Demonetisation: Myanmar, China demonstrate how good intentions can have disastrous results

Since November 8, when the Union government invalidated high-value Rs 500 and Rs 1,000 currency notes overnight, several people have invoked patriotism and a spirit of sacrifice to build support for the decision, which has clearly been insufficiently thought out and poorly implemented.

One of the cardinal mistakes made in the social sciences is to examine a policy by its stated intentions, and not by its potential consequences. When policies are formulated on the basis of gut feeling and unexamined assumptions, the results are usually the opposite of those intended.

An opportunity for counterfeiters

Let us begin with the claim that demonetisation will solve the problem of counterfeit currency and terror financing in India. Not because this is the most serious issue, but because there is straightforward logic involved. The scarcity of valid legal tender in the country is so severe that people are accepting Bhutanese currency in the North East for their transactions.

Given that the new series of high-value currency notes have the same security features as the ones that have been withdrawn, counterfeiters have hit the jackpot. They already have the technology, the resources, and the distribution network. Now, a massive export opportunity has just opened up too. No wonder former Pakistan President Pervez Musharraf said that he wholeheartedly supports demonetisation in India. Never disturb your enemy when he is making a blunder.

The Burma experiment

In 1987, Burmese leader Ne Win demonetised Burma’s national currency, the kyat, to fight the menace of black marketing. The intention was noble, but the results on the ground were entirely different. For one, rice cultivation suffered. More importantly, farmers began to use rice as a substitute for cash. Like money, rice is infinitely divisible, and it is universally accepted in a barter system. Food inflation meant that it was an excellent store of value. People earn just by hoarding it. As a result, there was a massive shortage of rice in urban areas, and food riots broke out all over the country. The Army had to open fire on protesters, and by independent estimates more than 10,000 protesters were shot dead before order was restored.

Given this bloody experience of a neighbouring country, it is mystifying why New Delhi undertook its demonetisation exercise at the peak of the agricultural calendar. Ominously, wheat prices have started to heat up, and this is just November.

A meteor has hit us

Additionally, macroeconomic consequences are potentially catastrophic. Right now M1 (the metric for money supply relevant for the formal economy) is down by 50% and currency with the public (used primarily in the informal economy) is down by a whopping 86%. To put these figures in perspective, the Great Depression (1929-1939) in which the US lost around 46% of its gross domestic product, was caused by a mere 27% contraction in money supply.

It is true that the current shortage of currency in India is temporary, and it is hoped that the economy will bounce back once liquidity conditions improve. But by that time, the velocity of money will slow down because people will hoard cash rather than spend it, an output gap (difference between actual output of an economy and the maximum potential output) will develop, deflationary expectations will have set in and the economy would be in a slowdown mode. For a variety of reasons, the Reserve Bank of India will find it hard to aggressively cut interest rates without triggering an outflow of capital from the economy and precipitating an external crisis.

Economies have failed to absorb much more benign demand shocks. For instance, in the early 1990s, after its asset bubble burst, Japan had to endure an entire lost decade in which its economy performed sluggishly.

India has not been hit by a nuclear explosion but by an enormous meteor. The sheer magnitude of the monetary squeeze should spook us. Demonetisation to fight corruption is very much like burning your house down to smoke out a few rats. It does provide a thrill for a moment. But after that you have to start from scratch.

The road to hell…

The law of unintended consequences makes no exception for the sincerity of purpose. In the 1950s, when China’s Chairman Mao started his sanitation campaign against what was referred to as the “Four Pests” ­(flies, mosquitoes, rats and sparrows), little did he realise that the campaign – which led to a proliferation of crop-eating locusts because sparrows, their predators, were being exterminated in large numbers – would help contribute to the Great Chinese Famine that would kill more than 20 million Chinese.

It is strange that India – a civilisation that first understood the law of unintended consequences and articulated it in the Mahabharata – should forget its formative lessons.

Myanmar, which has lived through a demonetisation-triggered nightmare, has evidently learnt its lessons. Its 2008 Constitution expressly prohibits the demonetisation of its legal tender.

That half-a-dozen people, no matter how sincere and wise, can decide the destiny of 1.3 billion people should worry us. When the people are asked to endure transitional pain in the interest of a greater good and bright future, history has evidence to show that it does not end well.