Like everyone else, we were surprised by the dramatic action taken by Indian Prime Minister Narendra Modi to demonetize the existing 500 and 1,000 rupee notes. This is by far the most sweeping change in currency policy that has occurred anywhere in the world in decades.
First, it affects notes that are in widespread use, being valued at $7.34 and $14.68, respectively. While it might be argued that because India is much poorer than the United States, $15 in India is equivalent to $100 in the United States, the reality is that most Americans in the top 1 percent of the income distribution do not handle $100 bills on even a weekly basis, whereas 500 rupee notes are very widely used in India.
Second, and more fundamental, actions like those taken by the ECB or those proposed for the United States end the creation of new high-denomination notes. They do not contemplate declaring what has been legal tender to no longer be legal tender essentially overnight. It is the imminent prospect of notes currently held becoming worthless that has created such alarm and disruption in India. Small and medium-size merchants have seen their shops (which transact mostly in cash) deserted, and ordinary Indian citizens have spent the past week in line outside banks hoping to be able to exchange their cash holdings for legal tender.
We recognize that many of those who hold large quantities of cash in India have come by their wealth in corrupt or illegal ways. So, the temptation to expropriate is understandable. After all, as the argument goes, anyone who came by their wealth legally has nothing to fear from coming forward and exchanging old notes for new ones.
Most free societies would rather let several criminals go free than convict an innocent man. In the same way, for the government to expropriate from even a few innocent victims who, for one reason or another, do not manage to convert their money is highly problematic. Moreover, the definition of what is illegal or corrupt is open to debate given commercial practices that have prevailed in India for a long time.
There are also questions of equity and efficacy. We strongly suspect that those with the largest amount of ill-gotten gain do not hold their wealth in cash but instead have long since converted it into foreign exchange, gold, bitcoin or some other store of value. So it is petty fortunes, not the hugest and most problematic ones, that are being targeted.
Without new measures to combat corruption, we doubt that this currency reform will have lasting benefits. Corruption will continue albeit with slightly different arrangements.
On balance, nothing in the Indian experience gives us pause in recommending that no more large notes be created in the United States, Europe, and around the world. We were not enthusiastic previously about the idea of withdrawing existing notes from circulation because we judged the costs to exceed the benefits. The ongoing chaos in India and the resulting loss of trust in government fortify us in this judgment.
Lawrence H. Summers, the Charles W. Eliot university professor at Harvard, is a former treasury secretary and director of the National Economic Council in the White House. He writes occasional posts on Wonkblog about issues of national and international economics and policymaking.
Natasha Sarin is a JD/PhD candidate at Harvard University, with a focus on research in finance and labor. She recently co-authored a paper with Lawrence Summers entitled “Have Big Banks Gotten Safer,” which is forthcoming in the Brookings Papers on Economic Activity.