Mar 6, 2017

Larry White on India’s Demonetization and Austrian Macroeconomics

David Beckworth Senior Research Fellow , Lawrence H. White Distinguished Senior Fellow, F. A. Hayek Program for Advanced Study in Philosophy, Politics and Economics

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Larry White is a professor of economics at George Mason University and has written widely on monetary theory, free banking, and the Austrian School of Economics. Today, he joins the show to discuss the recent demonetization efforts in India to crack down on corruption. White argues that India’s efforts to end the circulation of large notes and begin the circulation of new notes is having pernicious effects on the Indian population. He and David also discuss Austrian Business Cycle Theory, how this theory was developed by great economists such as Ludwig von Mises, and how the theory may have played a role in the lead up to the Great Recession.

Read the full episode transcript

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to

David Beckworth: Larry, welcome to the show.

Lawrence White: Thanks, David. Good to be here.

Beckworth: We're glad to have you on. Let's begin by asking how did you become a macro economist?

White: Well, I guess it goes back to when I first started reading economics in high school. I didn't have any particular specialty in ... special interest in macro at that point. But I read Murray Rothbard's thousand page book, Man, Economy, and State, in the summer before I went to college, thinking this would give me a head start on economics. Little did I know, it wasn't the kind of economics they were teaching at Harvard. So, when I took my freshman economics course, I discovered to my shock they were still teaching Keynesian economics. They didn't know it had all been refuted.

White: But, that gave me a skeptical take, you might say, on mainstream macro.

Beckworth: Okay.

White: In that course, I actually wrote a term paper on Bohm-Bawerk's interest theory because I wasn't satisfied with the treatment of interest rate I was getting in the Keynesian models they were teaching. That's still not quite macro, I guess, but my undergraduate intermediate macro teacher was Arthur Smithies. I don't know if that name means anything to you or other listeners, but he was in his late 60s at the time. He had been one of the original Keynesians, one of the first Keynesians at Harvard.

Beckworth: Okay.

White: Only later did I discover that he'd briefly been a Hayekian, and in fact, he had written a review of Pure Theory of Capital when it came out in 1941. But when I told him I was interested in Austrian economics, he told me it was a will of the wisp. That was his expression.

Beckworth: Nice.

White: I went to graduate school at UCLA where I studied macro with Michael Darby, who taught a Friedman model. And Axel Leijonhufvud, who had his own version of Keynesian economics. But Axel was very wide ranging in his interests, so in his macro course, he actually taught us Wahlroos, and Marshall, and even some Hayek. Then he taught a monetary theory course. This is after macro for a monetary theory field. The year I took it, he focused on the 19th century currency and banking debates because he said he was tired of modern macro.

Beckworth: Interesting.

White: That's when I first wrote a term paper on free banking, the free banking experience in Scotland. He said, "That's interesting. Why don't you turn that into a dissertation?" So that got me into banking, and then trying to combine banking theory with macro, or more generally, take a microeconomic approach to macro that incorporates a decent interest rate theory as found in Bohm-Bawerk, or Wicksell, or Fisher. That became one of my interests.

White: So, I haven't taught macro, or hadn't taught macro, until I got to George Mason in 2009. But I've been teaching macro ever since. So that's raised my interest in what's going on in contemporary macroeconomics.

Beckworth: We should mention to our listeners that you have the book on the Scottish free banking experience, and it sheds a lot of light on what issues there are in banking, and helps us understand, maybe, some of our issues here in the U.S. It also sheds light on the Canadian banking experience. I want to encourage listeners to take a look at that. But that's an interesting journey coming into macroeconomics. You read that huge book the summer after your senior year. That's pretty impressive. I'm just curious, how did you even come across that Austrian book at that time in your life?

White: Well, in high school I was subscribing to the New Republic, and-

Beckworth: Okay.

White: Right? Which is a left liberal publication.

Beckworth: Right, right.

White: But, for some reason, they had to ... They traded ad space, I guess, with a business called Books for Libertarians. I started ordering from that book service. So, I read Friedman's Capitalism and Freedom, Hazlitt's Economics in One Lesson, and worked my way up to reading this massive book, which I figured would cover everything I would need to know.

Beckworth: Well, that's impressive. Not many high school seniors would have the interest or desire to work through a book that large in the summer time. But hat's off to you for doing that. Well, you were teaching a money and banking course. As you say, you just started teaching macro in 2009. But you have been in this field ever since you got out of grad school, right? You've been-

White: I've been teaching money and banking all the time, yes.

Beckworth: Yeah, so really, you're still in the field. And you've had many articles. Just so listeners know, I went to the University of Georgia where you used to teach, and I also had George Selgin, a previous guest on the podcast show, and I just happened to miss you because you left. You were there, you were going to teach-

White: Of course, Selgin was my dissertation student at NYU.

Beckworth: Okay, I guess I'm a grandchild of yours, then.

White: That's right.

Beckworth: So, indirectly, I've been influenced by your work. But I was always disappointed that I didn't get that second money sequence course from you at University of Georgia. You had left by that point. You were there when I started, but you had left about halfway through my program. Okay, well let's move on to some of these events that we want to discuss, some of the issues. First one is the demonetization efforts in India. Tell us about it, and then we can jump into some of the articles you have written on it.

Demonetization Efforts in India

White: Back in early November, the government of India ... the prime minister of India, Narendra Modi, went on TV and to everyone's shock, because he had kept this secret, he announced that they were demonetizing the two largest denominations of bank notes, which are the 500 rupee note and the thousand rupee note. Those are the largest two. They together constituted something like 80% of all the currency in circulation. What he announced was starting tomorrow they are no longer valid, so the government will no longer accept them, the courts will no longer accept them. You have to trade them in for new notes, except that we don't have all the new notes ready yet, so it'll be a while. It was a big shock to the economy, so it's-

Beckworth: Really?

White: Like a textbook example of a liquidity shock. Suddenly, in effect, the money supply is cut in half. If you take 80% of the currency stock out of circulation, and currency is a large share of M1 in India, it's about 60% of M1, so together it's about, if we're multiplying, it's about half of the M1 is now invalidated. Now, people had 50 days to turn in the old notes for new notes, so they could continue to spend the old notes if somebody would take them. But they quickly fell to a discount in the market. People had to line up, or queue up, as they would say in India, to trade in the old notes for new note.

White: The idea was to smoke out untaxed currency holdings, what's called black money in India. But the result was people spent hours standing in line, sales of goods for currency, which is a large share of the Indian economy ... Taxi drivers, sidewalk tea sellers, only take currency. In fact, the construction industry runs entirely on currency. So, it all came to a standstill. Eventually ... By now, a lot of the new currency ... They replaced the 500 rupee note, and they ... In place of the thousand rupee note, they have introduced a 2,000 rupee note. But as I said, they don't have enough to fully replace what was demonetized. So, it's been a big drop in the money stock.

White: It's been an enormously costly operation. So, I wrote a piece for Alt-M about what was happening, and emphasized ... It was co-authored with Shruti Rajagopalan, who is a former GMU student, now teaching at SUNY Purchase. She has her ear to the ground of what's happening in India. What we emphasized in the Alt-M piece is that-

Beckworth: Just to be clear to our listeners, Alt-M is a monetary blog at the CATO Institute, if they want to go check it out.

White: Alt hyphen M, dot org.

Beckworth: Okay.

White: We emphasized the fiscal aspect of this move. If the government cancels old currency and now gets to issue new currency to replace it, it's a one time tax, a capital levity on the holders of the old currency. Their wealth value is just wiped out to the extent of their currency holdings. And the government gets to spend new currency into circulation. So, for every note, every thousand rupees that's canceled and a new thousand rupee note is introduced by the government spending it into circulation, or using it to buy back and cancel old debt, that's a windfall, a fiscal windfall to the government. That may help explain why they were enthusiastic about it, even though if you think about it, it's not the best way to fight black money because it didn't do anything to change the incentives people have to evade taxes or to do transactions in cash. And of course, new notes are being introduced, so black money will repopulate the economy pretty quickly.

Beckworth: One of the, I guess, big questions I had about this effort is it seems to me they really are going after the wrong crowd. Right? Most of the folks that use money, this transaction money, are the poor, the people in rural settings. You mentioned some in the city, as well, taxi drivers. But I suspect most of the big corruption, the big gains in terms of getting more tax revenue, would be the elites in society, people in government, people in business, who have the resources to evade taxes.

White: That's right.

Beckworth: So, it's-

White: Those people are sophisticated, and they don't hold their wealth in currency.

Beckworth: Right.

White: They hold it in real estate, in gold, in foreign exchange, foreign bank accounts, and so on. So, it's the un banked, the people who are reliant on currency, which is almost half the population.

Beckworth: Yeah, that's-

White: They're the ones who are hit hard by this.

Beckworth: This is mind blowing. You mentioned in your article about 600 million people, big distributional effects here.

White: Yeah.

Beckworth: The ones that can least afford it, that are least able to handle the huge shock to their activity. And as you mentioned, they still haven't replaced all the notes. I did some digging around, and someone suggested it may be September of this year before they actually get all of the notes back in place. That's a huge, long disruption for many poor people.

White: Yeah. Some people have tried to estimate based on the printing capacity of the printing presses how long it's going to take-

Beckworth: Right.

White: Estimates range from May to September.

Beckworth: I also read another challenge. I was reading J.P. Koning blog on this, and he had observed another issue for these folks is that the new notes are actually going to be smaller than the existing notes, and this creates logistical challenges like for ATMs.

White: That's right.

Beckworth: There's all kinds of hiccups along the way when you have a sudden, unplanned ... This is truly a shock, truly a neck breaking shock for the economy. When I was reading this, I was thinking Friedman is rolling in his grave. They clearly did not read Friedman and Schwartz, History of the U.S. Monetary Experience. The notion that you can suddenly jar an economy free of so much money and expect it to be a benign experience.

White: Well, there have been a couple of defenses offered somewhat after the fact. Shruti and I wrote a second piece responding to one of the defenses, which was made by the well known trade economist Jagdish Bhagwati and a couple of co-authors. They said, "Well, really, we can't think of it as something that fundamentally changes the incentives to hide your wealth from the tax man, but we should think of it as a one time tax on black money holdings. If we do that, and they do a back of the envelope calculation, it's going to generate something like two trillion rupees in revenue, so we can consider that a success."

White: We make the point that if you're going to call it a tax, you need to compare it to the dead weight cost of collecting that tax. We look at some estimates of what this operation has cost in terms of lost output and lost ... and the cost of printing money, and so on. It turns out to be a very high dead weight cost tax. So, even focusing it down to the revenue aspect, although it sounds like a dead weight ... Sorry, a capital levee is not supposed to have any distorting effects. Because nobody expected it, then it didn't discourage any activity. But the fact that it was accompanied by this liquidity shock, this excess demand for money has made it enormously costly as a way of collecting revenue.

Beckworth: Again, it's really ... it's a one time tax on poor people. That point could be made often enough, that they really didn't think this through. There's other ways ... and you mention this in your first article, I believe, there are other ways to address the bigger issue that we think is behind the prime minister's efforts, and that's to get rid of corruption. Then you mention structural reforms, and then other things that would make more meaningful, more lasting effect.

White: Yeah. Deregulation would mean fewer bribes to be paid in cash. Reform of the tax system would give people fewer incentives to hide their cash, and so on.

Beckworth: India also has capital controls to some extent, don't they?

White: Yes. Yes, they do. In fact, they've been trying to defend the rupee against devaluation in various ways. One of the most recent was they put special taxes on gold because one way people ... one asset people buy to serve as an inflation hedge in India is gold. It used to be when you go to India you shop for gold jewelry because it's relatively cheap there. Not anymore.

Beckworth: Yeah. It just seems a lot of these restrictions, regulations, capital controls being one of them, if you don't have a country with good institutions, good rule of laws, good contracts, it's going to be susceptible to corruption, to cheating, to bribing, and this ... Again, this big tax on the poor people, I think really speaks to maybe a pattern we see there. Let's move to the more general point, though, of getting rid of cash as a way to address crime. India maybe is an experiment, and Ken Rogoff had a-

White: Even Ken Rogoff didn't like it.

Beckworth: He didn't like it, right. And Larry Summers had an article in the Washington Post.

White: That's right.

Beckworth: He didn't like it either. Because Larry Summers had also-

White: Good for them.

Beckworth: But they have been advocating this approach in other settings, in advanced economy settings. Ken Rogoff, of course, well, he may be probably the most vocal with his recent book, The Curse of Cash. His argument for getting rid of cash ... Now, to be fair to him, it's more of a gradual process. Start with the larger notes first. But over a time period, eventually get rid of cash. His argument is, one, to deal with crime in the underground economy, and two, to deal with the zero lower bound. The second concern, the zero lower bound, if you take that critique seriously, people like Miles Kimball have show there is a way to get around the zero lower bound without getting rid of cash.

Beckworth: We don't have to go into that in great detail, but his argument in brief is that if you make the exchange rate between cash and deposits floating during periods of deep depressions, you can solve the zero lower bound problem. So, I don't see his argument on the zero lower bound convincing in terms of getting rid of cash. So then this brings us back to the crime issue. Rogoff really argues that there is a lot of criminal activity in the U.S. that could be fixed by getting rid of cash, or at least make life tougher for criminals by getting rid of cash.

White: Yes.

Beckworth: What is your reply to Ken on this point?

White: Well, so I have an earlier piece on the Alt-M blog on the currency prohibitionists, as I call them.

Beckworth: Nice.

White: This was also something you see in the Indian debate, where people have tried to, after the fact, defend the demonetization on the grounds that it will kickstart the process toward a digital payment system without cash. But of course, India's the last place that you expect that to eventually come about because it's so cash dependent now. Anyway, the tendency is to emphasize this benefit without accounting the costs. So, the way that abolishing cash is supposed to suppress crime is that it's going to ... and this part is not usually stated overtly. It's going to suppress privacy. The loss of privacy is something that doesn't trouble the people who want to abolish cash. So, if every transaction is through the banking system, and the government has access to all the bank records, then there's no financial privacy anymore.

White: They seem to be willing to make that trade as though they're ... And so, when you abolish large denomination notes, they typically forget that some people use them for honest purposes. People buy cars with large denomination notes. It varies from place to place what the payment practices are, but there are parts of Europe where 500 euro notes were used. Those are now being phased out. Were commonly used, people buying cars who wanted to pay cash. But more generally, my concern is that if you want to fight crime, you should fight crime without using this kind of blunt instrument that makes life less convenient for ordinary, honest citizens. The defense is, well, it makes life less convenient for criminals. Well, sure. But for the rest of us, too, and you need to take that into account.

Beckworth: Yep.

White: It's better to find ways that make life inconvenient for criminals that don't make life inconvenient for the rest of us.

Beckworth: Right. I also wonder if we were to go down this path to get rid of cash, that there would be something that would emerge in the margins, in the shadow. There would always be some kind of shadow money. You get rid of cash, and suddenly bitcoin becomes a whole lot more popular. You would never be able to completely ... It'd be a whack-a-mole, completely get rid of some medium of exchange.

White: I think that's right.

Beckworth: Yes.

White: It's similar to the frustration that Henry Simons had when he said, "I would like to have a system where banks don't issue money backed by risky assets. So deposits should only be backed by government bonds." But, he said, "I realize that banks would then have an incentive to issue near monies and use that to finance the kind of lending they specialize in. So, never mind. Let's pursue a stable price level instead."

Beckworth: Right. Now, on Econ Log, which is also a blog, a gentleman named Pierre Lemieux, if I'm saying his name right, he had a piece called In Defense of Cash. He brought up a novel argument that I hadn't thought of for keeping cash. His argument is look, some amount of crime is optimal. We actually want to have some crime, and in particular as-

White: Given the cost of suppressing it.

Beckworth: Given the cost of suppressing it, and given that some activity that we call crime may not necessarily be so bad, things that maybe shouldn't be considered a crime. So I want to just read a couple excerpts from his piece. He goes, "Furthermore, some activities that the law currently defines as crimes, certain countries may actually provide useful, built in constraints against abuse of power. Tax dodging, for example, limits the veracity of the state. It increases the cost to the state of raising taxes, and thus tends to maintain them at a level more likely to gain the consent of most citizens. The same argument applies to the underground economy more generally, and provides a built in constraint against overregulation. As regulation increases, more people, consumers, entrepreneurs, unfashionable minorities move to the underground economy. Thus, government cannot regulate past a certain point, and this constraint kicks in more rapidly in a free society."

White: I have a lot of sympathy for that argument. There, of course, have been historical cases where governments have used their access to the banking system to oppress their citizens, confiscating their money, tracing their movements, and so on. So, those are things that we need to be concerned about. One of Barack Obama's last executive orders before leaving office makes data from the NSA available to the Drug Enforcement Administration. So, I think that's something people can be concerned about, even if they're not in favor of legalizing drugs. There are inevitably privacy abuses that are going to happen.

White: Pierre's argument makes the valid point, I think, that one of the reasons governments want to be able to trace everybody's transactions is that they're trying to suppress victimless crimes. Those are the crimes ... People are buying and selling drugs, or untaxed cigarettes, or whatever. If you have sympathy for the ... If you don't think those should be crimes, then of course you're going to by sympathetic to ... Well, sorry. Let me put it this way. Unless you think it's ... Unless you favor a scorched earth policy towards suppressing those activities, you ought to consider the spillover costs on limiting people's liberty and privacy from efforts to suppress them by chasing people through their transaction records. But that's the reason why governments want to suppress cash, in part, is that they want to outlaw things that involve mutually consented transactions between adults.

Beckworth: Yeah. And this is just one more step towards the all pervasive sight of the state seeing everything you do. I guess the other general point is, as economists we need to look at costs and benefit, which is what you stressed in your pieces, and what he's getting at here. Some of the costs maybe Rogoff is not considering are these issues that we've talked about.

White: Well, and we need to be concerned that the governments that will be exercising these powers may not be staffed entirely with people as well meaning as Ken Rogoff.

Beckworth: Right. Good point. Right. Along these lines, something else that strikes me is that many countries around the world use the dollar as a medium of exchange. I was talking to JP Koning in a previous podcast about the case of Zimbabwe. Zimbabwe, of course, had the famous hyperinflation that reached a head in 2008. After that, the government kind of gave up, turned off the printing press, and they allowed foreign exchange to circulate as a medium of exchange, as the money in the country. The dollar and the South African rand became the main currencies, and the dollar really leaped up front.

Beckworth: If we were to follow Ken Rogoff's prescription, that would eliminate the hundred dollar bill, which is what is widely used in places like Zimbabwe and other parts of the world. Yes, drug lords and criminals use the hundred dollar bills, but so do countries like Zimbabwe who don't have good institutions. And so, it struck me that if we got rid of that hundred dollar-

White: Absolutely.

Beckworth: Hundred dollar bill, we're going to be harming many developing countries around the world that don't have stable monetary systems. And yes, I know there's costs that also come with that, so if they use the dollar, they're going to get Fed policy. So, yelling tighten this policy or loosen this policy is going to affect them. But at least they have the option. Having the option of the dollar in some sense puts more discipline on the government of Zimbabwe, or whatever country is ... Panama, or Ecuador, or El Salvador, that are using the dollar. That's another cost of eliminating these large dollar bills that we should keep in mind, that we have the main reserve currency of the world. Other parts of the world depend upon it. If we get rid of that hundred dollar bill, it will affect them adversely.

White: Well, not just reserve currency in the sense that central banks hold it, but popular currency.

Beckworth: Yep. Yep.

White: I remember when they introduced the new counterfeit proof hundred dollar bill. The first picture I saw of it was a photograph of a woman holding it up to the sun in Moscow.

Beckworth: Wow.

White: Right? That's where they're really concerned about the validity of the U.S. dollars they hold.

Beckworth: Right.

White: Right? She was not a drug lord. She was an ordinary citizen. But this was her savings, and she wanted to make ... familiarize herself with the anti counterfeiting devices in it.

Beckworth: This is part of the Triffin dilemma on a common scale. The Triffin dilemma says that the country at the main reserve currency has to run current account deficits, or in more plain English, it needs to create more money, more treasuries than it really needs itself. This is, I think, one facet of that. People want our dollars because the alternative they have at home is not very strong.

Beckworth: Well, let's switch gears. This has been fascinating, but let's switch gears and move into another area in which you're well-versed, and that is Austrian macroeconomics. All right, so you've mentioned some of your background has been with some Austrian thought leaders, and also some of the history of economic thought. You mentioned some of them earlier. But tell us, what is Austrian macroeconomics, and how is it different than mainstream macro?

Austrian Macroeconomics vs. the Mainstream

White: Well, there's a lot of skepticism among Austrian economists about the validity of the concept of macroeconomics. But the book I teach from, actually, in my graduate macro course, is Roger Garrison's Time and Money. Garrison says we can define macroeconomics as the economics of problems that involve time and money. So, it's a combination of monetary theory and intertemporal exchange theory. That's the way I teach the course. The first part is about intertemporal exchange, intertemporal equilibrium, savings and investment equilibrium. Plans of consumers to defer consumption match the plans of investors to invest to provide the future consumption that people are saving for, that sort of thing.

White: The next segment of the course is about monetary equilibrium. There, I teach using, actually, some of Michael Darby's texts that I had in graduate school, and some other restatements of the quantity theory of money to get the simple concept of equality between the demand for money and the supply of money at the existing price level. Then the third part of the course is business cycle theory, which is when these equilibria get disrupted, in particular how a disruption of monetary equilibrium, for example, through a central bank over issuing money, issuing more money than people want to hold at the existing price level, how that spills over into the financial markets to depress interest rates, creating an intertemporal disequilibrium, and what happens when those chickens come home to roost, how that distorts investment incentives.

White: So, this story ... Well, business cycle theory generally goes back to the debate in the middle of the 19th century between the banking school, the currency school, and the free banking school, about what was causing the business cycles of the day. From that debate in which the currency school and the free banking school emphasized the importance of monetary disturbances, namely Bank of England policy, in explaining why the economy was going through an upswing, followed by a downturn, basically the idea that the idea that the Bank of England issued more money than people wanted to hold. The money started to flow overseas. That drained gold from the reserves of the Bank of England, and constrained by the gold standard, the Bank of England then had to suddenly contract when they woke up to what was happening, and that caused the credit crunch and the recession.

White: So, that's a basic monetary theory of the business cycle. In his great 1912 book, The Theory of Money and Credit, the Austrian economist, that is, raised and educated in Vienna, I should say educated in Vienna, Ludwig von Mises, combined that simple theory with a sophisticated interest rate theory that he got from Bohm-Bawerk, the idea that the interest rate establishes an intertemporal equilibrium. And not just Bohm-Bawerk, but the more sophisticated restatement of Bohm-Bawerk's theory by Wicksell. And of course, Wicksell is known for the distinction between the natural rate of interest, the intertemporal equilibrium rate of interest, in other words, and the prevailing current market rate of interest, which may be out of equilibrium due to monetary policy, or due to a sudden change in the public's demand for cash balances. But more commonly, what varies rapidly is money issue rather than money demand.

White: Wicksell explained that if the central bank is trying to hold the market interest rate below the natural rate, it has to keep injecting money to use the liquidity effect to do that, and that creates what's called a cumulative process where, as the price level starts to rise, and therefore the real money supply starts to shrink, the central bank has to keep injecting faster and faster. And either something like the gold standard brings that to an end, that's the story of the currency school and the free banking school, or you get a hyper inflation. So, Mises put on top of that the suggestion that the low interest rates are going to cause distortions in investment drawing on Bohm-Bawerk's capital theory.

White: Hayek then picks this up in his monetary theory in the trade cycle in 1929. That's a general argument for money being an important element of any business cycle theory because without money as what he calls a loose joint, we should expect to see general equilibrium. We shouldn't expect to see booms and busts. But money creates a factor that can be in excess supply due to central bank policy, or in Hayek's view, due to the banking system going off the rails. In Prices in Production, Hayek ... it's a series of lectures published in 1931. Hayek combines that with the Austrian capital theory, Bohm-Bawerk capital theory, and uses a series of diagrams that have become well-known among Austrian economists, at least, showing the so called structure of production where goods travel from the earliest stages, from raw materials stages through refining, and manufacturing, and marketing, and distribution, and retail sales.

White: The argument is that stages of production that are farthest from consumers in time, so are ... final consumption sales are many years off, the value of activity at those stages is discounted back from the expected future sales, and so the discount rate enters into the profitability calculations. Therefore, those activities are more sensitive to changes in the interest rate, and will suffer more distortion if interest rates are driven above or below the interest rate that would actually coordinate activities. So you see, this is designed to explain why you see bigger swings in heavy industry than you do in retail industry.So, Hayek ... A lot of people react to Prices and Production, and Hayek responds to them in a series of essays which are gathered together in a book called Profits, Interest, and Investment, published in 1939. And finally, Hayek writes The Pure Theory of Capital, which is published in 1941. But by that time, everyone was a Keynesian, and that book kind of fell on deaf ears.

White: There were some empirical efforts in the '30s, in particular Lionel Robbins and his book on the Great Depression, tried to bring the facts of the Great Depression together with this theory and show that they fit in some sense. There's a book by Phillips, McManus, and Nelson which has even more detailed empirical illustration, you might say, of the theory. It's not formal hypothesis testing. But it's a useful source of why people thought this theory was appropriate to explaining what was going on. There's a much bigger swing in investment during the Great Depression, during the boom in the '20s, and then it rises more than final goods. Then in the crash, of course, investment really drops to the floor much more than consumption does. So, it's designed to try and explain that.

White: Of course, Hayek made a comeback in the recent financial crisis, in the boom preceding 2007, and then the crash. The boom was in a time and interest sensitive industry, the housing industry, and then of course, so was the crash. So that restored it to at least some plausibility. The fact that the boom and bust were not captured, or explained, or predicted by current DSGE models, or DSGE models as of 2007, has led a lot of mainstream economists to say well, there's something missing from our models, and some of them have cited Hayek as somebody who had something worth learning, the idea that there are credit booms and busts, and that's part of the story.

Beckworth: Yeah, definitely you see much more interest in credit and financial issues brought into the DSGE models now. Now, let me go back to your description of the Austrian business cycle theory. One of the terms you often hear is mal investment. I'm guessing this is what arises when a central bank keeps the market rate of interest below the natural rate of interest. Is that right?

White: Right. Mal investment, bad investment, is investment that looks profitable at low interest rates, at artificially low interest rates, but when interest rates rise back to equilibrium, it turns out those projects are not profitable and have to be scrapped.

Beckworth: Okay, and that could be ... It could be like the tech boom in the late '90s. It could also be the housing boom. Now, a question I have ... So, this mal investment, is this more of like a ... You mentioned more of a temporal ... a time issue. But could it also be one of geography and location, or is it just more of a time issue?

White: Well, in the housing boom, of course, it was worse in many ... in specific places than it was country-wide.

Beckworth: Okay.

White: So, the way Garrison puts it is that the cheap money policies enable an investment boom to go further than it ought to. So, you get mal investment on top of what would have been viable investment, sustainable investment. So, in places that were already having some housing expansion, like Las Vegas or Florida, you saw investors pile in when interest rates were artificially low because that's where the investment was taking place anyway. A low interest rate is not going to lead someone to build lots of housing in a place that isn't growing.

Beckworth: This also speaks, I think, to a bigger point that ... I think that point applied more generally is that there will be legitimate gains that create euphoria, maybe, that fuel optimism, and the central bank plays a role in making that more announced. George Selgin and I have a paper where we argue ... kind of a complement to John Taylor's argument. He argues the Fed kept rates too low for too long. We ask the question well, why? We argue because there's a productivity boom between 2002, 2004, productivity growth accelerates, and of course, that's a boost for the economy, a fundamental improvement in the economy. But it also put downward pressure on inflation, the Fed responds, and further fuels the growth that was happening during that time.

White: Yeah, that's an important point. The way the Austrian theory is sometimes exposited, it goes like this. The economy is on an even keel, and suddenly the central bank decides to drive interest rates down. That's sometimes the way Mises tells the story. But that leads to obvious questions, which is why don't people realize that the interest rate is artificially low and refuse to be fooled? I think that's a valid criticism if that were the only story. But the more common scenario, and the one you were just mentioning, is where there is for some reason an increase in productivity, or an anticipation of gains to be made from investment in new technologies. There is already an increased demand for investment. Instead of letting the interest rate rise because the natural rate, in the Wicksellian sense, has risen, the central bank thinks that its job is to keep interest rates from rising so as not to constrain the boom. But by keeping interest rates where they had been, they're not keeping interest rates below where they ought to be.

Beckworth: Yeah.

White: Holding ... It's not that they've lowered the market rate, but they've held the market rate below the rising natural rate. Then, investors don't get the signal from the interest rate falling. What they see is that the investment project has now been green lighted, and it's not surprising that investors would say oh, well then I'm going to go ahead and make the investment now that the bank has approved it. They're not going to say oh, well if they're going to lend me money, I don't want it.

Beckworth: Right. Well, this point that you're making is that it's the relative gap or distance between the natural rate and then the actual rate, the Feds manipulating in the short run. You mentioned you could keep the ... the Fed could keep the Federal funds rate at a constant value, but if that natural rate is going up, it's effectively easing. Right?

White: Right.

Beckworth: So it's the difference between the two. And this is-

White: Exactly. In 2002 to 2004, the Fed kept the Fed funds rate around one percent when they should have been raising it.

Beckworth: Right.

White: As John Taylor says, they held it too low for too long. Even though the one percent may have been appropriate when they started it, they held it too long as natural rates were rising.

Beckworth: I guess my question is that this point, I think, is understood by mainstream economists. You look at Michael Woodford's book, he too talks about the importance of the natural interest rate. He draws upon Wicksell, the natural interest rate relative to the actual short term interest rate, and he frames it in terms of an output gap. He says the output gap is equal to the expected future path of this interest rate gap, the difference between the natural rate and the actual rate. I think the deficiency ... Again, as you mentioned, up until 2008, at least, is that's all they looked at, and they ignored often credit, and markets, and sometimes even capital in their models. But if they add capital in, I think you get back to a very similar story. But do you see similarities or differences in how the new Keynesians use this idea of a natural rate, and how the Austrians use it?

Keynesian vs. Austrian Understanding of the Natural Rate

White: Well, I actually have a paper forthcoming entitled Hayek in Contemporary Macroeconomics. That'll be in a journal called Advances in Austrian Economics, where I force myself to look at a lot of the new Keynesian literature. There are some connections, of course. Hayek talked about the job of business cycle theory being to form a story that's consistent with our ordinary equilibrium models in economics. I have the quote in front of me. The incorporation of cyclical phenomena into the system of economic equilibrium theory with which they are in apparent contradiction, unquote. That's the job of macroeconomics. That theme was picked up by Lucas. In fact, Lucas quoted Hayek and said we would make more progress if we would stop using Keynesian models and go back to this idea we get from Hayek, resume the work of the pre Keynesian theorists who are trying to make business cycle theories consistent with general equilibrium theory.

White: Now, Lucas's idea of consistency was a little different from Hayek's. Hayek's idea was you explain why the economy deviates from equilibrium and returns to equilibrium, and Lucas doesn't want to talk that way. He wants every period to be a temporary equilibrium, at least. So it's a question of how the impulse and response functions work. But they both had this monetary shock theory of a monetary shock having real effects, and that's the business cycle. For Hayek, it was through interest rates. For Lucas, it was through the price level.

White: That was then sidelined by real business cycle theory, or rather the real business cycle empirics of Kydland and Prescott convinced Lucas that most of the action was in technology shocks and not in monetary shocks. But Lucas continues to say that to explain the Great Depression and to explain the recession after 2007 we need to understand monetary shocks, that those were operating then. But the ... Lucas's story, as I said, was not about interest rates, and some new Keynesians have picked up the importance of interest rates.

White: So, there is that similarity, but if you look into the models in ... the DSGE models that incorporate a Taylor rule as one of their fundamental equations, it's kind of assumed that the central bank knows what the real natural rate is, and the policy rate that they then set is equal to that plus something that will help keep the inflation on the desired path, or the price level on the desired path. Whereas the problem is that the central banks can create deviations from the real natural rate that they don't intend.

Beckworth: Yeah, absolutely. Orphanides, in that vein, wrote about the 1970s, and he argued that the Federal Reserve messed up, and one of the big reasons it messed up is because it didn't know in real time the output gap. But that same critique could be applied to the natural interest rate, too. Right? As the productivity growth rate was slowing down in the '70s, that may have also been at play. But it's interesting, at least from my perspective, to see new Keynesians, they also invoke Wicksell, Austrians invoke Wicksell. And I'm just wondering now that the new Keynesians are taking credit more seriously, there might be some convergence in the future. But let's move on. I want to ask a question-

White: Well, one of the big differences, of course, is that in the new Keynesian models, money doesn't play an important role.

Beckworth: No, absolutely. I guess my ... I'm hoping, maybe is the better word, that there's going to be some movement back toward the importance of money, credit, and how they interact with this interest rate gap.

White: I also hope so.

Beckworth: Yeah. Well, I've ... One article, and I sent this to you ahead of time, I'll just mention it briefly, Larry Christiano and some other authors in 2010 put an article out for the Jackson Hole meetings, symposium put on by the Kansas City Fed, and it has a very Austrian message to it. They don't call themselves Austrians by any means, but their model was a new Keynesian DSGE model, and they show that a central bank that worries too much about inflation, that excessively tries to get inflation down when there's these productivity booms that lead to higher expected growth rates can create destabilizing stock market booms. When I read that, I'm like man, that is very much an Austrian argument, and it's using the new Keynesian framework. What they point out, though, in order to get that result is they have to bring credit back into the model. So, I do see maybe in the future some convergence.

White: Yeah. There are similar points that have been made by William R. White, no relation, and Claudio Borio at the Bank for International Settlements.

Beckworth: Yeah, they had a really good paper, “Is Price Stability Enough?” They've been advocates of that all along, too. Now, one other question about mal investment. So again, this is the Austrian idea where you have the divergence between the natural interest rate and the actual interest rate, and it leads to excessive capacity, too much investment spending, and I wonder if there's any relation, or if you see any similarity to the Keynesian idea of hysteresis, the idea that when you have excessive demand busts, that over time that can affect the productive capacity in the economy. In other words, are they in any sense a mere image of each other? The Austrians worry about the boom, and during the boom stages, these disturbances lead to excessive build up of capital, where the Keynesians worry about the opposite. There's going to be a reduction in the productive capacity because of demand shortfalls. Any math in between the two, or not?

White: Well, I'm just spit balling here, but the boom period in the Austrian theory is characterized by interest rates that are out of whack, which distorts investment incentives. You could have the same thing in a recession if the market rate is being held above the natural rate, and that discourages investment, and therefore discourages improvements in the productivity of labor, and discourages investments in human capital, which would discourage the increases in the productivity of labor. That could have effects that stretch out over time because of the change in the capital stock. So, offhand, I don't see any reason to think that there couldn't be some kind of symmetry there.

White: The Austrians typically think of the recession as the correction from the excesses of the boom. If you could follow a gentle glide path back to equilibrium ... But of course, then you wouldn't worry about the natural rate being too high. But that's probably not what we usually see. We probably do see problems in both directions. Certainly, there have been recessions due to excessively tight money, so you would expect these kind of effects.

Beckworth: Yeah, I guess the new Keynesian would argue yes, Larry, that's exactly what has happened over the past eight year. Right? We've been stuck in the zero lower bound, so the policy rate was ... Now, of course, the real rate was lower than zero, but their argument would be the policy rate was stuck at zero because of the zero lower bound. The natural rate was well below that. And so we get this mal investment on the downside. So, maybe a ... Here's another way of framing this question.

White: I'm not so keen on the idea that the natural rate was significantly below zero, but go ahead.

Beckworth: Right. No, I ... That's an assumption, right. That's a premise. But if it were true, I think what you're saying is yes, if we can ... If that were true, and you're questioning whether it was true or not, but if it were true that the policy was tied relative to where it should be, then you could get this mal investment on the downside. So, does that also mean then that secular stagnation is possible from the Austrian prospective?

White: I'm not sure I would call that secular stagnation.

Beckworth: Okay.

White: I do think there is something to the argument that Claudio Borio has made that we're in a period where there's still a hangover from the bad investments made during the boom. That's holding down productivity. But when I eyeballed the data on real GDP, I see a drop during the recession. The path shifts down. Then it assumes a fairly smooth growth path since then, since 2009. People who are worried about money being excessively tight seem to be making that judgment based on the measured output gap. But I think your potential GDP was too high. If you look at the path of potential GDP, it hardly shows any change with the recession. It's gently curved downward because labor force participation has been falling. But there's no recognition that a bunch of capital was destroyed by the boom and the bust. That's my hypothesis as to why we've had a downward shift in real GDP. I don't think we've had eight years of tight money. That seems implausible to me that a monetary disequilibrium would last that long or that interest rates would be out of whack for that long.

Beckworth: We are almost out of time, but I did want to ask you one other question about Austrian macroeconomics, and that is, within Austrian macroeconomics there are some divergent views. There are folks like you who believe in the idea that you can have monetary disequilibrium. I think you would call that group the monetary equilibrium theory approach.

White: Some people have called it that, yeah.

Beckworth: Yeah. Then there are others which I will call the Rothbardians after Murray Rothbard, who are very-

White: I think that's the right label.

Beckworth: Okay. They're much more strident. So someone like you is sympathetic to the possibility that the Fed can both be accessibly easy, accessibly tight. You're also ... You're a free banker, you're open to fractional reserve banking, where the Rothbardians, they have a hard time appreciating some of those points. Can you speak to this difference of views within the Austrian school of thought?

White: Yeah. I don't think it's a matter of mood, so I wouldn't use the word strident. But I think there is a connection between the hundred percent reserve view and the view that ... of Rothbardians, that any increase in the money supply is dis equilibrating, even if the real demand for money has risen. They have this asymmetric view that if you inject money, it causes all kinds of trouble, but if you withdraw money, no problem. The price level will just adjust downward.

White: If you read Rothbard's book, America's Great Depression, there is this very strange undercurrent because he favors a collapse of the money supply down to the point where banks have a hundred percent reserves. He cheers every time the money supply shrinks, and is unhappy when the money supply doesn't shrink. So, that seems to me to be a strange way to understand why there's a Great Depression. So, the argument is that okay, the money supply shrank, that was great. The only problem was that prices didn't fall at the same rate. And why did that happen? Well, we have to find some government policy to blame. So, there's a tendency to minimize problems caused by price stickiness.

Beckworth: Okay.

White: Whereas, I think ... Yeah, price stickiness is a real thing.

Beckworth: It matters.

White: It matters, and that's why monetary policy matters in both directions.

Beckworth: Right. So the aim is to keep monetary policy as neutral as possible.

White: That's a good way to describe it.

Beckworth: Yeah.

White: Assuming we have a central bank.

Beckworth: Assuming we have a central bank, right. Fair point.

White: Another way to make monetary policy neutral is to have no monetary policy, have a market system for determining the quantity of money.

Beckworth: Right. I would encourage our listeners, if they're interested in that, to check out Larry's work on free banking. Well, our guest today has been Larry White. Larry, thank you so much for being a guest on our show.

White: My pleasure.


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