from the fact that the government does not seem to find any problem with betraying the trust of the people.
I do not suggest that demonetisation, however painful it has been, would by itself crush the confidence of the people. However, the confidence of the people in any system cannot be taken for granted. Beyond all the pomp of creating a cashless society, the government recognises how far in the future this goal is and how crucial cash is to a major chunk of the informally employed in the economy. It must be reinforced that in the age of representative paper money, the piece of paper is not legitimised by any physical element as in the old gold standard. People use it because they perceive it as being worth the value printed on its face. If people lose confidence in the currency and decide that the piece of paper is of no value, there is no law which can prevent two agreeing people from exchanging two goods in barter. The costs to the economy and to welfare will be very large.
Understanding this is absolutely essential so that populist means such as overnight demonetisation, and the promulgation of lies that has followed do not become a habit of any government. This is hollow middle-class populism. Underneath the thin populist coating lies an ocean of distrust and panic.
Dr Manmohan Singh, writing in The Hindu, opened his argument against demonetisation with an important statement. “At the stroke of the midnight hour, on November 9th, the confidence of more than a billion Indians was destroyed.” The lessons from this reasoning go beyond demonetisation. One of the most important requirements of the kind of free market systems that we envisage today is the willingness of people to invest some minimum amount of trust in institutions of the state. The state shall betray the people only at the peril of deconstructing the efficient functioning of the free market.