Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

It is not money but credit that makes the world go round

After the Indian government withdrew most of the Indian currency notes from circulation last night, there has been a fear that this would be so disruptive that the economy would just go off the cliff. I think this fear is totally misplaced. Contrary to what some economists might tell us, money does not make the world go round. We finance people know that the world actually runs on credit. Economists tend to think that credit is what you use when you run out of money. Nothing could be further from the truth. In reality, money is what you use when your credit has run out. I work for my employer on credit, my newspaper vendor sells me newspaper on credit, companies buy raw material on credit and sell their products on credit. If you find somebody having difficulty doing any of these transactions on credit, you can be sure that that somebody is a whisker away from bankruptcy.

Yes, today you will not be able to go to your neighbourhood grocery store and buy anything with the 500 rupee note in your wallet. But if you cannot buy whatever you like on credit from the same neighbourhood grocery store, then you have a very serious problem on your hand; a problem that will not go away when the banks reopen tomorrow. If you really find yourself in that position, you should be very worried and you should drop everything that you are doing, and work slowly and painstakingly on rebuilding your credit. For in a capitalist society, if you have lost your credit, you have lost everything.

So, yes, the Indian economy will be fine even though it is denuded of most of its currency for the next few days. Apart from the few people who are travelling (other than your credit card, you have no credit amidst strangers), it will not even be too inconvenient for the vast majority of people. I have no first hand knowledge of the black economy and would be reluctant to comment on that, but I suspect that this too runs more on credit than on cash. It might be premature to conclude that the economy would suffer from a fall in demand due to disruption of the black economy.

If you want historical evidence on how the world copes with disruptions to money supply, I would recommend an excellent article early this year by the Bank of England on how Ireland coped with a six month long bank strike in the 1970s. Or you could look at the experience from 19th century US in the wake of frequent bank failures and how cities and towns rebuilt their economy on alternative credit networks. Or you could read Niklas Blanchard on complementary currencies.

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7 responses to “It is not money but credit that makes the world go round

  1. Pingback: Case of fiat currency: history, power and denominations.. | Mostly Economics

  2. Pingback: Ran out of 500 and 1000 notes? Here's why credit is going to bail you out | The Indian Economist

  3. Kaustubh November 10, 2016 at 4:50 pm

    Dear Prof, I have one query, If the black economy too runs on credit, how would these measures curb black economy? They would just make old black money redundant (which somehow would find its way back); but would it stop creation of new black money or destroy black economy?

    I read that Sweden has 97% of its economic activity in cashless form. That is the only way to destroy black economy. Is my understanding correct?

  4. Powel Talwar November 11, 2016 at 6:33 pm

    For people in smaller cities who have moderate amounts of untaxed money(no swiss accounts, no foreign currency holdings), savings is the main source of purchasing power. Since earnings come at the end of periodic business transactions (more untaxed income and thus increased savings), these built up reserves serve the source of lavish spendings, outings and purchases of branded goods. After making these reserves void, the luxury sales should be worst hit. This fall cannot be ignored and the negative sentiment will be difficult to curb. Its only after the stipulated period can we observe the true effect on demand and economy.

  5. Manas November 14, 2016 at 12:08 am

    Dear Sir,

    Am wondering what would be the eventual impact on RBI balance sheet leading eventually to long term inflation, asset base and rates.

    Tx

  6. Ritesh Chauhan November 14, 2016 at 2:01 am

    Sir,
    This is not directly concerned to above subject. But, after reading this i strike a viral vedio, on Youtube pertaining to a proposal for cashless economy, and somewhat regarding credit paying system, of Anil Bokil of Arthakranti Sanstha. Please write something about this, pros and cons of the proposal. Is it really arduous to convince public for this plan..?
    I shall be highly obliged to you for this.

    Your Sincerely.

  7. Pingback: Magnitude of Demonetization (?) – ekoshapu

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