I'm sitting here with Mark Thornton, senior fellow and resident fellow at the Mises Institute,
and we're going to be talking about the relationship of the Fed to the boom-bust cycle in the most
present case.
So, you're not going to get too technical on this, are you, Mark?
No, not too technical, pleasure to be here.
Okay.
Well, I guess it was inevitable that there would be a dispute about the extent of the
Fed's responsibility for the boom and therefore the bust.
Do you want to address that?
Yes.
I mean, it's a big problem and so everybody's trying to blame everybody else.
Now that the campaign is over, you notice that the Republicans were blaming the Community
Reinvestment Act, giving away loans to people with subprime credit, and the Democrats were
blaming monetary deregulation for the problem.
And of course, we've been blaming Alan Greenspan and the Fed right along since 2003 for this
The Central Bank manipulates the interest rates in the money supply, leading to massive malinvestment in the economy, which subsequently comes undone.
None of those other boom bust cycles had community reinvestment acts or things of that nature in them.
They didn't have Fannie Mae and Freddie Mac back in the 1920s.
and so we would label Fannie and Freddie and the Community Reinvestment Act as features of this business cycle but not the cause of a business cycle that involves a huge credit bubble which subsequently goes bust.
So you're looking at necessary and sufficient conditions for a sign and blank.
The Theory of Money and Credit
The Austrian Business Cycle Theory is an across the board, even macroeconomic boom that was
funded in some sense supported by the Fed affecting all of a particular type of investment
equally.
But that's not true.
No.
Of course it's not true.
We heard this from all of the naysayers about the housing bubble in 2003, 2004, 2005, 2006,
including Greenspan himself that, well, there's not really a housing bubble because it's only
A real drawdown on their access to capital and real resources like labor.
Yeah.
Now, to establish the Fed's culpability here, what money data are you looking at?
Well, you know, I don't look at any particular measure of the money supply.
I look at all of the measures of the money supply. Credit, right across the board, you should see some general patterns. So I look at the monetary base, I look at M1, I look at M2, I look at the true money supply that we calculate here at the Institute, as well as specific indices that relate to housing itself.
When you look at all of the measures back in 2001, when the bubble really got started in the American economy, a lot of the seeds were set in place before then, but you see tremendous increases in monetary measures in 2001.
and this is the very first time that I've ever seen where housing did not go into a slump during a recession and we had a recession at that time and housing prices did not decline on a real adjusted basis construction of homes continued did not decline that's the first time we've ever saw that and you know so housing prices go up and down
with the economy, generally speaking. But in this case, that didn't happen. So that's
a very clear indication that a bubble is brewing in the economy where there's no real other
explanation for it except for the great availability of credit in the economy, incredibly low interest
The Federal Funds Rate is down from 6.5% down to 1% which indicates that the Fed is
The Federal Reserve is going to an easier monetary policy and then, of course, when you look at the monetary measures, the monetary base M1, M2, they all are increasing at very rapid rates.
The Fed funds rate is something that the Fed controls directly.
They control that directly and that's where they're injecting money into the banking system.
and if you look at a chart of the federal funds rate and short-term interest rates on treasuries you'll see that they go hand in hand with one another and people have brought this up to me they say well you know it looks like short-term rates are actually in front of or taking place prior to changes in the federal funds rate so that the Fed is not really controlling the money supply and interest rates
The Fed is really catching up to the market, but of course it's really the market that is forecasting what the Fed is going to do, and there's very sophisticated markets in the economy whereby market players can predict what the Fed is going to do.
We all have some ability to predict what the Fed is going to do.
They signal us beforehand.
They give us policy statements that they are tending to go in an easier direction or a
neutral position or a stricter position.
So it's not really the market that's setting the rate and the Fed is just following along.
It's that the market is able to predict what the Fed is going to do.
This is even more complicated in light of monetary deregulation than, for example, it would be to discern these patterns in the 1920s. We have so much information.
Right. We have a whole new mystery of banking, as Doug French has pointed out. Everything was fairly straightforward in the 1920s.
The Federal Reserve has made the Fed less able to directly control money aggregates.
The Fed now has a much more complex financial industry that it's regulating and these firms
now have more scope in their activities and a greater ability to move funds around prior
to of course the crisis, the onset of the crisis and I think you've got the derivatives
and also, is it at all possible to understand this bubble absent a thorough understanding
of the relationship between interest rates and the capital stock?
I mean, it seems like the study that came out the other day from Henderson and Hummel
Capital is looking only at money aggregates but not focusing on the effects of interest
rates on the capital structure.
Well that's true but I don't think it really has to get that complex.
We had lower interest rates, we had big increases in the money supply during the boom which
started in 2001.
That continued as interest rates remained low and as the money supply continued to expand
Coincided with increases in the interest rates, a decline in the growth of the money supply,
and then of course the bubble continues onward from that point, but it's money that's already
in the system that it's carrying on.
Along with Hummel and Henderson's article, I hesitate to criticize something that calls
for the Dismantling of the Federal Reserve, but I think that their basic point is just
incorrect.
When they first came out with this in Investor's Business Daily, I pointed out to them that
the money supply was growing very rapidly when the bubble started.
The money supply continued to expand as the bubble filled out and the bubble topped off
when the Fed started being more restrictive.
You can't really exonerate Alan Greenspan and the Fed in any way for the bubble.
As a matter of fact, when they started to increase interest rates, that's exactly when
Alan Greenspan, using the bully pulpit, said that there was no housing bubble and that
everything in credit markets was great and that these home mortgages and second mortgages
and Money and said that everything was fine, that things were now better than ever in terms
of regulating the mortgage industry and things of that nature.
So they were cheerleading on all of these just crazy financial packages and loans that
were being made even though that they were pulling the plug on the party.
They were increasing interest rates at the time.
I suppose that it's not at all surprising that there would be disputes about the culpability
of the Fed for this current boom-bust cycle because, of course, the disputes over the
1920s still continue to this day, with the Austrians pointing to expansionary money policies
from the Fed and the monitors typically saying, well, there's no evidence of inflation in
the 1920s at all.
That's right. The problem is the Fed has the economic power to back up their position.
They control either directly as employees or through grants or as former employees, virtually
all of the PhD monetary and macroeconomists in this country. It's hard to find a prominent
monetary theorist or macro-money person who hasn't directly benefited from the Fed.
And of course, and this is something they'll admit to, I mean, if you go against the grain
of the Fed, you know, they don't take kindly to that sort of thing.
So it's very difficult to get prominent people to come out against the Fed.
Everybody's sort of pro-Fed, au naturel.
Things have changed on Main Street, I think.
More and more normal people are willing to blame the Fed, so there are a few more investment
advisors who aren't just crazy for the stock market anymore and that are against the Fed,
and there are a few normal people who realize that the Fed is at the heart of our problem
and of course the number of people that are finding their way to Mises.org are really
The Federal Reserve, fiat money, fractional reserve banking, Human Action, Man Economy and State, The Theory of Money and Credit
The Money Supply that gets built on top of that can simultaneously shrink because banks
are not willing to make loans to people when you are entering a recession, when people are
When people are losing their jobs, when people are defaulting on loans and on mortgages, it's
perfectly rational for banks to say, I don't want to lend at any interest rate.
We're protecting ourselves.
We're doing the right, rational, economic thing by not making as many loans and making
those loans on either traditional terms or even stricter than traditional terms.
In the boom, in the bubble, you're making loans on no terms at all, essentially, but
in this phase, during the contraction, the Fed is trying to stimulate the money supply,
but they need the banks to cooperate and to lend out money, and banks have resorted at
least to the old traditional norms, if not more strict.
Well, so let's just back up a second to the boom again. If the money supply is expanding
dramatically as it was during the boom, there's less pressure on the Fed to increase the money
base. Am I right? That's correct. Yes. Because banks are willing to make loans, that increases
is the expansion process to its fullest extent. And also, of course, there's been a secular
trend towards a smaller amount of bank reserves financing a larger amount of loans. That's
been going on ever since the Fed took control. So let's say I'm on the Fed and I want to
create a boom. I lower the federal funds rate dramatically and I notice that the money supply
The Federal Reserve, fiat money, fractional reserve banking, Human Action, Man Economy and State, The Theory of Money and Credit
Bank of Japan experienced the same thing after its stock market crash in 1989. They lowered
interest rates to zero, but banks were not willing to lend. The economic circumstances
The Federal Reserve is a natural economic response to the Fed in the 1920s and 30s.
They lowered interest rates after the stock market crash, they increased the monetary
Let me ask a fundamental question about the relationship between the Fed and money creation.
I suppose it's more true under a deregulated environment that market conditions are largely responsible for the creation of money.
The Fed has the ultimate responsibility in credit markets these days. It determines the price of money. If it's maintaining a very low price for credit, then more credit is going to be
In 2001, Greenspan was taken into the banking system and then expanded throughout the banking system, causing the bubble.
So there's really no denying the historical significance of what Greenspan did in 2001,
in the interest rate, opening the floodgates of credit and keeping the housing market in
an upward spiral at a time when it otherwise should have gone into a contraction. And this
is essentially what created the market conditions in banking and home construction where people
thought that housing prices could never go down, that nobody ever lost money in housing.
and that all new sorts of people came into the home construction arena and made profits even though they had no experience in the business and it was that kind of setting the psychological tone by providing super abundance of credit which caused this bubble and there's really no other explanation that really holds water and the fact that Greenspan and Bernanke piled on
Chair leading the market right before they were reversing policy course means that I think that they share really all the blame for everything that took place and this sure you know lending standards were reduced and there were some corrupt business practices that take place but you know when the Fed increases the availability of credit increases the amount the banking the banking system has to lend it
to people with lower credit standards, lower credit ratings, because all the other people who have good credit are already covered.
And so really all aspects, even the things that don't appear to be related to the Federal policy, like these unscrupulous mortgage lenders
and the Green-Span Put, the Bernanke Put, the Green-Span Put, the Green-Span Put, the
And now the Bernanke put, which is a market way of saying that everybody believed that
if there was trouble in the housing market or any other market, that the Fed would come
to the rescue, that the Fed would fix everything and that nobody would lose money.
So every aspect of this bubble is directly the result of Fed actions, Fed speeches and
and the perception that they created in markets that all investment was riskless.
Yeah, and I should really apologize to you because for years I've been doubting you on
this point about the guarantee of the too big to fail aspect of these housing mortgage
things.
I really had my doubts that you were right about this and yet history has borne you out
completely.
It's rewarding lately. It's rewarding getting letters from people that said that they didn't
buy a house in 2004, 2005, or 2006 because they read my article on Mises.org. That's
very rewarding, but it was a tough time between 2003 and, say, 2007 when, you know, in 2007,
basically no one in the media, no one in the Fed, no one on Wall Street would even admit
to a Housing Bubble.
And now, of course, it's fairly obvious what happened and I think why it happened more
precisely is that there's a scientific way of identifying the cause, the effect and attributing
blame here and I think that when you look at all the evidence, not just some kind of
The Federal Reserve, fiat money, fractional reserve banking, Human Action, Man Economy and State, The Theory of Money and Credit
The Lowering of Standards, which gets identified as corruption.
Same thing happened with Enron, you know, oh, corruption, corruption, corruption, but
there's all this easy money, banks were lending it to anybody that would be willing to take
it.
And so Enron came up with new deals of how they could take more money.
And that's the story.
Well, wait, thank you for taking us through the evidence, and I'm sure there'll be more
talks along these lines in the coming days.
Thank you, Dr. Targman. Thank you, Jeff.