WEBVTT

NOTE Banking and the Business Cycle

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Okay, today's lecture is banking and the business cycle.

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So what I'll do is I'll devote some of the lecture to explaining the basic principles of banking

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and then the rest to the Austrian theory of the business cycle.

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Let's start with the distinction between two types of banking that have become mixed in the contemporary world,

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and that is loan banking and deposit banking.

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And what we'll do is use a double entry or T account as a device to explain the effects of banking and the difference between loan and deposit banking and between 100% reserve deposit banking and fractional reserve banking.

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So, let's first look at loan banking. Loan banking goes back many years to really the middle ages, but with loan banking, the institution, the bank, is a pure financial intermediary.

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makes genuine savings and it finds borrowers for those savings.

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And I can give you an example of using a T-account of a simple loan bank.

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A loan bank can be owned by a single proprietor, by a partnership or by a corporation.

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And before I show you the illustration, I want to point out that what we use is the simple equation that assets are equal to liabilities plus equity.

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Okay, and I'll explain that when I show you the illustration here.

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Okay, let's assume, and this is from Rothbard's book, so he uses himself as an example of a single proprietor of this loan bank.

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He saves up $10,000. Okay, Lunder always has to do savings prior to making any sort of a loan.

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And he invests in setting up this loan bank, and he is the equity owner. He owns the bank. So equity is on the right side.

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Now, the assets of the bank are the cash. The cash is what he intends to use to make interest-bearing loans.

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and since this is a T-account, both sides have to equal, okay?

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Any change in one side has to be reflected by an equal change in the other side of the account

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or by a negative change, the same amount on the same side of the account.

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So let's say he makes a loan.

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He retains $1,000 in cash and he loans $9,900 to me, Joe, which is then used for an investment or for some other business activity.

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So now both sides total $10,900. Their assets consist of the cash and the IOU from Joe.

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from Joe. The equity consists of Rothbard's investment in the bank. Note a few things about this transaction.

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Actually, before I do that, let me just show you one other transaction which we use a corporation as an example.

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Okay, now let's say the bank expands, we have shareholders, make it a little bit more complicated.

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In this case, the shareholders contribute $100,000, they buy stocks in this publicly traded corporation, loan bank.

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And again, they make loans of $95,000 at their interest and on the other hand, they retain $5,000 in cash.

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and both sides are equal and we can make it slightly more complicated because shareholders may also issue bonds and other types of instruments at the top there to increase the money they have to loan, the funds that they have to loan so what we see here then is not only the original shareholders of equity but they also issue bonds that they sell to people for $50,000

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$50,000 and they promise to pay interest on those bonds, so that's $50,000 more in funds that they have that have been saved by the bondholders and that will be loaned out.

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The bondholders in exchange, as I said, get an interest return.

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They also issue shorter term debt, which is certificates of deposit of three, six, nine months, two years, and the holders of the certificates of deposit also receive an interest return.

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So now there's a total of $170,000 in funds in this loan bank and $95,000 is loaned out initially and they have now accumulated $75,000 in cash from the bonds and the certificates of deposit that they have sold.

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Now, obviously, they want to earn interest on this, so they loan most of that out, so they loan $70,000 of that cash out, and their IOUs, which are the loans that they have made and that they are in interest on, expand to $165,000.

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The total remains the same on both sides. The shareholders get the difference between the interest that they pay to the bondholders and the certificate of deposit and the higher interest rate that they receive from those people to whom they have loaned.

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That interest differential does have to cover the cost of administering the loans and so on.

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So they receive a dividend on their investment.

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Now, a few things about this loan operation, okay?

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First of all, notice the maturities will equal the structure of maturities.

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The assets will equal the structure of maturities of the liabilities, okay?

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So let's say that the bonds that they've issued are five-year bonds, well then they can make five-year loans, okay?

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Ensuring that the money is back when the bonds come due and they have to repay those bonds.

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Then they might have, let's say, one year certificate of deposit so they make shorter term loans.

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Once again ensuring that the loans, those funds are returned so that they can pay off the holders of the certificates of deposit.

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So what we call the time structure of the maturities of the assets equal the time structure of the maturities of the liabilities.

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All businesses operate in this way or, as we'll see, they go bankrupt.

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If they can't pay their creditors, in this case the bondholders and the holders of the CD on time,

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then they are effectively illiquid and possibly insolvent.

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Now, the second thing to keep in mind is that no money has been created in these transactions.

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The money that the shareholders have contributed and that the bondholders and the owners of the certificates of deposit are genuinely saved funds that they have given up for a period of time to match the money or the period of time during which the money is in the hands of those who have borrowed it.

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So no new money has been created. The money that they have lent or invested in this loan bank is not, they are unable to use until the loans have been returned, so there's no increase in the money supply.

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So as I mentioned, loan banking began in Venice actually in the late Middle Ages and also spread in England in the 17th century.

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Now let's look at deposit banking, which is a totally different institution.

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The essence of it, the central nature, economic nature, is different from loan banking.

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It began with the goldsmith bankers, at least in Western Europe in the 17th century.

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What happened with the goldsmith bankers was simply this.

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People were looking for a place to store their gold.

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They were on a gold standard. People had gold coins. They were very costly to store and they were inconvenient to carry around.

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It was also costly to store them because you needed safes and so on.

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So a division of labor grew up. That is that goldsmiths already had the various equipment necessary to keep gold safe and to store it.

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So they began to specialize not only in using the gold to make various items, but also to use their premises and their equipment to store other people's gold.

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So let's take a typical goldsmith and this is a deposit transaction. So the goldsmith engages in a deposit transaction.

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Depositors come in, they see their gold, they give up control of their gold to the deposit bank.

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The deposit bank agrees to store it, just like any warehouse would store something of yours.

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If someone was going away for, let's say, one year for business reasons and wanted to store some furniture, they would then in return get receipts.

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Now, this is not a loan. The gold is not being loaned to the goldsmith. In the case of a loan, the borrower is permitted to do whatever he or she wishes with the loan funds, as long as they have them back on time.

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They don't have to be the exact same funds, they have to be the same quantity.

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In the case of a deposit, it's what is called a bailment, okay?

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The bailer is the person who gives over the property.

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The bailee is the person who receives the property.

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In the case of a bailment, the agreement is that the person who receives the property,

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the warehouse, will only perform certain functions that have been agreed upon with that property.

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They cannot, for example, if you store your furniture, or if a woman, for example, brings a fur coat in to be clean, and the cleaner knows that she's not going to come back for a month for it, let's say she's heavy cleaning in the summer or something, he can't rent that fur coat out, even if he has it back on time, nor can the furniture warehouse lease out the furniture for a year to someone to collect the rent, and collect the lease payments,

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What if he has that furniture back in the same condition when the person comes in to claim his or her property?

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That's the difference between a bailment and a loan.

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This was a bailment, but bailment law wasn't fully developed.

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So there was a certain incentive, or there was a definite incentive that Goldsmiths faced for various reasons

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Before we talk about those incentives, let's point out that in the case of a true deposit, there's 100% reserves, that is that every warehouse receipt that is held by the depositors is backed by a loan agreement.

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Now, actually, there's an incentive for these warehouse receipts to be used as what we call money substitutes, to substitute for gold in exchange.

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Now, why is that the case? Well, think about it in this way. Let's say you want to purchase a plow from someone.

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And that plow costs you a certain number of ounces of gold. Let's say it's going to cost you five ounces of gold to purchase that plow.

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Let's say it's going to cost you a certain number of ounces of gold. Let's say it's going to cost you five ounces of gold to purchase that plow.

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You can do one of two things. You can pay for it as a purchaser by going to the bank, turning in five ounces of receipts, receiving the gold, then carrying the gold, which is inconvenient and also not necessarily safe, carrying the gold to the seller of the plow and handing it over to the seller.

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If you have the seller and other people in the town have confidence in the goldsmith, it would be much easier and save time if you simply signed over the receipts, five ounces worth of receipts to the seller, okay?

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So the warehouse receipts to gold began to be used as substitutes in exchange for the money.

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they themselves were not money, they were merely substitutes for the gold in the bank

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this did not change the money supply

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because as i said they were substituting in circulation for the gold which was held

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in the vaults of the goldsmith

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or of the deposit bank

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and so it reduced transactions costs

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instead of the purchaser making the trip and getting the gold then

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paying it to the seller who then

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return the gold to his own account

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at the goldsmith, he would just sign over these receipts. These receipts became known as

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banknotes.

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Also, what were called open book accounts were also

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used here. People would put a sum of gold in the

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bank, maybe businesses,

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who made more transactions,

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and instead of having receipts in exchange, they would have an open book account, in

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effect, a checking account.

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and they could draw on the gold by simply writing an order to the goldsmith to pay gold into the account of the person who received the check from the business.

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Okay, once again there was no inflation involved in this.

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It just changed the form of the money in circulation.

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partially from gold coins to checks and fully-backed checks and banknotes.

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Okay. Right now, here's where the incentives come in for the goldsmith to subtly transform this from a bailment to a loan.

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Okay. Let's assume for a moment that the goldsmith recognizes that, and this is not an unrealistic assumption,

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recognizes that on any given day, since people have confidence in the bank,

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only very small amounts are taken out.

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And over time, the amounts withdrawn are pretty much matched, more or less,

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by the amounts that are deposited.

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So he needs to keep only a little bit of the gold on hand

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to use for his everyday functions.

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That is to pay out gold when people come in to withdraw it.

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He doesn't need more than let's say 10 or 20 percent, even that might be high.

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So he can certainly loan out 50 percent.

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So let's say now he secretly loans out 50 percent of the gold that's deposited with him.

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Half of that $50,000 worth of gold, he loans that out.

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So now he's not only earning a fee from the original depositors,

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But he's also earning interest on the $25,000 worth of gold.

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Now what has happened to the money supply in this case?

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Now you have, let's say, $50,000. Let's say everybody put their gold in the bank to make it simple.

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So you had $50,000 of warehouse receipts circulating with your claims on gold.

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And then you have another $25,000 worth of gold coin that has been loaned out.

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Another way of doing this, by the way, is to simply print up more warehouse receipts.

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Not to loan out any of the gold, but to print out warehouse receipts that look just like the warehouse receipts that you've given to the genuine depositors and then loan them out at interest.

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Then they circulate, they become mixed with the true warehouse receipts, we'll call them pseudo warehouse receipts, there's no distinction, and the money supply increases.

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So let me give you an example of that.

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Let's say that this goldsmith, recognizing that people accept his warehouse receipts

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in exchange, loans out another, let's say, $80,000 worth of warehouse receipts.

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He prints them up and he loans them out, makes a loan to someone who wants to invest in some

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and now earns interest on them. So not only does he earn the fee from storing the $50,000 worth of gold, he earns interest on the $80,000 worth of pseudo warehouse receipts.

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Now, Smith then pays those receipts out to laborers, to suppliers, to construction workers and so on, people that he's hiring and purchasing from in his business venture.

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They then, some of them, may use another bank or they may need gold for various transactions, so they will then go and use those warehouse receipts to withdraw the gold.

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So now the gold is being withdrawn by people who have not deposited it.

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But look what has happened now to the money supply.

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The money supply has increased by $80,000.

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The prices in the area are bid up by the pseudo-warehouse receipts and the purchasing power of money begins to fall, so you get inflation, okay?

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You also get a mismatching of the time structure of assets and liabilities, okay?

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People have the right to claim $130,000 worth of gold, both the people who originally deposited the gold

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and the people who have received the pseudo-warehouse receipts from the person who borrowed them from the deposit bank.

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But yet, the goldsmith has on hand, so by the way, those liabilities are instantaneous. They must be paid on demand, okay?

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And the only part of the assets are instantaneous. Only the $50,000 worth of gold in the vault is instantaneously available, okay?

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The loan to Smith might be a one-year loan, a two-year loan, or a three-year loan.

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So if everyone were to come in or to claim the gold to the full amount of the $130,000 worth of gold receipts out there, then what happens is the bank can't pay off and it goes bankrupt.

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So, when it's suspected that the bank has loaned out more than it has in reserve, it would create the conditions for a bank run, for people lining up to get their gold, and only the people who get their first will get the gold out of the bank.

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So in that sense of bank, when it's now a fractional reserve bank, keeping only a fraction of its liabilities in the form of reserves, cash reserves, in that case it's a fractional reserve bank, so the fraction is 5 thirteenths, and you can figure that out in decimal points.

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Now, there were cases brought against this type of banking, but the courts ruled in favor of the banks and claimed that, well, in the case of money, it's not really a bailment, it is, in fact, a credit transaction or a loan.

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Even though, for example, when grain warehouses, warehouses that store farmers' grain, some of them had engaged in this type of behavior in, I guess, the 1960s and 1970s.

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They printed up more receipts to the grain that they had stored in the warehouses, pseudo receipts, and they used it to speculate on futures markets, and they were prosecuted for fraud, for embezzlement.

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But over time, this was not seen as embezzlement, it was seen as a function of, a legitimate function of banking.

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So now what you get is loan banking and deposit banking becoming mixed.

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And they're certainly mixed together today.

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What's loaned out is not only the genuine savings that people who put money in the bank, for example, by buying certificates of deposit,

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It's not only genuine savings by the shareholders and people who are loaning to the bank, but also there's a deposit component which is not real savings, that is where people will put money in the bank which they can withdraw at any time, either from their savings account or their checking accounts.

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Those accounts promise or come with a promise to pay on demand and yet they're loaned out for greater or lesser periods of time.

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And of course, that increases the money supply.

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Okay, now let's talk about what we call multiple bank credit expansion.

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Okay, the bank that loans out funds to another bank, another fraction or to an individual,

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in a system where there are many fractional reserve banks operating,

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It will result in a multiplication of the original loan, in terms of addition to the money supply.

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I'll give you a simple example of this.

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Let's say that you get a graduation present from your aunt, let's say $10,000.

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A rich aunt gives you a graduation present, and you put it in your bank.

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And let's start here.

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I'm going to draw a very simple t-account, assets and liabilities, and we're only going to record the changes, okay?

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So you go to the first national bank, which is your bank, and you add that $10,000 to your checking account, okay?

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your demand deposit, DD. So the bank's liabilities go up by $10,000, but they have, it was a cash gift, let's assume, so you put the cash into the bank, now they have an addition to their reserves, their cash reserves of $10,000, so it's plus $10,000.

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But they're not going to keep all of that cash in the vault, because it's not earning interest.

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I'll just focus on it a little bit more.

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It's not earning interest. What they're going to do, and in today's world they're permitted by law to loan out about 90% of their checking deposit.

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So they loan out 90 percent, so the addition to reserves ultimately is really only $1,000.

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The other 90 percent, I'll use alpha loans, goes to loans.

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So they make an automobile loan to someone.

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That individual takes the money, purges the car with it, so this is the loan, say auto loan, and the person who receives the money, who sold the car, will then re-deposit that money in their own checking account or in his own checking account in another bank, so the second whatever bank.

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and assets and liabilities and so you see what happens is that the there's a

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$9,000 increase in demand deposits and the reserves I'll just take us a few

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steps the reserves of the bank go up by okay 8100 because they're really I'm

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sorry what by um not $900 they only keep $900 in reserves and they loan out the

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The other 90 percent, which is $8,100, $8,100, so these should all be pluses, both sides balanced.

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And that loan, now notice what has happened, there's no change in the money supply when the first person puts $10,000 worth of cash into the bank and gets a check account for $10,000, okay?

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That's a pure deposit. All that has happened is that the form of the money supply has changed from cash to checks.

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But now when that $9,000 is loaned out and deposited in another bank, you now have another $9,000 checking account created.

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So the money supply is increased by $9,000. Similarly, when the $8,100 is loaned out,

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You have it being redeposited by whoever receives it from the borrower in another bank, okay, third bank, third whatever bank, and you have the assets and liabilities, and I'll just take it to this round, okay.

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That increases checking accounts by $8,100, so there's another $8,100 in the money supply.

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The Money Supply basically equals the amount of currency in the economy plus the amount of checking account money in the economy.

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And I would add in a few other things.

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But for simplicity, we'll just keep it to that.

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And in that particular case, then you have $720 being loaned out and $7,200 being loaned out and $810 being kept in reserve.

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You only need to keep 10% to back up the checking account.

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So that goes up by 810 reserves.

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Loans go up by the difference, which is 7200-something.

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And it keeps going.

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So now, just in the first three rounds,

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There is a $9,000 addition to the money supply, then $8,100, then around $7,200, and so on.

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Now, this process will stop, okay, there's a simple mathematical formula to tell us the maximum amount by which the amount of checking account money in the economy can be increased.

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and that formula is known as the money multiplier, called MM, money multiplier is equal to, or simply it's actually the deposit multiplier, deposit multiplier is equal to 1 over the reserve requirement, if the reserve requirement, before central banking the banks were permitted to determine their own reserve requirements, according to their level or degree of prudence,

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After central banking, after the Fed, for example, was created in 1914, they legally, they had the power to legally determine reserve requirements.

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So the reserve requirements today are approximately 10%.

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So every $10 of new check account money, or every $10 of check account money is backed up by $1 of reserves.

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Or to put it another way, every additional dollar of reserves in the banking system can support 10 new dollars of money in the economy.

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So when you deposit money, if you deposit $100 in currency in your bank account, ultimately it is multiplied 10 times because the deposit multiplier which is equal to 1 over RR is equal to 1 over 0.10 which is equal to 10.

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So what I'm telling you here is that when you deposit $10,000 in currency, there's going to be a change in the money supply, delta means change, equal to the change in currency in the economy plus the change in demand deposits, which is checking accounts.

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So in that case, checking accounts will go up, okay, we can figure out the change in checking accounts or demand deposits, will always be equal to 1 over the reserve requirement times whatever the amount of new reserves in the banking system are, or is.

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So if the amount of new reserves in the banking system is the $10,000 that has been deposited in the checking account, that's the currency that's been put into the banking system,

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System, that currency is going to be able to be multiplied 10 times to give us an increase of $100,000, okay, is equal to 10 times $10,000.

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So $100,000 of new checking account money will be created out of thin air by that deposit of $10,000 of currency.

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Now, so you get $100,000 more of demand deposits, but if you take currency out of circulation and put it in the bank, we do reduce the amount of currency by $10,000.

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So overall, the money supply increases by $90,000 net.

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There's $10,000 more of checking account money in the economy, but there's $100,000 more of checking account money in the economy, but there's $10,000 less of currency.

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of Currency, because that's now in the vaults of the banks. Yes?

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We'll call that the deposit multiplier.

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Or simply the...

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Demand deposits.

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DD is demand deposits.

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Demand deposits refer to any deposit that can be withdrawn on-demand,

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or that can be withdrawn instantaneously.

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So even our savings deposits in today's economy are demand deposits.

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You can ship them immediately through your ATM to your checking accounts

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or you can withdraw them. Even if you can't write checks on them, they are still

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demand deposits in effect,

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or in essence.

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Yes, Alex.

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You take another check and deposit it?

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Yeah, for instance, if I give you a check for my bank, but it's a lot, like 90% of it is actually inflated.

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So then you put it in your bank, does that increase, is it like inflated on credit?

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No, the question is, what happens if someone deposits a check from someone else in his own bank?

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Money that's been created elsewhere.

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No, what happens is that all that happens is that the reserves shift from one bank to the next,

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But the total amount of money in the economy stays the same.

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Now, during Christmas, people, for example, will want to walk around with more cash because they make small purchases.

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It's the shopping season, during the holiday season at the end of the year.

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Okay, beginning probably before Thanksgiving and lasting through the new year.

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What happens is that people withdraw billions of dollars from their checking accounts.

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And that would tend to reduce the money supply.

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So if you take a billion dollars out, let's say, let's say a billion dollars is taken out in currency,

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so that people can have more cash with which to make smaller expenditures and so on.

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What will happen is we'll have a reverse or contraction, a multiple contraction going on.

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What's going on? So the money supply will ultimately decrease by ten billion dollars, ten times that. That's the maximum.

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The Fed, as we'll see in a moment, can offset that and will offset that with what are called open market purchases.

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It will recreate that money during that period, that checking account money, and then later on drain it out when people redeposit, when the businesses redeposit these funds in the checking account.

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Change in the Money Supply. Change in Currency. Currency and demand deposits, widely construed demand deposits, meaning any deposit of bank that can be instantaneously withdrawn or redeemed in cash, that is included on the demand deposit.

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How is the currency able to be in circulation?

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and the supply of money, which we call your cash balance, okay?

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By the way, about 80% of U.S., between 60 and 80% has been estimates of U.S. currency is not in our country.

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It's not in the U.S. It's outside the country, financing transactions in illegal drugs

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or being held by people that are afraid of inflation in their own countries,

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Eastern Europe, Latin America and so on,

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And then China has the most U.S. banks?

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Well, when foreign central banks hold U.S. dollars, they don't actually hold the paper dollars, okay?

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They'll hold those dollars in the form of either government securities, short-term, you know, Treasury bills and so on,

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or they'll hold it in American banks here. In other words, the Bank of China, the Central Bank of China has accounts.

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I'll tell you about the breakdowns. I believe at the Federal Reserve Bank as well as at commercial banks here in the U.S.

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and they earn interest on those accounts.

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So they don't actually hold dollars, it's the citizens that will hold the paper currency.

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Yes?

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I'll follow up on that. I was wondering if the cash, is that going to be...

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I'm not sure of the breakdown, but again, the governments, Middle Eastern governments may very well hold U.S. dollar-denominated assets.

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In other words, the dollars that their central banks get are invested in interest-bearing U.S. assets.

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So they don't necessarily hold U.S. currency for governments.

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Curtis.

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Is there some benefit to bankers if they can use a debit card as an institution of trust?

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It's much more convenient, in fact, when I make food purchases at grocery stores around here, I just use my debit card.

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I wouldn't use a check. If there were no debit cards, I think I would use cash to make some of these small purchases.

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So it causes more reserves to go into the bank as people put more money in their checking accounts because they can draw on that not only with paper checks,

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which have some transactions cost, but with the debit cards, which are easier to use.

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Can I ask a follow-up to one more question? Can I ask a follow-up to one more question?

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Can I ask a follow-up to one more question?

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In other words, the banks have invested in assets of different maturities, some being much more liquid than others.

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But they're still not instantaneous, in the sense that they can immediately call them in when someone comes into demand cash.

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Going back to the center line, 100% of the money is in the ______ ______ ______ ______

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I don't think that's necessarily the case. No. The bank would be split into two departments where one department was simply a loan bank or a genuine savings bank where you put money for periods of time and they could do that by issuing certificates

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of Deposit, and other sorts of instruments, and then loan that money out, match the loans

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to the maturities of the deposit that they have gotten in these instruments, or the savings.

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And then the other part would be simply a warehousing function.

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The other part of the bank would engage in a warehousing function in which they would

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charge for administering checking accounts.

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not only would you not earn interest on checking accounts, but you would have to pay a fee to have your checking accounts held at a certain bank

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because there are costs of administering those checking accounts

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so that argument has been brought up, but it's really a question of knowing what the law is and the law clearly defining what is permissible and what is not permissible

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I don't want to get into the ethics of fractional reserve banking.

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I just want to stick to the economics of it.

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But it is enough to know that it was conceived in fraud or an embezzlement, as people at the time understood that.

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So that's how money is created.

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Now, let me just mention very quickly that as central banks came in, if one bank were to expand its bank notes and checking accounts very rapidly and to a much greater extent than surrounding banks, then prices would begin to go up in the area of that bank.

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Bank. So what would happen is that as prices rose in the region in which that bank was located, people would begin to use the bank's notes to buy things from other regions where prices were lower because the other banks weren't as inflationary, which would mean that those bank notes would then begin to be redeposited in other banks and so the amount of notes that the other banks

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had of the bank that was inflating would exceed the amount of notes of the less inflationary banks that the bank, the inflationary bank was holding.

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So when they went to clear their notes and their deposits, the bank that was inflating would lose gold, because the other banks ultimately want gold.

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They don't want to hold the bank's notes, especially if the bank is inflating.

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So there's a mechanism that operated under what was called free banking

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to keep strict limits on a particular bank

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from inflating too much more than surrounding banks.

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Because if they did, once again,

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the exports in their areas would fall because the prices were higher as people

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spent their notes

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and imports from other areas would go up, so other banks would receive more and more

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of their notes and they'd want to exchange those notes for gold, so the bank would begin losing its

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reserves and it would reduce,

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would have an incentive to reduce the expansion of its own notes and deposits.

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When central banking came in, it removed these limits. There's a

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number of limits that

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free banking

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had provided

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against inflation. I mean, there was still local inflation and it was

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still inflationary to an extent,

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fractional reserve banking.

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But before central banks

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there were these limits.

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The limits were, for example, the extent to which people used banks. When you had central banking, people began to trust central banks as lenders of last resort.

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That is that if the bank, if a particular bank failed, the central bank would bail that bank out by loaning to the bank.

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So people began to use banks more and more, put more money into banks.

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Each individual bank, you had that limit being removed because as central banks came in, what they did was they centralized gold reserves.

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For example, in 1917, a few years after the Federal Reserve Bank was created, a law was passed that mandated that all gold reserves be held at the local or at the regional Federal Reserve banks.

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So in exchange for these reserves, what did they get? They got Federal Reserve notes.

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So when people came in to ask for the cash checks and so on, they got Federal Reserve notes rather than their gold.

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Now they could still demand the gold because the Federal Reserve notes themselves were payable in gold.

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But the key point was that people became familiar with these central bank notes

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and they began to look on the paper dollars issued by the central bank as money.

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So the use of gold was discouraged by the fact that they trusted the central bank notes and everyone accepted them.

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They had a much broader acceptance than the individual private bank notes.

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And confidence in banks was bolstered by the central bank.

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There was trust that if the banks got in trouble, they would be bailed out by the central bank.

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and so there was a reduction in bank runs. Now, ultimately, this did not prevent a rash of bank runs during the Great Depression, at the beginning of the Great Depression, from 1931 to 1933.

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Hundreds, thousands of U.S. banks collapsed and eventually to restore confidence in the banking system, as people were pulling their cash out of the banking system,

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To restore confidence, the Federal Deposit Insurance Act was passed, which set up the Federal Deposit Insurance Corporation, the FDIC.

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And that restored confidence.

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And finally, this removed the limit on inflation on any given bank, because now all banks received injections of new reserves.

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Each bank did not hold its own gold. The gold was held in the central bank and the reserves that the banks held were in the form of cash or central bank notes and reserves or deposit, reserve deposits at the central bank.

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So as a central bank, and I'll show you in a moment, as they expanded the money supply or they expanded bank reserves by creating more bank reserves through open market operations and so on, all banks got some of these new reserves.

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So all banks in effect inflated together because the central bank was able to create reserves out of thin air.

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Okay, so let's now, and eventually when we don't run off the gold standard, after 1933 and certainly after 1971, there was really no more, there's no limit on how much the Federal Reserve can increase the money supply. Patrick?

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If you're going to have a central bank in the same place, wouldn't your job necessarily be going to interfere with that when you're back to work with things that haven't been done yet, but the bank that's been run by a central bank?

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Why didn't the Fed act as a lender of last resort in the early 1930s?

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Is that what you're saying? They were trying to. They were increasing reserves.

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But people were pulling their currency out so rapidly that the fall in currency more than offset the increase in bank reserves.

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Okay, now what type of control does the central bank exercise over the money supply?

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Well, the most, the tool that we can call it or a policy tool that they use most frequently and they use really on a daily basis that allows them to manipulate the money supply is called open market operations.

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And that's the purchase or sale of government securities on the private market, either to commercial banks or to individual bond dealers, okay?

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Any time the central bank purchases anything, any time the Fed purchases anything, it increases the money supply, okay?

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Let's assume that you have a used car for sale for $5,000. Let's take a simple example.

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And by the way, since 1980, the Feds permitted to buy almost any asset.

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They used to be restricted to certain assets, government securities, short-term government securities.

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But now they can purchase not only U.S. government securities, they can purchase securities from foreign governments.

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from foreign governments, they're permitted to do that, they can purchase private securities from corporations and so on, so they can purchase, you know, they can buy up the whole economy in effect, if they wish to, but let's say they purchase your used car, okay, they write out a check, say for $5,000 for your used car, they sign it to Fed, okay, you deposit that check in your checking account, and what happens?

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All of a sudden, where there was no money before, there's $5,000 new dollars in checking account money.

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Now your bank loans out 90% of that, and the deposit multiplier process kicks in,

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and over time, that can reach a maximum of $50,000 new dollars in checking accounts throughout the economy.

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Where does that $5,000 come from that the Fed pays you with?

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Finair. They just, you know, just ink. I mean, they're just literally out of finair.

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Yes?

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That's also in front of your office, right? The policy of the central bankers to authorize some kind of bank to do the paper.

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Well, I mean, when the governments run a deficit, governments run a deficit, they can have the central bank indirectly finance

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to finance this deficit by increasing its purchase of bonds, okay?

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Now, what the Fed usually purchases, and then every day between 9 and 11 o'clock,

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it's called Fed time at the New York Federal Reserve System,

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they deal with about 30 privileged bond dealers in New York City.

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What they can do then is they can buy large sums of bonds from these bond dealers.

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Let's say that they purchase $10 million or $100 million worth of bonds from these bond dealers on a given day, and again, they sign it to Fed, well, I mean, it's all done electronically now, it's not even done with paper checks, they'll just shift funds to the bank that the bond dealer uses.

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So now there's a hundred million dollars more in reserves in the banking system.

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The banks can loan them out, the initial banks that receive the deposits of this new money that has been paid for the bonds from the bond dealers and it's multiplied ten times.

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So over time that will increase the money supplied by up to a billion, one billion dollars.

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There are reasons why the maximum amount is never reached, okay?

364
00:50:36.240 --> 00:50:40.740
People will keep some of that money out in the form of currency and will not redeposit it.

365
00:50:40.740 --> 00:50:44.740
To the extent that they do that, the money supply doesn't...

366
00:50:44.740 --> 00:50:49.740
The increase in the money supply is less than $1 billion in this case, okay?

367
00:50:49.740 --> 00:50:56.240
There's also, in certain situations, banks may not loan out all the money they're legally permitted to loan out, okay?

368
00:50:56.240 --> 00:50:59.240
So they can hold what we call excess reserves.

369
00:50:59.240 --> 00:51:05.240
So it might be two and a half or three times the original increase in reserves.

370
00:51:05.240 --> 00:51:13.240
The money multiplier might be. It may not be the full ten times.

371
00:51:13.240 --> 00:51:18.240
Alright, that's open market operating. So if the government wants to decrease the money supply, it does the reverse.

372
00:51:18.240 --> 00:51:24.240
It takes drains reserves out, it sells, it has a huge stock of government reserves.

373
00:51:24.240 --> 00:51:29.240
The Fed earns an enormous income from government securities that it has purchased in the past.

374
00:51:29.240 --> 00:51:36.240
I forget the figures, I meant to bring the article on it, but it's a huge amount.

375
00:51:36.240 --> 00:51:39.240
Most of it is rebated to the Treasury, it's given to the Treasury.

376
00:51:39.240 --> 00:51:43.240
The rest of it is used by the Fed itself to pay its expenses.

377
00:51:43.240 --> 00:51:49.240
And all the regional Federal Reserve banks, the 12 regional Federal Reserve banks, are very, very lush

378
00:51:49.240 --> 00:52:04.240
They used to have a fleet of helicopters. They may have sold them off. The salaries are very, very high. So they're a bureaucracy that does very well for themselves.

379
00:52:04.240 --> 00:52:15.240
In any case, that is the tool that is the most effective tool and the most generally used tool for changing the money supply.

380
00:52:15.240 --> 00:52:26.040
Something else that the Fed is permitted to do and does on occasion is to change the reserve requirement.

381
00:52:26.040 --> 00:52:28.040
Change the reserve requirement, okay?

382
00:52:28.040 --> 00:52:36.740
If it changed the reserve requirement from, let's say, 10%, if it lowered it to 5%, they would never do this because it's an extreme action, okay?

383
00:52:36.740 --> 00:52:50.740
And let's assume for the moment we have about, let's say we have about $600 billion, it's near enough true, in checking account money.

384
00:52:50.740 --> 00:53:00.740
And we have six, so this is equal to total demand deposits in the U.S. system, and we have about $60 billion, let's say, in reserves.

385
00:53:00.740 --> 00:53:08.740
Most of that money is not in cash, most of that money is held in checking accounts at the Federal Reserve Bank.

386
00:53:08.740 --> 00:53:14.740
So the bank's reserves are held as checking accounts at the Federal Reserve.

387
00:53:14.740 --> 00:53:18.740
The Federal Reserve Banks are the banker's bank.

388
00:53:18.740 --> 00:53:25.740
Now suddenly, if they can, they only need to hold 5% to back up the checking accounts rather than 10%,

389
00:53:25.740 --> 00:53:31.740
All banks find that they have in total 30 billion dollars in excess reserves.

390
00:53:31.740 --> 00:53:36.740
30 of that 60 billion does not have to be held. What can they do? They can loan it out.

391
00:53:36.740 --> 00:53:43.740
And as they loan it out, it will be multiplied, as it goes through the multiplier process.

392
00:53:43.740 --> 00:53:47.740
And over time, what's going to happen is that the money supply will double.

393
00:53:47.740 --> 00:54:00.040
Okay, you'll have 60, the reserves don't disappear, the 60 billion dollars in reserves will support 1 trillion, 200 billion dollars in checking account money, okay?

394
00:54:00.040 --> 00:54:03.040
So they can double the money supply at the stroke of a pen.

395
00:54:03.040 --> 00:54:08.440
Now, they don't do that, when they change the reserve requirement, they change it very, very slowly, okay?

396
00:54:08.440 --> 00:54:17.540
They lowered it from 13%, you know, at the end of the 70s sometime, they lowered it slowly to 10%.

397
00:54:17.540 --> 00:54:28.540
Or if they raised it to 20%, all banks would be in violation of the law, all banks would have only 10% in the reserves for the checking account money,

398
00:54:28.540 --> 00:54:36.540
and so they would be all deficient, they would have to call in their loans and it would be a chaotic situation in the banking system.

399
00:54:36.540 --> 00:54:38.540
So they wouldn't do that.

400
00:54:38.540 --> 00:54:43.040
So they only change this very slowly and very infrequently, okay?

401
00:54:43.040 --> 00:54:47.740
Again, it's open market operations that are the most important tool.

402
00:54:47.740 --> 00:54:52.440
And finally, they can change the discount rate.

403
00:54:52.440 --> 00:54:58.140
The discount rate is the rate at which the Fed will loan to banks.

404
00:54:58.140 --> 00:55:00.940
Not many banks will borrow from the Fed, okay?

405
00:55:00.940 --> 00:55:06.840
The reason being that when you, there's an overnight, if banks need reserves, they can borrow from one another.

406
00:55:06.840 --> 00:55:09.640
There's an overnight market called the Fed Funds Rate.

407
00:55:09.640 --> 00:55:12.360
Banks that have x reserves at the end of the day,

408
00:55:12.360 --> 00:55:13.960
okay, reserves that are not earning interest,

409
00:55:13.960 --> 00:55:17.520
but that they don't need to back up their checking account money,

410
00:55:17.520 --> 00:55:20.720
those reserves will be loaned out overnight

411
00:55:20.720 --> 00:55:23.600
to banks that don't have enough reserves.

412
00:55:23.600 --> 00:55:26.360
So it's called the Fed Funds Market.

413
00:55:26.360 --> 00:55:30.560
And banks, if they need reserves,

414
00:55:30.560 --> 00:55:35.480
can get reserves for the short term from each other.

415
00:55:35.480 --> 00:55:47.480
If a bank goes to the Fed, or by the way, if they need longer-term funds, they can issue certificates of deposit and pay interest to people who want to invest their money in the bank for shorter or longer periods.

416
00:55:47.480 --> 00:55:58.480
However, if they go to the Fed to ask for a loan, the Fed will assume that it's having problems.

417
00:55:58.480 --> 00:56:03.480
There's all these funds out there that they can get on the private market. Why are they coming to the Fed?

418
00:56:03.480 --> 00:56:11.480
And usually they wouldn't be having problems. That is, no one will loan to them at a reasonable interest rate because they're in bad shape.

419
00:56:11.480 --> 00:56:20.480
So to make a long story short, the discount rate, when the discount rate is lowered, the bank will, the money supply will increase.

420
00:56:20.480 --> 00:56:31.480
But not many banks are in debt to the Fed and there is maybe an incentive to increase your indebtedness to the Fed, to borrow more from the Fed.

421
00:56:31.480 --> 00:56:36.480
When the discount rate falls, that increases the money supply, as we'll see, and I'll show you why in a moment.

422
00:56:36.480 --> 00:56:40.480
And when the discount rate goes up, banks will tend to pay back their loans to the Fed.

423
00:56:40.480 --> 00:56:44.480
Now, what happens when the Fed loans money to a bank?

424
00:56:44.480 --> 00:56:49.480
Let's say a bank wants to borrow, is having liquidity problems.

425
00:56:49.480 --> 00:56:56.480
And people are withdrawing funds from the bank for various reasons, and their reserves are shrinking.

426
00:56:56.480 --> 00:57:04.480
And they have to pay high interest rates on the private market to get more reserves, so they turn to the Fed.

427
00:57:04.480 --> 00:57:12.480
So they go to the Fed, they call the Fed loan officer and they ask for a loan, let's say, of $100 million.

428
00:57:12.480 --> 00:57:18.480
And at the end of the day, the loan officer calls back and says, you have the loan.

429
00:57:18.480 --> 00:57:24.480
Now, where does the money come from that the Fed loans?

430
00:57:24.480 --> 00:57:26.480
Simply, it's just a blip in a computer.

431
00:57:26.480 --> 00:57:30.480
What the Fed does, it goes to the bank's account at the Fed, which is its reserves,

432
00:57:30.480 --> 00:57:37.480
and it simply credits its account with $100 million.

433
00:57:37.480 --> 00:57:41.480
And then it calls up the bank and says, you now have $100 million that you can loan out.

434
00:57:41.480 --> 00:57:47.480
So just at a key stroke on a computer, bank reserves increase by $100 million,

435
00:57:47.480 --> 00:58:01.480
and that will be then multiplied and expand the money supply by a maximum of 10 times that or $1 billion.

436
00:58:01.480 --> 00:58:10.480
So those are the tools. Now, the key here is to get to the business cycle and we don't have that much time to talk about the business cycle,

437
00:58:10.480 --> 00:58:24.480
We have enough to outline it. Most of the money that is deposited in banks, most bank loans, let's put it that way, most of the bank assets, are loans to businesses.

438
00:58:24.480 --> 00:58:37.480
So what happens when a business gets a loan, a loan that's created out of thin air, a loan that's not based on genuine savings that have been deposited in the bank for a period of time,

439
00:58:37.480 --> 00:58:51.480
of Time, when it's not based on genuine savings, there is a, in order to, let's say the following way, let's say the Fed increases the bank reserves, right, so banks now have more money to loan out, okay.

440
00:58:51.480 --> 00:59:01.480
In order to make additional loans, given that the supply and demand for money is equal at the going loan rate, there's going to have to be a lowering of the interest rate.

441
00:59:01.480 --> 00:59:10.480
If you want to induce businesses and others to borrow more money, the additional reserves that have been created by the Fed out of thin air,

442
00:59:10.480 --> 00:59:14.480
what you have to do then is to induce them by lowering the interest rate.

443
00:59:14.480 --> 00:59:21.480
So what it looks like is the following graphically.

444
00:59:21.480 --> 00:59:29.480
It looks like there has been an increase in genuine savings in the system.

445
00:59:29.480 --> 00:59:57.480
If you look at the top graph here, let's say the going interest rate is 10%, the Fed increases reserves in the banking system through open market operations, loans, loanable funds that the banks have increase, so the banks want to loan more out at 10%, they want to loan this much out.

446
00:59:57.480 --> 01:00:00.480
However, there are no borrowers there at 10 percent.

447
01:00:00.480 --> 01:00:06.480
At 10 percent, borrowers are borrowing this amount, S1, that's how much they want to borrow at 10 percent.

448
01:00:06.480 --> 01:00:16.480
So the banks have to lower their interest rates. So as interest rates are reduced to 7.5 percent, the quantity demanded of loanable funds increases.

449
01:00:16.480 --> 01:00:21.480
So now businesses have more money to invest.

450
01:00:21.480 --> 01:00:33.380
So, the increase in the money supply that goes through the credit markets and winds up in the hands of businesses are then spent on capital goods, and that drives up the price of capital goods, okay?

451
01:00:33.380 --> 01:00:43.080
However, when those new capital goods are, when there's an increase in the production of capital goods to meet this increased demand,

452
01:00:43.080 --> 01:00:51.840
that money is paid out to the construction workers that are building new factories to the factory workers that are producing more machines and so on

453
01:00:51.840 --> 01:00:53.840
the laborers

454
01:00:53.840 --> 01:00:59.360
they're spending money in the same old proportions, in the same old consumption saving ratio

455
01:00:59.360 --> 01:01:02.800
they're going to spend, or spend most of that money on consumption

456
01:01:02.800 --> 01:01:07.760
they're not going to save it, they're not going to reinvest it in the loanable funds market

457
01:01:07.760 --> 01:01:10.400
so what's going to occur

458
01:01:10.400 --> 01:01:11.600
is that

459
01:01:11.600 --> 01:01:38.600
After a little while, the supply of loanable funds will shift back, the interest rate will rise, and the businesses will find out that those investments that they made in the belief that the 7.5% rate was going to continue as the rate on the loan market, that rate is going to rise to 10% and suddenly investment is going to be cut back.

460
01:01:38.600 --> 01:01:42.000
Now, what happens is that the Fed has the power to prevent the interest rate from rising.

461
01:01:42.000 --> 01:01:50.200
That's why they're always saying, they never talk in terms of increasing the money supply, ever since the Greenspan era, the end of the 80s.

462
01:01:50.200 --> 01:01:59.600
Greenspan began to say, we cannot measure the money, not only can't we measure the money supply, or not only can't we control the money supply, we can't even measure it.

463
01:01:59.600 --> 01:02:11.600
So from that point onward, the Fed began to talk about setting interest rates, setting the Fed funds rate, the rate at which banks loan to one another overnight.

464
01:02:11.600 --> 01:02:17.600
But of course, in order to do that, in order to change interest rates, you have to create more money.

465
01:02:17.600 --> 01:02:25.600
But they shifted the focus from changes in the money supply to changes in the interest rate.

466
01:02:25.600 --> 01:02:39.600
So the Fed can prevent this rebounding of the interest rate back to its old level and that level reflects people's true time preferences as expressed in their saving consumption decisions.

467
01:02:39.600 --> 01:02:54.600
The Fed can prevent that from happening and therefore prevent a recession, prevent people from getting laid off in the capital goods industry by continually injecting new money into the system day after day to prevent the rise in interest rates and that's what they're doing today.

468
01:02:54.600 --> 01:03:19.600
In fact, let me show you then, symbolically, how true economic growth differs from what seems to be economic growth that is precipitated by a fall in interest rates that has been orchestrated by the Fed.

469
01:03:19.600 --> 01:03:26.600
So if we start from the Fed increasing bank reserves, so we have open market operations here.

470
01:03:31.600 --> 01:03:36.600
So open market purchases, the Fed's buying securities on the open market.

471
01:03:36.600 --> 01:03:39.600
There's been no change in people's time preferences.

472
01:03:39.600 --> 01:03:41.600
Time preferences haven't fallen.

473
01:03:41.600 --> 01:03:57.600
What that does is to increase bank reserves. And when bank reserves are increased, you get a fall in the interest rate, so the fall in the interest rate.

474
01:03:57.600 --> 01:04:09.600
Businesses borrow more, so we're going to see the effects on two sets of industries here, the consumer goods industries at the top and capital goods industries at the bottom.

475
01:04:09.600 --> 01:04:21.600
As the interest rate falls, there's an increase in investment, which leads to an increase in the demand for capital goods. D sub k represents capital goods.

476
01:04:21.600 --> 01:04:27.600
So the price of capital goods begin to go up now as this new money is spent on capital goods.

477
01:04:27.600 --> 01:04:44.200
The price goes up, leads to an increase in profit, pi sub k, leads to an increase in wages, demand for labor increases,

478
01:04:44.200 --> 01:04:54.200
I should also put that there, demand for labor increases, get higher in capital goods industry, so let's say DL here.

479
01:04:54.200 --> 01:05:09.200
So the demand for labor goes up, and you get an increase in your production.

480
01:05:09.200 --> 01:05:15.200
So you get an increase in the output of capital goods, a beginning of an increase in the output of capital goods, so capital goods go up.

481
01:05:15.200 --> 01:05:19.200
So there's more capital goods being produced in the economy.

482
01:05:19.200 --> 01:05:27.200
But on the other hand, have people cut back on their consumption? No. People do not want more future consumption goods.

483
01:05:27.200 --> 01:05:34.200
The consumption saving ratio stays the same. The Fed has caused the decrease in the interest rate.

484
01:05:34.200 --> 01:05:40.200
It has not been caused by the voluntary actions of individuals who are now saving more and consuming less.

485
01:05:40.200 --> 01:05:47.200
So what's interesting is that there is no change in the demand for consumer goods. That stays the same.

486
01:05:47.200 --> 01:06:01.200
The demand for or the price of consumer goods stays the same as does profits in the consumer goods industry, and wages stays the same.

487
01:06:01.200 --> 01:06:12.200
Now, what happens, because wages are rising in the capital goods industry, workers will leave the consumer goods industry, go into the capital goods industry,

488
01:06:12.200 --> 01:06:32.200
We will have fewer consumer goods produced for a while, and more capital goods produced, as labor leaves here, to get the higher wages that are being offered in the production of capital goods.

489
01:06:32.200 --> 01:06:37.200
What happens, however, is that eventually when those laborers get that new money that has been injected into the system,

490
01:06:37.200 --> 01:06:44.200
when the laborers that are working in the capital goods industry and have received higher wages,

491
01:06:44.200 --> 01:06:52.200
and workers that have transferred from consumer goods industries, from, let's say, making McDonald's hamburgers to producing ovens,

492
01:06:52.200 --> 01:07:01.200
or from working in retail stores to producing more factories and machines that will produce more clothing in the future,

493
01:07:01.200 --> 01:07:07.600
When they begin to make that transition, you get a fall in consumer goods and a rise in the amount of capital goods.

494
01:07:07.600 --> 01:07:14.300
However, at some point, these workers, when they get the new money, they begin spending it, guess where?

495
01:07:14.300 --> 01:07:19.400
On consumer goods. That new money is spent back here on consumer goods.

496
01:07:19.400 --> 01:07:29.400
So the demand for consumer goods goes up and from this angle, all the prices go up, profits go up, demand goes up,

497
01:07:29.400 --> 01:07:33.400
We already said demand for consumer goods go up because the new money is coming into the system.

498
01:07:33.400 --> 01:07:40.400
Now this has an effect of drawing the workers back away from capital goods industries.

499
01:07:40.400 --> 01:07:45.400
If the government stopped, if the Fed stopped increasing the money supply at that point,

500
01:07:45.400 --> 01:07:53.400
it just increased at once, eventually after a few months we would find out that the demand for capital goods,

501
01:07:53.400 --> 01:07:57.400
since there's no more extra funds being loaned out,

502
01:07:57.400 --> 01:08:10.400
The demand for capital goods would fall, wages would tend to fall, and so on, but on the other hand, consumer goods prices would be going up, and profits would be going up, and wages would be going up in the consumer goods industry.

503
01:08:10.400 --> 01:08:24.400
So the economy would, on its own, reallocate labor back to consumer goods, which is what people wanted, because they've never changed their preferences between consumer goods and capital goods.

504
01:08:24.400 --> 01:08:30.400
When that happens, some of the firms that have expanded in the capital goods industry go bankrupt.

505
01:08:30.400 --> 01:08:34.400
Others contract, you get a recession.

506
01:08:34.400 --> 01:08:44.400
The recession would not be very big if it occurred right away after the Fed increased the money supply once, let's say.

507
01:08:44.400 --> 01:08:49.400
But the Fed knows that this is going to happen, it has experience, it knows that once it's lowered the interest rate,

508
01:08:49.400 --> 01:08:55.400
If the interest rate, if it allows the interest rate to go back up, it's going to result in a recession.

509
01:08:55.400 --> 01:09:01.400
So the Fed has the power and the will to continue to increase the money supply day after day.

510
01:09:01.400 --> 01:09:12.400
Now, what eventually undermines the will of the Fed to continue that, increase the money supply and continue maintaining a lower interest rate?

511
01:09:12.400 --> 01:09:25.400
and the fact that eventually the continued increase in the money supply will bring about greater and greater increases in the prices of consumer goods, okay?

512
01:09:25.400 --> 01:09:27.400
So the Fed will want to put a cap on inflation.

513
01:09:27.400 --> 01:09:29.400
This happened in the 70s, okay?

514
01:09:29.400 --> 01:09:34.400
The Fed slammed on the brakes in 1979 when inflation was threatening to get out of hand.

515
01:09:34.400 --> 01:09:39.400
It was up to, you know, 16% on a per annum basis at the end of the court administration.

516
01:09:39.400 --> 01:09:43.240
and that's when they reduced the rate of growth in the money supply.

517
01:09:43.240 --> 01:09:46.680
It was growing very, very rapidly, over 10 percent.

518
01:09:46.680 --> 01:09:49.840
And then they reduced it pretty rapidly, actually.

519
01:09:49.840 --> 01:09:53.320
And the economy was plunged into a deep recession.

520
01:09:53.320 --> 01:09:59.160
Now, during the recession, what businesses go out, what industries are affected the most?

521
01:09:59.160 --> 01:10:06.440
Do you see Walmarts going out of business or Sears or McDonald's?

522
01:10:06.440 --> 01:10:07.120
No.

523
01:10:07.120 --> 01:10:08.720
I mean, they're hurt.

524
01:10:08.720 --> 01:10:14.820
There's a destruction of capital during recession, and people are less wealthy, so you have some effect in consumer goods industries,

525
01:10:14.820 --> 01:10:21.320
but you don't see massive declines in consumer goods industries.

526
01:10:21.320 --> 01:10:33.520
Where do you see the declines? In the construction industry, in the steel industry, in public utilities, in exploring for oil, in mining, all higher order goods.

527
01:10:33.520 --> 01:10:48.520
So what has happened is that the structure of production, if we want to use that terminology, has been artificially lengthened as people began to build more capital goods as a result of the fall in the interest rate.

528
01:10:48.520 --> 01:10:57.520
And it snaps back to its original and correct length when the recession occurs.

529
01:10:57.520 --> 01:11:09.520
So, during the recession, Austrians believe that the recession is the adjustment period, it's a recession adjustment process.

530
01:11:09.520 --> 01:11:18.520
The sooner it happens, the better it is for the economy.

531
01:11:18.520 --> 01:11:23.520
According to the Austrians, recession can only be postponed.

532
01:11:23.520 --> 01:11:26.520
Recessions cannot be abolished.

533
01:11:26.520 --> 01:11:32.880
You plant the seeds of the recession when the Fed begins to inflate.

534
01:11:32.880 --> 01:11:40.640
So the Austrian policy remedy for recession, if you want to prevent recessions,

535
01:11:40.640 --> 01:11:49.760
you don't engage in inflating bank credit or expanding bank credit to begin with.

536
01:11:49.760 --> 01:11:53.240
And that will prevent recessions. However, once you are in a recession,

537
01:11:53.240 --> 01:11:58.480
Don't try to keep the recession from occurring or to get out of the recession by printing new money

538
01:11:58.480 --> 01:12:03.320
because all that does is it causes more maladjustments in the economy,

539
01:12:03.320 --> 01:12:06.760
more labor is being misallocated to capital goods industries,

540
01:12:06.760 --> 01:12:13.240
which will only postpone the recession and make it more intense at some point in the future.

541
01:12:13.240 --> 01:12:23.240
So, it's the inflation that causes the misallocation of resources and the destruction of wealth, okay?

542
01:12:23.240 --> 01:12:32.740
The recession is the adjustment, okay? The inflation causes the maladjustment.

543
01:12:32.740 --> 01:12:38.240
And eventually, the inflation has to come to an end and result in recession

544
01:12:38.240 --> 01:12:48.240
This is because prices begin to rise at rates that are politically unpopular, so the Fed responds to that by slamming on the brakes.

545
01:12:48.240 --> 01:12:57.240
This is why central bankers talk of overheated economy as a means to, because they know that it's going to happen.

546
01:12:57.240 --> 01:13:04.240
Exactly. That's a very good point. The point being that central bankers use the terminology of an overheated economy.

547
01:13:04.240 --> 01:13:07.240
When we have growth, somehow that's going to cause inflation.

548
01:13:07.240 --> 01:13:13.240
But genuine growth, as we saw when we talked about the structure of production, does not cause inflation.

549
01:13:13.240 --> 01:13:18.240
It causes increases in supplies of goods, which causes deflation.

550
01:13:18.240 --> 01:13:21.240
What we might call a growth deflation.

551
01:13:21.240 --> 01:13:28.240
What causes inflation is the fact that the Fed is increasing the money supply.

552
01:13:28.240 --> 01:13:46.240
And it appears as if there's growth going on at the same time because capital goods industries have been stimulated artificially by the lowering of the interest rate and the more ready availability of these funds, which are not really truly saved funds, okay?

553
01:13:46.240 --> 01:13:56.240
So it appears as if growth and inflation goes together because that's an artifact of central banking itself, which attempts to artificially stimulate the economy.

554
01:13:56.240 --> 01:14:02.240
So that's why, and that allows essential bankers to position themselves as people who fight inflation.

555
01:14:02.240 --> 01:14:06.240
They say things like, you know, the economy is overheated.

556
01:14:06.240 --> 01:14:13.240
So we have to respond to that by raising interest rates slightly.

557
01:14:13.240 --> 01:14:14.240
But we don't want to raise them too much.

558
01:14:14.240 --> 01:14:19.240
In other words, they don't want to allow the full recession adjustment process.

559
01:14:19.240 --> 01:14:24.240
But eventually as inflation gets worse and worse, they have to do that.

560
01:14:24.240 --> 01:14:36.240
Milton Friedman thinks that the money goes to 3% per year, or 3% to 5% per year?

561
01:14:54.240 --> 01:15:01.240
He advocates that the money supply grows by about the same rate of growth of the real output in the economy.

562
01:15:01.240 --> 01:15:10.240
So if real output is growing by about 3 percent, and if you increase the money supply by about 3 percent per year, you should have zero inflation.

563
01:15:10.240 --> 01:15:14.240
It should hover around zero. And that's what he advocates.

564
01:15:14.240 --> 01:15:24.240
and he does not believe in the Austrian theory of the business cycle, so he believes that recessions are inherent in the free market economy, which is really a Marxist view,

565
01:15:24.240 --> 01:15:36.240
but that they would end very quickly and they wouldn't turn into anything like the Great Depression if the Fed just maintained a steady course, just kept increasing the money supply at the same rate,

566
01:15:36.240 --> 01:15:43.740
and that inflation and recession are actually due to the Fed following the raw monetary policy.

567
01:15:43.740 --> 01:15:51.240
That is, they either increase the money supply too quickly and too late after the recession has already ended and that brings about a boom.

568
01:15:51.240 --> 01:15:58.240
And then when they respond to the boom, they choke off the increase in the money supply too rapidly and that brings about a recession.

569
01:15:58.240 --> 01:16:02.740
So for Milton Friedman, the worst inflations and recessions result from the Fed.

570
01:16:02.740 --> 01:16:10.740
You would have minor recessions and minor increases in prices as a result of people changing their demand for money, for example.

571
01:16:10.740 --> 01:16:22.740
So Milton Friedman then does not see that even a small increase in the money supply will cause a recession somewhere down the line.

572
01:16:22.740 --> 01:16:42.740
Even one that does not raise prices. We saw in the 1920s, prices did not rise despite the fact that the money supply was increasing at a very rapid rate, somewhere between six and seven percent, according to a definition of the money supply that I believe is the correct definition.

573
01:16:42.740 --> 01:16:47.440
but yet prices hardly rose and the reason why was because

574
01:16:47.440 --> 01:16:51.740
there was tremendous economic growth that occurred during the 1920s

575
01:16:51.740 --> 01:16:54.320
new consumer appliances, electricity,

576
01:16:54.320 --> 01:16:56.800
mass production of automobiles

577
01:16:56.800 --> 01:16:58.480
and so on

578
01:16:58.480 --> 01:17:00.280
and that happened in the 1990s

579
01:17:00.280 --> 01:17:05.320
we had a recession in 2000-2001 prices didn't rise much because again

580
01:17:05.320 --> 01:17:06.560
we had

581
01:17:06.560 --> 01:17:12.060
we had tremendous amount of growth now part of that growth was

582
01:17:12.060 --> 01:17:15.360
artificially stimulated by the lower interest rates.

583
01:17:15.360 --> 01:17:19.860
We did, however, have the collapse of the high-tech bubble,

584
01:17:19.860 --> 01:17:22.500
bubble of financial markets.

585
01:17:22.500 --> 01:17:27.580
And that reflected the fact that the money, just as in the 1920s,

586
01:17:27.580 --> 01:17:31.980
we had a huge boom in the stock market and in certain real estate markets in the 1920s,

587
01:17:31.980 --> 01:17:34.700
just as we did in the 1990s.

588
01:17:34.700 --> 01:17:40.100
So the new money that was being created was causing some distortions in the economy.

589
01:17:40.100 --> 01:17:46.100
It just was hidden by the fact that the increase in the supplies of goods kept prices from rising.

590
01:17:46.100 --> 01:17:47.100
Yes, Alex.

591
01:18:10.100 --> 01:18:26.100
Okay, so the point is that there were only recessions during the periods when we had a quasi-central bank, the first and second banks of the United States, and that during the free banking era there were no recessions.

592
01:18:26.100 --> 01:18:55.100
Well, I think we had minor recessions in the 1850s, but you're right, to the extent that the recession of the 1830s was caused by the previous inflation stimulated or orchestrated by the Second Bank of the United States, which was eventually abolished or not renewed through the efforts of Andrew Jackson.

593
01:18:55.100 --> 01:19:04.100
I just wanted to point out that because it's inherent to the market economy, it's kind of strange because the real recessions, the big ones, really happen on the central bank.

594
01:19:04.100 --> 01:19:15.100
Well, most economists would believe, and certainly Keynesians do, that recessions are inherent in the market economy and that view was really pushed by Karl Marx.

595
01:19:15.100 --> 01:19:23.100
Now, Friedman, to his credit, believes that the worst recessions are caused by bad government policies, including central bank policies.

596
01:19:23.100 --> 01:19:33.100
But he still believes that there are minor recessions that will occur in the economy and that you shouldn't try to fine-tune the economy out of those recessions through fiscal policy and monetary policy.

597
01:19:33.100 --> 01:19:37.100
Just keep a steady growth in the money supply.

598
01:19:37.100 --> 01:19:47.100
Which I certainly am opposed to, and most Austrians would see it as causing recessions of its own.

599
01:19:47.100 --> 01:19:52.100
Which Austrian turn up with it, and what is high theory about it?

600
01:19:52.100 --> 01:20:02.100
Well, this theory was originally outlined by Ludwig von Mises, based on the British currency school, some of the writings of the British currency school.

601
01:20:02.100 --> 01:20:12.100
He put that together with Boehm-Bawerk's capital theory and with Vicksel's theory of the effect of changing the money supply on the interest rate.

602
01:20:12.100 --> 01:20:22.100
So there were four runners, but he was the first one really to outline this theory of the business cycle, which is known as the Austrian theory of the business cycle.

603
01:20:22.100 --> 01:20:29.100
Hayek elaborated it even further and cast it in terms of the structure of production.

604
01:20:29.100 --> 01:20:36.100
So, Hayek was, his exposition is very, very good, I highly recommend it.

605
01:20:36.100 --> 01:20:44.100
Mises first outlined the theory in The Theory of Money and Credit in 1912, elaborated it more in 1928.

606
01:20:44.100 --> 01:20:53.100
Hayek wrote a book, Monetary Theory and the Trade Cycle, came out in 1928, that elaborated parts of this theory,

607
01:20:53.100 --> 01:21:00.140
theory, but then fully elaborated it in a series of lectures that became prices and production.

608
01:21:00.140 --> 01:21:04.140
Those lectures were given at the London School of Economics in 1930.

609
01:21:04.140 --> 01:21:08.620
So it's sometimes with the Mises-Hayek theory of the trade cycle.

610
01:21:08.620 --> 01:21:14.860
Hayek did make important contributions to this theory.

611
01:21:14.860 --> 01:21:19.340
So it is Mises's, Mises originated the theory.

612
01:21:19.340 --> 01:21:27.340
And Rothbard added some refinements and accepts this theory.

613
01:21:27.340 --> 01:21:32.340
What is Hayek's Triangle?

614
01:21:32.340 --> 01:21:44.340
Hayek's Triangles are a way of representing the structure of production and the effects of injections of money through credit markets,

615
01:21:44.340 --> 01:21:54.340
and the creation of credit by the Fed, the effects of that on distorting the structure of production and bringing about the business cycle.

616
01:21:59.340 --> 01:22:04.340
I don't know what Dr. Block's criticism of the triangles are. I'll have to take a look at that. Curtis?

617
01:22:14.340 --> 01:22:38.340
In Europe, the question is, in Europe there is inflation targeting, where central banks aim at a certain rate of inflation, a deliberate rate of price increase, not just an increase in the money supply, but they want to increase prices in a certain range, let's say 2 to 4 percent.

618
01:22:38.340 --> 01:22:49.340
And our current chairman of the Federal Reserve, Ben Bernanke, is also an advocate or has written on the inflation targeting.

619
01:22:49.340 --> 01:22:59.340
What's interesting is, this is certainly not based on the Austrian theory by any means, the rates that people are looking at, 3, 4%, whatever it is,

620
01:22:59.340 --> 01:23:10.340
because older Keynesians like Paul Samuelson call that, year after year, increase the price level, they call that a disease, okay?

621
01:23:10.340 --> 01:23:22.340
So people's mentalities have changed since we've had experience with inflation, high inflation in the 70s and 80s, okay?

622
01:23:22.340 --> 01:23:40.340
It's certainly against it and it certainly will cause a business cycle and in fact, as people begin to expect this inflation to continue, there may be an effect on their demand for money.

623
01:23:40.340 --> 01:23:50.340
People may reduce their demand for money causing inflation to go above the range and then the central bank might be frightened to stop that inflation for fear of a recession.

624
01:23:50.340 --> 01:24:00.340
So there are real problems with this inflation targeting approach. There are other problems. I'm not going to get into now. Any other questions? Alex?

625
01:24:00.340 --> 01:24:25.340
Yes, I want to address, there's been a lot of people saying that a revert back to the gold standard would be correct, or it would be feasible, because the amount of transactions going on in the United States and the world is not sufficient to supply gold, or in the world is not sufficient to supply the transactions.

626
01:24:25.340 --> 01:24:36.840
I mean, so the objection of going back to the gold standard is that there isn't sufficient amount of gold in the world to support the transactions that are occurring, okay?

627
01:24:36.840 --> 01:24:42.840
Well, the simple answer to that is that at the right price is always enough gold, okay?

628
01:24:42.840 --> 01:24:48.840
So if gold was $2,000 an ounce, there would be enough gold to back up or $5,000 an ounce.

629
01:24:48.840 --> 01:24:54.840
There would be enough gold in the world to serve as a medium of exchange, okay?

630
01:24:54.840 --> 01:24:59.840
Now, there are real problems with the transition back to a gold standard.

631
01:24:59.840 --> 01:25:10.840
It doesn't mean that they can't be solved, but we have to be very careful in planning how to get gold back into circulation as money.

632
01:25:10.840 --> 01:25:22.840
The gold that was stolen from the American people in 1933 by President Roosevelt is all held now by the government.

633
01:25:22.840 --> 01:25:40.840
One way of getting back to a gold standard is to redefine the dollar in terms of gold, but the price of gold will be very, very high in order to back demand deposits and currency with gold, 100% for example.

634
01:25:40.840 --> 01:25:52.840
Do you agree with creating legal tender, practice metals as legal tender, not backing the U.S. dollar with practice metals, making practice metals also legal tender?

635
01:26:10.840 --> 01:26:21.840
so that as paper money depreciates or starts to depreciate very rapidly, people will then have the alternative to begin to use gold as a medium of exchange.

636
01:26:21.840 --> 01:26:38.840
I think there's problems with that, but I'm certainly in favor of going back to or getting rid of the legal tender laws that force people to accept paper money for payment of debt, for discharge of debts that are incurred.

637
01:26:38.840 --> 01:26:43.560
and Kirk. But I don't know if that plan will get us back to a gold standard. I

638
01:26:43.560 --> 01:26:48.240
think this is a frontier of Austrian economics where we have to have more

639
01:26:48.240 --> 01:26:56.320
research done. Okay, any other questions? Okay, thank you.