(This is a slightly revised version of an article published by The Telegraph, Kolkata on 15 November, 2016. The link for the Telegraph article is http://www.telegraphindia.com/1161115/jsp/opinion/story_119149.jsp#.WCs58vl97IU)

There is an elementary piece of economic truth that remains unshaken since time immemorial. Put simply, it runs: “Nothing comes from nothing”! Or, using economic jargon, there is a price to be paid to ensure any outcome that generates comfort. At the level of the individual, a decent dinner calls for a payment. At the level of society, weeding out black money from the system calls for hardships as well. To be borne by millions of innocent common men and women queueing up in front of ATM kiosks to withdraw measly sums of cash to try and satisfy their demand for daily essentials. According to reports, the hardship has been somewhat extreme, for some senior people at least are said to have collapsed as they waited endlessly on the streets for their Rs. 2000 in cash. And died, as NRI’s sitting in Japan were clapping and giggling away in vulgar glee that the motherland they never intend to return to was being cleansed.

Quite obviously, the shortage of cash in the pockets of the unlucky ones living in India will ensure that they restrict their expenditure to commodities that are truly necessities. Since creating a shortage of currency in the economy was never known to be an antidote to profane corruption, essential commodities can well disappear for a while from the markets, hand in hand with dirty money. The example that comes readily to mind is the case of common salt. The price of salt soared up for no obvious reason from Rs. 12 to Rs. 300 per kilogram, if the news channels are to be trusted. Despite claims to the contrary, in some areas of the country at least, salt appears to have turned into the scarcest of commodities. When an essential commodity turns scarce relative to the demand for it, people need to spend more to acquire it and the spending in the present instance is taking the form of toilsomely acquired cash, recognized white cash, that is turning instantaneously into black money.

This of course is the least important of examples of the re-emergence of black money even as the common man is bearing the labour pains necessary to deliver a clean India. A new class of middlemen has sprung up that, according to reports, is exchanging bad money for good by charging a premium. How they are managing to get rid of the bad money they are accumulating is for the law keepers to figure out. However, there were at least two persons who were interviewed by TV channels, one located in Delhi and the other in Mathura, who claimed to be ready to perform, and openly so. One of them was ready to offer coins in exchange, quite independently of the total sum of money being exchanged! Hence, one probably hears further that Rs. 10 coins too now stand banned. These individuals could well have been bluffing of course. However, given that the formal banking system is yet to penetrate vast areas of the country, one can easily guess the nature of happenings right now, beyond the boundaries of the metropolitan areas.

Powerful money lenders have not disappeared from our rural economy. Nor have poor farmers and landless labourers. These latter groups of people are doubtlessly being charged steep rates of interest for the white money they are borrowing to sustain their hand to mouth existence. Classroom economics too teaches us that interest rates rise with a fall in money supply relative to demand, though the channel through which the rise comes about is quite different.

The immediate impact of stripping Rs. 500 and Rs. 1000 notes of their legal tender status is a fall in the money supply. This results in the existing money demand as a whole (i.e. demand for currency plus money in the form of bank deposits) to exceed the new money supply (i.e. the sum total of bank deposits and the reduced currency supply). Textbook logic tells us that the excess demand for money leads to a sale of interest bearing financial assets in search of non-interest bearing money required to carry out daily transactions. The rush to sell off such paper assets leads to a fall in their prices relative to the face value of their nominal returns. This works out into a rise in interest rates. Whichever way we look at it then, interest rates in general are likely to go up in the near future, when the business sector, backed by the government, has been clamouring for lower interest rates. Ironically enough, we are told that Mr. Raghuram Rajan refused to serve a second term as RBI Governor on account of his disagreement with the government over the very same interest rate issue. He was not in favour of low interest rates, given his concern about inflation.

Higher interest rates can cause a fall in the demand for loans to purchase durable consumer goods, thus slowing down the manufacturing sector. It will also reduce the demand for loans on the part of the manufacturers to purchase raw materials. This in turn will weaken the demand for transport services required to deliver finished or semi-finished products and reduce along with it the incomes of daily wage earners in that sector.

There is yet another route through which such transport services can be affected and this is not linked to interest rates. Given the telltale signals that the problem surrounding the shortage of currency is not about to disappear soon, many of the markets where cash transactions dominate will come to a standstill. In such markets, neither will the grocers be able to sell, nor buyers be able to buy. Consequently, business activities will dry up in the “short run”, which in turn will affect the transporters to these markets.

The price then is being paid and will continue to be paid till the cash supply turns normal in the economy. Normalcy though does not mean smoothly working ATMs alone. Let us recall that a huge chunk of money has been banned from the system. Presumably the RBI will increase the money supply back to where it was before demonetization through repo rate reductions, open market operations and so on. The interest rate will fall again perhaps, but as most commentators have noted, this by itself is unlikely to eradicate corruption.

Instead it could well turn out to be a story of new black money driving out old black money. If demonetization turns out to be the chosen tool for getting rid of black money, then the policy has to be repeated over time. Perhaps this is what the government has in mind, going by the announcement heard from Japan. More is in store we were told, beyond 30 December. In the meantime though, the growth rate of the economy might fall during the second quarter. Combined with the first quarter low growth rate, the annual growth rate is almost certain to be lower than projected. And we have no clue at all about the inflation scenario that might emerge.

Robert Lucas, Nobel Laureate and father of the Rational Expectations School of thought had an important piece of advice for governments engaged with monetary policy. He believed, on the basis of his theory, that monetary policy was not likely to have any perceptible impact on an economy unless it took the shape of random shocks which caught the populace unawares. However, repeated random shocks, even if they produced intended results in the immediate future, were likely to destabilize the economy and result in unwarranted economic cycles.
Perhaps the Government of India has a lesson to learn from Lucas and stop gloating over the shock therapies it is planning for the nation. A price is being paid right now, but one cannot fool all men for all time.

The economy had better improve in the not too distant future.