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Demonetization on Five Continents

Summary:
CAMBRIDGE – Around the world, several countries are currently undergoing “demonetization,” or currency reforms in which the government removes banknotes of a certain denomination from circulation and replaces them with new notes. Governments pursue demonetization for a variety of reasons, and some of the recent initiatives are going better than others. When demonetization is particularly dramatic and disruptive, it is often a signpost on the road to hyperinflation. This seems to be the case in Venezuela, where President Nicolás Maduro recently recalled the 100-bolivar note, and will replace it with new notes denominated at 500-20,000 bolivars. Economists define hyperinflation as a pattern of monthly price increases that exceed 50%, which may happen in Venezuela in the next few months. Hyperinflation has been much rarer this century than in the twentieth century, and Venezuela will be the first country to experience it since Zimbabwe in 2008-09. The current Venezuelan episode continues a long tradition of gross currency mismanagement in Latin American and former Soviet-bloc countries, where past governments used demonetization to transfer wealth from the public to themselves. In each case, the fundamental problem is that the government cannot finance its unsustainable spending through taxation or borrowing, so it resorts to debasing the currency.

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CAMBRIDGE – Around the world, several countries are currently undergoing “demonetization,” or currency reforms in which the government removes banknotes of a certain denomination from circulation and replaces them with new notes. Governments pursue demonetization for a variety of reasons, and some of the recent initiatives are going better than others.

When demonetization is particularly dramatic and disruptive, it is often a signpost on the road to hyperinflation. This seems to be the case in Venezuela, where President Nicolás Maduro recently recalled the 100-bolivar note, and will replace it with new notes denominated at 500-20,000 bolivars.

Economists define hyperinflation as a pattern of monthly price increases that exceed 50%, which may happen in Venezuela in the next few months. Hyperinflation has been much rarer this century than in the twentieth century, and Venezuela will be the first country to experience it since Zimbabwe in 2008-09.

The current Venezuelan episode continues a long tradition of gross currency mismanagement in Latin American and former Soviet-bloc countries, where past governments used demonetization to transfer wealth from the public to themselves. In each case, the fundamental problem is that the government cannot finance its unsustainable spending through taxation or borrowing, so it resorts to debasing the currency.

The Venezuelan government’s latest “currency reform” may ostensibly be aimed at curbing high inflation. But fundamental macroeconomic reform requires that the government rein in its excessive primary budget deficits, so that it does not have to keep printing money. Barring that, each new demonetization scheme only furnishes more evidence of mismanagement.

But governments also decommission and replace bills for more benign, technical reasons, such as to remove unpopular notes; introduce new counterfeit-proof bills; switch national currencies, such as when a country enters the eurozone; or honor a national hero. For example, in April, United States Treasury Secretary Jack Lew announced that the $5, $10, and $20 bills will be replaced with new designs that include women and civil-rights leaders.

With this form of demonetization, citizens are given enough time to trade in the old bills for the new, and the monetary authorities plan ahead, so that they have plenty of the new currency available. In these scenarios, there is minimal economic and social disruption. When Lithuania left the litas and adopted the euro in 2015, its currency transition went smoothly, as did Germany and France’s adoption of the euro in cash form in 2002, and so on with all 19 countries that have joined the eurozone.

A third form of demonetization is embodied in Indian Prime Minister Narendra Modi’s November 8 announcement that 500- and 1,000-rupee bills – constituting 86% of the cash in circulation in India – would no longer be considered legal tender and should be exchanged for newly issued bills by the end of the year. Since then, the country has been reeling. Indians have been waiting in long lines at banks, only to discover that the banks had not...

Jeffrey Frankel
Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.

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