The reasons given for demonetisation were probably, on balance, right: reducing black money, eliminating counterfeit currency, stopping terrorism financing, and moving to a less cash-oriented economy.
The focus of the Modi government must now be on the present: steps to reverse the ongoing contraction of the economy, shore up demand, and protect and compensate the least well-off - those in the bottom half of India's income distribution.
These households have been steadfast supporters of demonetisation so far, despite bearing a large part of costs. People working as daily labour, on farms, the construction sector, small and medium industries, retail trade and small rural and urban services.
My recent visit to India's small towns and countryside in Bundelkhand, Madhya Pradesh and Uttar Pradesh - away from Delhi's 'bubble' - confirms an ongoing deep contraction of jobs and incomes. A young taxi driver at the Jhansi railway station said: "I made up my mind to immediately offer you the lowest price, against my competitors, because we have had so few visitors for the past three weeks. All of us are sitting here, waiting for things to get better." Their capacity to withstand a further prolonged period of downturn is teetering on the edge.
The size of economic contraction was underestimated. A simple accounting equation, the quantity theory of money (MV=PQ, or money stock times velocity of circulation of money must equal the price of goods times their quantity) should have suggested the large size of expected contraction right from the start. As cash money stock fell, and as velocity of money also fell (as people lowered spending and hoarded scarce new cash), the size of expected contraction had to be big. The Reserve Bank of India (RBI) even now suggests an implicit 1-2 percent contraction in GDP from trend-expected growth over one to two quarters (equivalent to 0.5 percent lower GDP growth for the year as a whole).
That is a serious underestimation. It's more likely to be three to four times as big. Prices don't contract as much because of 'stickiness': people do not lower their wages or prices below some reservation levels. Instead, the quantity of goods and services has to fall to equilibrate demonetisation, in cash-dependent sectors.
Economist Jagdish Bhagwati's recent suggestion is right: the focus now has to be on reducing the extent of these costs. We need to reverse the first inevitable leg of a V-shaped contraction and get back on the upward leg as soon as possible. That means injecting speedily new cash into the economy. The problem is that clearly we don't have enough presses to do the job fast enough. The RBI should consider augmenting the cash supply by emergency printing abroad - there are enough high-security presses abroad, and if we can import the paper, why not the notes? Do it confidentially, if need be.
And to reach the poor swiftly, the cash also needs to be dispensed in small denomination notes, targeting rural and small-town banking branches, and providing accelerated emergency short-term cash credit life lines to small farmers, manufacturers, traders and retailers. Accelerating digital payments is fine for urban areas, but not for the rural and informal economy. During my visit, the few payments machines available did not have connectivity.
A second, equally crucial step is stepping up expansionary fiscal spending - to counteract demand collapse and shore up the path of recovery in these deflationary times. Monetary policy is ineffective because the RBI also needs to protect the rupee against an imminent U.S. Federal Reserve hike in interest rates and foreign portfolio outflows. Banks with burgeoning new deposits are no panacea either, given their balance sheets and clients facing collapsed business.
At this time, India's ministry of finance has to act counter-cyclically by injecting cash and demand into the economy. Spend bigger sums immediately on small things that boosts spending and demand fastest for the poor in India - everything from NREGA (Mahatma Gandhi National Rural Employment Guarantee Act), salaries in cash for lower income employees, guarantees against emergency credit-lines and public procurement of grains, to accelerating spending on small contracts through government agencies and speeding up transfers and cash advances to states. At least for the next two quarters.
Even consider 'compensating' small consumers, those who have stood the longest in lines. Pay them small amounts per account holder, in Jan Dhan if need be. Politically, that would be a winner too. Announcing its plans credibly for recovery would engender greater confidence. The challenge will be traditional fiscal conservatism. The ministry of finance, nevertheless, has the capability to respond quickly and innovatively - if it is convinced.