Gresham’s
Law in economics is simple –‘Bad money drives out good.’ Sir Thomas Gresham
after whom this law is named was the financial advisor to Queen Elizabeth I in
the Sixteenth Century, when he observed that the newly minted coins (good
money) were not found to circulate and the old coins (bad money) which were
intended to be replaced continued to be in circulation. Where did the new coins
go? The newly minted coins were being hoarded.
You
would have observed that when you need to pay by currency notes, you choose to
give those notes which are soiled and worn out (bad money) in preference to the
crispier newly minted notes (good money). You probably had also arranged the
notes in your purse with the crumpled and dirty notes at the outer side ready
to be picked up for paying and the newer notes at the other end. By a similar
reasoning, you receive soiled notes in return as change when you pay by a
higher denomination currency, which you try and dispose at the earliest
opportunity. Thus what circulates is bad money while the good money stays on in
your purse and in effect is driven out from circulation. This is a true but
harmless manifestation of Gresham’s law.
To
get a feel of Gresham’s law at work in the context of the demonetisation, just
take a peek into your purse and perhaps into the purse of others in your family.
Now count the number of 100 Rupee notes that you hold. Just how many did you
hold before demonetisation? You probably held four, five or may be six of that
good currency on a typical day before demonetisation. Today, between you and
your wife, you probably will count about thirty of the good 100 Rupee notes.
Some may have a few less and some others have several more.
Before
demonetisation, you did not think twice about parting with a couple of 100 Rupee
notes to pay for a routine meal in a restaurant even if they were among the
last few in your purse. But today, you tend to retain these in your purse and
pay for that by your credit card. People have switched to alternate means to
pay, such as by credit card, debit card, Paytm and their ilk. The 100 Rupee bills
that one holds have turned out to be more precious than what they until
recently were.
So
how long did a 100 Rupee note remain in your purse before demonetisation? May
be it was for just two or three days, since there weren’t many of them then in
your purse anyway. But now, a typical 100 Rupee bill, particularly a crispy new
one, will remain for a good many days before it is used in exchange for a good
or a service. In other words, these 100 Rupee bills are driven out of
circulation and become what a production engineer would call a non-moving
inventory.
In
the context of Gresham’s law, the good money is the 100 Rupee bill. These are
good money, because these can be exchanged for a good or a service anywhere and
everywhere. You can tender these notes, to buy a loaf of bread and a dozen eggs
from the small grocery store in your neighbourhood or to pay for your haircut;
not just in supermarkets. On demonetisation these notes have become far more
precious than what they once were; and so remain undisposed for a longer
period.
Contrary
to what you perhaps expected, the bad money in this context is not the
demonetised 500 and 1000 Rupee notes. The bad money is the substitute for the
100 Rupee notes, namely electronic money such as credit card and debit card. It
includes the 2000 Rupee notes as well. The 2000 Rupee note cannot pay to the
small-time grocer and the neighbourhood vegetable vendor. These will also
remain in your purse unused for long, not because you wish to hoard them (as an
honest tax paying citizen), but because they are not in demand. If you tender a
2000 Rupee note for a purchase that cost Rs. 1100, the vendor will need to
return to you nine precious 100 Rupee notes (good money) which he is reluctant
to part with, even though he has that many, and more such bills in his cash box.
He may even offer to take the 2000 Rupee note if you will accept a lesser
number of 100 Rupee bills than what is due to you after your purchase. So your
new 2000 Rupee note is bad money and less valuable for circulation. The 2000
Rupee note of course will pay for high value purchases such as consumer durables,
where alternate bad money payment options by credit card etc. are also available.
The new 500 Rupee notes, are perhaps neutral and are in between good money and
bad money.
What
is the net result? The 100 Rupee bills get hoarded because they are more
precious. The 100 Rupee bills do not get circulated, but get snugly ensconced
in ladies’ purses, because these notes are precious and a lady’s purse is
spacious to hold them.
One
consequence of Gresham’s law at work is substitution of e-money transactions
for currency transactions. But these are transactions between the ‘haves’ and
the ‘haves’; between those who own credit cards and those who can receive
payments by credit cards. Unfortunately though, India comprises predominantly
of the ‘have-nots’ who neither pay by credit/debit card nor receive payments by
credit/debit cards. The demonetisation is a bad consequence for the small-time
grocer and the neighbourhood vegetable vendor who lose their business for
shortage of good money for their business transactions.
By
demonetisation, about 86% by value of currency notes which were in the form of
500 Rupee and 1000 Rupee bills has been invalidated. These are very gradually
being replaced by the new 500 Rupee and 2000 Rupee bills. Of these, the 2000 Rupee
bill is bad money for the informal sector and thus is not much help.
This
could trigger a vicious circle, where 100 Rupee notes become precious and so
people hoard them. This makes these notes scarce. Therefore the notes become
more precious leading to more hoarding. These hoarders are not the few
indulging in real estate who were hoarding the 1000 Rupee notes to evade tax or
for unaccounted payments, but the billion people like you and me who hoard a
little each to meet day to day expenses without inconvenience; for instance, to
pay for a can of clean water. Similarly, a small vendor to keep his business
going when one waves bad money namely 2000 Rupee note, he needs to have a stock
of 100 Rupee notes. Thus, the 100 Rupee notes good money become even more
precious.
The
vicious circle causing spiralling of demand has not yet been triggered. This is
due to a transient effect of the demonetisation brought about by the illegal
exchange of the demonetised 500 Rupee and 1000 Rupee notes for four 100 Rupee
notes and eight 100 Rupee notes respectively. These illegal transactions are
taking place due to the various loopholes in the system. This has released for
circulation 100 Rupee notes from the available stock of 100 Rupee bills and
also reissue of 100 Rupee notes which were withdrawn against RBI’s clean note
policy. But this is a transient phenomenon. Once these loopholes are
effectively plugged or when the very limited currently hoarded 100 Rupee bills
(by homemakers etc.) dry up; whichever is earlier, the Gresham’s law effect could
grip the system and virtually paralyse the informal sector.
On
demonetisation 1,658 crore 500 Rupee notes and 668 crores of 1000 Rupee notes became
invalid. The augmented printing capacity to meet the demand for 500 Rupee
notes, is between 100 crore and 200 crore pieces a month. At this rate, it
would be about eight months from now, say by June 2017 when there would be a
reasonable number of 500 Rupee notes in circulation. To replace the 1000 Rupee
notes with 2000 Rupee notes needs only a couple of months. However this is not
much help as this is still bad money. Nevertheless the misplaced focus has been
to rapidly replace the demonetised 1000 Rupee notes with newly printed 2000
Rupee notes, with the object of putting into the system a significant part of
the 86% of money value that was demonetised. In effect the focus has been on
replacing the currency notes in circulation with bad money, not helpful for
informal business.
India
has been enjoying a high GDP growth rate even in the face of worldwide
recession, proudly upping its thumb on China recently. Different estimates
inform that the demonetisation will reduce the GDP growth rate by 0.7 to 3.0
percent. The Sensex has been constantly moving down.
These
estimates and indications have not factored-in Gresham’s law phenomenon. Considering
that India is an economy of small businesses where the informal sector accounts
for 45% of our GDP and 80% of employment and that the Gresham’s law phenomenon
primarily affects the informal sector, the demonetisation effect on the GDP
growth rate is expected to be far more pessimistic.
Since
80% of employment in India is through informal business, the impact is on the morale
of those employed in these businesses. The morale that will be affected over
the several months will have a long term effect on the GDP. In the face of the
badly hit morale, loans available at reduced interest rates, is hardly any
incentive to revamp informal businesses. Thus the predictions, that there will
be long-term growth rate of GDP for the current pains, are unrealistic.
Queues
which were a common phenomenon in the USSR prior to Gorbachev’s Perestroika
have become a common phenomenon in India after demonetisation.
There
is much discussion and monitoring of the printing and distribution of 500 Rupee
bills and 2000 Rupee bills which will replace more effectively the value of
demonetised currency. There is very little attention being paid to the printing
and distribution of good money namely 100 Rupee bills.
In
order that the drop in GDP growth rate does not come to stay, the printing and
distribution of good money in the form of 100 Rupee notes will need to be taken
on a war footing. If not, the by-product of demonetisation namely Gresham’s law
phenomenon would result in robbing the ‘have-nots’ to pay the ‘haves’ in the
country and cripple informal business.
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