Demonetization and Populism

by George Hatjoullis

Money in the form of cash and coins has some very useful attributes. It is divisible making it possible to exchange precise sums. It is widely acceptable. Some version is always widely acceptable even if it is the cash of a foreign nation deemed to have a more stable value. It comes in bearer form so that you need not prove ownership nor leave a personal trace of your exchange. It is default free in that a pound is always a pound even if a pound is worth less because of inflation. The downside is that it is difficult to store large amounts safely. Nevertheless, these attributes make cash and coin a useful vehicle for transactions in the black economy.

The black economy refers to all transactions that are officially unrecorded and carry no official trace. In this economy we find money launderers and tax avoiders, terrorists and criminals. Every nation-state has one and every citizen has probably transacted in this economy at some point. Have you ever paid your gardener in anything but cash or asked for a receipt? Do service sector workers always declare all tips? Have you ever bought anything in the pub for cash or at a car boot sale? Without the black economy, tax avoidance and other illicit activities becomes very difficult. Indeed organised crime becomes very difficult because there is no way to hide and use the gains from crime. Needless to say most authorities would like to minimise the black economy (but often still pay their gardeners in cash).

One plausible way to try to do this is to demonetize the economy. Just eliminate cash and coin. All transactions would be carried out digitally leaving a digital trace. Illicit transaction thus become hard to conceal. Bitcoin and blockchain technology seem to have been an attempt to preempt such a development but it seems Bitcoin is not as anonymous as cash and coin. The response of the black economy is clear though. It would not simply give up but it would seek other ways to operate. It might take a brief while to establish a new medium of exchange and store of value but all the evidence is that it would not take long. Demonetizing the economy in order to kill the black economy is unlikely to work in the long run. It could also harm the white economy.

If a demonetization is announced and phased it would allow the black economy time to adapt. To be effective, in the short-term at least, it must be abrupt and unannounced. However, this effectively amounts to collapsing the money supply. Both economies would be adversely affected as they are usually integrated and not separate sets. Time would eventually see both economies recover though perhaps operating with a different form of money. Black economies do not exist and thrive just because there is a suitable form of money. Black economies create forms of money that they need to operate.

The only effective way to attack a black economy is to look into the details of individual lives. If consumption exceeds white economy income the individual can be required to explain. This is very resource intensive and highly inefficient. Ultimately, one needs to create a society in which all citizens feel themselves to be stakeholders. This is a necessary condition, and for many sufficient, to minimise the black economy. Stakeholders are law abiding, tax paying, citizens. It is alienation that feeds the black economy and the size of the black economy says much about the lack of cohesion within a society.

India has recently attempted an unannounced partial demonetization. The consequent distress it has caused will only increase alienation and fracture the society further. It will not unfortunately end the black economy. Demonetization must have had a glib plausibility for the Indian authorities. This seems to be a growing trend amongst populist politicians. Glib ideas displace evidence based and carefully crafted policies. A good policy becomes one that the uneducated and unthinking can grasp and typically has popular appeal. Dismissing experts has such an appeal. But to listen to whom?