Ken Rogoff and case of Indian Demonetization

Ken Rogoff’s recommendation is based on flawed understanding of Money

In the last few days where every other news, from final assault on Mosul to a 7.4 richter scale earthquake in New Zealand, is relegated to page 3 or further back due to US elections and its post result analysis paralysis, India has managed to stay on front page of financial media by engaging in an experiment that has failed twice earlier in 1946 and 1978.

The Indian professional class as well as NRIs are praising the step as they are wont to believing that this pain is a small price to pay for eliminating black money and corruption, it is the lower class that will end up suffering. 16 People Have Already Died After Demonetisation And It Has Only Been Five Days.

Harvard economist Kenneth Rogoff, who had earlier gained notoriety for the Excel error that changed history, couldn’t have been happier. Modi’s step couldn’t have come at a better time as Ken Rogoff has just published his book “The Curse of Cash” wherein his premise is that we should move towards cashless society as cash especially large denomination notes help criminals and underground economy. I presume Ken Rogoff doesn’t read science fiction or history unless it forwards his arguments. One has to only look at his twitter timeline to realize that he loves self-promotion (rarely have I seen any other academic retweet so much praise of oneself).

Rogoff is also very supportive of Modi’s actions as it not only promotes his book but also acts as a “pressure cooker” guinea pig for his prescriptions. Below is the nuanced manner in which he showed his support.

He starts his book with a history of paper currency dedicating first chapter to early metal coinage, then advent of paper currency in China, followed by currency in American colonies, gold backed currency and finally modern day currency. This is where I think the problem lies with his book. Starting with currency instead of money. He doesn’t dwell on the fact that money may not necessarily be in the form of currency i.e. coinage, paper (or plastic) etc.

Felix Martin in his delightful “Money: An unauthorized biography” gaves us three examples which kind of break the case for demonetization as made by Mr. Rogoff.

Example 1: Pacific Island of Stone Money

The Pacific island of Yap was, at the beginning of the twentieth century, one of the most remote and inaccessible inhabited places on earth. An idyllic, subtropical paradise, nestled in a tiny archipelago nine degrees north of the equator and more than 300 miles from Palau, its closest neighbour, Yap had remained almost innocent of the world beyond Micronesia right up until the final decades of the nineteenth century.


Furness expected to find nothing more advanced than simple barter. Indeed, as he observed, “in a land where food and drink and ready-made clothes grow on trees and may be had for the gathering” it seemed possible that even barter itself would be an unnecessary sophistication.

The very opposite turned out to be true. Yap had a highly developed system of money. It was impossible for Furness not to notice it the moment that he set foot on the island, because its coinage was extremely unusual. It consisted of fei — “large, solid, thick stone wheels ranging in diameter from a foot to twelve feet, having in the centre a hole varying in size with the diameter of the stone, wherein a pole may be inserted sufficiently large and strong to bear the weight and facilitate transportation.” This stone money was originally quarried on Babelthuap, an island some 300 miles away in Palau, and had mostly been brought to Yap, so it was said, long ago. The value of the coins depended principally on their size, but also on the fineness of the grain and the whiteness of the limestone.

At first, Furness believed that this bizarre form of currency might have been chosen because, rather than in spite, of its extraordinary unwieldiness: “when it takes four strong men to steal the price of a pig, burglary cannot but prove a somewhat disheartening occupation,” he ventured. “As may be supposed, thefts of fei are almost unknown.” But as time went on, he observed that physical transportation of fei from one house to another was in fact rare. Numerous transactions took place — but the debts incurred were typically just offset against each other, with any outstanding balance carried forward in expectation of some future exchange. Even when open balances were felt to require settlement, it was not usual for fei to be physically exchanged. “The noteworthy feature of this stone currency,” wrote Furness, “is that it is not necessary for its owner to reduce it to possession. After concluding a bargain which involves the price of a fei too large to be conveniently moved, its new owner is quite content to accept the bare acknowledgement of ownership and without so much as a mark to indicate the exchange, the coin remains undisturbed on the former owner’s premises.”

When Furness expressed amazement at this aspect of the Yap monetary system, his guide told him an even more surprising story:

[T]here was in the village near by a family whose wealth was unquestioned — acknowledged by everyone — and yet no one, not even the family itself, had ever laid eye or hand on this wealth; it consisted of an enormous fei, whereof the size is known only by tradition; for the past two or three generations it had been and was at that time lying at the bottom of the sea!

This fei, it transpired, had been shipwrecked during a storm while in transit from Babelthuap many years ago. Nevertheless:

[I]t was universally conceded … that the mere accident of its loss overboard was too trifling to mention, and that a few hundred feet of water off shore ought not to affect its marketable value … The purchasing power of that stone remains, therefore, as valid as if it were leaning visibly against the side of the owner’s house, and represents wealth as potentially as the hoarded inactive gold of a miser in the Middle Ages, or as our silver dollars stacked in the Treasury in Washington, which we never see or touch, but trade with on the strength of a printed certificate that they are there.

When it was published in 1910, it seemed unlikely that Furness’ eccentric travelogue would ever reach the notice of the economics profession. But eventually a copy happened to find its way to the editors of the Royal Economic Society’s Economic Journal, who assigned the book to a young Cambridge economist, recently seconded to the British Treasury on war duty: a certain John Maynard Keynes. The man who over the next twenty years was to revolutionise the world’s understanding of money and finance was astonished. Furness’ book, he wrote, “has brought us into contact with a people whose ideas on currency are probably more truly philosophical than those of any other country. Modern practice in regard to gold reserves has a good deal to learn from the more logical practices of the island of Yap.”

Example 2: Money in an Economy Without Banks

On 4 May 1970, a prominent notice appeared in Ireland’s leading daily newspaper, the Irish Independent, with a simple but alarming title: “CLOSURE OF BANKS.” The announcement — placed by the Irish Banks” Standing Committee, a group representing all of Ireland’s main banks — informed the public that as a result of the severe breakdown in industrial relations between the banks and their employees, “a position has now been reached where it is impossible for the undermentioned banks to provide even the recent restricted service in the Republic of Ireland.” “In these circumstances it is with regret,” the notice continued, “that these banks must announce the closure of all their offices in the Republic of Ireland on and from Friday, 1st May, until further notice.”

It may come as a shock to learn that virtually the entire banking system in an advanced economy could have shut down overnight as recently as in 1970. At the time, however, this development was widely expected — not least because it had happened once before, in 1966. The matter of dispute between the banks and their employees was a familiar one in the Europe of the late 1960s: the extent to which pay was keeping up with prices. High inflation throughout 1969 — by the autumn, the cost of living had risen by more than 10 per cent over the previous fifteen months — had prompted a demand by the employees’ union for a new pay settlement. The banks had refused, and the Irish Bank Officials’ Association had voted to strike.

From the beginning, it was expected that the banks’ closure would not be short-lived, so preparations were made. The first reaction of businesses was to stockpile notes and coins. The Irish Independent reported that:

There were massive withdrawals of cash throughout the country as firms built up their reserves in anticipation of a shutdown. Insurance companies, safe dealers, and security firms are expected to do brisk business while banks remain closed. Factories and other concerns with large payrolls have arranged to obtain ready cash from large retailers such as supermarkets and department stores to meet wage bills.

But in the first month of the crisis, it became apparent that things might not turn out quite as badly as feared. The Central Bank of Ireland had deliberately accommodated the additional demand for cash in March and April, so there were about £10 million more notes and coins in circulation in May than usual. There was an inevitable tendency for the stream of payments to give rise to gluts of small change in some places — generally shops and other retail operations — and dearths in others — usually wholesalers and public institutions which had no reason to take in cash in the course of their daily business. The Central Bank even made a vain plea to the state-owned bus company to have it distribute cash to passengers. But these blockages in the circulation of coins and notes proved a relatively minor inconvenience.

The reason was that the vast majority of payments continued to be made by cheque — in other words, by transfer from one individual’s or business’ current account to another’s — despite the fact that the banks at which these accounts were all held were shut. In its review of the whole affair, the Central Bank of Ireland noted that prior to the closure “some two-thirds of aggregate money holdings are in the form of credit balances on current accounts, the remainder consisting of notes and coin.” The critical question, therefore, was whether this “bank money” would continue to circulate. For individuals in particular, there was really no other option: for any expenses in excess of the cash they had in hand when the banks shut their doors on 1 May, their only hope was to write IOUs in the form of cheques and hope that they would be accepted.

Remarkably, as the summer wore on, transactions continued to take place and cheques to be exchanged almost exactly as usual. The one difference, of course, was that none of the cheques could be submitted to the banks. Normally, this facility is what relieves sellers of most of the risk of accepting credit payments: cheques can be cashed at the end of every business day. With the banking system shut, however, cheques were for the time being just personal or corporate IOUs. Sellers who accepted them were doing so on the basis of their own assessment of buyers’ credit. The main risk, therefore, was of abuse of the improvised system. Since cheques were not being cleared, there was nothing in principle to prevent people writing cheques for amounts that they did not have. For the system to work, payees would have to take it on trust that payers’ cheques were not going to bounce — and all this when they had no clear idea when the banks would reopen and allow them to find out. The Times of London was following events over the Irish Sea with interest — and in July it noted both the extraordinary fact that nothing much seemed to have changed, and the apparent fragility of the situation. “Figures and trends which are available indicate that the dispute has not had an adverse effect on the economy so far,” wrote its correspondent. “This has been due to a number of factors, not least of which is the prudence which business has exercised against overspending.” But could the balancing act continue? “There is now, however, a psychological risk that if the dispute drags on, caution will be cast aside, particularly by smaller businesses.”

Sure enough, cracks did begin to appear here and there. A month into the closure, there was a scare when some livestock markets announced that they would no longer accept private cheques. In July, a farmer from Omagh who had been convicted of smuggling seven pigs into the Republic was unable to pay the £309 fine handed down to him, for want of ready cash. And over the summer, the business lobby — encouraged by the banks and exasperated by the expenses they were incurring to find ways round the closure — began planting scare stories in the newspapers claiming, for example, that “a rapidly growing paralysis is spreading through the economy because of the banks dispute.” But the evidence collated by the Central Bank of Ireland once the crisis was finally resolved in November 1970 showed quite the opposite. Their review of the closure concluded not only that “the Irish economy continued to function for a reasonably long period of time with its main clearing banks closed for business,” but that “the level of economic activity continued to increase” over the period. Both before and after the event, it seemed unbelievable — but somehow, it had worked: for six and a half months, in one of the then thirty wealthiest economies in the world, “a highly personalized credit system without any definite time horizon for the eventual clearance of debits and credits substituted for the existing institutionalized banking system.”

In the end, the main impediment imposed by this highly successful system turned out to be logistical. By the time the banks and their employees finally reached a new pay settlement, and it was announced that the banks would reopen on 17 November 1970, an enormous volume of uncleared cheques had accumulated with individuals and businesses. Advertisements were placed in the newspapers warning customers not to submit all of them at once, and forewarning that it was unlikely that account balances would be reconciled fully for several weeks. It was another three months — until mid-February, 1971 — before matters had returned completely to normal. By then, a total of over £5 billion of uncleared cheques written during the period of the closure had been submitted for clearing. This was the money that the Irish public had made for itself while its banks were on strike.

How had this apparent miracle of spontaneous economic co-operation come to pass? The general consensus after the event was that several features of Irish social life were uniquely conducive to its success: not least, that most famous feature of all, the Irish public house. The basic challenge was that of screening the creditworthiness of those paying by unclearable cheque. Ireland had an advantage in that communities, both in the countryside and in the cities, were close knit. Individuals had personal knowledge of most of the people they transacted with, and so were comfortable forming judgements as to their creditworthiness. But by 1970 Ireland was nevertheless a diverse and developed economy, so this could not always be the case. It was here that the Republic’s pubs and small shops came into their own, by serving as nodes in the system, collecting, endorsing, and clearing cheques like an ersatz banking system. “It appears,” concluded the Irish economist Antoin Murphy, with admirable circumspection, “that the managers of these retail outlets and public houses had a high degree of information about their customers — one does not after all serve drink to someone for years without discovering something of his liquid resources.

Example 3: Case of Argentina

In December 2001, the economic crisis that had been brewing in Argentina for over three years came to a head. The country had pegged the value of its peso to the U.S. dollar for over a decade under a so-called “currency board” arrangement that had delivered unprecedented stability and prosperity for much of the 1990s. But when Brazil devalued its currency in January 1999, Argentina was suddenly priced out of its largest export market and its economy tipped into recession. As the world’s craving for the United States’ new economy drove the U.S. dollar higher and higher over the next two years, it took the Argentine peso with it — heaping yet more misery on an economy that with its reliance on the production of agricultural commodities looked decidedly old. By the middle of 2001, the country had been in recession for almost three years and its public finances were unravelling despite several attempted austerity programmes. Argentina’s much-vaunted fixed exchange rate had become a severe obstacle to its international competitiveness, and both the public and the financial markets began to suspect that it could not hold. In April 2002 they were proved correct, when the sixth Economy Minister in a year announced the end of the currency board. Within weeks, the exchange rate had collapsed from 1 to 4 pesos to the U.S. dollar, and Argentina had defaulted on its external debts, entering an exile from the international capital markets that continues to this day.

The government’s strenuous efforts to stave off this catastrophic outcome had meant that Argentina’s monetary and financial system had been in dire straits for months leading up to the crisis. A year previously, Domingo Cavallo — the father of the currency board arrangement, the man who had single-handedly delivered Argentina from its troubled history of inflation and instability — had been recalled to the government to galvanise popular support and regain the confidence of the markets. Over the summer, he had committed unwaveringly to the maintenance of the dollar peg. The consequence had been that as the economy had continued to shrink and the banks become yet more distressed, private capital had continued to flee the country and pesos had become more and more scarce. On 2 December 2001, the beginnings of a full-scale run on the banking system had forced Cavallo to make the most embarrassing of announcements. To preserve the liquidity of the banks, a strict limit was imposed on the amount of cash that depositors could withdraw from their accounts. It was a desperate measure that provoked extraordinary popular resentment. Cavallo’s so-called “corralito” (“little enclosure”) succeeded in preventing the imminent collapse of the banking system — but at the cost of causing an immediate and acute shortage of peso liquidity.

The Argentinian public’s response to the sudden drought of money was no less entrepreneurial than that of the Irish had been thirty years before. Where the state would not oblige, substitute moneys sprang up spontaneously. Provinces, cities, and even supermarket chains started to issue their own IOUs, which rapidly began to circulate as money — in open defiance of the government’s attempts to keep liquidity tight to support the peso. By March 2002, such privately issued notes made up nearly a third of all the money in the country. A report in the Financial Times painted an evocative picture of the situation:

As they finish their tea and croissants, two elegantly dressed ladies at a Buenos Aires cafe ask their waiter how they might pay. As if reciting the day’s menu from memory, the waiter gives them several options: pesos, lecops, patacones (but only Series I) and all classes of tickets luncheon vouchers that circulate widely at restaurants and supermarkets in the city.

The monetary authorities were mortified. But embarrassing as it might be for the Governor of the Central Bank of Argentina to witness his friends paying for their breakfast with patacones signed by officials of the province of Buenos Aires, at least they were liabilities of some level of government. And at least they were still denominated in the national unit of account. There was, however, worse to come. By July, nearly one in ten of the adult population was discovered to be using the Crédito — a mutual credit money issued by local exchange clubs on its own, independent standard. Even the peso’s much-reduced role as the natural denomination for financial contracts was fading away. A significant part of the Argentine economy was now operating using a glorified swap shop.

There are obvious similarities between this eruption of sub-sovereign and private moneys in Argentina in 2002 and the IOU economy that sprang up in Ireland during its bank closure. But there was also a crucial difference. In Ireland, the government had been trying earnestly to prevent the shutdown of the monetary system, and it had actively encouraged the search for sources of private monetary credit that could substitute for bank deposits in preparation for the closure. In Argentina, it was the government itself that imposed the effective closure of the banks, as the central plank of a policy to forestall a run and to prevent the flight of capital into foreign currencies. By the same token, the creation of quasi-currencies was not done in patriotic alliance with the government against a common enemy. It was an act of open defiance of the government’s draconian monetary policy. The government, it was widely held, had lost its bearings. It was working for the interests of blood-sucking usurers and foreign capitalists: its policies were harmful and illegitimate. The local politicians, businesses, and communities that fought them by issuing their private currencies saw themselves as a monetary version of France’s famous Maquis — the “Army of Shadows” that organised popular resistance to the puppet Vichy government during the Second World War.4 To the dismay of the monetary authorities and their advisers, their efforts were effective. In April 2002, the International Monetary Fund (IMF) warned the Argentine government that the efflorescence of substitute moneys had “complicated economic management, raised the threat of inflation, and undermined confidence in the public finances.” Until the peso regained its monopoly over the monetary franchise, the government would not be in control of the country.

So What is Money

This description of nature of Money from Felix Martin comes in chapter 2 of his book and is pithy.

The case of the Irish bank closure provides an unusually useful opportunity to understand more clearly the nature of money. Like Furness’ report from Yap, it forces us to reconsider what is essential to the functioning of a monetary system. But because the Irish case is so much closer in time and technology to our own, it is much more suitable for economic triangulation. The story of Yap showed that the conventional theory of the origins and nature of money is confused. The story of the Irish bank closure helps point the way to a more realistic alternative.

The story of Yap stripped away a central, misleading preconception about the nature of money that had bedevilled economists for centuries: that what was essential was the currency, the commodity coinage, which functioned as a “medium of exchange.” It showed that in a primitive economy like Yap, just as in today’s system, currency is ephemeral and cosmetic: it is the underlying mechanism of credit accounts and clearing that is the essence of money. We were left with a very different picture of the nature and origins of money from the one painted by the conventional theory. At the centre of this alternative view of money — its primitive concept, if you like — is credit. Money is not a commodity medium of exchange, but a social technology composed of three fundamental elements. The first is an abstract unit of value in which money is denominated. The second is a system of accounts, which keeps track of the individuals’ or the institutions’ credit or debt balances as they engage in trade with one another. The third is the possibility that the original creditor in a relationship can transfer their debtor’s obligation to a third party in settlement of some unrelated debt.

This third element is vital. Whilst all money is credit, not all credit is money: and it is the possibility of transfer that makes the difference. An IOU which remains for ever a contract between just two parties is nothing more than a loan. It is credit, but it is not money. It is when that IOU can be passed on to a third party — when it is able to be “negotiated” or “endorsed,” in the financial jargon — that credit comes to life and starts to serve as money. Money, in other words, is not just credit — but transferable credit. As the nineteenth-century economist and lawyer Henry Dunning Macleod put it

These simple considerations at once shew the fundamental nature of a Currency. It is quite clear that its primary use is to measure and record debts, and to facilitate their transfer from one person to another; and whatever means be adopted for this purpose, whether it be gold, silver, paper, or anything else, is a currency. We may therefore lay down our fundamental Conception that Currency and Transferable Debt are convertible terms; whatever represents transferable debt of any sort is Currency; and whatever material the Currency may consist of, it represents Transferable Debt, and nothing else.

As we shall see, this innovation of the transferability of debts was a critical development in the history of money. It is this, rather than the graduation from a mythical barter economy, which has historically revolutionised societies and economies. In fact, it is barely an exaggeration — if we make allowance for the unmistakable overtone of Victorian melodrama — to say, as Macleod did:

If we were asked — Who made the discovery which has most deeply affected the fortunes of the human race? We think, after full consideration, we might safely answer — The man who first discovered that a Debt is a Saleable Commodity.

The recognition of this third fundamental element of money is important. It explains what determines money’s value — and why money, even though it is nothing but credit, cannot just be created at will by anyone. For sellers to accept buyers’ IOUs in payment, they must be convinced of two things. They must have reason to believe that the debtor whose obligation they are about to accept will, if it comes to it, be able to satisfy their claim: they must believe, in other words, that the money’s issuer is creditworthy. This much would be enough to sustain the existence of bilateral credit. The test for money is more stringent. For credit to become money, sellers must also trust that third parties will be willing to accept the debtor’s IOU in payment as well. They must believe that it is, and will remain indefinitely, transferable — that the market for this money is liquid. Depending on how powerful are the reasons to believe these two things, it will be easier or harder for an issuer’s IOUs to circulate as money.

It is because of this third critical element of transferability that money issued by governments, or by the banks which governments endorse and backstop, is thought to be special. Indeed, there is an influential school of thought — known as chartalism — which argues that governments and their agents are the only viable issuers of money. But the story of the Irish bank closure exposes this as another misleading preconception. The closure of the Irish banks showed that the system of credit creation and clearing need not be the officially sanctioned one. The official system — the banks — was suspended for the best part of seven months. But money did not disappear. Like the infamous fei that sank to the bottom of the sea, the associated banks suddenly vanished — and with them official apparatus of credit accounts and clearing — and yet money continued to exist.

The Irish bank closure demonstrates that the official paraphernalia of banks and credit cards and solemnly printed notes with unforgeable insignia is not what is essential to money. All of this can disappear and yet money still remains: a system of credit and debt, ceaselessly expanding and contracting like a beating heart, sustaining the circulation of trade. What matters is only that there are issuers whom the public considers creditworthy, and a wide enough belief that their obligations will be accepted by third parties. For governments and banks to fulfil those two criteria is generally easy; whereas for companies, let alone individuals, it is generally hard. But as the Irish example goes to show, these rules of thumb do not apply universally. When the official monetary arrangements disintegrate, it is surprising how effective society is at improvising an alternative.


Like every one else I am looking forward to how the Indian experiment plays out. However, except for flawed understanding of Ken Rogoff of money as currency, there is no theory stating that going cashless will lead to reduction in underground economy. The experiment is likely to fail.

Quite a few entrepreneurs and techies are pleased that this may move India by leaps and bounds into a cashless society and may even make India a trailblazer in electronic payments market. Who knows, may be India will lead the way in new ways to run the underground economy in a cashless economy.

Author is a graduate of London Business School

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