Well, this is the second time. Thank you all very much, by the way. It is, well, you guys must seriously need some extra credit. That's all I've got.
All the same, though, it is a really unique type of individual who hears, hey, there's a lecture on campus. I think I'll go. You know, that's a really self-selected group, and I'm very glad that you're all able to be here.
This is my second time at Penn State. The first time was in 1989. See, I can say this now. I'm long out of high school, so all the things I did that made me a dork in high school, it's long forgotten. You know, it's all over.
I was the captain of the math team. People are laughing at that. Can you believe they're laughing at me up here? I was the captain of the math team. I was Mr. Math and everything.
and Penn State hosted the Eastern Massachusetts, well I was on the Eastern Massachusetts all-star math team.
So I made the all-star team. And Penn State sponsored the whole national thing.
I did that for two years, like 89 and 90, so here I am again.
So my dorkiness has just taken a slightly different tack now, that's all.
Basically the same dorky guy, but slightly different emphasis basically.
So what I'm going to do today is, just as the topic indicates, I'm going to try to look at what the heck is going on in the economy,
but try to argue to you that it is not merely special pleading to say that this is not an example of the free market having failed.
If I hear that one more time, I'm going to commit an atrocity.
So tonight we're going to try to relieve ourselves of this misapprehension and try to get a hold of what the reality is.
Now, I'm not going to assume any prior knowledge, yet here and there I might assume a little bit, and if that's the case, ask me about it in the question session.
I have a book coming out on Monday, this will be my number nine for me, it's called Meltdown, and the subtitle, and I have nothing to do with the subtitle, it's like 900 words long, nothing to do with me.
But, it's called a free market look at why the stock market collapsed, the economy tanked, and government bailouts will make things worse
with a foreword by Ron Paul, which will sell more copies of the book than the book itself.
So, the market has failed is the assessment we hear from all quarters. It's everywhere.
Even people who ordinarily defend the free market find themselves so much on the defensive that they're willing to make concessions that,
In my judgment, they shouldn't be making.
And the situation we face...
If only this would go in. It just won't.
The situation we face is...
There are some people, I think, who are, I don't know, on the right, let's say, politically,
who are trying to downplay the seriousness of the situation.
Although now that Obama is the president, now they'll say,
Oh, it's terrible, terrible, terrible.
Whereas six weeks ago, it was still kind of okay, and just the liberals are exaggerating it.
The current economic downturn that we are experiencing is well on its way to becoming the longest one in the period following World War II.
Also, in December, we unexpectedly, or at least it wasn't unexpected to some economists, but to many people, we unexpectedly saw the reduction of employment be even greater than anticipated.
So unemployment rose to 7.2% in December, which is the highest in 16 years.
Now it's worth noting that during the 1980s and 1990s, Republicans and Democrats alike began to massage the unemployment figures and the way they're calculated, so as to make them look better than they really are.
Shocking, I know, right? They want to obscure the reality of the situation.
If you accurately calculate the current unemployment rate the way they calculated it in the 1970s, so that you can compare episodes, what you actually find is that the unemployment rate is between 16 and 17 percent.
Now, if you're interested in that, by the way, I recommend a website. Unfortunately, it's subscription only. Boo-hiss.
but there is a website called shadowstats.com and the proprietor of this site gathers a variety of data including I believe the CPI which measures price inflation but also the employment figures he measures them the way they used to so that you can find out what's really going on so we have this fact we have the fact of mortgage foreclosures increasing dramatically we've got about two and a half million foreclosures that we've just found out about the average work week we know
In fact, we found out that just last month, the part-time numbers, the numbers of people working in part-time jobs rose by 10% in a month, by 700,000 people, which is the highest jump I've ever seen.
I don't know how long that is, but so that indicates that even these rosy employment figures that we're hearing, I mean they're not rosy, but relatively speaking they're rosier than they would be, if we could somehow factor in how many people are involuntarily employed in part-time work.
And if we look at statistics regarding retail sales, industrial production, income, it's pretty wretched.
Now, of course, the housing situation is more wretched still.
And it's particularly wretched in certain parts of the country.
Some parts are faring better than others.
I live in Auburn, Alabama.
We're sort of doing okay.
Las Vegas is not doing okay.
San Francisco is having some trouble.
And as well it should.
It doesn't make sense that a 2x2 cubicle should cost you $900,000.
There was something wrong with that, and it's odd to me, although not altogether surprising,
that the same federal government that claims to support affordable housing, right?
What we need is affordable housing in this country, and then when housing prices start to come down,
they act as if this is the greatest catastrophe in world history.
But here it is, right? The market is trying to lower the price. You can't satisfy these people.
They're too high, they're too low, they're never just right for the government.
Now, the housing situation, of course, has been going on for, I don't know, at least arguably 10 years.
It's not just since 9-11, whereby we've seen housing prices appreciating very dramatically, year in and year out.
And in fact, in the recession of 2000-2001, a relatively mild recession,
That was the only recession on record in which new housing starts did not decline.
So housing has been extremely robust even during a recession
that we had following the dot-com collapse of all those dot-com companies.
So housing has been wonderful, it seems.
It seemed to people that they could retire on the basis of their home equity they'd built up.
They could take out loans, they could borrow against the equity of their homes,
They could borrow it, go out and use it to finance plasma TVs and giant cars and whatever else.
You know, a yacht, or if they get bored with their yacht, they could get a plane.
Or a yacht where they could land a plane, like whatever.
But the point is that it just seems like this is a cash cow.
It's like, you know, physicists tell you there's no perpetual motion machine.
But this seems like this is just a perpetual money machine.
And we began to hear, right around that time, during that recession, when housing seemed to be the one robust sector, that you see, it just goes to show, housing prices never come down.
This was the conventional, they always go up. Housing prices always go up. It's the best investment you can make, buying a house.
In fact, you can buy houses and flip them. You can put in new carpeting, a couple new lights, repaint it, make 50 grand in three weeks.
This is a great way to make money. This is what people were told, what everybody believed, and don't worry.
There can never be a nationwide housing contraction.
The housing market cannot decline nationwide, because real estate, everybody knows, is regional.
Sure, this city may experience a decline, that city, but never the whole country.
That was the conventional wisdom.
and it was on the basis of that that we got this crazy mania in housing and in fact the Federal Reserve Chairman at that time, Alan Greenspan, is on record as having said it's impossible for there to be a national housing collapse, this just can't happen, real estate is a regional thing, so this is just a one for this, it's not a bubble, in other words these prices are not artificially high, these are sustainable housing prices, Greenspan said, in fact Greenspan told
The best thing they could do was take out an adjustable rate mortgage.
A mortgage that has a super, super low rate in the beginning, and then a few years down the line it could jump up.
Well, that's what's happening to people now. They're finding that these rates are jumping up.
And I'm not saying, by the way, that adjustable rate mortgages are in themselves bad.
They're a way for lenders and borrowers to share risks.
If they don't know what the future is going to hold, maybe interest rates will plummet.
Maybe they'll rise. This way both lender and borrower can share the risk of that.
Well, in this case we've seen what the risk was. The risk is that, in fact, credit is going to get tighter
and people are going to find their mortgage payments doubling, tripling in some cases.
And yet the geniuses, the people we're supposed to look to, to lead us out of this, all fell for the housing bubble.
They all said this is a, if not quite permanent, in the rate of increase.
Nevertheless, it's going to continually increase at one rate or another, and that this is a wonderful thing, there's nothing to worry about, the fundamentals of the economy are sound, as they all say in Washington.
Alan Greenspan told us this, Ben Bernanke said that everything would be just fine by the end of 2008, housing would be robust again.
Meanwhile, again, now we've got the fewest new housing starts we've had in years and years and years,
And yet these are the people we're looking to, to tell us how to get out of this.
Hank Paulson, the former Treasury Secretary, told everybody that our financial institutions are in excellent shape, the best shape I've seen them in my career.
He said that in 2007.
Ben Bernanke, he said, don't worry about the mortgage market, that maybe there are too many risky mortgages.
My regulators already investigated the mortgage market, and it's better than ever, he said.
The regulators looked at it and said it was great, because the experts we're supposed to trust all believed in the myths of the housing bubble.
This thing's not going away. These inflated prices are not bubble prices, they are sustainable.
And it's on that basis that we got all these rosy predictions. And that's totally wrong.
And it's on this basis, by the way, that a lot of unsound investments in housing were made.
People were just listening to the experts and the experts regulators.
So, now, I've been a little harsh on these people, but it seems to me rather deserved,
because these are the same people that when you tune in on TV, there they are smiling at you,
and they're going to tell us what we should do to get out of this.
One of my favorite investment advisors is a guy named Jim Rogers.
I love the United States of America and I'm not going anywhere, but in 2007, at exactly the right time,
Jim Rogers sold his home just before the bubble burst and moved to Singapore.
There, people actually care about prosperity, and maybe my kids can grow up in some kind of prosperity.
But Jim Rogers was on a financial show on CNBC not long ago and somebody was asking him,
And Jim Rogers said, listen, if you had me on your show, and week after week after week, I was totally wrong, everything I said was wrong, would you keep inviting me on your show?
Then why do we keep listening to these people? Why do we care what Ben Bernanke says, that he's the chairman of the Federal Reserve system now, in case you don't know?
I mean, why should we care? Good question.
So what I'm going to outline for you is what would be considered an unorthodox way of looking at things.
But given the fact that all the orthodox models in economics utterly failed to see this collapse coming,
given that those have failed, it's time to look at other alternatives.
And what I'm going to lay out to you tonight is a thesis that won the Nobel Prize for the economist F.A. Hayek in 1974.
An economist named James Galbraith said that of the roughly 15,000 professional economists
in the country, he estimated that maybe 10 or 12 saw this collapse coming.
So maybe ten or twelve of the people James Galbraith hangs around with saw it coming.
But in fact hundreds of economists who follow the views of Professor Hayek have warned about
this for years and yet, under the Bush administration and under the Obama administration, have any
of these people been called to the White House, oh you saw this coming, maybe you can help
get us out of it?
No.
The more you are blindsided by it, the more of a blockhead you are, the more we want to
There is one more thing I should introduce in case people don't know about it, because
you might wonder, how could this big downturn that we see in housing, why would it have
such far-reaching effects in sectors of the economy that have nothing to do with housing?
Why is it having such a big ripple effect?
Part of the answer to that question is that when housing declines it's not just construction
companies that suffer.
Think about all the things that go into a new house when you buy it and all the raw
materials and the production processes that go into creating those things that are necessary.
Now all those things are going to suffer.
And then on top of this we have the fact that institutions have been buying securitized
Mortgages
Mortgage-backed securities
Securitization
A mortgage
A car debt
Any type of debt, bundling a bunch of them, let's say the first three rows of people here, take all your credit card debt, bundle them all together in a single financial product, and we slice and dice it, and we sell little bits of it to investors.
And when you pay your credit card payment every month, or your mortgage payment, or whatever kind of securitized debt it is, the investor who buys that, he's the one who actually gets this flow of payments coming from you and all the other people who are bound up
in the securitized loan he has bought.
Now overwhelmingly, the greatest degree of securitization occurred in housing,
where the local bank or even some mortgage company will issue a mortgage to a family,
but then instead of holding that mortgage and collecting the mortgage payments from that family,
they would sell that to some investor or some institution,
and that investor or institution would actually get the proceeds.
So if it turns out that housing begins to decline and there are foreclosures,
people can't make their mortgage payments,
these mortgage-backed securities now are not worth as much as they were before
because the stream of mortgage payments is going to be lower than expected.
It's going to be interrupted in some cases by foreclosures.
And so a lot of investors who have gone into this type of investment
The first time I've ever spoken on this subject in public. It was not quite true. I've spoken on the business cycle theory that I'm about to get to, but I just want to make sure I don't miss anything. I like to do everything by heart, but if I miss something, I'm telling you, I wouldn't sleep tonight, kicking myself, but I deprive you guys of the opportunity to talk about it.
I don't want to make sure I don't miss anything. I like to do everything by heart, but if I miss something, I'm telling you, I wouldn't sleep tonight, kicking myself that I deprived you guys of it.
So let's look at this housing bubble, the contributing factors to it, and the last contributing factor will require us to explain what Hayek said.
And I'm telling you, once you hear what Hayek says, this great economist who died, and he wrote his last book when he was like 92, or even over, no, I think he was 88 when he wrote his last book, and then he died in 1992.
When you hear this, I'm telling you, you will understand the world better than 99% of your friends.
And that's just what your friends love, by the way, when you know more than they do.
That's just the way to become popular, by the way.
So, one contributing factor, and I'm going to start with every other factor I'm going to give you,
is relatively minor in my view, until we get to the last one.
One contributing factor to why there was this artificial stimulus to home construction
that is now coming back to bite us, you know, wherever, is something, is our Fannie Mae and Freddie Mac.
Now, if there's anybody in the room who keeps hearing these, and you don't know what the frickin' heck this is,
what, who, who are these people? Well, they're actually, these are actually nicknames for institutions that are supposed to help people get, you know, affordable mortgages.
and Fannie and Freddie were both basically, Fannie was started in the 1930s as a government institution
and then later sort of became a private company but sort of not, nobody really quite knew what Fannie Mae was
is it a government agency, is it a private agency, it was called a government supported enterprise
so some kind of weird middle of the road thing no one's quite sure
Freddie Mac likewise, that was started much later and again that was started as an apparently private company
in a private company.
But what makes these institutions unusual
in terms of so-called private companies
is that they got special tax and regulatory advantages
that other mortgage guarantors did not get.
And in addition to many other advantages,
everybody knew that the US taxpayer would bail them out
if they ever went belly up,
if they made so many risky mortgages
and that people just couldn't make those payments anymore
and Fannie and Freddie were just suddenly going under.
Everybody knew the government would bail them out.
And so therefore, Fannie and Freddie
were able to attract more of the mortgage markets themselves.
They were able to make riskier loans than a surely
private organization would, because they
knew that you and me would wind up paying for them
if they went sour.
If they paid off, well, they, of course,
get to keep all the profits.
They're not going to come to us and say,
thanks to all the government advantages we got,
we've earned a lot of profits, and we'd
like to share them with you.
The rules are they keep the profits. They spread the losses all around.
Now if you were in that situation, you would probably make risky mortgages too.
Why not? There's no reason not to. So that is a factor.
Secondly, there is this piece of legislation called the Community Reinvestment Act.
And that's passed in the late 1970s.
But then given real regulatory enforcement teeth in the 1990s under Bill Clinton.
And I do believe this plays a role, but not nearly the role that we often hear in conservative circles.
And you know, I'm more or less, you know, I kind of sympathize with conservatives.
I'm more of a libertarian myself, but I think a lot of them are just saying it's this one thing or it's this plus family.
The depth of what we're facing here is far more, is far too substantial for it to be explained by something so small.
But basically, the Community Reinvestment Act required banks to make loans in the neighborhoods in which they were resident and not simply extend loans, you know, like in the suburban areas and neglect the sort of the beginner city area.
So they had to extend additional loans, and the understanding sort of was that if you're not extending loans to people of various racial groups in proportion to their percentage of the population,
then the presumption is that you're guilty of discrimination. You're not offering enough loans to members of each particular group.
So, therefore, what banks wound up doing was making loans that they might not otherwise have made
because they didn't want to get sued and be ruined, basically. They didn't want $500 billion loss.
Now, what I have here is a quotation. I think I'm just going to set up shop. Let's just move over.
Okay. I have a quotation here from Andrew Klohner, who was the second of the Secretaries of Housing and Urban Development under Bill Clinton.
This is what he said, and I hasten to point out, the Community Reinvestment Act is not the only federal law or regulation that required banks, in effect, to engage in affirmative action and lending.
It's not just the Community Reinvestment Act.
Fannie and Freddie were starting to require it.
The Federal Reserve System was pushing it.
The Federal Housing Administration was pushing it.
It was everywhere.
Andrew Cuomo, Secretary of Housing and Urban Development said after the AcuBank group was sued for discrimination and they were required as a penalty to make $2.1 billion in loans to so-called underserved communities.
And here's what Andrew Cuomo said.
The bank will take a greater risk on these mortgages, yes.
Give families mortgages who they would not have given otherwise, yes.
They would not have qualified but for this affirmative action on the part of the bank, yes.
Lending that $2.1 billion in mortgages will be a higher risk.
And I'm sure there will be a higher default rate on those mortgages than on the rest of the portfolio.
Well, as long as he's comfortable with that, I guess that's all that matters.
Another factor is something we might call the green-span put, which employs a stock market term.
The green-span put was this idea that people had, that as long as Alan Greenspan is the Fed Chairman,
Chairman, no matter how much we screw up on Wall Street, he'll rescue us somehow. Alan
Greenspan will come right into the rescue. So therefore, what is the incentive again?
To make riskier investments than you would otherwise have made. To buy mortgage packages
that might be kind of risky. Man, the returns are so high. And if this thing should ever
go bust, well, you know, old Alan's in our corner. He'll come save us. So what we have
I have here, I have just a quotation from the Financial Times newspaper, who described this idea of the Greenspan hook, which is not something the Greenspan himself would ever admit to.
He said, oh no, no, no, that's not me at all. But every financial guy knew the Greenspan was sort of unofficially known as Mr. Bailout.
He'll always be there to line your pockets if you're a rich investor and you're a big, big, big time institution and you get in trouble.
So the Financial Times said, when markets unravel, you can count on the Federal Reserve and its chairman Alan Greenspan eventually to come to the rescue.
And as a result, the Financial Times says, there is a destructive tendency toward excessively risky investment, supported by hopes that the Fed will help if things go bad.
Likewise, the economist Anthony Mueller says this, he said,
Since Alan Greenspan took office, 1987, financial markets have operated under a quasi-official charter,
which says that the central bank will protect its major actors from the risk of bankruptcy.
Consequently, the reasoning emerged that when you succeed, you will earn high profits and market share,
and if you should fail, the authorities will save you anyway.
When monetary authorities repeatedly act to ward off economic downturns
and continue to feed the markets with fresh liquidity,
the belief in an eternal boom becomes more widespread with time,
and economic activity becomes more intensive,
and most importantly, prudence diminishes
and new types of entrepreneurs appear.
Not the old types who were very careful about weighing risk,
but the new types who take great risks
with the knowledge that they can keep the proceeds
and probably socialize the losses.
Now, all these things are factors of one type or another.
But the most significant factor involves an institution that most Americans don't know the first thing about.
And my secret opinion is that's just the way they like it.
Not the American people, but the institution.
The Federal Reserve System.
You ask people, what is the Federal Reserve System?
I mean, you may as well be speaking Chinese.
I mean, no one has any idea what in the world you are talking about.
They know that the dollar bill says Federal Reserve Note.
That's about it. Otherwise, I don't know what this thing is, and when you try to follow it in the news and what the Fed is cutting rates, and they're doing this, and they're cutting this by 50 basis points, you're saying, what the heck?
How do you expect me to understand any of this? But we do need to understand this, and this is why part of the reason I'm writing my book is to explain this so that the average person can get it.
The average American has got to understand this system, got to understand the Federal Reserve System.
For here, all I'm going to give is an extremely streamlined view.
Just a couple of things about the Federal Reserve System, just in the interest of time.
But the Federal Reserve System is basically responsible for money in the United States, for the supply of money.
They can increase the supply of money, and they can contract the supply of money.
They are also in a position to act as a lender of last resort.
So if some institution should find itself in financial straits, the Fed has the ability to enter the market and just flood them with money.
When it does that, where does this money come from?
Well, typically the Federal Reserve just creates the money out of nothing.
It just ejects it into the economy.
That'd be a nice racket to have, right?
And in fact, the economic consequences of what it does are very similar to what happens when a counterfeiter just starts injecting phone money into his local neighborhood economy.
But that's another matter I'm not going to get into the Fed as a counterfeiter.
But the point is, we've come in to call the Federal Reserve System the Fed, for short.
And the Fed, when it increases the supply of money, when it just increases that supply, which it does through the banking system, through various means, it lowers interest rates.
Because if banks now have fresh reserves they can lend, if they're going to be able to lend out these additional reserves in order to attract additional borrowers, they're going to have to lower the interest rate to attract them.
Because banks are typically full up with loans at any given time, so if you give them more to lend, if they're going to be able to attract more people to borrow, the interest rate has to come down.
They have a greater supply of things to lend, so in effect the price of lending goes down.
So they can lower or increase interest rates, and that's the key thing, because in the wake of the dot-com boom and bust, and then 9-11, Alan Greenspan decided to just flood the economy with money.
And he was going to target an important interest rate called the Federal Funds Rate at 1%, which is an astonishingly low rate, where he held it for a year, from 2003 to 2004, and this is in the heart of the housing bubble.
This particular interest rate reverberates throughout the whole structure of interest rates, and it distorts people's decision-making process.
In effect, it was the engine that pushed forth the housing model.
It was only this continuous injection of new money and the continual pushing down of interest rates
That made it seem like a good idea for people to buy $700,000 houses and have their fancy cars and buy plasma TVs and go on big vacations and have $1,000 in the bank, which is what a lot of people did.
This was the enabler. People who become addicted to spending, the Federal Reserve System is the enabler of this addiction.
So this is the point at which I want to introduce to you what this great economist, unsung, unfortunately, although he did win the Nobel Prize, which was amazing to me,
F.A. Hayek, H-A-Y-E-K, what he had said, because today I hear, I've actually heard people say,
well, you know, free market economists like F.A. Hayek have been proven wrong by what happened with the economy.
Proven wrong? Have you read three sentences of what Hayek wrote? He anticipated exactly what just happened.
What Hayek said is basically this, it's a very streamlined version.
But let's suppose you have a Federal Reserve System, or a central bank as it's called,
and it forces interest rates down.
If you are a potential borrower, you are more likely to borrow when the interest rate is lower.
I mean, just common sense.
Well, think of it this way, imagine you're a businessman, you're an investor.
Let's say you want to build a new physical plant, or you need to buy some new machinery,
but you have to borrow the money because it's just too expensive.
Or you want to expand your mining capacity, and you need to borrow for that purpose.
The interest rate is 10%, you might just say, I'll forget it.
I would never make a profit if I had to keep paying 10% interest.
But suppose the interest rate comes down to like 3 or 2%.
Well then you might do the calculations and say, this is a good investment.
This investment will be profitable for me.
So what the Fed does when it artificially pushes interest rates down
is it makes people think that stupid investments are good ones.
In effect, I don't want to say it makes the economy drunk, but it makes the interest rate drunk.
And in turn, it makes investors kind of drunk.
Well, well, well, maybe I will borrow $15 million to build my Cold Stone Creamery opening store.
Because I'm sure forever people are always going to want a $7 ice cream cone.
I can't see any of this business model.
So, the artificially low interest rates get the economy going on an unsustainable investment boom.
Because where does the investment typically go?
Well, the longer term your investment project is, suppose you have an investment project
that it's going to take you 10 years before this thing turns a profit.
It's going to take 10 years before this thing starts producing consumer goods.
Well, that is much more interest rate sensitive than a project that's going to take you one week.
Because when you have to pay back a loan over ten years, you're very depressed that first year you're paying back a loan.
And almost everything is interest you're paying.
Like, if you've taken out a 30-year mortgage that first year, your mortgage payment is $2,300.
And $2,000 of it is interest.
Ho-ho! Whoa!
So the longer term the investment is, the bigger the difference when the interest rate comes down.
The Federal Reserve, fiat money, fractional reserve banking, Man Economy and State, The Theory of Money and Credit
by Force.
We want low interest rates, so we're going to have them, and they just push them down.
But the other way is, the public saves more.
Those are the two ways, the Fed forces them down, or the public saves more.
Now when the public saves more, everything works out.
Everything works out because when you save, you are indicating that you're not going
to consume so much in the present, you're postponing your consumption for the future.
Well great, that's when it makes sense for investors to engage in investment projects aimed at, wait for it, the future, okay?
So the interest rate coordinates time here.
So when the interest rate is low because people are saving more, investors invest in future oriented projects for when the big savers are going to spend in the future.
When the interest rate comes down, on the other hand, because the Fed forces it down,
people have not indicated that they're going to postpone their consumption for the future.
Investors are going ahead, doing long-term investing,
but meanwhile consumers are demanding goods right now.
So businesses are engaged in product development, developing new products,
whereas people are demanding more of the existing products right now.
So there's a mismatch of time.
So time is the important element here,
which is left out of almost all current economic model that helps us understand the problem with what the Fed is doing.
It's creating a time mismatch in the economy.
It's encouraging people to engage in long-term investment geared toward the future at a time when people are consuming in the present
and they are not deferring consumption in the future.
So this mismatch is going to cause problems. It's going to make these projects not profitable at all.
Secondly, if the interest rate comes down because people are saving, when people save
resources, those resources are what investors use to see their projects through completion.
But if interest rates have been brought down because the Fed just artificially forced them
down, there are no additional resources in the economy.
Ben Bernanke doesn't create new steel just because he forced interest rates down.
There are no additional goods created.
Just the interest rates have been forced down.
So now the material wherewithal to see all this new investment through to completion
does not exist and so therefore all these investment projects cannot be profitably completed
and that's going to become obvious as the years go on.
What investors will find is that their input process are going to be much higher than they
anticipate because insufficient resources have been released.
So for example, during the dot-com bust, one of the reasons the dot-coms went bust is that
The Internet is the wave of the future. I'm going to start groceries.com. Everybody is going to want to buy his groceries on the Internet. Who wouldn't want to do that?
Well, all right, I guess not many people apparently, but everybody thought any Internet business you could think of would be great.
But now all of a sudden you've got this artificial boom, encouraged by artificially low-interest rates, and all these people are engaged in all this long-term investing, but there hasn't been any additional saved resources.
The fixed goods they need to finish all their projects don't exist in the numbers they anticipated.
They've been misled by the interest rate.
So they found that programmers, computer programmers, suddenly were commanding double the salaries they used to do.
They suddenly find that coveted domain names like TB.com, that cost $15,000 at the outset of the .com boom.
Toward the end, business.com is costing $150,000.
So suddenly, investors find that they have started on projects that cannot be profitably completed given the resource base that exists in the economy.
When the free market is allowed to coordinate interest rates, it coordinates this production process perfectly.
And a very useful analogy that the economist Ludwig von Mises made was to imagine a master builder building a home.
Now this master builder, let's say he's been misled into thinking that he has 20% more bricks than he really has.
So what's he going to do? He's going to lay the bricks more broadly than the otherwise would.
He's going to anticipate building a larger house than the otherwise has.
This is an analogy we're drawing with the economy as a whole.
Imagine the economy as a whole as one house built by a master builder.
Now let's suppose he continues to build, continues to build, at some point, and let's assume for the sake of argument
He's been misled. Now, what is the best solution to this? Now, there are people who say that when we have an economic downturn like this, what we need is the Fed to pump more money in, keep it going, you know, just try to revive this corpse back to life. That's what we need to do. Just do more of the same that got us into this mess. That ought to solve this problem.
and they keep saying let's do that let's do that well that's the equivalent of
saying that the way to get this master builder out of his problem is to just
keep getting him drunk so that he doesn't notice that he's got this
dwindling supply of bricks he just keeps on laying them not even looking not
knowing what's going on well if we did that he's obviously worse off if he has
to destroy almost a whole house and squander all those resources and all that
If he had had that labor time, then he would have been, if we had cut it off sooner, when he had laid, let's say, just two rows of words, that would have been, sure, there would have been some pain, but far better do that, than to let the guy almost finish the whole project and then say, oh, by the way, you don't have enough ribs for this.
And that, in effect, is what the Fed is doing here. Every time we get told, well, the Fed, in order to avoid the recession, needs to just pump more money in.
But the recession is inevitable because all the projects that have been started can't be finished.
The resources aren't there to finish them. That's a fact. That can't be avoided forever.
If you simply throw more money into the economy, all you're doing is encouraging investors to continue down this unsustainable trajectory.
All you're doing is encouraging this home builder to just keep on putting bricks on a house he can never finish.
That is obviously not going to help the situation.
And as I pointed out a little while ago, when we had the downturn of 2000-2001, that's exactly what the Fed did.
It said, you know, we've got to get out of this downturn, so let's just start flooding the economy with money.
Let's just cut rates like mad, just throw a lot of money into it.
And so remember, that's the first and only recession on record in which new housing starts did not decline.
And so because of that, because the Fed was trying to postpone or mitigate the effects of the recession, all it did was sow the seeds for the worst one that we're enduring now.
Because instead of people realizing right then what the real value of their houses was, they drew exactly the opposite conclusion.
People said, well, you know what, everything else may go down as it is doing in this recession, but apparently housing just never does.
So in the effort to avoid the pain of that recession, the Fed simply encouraged people to continue along unsustainable paths, both unsustainable investment patterns and unsustainable consumption patterns.
People were misled into thinking their houses were worth more than they were, they borrowed money against these houses, they bought boats with them.
Whereas if the recession had been allowed, yes, to go on fully at that time, people would have had a rational assessment of the values of their assets and we would not have perpetuated this unsustainable bout of consumption.
Now that, in a nutshell, is what's called the Austrian business cycle theory.
And it's named that because it was devised by people who belonged to something called the Austrian School of Economics.
The Austrian School is not a physical building. It's a school of thought.
And it's not physically in Austria. They're called that because the main figures in the school,
beginning with Carl Menger in the 1870s and Boehm-Bawerk and Ludwig von Mises and F. A. Hyde were all Austrians.
So this becomes known as the Austrian theory of the business cycle.
And it explains a lot of the unexplained questions that require an answer.
For example, it needs to be answered why it is that all of a sudden entrepreneurs of economy-wide
Why suddenly seem to make disastrous business errors of the same type at the same time?
Why should that be?
That demands an explanation.
Why should that happen?
We understand, you know, a business might go out of business here or there, you know,
nobody can forecast the future perfectly.
You know, you're going to, some people are going to go out of business, but various sectors
of the economy might go up and down, but why should the whole thing move in a cyclical
pattern?
What is the explanation of this?
And normally the explanation you get is no explanation at all.
Well, you know, the market has a weird psychology, nobody knows why,
animal spirits, you know, sometimes people feel, they feel optimistic or they feel pessimistic.
So apparently if all of us just had psychiatric help, we wouldn't have the cycle.
But this is a totally unsatisfying explanation.
And it suggests that there are no real factors accounting for the data check.
and that helps to explain why there are different approaches to what now needs to be done.
If you think that basically the downturn has no explanation, people just got pessimistic all of a sudden,
then the way to revive it is to just stimulate it, just have this stimulus package.
Let's just take this corpse and just get it going again by throwing a lot more money into the economy
and basically saying to people, we want you to keep spending at your old level of spending.
But we've just seen the old level of spending could not be sustained.
People are broke, they can't pay it back now.
They can't pay back all the debts they've wrapped up.
We've got a credit card, it's gonna be the next thing
that needs to be bailed out.
Because we've got unpayable credit card debt.
To say to people that the solution to our problems
as an economy is for you guys to keep on spending
as if nothing has happened is so absurd
that only somebody in a lunatic asylum
or on the editorial page of the New York Times would accept it.
Whereas the Austrian approach is to say this downturn isn't because of, you know, animal spirits or, you know, unpredictable factors.
It's because there have been real resource misallocations in the economy.
Investment has been made in incorrect, unsustainable lines.
That needs to be flushed out.
We need to reallocate labor away from firms that were catering to this unsustainable level of spending.
So maybe there aren't going to be as many cold stone cream reeds as there were marble slab or whatever they are.
Maybe there won't be as many of those. There'll be fewer houses built.
It takes time for labor and capital to be shuffled back around the economy into a sustainable pattern.
But we need entrepreneurs who are informed by the price system to be allowed to do this peacefully and without interruption.
Every time there's some distraction whereby the government starts spending 800 billion dollars or a trillion dollars on various things,
That only confuses auto-criminalists, because now it's very hard for them to assess demand.
Well, this demand is just coming from the government, so do I really want to expand here, should we really expand here?
Is it really good for the government to engage in stimulus that results in the expansion of construction companies?
I mean, how is that? That's not a long-term solution.
At the end of this, we'll be in much more debt and we'll still have an unbalanced economy.
We'll still have too many people in construction.
We will not have solved any of the underlying problems that, let me see, I forgot to bring
one thing.
I forgot to bring my watch.
Okay.
Good.
I sold it a little bit of time.
Good.
Now, let's...
Let me give you some actual examples of this in practice, from history, which is my field.
Nobody has ever heard of the Great Depression of 1920.
Nobody.
That's not because there wasn't one, it's because nothing was done to fix it. Nothing.
Other than the market, and again, what proceeded in the Great Depression of 1920?
Where you had a worse, the first year of the Great Depression of 1920 was worse than the first year of the Great Depression of 1929.
In terms of employment, production, all the statistics, it was worse.
And yet, what was done about it? What was done? Well, first of all, we had President Warren Harding elected in 1920,
who was sort of like an amiable adult. So even if he had wanted to do something, by the time he got around to it, the thing's all over.
So what you had was, again, a massive credit expansion, which led to over-investment in certain lines, under-investment in others.
And the result was, well, we had this downturn in 1920.
So what did they do? Did they have a big fiscal stimulus package? No, to the contrary, the government cut its budget.
Now, we're told today that if the government cuts its budget, that's terrible, because we just need people spending. Spend, spend, spend, spend, spend, spend, spend.
By the way, if that's what people did forever, we'd still be living in the Stone Age. You need to save in order to finance, you know, things like this, investment, whatever.
But they didn't do a thing. The Fed was very new at that time and hardly knew what to do.
So they did nothing. And the result was within 18 months the economy was on its way to recovery
and before you knew it was setting production records again.
In 1929 on the other hand, we have the first time in American history in which instead of allowing
these underlying imbalances to be corrected, instead exactly the opposite was done at every turn.
The government said, you know what, we're going to roll up our sleeves and fix this problem.
to fix this problem.
And it went on for year after year after year.
Now today, there is some dispute about the unemployment figures of the 1930s.
But no matter what set of statistics you look at, this is not an enviable decade.
By 1940, you still have double-digit unemployment.
Year after year after year.
Now, sure, you can draw examples from history all day long,
but those two are pretty close together in history.
And you might think there's a little bit of a lesson there.
But if you're not persuaded by that, then I direct your attention to what happened in Japan.
Now Japan, again, had an insane credit-fueled boom in the late 1980s.
And then that thing went bust.
What did Japan try to do to reverse its economic decline?
Did it say, well, you know, we need, after this credit-fueled boom,
we need resources that have been misallocated to be now reallocated in sustainable lots?
No, no, no. We're going to interfere with that process every step of the way and then pretend to be shocked that there's no recovery.
So for over a decade and arguably until the present, the Japanese economy has stagnated.
And let's just go down the list of what they tried.
They tried partial nationalization of the banks.
They tried trillions of yen in public works, stimulus spend.
They pushed interest rates all the way down to zero.
They had a special fund to help bail out zombie companies.
And what did they get?
Well, what you would expect.
They got a night of a living dead economy.
That's it. That's what they got.
And now which one of those things has not been recommended
or actually done in our own case?
And then we're supposed to expect that the consequences are going to be different.
Now all of this follows, though, by implication from Austrian business cycle theory.
Because, as we've seen, now that we know that when you artificially interfere with the industry, it's like artificially interfering with any price, except that the industry, in effect, is a price that is present throughout the whole economic structure.
So it's going to have economy-wide consequences. This is the solution to why businesses all seem to fail, because they're all misled by the same indicator.
So this answers these questions, and it also helps us to figure out what is the way out.
Well, if we know that the problem is excessive credit creation, then the solution cannot be excessive credit creation.
The solution cannot be forcing interest rates down. That's what got us here.
The solution can't be just throwing more money at it or going further into debt.
Excessive debt is what brought this problem to life in the first place, where people suddenly couldn't make their mortgage payments.
They can't make their credit card payments. That's not a sustainable structure of spending.
And we do not want to stimulate that structure of spending back into existence.
That would be a bad thing.
Because since it is unsustainable, eventually it's going to have to collapse.
And the collapse will just be all the harder if we don't just take our medicine now.
Now if we look at the Japanese economy, by the way, we want to confirm the relevance of the Austrian Business Cycle Theory.
Austrian Business Cycle Theory tells us that the further removed from consumer goods an investment is,
The more interest rate sensitive it is and the more of an artificial boom there will be there
when interest rates are artificially low.
We look at the Japanese example, what do we see?
The worst downturns are in the following order.
And this happens to be the order of farthest away from consumer goods all the way down to the consumer.
So we've got mining, manufacturing, wholesale and retail, and services.
Services are right at the consumer.
for a Massage, again, that's immediately consumable by the consumer, and that's sufferably least,
but in increasing order of suffering, it's increasing order of how long in time these
investments are from the fruits of them being reached, that's exactly what Austrian Business
Cycle Theory would predict, it is not what this, we're not spending enough theory to
predict, if that were the case, then the worst downturns should be in services and they should
in consumer goods, but it's an empirical fact that in all these downturns, consumer goods do relatively well compared to real estate, capital goods, and goods farther down the line in the production process.
So it is only the Austrian business cycle theory that can account for this. And notice now what the obvious implication of all this is.
Now this has anything to do with the free market. This was an interference of the free market.
When you push interest rates below where the market would have set them,
how could the consequences possibly be the fault of the market?
The Federal Reserve system is not a part of the free market.
It was established by Congress in 1913. Its chairman is appointed by the U.S. government.
It gets government-granted monopoly privileges. It is the very opposite of the free market.
And for years and years, the Federal Reserve System has been doing this.
And yet, the free market takes the blame.
Capitalism has failed, we get told, over and over again.
And that's why, in one of my chapters, I ended by noting
that the Federal Reserve System is the elephant in the living room that everyone pretends not to notice.
On TV, we've got all these explanations for what's going on, but with a few honorable exceptions, the Fed is never mentioned.
You just hear crickets, so no mention of it at all.
But meanwhile, the devastating results of what the Fed does are then blamed on capitalism.
And so as I say to the folks, it's time to start considering the possibility that maybe it's the elephant that's wrecking all the furniture in the living room and not a little giant.
And so, as I just sort of bring this to a close, I think if we're going to have some success in getting out of this, the Federal Reserve System needs to be put on the table, needs to be a part of national discussion.
It hasn't been. It has existed for almost a hundred years. And during its hundred year existence, the value of the dollar has declined by 95%.
95%! Now suppose that happened when we had the dollar back by gold. Well, we never hear the end of it. Oh, well, that just shows having the dollar back by something is a terrible idea.
But when the Fed does it? No, nothing. Silence. Not even mentioned. And yet, we are sort of conditioned to believe that this is the best of all possible worlds.
that this system that discombobulates the market through its artificial interest rate reductions
that then leads to bankruptcies and the bankrupt firms then turn to the Fed to create more paper money to bail them out
and we have these crazy cycles going on and people get thrown out of work and discombobulated
Is this so obviously the best possible system that any non-trivial alternative is to be rejected out of hand?
This is a legitimate subject for debate.
And in case you're tempted to say, but you know, we did have Boehm and Bastiat.
We did have economic cycles before we had a Federal Reserve system.
So you can't blame all these people.
The same causes are at work in all of those.
In the Panic of 1819, 1837, 1857, 1873, 1893, and 1907, they're all based at the same cost.
There is preceding the panic.
In the pan, there is excessive money creation, which leads to misallocations of resources and eventually a bust. It happens in every single case.
So it seems to me that if you're looking for confirmation of this theory, it is absolutely everywhere.
Now the trick is getting the theory into circulation among the general public,
so that we do not wind up suffering a ten-year depression and then, at the end, the added indignity of being told that it was the government's brilliant plan that eventually rescued us.
So, thank you very much.