In the Indian government announced a surprise demonetization. All 500 and 1,000 rupee notes would lose their status as legal tender. Anyone holding such notes had until the end of the year to exchange them for new bills or to deposit them in bank accounts.
The policy was designed in part to attack the underground economy by making cash more legible to the government. The theory was that when people deposited or exchanged their cash reserves, pools of undeclared income would suddenly become visible to the tax collector. In addition, if people were afraid to convert their currency because this would be an implicit admission of having gotten such quantities of money illegally, the money would become worthless and this would amount to a de facto government seizure of the assets. There was also the hope that this policy would reduce people’s confidence in holding and using cash, and that they would switch to digitized forms of exchange that would be easier for the government to track.
In the latest Journal of Economic Perspectives, Amartya Lahiri runs an autopsy on this bold demonetization policy, and concludes:
The evidence points to demonetization having mostly failed to have achieved its stated objectives. The goal of eradicating black wealth and corruption by demonetizing currency was problematic from the start, given the widespread acknowledgement of the fact that undeclared income is seldom held for long periods in terms of cash. Moreover, demonetizing currency, which attacks a stock, does little to impede the fresh creation of undeclared income, which is a flow problem.
―Amartya Lahiri, “The Great Indian Demonetization” Journal of Economic Perspectives 34(1), , pp. 55–74
Lahiri says that the policy did not appear to have any significant effect on the ongoing trend of increased payment digitization, or on the number of tax filers or amount of tax revenue. Almost all of the outstanding currency was deposited or converted, and so the government also gained little or nothing through de facto seizure. However the abrupt demonetization policy was costly, and disrupted the economy in the short term, particularly the informal sector (roughly 25% of the total Indian economy). “On balance, demonetization appears to have failed the cost-benefit analysis of public policy initiatives: it had little success in achieving its stated goals while having imposed significant costs on the public.”
This experience may cool the heels of economists who have advocated for more countries to use demonetization as a way to increase government oversight of economic behavior, broaden the tax base, reduce the size of the informal economy, fight corruption and organized crime, and so forth.
