WEBVTT

NOTE Banking and the Business Cycle

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Good afternoon. This lecture is on banking and the business cycle.

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And it follows up on the lecture this morning about money and prices.

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One thing I did want to point out this morning when we talked about the real money supply and hyperinflation.

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Under hyperinflation, at the end of a hyperinflation, of course, the real value of the money supply, the real money supply,

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Despite all the trillions of marks that were in circulation, it was effectively zero, because at that point, no matter how many marks you brought, you couldn't buy an egg with them.

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So one thing that hyperinflation does is actually to reduce the real money supply towards zero as the nominal money supply increases towards infinity.

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So the government can always destroy the value of the real money supply, but really can't increase it.

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Okay, so let's get to banking as a lead-in to the Austrian theory of the business cycle.

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I want to distinguish between two forms of banking right off the bat, and that is what is sometimes called loan banking and deposit banking.

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And what we have today is a hybrid of the two.

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In order to analyze banking, what we need is what's called a T-account or a balance sheet.

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It's basically double entry bookkeeping. That's really come down from Renaissance Italy and even further back from Arab North Africa.

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But basically in a T-account or a balance sheet, what we have is on the right side is the amount of the various assets contributed by various individuals.

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And on the left side, we have the total assets of the business firm and what they are invested in.

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So, let's start with a simple example that Murray Rothbard has used to illustrate loan banking.

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Now, loan banking, as you'll see, is non-inflationary.

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If someone wants to start a bank, they take $10,000 of their own funds and that appears on the right side as equity and immediately then they have assets on the left side of $10,000.

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Now, what they've done is they've diverted cash from other uses and have begun this bank, so there's been no addition to the money supply, that's a key point.

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Once that bank has been started, begins operations.

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A loan is made, let's say, for $9,000 in exchange of present money, let's say there's a 10% interest rate.

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Great. So the loan is made from the Rothbard bank to an individual named Joe, and a thousand dollars of cash is kept on hand as part of the assets.

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Once again, there has not been any increase in the money supply. There has been a transfer of money from Rothbard's cash balance to Joe's cash balance.

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Okay, so money has changed hands, but it has not increased. That's an important point.

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Now, this loan bank can certainly issue stock and broaden its, or increase its equity,

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It's equity, but let me mention that when the loan is paid back, the $9900, that is $9000 principle, $900 in interest, again the money supply changes hands, is transferred from one cash balance to the other, but there is no change in its total amount.

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Now if this bank quote goes public, this equity bank, it issues stocks and you have then on the right side equity owned by shareholders and let's say the bank expands to $100,000 of equity and then again loans are made, $95,000 of that equity is transferred to borrowers and those borrowers then spend the money.

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The money is not available, then, to the shareholders, until it is returned at the end of the term of the loan.

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Once again, the bank going public does not change the fact that loan banking cannot increase or change in any way the money supply.

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The bank may further expand by issuing bonds. It is debt. Bonds and certificates of deposit.

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CDs are more or less short-term debt, bonds are longer-term debt, and so they get an additional $70,000 of assets so that the bank's assets on the left side increases

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On the right side, they now have liabilities, debts that they owe to other owners who have contributed cash to the business.

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Once again, the issuing of debt, the sale of bonds and certificates of deposit in exchange for cash has no effect on the money supply.

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Of course, they're not going to keep that $70,000 lying unused in the bank's vault, but they will lend that out.

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So the amount of loans they make will now increase.

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So you see on the right side is $170,000 in total of equity and liabilities and $170,000 of assets.

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Not one penny increase in the money supply has occurred as a result of these loan banking operations.

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So basically, let's sum up about loan banking.

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Bank lending, even the lending of borrowed funds at $70,000 does not involve the creation of M.

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It's not inherent in a financial intermediary.

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Because what the bank is doing here, when it borrows at $70,000 and loans it to another set of borrowers,

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the bank is acting as a financial intermediary, bringing together ultimate lenders with borrowers of funds.

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It also channels savings into productive loans and investments.

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So it increases the efficiency of the economy.

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If it makes unsound loans, if some of those $165,000 worth of IOUs are not repaid,

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the bank's creditors and the bank's shareholders suffer.

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There is no effect on the total amount of money in the economy.

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Now let's move on to deposit banking.

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That is pure deposit banking, not the hybrid form that we have today.

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And deposit banking arose, at least in the English-speaking world,

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in the 16th century.

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When goldsmiths began to rent out their vaults, their safes, their deposit boxes for the safekeeping of gold and silver that people brought to them.

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Basically, what a depositor in a warehouse does under deposit banking is to put on deposit or in trust some form of property,

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In exchange, the depositor receives a warehouse receipt, which entitles them to come in and claim their property at any moment in time, that is on demand, so they can redeem it instantaneously.

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Now, there's a difference between depositing money in a warehouse and depositing things

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like furniture or wheat or corn or whatever it is, because the wheat or corn, people are

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interested in getting, or rather, let's keep away from wheat and corn for a moment, let's

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talk about furniture, people are interested in getting back, okay, deposit, are interested

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in getting back their specific items of property, okay, when it comes to things like furniture.

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But when it comes to something like money, they're not interested in getting back the

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exact same units.

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They're interested in getting back the same weight of money.

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And secondly, with other commodities, they tend to be used.

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So eventually they're going to be withdrawn.

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So even if it is wheat or it's furniture, eventually that will be removed from the warehouse

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at some point in time.

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However, money can perform its job as a medium of exchange by remaining on deposit and having

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the warehouse receipt be transferred from one person to the next.

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That's certainly not true of furniture.

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If you sell your furniture, the person buying it wants the use value of it, they want to

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use it.

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Now over time, the warehouse receipts of the more trustworthy warehouses begin to be

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used as money.

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So if I purchase a horse from you for three gold ounces, I could go withdraw the three gold ounces from the warehouse, then carry them to you, and then purchase the horse, after which you would then redeposit them in your account at the warehouse.

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So a lot of trouble, a lot of risk can be taken out of that, the risk of loss, the risk of getting robbed or having the gold lost in a fire.

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A lot of that risk and effort can be removed if I simply transfer the right or the title to that amount of gold to you.

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So, in that case, then, the warehouse receipts begin to be used as what we call certificates of the gold certificates.

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Now, the use of these paper gold certificates do not increase the money supply.

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And the reason why they don't is because the money is being transferred for storage in the facility, in the money warehouse.

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It changes the form, okay? So let's say there's a hundred million dollars worth of gold circulating in an economy.

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If 70 million is deposited in the bank, that money is substituted for by the money certificates, okay?

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The bank notes circulate. So the form changes. Now, in circulation, we have 30 million of gold coin and 70 million of the bank notes.

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Where's the other 70 million dollars worth of gold? Well, they're locked up in the vaults. They're the property that the bank notes are titled to.

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So there is no increase in the money supply in that case.

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Something else to keep in mind about deposit banking. The deposited gold, at least initially, was not looked upon as a property of the owner of the money warehouse, as it would be in the case of a loan, which we talked about in the loan banking.

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That becomes the property of the borrower until the term of the loan is up and the borrower must return the money.

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In this case, it's what's called a bailment. It's not a loan.

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Bailment is a legal term for when property is transferred from one person to another for a specific purpose.

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In this case, just to be stored. Not to be used, not to be invested, not to be spent on any particular item, but strictly to be stored.

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So if you were to be transferred overseas by your employer for a year and you stored your furniture, that would be a bailment.

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And in fact, if that furniture was rented out for that year by the warehouse owner, that in fact would be embezzlement.

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You'd be using it in a manner that violates the bailment agreement.

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Same thing with, you know, in the short term, if you bring your shirts to a cleaner, you expect only that the shirts be cleaned and then returned to you.

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No other act can be performed with that property outside of that specified in the agreement.

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Now the warehouse owner is particularly susceptible to this temptation of embezzlement when the property that is lent to him is homogeneous or fungible.

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Again, when people don't care whether they get back the same bushel of wheat or the same ounce of gold.

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So in that case, all people care about is really getting back the same quantity.

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That's known as a general deposit rather than as a specific deposit.

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And in law, the owner of the warehouse is permitted to mix it together as long as he keeps the same total amount on hand.

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In other words, he doesn't have to earmark one bushel of wheat for you, as long as the whole amount is being kept, he can give you any bushel of wheat back.

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So why would there be this overriding temptation for embezzlement?

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Well, in the case of wheat, there is less of an incentive because wheat is a production good which is turned into a consumer good, flour and then bread, or other wheat products, so that's going to be removed periodically, but gold, as we pointed out, can stay there, and does stay there in performing its function.

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So all the warehouse owner has to do is arrive at a more or less conservative estimate of how much gold will be withdrawn at any given day, and then keep on hand more than that, to make sure that whatever warehouse we see is brought in can be redeemed.

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Now the English goldsmiths began to embezzle not by physically lending the gold out, keeping all the gold on hand, but in fact lending out or printing up pseudo warehouse receipts and lending the matter at interest.

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So now, the warehouse was earning a rent or a fee from storing the gold,

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but in addition, it was also earning interest from lending out these pseudo-warehouse receipts.

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And in fact, this was challenged in the courts, but by the 19th century,

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it was very unclear, by the way, the bailment law, the common law relating to bailments wasn't clear.

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But by the mid-19th century, British courts had ruled that the general bank deposits, those that were outside of safety deposit boxes, were debts and not bailments, so that they were seen as loans to the banks, and the banks, during that period of time in which it kept those deposits, was permitted to loan them out.

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That's how it was resolved legally in the British courts. I think it took a little longer in the Spanish courts, if you read Werta de Soto's book.

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I think it was a court case maybe in the early 20th century.

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So when deposits are treated as creditors rather than

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bailors, those who give property for specific purpose,

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the gold becomes an owned asset of the bank.

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The gold suddenly appears on the left side of the balance sheet.

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Now, when you bring your shirt or your furniture

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to someone to perform a specific function with it, that is not their property.

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or even your safety deposit box in a bank is not considered on the asset side of the bank

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or if you store your jewelry, staying at a hotel for a couple of weeks, if you store it in a hotel safe

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they don't enter that as an asset, it's clearly a bailment

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but the banks were permitted then, once it was ruled that these were debts and not bailment contracts

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It was ruled that once that ruling occurred, they were able to count them as assets.

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So what we had initially was 100% reserve banking, given that the banks held all the gold for which they had issued warehouse receipts.

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So if this is the Rothbard deposit bank, and I'm using examples from his book, Mystery of Banking,

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If people deposit $50,000 in gold, well their total liabilities are $50,000.

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They owe their depositors $50,000.

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On the left side, they now have gold, coin or bullion in their vaults that are being

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held 100% to back up the warehouse receipts they've issued.

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So their total assets and liabilities are equal.

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This is known as 100% reserve banking.

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Because 100% of the deposits are held in reserve, but the principle has now been established

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that these assets are owned for the bank, by the bank rather, during the length of the

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deposit.

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Even though the depositor can come in at any moment and redeem the warehouse receipt

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on demand.

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So you can see that the equation for establishing the percent reserves is reserves in an enumerator,

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warehouse receipts are in the denominator, so $50,000 in reserves are held to back up

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the $50,000 worth of warehouse receipts, that's 100% reserves.

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Now things changed over time, the camel's nose was under the tent, the deposits were

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were considered assets of the bank and eventually what began to happen was the

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embezzlement, was the printing up of pseudo warehouse receipts. Once that

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happened we got a situation in which we had less than 100% reserve banking.

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So let's look at the fractional reserve example here. There's $50,000 worth of

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is gold-deposited, and then $80,000 of warehouse receipts are printed up and loaned out, but at the same time $50,000 worth of warehouse receipts have been issued to the original depositors, those are the legitimate warehouse receipts, so the bank now has in circulation $130,000 worth of warehouse receipts,

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50,000 that have been initially issued to the original owners,

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80,000 that have been printed up in an illegitimate fashion and loaned out at interest.

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So now we have fractional reserve banking. Assuming they keep the full amount of gold coin that was initially deposited,

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you now have a much less than 100% banking, even less than 50%.

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The key point, however, is that every single one of these $130,000 worth of warehouse receipts looks like every other one.

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You can't tell the counterfeit ones from the real ones or the pseudo ones from the legitimate ones.

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So everyone who has those receipts has a claim on that $50,000 worth of gold coin.

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So the initial depositors have been defrauded in that sense, okay?

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If everyone tried to turn those receipts in, at the same time, of course, the bank would go bankrupt, and many of the original depositors, if they didn't get their first, would never get their property back.

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Now something else we can say about fractional reserve banking, there is a tendency, an inherent tendency to deflation in the sense that when those $80,000 in loans are paid back, notice what happens.

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The cash suddenly disappears, the deposits suddenly disappear, or the bank notes are turned in, as they pay back their loans, and the money supply is deflated, so the money supply then drops by $80,000.

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Before that it had increased by $80,000.

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So one of the general characteristics of fractional reserve banking is that

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whenever there is a loan, whenever a fractional reserve bank makes a loan, it increases the money supply.

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Whenever it cancels a loan, it decreases the money supply.

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Now, let me just mention very quickly something else here. There are two basic forms of warehouse receipts that had been issued.

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One was the bank note, which was the physical warehouse receipt, but another was an open book account.

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Some of the larger depositors preferred not to carry the paper notes around, but to have an account in which balances were kept at the bank,

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and they could write checks on these open book accounts. So they were basically checking accounts, and then transfer the balances,

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which stayed at the bank, but was transferred to a second party that had sold something to the business.

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As fractional reserve banking developed, there's really a mixing between deposit banking, and today we have this, and loan banking.

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Today we have something called commercial banks and they're basically hybrid banks.

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Banks in which deposit banking is mixed together with loan banking.

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So a bank is operating as a loan bank if it issues a certificate of deposit.

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If you buy a six-month certificate of deposit for $10,000,

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that is not inflationary in the sense that it does not increase the money supply.

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The $10,000 is transferred through the bank from you to a borrower,

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and then in six months it's repaid and you get your principal plus the interest back.

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However, if you put your money in a checking account, in the U.S. today, 90% of that can be loaned out, approximately 90%.

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And that then increases the money supply.

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And I will show you how that actually occurs here.

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Right before I show you how it actually occurs, let me just sum up fractional reserve banking.

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First of all, it's inflationary. It's inherently inflationary because whenever it makes any loans, it increases the money supply.

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As in this case, it increases the money supply by $80,000 and that increases prices eventually.

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To the extent that the amount of warehouse receipts exceeds the deposited gold, that amount of warehouse receipts operate as inflation or operate in an inflationary manner.

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Secondly, the fractional reserve banks can create money out of thin air.

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When they print up these receipts over and above the amount of gold that has been initially deposited, there is an increase in the money supply.

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And it's done ex nihilo, that is, from nothing. You suddenly have money in the economy.

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They're also inherently bankrupt because the time structure of their assets do not match the time structure of their liabilities, meaning the following.

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If you look on the right side, you'll see that total notes and deposits, that's the total liabilities, the total amount they owe, instantaneously or on demand, comes to $1.8 million.

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But on the left side, the only cash they have on hand to meet that $1.8 million, which is an instantaneous liability, is the $300,000 they keep in cash reserves.

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The rest is loaned out at different maturities for greater or shorter periods of time.

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So all of its liabilities are instantaneous, but only a very small part of its assets are instantaneously available.

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So what that implies is that the maturity structure or the term structure of the assets far exceeds that of the liabilities, temporally speaking.

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Also, whether or not fractional reserve banking is based on gold, as it was under gold standard in the 19th century, for example in the US and in Great Britain, or whether it's based on fiat money as it is today, it still operates in the same way, it's still inherently inflationary, it still creates money out of thin air, it still results in a mismatch between the time structure of assets and liabilities.

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Now, there are two difficulties that limit fractional reserve banking before you get

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a central bank, in the absence of a central bank.

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And one is that the more that a particular bank inflates the money supply, the higher

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the prices are in its area of operation, and with higher prices, what happens is that people

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in that area begin to take these banknotes and buy things in other areas where prices

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have not gone up yet. And when those notes return to other banks, the first bank's notes,

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those other banks then demand their gold. So if one bank inflates more than surrounding banks,

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it's going to lose gold reserves to those other banks because it's going to drive prices up in its area

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and discourage exports from that area and encourage people to purchase imports from abroad.

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So there's going to be disequilibrium between the notes it gets from the other banks

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from the other banks and the notes that other banks get from it.

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So the other banks will accumulate more of its notes.

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And the only way you can pay for that difference,

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if the notes were equal, they would just exchange notes.

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But if the other bank holds more of your notes than you do of its notes,

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you have to pay that difference in gold.

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So the bank begins to lose reserves, people begin to lose confidence,

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and they risk a bank run.

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If everyone comes into the bank at the same time,

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obviously this bank would immediately collapse,

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And secondly, in order for the warehouse to cease to function as substitutes for gold or for the government notes, whichever is the base money, the bank must build up a reputation for honesty and safety and make people believe that it's able to instantly redeem its deposits.

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So the bank has to be conservative in some sense.

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If it starts to make bad loans and people see that borrowers are defaulting on the loans, they're going to begin to come to the bank and demand their gold.

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Now let's look at how fractional reserve banking increases the money supply beyond just one bank.

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on Bank, how the system as a whole will operate to increase the money supply.

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Let's take the first national bank on the left side, okay?

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Looking at this T account here, okay?

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Notice that the liabilities, the demand deposits or check accounts,

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we'll talk in terms of checking accounts now, are $10,000.

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Okay, initially it has reserves of $10,000.

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But since it's only going to keep a fraction of those reserves,

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and wants to loan the rest out, and the incentive, of course, is to earn interest,

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what's going to happen is that, let's say it keeps only 10% reserves

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and loans out $9,000 and what it does is it makes an auto loan to someone.

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Now that individual then will take the money and let's say purchase an automobile.

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The automobile dealer will then take the money to his own bank

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and deposit the $9,000 that he received for the automobile

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in the second national bank let's say

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and that bank will not want to keep the full $9,000 just lying there not earning interest

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But we'll loan out, let's say, $8,100, which is 90%.

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Now notice what has happened.

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As soon as the automobile dealer redeposits that money,

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what has happened to the money supply?

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It's now increased by $9,000 because the original depositor

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still has his check account for $10,000.

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But now the automobile dealer has $9,000.

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That $9,000 was not in the economy prior to that loan being made

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and the money being redeposited.

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Now, this is exactly what happens when you deposit money in your checking account.

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As I said, approximately 90% is loaned out.

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Now, let's say the Second National Bank makes a loan to someone who wants to start a small dry cleaning establishment

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and makes an $8,100 loan and that person pays workers and buys supplies and so on

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so that that establishment can be built.

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And notice what happens.

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The workers and the suppliers redeposited in the third bank, or many other banks, but it doesn't matter, let's take one bank.

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And that demand deposit, those deposited funds are now $8,100.

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So now there's a new checking account out of thin air for $8,100.

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So there had been a 9,000 one established in the second bank, and then an $8,100 checking account.

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And you can see here, this is a multiplicative process.

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It's called multiple demand deposit expansion.

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And then, of course, this bank makes a $7,200 loan.

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It goes on and on with the sum of new deposits getting smaller and smaller at each point, the amount of new deposits.

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There is a very simple formula that we use to tell us what the multiplier is.

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That is, by how much can each dollar deposited in a fractional reserve bank be multiplied in increasing the money supply?

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And that is simply one over the reserve requirements.

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So in today's world, under the Federal Reserve System, there's a legal reserve requirement of 10 percent,

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which means that if you divide one by 0.10, you get a multiplier of 10.

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Now what that tells us then in this case, the total change in demand deposits down here,

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checking account money, is 10, as that money is redeposited throughout the banking system,

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the multiple expansion process I was talking about, times the original $10,000 that you

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or I have deposited in our bank.

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Because that $10,000 can serve as reserves for $100,000 of checking account money.

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So out of thin air, 90,000 new dollars are created.

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And why is it only 90,000 and not 100,000?

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Because obviously someone took $10,000 out of their currency,

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they've had currency, and they put it in a bank account.

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And then, so you have to subtract the 10,000 from the currency.

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But on the other hand, that became the basis of $100,000 of demand deposits.

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And so what you get then is 90,000 new dollars in the economy operating to raise prices and to have the other effects that inflation has on the economy.

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Now there's a few assumptions here, and that is that every single dollar that's loaned out is redeposited.

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We know that doesn't happen. In the real world, people want the wholesome currency.

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So everybody who takes a loan out will hold some currency and redeposit only a part of the money that's been lent to them.

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to them, which means the multiplier isn't quite ten, that's the maximum.

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So think about it, anytime you deposit money in a checking account, you're giving more

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reserves to the bank and the bank can then loan out and that becomes loans to someone

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who redeposits it in another bank and over time, in a few weeks time, let's say you deposit

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a thousand dollars, that thousand dollars of currency is multiplied ten times into ten

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$10,000 of checking account money, okay? So the money supply increases as a result.

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On the other hand, if you withdraw money from the banking system, if you need $10,000 in cash, which you withdraw,

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what's going to happen is that the bank is suddenly going to find itself with insufficient reserves,

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and it's going to have to call in some loans. Every day loans are coming into the bank,

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which they then make new loans with, because they don't want to lose interest.

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But in this case, some of those loans will have to be canceled, and it will be a reverse multiplier effect.

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So in a real world example, people during the holidays, from Christmas through New Year's, or actually before Christmas,

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take a lot of money out of American banks. They make a lot of small purchases during the Christmas season, and they carry around a lot more currency.

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So let's say they take out $50 billion of currency from their checking accounts.

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What would happen is, ultimately, that will be multiplied ten times, and that will result in a deflation of the demand deposits by $50 billion.

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Just by taking out that $5 billion. Now, the Fed knows that. What do you think the Fed does during that period?

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I'll show you how in a moment. What the Fed will do then is to offset that, is that it will create $5 billion of reserves out of thin air,

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and then inject them into the banking system and we'll show you how they have instruments to do that

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and then when that occurs, that will offset the reverse multiplier process.

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Now, after the Christmas season is over, what do they do?

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People put back their money, currency as the sellers, the retailers,

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redeposit the currency into the banking system that they've received in exchange.

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Well then, the reserves of the bank begin to increase and the Fed drains the money out of the banking system, okay?

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Now, how does the Fed do that? Oh, one other thing, remember the Y2K scare.

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Everyone thought that the computers would go down and that somehow their checking accounts would be lost or their savings accounts and so on,

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So, what did the Fed do to calm fears? What it did was, it injected, and you can see a big spike in reserves, it injected a tremendous amount of reserves into the system, right before Y2K, and the banks kept those reserves in their vaults, they didn't really loan them out, but after the Y2K passed without any incident, they drained all that money out of the system.

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How do they do that? How do they inject reserves and drain reserves out?

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Well, let's take a very simple example.

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Let's say that I have a car for sale, a used car.

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Now, since 1980, the Fed can literally buy any asset.

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Up to that point, it can only buy short-term government bonds.

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It can buy long-term government bonds.

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It can purchase now foreign government bonds.

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It's permitted in an indirect way to actually purchase stocks by making 0% loans to banks.

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So it can literally almost purchase any asset it wishes.

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So let's say it purchases my car.

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Now how would the Fed go about purchasing my used car for $5,000?

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Well, being the Fed, the Fed would simply write out a check to Joe Salerno for $5,000, sign it to the Fed.

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Now, where did the Fed get that money?

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They just created it. In fact, it doesn't even have to be on paper.

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It can be just a blip in a computer that transfers funds directly to my bank account.

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The bank, your bank now has 5,000, if I, when I redeposit that check in my bank account or when I deposit the check in my bank account that was drawn on the Fed, or the money is wired to my bank account, it doesn't matter, my bank has 5,000 new dollars in reserves that were previously not there, okay, there's simply an entry in a computer now, which means my bank can now lend out the full $5,000. So as a result of that purchase of my car, eventually the money supply will increase by about 10 times that, by 50%.

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In the U.S. today, the real money multiplier is somewhere between two and a half and three, so it will increase by $15,000, because money leaks out in currency, banks hold some of the new money as excess reserves, so the point is, though, that the Fed will set in train a multiplicative process, multiplying those reserves.

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Now, how does the Fed really inject the money into the economy?

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Well, they do it right near my school, in fact, three blocks away from the World Trade Center, Pace University is.

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And the New York Fed is a little further away than that.

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But there's an open market trading desk, okay, and it really is only at the New York Fed.

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And every morning between 9 and 11 o'clock, there's something called Fed Time.

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and the various bond dealers, there's a select group of privileged bond dealers, I've heard 30 or around that number, that call in and they bid on, or they either, if the Fed wants to buy government bonds, they'll then ask certain prices and then the Fed will take the cheapest prices and will purchase those government bonds.

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So let's say they purchase a hundred million dollars worth of government bonds, and they can do hundreds of millions of dollars and even more of business in a day.

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So if they purchase a hundred million dollars, the bond dealers then get checks from the Fed, or more likely the money's wired to their banks, worth a hundred million dollars.

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They then deposit those checks into their accounts at the Citibank and whatever banks they use,

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And the banks now have a hundred million dollars free and clear of new reserves that they can lend out at interest.

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Now when they lend it out, the people who borrow it don't hold it, they spend it on something.

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The sellers then redeposit in their bank. Their bank now has more reserves.

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So that multiplier process then is precipitated,

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and the $100 million in a few weeks time is turned into $1 billion new dollars.

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That's the maximum in new checking account money.

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That's how the Fed increases the money supply.

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That's known as an open market operation.

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The Fed uses that on a daily basis.

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If the Fed wants to drain money out of the economy,

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well, what it does is it goes into the market in the morning and it buys,

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or rather it sells, has a whole stock of billions and billions of dollars worth

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of Government Bonds, that's built up since 1914, and it will sell some of those, okay?

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Now how are they paid for?

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Bond dealers will write checks on their banks and pay for them.

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When those checks go to the Fed, the Fed then informs the banks that they have fewer reserves,

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that their reserves have fallen by $100 million, let's say, okay?

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So then the banks have to begin to call in loans because their reserves are insufficient

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to back up their checking account money and the money supply shrinks.

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So when the Fed buys anything, it increases the money supply.

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When it sells anything, it decreases the money supply.

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Once again, where does it get the money to buy things?

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Just writes on a piece of paper or makes an entry into a computer.

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The Fed doesn't have any money of its own, but it's legally empowered to create money out of thin air through open market operations.

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It can also change the reserve requirement.

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There's about $600 billion worth of checking account money in the U.S. today.

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The reserve's backing it up around $60 billion. I should have looked this up before I came down, just to give you the real figures, but they're close to those.

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So there's a 10% reserve requirement.

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What if suddenly the Fed said that now you only have to hold 5% to back up your checking account money?

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All the banks would need now is not $60 billion, they'd only need $30 billion.

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They'd only need 5% of their deposit.

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They'd now have $30 billion to loan out.

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And as they loan that out, that would be multiplied 20 times.

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So the money supply would double, or at least the checking account component of the money supply,

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the demand deposit component, would double from $600 billion to $1.2 trillion.

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Now the Fed does not use the reserve requirement, changes in the reserve requirement on a regular basis, okay.

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They lowered it very, very slowly in the last few decades, okay, it used to be about 13% and 3% on savings accounts.

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They lowered it from 3% to 0% on savings accounts and they lowered it from about 13% to about 10%.

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Now not all banks have to hold 10%, country banks and city banks hold different amounts depending on the location of the bank,

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But on average, it's about 10 percent, okay?

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And you can look in any money and banking textbook and see the exact amount.

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Okay, now the question becomes,

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what happens when the Fed increases the money supply?

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Does it have any other effects besides raising prices?

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And indeed, it does, okay?

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Now, let me focus in on this.

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Remember, this money, or these reserves, these new reserves, are injected into the economy through what?

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Through the loan market, as opposed to when money was simply printed up by governments,

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and they spent it on military goods, or they spent it on consumer goods, or whatever it was they spent it on.

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Now, new money is created through the banking system, in modern times.

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The banks, let's say the interest rate is initially 10%, that's equilibrium.

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The first two supply and demand curves intersecting.

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In order to get people to borrow the new money or the reserves that have been injected into the banking system,

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at 10% people are borrowing as much as they want to.

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To induce them to borrow more, what do you have to do?

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You have to lower your interest rates.

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So as the supply shifts out of the new credit, the credit that's created by banks,

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That is added to the supply of voluntary savings, the amount of money that people voluntarily withhold from spending on consumption goods and put into the banks and into other financial intermediaries.

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So now added to that is this fictitious money, or it's actually real money, but it's money that's simply printed up out of thin air.

382
00:45:29.640 --> 00:45:34.640
And that pushes the interest rate down, let's say in this case, to 7.5%.

383
00:45:34.640 --> 00:45:41.640
Suddenly, businessmen, entrepreneurs, see opportunities for profit.

384
00:45:41.640 --> 00:45:45.640
They see that they can get a 9% return on a particular investment project

385
00:45:45.640 --> 00:45:47.640
or an 8% return on a particular investment project,

386
00:45:47.640 --> 00:45:52.640
which wasn't worthwhile investing in before because the borrowing rate was 10%.

387
00:45:52.640 --> 00:45:59.640
Now, if they can borrow at 7.5%, they begin to borrow more money and invest it.

388
00:45:59.640 --> 00:46:00.640
What happens?

389
00:46:00.640 --> 00:46:04.640
What happens? That money is invested in purchasing new capital goods.

390
00:46:04.640 --> 00:46:13.640
So as I'll show you in a moment symbolically, the capital goods industry suddenly experienced a big boom.

391
00:46:13.640 --> 00:46:20.640
So more factories are constructed, the construction industry is stimulated, the oil drilling industry is stimulated,

392
00:46:20.640 --> 00:46:27.640
the shipbuilding industry is stimulated, the electric power generating industry is stimulated.

393
00:46:27.640 --> 00:46:35.640
So you begin to get an increase in the amount of capital goods, but have people's time preferences changed?

394
00:46:35.640 --> 00:46:40.640
Have people really voluntarily decided to postpone some of their consumption into the future?

395
00:46:40.640 --> 00:46:44.640
No. Okay, this money has been created out of thin air.

396
00:46:44.640 --> 00:46:53.640
So what you get then, I'm going to have to zoom out again, hold on here.

397
00:46:53.640 --> 00:46:58.640
We have our two sets of industries here.

398
00:46:58.640 --> 00:47:01.640
On the top, we have the consumer's goods industries.

399
00:47:01.640 --> 00:47:03.640
Bottom, we have the capital goods industries.

400
00:47:03.640 --> 00:47:07.640
C represents consumer goods. K represents capital goods.

401
00:47:07.640 --> 00:47:12.640
So the Fed enters the market, makes open market purchases, expands the money supply.

402
00:47:12.640 --> 00:47:17.640
Bank reserves go up. You see R goes up there.

403
00:47:17.640 --> 00:47:20.640
That drives the interest rate down as I've shown you.

404
00:47:20.640 --> 00:47:22.640
And now two sets of effects are set into motion.

405
00:47:22.640 --> 00:47:29.640
Immediately, the one set of effects is that at the lower interest rate, businesses borrow the additional funds,

406
00:47:29.640 --> 00:47:33.640
they increase their investment, which drives up the demand for capital goods,

407
00:47:33.640 --> 00:47:37.640
and as the demand for capital goods increase, the prices of capital goods go up,

408
00:47:37.640 --> 00:47:41.640
which means that the profits in pi, the Greek symbol pi represents profits,

409
00:47:41.640 --> 00:47:47.640
and the capital goods industries are increased, which stimulate those industries to expand.

410
00:47:47.640 --> 00:47:59.640
As they expand, they raise the wages to get more workers, the demand for labor in the capital goods industry goes up, and eventually they begin to produce more capital goods.

411
00:47:59.640 --> 00:48:11.640
That's what happens in the capital goods industries. When we have more voluntary saving, we know then that there's going to be less consumer goods demanded.

412
00:48:11.640 --> 00:48:17.640
And that allows the workers to be transferred from the consumer goods industry to the capital goods industry.

413
00:48:17.640 --> 00:48:20.640
But here, that doesn't happen.

414
00:48:20.640 --> 00:48:27.640
What happens is that the workers are paid that new money and they begin spending it.

415
00:48:27.640 --> 00:48:31.640
They don't save it. The people who are paid that new money do not save it.

416
00:48:31.640 --> 00:48:35.640
Their time preferences haven't changed. They spend most of it on consumers' goods.

417
00:48:35.640 --> 00:48:41.640
But at the beginning, when the money is first issued, nothing happens in the consumer goods industry.

418
00:48:41.640 --> 00:48:48.640
The consumption-saving ratio stays the same. People don't cut back on their consumption and increase their saving.

419
00:48:48.640 --> 00:48:55.640
So when the workers get paid that additional money, what you see happening is that the demand for consumer goods goes up,

420
00:48:55.640 --> 00:49:01.640
the price of consumer goods go up, profits of consumer goods go up. That's only after all this has happened.

421
00:49:01.640 --> 00:49:09.640
And then they're losing, well initially actually, notice that I have a bar over these. Ignore the arrows.

422
00:49:09.640 --> 00:49:15.640
Initially nothing happens, okay? There's no change in demand, price or profits in consumer goods industries.

423
00:49:15.640 --> 00:49:21.640
In fact, they begin losing laborers. The laborers respond to the higher wage rates in the capital goods industry,

424
00:49:21.640 --> 00:49:26.640
where the money is being spent, and they leave the consumer goods industries.

425
00:49:26.640 --> 00:49:29.200
costs rise in the consumer goods industries.

426
00:49:29.200 --> 00:49:33.360
So we get a fall initially in consumers' goods,

427
00:49:33.360 --> 00:49:35.000
in the production of consumers' goods.

428
00:49:35.000 --> 00:49:40.080
But, as I mentioned before, once the workers get paid those increased wages, the new money,

429
00:49:40.080 --> 00:49:42.560
what happens is there's a reaction.

430
00:49:42.560 --> 00:49:46.880
And the reaction is that now, after all of these things have happened,

431
00:49:46.880 --> 00:49:50.480
you get an increase again in consumers' goods,

432
00:49:50.480 --> 00:49:53.320
because the extra money is now coming to the hands of consumers,

433
00:49:53.320 --> 00:49:59.240
an increase in prices, an increase in profits, and costs go up even further

434
00:49:59.240 --> 00:50:03.400
and what happens is that now the capital goods industries find that

435
00:50:03.400 --> 00:50:09.160
because of their rising costs, these new projects are not profitable.

436
00:50:09.160 --> 00:50:15.520
Not only that, but notice that if the government stops inflating,

437
00:50:15.520 --> 00:50:21.360
what's going to happen to the interest rate?

438
00:50:21.360 --> 00:50:29.240
Right. Unless they keep adding new money month after month after month to the banking system,

439
00:50:29.240 --> 00:50:40.640
through increasing reserves, what's going to happen is that this supply of savings is going to shift back to this point,

440
00:50:40.640 --> 00:50:46.920
which is the amount of voluntary savings. And the interest rate is going to jump up from 7.5% to 10%.

441
00:50:46.920 --> 00:50:51.600
At the same time, the costs are rising to the capital goods industry.

442
00:50:51.600 --> 00:50:55.080
So, what happens to their profit margins?

443
00:50:55.080 --> 00:51:02.120
They become squeezed or they turn into losses and you begin to have bankruptcies in the capital goods industries.

444
00:51:02.120 --> 00:51:07.400
And if you'll note, in the real world, when we have recessions in the U.S. or elsewhere,

445
00:51:07.400 --> 00:51:15.800
do you find retail stores like Walmarts and Sears and restaurant chains like McDonald's going out of business

446
00:51:15.800 --> 00:51:18.400
or cutting back substantially? Of course not.

447
00:51:18.400 --> 00:51:23.600
What firms or what industries suffer huge losses?

448
00:51:23.600 --> 00:51:28.600
Construction, steel, power generation.

449
00:51:28.600 --> 00:51:32.600
Why? Because they have been over-expanded.

450
00:51:32.600 --> 00:51:35.900
So the recession is the adjustment process.

451
00:51:35.900 --> 00:51:41.400
The recession, from the point of view of Austrians and causal realistic analysis,

452
00:51:41.400 --> 00:51:46.840
is simply the readjustment of production back to the consumer's true time preferences.

453
00:51:46.840 --> 00:51:52.200
The consumers do not want more capital goods, meaning they don't want to wait for the consumer goods into the future.

454
00:51:52.200 --> 00:51:56.720
They have not changed their preferences for consumer goods now and consumer goods in the future.

455
00:51:56.720 --> 00:51:59.120
They've stayed the same.

456
00:51:59.120 --> 00:52:06.640
Now, one objection to the Austrian theory is, well, it all sounds good, but how come then, in the real world,

457
00:52:06.640 --> 00:52:16.140
As soon as the Fed inflates, why don't we see a reaction a month or two later after the workers get paid this new money, begin spending it, and interest rates begin to rise?

458
00:52:16.140 --> 00:52:32.140
Why do we see a boom go on as it did in the 1990s from 1993 or so until 2000, when we had a recession, or from 1982 when we had a recession, until 1990 when we had a recession?

459
00:52:32.140 --> 00:52:37.420
Well, how could a boom go on for years, okay, without a recession, if what the Austrians say are true?

460
00:52:37.420 --> 00:52:39.420
Or officially lower interest rates?

461
00:52:39.420 --> 00:52:46.060
Exactly. In other words, what happens is that the Fed keeps injecting new money, because it sees the interest rates going up,

462
00:52:46.060 --> 00:52:53.580
and it knows that if interest rates go up, business is going to be bad, okay, and that's not good for the incumbent administration, especially near an election time.

463
00:52:53.580 --> 00:53:02.060
So what are they going to do? They're going to continue to increase the money supply, lower interest rates, and keep the boom going.

464
00:53:02.060 --> 00:53:05.060
And the longer the boom goes, the more capital that is wasted,

465
00:53:05.060 --> 00:53:11.060
the more resources that are misallocated to producing capital goods that are eventually not going to be useful,

466
00:53:11.060 --> 00:53:20.060
that are either abandoned or are partially abandoned or are reallocated to lower value uses.

467
00:53:20.060 --> 00:53:24.060
So that's one objection.

468
00:53:24.060 --> 00:53:29.060
And the response, of course, is that, well, the Fed can print money out of thin air and keep the boom going for a while.

469
00:53:29.060 --> 00:53:34.060
Second objection is, well, if they can keep it going for a while, why don't they just keep it going permanently?

470
00:53:34.060 --> 00:53:37.060
Why don't we simply, and this is what Cain said.

471
00:53:37.060 --> 00:53:45.060
Cain said the cure for an inflationary boom is war boom.

472
00:53:45.060 --> 00:53:47.060
Why can't we do that?

473
00:53:47.060 --> 00:53:51.060
Well, it's like taking a fentanyl instead of eating a balanced diet.

474
00:53:51.060 --> 00:53:57.060
So the implication being that eventually you crash, or it's like a heroin addict.

475
00:53:57.060 --> 00:54:02.660
He can keep his high going. If he tries to stop, it's going to be terrible withdrawal symptoms.

476
00:54:02.660 --> 00:54:06.660
But now, of course, the Austrians point out that if you continue to keep the boom going,

477
00:54:06.660 --> 00:54:11.460
eventually you get to Germany in 1923. You get hyperinflation.

478
00:54:11.460 --> 00:54:15.360
But even before that, you begin to get very, very unpopular rates of inflation,

479
00:54:15.360 --> 00:54:19.160
as we did in the late 1970s, early 1980s.

480
00:54:19.160 --> 00:54:25.360
And that's when Reagan, or when Reagan, was it still Carter at the time?

481
00:54:25.360 --> 00:54:29.360
It was Carter who appointed Volcker, I believe.

482
00:54:29.360 --> 00:54:33.360
And Volcker reduced the rate of growth in the money supply.

483
00:54:33.360 --> 00:54:37.360
He didn't cause deflation, but he reduced the rate of growth. It was called disinflation.

484
00:54:37.360 --> 00:54:42.360
And what happened was interest rates shot up, and the economy went into a recession in 1980,

485
00:54:42.360 --> 00:54:46.360
to about the middle of 1980, and that was an election year.

486
00:54:46.360 --> 00:54:52.360
And there have been studies showing that Americans have sort of a one-year memory about the economy.

487
00:54:52.360 --> 00:54:53.360
economy.

488
00:54:53.360 --> 00:54:57.920
So if the economy is in recession within one year before an election, this is true, it's

489
00:54:57.920 --> 00:55:01.920
a pretty sure bet that the incumbent president is going to lose a lot of votes as a result

490
00:55:01.920 --> 00:55:06.160
of that and is going to lose the election, which he caught and then lost the election.

491
00:55:06.160 --> 00:55:13.120
Same thing was true with Bush, in fact Bush is to this day, the older Bush, complains

492
00:55:13.120 --> 00:55:19.720
about Alan Greenspan having caused him to lose the election because Bush was elected

493
00:55:19.720 --> 00:55:25.120
in 88 and so that he was running for reelection in 92 and we were in a recession in 91 and

494
00:55:25.120 --> 00:55:30.360
a very slow recovery, okay, and that was one of the main reasons why he lost the election.

495
00:55:30.360 --> 00:55:36.000
Remember what, I don't remember if this was Reagan when he was running against Carter?

496
00:55:36.000 --> 00:55:43.000
No, it was Clinton. The Clinton campaign, their slogan was, it's the economy, stupid.

497
00:55:43.000 --> 00:55:47.760
So they just harped on the fact that we had this slow economy, okay, and Reagan asked

498
00:55:47.760 --> 00:55:52.880
That's a very, very compelling question.

499
00:55:52.880 --> 00:55:58.960
He said, are you better off today than you were when Carter took over as president?

500
00:55:58.960 --> 00:56:01.560
And again, it was directed at the economy.

501
00:56:01.560 --> 00:56:03.200
People weren't economically better off.

502
00:56:03.200 --> 00:56:05.200
The misery index had gone up.

503
00:56:05.200 --> 00:56:08.440
The inflation rate plus the unemployment rate had gone up.

504
00:56:08.440 --> 00:56:12.400
So those are a couple of the objections.

505
00:56:12.400 --> 00:56:18.000
Let me look at, there's one other one I want to bring up.

506
00:56:18.000 --> 00:56:24.500
The third objection is, alright, even if all of that is true, why should a reset, the Austrians,

507
00:56:24.500 --> 00:56:27.640
let me just mention, the Austrian policy during a recession is to leave everything alone,

508
00:56:27.640 --> 00:56:32.220
let everything adjust, allow prices of capital goods to fall, which is what must happen,

509
00:56:32.220 --> 00:56:36.700
and capital goods industries to, some capital goods firms to go out of business, and that

510
00:56:36.700 --> 00:56:48.700
And that will bring about a situation in which the, what happens here, the workers, there will be a lot of unemployment for a while,

511
00:56:48.700 --> 00:57:00.700
but eventually the workers who are thrown out of the capital goods industries, okay, because there's been over expansion, will go back and be reintegrated, it takes a while, and will be reintegrated into the consumer goods industries.

512
00:57:00.700 --> 00:57:05.700
And if you take one of the very deep recessions or even depressions that we had in the US,

513
00:57:05.700 --> 00:57:09.700
it was in 1920-21, it was the last recession before the Great Depression.

514
00:57:09.700 --> 00:57:15.700
And it was very deep. There was something like one-third deflation of the money supply,

515
00:57:15.700 --> 00:57:20.700
wholesale prices were cut in half. It was a very deep recession.

516
00:57:20.700 --> 00:57:27.700
However, by the time Congress got around to trying to pass some law

517
00:57:27.700 --> 00:57:35.700
to get the economy moving, some public works programs, it was already over, it was over in 16 months.

518
00:57:35.700 --> 00:57:38.700
Now the reason why it was over so quickly was because we had a flexible price system.

519
00:57:38.700 --> 00:57:46.700
We didn't have unions, we didn't have minimum wage laws, union powers were extremely, there were some unions, but they weren't very powerful.

520
00:57:46.700 --> 00:57:52.700
So wages fell to the level that was consistent with the fall in the money supply, because the money supply was deflated,

521
00:57:52.700 --> 00:57:58.700
and consistent with the fact that capital goods prices have to fall in relation to consumer goods prices.

522
00:57:58.700 --> 00:58:01.700
During the recession, all prices do not have to fall.

523
00:58:01.700 --> 00:58:04.700
Capital goods prices have to fall.

524
00:58:04.700 --> 00:58:07.700
And we were over the recession.

525
00:58:07.700 --> 00:58:17.700
Now, in the Great Depression, it took us from the deep depression of 1930 to World War II to get us out.

526
00:58:17.700 --> 00:58:22.700
Certainly, the New Deal did not get us out of the recession or the Great Depression.

527
00:58:22.700 --> 00:58:30.700
In fact, we had something like 12 million people unemployed at the outset of World War II,

528
00:58:30.700 --> 00:58:37.700
and about 11 million were sent overseas, and the other 1 million went to work in defense factories.

529
00:58:37.700 --> 00:58:40.700
So the Austrian response would be what?

530
00:58:40.700 --> 00:58:48.700
In the 1930s, unlike the 1920s, we didn't allow the recession adjustment process to run its course.

531
00:58:48.700 --> 00:59:00.700
Hoover almost immediately, as the recession deepened in 1930, had famous White House meetings with big businessmen, including Ford and so on,

532
00:59:00.700 --> 00:59:04.700
and convinced them to hold the wage rates high.

533
00:59:04.700 --> 00:59:19.700
And I think I mentioned this earlier, his theory was, and the theory of his advisors was, that if you kept wage rates high, or if you cut wage rates, there'll be less spending on consumption goods, and with less spending on consumption goods, there'll be less production, more unemployment.

534
00:59:19.700 --> 00:59:25.700
But in fact, what happened was that there was just simply more unemployment because the demand for labor was falling.

535
00:59:25.700 --> 00:59:29.700
And if the demand for labor falls, and if you want to keep people working, you have to allow wages to fall.

536
00:59:29.700 --> 00:59:53.700
And then when Roosevelt, the Roosevelt administration came in, they made this even more comprehensive, this sort of program, with the National Recovery Act, in which they set up what basically was cartels in different industries, which would then set prices and not allow them to fall.

537
00:59:53.700 --> 00:59:58.060
So in the middle of a situation which people were not getting enough food, were starving,

538
00:59:58.060 --> 01:00:02.460
we had goods piling up on shelves in stores or in granaries and so on.

539
01:00:02.460 --> 01:00:06.540
They couldn't be sold because their price was above the equilibrium price.

540
01:00:06.540 --> 01:00:12.420
And people, we had 25% unemployment by 1933, one-quarter of the labor force was unemployed,

541
01:00:12.420 --> 01:00:15.060
and yet wages were held up.

542
01:00:15.060 --> 01:00:19.580
In fact, real wages, believe it or not, for the first few years of the Great Depression,

543
01:00:19.580 --> 01:00:20.580
went up.

544
01:00:20.580 --> 01:00:34.380
In other words, prices did fall, but they fell more than wages fell, which meant that relatively costs had gone up, so that made the depression even worse.

545
01:00:34.380 --> 01:00:41.580
So the Austrian response was, well, the Great Depression wasn't really a result, it wasn't a garden variety recession.

546
01:00:41.580 --> 01:00:46.780
The government turned it into what von Mises once called a crisis of interventionism.

547
01:00:46.780 --> 01:00:51.580
it was all these price controls and cartels that were established by government

548
01:00:51.580 --> 01:00:55.460
that made the economy much less flexible

549
01:00:55.460 --> 01:00:59.300
and impeded the recession recovery process

550
01:00:59.300 --> 01:01:03.140
so for the Austrian it's the boom that is artificial

551
01:01:03.140 --> 01:01:07.220
stimulated by the pushing down

552
01:01:07.220 --> 01:01:10.740
of the interest rate by credit expansion

553
01:01:10.740 --> 01:01:14.460
and it's the boom that misallocates resources and puts people to work

554
01:01:14.460 --> 01:01:16.360
in the wrong areas.

555
01:01:16.360 --> 01:01:20.500
And later on those people must be reintegrated into the economy and that takes a few months.

556
01:01:20.500 --> 01:01:23.480
So if there was no interference by government

557
01:01:23.480 --> 01:01:26.140
beyond simply the increase in the money supply,

558
01:01:26.140 --> 01:01:32.360
you would have gotten a rapid recovery coming around in 1930-31.

559
01:01:32.360 --> 01:01:36.580
Something else happened and that was we got deflation in

560
01:01:36.580 --> 01:01:39.960
1931-33 as the banks began to collapse

561
01:01:39.960 --> 01:01:42.280
and people's checking accounts and savings accounts

562
01:01:42.280 --> 01:01:44.380
disappeared into thin air.

563
01:01:44.380 --> 01:01:52.080
If you saw the movie, It's a Wonderful Life, you've seen that famous movie with James Stewart,

564
01:01:52.080 --> 01:02:01.180
that takes place during the Depression and, you know, he's painted as the hero and the people who are trying to get their money out of the bank are painted as the bad guys,

565
01:02:01.180 --> 01:02:08.080
but in fact, you know, his bank was part of the system that inflated the money supply during that period.

566
01:02:08.080 --> 01:02:12.480
So I had no sympathy for him.

567
01:02:12.480 --> 01:02:15.840
So, that's another reason why you have to allow prices to fall, okay?

568
01:02:15.840 --> 01:02:19.760
If you have a fractional reserve banking system, and the banks begin to collapse,

569
01:02:19.760 --> 01:02:26.200
as, you know, one half of them collapsed during the Great Depression,

570
01:02:26.200 --> 01:02:28.640
there's going to be a fall in the money supply.

571
01:02:28.640 --> 01:02:32.640
So, it's going to make matters worse if you try to keep prices up above their equilibrium levels,

572
01:02:32.640 --> 01:02:37.360
as prices have to be allowed to fall, okay, to reflect the deflation.

573
01:02:37.360 --> 01:02:40.160
Also, people are going to hold more money,

574
01:02:40.160 --> 01:02:42.800
because they're much more uncertain about the future.

575
01:02:42.800 --> 01:02:44.960
So an increase in the demand for money,

576
01:02:44.960 --> 01:02:47.640
which means that people are avoiding spending

577
01:02:47.640 --> 01:02:50.320
as much as they had, is also going to drive prices down.

578
01:02:50.320 --> 01:02:53.040
But again, those prices were not permitted to adjust

579
01:02:53.040 --> 01:02:54.520
during the Great Depression.

580
01:02:57.200 --> 01:02:59.360
Now what should the government do?

581
01:02:59.360 --> 01:03:01.760
Should it follow Keynes's advice

582
01:03:01.760 --> 01:03:04.280
and increase the money supply,

583
01:03:04.280 --> 01:03:07.040
which was also Milton Friedman's advice?

584
01:03:07.040 --> 01:03:09.080
Well, the point is that if you try to do that

585
01:03:09.080 --> 01:03:39.080
During a recession, first of all it may not work, people's expectations may be such that they just expect that this recession is going to continue, they may just hold that money, but let's say you inject new money into the system and do push interest rates down and people respond to some extent, investors respond to some extent, they become more optimistic, what you're doing is simply recreating conditions for a future boom and recession. So in other words,

586
01:03:39.080 --> 01:03:43.680
All you're doing is postponing the final day of reckoning

587
01:03:43.680 --> 01:03:47.800
and setting up conditions for having another recession in the future.

588
01:03:47.800 --> 01:03:49.320
They make things worse.

589
01:03:49.320 --> 01:03:53.000
The other recommendation of Keynes was straight deficit spending.

590
01:03:53.000 --> 01:03:55.880
The government should increase its spending on public works

591
01:03:55.880 --> 01:03:58.600
and on many other things, public services.

592
01:03:58.600 --> 01:04:02.800
And in that way, we could inject spending directly into the economy.

593
01:04:02.800 --> 01:04:05.400
But as Austrians point out,

594
01:04:05.400 --> 01:04:09.480
What that does is to increase spending on consumers' goods, okay?

595
01:04:09.480 --> 01:04:12.280
And that makes things worse in the capital goods industries,

596
01:04:12.280 --> 01:04:14.680
because you drive up the price of consumers' goods,

597
01:04:14.680 --> 01:04:22.360
and you cause more and more redirection of workers away from the capital goods industries

598
01:04:22.360 --> 01:04:27.160
into consumer goods industries, and the capital goods industry shrink even more.

599
01:04:27.160 --> 01:04:31.800
So Hayek pointed out, okay, who was one of the great expounders,

600
01:04:31.800 --> 01:04:34.720
expositors of the Austrian theory of the business cycle,

601
01:04:34.720 --> 01:04:40.320
he pointed out that you saving actually helps during a recession if you the more you save

602
01:04:40.320 --> 01:04:45.520
the lower you'll keep the interest rate okay if you if you can

603
01:04:45.520 --> 01:04:49.320
this curve is pushed out by voluntary serving saving okay remember when it

604
01:04:49.320 --> 01:04:54.420
goes back after the Fed stops inflating it shifts back supply curve okay

605
01:04:54.420 --> 01:04:58.720
if people save more then there'll be more saving on the market and the interest rate

606
01:04:58.720 --> 01:05:02.020
rises high and the recession will not be as deep

607
01:05:02.020 --> 01:05:04.020
which is sort of paradoxical.

608
01:05:04.020 --> 01:05:08.860
And so many of the Keynesian economists laughed at Hayek

609
01:05:08.860 --> 01:05:12.020
by saying he wants to save his way out of the Depression

610
01:05:12.020 --> 01:05:15.180
when in fact that's what caused the Depression in the first place.

611
01:05:15.180 --> 01:05:18.460
Well, of course it wasn't voluntary saving that caused the Depression.

612
01:05:18.460 --> 01:05:20.420
It was the artificial manipulation

613
01:05:20.420 --> 01:05:23.260
or it was the manipulation by the Fed of the interest rate

614
01:05:23.260 --> 01:05:26.060
that caused the Depression.

615
01:05:26.060 --> 01:05:27.860
And if I might add one more thing,

616
01:05:27.860 --> 01:05:38.460
The 1990s were very like, and even today, even in the first decade of the 21st century, it was very like the 1920s.

617
01:05:38.460 --> 01:05:51.160
Okay, because in the 1920s, the reigning theory or view of American economists and British economists was that,

618
01:05:51.160 --> 01:05:57.760
you know what, if we can just keep the price level stable, if we can prevent consumer prices from rising,

619
01:05:57.760 --> 01:06:04.860
We won't have any more recessions or depressions because it's inflation that sows the seeds for the next recession.

620
01:06:04.860 --> 01:06:11.560
So if we can keep inflation from breaking out, then we will not have a depression.

621
01:06:11.560 --> 01:06:18.660
Now Irving Fisher was the most prominent American economist and he was a forerunner of Milton Friedman.

622
01:06:18.660 --> 01:06:20.460
He was sort of a proto-monitorist.

623
01:06:20.460 --> 01:06:28.940
So he advised the Fed to maintain an increase in the money supply such that you would keep prices stable.

624
01:06:28.940 --> 01:06:33.140
And in fact, that's what occurred from about 1921 to 1928.

625
01:06:33.140 --> 01:06:40.120
Prices, wholesale prices were pretty much stable, even they have gone down slightly.

626
01:06:40.120 --> 01:06:48.420
So Fischer said, this is a new era, he called it the new era, just like Greenspan called the 1990s the new economy.

627
01:06:48.420 --> 01:06:58.920
and he said, this is the era of perpetual prosperity, we now know how to control the economy in a way that we will have banished forever depressions.

628
01:06:58.920 --> 01:07:14.560
So that was, you know, he was saying all these things in the late 1920s, but what happened and what American economists were just focused on the consumer price index did not recognize was that we had a tremendous burst of productivity during the 1920s.

629
01:07:14.560 --> 01:07:20.120
Remember, it was called the Roaring Twenties, when mass-produced automobiles began to be sold,

630
01:07:20.120 --> 01:07:26.960
refrigeration came in, electric lights, electricity was spread throughout the country and so on.

631
01:07:26.960 --> 01:07:29.360
So we had tremendous productivity increases.

632
01:07:29.360 --> 01:07:35.480
So what happened was that the Fed had to increase the money supply at a very high rate just to keep prices from falling,

633
01:07:35.480 --> 01:07:40.320
because we know when we have increases in supplies of goods and services, prices will fall.

634
01:07:40.320 --> 01:07:46.080
And so the inflation was masked by the fact that prices didn't go up.

635
01:07:46.080 --> 01:07:53.200
And Murray Rothbard in his book, America's Great Depression, estimates that the money supply increased at about 7% per year.

636
01:07:53.200 --> 01:08:03.400
Now what did that do? Well, it didn't raise prices because prices would have fallen, prevented them from falling, but it did push down the interest rate artificially.

637
01:08:03.400 --> 01:08:33.400
And the Austrian economist at the time saw this in 1924-23, Hayek toured the United States, he was only something like 23 or 24 years old and he saw how productive the American economy was becoming and he saw what Fed policy was like and when he went back to his business cycle research institute that he was working at in Vienna, he wrote some things that said that the American economy is due for a great crash,

638
01:08:33.400 --> 01:08:38.400
What we did see in the later 20s, of course, was the asset bubbles.

639
01:08:38.400 --> 01:08:41.400
We saw a bubble in the stock market and in real estate.

640
01:08:41.400 --> 01:08:45.400
So inflation was manifesting itself that way.

641
01:08:45.400 --> 01:08:49.400
Mises also predicted the Great Depression.

642
01:08:49.400 --> 01:08:54.400
There are stories by his students that when they were walking home after a seminar,

643
01:08:54.400 --> 01:08:57.400
Fritz Machluck, who was a famous economist in his own right,

644
01:08:57.400 --> 01:09:01.400
and came to the United States later on, was walking with Mises.

645
01:09:01.400 --> 01:09:31.400
I was working with Mises and the main Austrian, the biggest Austrian commercial bank was the Credit Anstalt which was one of the first banks to fail in Europe during the Great Depression and Mises would always point to the bank as they walked by and he would say there's a great crash coming and that institution is going to be one of the first to go and he had actually been offered the presidency of that bank and turned it down. Now on the other hand, Mark Thornton has done some research on what American economists were saying.

646
01:09:31.400 --> 01:09:35.480
I mean, although in the 20s, you can look back at the writings of the Austrians

647
01:09:35.480 --> 01:09:38.200
and they were saying that there was going to be a recession.

648
01:09:38.200 --> 01:09:42.560
The most you can do when you have an inflation is postpone the recession, okay?

649
01:09:42.560 --> 01:09:44.840
You can never abolish the recession.

650
01:09:44.840 --> 01:09:50.960
But Irving Fisher, this is September 5th, who was really the father of monetarism,

651
01:09:50.960 --> 01:09:53.960
this is September 5th, 1929, he said,

652
01:09:53.960 --> 01:09:58.360
there may be a recession in stock prices, but not anything in the nature of a crash,

653
01:09:58.360 --> 01:10:02.360
Okay, this is a month before stocks lost 90% of their value.

654
01:10:02.360 --> 01:10:04.960
He says, dividend returns on stocks are moving higher.

655
01:10:04.960 --> 01:10:09.960
This is not due to receding prices for stocks and will not be hastened by any anticipated crash.

656
01:10:09.960 --> 01:10:12.760
The possibility of which I fail to see.

657
01:10:12.760 --> 01:10:15.260
Okay, so you didn't see any crash.

658
01:10:15.260 --> 01:10:21.660
Stock price had stopped rising that August, okay, and people were starting to get worried.

659
01:10:21.660 --> 01:10:25.960
Now, even after stocks started to fall in value,

660
01:10:25.960 --> 01:10:34.480
Fischer stated on October 16th, 1929, that stocks had reached a permanently high plateau.

661
01:10:34.480 --> 01:10:39.200
Okay, because they had stopped rising, but he claimed that on a permanent plateau, they're going to stay high.

662
01:10:39.200 --> 01:10:45.680
And that he expected, quote, to see the stock market a good deal higher than it is today within a few months.

663
01:10:45.680 --> 01:10:54.400
And that in any case, he did not, quote, feel that there will soon, if ever, be a 50 or 60 point break below present levels.

664
01:10:54.400 --> 01:11:00.000
However, on October 22nd, he was quoted as saying that he believed the breaks of the last few days,

665
01:11:00.000 --> 01:11:03.600
now that it had started to break in October, the stock market,

666
01:11:03.600 --> 01:11:07.800
the breaks in the last few days have driven stocks down to hard rock,

667
01:11:07.800 --> 01:11:12.000
meaning that 50-point drop, you know, it's not going to fall any more than that.

668
01:11:12.000 --> 01:11:15.900
I believe that we will have a ragged market for a few weeks, only a few weeks,

669
01:11:15.900 --> 01:11:21.000
and then the beginning of a mild bull market, bull movement will gain momentum next year.

670
01:11:21.000 --> 01:11:24.400
However, on October 24th, he was quoted as saying that,

671
01:11:24.400 --> 01:11:31.760
if it's true that 15 billion dollars in stock quotation losses have been suffered in the present break,

672
01:11:31.760 --> 01:11:35.320
I have no hesitation in saying values are too low.

673
01:11:35.320 --> 01:11:40.200
So now he's claiming the stocks had fallen too far, okay, and we still didn't have the great crash.

674
01:11:40.200 --> 01:11:48.240
And yet, once again, on the next day, the New York Times reported the worst stock crash with nearly 13 million shares swapping the market.

675
01:11:48.240 --> 01:11:59.240
Then less than a week later, on October 28th and 29th, the Dow Jones Industrial Average plummeted with a 70-point break and a two-day loss of almost 25 percent.

676
01:11:59.240 --> 01:12:08.340
The stock market lost one-third of its value during 1929, and on November 3rd, Fisher was quoted as saying that stock prices were absurdly low.

677
01:12:08.340 --> 01:12:13.040
He had better have been telling that to his wife because he lost her whole fortune in this.

678
01:12:13.040 --> 01:12:15.900
He did. He married a very rich woman.

679
01:12:15.900 --> 01:12:20.200
Economists tend to do that. Some famous economists have married very rich women.

680
01:12:20.200 --> 01:12:22.500
They're not economists for no reason.

681
01:12:22.500 --> 01:12:27.700
However, stocks had much further to fall and in two years following his predictions,

682
01:12:27.700 --> 01:12:30.900
the Dow Jones lost almost 90% of its peak value

683
01:12:30.900 --> 01:12:38.400
and the market value of the leading investment trusts lost 95% of their market value.

684
01:12:38.400 --> 01:12:43.000
So, so much for the age of perpetual prosperity.

685
01:12:43.000 --> 01:12:49.560
By the way, he wrote a book explaining what had happened in 1932, so he's looking back now.

686
01:12:49.560 --> 01:12:56.560
And he still couldn't get it through his head that his policy that he advocated in 1920s was the cause of all of this.

687
01:12:56.560 --> 01:13:01.600
He says, as this book goes to press, recovery seems to be in sight.

688
01:13:01.600 --> 01:13:04.640
OK, this is 1932. Of course, we didn't recover until World War II.

689
01:13:04.640 --> 01:13:11.240
In the course of about two months, stocks have nearly doubled in price and commodities have risen five and a half percent.

690
01:13:11.240 --> 01:13:17.320
So he was still claiming, maybe to appease his wife, that recovery was just around the corner.

691
01:13:17.320 --> 01:13:28.400
But the Austrians, Mises, Hayek and other Austrians, saw this as, properly was in fact, a readjustment.

692
01:13:28.400 --> 01:13:40.240
And Mises went on to say when he wrote something in 1932, his point was that unless you stopped trying to prevent prices from falling

693
01:13:40.240 --> 01:13:46.240
and stopped introducing cartels into the economy and propping up unions and so on.

694
01:13:46.240 --> 01:13:52.240
This was going to go on and it was not a normal recession. In fact, it was a crisis of interventionism.

695
01:13:52.240 --> 01:14:00.240
That is, of government intervention into the economy that made the economy inflexible and unable to readjust.

696
01:14:00.240 --> 01:14:04.240
I will stop there and take any questions you may have. Yes.

697
01:14:04.240 --> 01:14:12.740
It seems to me one of the basic problems with our measure of inflation in the price index is a very poor measure.

698
01:14:12.740 --> 01:14:18.240
How can we bring in – this happened in the 1920s and again in the 90s –

699
01:14:18.240 --> 01:14:25.240
how can we bring in what happens to real estate going up and stocks going up?

700
01:14:25.240 --> 01:14:33.240
How can we incorporate that to the CPI so we have a much better measure of inflation?

701
01:14:34.240 --> 01:14:38.720
I'm very suspicious of very large indexes that try to incorporate everything, okay?

702
01:14:38.720 --> 01:14:42.320
I think if you want to look at, you know, if there's inflation of prices, you know,

703
01:14:42.320 --> 01:14:46.720
you just look at things like bread and newspapers, things that don't change much in quality.

704
01:14:46.720 --> 01:14:51.120
But even better, I think you have to look at the money supply.

705
01:14:51.120 --> 01:14:52.920
And we're not doing that now, right?

706
01:14:52.920 --> 01:14:59.200
Since Greenspan claimed that we can't measure the money supply back in the late 80s, and

707
01:14:59.200 --> 01:15:02.600
even if we could, we can't control it, meaning we the Fed.

708
01:15:02.600 --> 01:15:05.600
And why the heck is he the Fed Chairman if he's saying these types of things?

709
01:15:05.600 --> 01:15:08.600
And they cancel the use of M3.

710
01:15:08.600 --> 01:15:11.600
Yeah, absolutely. The broadest measure of the money supply was...

711
01:15:11.600 --> 01:15:14.600
Because it's too closely correlated.

712
01:15:14.600 --> 01:15:25.600
Yeah, they stopped announcing what M3 was. However, the St. Louis Fed, you can find that information on their website, St. Louis Federal Reserve Bank.

713
01:15:25.600 --> 01:15:37.600
But once again, the key point here is that whenever you increase the money supply and regardless of what happens to consumer prices,

714
01:15:37.600 --> 01:15:44.600
you are causing distortions in the interest rate and that sooner or later those distortions are going to cause entrepreneurs to make errors.

715
01:15:44.600 --> 01:15:53.600
Entrepreneurs that previously were doing very well and all of a sudden, why would all these entrepreneurs engage in a cluster of errors

716
01:15:53.600 --> 01:15:59.600
In which many, many firms go bankrupt and have to cut back and fire and lay off workers and so on.

717
01:15:59.600 --> 01:16:04.600
What's the explanation? Did all the entrepreneurs become stupid at once?

718
01:16:04.600 --> 01:16:13.600
No, they were misled. Their monetary calculations, their calculations of profits and losses were misled by the inflation of the money supply.

719
01:16:13.600 --> 01:16:35.600
If governmental manipulation of the interest rates explains booms and busts, how do you explain the horrific booms and busts in the history of the United States before the founding of the Federal Reserve in 1913?

720
01:16:43.600 --> 01:16:48.600
The data wasn't as good back then, and they look worse than they really were. But there were.

721
01:16:48.600 --> 01:16:52.600
The key there is that there still was fractional reserve banking.

722
01:16:52.600 --> 01:16:57.600
And that these banks did expand and did increase the money supply.

723
01:16:57.600 --> 01:17:02.600
But they tended to be shorter.

724
01:17:02.600 --> 01:17:08.600
And the recession would be shorter because no one propped up the banks.

725
01:17:08.600 --> 01:17:11.600
The banks kept the money supply growing.

726
01:17:11.600 --> 01:17:34.600
The deflation was more serious, yes. Very sharp, very, very sharp. In the 1830s, we had one that was extremely sharp, but what happened was that it was quickly over, it was during Jackson's presidency, and it was interesting, even during that period, consumption was still growing.

727
01:17:34.600 --> 01:18:03.600
Two-part question. First of all, does the national debt include money that's owed to the Federal Reserve for the bonds that they hold? And if so, what would happen if the Federal Government repudiated just a portion of the national debt owed to the Federal Reserve?

728
01:18:04.600 --> 01:18:12.100
Does the national debt include the portion of bonds that have been sold to the Federal Reserve?

729
01:18:12.100 --> 01:18:19.600
Well, first of all, the Treasury is not allowed to sell bonds by law directly to the Federal Reserve.

730
01:18:19.600 --> 01:18:25.600
So the Federal Reserve does not buy bonds from the government directly. It buys it from you and I.

731
01:18:25.600 --> 01:18:30.100
So yes, when those bonds are issued, it's certainly counted as part of the national debt.

732
01:18:30.100 --> 01:18:41.100
But, to answer the second part of your question, what happens is that when the Fed receives the interest on the national debt from the Treasury, it rebates most of that interest back to the Treasury.

733
01:18:41.100 --> 01:18:53.100
It's just an accounting fiction. It keeps some of it, it keeps a part of it, but most of it is rebated. So the interest is never paid to the Fed, for the most part.

734
01:18:53.100 --> 01:19:00.100
It's rebated back to the Treasury. I don't know the exact details. I suspect it's simply just an accounting operation.

735
01:19:00.100 --> 01:19:06.100
So for all practical purposes that debt doesn't really exist because there's no interest on it?

736
01:19:06.100 --> 01:19:18.100
In the sense that it's really owned by another branch of the government despite the fact that the Fed claims that it's independent of the Federal Government. It really is not, yes.

737
01:19:18.100 --> 01:19:27.100
So the federal government would repudiate that portion of debt with really no adverse consequences?

738
01:19:48.100 --> 01:19:53.020
so they keep a portion of it and then they rebate the rest of it back so yeah

739
01:19:53.020 --> 01:19:58.980
there wouldn't be any adverse consequences as a result of quote

740
01:19:58.980 --> 01:20:03.980
without repudiating the debt, to the Fed, not, okay, yes.

741
01:20:08.740 --> 01:20:11.340
Do you see any similarities today,

742
01:20:11.340 --> 01:20:13.760
due back to the late 20s,

743
01:20:13.760 --> 01:20:17.460
with, I mean, China's turning money like crazy,

744
01:20:17.460 --> 01:20:20.780
the US is turning money like crazy.

745
01:20:20.780 --> 01:20:24.140
It just seems like the inflation is being masked

746
01:20:24.140 --> 01:20:26.140
a little bit because of,

747
01:20:26.140 --> 01:20:56.140
Right, so the question is, are there parallels between today and the 1920s, because there is inflation of the money supplier, expansion of the money supply in China and other parts of the world, also there's great productivity growth in China and India and so on, so that we're getting increased supplies of goods that are masking the effects of the monetary expansion,

748
01:20:56.140 --> 01:20:59.240
And, yeah, I would completely agree with that, okay?

749
01:20:59.240 --> 01:21:04.540
During a period of rapid productivity, inflation tends to be masked.

750
01:21:04.540 --> 01:21:08.340
That happened in the 1920s, it happened in the 1990s, and it is happening now.

751
01:21:08.340 --> 01:21:10.440
You're absolutely right.

752
01:21:10.440 --> 01:21:12.940
Someone else with their hand up?

753
01:21:12.940 --> 01:21:13.440
Yes?

754
01:21:13.440 --> 01:21:14.540
I was going to ask you a similar question.

755
01:21:14.540 --> 01:21:18.640
What point along the business cycle would you say we are today?

756
01:21:18.640 --> 01:21:23.340
What point in the business cycle are we today?

757
01:21:23.340 --> 01:21:28.040
Well, it seems like we're at the end of the long asset boom

758
01:21:28.040 --> 01:21:35.240
because the air has been being taken out of the real estate market.

759
01:21:35.240 --> 01:21:42.040
Now, whether or not the Fed is going to allow that adjustment process to complete itself is another question.

760
01:21:42.040 --> 01:21:45.940
So you really can't tell until you know what the Fed is going to do.

761
01:21:45.940 --> 01:21:49.440
They don't seem inclined to lower interest rates by printing more money,

762
01:21:49.440 --> 01:21:51.840
though interest rates are not a good gauge,

763
01:21:51.840 --> 01:21:54.840
they're not a very accurate gauge of the rate of monetary growth.

764
01:21:54.840 --> 01:22:00.440
You have to actually look at how fast the money supply is growing.

765
01:22:00.440 --> 01:22:06.340
But initially they seemed like they were going to lower the interest rate,

766
01:22:06.340 --> 01:22:08.240
that was the expectation earlier in the year,

767
01:22:08.240 --> 01:22:12.940
but now it seems like the markets believe they're going to hold firm.

768
01:22:12.940 --> 01:22:16.440
Now you have to look more closely at the money supply figures

769
01:22:16.440 --> 01:22:19.640
to see what's actually occurring there.

770
01:22:19.640 --> 01:22:24.140
But, again, it really all does depend on the Fed's reaction.

771
01:22:24.140 --> 01:22:29.040
And they're more likely to react if the market starts to deflate,

772
01:22:29.040 --> 01:22:34.740
the real estate market starts to deflate rapidly than if it deflates slowly.

773
01:22:34.740 --> 01:22:39.640
And some evidence that they're concerned, though, is that a few days ago,

774
01:22:39.640 --> 01:22:45.140
I heard on the National Public Radio that Bernanke and the Fed were meeting

775
01:22:45.140 --> 01:22:52.140
to talk about the problems that are beginning to arise as a result of the bursting of the real estate bubble,

776
01:22:52.140 --> 01:22:57.640
especially in the subprime market, and how they are going to react with regulations,

777
01:22:57.640 --> 01:23:02.140
or they will discuss what regulations should be put in place.

778
01:23:02.140 --> 01:23:05.140
So they are concerned about it.

779
01:23:05.140 --> 01:23:07.140
Okay, thank you.