Six years ago today, India experienced an economic earthquake.

According to news reports at the time, the union cabinet was gathered in a closed room without their mobile phones while prime minister Narendra Modi made a fateful address to the nation at 8.15 pm on November 8, 2016.

After a rambling list of his administration’s programmes and their success in turning around a faltering economy, he came to the main issue – the “festering sores” of “corruption, black money and terrorism” that were, he claimed, “holding us back in the race towards development”, with “enemies from across the border” running their operations with “fake currency notes”.

“To break the grip of black money and corruption,” he announced, “we have decided that the Rs 500 and Rs 1,000 currency notes presently in use will no longer be legal tender from midnight tonight.”

With less than four hours’ notice, 86 percent of the 17.74 lakh crore of currency in circulation, as on November 4, was rendered “worthless pieces of paper”, in Modi’s own words. 

At the time, Jagdish Bhagwati, professor of economics at Columbia University hailed it as a “courageous and substantive economic reform that had “the potential to generate large future benefits”. In this report, I take a critical look at such claims about the effects of the monetary shock and ask – did it do any good? 

Money, currency and the economy

To understand the import of the cataclysm that was visited upon the Indian economy, we need to take a step back. 

What is money, what relationship does currency have with money, and what role does money play in a modern economy?

In economics, money has three interlinked, but not necessarily interdependent, functions. It is a medium of exchange (“I will give you a ride in my auto rickshaw if you pay me Rs 150), a store of value (“I have Rs 10,000 in my safe”), and a unit of account (“Infosys is worth $78 billion”).

In modern economies, only a small part of the money supply is in the form of currency notes or coins. Money is simply a measure of how much “credit” you have in a bank account. So, as on November 11, 2016, according to the Reserve Bank of India, M3 money was Rs 123.77 lakh crore. M3 money is a measure of money supply that includes currency money (Rs 17.74 lakh crore), demand deposits in banks (Rs 10.9 lakh crore of money that an account holder can demand immediately), and fixed deposits in banks (Rs 97.5 lakh crore).

Notes and coins are simply a convenient form of money that can be easily carried around and used as a universally accepted and trusted medium of exchange. A Rs 500 note is essentially an IOU issued by the RBI that everyone trusts and accepts in settlement of obligations.

The role of transactions in an economy is often not sufficiently appreciated. Economic activity – transactions between individuals, firms, government offices, service outlets and shops where goods and services are exchanged for money – is the cornerstone of a modern economy. The circular flow of money means that one man’s expenditure is another’s income. All things being equal, the more that individual economic actors earn, spend, buy, sell, save and invest, the bigger the economy as measured by the GDP.

When ordinary economic activity seizes up, as happened during the Covid lockdowns, the economy stalls. Businesses shut, livelihoods disappear, firms and individuals stop trading, and the GDP shrinks. 

Assessing the economic impact of demonetisation

With this basic understanding of money and the role of transactions, we can turn to examining the effects of demonetisation or notebandi, as it came to be called.

Loyal defenders of Modi’s policy have fallen all too easily into the trap of attributing to demonetisation any positive change observed after 2016. They have fallen prey to a logical fallacy known as ‘post hoc ergo propter hoc’ – just because we did X and observed a change Y, it does not follow that X was the cause of Y. 

In assessing outcomes, the economist’s perspective is, firstly, always to consider the net effect on the whole system. Secondly, the economist considers whether the claimed outcome would not have happened even in the absence of the intervention.

The claimed benefits of demonetisation

The three official stated aims of the exercise, to quote the prime minister’s address and tweets from the time, were (a) to flush out black money; (b) to free the country from corruption; and (c) to deal a blow to cross-border terrorism by eliminating counterfeit currency.

The case for black money rested on the belief that corrupt crooks and criminals had sacks of high-value currency notes of Rs 1,000 and Rs 500 stashed away. They would now be compelled to either come forward to deposit these notes and account for them, or burn and discard their ill-gotten wealth to escape prosecution. 

As Karan Thapar wrote nearly a year after demonetisation, the government estimated that Rs 3-5 lakh crore would never be handed back into the system, and this would be a one-off windfall gain for the government. Since currency notes are basically promissory notes issued by the RBI, any notes that are extinguished result in a drop in the RBI’s liability. The extra capital can then be returned to the government as a one-off dividend. This was a widely touted and anticipated outcome.

It never happened. 

Anyone who understands money and wealth could have told the government that the expectation was wildly speculative. Those who make money illegally do not park the cash under their beds. They invest it in real estate, jewellery, vehicles, or spend it on luxuries. They use their ill-gotten cash as a medium of exchange not, except for short durations of time, as a store of value.

To the extent that crooks and criminals held ill-gotten wealth as cash, they would also have the means and resources to launder their stash of old currency notes and convert them into new ones or bank deposits. 

The results were an embarrassment for the RBI which, after as long a delay as possible, announced in September 2017 that all but Rs 16,000 crore had flowed back into bank accounts. That is a mere 1.04 percent of the cash rendered “worthless pieces of paper”.

Were people caught with hoards of cash? They were, but the vast majority was probably legitimate. In his budget statement in 2017, then finance minister Arun Jaitley said that between November 8 and December 31, 2016, an average of Rs 5.03 lakh was deposited in each of 1.09 crore accounts; and an average of Rs 3.31 crore in each of Rs 1.48 lakh accounts. That is a total of 110 lakh accounts that would have needed close scrutiny to detect irregularities and levy potential tax claims and penalties. Tax officials were unprepared and under-resourced for this task.

The fact is that many of these high-value accounts were probably perfectly honest business accounts that needed to store cash periodically on a rolling basis for perfectly legitimate reasons, such as disbursements to suppliers or to pay wages of daily wage workers. Remember, much of India functions on a cash-in-hand basis. 

In the months and years after 2016, the government did not put out any further data on the scale of illegitimate wealth flushed out by the demonetisation exercise and whether the culprits were ever prosecuted. The speculation has to be that there were few gains from this exercise. 

The aim of ending corruption was heavily touted as an immediate and lasting benefit of demonetisation. Alas, if the level of corruption reduced at all, it was too small to be noticeable. 

Transparency International’s Corruption Perceptions Index tracks the perceived level of corruption in countries across the world each year. Denmark is ranked on top. India has consistently had a CPI score of around 40/100 and ranked a steady 40 or 41 out of 180 countries between 2016 and 2021.

The scale of corruption involving political parties, businesses and wealthy individuals in India rose dramatically with the enactment of electoral bonds in 2017, without any meaningful debate in Parliament. As Milan Vaishnav wrote in November 2019, political finance has “long served as the wellspring of corruption in India”. And the advent of electoral bonds has ensured that that source of corruption has continued to poison India’s polity. 

Additionally, recent revelations in Karnataka about the scale of petty venality and corruption involved in the awarding of civil infrastructure contracts show that demonetisation was never going to be the right policy response to India’s endemic corruption. 

What about the third claim, that it would cut down counterfeit notes and terrorism?

The evidence is clear that to choke terrorist financing, you need international collaboration through the Financial Action Task Force, of which India has been a member since 2010. While counterfeiting is one of the means of financing terror, it is by no means the main one, nor is it confined to counterfeiting high-value Indian rupee currency notes. Indeed, the US dollar is the favoured currency of international criminal and terrorist gangs.

The idea is ludicrous – that changing notes overnight, and in a hurry, would seriously deter terrorists from learning how to counterfeit the replacement Rs 2,000 notes. Indeed, one doesn’t have to go further than a standard ATM to find fake Rs 200 notes. In any case, the demonetisation of 86 percent of currency to tackle counterfeiting sounds like a scorched earth policy, one that hurts legitimate citizens far more than it temporarily inconveniences the committed criminal or terrorist.

Post-hoc justifications for demonetisation

As the ill-effects of notebandi began to bite, and as the claimed benefits of the exercise rapidly evaporated, new benefits were identified in an ill-disguised attempt to salvage the government’s credibility. This is where we need to guard against the ‘post hoc ergo propter hoc’ fallacy of logical reasoning.

One of these was that the economy would shift to a digital or electronic cash settlement system. People would use alternative and newer means of payments and move to a cashless or less-cash economy. There is, of course, the question of whether and how digital payment systems are necessarily better than cash, and I shall return to this question later.

But before going further, we need to be clear that the use of cash has not only not reduced in India, but it has grown dramatically. In fact, six years later, currency notes in circulation now are 72 percent higher than in November 2016 just before demonetisation. RBI data shows that the value of currency in circulation dropped dramatically in the weeks and months following November 8, 2016. Then, as the new notes were printed and brought into circulation, the stock of paper money grew rapidly to reach, and then far exceed, the level before demonetisation.

In numbers, the nadir was in the week ending January 6, 2017 when the currency stock bottomed out at Rs 8.73 lakh crore and then began its upward growth. It recovered to its pre-demonetisation level by early March 2018 and reached Rs 31.8 lakh crore by the end of October this year. 

A less-cash economy

In his address on November 8, 2016, Modi made no reference to the shift to a less-cash economy as one of the reasons for the demonetisation exercise. It was clearly a post-hoc justification that amounted to clutching at straws.

But even if a less-cash economy was a desirable objective (albeit after the event), there are two fundamental arguments that applied even at the time. 

The first is a theoretical consideration of the relative costs, advantages and disadvantages of paper versus digital money as they apply to different sections of a country as economically diverse as India. Brett Scott, in this deeply perceptive essay, makes the argument that with paper money, the transaction costs are borne by the state. The burden of printing, distributing and safeguarding currency notes falls on state institutions.. 

But the advantages to the people are obvious. There is no fixed cost to holding a crumpled Rs 500 note in the pocket of a torn trouser as there is to holding the same Rs 500 in an e-wallet, where the bank may impose a minimum balance before you can operate the account. For those scores of millions who live hand to mouth, for whom the evening meal is paid for by the day’s earnings, paper money is vital.

On the other hand, the costs of digital money are borne by each and every individual. Each citizen needs an account with a bank or other financial service provider, businesses need card readers, and everyone needs a mobile smartphone that is charged and has an up-to-date app.

For Indians at the bottom of the pyramid, demonetisation cruelly and uncaringly took away the meagre amounts of cash they carried for their basic needs.

It is telling that in the weeks following demonetisation, as scores of millions lost their wages, livelihoods and jobs, the one sector of the economy that carried on regardless was air travel – an industry that catered to the well-heeled and whose customers were able, willing and accustomed to relying almost entirely on electronic money. 

The second argument is pragmatic. Much is now made of the growth of electronic payment systems such as UPI, RuPay and mobile payments systems, as if these ideas arose only because of demonetisation. Yes, it is the case that retail payments through UPI grew remarkably, reaching 730 crore transactions totalling Rs 12.11 lakh crore in value in October 2022. But can this be attributed to the demonetisation of six years ago? Wouldn’t it have happened organically without the hugely disruptive, damaging effect on the economy of arresting economic activity in its tracks? 

A part of the problem, of course, is that there is no way of counting the vastly greater number of daily transactions that occur in cash. Cash is anonymous, there is no paper record except if there is an invoice or receipt, and there is certainly no electronic record of every cash transaction. The only measure we have of the size and scale of cash as a medium of exchange is the growth in the amount of currency in circulation. And there, the evidence is clear – paper cash is back.

In October 2016, weeks before demonetisation was announced, Visa India put out a report on the prospects for growth of digital payment systems in India. Titled Accelerating the Growth of Digital Payments in India: A Five-Year Outlook, it carried a foreword by none other than Amitabh Kant, chief executive of Niti Aayog. 

The report did many things. It was a thoughtful analysis of the many problems involved in transitioning to a less-cash economy. It concluded that with the right mix of policy, fiscal incentives, regulatory framework and a programme of carrying everyone along at a pace they were comfortable with, it would be possible for India to move significantly to an economy less dependent on cash.

The significance of this report to the debate on demonetisation is two-fold.

First, it shows that demonetisation cannot have been under serious consideration by policymakers at the highest level if a report endorsed by Niti Aayog, and published just weeks before, makes no mention of it. The prime minister said in his televised address that an element of surprise was necessary for the exercise. Are we to believe this report was a decoy to maintain that element of surprise? If that was the case, then if anyone was surprised it was the Indian economy that suffered a grievous blow to its growth prospects.

Second, the report shows how a shift to digital transactions could have been achieved by sensible and considered policies while also safeguarding the interests of the poor. Assuming it was an unstated objective of the demonetisation exercise, a planned strategy was sacrificed in favour of a dramatic and cataclysmic event that achieved misery for crores and crippled the economy. 

Demonetisation and economic growth

When announcing demonetisation, the prime minister said the move would “open up new opportunities for the poor, neo-middle class and middle class”. In the same breath, he also held out the promise that “real estate prices, higher education and healthcare” would “come within reach of common citizens”. 

The connection between new economic opportunities for the masses and cancelling 86 percent of currency is not immediately obvious. Presumably the effect would come about through the elimination of corruption, the formalisation of the economy’s informal sector, and the consequent economic growth that would follow with more plentiful jobs, productivity growth, flowering prosperity and greater wealth. 

There was some lukewarm support for this view from a few economic experts, including Eswar Prasad, a professor at Cornell University. He argued that the short-term economic turmoil would be followed by long-term gains from reduced inflation and a return on investment. That would depend, he said, on the right follow-through policies and sufficient incentives for investments. 

Was he suggesting that demonetisation was a policy response to inflation? That is like arguing that a tsunami or fire may be good in the long term if and when people return and, with the right incentives and policies, manage to ‘build back better’.

But even if we ignore the typically caveated support from a few economists, the fact is that inflation was falling at the time. It was 6.67 percent in 2014, it fell to 4.9 percent in 2015, and was 4.95 percent in 2016. In any case, it is hard for anyone with credibility in economic policy to argue that demonetisation was the right tool with which to fight inflation.

The argument was also advanced at the time that banks would have more of the money that ‘came into the system’ to lend out to businesses. This is nonsense for two reasons. One is that the lack of funds was not the reason for weak bank lending. Banks had a vastly greater pool of bank deposits (M3 money), far in excess of the amount in currency notes. But the second reason may be more important. If banks were not lending, it was, according to the Economist, because of “insufficient shareholder capital to absorb potential losses, and by the over-borrowed balance-sheets of many industrial customers”.

Among the strongest voices articulating the economic devastation from demonetisation was journalist and rural affairs expert P Sainath, who spoke about and documented its effects on the lives of people in smaller towns and villages, where 50 percent of India’s population depended on an agrarian economy that generated just 20 percent of India’s GDP.

To quote the Economist again: “Managing an economy’s money is among the most important tasks of the government. Clumsy use of monetary instruments comes with high risk. John Maynard Keynes, an economist, was echoing Lenin when he wrote in 1919: ‘There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. Trust is fragile, and precious.’”

By “debauch” the currency, he meant the loss of value due to inflation. Demonetisation didn’t just reduce the value of currency in circulation, it reduced paper currency, for a while, to nothing. 

Whatever the theoretical arguments at the time, today, six years on, we have the benefit of hindsight. The statistical record of GDP growth speaks for itself. Quarterly GDP growth fell for five successive quarters from 9.67 percent per annum in July-September 2016 to 5.32 percent in July-September 2017. It then picked up a bit to around seven percent in late 2017 but again fell in eight successive quarters to reach a low point of 3.01 percent in January-March 2020. 

Then, as is well known, the economy contracted by an unprecedented -24.4 percent in April-June 2020 thanks to Covid. 

Is it possible to make a direct causal link between demonetisation and the economic slowdown in the period before the pandemic? Perhaps not directly, but arguing from first principles of the factors that impact economic activity and growth, one can make the case that a sharp monetary contraction can only dampen growth. Economists talk of the multiplier effect of injecting cash, even at the risk of stoking inflation, into an economy. Increasing purchasing power has a ripple effect through the economy as spending stimulates new demand setting up a circle of ever expanding economic activity. 

The converse of this multiplier effect is equally true. If demand is sucked out of an economy by a shock – such as a sharp rise in interest rates, a war, or a pandemic – then the ripple effect of people not spending spreads through the economy. This leads to businesses shutting, suppliers going bust, and jobs and livelihoods being lost. 

India is an economy of millions of small businesses and the majority of them use cash as the medium of exchange that keeps the wheels oiled. Take out the means of transacting business and the business folds. Nowhere was this downward spiral more starkly seen, and more keenly felt, than in rural India. All those government economic ‘experts’ and apologists who extolled demonetisation were speaking from the vantage point of the 25-40 percent of Indians who possess smartphones, credit cards and a cushion of bank balances.

Demonetisation and the formalisation of the economy

On the second anniversary of demonetisation, Arun Jaitley defended it as an important step towards the formalisation of the economy. This justification was not only post-hoc but also specious. But there is more to an understanding of the formal and informal sectors of the economy than simply how workers in each are paid. 

In the formal sector, there is job security, paid holidays, union support, and legal protections of working conditions. Simply forcing poor and exploited workers in the informal sector into a less-cash, digital-money payments system does nothing to either alleviate the precarious nature of their livelihoods or deal with a growing jobs crisis.

Besides, payment through digital means does not by itself lead to greater tax revenues – that depends on whether people earn more than the tax thresholds. The vast majority of Indians do not pay direct taxes, not because they are by nature tax-dodgers, but simply because they earn far below the tax threshold.

The net effects of demonetisation

Strangely, for a policy move that has caused so much damage to the economy, there has been no formal parliamentary enquiry into how the policy came to be conceived, what expert analysis and advice informed the decision, or any definitive study into the overall net effects on the people, their livelihoods, and the economy. 

Suffice it to note that even the government’s ardent defender, R Jagannathan, acknowledged the failure of demonetisation in a June 2017 article in Swarajya headlined “Modi’s DeMo Gambit Failed: Costs Exceed Gains And Farm Anger Is The Final Piece Of Evidence”.

To end, it’s worth reading Bhaskar Chakravorti’s piece in Harvard Business Review, written on the first anniversary of demonetisation. India needs to understand that demonetisation failed, not because it was badly planned, but because it was a flawed idea. As the American writer HL Mencken said, “For every complex problem, there is an answer that is clear, simple and wrong.”