Gresham’s Law in the Face of Demonetisation

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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