WEBVTT NOTE Anatomy of a Market Meltdown 1 00:00:00.000 --> 00:00:05.200 Okay, I might mention that the title was suggested to me by the conference organizers. 2 00:00:05.200 --> 00:00:12.000 I hope the talk lives up to the title, but I also say if you don't find the talk particularly uplifting, 3 00:00:12.000 --> 00:00:14.400 then you want to blame the organizers and not me. 4 00:00:14.400 --> 00:00:18.000 We're talking about a meltdown here. 5 00:00:18.000 --> 00:00:21.900 But I talk about these same sorts of things in class. 6 00:00:21.900 --> 00:00:26.900 And in fact, I tell my class that if they sign up for my course in macroeconomics, 7 00:00:26.900 --> 00:00:28.800 they'll get a balanced view. 8 00:00:28.800 --> 00:00:34.800 That is one view from me and another view on the network news when they hear from the administration officials, okay? 9 00:00:34.800 --> 00:00:40.800 Things aren't quite as rosy as the officials would lead you to believe. 10 00:00:40.800 --> 00:00:48.800 The anatomy of a market breakdown. I do teach macroeconomics, so I'm inclined to think in terms of fiscal policy and monetary policy. 11 00:00:48.800 --> 00:01:00.800 In fact, what most of us see brewing right now is a collision course that is going to have the monetary authority at odds with the fiscal authority. 12 00:01:00.800 --> 00:01:17.800 And it all hinges on such things as the national debt and the annual deficits, the trends in saving these days, and the Fed's ability to control credit markets and monetary aggregates. 13 00:01:17.800 --> 00:01:20.800 So those are the kinds of things I'll be focusing on. 14 00:01:20.800 --> 00:01:23.800 And where better to start than what's been in the news lately, 15 00:01:23.800 --> 00:01:27.800 which is the federal budget deficits. 16 00:01:27.800 --> 00:01:31.800 So on my first slide here, I've pulled up a number of charts, 17 00:01:31.800 --> 00:01:35.800 this being the first one that will clue you in about what's going on 18 00:01:35.800 --> 00:01:39.800 and put in perspective what you've been seeing on the news. 19 00:01:39.800 --> 00:01:43.800 The yellow line is the zero line, that's a balanced budget. 20 00:01:43.800 --> 00:01:55.800 You can see that we had a surplus during the boom years of the Clinton administration, a deficit to follow, and this chart comes from the St. Louis Federal Reserve. 21 00:01:55.800 --> 00:02:07.800 Federal Reserve Economic Data, affectionately known as FRED, I've got it linked to my own website where you can click in and see what's going on graphically and otherwise. 22 00:02:07.800 --> 00:02:17.600 This chart shows the deficit as of the end of this previous fiscal year, which ended the first day of this month. 23 00:02:17.600 --> 00:02:23.500 And it's got an overestimate. It shows just over $400 billion in the red. 24 00:02:23.500 --> 00:02:27.200 And if you've listened to news accounts lately, it came in a little less than that, 25 00:02:27.200 --> 00:02:32.400 something that the administration ballyhooed quite joyously. 26 00:02:32.400 --> 00:02:36.200 It came in at $374 billion. 27 00:02:36.200 --> 00:02:49.200 And in a way I wish it had come in just a little less. I would have liked to have seen the figure 365 billion because that might have reminded a few people that that translates into a billion dollars a day. 28 00:02:49.200 --> 00:03:01.200 That's the rate at which the government's borrowing. And in fact, these days it's been borrowing at a clip of about a billion and a half a day. 29 00:03:01.200 --> 00:03:09.000 Now, projections for the next fiscal year are for 500 billion dollars or more, and that's 30 00:03:09.000 --> 00:03:11.040 from the administration officials. 31 00:03:11.040 --> 00:03:16.720 And so my suspicion is it will be more and possibly quite a little bit more. 32 00:03:16.720 --> 00:03:22.720 We can add that onto our graph, expect it to go down to about 500 billion, something 33 00:03:22.720 --> 00:03:23.840 like that. 34 00:03:23.840 --> 00:03:29.360 And if it goes to 525, that's sort of another interesting figure because that one translates 35 00:03:29.360 --> 00:03:32.720 into a million dollars a minute, all right? 36 00:03:32.720 --> 00:03:36.600 Again, borrowing at a pretty good clip. 37 00:03:36.600 --> 00:03:37.760 It's not even tapering off. 38 00:03:37.760 --> 00:03:40.040 If you adjust for the 374 this time, 39 00:03:40.040 --> 00:03:43.040 it's pretty much a straight line headed down. 40 00:03:43.040 --> 00:03:45.520 Let's take a close-up at this, 41 00:03:45.520 --> 00:03:50.520 or rather take a long shot at this same graph 42 00:03:51.100 --> 00:03:56.100 and put in perspective the previous depths of debt 43 00:03:56.800 --> 00:03:58.500 and the current depths. 44 00:03:58.500 --> 00:04:04.100 Because you hear it debated on the news whether or not the current level of indebtedness or 45 00:04:04.100 --> 00:04:11.940 the current rate of borrowing, the deficits, is worse than the deficits that were run under 46 00:04:11.940 --> 00:04:16.180 the first Bush administration. 47 00:04:16.180 --> 00:04:22.020 So we're entitled to ask, will the Bush 43 deficit of 2004, what we're going to take 48 00:04:22.020 --> 00:04:27.380 to be about 500 and that's a charitable figure. Is it worse than the Bush 41 49 00:04:27.380 --> 00:04:33.300 deficit of 1992? Once again let me get those deficits down there where they need 50 00:04:33.300 --> 00:04:39.860 to be, okay, something like that and then around 500 billion and if you look at 51 00:04:39.860 --> 00:04:50.020 at the point I've shown there that's the 500 and in 1992 deficits were as great 52 00:04:50.020 --> 00:05:16.520 is 293 billion. Well, you can look at it and see which one's worse in nominal terms, but the administration is right there to put a smiley face on it, put a happy face on it, and of course the first thing they do is divide it by gross domestic product and show you that it's not so bad now, given that GDP is actually higher and substantially higher than it was in 1992. 53 00:05:16.520 --> 00:05:22.020 The first thing I want to do is warn you against that particular reckoning of the deficit. 54 00:05:22.020 --> 00:05:30.240 If you remember your macro from college years, you know that GDP measures essentially everything. 55 00:05:30.240 --> 00:05:34.240 It's all spending on consumer goods, net investment, government spending. 56 00:05:34.240 --> 00:05:35.240 It's the whole shooting match. 57 00:05:35.240 --> 00:05:36.240 It measures everything. 58 00:05:36.240 --> 00:05:45.280 And it's almost trivially true that anything is fairly small compared to everything. 59 00:05:45.280 --> 00:06:15.280 Okay, it just works that way. It works that way. Okay, and so I show that to you in numbers for those of you who are numbers prone to compare deficit to GDP, 1992 is 4.7 percent, okay, and 2004 with, I'm allowing for a little growth next year, probably a little more than we'll actually have, 4.5 percent, so on that basis we're actually, looks like three tenths 60 00:06:15.280 --> 00:06:17.280 The Theory of Money and Credit 61 00:06:45.280 --> 00:06:51.760 Compute the figures and what you'll notice is that the saving has actually been going 62 00:06:51.760 --> 00:06:56.520 down in the last two or three years in absolute terms and it certainly hasn't been going up 63 00:06:56.520 --> 00:07:02.560 generally as fast as income, partly because of administration policies and Federal Reserve 64 00:07:02.560 --> 00:07:04.120 policies. 65 00:07:04.120 --> 00:07:07.000 So let's look at saving. 66 00:07:07.000 --> 00:07:08.440 So compare deficit to saving. 67 00:07:08.440 --> 00:07:13.100 This is my ratio and I'm amazed at how little this ratio ever gets used. 68 00:07:13.100 --> 00:07:37.400 In 1992, the government was borrowing the equivalent of about 28.8% of total gross savings, 69 00:07:37.400 --> 00:07:42.500 that's private and corporate savings, in this country. 70 00:07:42.500 --> 00:07:48.500 Now, it's up to 35.7, so well over a third of the total savings, right? 71 00:07:48.500 --> 00:07:52.500 And I argue that's a large number and it's a substantial increase. 72 00:07:52.500 --> 00:07:59.500 I'll show you later why this is a particularly relevant number and in what sense we consider 35.7% to be large, 73 00:07:59.500 --> 00:08:04.500 although it may occur to you as obvious that that's a fairly large figure. 74 00:08:04.500 --> 00:08:09.500 I might mention at this point that there's been an interesting turnaround 75 00:08:09.500 --> 00:08:28.500 In the apologetics about the government borrowing, if you remember back in the old days, the heyday of Keynesianism, the popular bromide, to dismiss any worries about deficits, is that we owe it to ourselves. 76 00:08:28.500 --> 00:08:34.500 You've heard that we owe it to ourselves. That was the old Keynesian bromide popularized by Abba Lerner. 77 00:08:34.500 --> 00:08:45.500 And it strikes me as odd that the current bromide is precisely the opposite of that, but supposedly equally effective, rhetorically, I guess. 78 00:08:45.500 --> 00:08:52.500 And the way it's typically stated is that, oh, we have access to world capital markets. 79 00:08:52.500 --> 00:08:58.500 Now, what that translates into is we don't owe it to ourselves. 80 00:08:58.500 --> 00:09:21.500 So watch, and it's not too unusual to find both claims in the same article, okay, don't worry about the deficit, because A, we owe it to ourselves, and B, we don't owe it to ourselves, because we're borrowing the world capital markets, okay, so we need to get it straight, which is it, and it turns out, of course, neither is an excuse for running astronomically high deficits. 81 00:09:21.500 --> 00:09:27.900 Now it's true, as someone might point out, that the federal government isn't literally 82 00:09:27.900 --> 00:09:32.780 borrowing 35.7% of your savings, of domestic savings. 83 00:09:32.780 --> 00:09:37.580 In fact, if they were, if the only access to saving they had was the saving that's done 84 00:09:37.580 --> 00:09:44.420 in this country, then interest rates would be sky high rather than in the basement. 85 00:09:44.420 --> 00:09:47.620 In fact, most of the borrowing these days is done abroad. 86 00:09:47.620 --> 00:09:51.620 and our foreign trading partners are the ones that are holding the debt 87 00:09:51.620 --> 00:09:55.620 and foreign central banks are holding the U.S. debt. 88 00:09:55.620 --> 00:10:02.620 But that creates a problem in its own right because there's no reason that we should count on them 89 00:10:02.620 --> 00:10:07.620 continuing to be willing to lend our government that much money. 90 00:10:07.620 --> 00:10:11.620 And should they stop, should they decide it's a bad deal, 91 00:10:11.620 --> 00:10:19.620 Then we would get the problems in a more dramatic way and in a more at home way with high interest rates. 92 00:10:19.620 --> 00:10:23.620 We'll see more about that later as well. 93 00:10:23.620 --> 00:10:34.620 Okay, well that having been said, maybe I've convinced you that deficit problem now, at least in comparison to savings, actually worse than before. 94 00:10:34.620 --> 00:10:39.620 But you might ask, well, why can't we just do the same thing we did before? 95 00:10:39.620 --> 00:10:41.300 or it looks like we got out of it before. 96 00:10:41.300 --> 00:10:43.700 In other words, look at your 1992 point. 97 00:10:44.780 --> 00:10:49.780 Can't we just do in 2003, what we did in 1992? 98 00:10:50.500 --> 00:10:52.660 Okay, and you can see it on the graph. 99 00:10:52.660 --> 00:10:57.660 In 2002, we came out of that borrowing binge, right? 100 00:10:58.060 --> 00:11:01.380 And so we can ask, well, can't we do the same thing then 101 00:11:02.680 --> 00:11:04.760 in 2003? 102 00:11:04.760 --> 00:11:07.340 And I'll show you why we can't, okay? 103 00:11:07.340 --> 00:11:12.340 First, let me remind you of what happened in 1992. 104 00:11:14.020 --> 00:11:15.980 The upturn started, actually, 105 00:11:15.980 --> 00:11:20.540 before the Bush 41 presidency ended. 106 00:11:20.540 --> 00:11:25.540 And it started with Bush's taking on of Jim Baker 107 00:11:26.240 --> 00:11:30.420 as his campaign advisor to think of something quick 108 00:11:30.420 --> 00:11:31.900 so that they didn't lose the election 109 00:11:31.900 --> 00:11:33.580 to that guy from Arkansas. 110 00:11:34.820 --> 00:11:36.840 And what Jim Baker could think of, of course, 111 00:11:36.840 --> 00:11:46.200 was a monetary stimulant, so the Federal Reserve began stimulating the economy in late 1992, 112 00:11:46.200 --> 00:11:51.280 too close to the election to have any effect before the election, in other words, too close 113 00:11:51.280 --> 00:11:59.520 to save George Bush from defeat, but it started then and eventually it created an economic 114 00:11:59.520 --> 00:12:08.080 Boom. Clinton kept the boom going and stepped it up going into 1996 in order to facilitate his 115 00:12:08.080 --> 00:12:16.600 re-election and so we had a tremendous boom of the sort that Sean Corrigan was telling you about in 116 00:12:16.600 --> 00:12:21.640 last lecture. Now the way it was triggered of course was by lowering the interest rates, 117 00:12:21.640 --> 00:12:27.760 dropping interest rates, getting interest rates low to stimulate investment and create the boom. 118 00:12:27.760 --> 00:12:32.760 Now, that can't happen now simply because interest rates are already in the basement. 119 00:12:32.760 --> 00:12:34.760 They're already too low. They're out of slack. 120 00:12:34.760 --> 00:12:38.760 Or as the way the press likes to couch it. 121 00:12:38.760 --> 00:12:46.760 I'm sort of amused by this because you hear this metaphor that Greenspan doesn't have many arrows left in his quiver. 122 00:12:46.760 --> 00:12:49.760 That's the way it gets stated. 123 00:12:49.760 --> 00:12:53.760 Well, let's take a closer look at that and see what we can make of it. 124 00:12:53.760 --> 00:13:03.760 Here, what I've plotted for you, again, I'm getting this straight out of the St. Louis Fed database is the federal funds rate. 125 00:13:03.760 --> 00:13:11.760 That's the interest rate at which banks swap reserves back and forth among themselves at the end of each business day. 126 00:13:11.760 --> 00:13:16.760 And the Fed is in there manipulating that rate by sweetening the pie. 127 00:13:16.760 --> 00:13:23.860 We'll add to the reserves if it wants the rate lower or subtract from the reserves if it wants the rate higher. 128 00:13:23.860 --> 00:13:34.060 Well, you can see if you look in 1992, I'll flag it for you right there, that the interest, the federal funds rate was about 4% in early 1992. 129 00:13:34.060 --> 00:13:43.360 You can see in late 92 and throughout 93, the interest rate was held down to around 3%, give or take a little. 130 00:13:43.360 --> 00:13:46.660 And that's what got the boom started, okay? 131 00:13:46.660 --> 00:13:58.360 But if you look at the situation now, we got a 1% federal funds rate, and so that's the idea that there's not much room left. 132 00:13:58.360 --> 00:14:05.260 And I'll take for you this small portion over here and just, okay, how many arrows are left in Greenspan's quiver? 133 00:14:05.260 --> 00:14:08.860 That's the burning question you want to take home with you, I guess. 134 00:14:08.860 --> 00:14:14.360 That's just a blow up of the last 10 years of that same graphic. 135 00:14:14.360 --> 00:14:26.360 And here, we can see that 1% rate, okay, and realize, though, that the way the Fed is set up, or at least the way it has been set up for decades, 136 00:14:26.360 --> 00:14:33.360 is that there's two rates that allow banks to borrow to meet the reserve requirement. 137 00:14:33.360 --> 00:14:39.360 One is this federal funds market, that's the 1%, the target rate, that's the rate you always hear on the network news 138 00:14:39.360 --> 00:14:46.360 The Federal Reserve, fiat money, fractional reserve banking, Human Action, Man Economy and State, The Theory of Money and Credit 139 00:15:09.360 --> 00:15:16.360 And the discount rate is, I call it an administered rate, which is to say it simply is what the Fed says it is. 140 00:15:16.360 --> 00:15:23.360 And the Fed has traditionally held that rate below the federal funds rate. 141 00:15:23.360 --> 00:15:29.360 Well, how far below can you go when the federal funds rate is 1%? 142 00:15:29.360 --> 00:15:35.360 Well, let's take a look. 143 00:15:35.360 --> 00:16:05.360 Here's the discount rate, and in late 2003 it was set at three quarters of one percent, which is a low of lows, okay, it'd be a fraction of a percent, in fact this is one of the reasons, this is one of the things that critics of the Fed would point to, to suggest it doesn't have many arrows left in its quiver, it's just trying to lower the federal funds rate and yet it has to keep that discount rate somewhere below the federal 144 00:16:05.360 --> 00:16:09.360 and the Federal Funds Rate, and here at 0.75%. 145 00:16:09.360 --> 00:16:12.360 Well, one thing you'll notice about this chart 146 00:16:12.360 --> 00:16:14.360 is that it looks like it stops. 147 00:16:14.360 --> 00:16:17.360 In fact, it does stop just short of 2003, 148 00:16:17.360 --> 00:16:20.360 but we're well beyond the beginning of 2003. 149 00:16:20.360 --> 00:16:24.360 And so it turns out that it's almost under the radar screen. 150 00:16:24.360 --> 00:16:27.360 It just didn't get much reporting on the news. 151 00:16:27.360 --> 00:16:29.360 But that whole policy was discontinued. 152 00:16:29.360 --> 00:16:31.360 The time series is discontinued. 153 00:16:31.360 --> 00:16:33.360 The discount policy, as we knew it, was discontinued 154 00:16:33.360 --> 00:17:03.360 and what was instituted instead was a system of primary and secondary credits depending on what kind of shape the bank is in and what was called the discount rate is now called the primary credit rate and if the bank is in trouble it borrows at some secondary credit rate which is a little bit higher but let me show you how that works the primary credit rate was 155 00:17:03.360 --> 00:17:31.360 at the very beginning of this calendar year at 2.25 percent, okay, so up here, in fact, I'll stick it on there like so, so you can see all of a sudden in just one policy move on the part of the Federal Reserve, it increased that used to be discount rate by that much and then dropped it even later in the year to 2.0 percent and that's where it stands right now. 156 00:17:31.360 --> 00:17:38.640 So now if you tap into the Federal Reserve website each time that the Federal Open Market Committee meets, 157 00:17:38.640 --> 00:17:45.280 instead of hearing or instead of reading an announcement about the Fed funds rate and the lower discount rate, 158 00:17:45.280 --> 00:17:51.440 you hear an announcement about the federal funds rate and the now higher primary credit rate. 159 00:17:51.440 --> 00:17:56.000 Now why do they do this? I suggest that the reason is to give them more room, 160 00:17:56.000 --> 00:18:00.240 to give them some slack between where they are, namely 1% and zero, 161 00:18:00.240 --> 00:18:28.240 To get that primary rate above the federal funds rate, I've plotted, in fact I pulled this off of the St. Louis Fed site and it's a new series because we just started it beginning this year, so it shows that primary credit rate at 2.5% or 2.25% and then dropping to 2% in middle of June, where it remains. 162 00:18:28.240 --> 00:18:44.240 So, I think I'll summarize down here, the Fed now has a primary credit rate above the Fed funds rate, instead of a discount rate below it, and that might help you out in your Fed watching, if any of you are in the business of Fed watching, to see what it's doing these days. 163 00:18:44.240 --> 00:18:51.640 Now, still, it doesn't have much room to maneuver, and some people have suggested that, well, 164 00:18:51.640 --> 00:18:56.980 the Fed can do more than just control the federal funds rate, or can do more than just 165 00:18:56.980 --> 00:19:02.060 control interest rates, it can control the money supply directly, just target reserves 166 00:19:02.060 --> 00:19:08.320 or target the money supply measured somehow. 167 00:19:08.320 --> 00:19:16.280 Let me speak first and very briefly about the possibility of it targeting other rates. 168 00:19:16.280 --> 00:19:20.000 This is a possibility and this is what the Fed itself has discussed. 169 00:19:20.000 --> 00:19:27.840 There was a conference at the Dallas Fed fairly early in 2003 to discuss the idea of how to 170 00:19:27.840 --> 00:19:31.840 deal in a zero-interest economy and what to do. 171 00:19:31.840 --> 00:19:37.560 And they're talking about the Fed funds rate possibly getting down as low as zero, at which 172 00:19:37.560 --> 00:19:51.560 The average point they conceive of possibly targeting other longer-term rates, of bidding down the long-term treasury rates, buying long-term treasury bills or treasury bonds or something like that, rather than short-term treasuries. 173 00:19:51.560 --> 00:19:58.560 It still has an effect on the Fed funds rate because when they buy, the funds they buy with become federal funds. 174 00:19:58.560 --> 00:20:03.560 They'll lend out a correspondingly lower rate than before the purchase. 175 00:20:03.560 --> 00:20:08.560 Plus, it's a little bit risky. It's a dangerous thing. In fact, it could be a part of the meltdown. 176 00:20:08.560 --> 00:20:19.560 It's a dangerous thing to be twisting that yield curve, to be pushing down long-term rates down close to where short-term rates are. 177 00:20:19.560 --> 00:20:24.560 Because if you think of it, the whole business of commercial banking is borrowing short and lending long. 178 00:20:24.560 --> 00:20:26.560 That's how profits are made in the banking industry. 179 00:20:26.560 --> 00:20:32.560 And if you've got a Federal Reserve in there pushing long rates down relative to short rates, 180 00:20:32.560 --> 00:20:41.560 You pretty much destroy the profitability of commercial banking and that would be another problem to deal with that might be worse than the one that they've got now. 181 00:20:41.560 --> 00:20:49.560 Now, beyond meddling with interest rates at all, it's certainly possible for the Fed simply to increase reserves. 182 00:20:49.560 --> 00:20:57.560 It always has the capacity to increase reserves and thereby increase the money supply and expand that way. 183 00:20:57.560 --> 00:21:05.060 But the Fed simply doesn't have the mechanisms in place to do that, that it once had. 184 00:21:05.060 --> 00:21:10.860 And it also stands to do more damage than harm in a very special way. 185 00:21:10.860 --> 00:21:12.560 Let me take a look at that now. 186 00:21:12.560 --> 00:21:20.060 So I'll ask the question here, should the Fed return to money growth targeting? 187 00:21:20.060 --> 00:21:26.560 That's what the Fed did when Volcker became chairman back in the late 70s. 188 00:21:26.560 --> 00:21:27.820 and that's what the Fed did 189 00:21:27.820 --> 00:21:31.160 for the first several years of the 1980s, 190 00:21:31.160 --> 00:21:34.280 only later to abandon it and to go once again 191 00:21:34.280 --> 00:21:37.640 to interest rate targeting. 192 00:21:40.020 --> 00:21:43.160 The first question that I would raise 193 00:21:43.160 --> 00:21:47.160 is the question of which monetary aggregate 194 00:21:47.160 --> 00:21:48.940 would they supposedly target? 195 00:21:48.940 --> 00:21:51.160 You see, back in the heyday of monetarism, 196 00:21:52.040 --> 00:21:54.360 there was an obvious monetary aggregate look at, 197 00:21:54.360 --> 00:21:58.040 and it was called M1. 198 00:21:58.040 --> 00:22:03.640 It was a crisp definition of the money supply if only because of the existence of regulations 199 00:22:03.640 --> 00:22:11.960 at the time that prohibited the writing checks on savings account and prohibited the payment 200 00:22:11.960 --> 00:22:14.400 of interest on checking accounts. 201 00:22:14.400 --> 00:22:19.720 You got a virtual black and white distinction between what's money and what's not money. 202 00:22:19.720 --> 00:22:24.440 And it gave a crispness to the definition of the money supply. 203 00:22:24.440 --> 00:22:32.560 But Regulation Q was phased out in the early 80s, and the monetary aggregates blend one 204 00:22:32.560 --> 00:22:38.320 into the other in a way that gives the Fed no clue of which one it should be looking 205 00:22:38.320 --> 00:22:39.320 at. 206 00:22:39.320 --> 00:22:46.080 There's even a wonderful soundbite from Greenspan testifying at the Joint Economic Committee 207 00:22:46.080 --> 00:22:55.580 Meeting, a sound bite that's made it onto the Jay Leno show, where Greenspan has asked 208 00:22:55.580 --> 00:23:02.760 the question, why don't you just control the money supply? 209 00:23:02.760 --> 00:23:08.920 And Greenspan said in almost a forlorn tone, well, we just don't know what money is anymore. 210 00:23:08.920 --> 00:23:15.200 Can you imagine the fun that Jay Leno had with this? 211 00:23:15.200 --> 00:23:22.920 Wouldn't you rather have a chairman who at least knew what money is, would help? 212 00:23:22.920 --> 00:23:28.400 But what he meant is that they had lost the crisp target because of the phasing out of 213 00:23:28.400 --> 00:23:36.960 Regulation Q. And you can see M1 has grown sort of haphazardly and in an odd pattern. 214 00:23:36.960 --> 00:23:41.840 But one thing that's revealing about the components of this M1, if you remember your 215 00:23:41.840 --> 00:23:48.040 Macro Theory, M1 consists of currency and coin, that's one component, it used to be 216 00:23:48.040 --> 00:23:53.640 a fairly small component actually, it used to be between 25 and 30 percent, and the rest 217 00:23:53.640 --> 00:23:59.320 of it, the bigger share of M1 is checking account money, some of the balances in your 218 00:23:59.320 --> 00:24:02.040 checking accounts, all right? 219 00:24:02.040 --> 00:24:07.000 And so we can divide this down in its components, and the interesting component to look at is 220 00:24:07.000 --> 00:24:10.000 The Currency Component 221 00:24:10.000 --> 00:24:15.000 Focus on the last 10 years or so of M1. 222 00:24:15.000 --> 00:24:19.000 It looks like it even sags a little and then picks up and so on. 223 00:24:19.000 --> 00:24:23.000 But now let's look at the currency component. 224 00:24:23.000 --> 00:24:31.000 It's going up almost in an exponential path, increasing as we go. 225 00:24:31.000 --> 00:24:38.920 And it turns out there has been a virtual skyrocketing of M1, or I'm sorry, of the currency component of M1. 226 00:24:38.920 --> 00:24:41.420 I've got some statistics on this. 227 00:24:44.600 --> 00:24:47.860 So we've had a dramatic rise in the currency ratio. 228 00:24:47.860 --> 00:24:52.360 That's the C currency divided by that basic money supply. 229 00:24:52.360 --> 00:24:55.200 During the last 10 years, and I went back and just spot checked 230 00:24:55.200 --> 00:24:58.360 and looked at the different currency ratios, 231 00:24:58.360 --> 00:25:03.360 They stayed in the mid to high 20% up until about 93. 232 00:25:04.160 --> 00:25:07.880 And after that, they begin rising fairly rapidly. 233 00:25:07.880 --> 00:25:12.880 So 1993, just 10 years ago, 28.5%, 2003, 50.7%. 234 00:25:16.320 --> 00:25:18.400 So well over half, well not well over, 235 00:25:18.400 --> 00:25:22.240 but just over half of the money supply reckoned as M1 236 00:25:22.240 --> 00:25:23.800 is in the form of currency. 237 00:25:23.800 --> 00:25:25.260 Now you're suspicious about this. 238 00:25:25.260 --> 00:25:28.200 You wonder about this because everything else tells you 239 00:25:28.200 --> 00:25:38.200 So that people tend to use less currency these days than before, they tend to use plastic and they use debit cards and so on, they use less currency. 240 00:25:38.200 --> 00:25:54.200 And the explanation for this is that most of that currency, in fact, that 50.7% adds up to about $650 billion. 241 00:25:54.200 --> 00:26:04.800 Okay, and it turns out that estimates vary, but about 320 billion, in other words, just about half of that currency, is currency held abroad. 242 00:26:04.800 --> 00:26:14.800 Leland Yeager, who is with us today, has compiled some interesting statistics on this currency held abroad. 243 00:26:14.800 --> 00:26:35.800 So as much as $320 billion is U.S. dollars held offshore, either in circulation like in Panama or in circulation in Russia or in stashes like we actually discovered in Iraq and some in Iran and the Middle East generally. 244 00:26:35.800 --> 00:26:46.800 Tremendous amounts of currency. Something like 90% of all the $100 bills are held outside the United States. 245 00:26:46.800 --> 00:26:58.800 And about 80% of the growth in the currency component over the last several years has been currency that has gone outside the United States. 246 00:26:58.800 --> 00:27:03.800 So there's a tremendous amount of currency out there, but offshore. 247 00:27:03.800 --> 00:27:19.800 Now, this is a worrisome thing to the Federal Reserve, because it has no control over how long that stuff stays over there and when it comes back, and how fast it comes back, and it would be very hard to react to it. 248 00:27:19.800 --> 00:27:31.800 The Federal Reserve has been fairly good at reacting to changes in the currency ratio that are minor changes and are caused by such things as the coming of Christmas. 249 00:27:31.800 --> 00:27:39.800 The Greenspan can predict every year, it hasn't missed it once, that Christmas is coming and people carry more cash and makes the adjustment. 250 00:27:39.800 --> 00:27:54.800 He predicts vacation times, okay, when people load up their station wagon and drive to California, well, they don't do that so much anymore, but people use currency and vacation times and Greenspan can compensate for it. 251 00:27:54.800 --> 00:28:00.800 But boy, this is the big one. This is a bunch of currency held abroad that could easily come back 252 00:28:00.800 --> 00:28:07.800 and could come back in a virtual tidal wave, if you stop to think about it, because people have choices these days. 253 00:28:07.800 --> 00:28:14.800 They can hold euros instead of U.S. dollars. 254 00:28:14.800 --> 00:28:22.800 Professor Yeager points out that there was a blip, pretty significant blip in foreign demand for currency 255 00:28:22.800 --> 00:28:28.800 just provoked by our issuing a new $100 bill. 256 00:28:28.800 --> 00:28:30.800 It spooked people. 257 00:28:30.800 --> 00:28:32.800 They didn't want to hold as much, okay? 258 00:28:32.800 --> 00:28:35.800 And possibly a blimp with this new 20. 259 00:28:35.800 --> 00:28:36.800 I don't know. 260 00:28:36.800 --> 00:28:39.800 I mean, the government's spending, what, $33 million trying to advertise the new 20. 261 00:28:39.800 --> 00:28:42.800 I hope it's doing plenty of advertising abroad. 262 00:28:42.800 --> 00:28:43.800 Okay? 263 00:28:43.800 --> 00:28:46.800 Get people to hold this new 20. 264 00:28:46.800 --> 00:28:48.800 Okay? 265 00:28:48.800 --> 00:28:58.800 But one possibly significant factor is that a hundred dollar bill is the largest bill the U.S. produces, 266 00:28:58.800 --> 00:29:03.800 where a euro is produced in 500 euro notes. 267 00:29:03.800 --> 00:29:13.800 And so, certainly for some uses, say in certain uses where you carry your money in suitcases, 268 00:29:13.800 --> 00:29:24.800 Big suitcases. You don't have to have quite as big a suitcase, if you have 500 euro notes, than if you have 100 dollar bills. 269 00:29:24.800 --> 00:29:31.800 So I can imagine that this is part of the discussion around that big boardroom table at the Federal Reserve. 270 00:29:31.800 --> 00:29:40.800 What happens if people substitute out of U.S. dollars and into euros and all those U.S. dollars come back? 271 00:29:40.800 --> 00:29:50.800 The Federal Reserve, fiat money, fractional reserve banking, Human Action, man economy, methodological individualism, Human Action, Man Economy and State, The Theory of Money and Credit 272 00:30:10.800 --> 00:30:16.800 The Federal Reserve is a kind of a tipping model, where once the thing starts to tip, it goes. 273 00:30:16.800 --> 00:30:21.800 And people dump dollars and use something else instead, euros. 274 00:30:21.800 --> 00:30:25.800 If that happens, all the Fed can do is to try to counteract it. 275 00:30:25.800 --> 00:30:34.800 And of course, to try to counteract it means to pull in the money supply, to raise federal funds rate, to contract, right? 276 00:30:34.800 --> 00:30:43.800 Which is to say to do just the opposite of what the fiscal authority wants them to do, which is lower interest rates and buy U.S. government debt. 277 00:30:43.800 --> 00:30:54.800 And in fact, this is the essential reason I say that a meltdown could be the product of a collision course between what the Fed might have to do if that currency comes back 278 00:30:54.800 --> 00:31:01.800 and what the Treasury wants the Fed to do given that it's borrowing at a clip about a million dollars a minute. 279 00:31:01.800 --> 00:31:06.800 Okay? This is certainly something to think about, right? 280 00:31:08.800 --> 00:31:16.800 I might also note, and I'll pull this graph out of a paper written in 2000 by Bradford DeLong. 281 00:31:17.800 --> 00:31:26.800 It's a graph that helps put monetarism of the Friedman brand in a sharp relief, sharp perspective. 282 00:31:26.800 --> 00:31:36.800 Because if you remember your monetarism, Friedman depended on a very tight statistical correlation between the quantity of money and the price level. 283 00:31:36.800 --> 00:31:43.800 And it turns out that that statistical fit was fairly robust during the heyday of monetarism. 284 00:31:43.800 --> 00:31:56.800 When, say, between 60 and 80, this purple line actually here is the pre-1980s trend in the velocity of money. 285 00:31:56.800 --> 00:32:04.800 So the average rate that dollars are spent in the economy had an upward trend, but it was very stable, very predictable. 286 00:32:04.800 --> 00:32:11.800 And in fact, you can see the actual movement in the velocity of money deviated very little from the trend. 287 00:32:11.800 --> 00:32:41.800 Now, it turns out that that all came undone in the early 80s. It was with the phasing out of regulation Q, I would argue, that started the undoing of that stable velocity, which actually I like to refer to as the irony of monetarism, that the monetarist statistics held only to the extent that there was pretty strict regulations imposed on what you can do with a checking account and what you can do with a saving account. 288 00:32:41.800 --> 00:32:49.200 Pull the regulations off and you lose the Christmas of the money supply and the velocity becomes unstable. 289 00:32:49.200 --> 00:32:57.400 It falls well below trend and part of that is because of money going overseas, at least starting in the early 90s. 290 00:32:57.400 --> 00:33:02.600 If we plotted this on out, this is the actual velocity of money. 291 00:33:02.600 --> 00:33:11.780 If you plotted it on out, what you'd see is this curve peeking out around nine, a little over nine, falling back now to somewhere around 8.4. 292 00:33:11.780 --> 00:33:18.780 So it hasn't picked up a different trend. It hasn't just moved to some other trend. It's still jagged up and down and very unpredictable. 293 00:33:18.780 --> 00:33:23.780 And so, see, these are the kind of things that made monetarism work at the time that it did work. 294 00:33:23.780 --> 00:33:33.780 You had a tight definition of money, well-defined, and you had a strong relationship between money and the price level because of a stable demand for money. 295 00:33:33.780 --> 00:33:42.780 and now you don't have any money supply that's easily controlled, you have worries about currency coming back from abroad 296 00:33:42.780 --> 00:33:53.780 and even if you can control the money supply, you don't have a hard line relationship between it and the price level because of this erratic and unstable velocity. 297 00:33:53.780 --> 00:33:56.780 There's a heyday of monetarism back there. 298 00:33:56.780 --> 00:34:03.500 Okay, now let's go back to the fiscal side of it and look at saving, okay, and you can 299 00:34:03.500 --> 00:34:09.820 see that this is a great graph because it's one that puts Keynes in his place, I think. 300 00:34:09.820 --> 00:34:16.100 Here is saving during the Clinton boom, income was going up, consumption was going up, saving 301 00:34:16.100 --> 00:34:21.780 was going up, everything was going up, okay, that's sort of a Keynes-style process and 302 00:34:21.780 --> 00:34:27.580 of course it's temporary and it was bound to turn to a bust but while it 303 00:34:27.580 --> 00:34:33.140 lasted the statistics looked very Keynesian but when the bust came then of 304 00:34:33.140 --> 00:34:36.560 course income growth slowed down actually turned negative in just a 305 00:34:36.560 --> 00:34:40.500 couple of quarters and so if you plotted income it would still be going up but at 306 00:34:40.500 --> 00:34:44.620 a slower pace but saving is going down even in an absolute sense and certainly 307 00:34:44.620 --> 00:34:50.100 relative to what it was okay so this is a saving trend which is one of the 308 00:34:50.100 --> 00:35:05.100 The things that puts the deposit-to-saving ratio up as high as it is, okay, because you've got reduced saving, probably hit around $1400 billion by 2004. 309 00:35:05.100 --> 00:35:16.100 So this makes the deficit-to-saving, puts it in perspective and shows that the Treasury is a big player in credit markets. 310 00:35:16.100 --> 00:35:19.700 Look at the likely movements in the deficit-to-saving ratio. 311 00:35:19.700 --> 00:35:25.060 The deficit is likely to go up, saving is likely to go down further, project those trends, 312 00:35:25.060 --> 00:35:31.100 and you like to have even a bigger player on your hands, which causes lots of trouble. 313 00:35:31.100 --> 00:35:36.660 In fact, here, now, I've summarized for you in a couple of minutes I have remaining what 314 00:35:36.660 --> 00:35:39.300 I like to call the short list of bad options. 315 00:35:39.300 --> 00:35:43.540 Put yourself in the position of a physical strategist for the U.S. government. 316 00:35:43.540 --> 00:35:47.380 What can you do and what should you do? 317 00:35:47.380 --> 00:35:53.700 To get the flavor of this, all you have to do is listen to the nine democratic contenders 318 00:35:53.700 --> 00:36:00.720 for the nomination debate, because each of them has to choose from this short list of 319 00:36:00.720 --> 00:36:04.820 bad options and explain what they would do, you see. 320 00:36:04.820 --> 00:36:06.860 So let's look at the options first. 321 00:36:06.860 --> 00:36:12.580 You could borrow domestically, start borrowing from people at home, monetize debt, get Alan 322 00:36:12.580 --> 00:36:31.580 and Greenspan on your side, borrow abroad, that's what they've been doing largely, raise taxes, you know how that plays in the polls, or continue debating, I mean, that's the current solution, but each of these has consequences, none of which are good, okay? 323 00:36:31.580 --> 00:36:36.100 Borrowed domestically, you're going to get high interest rates. 324 00:36:36.100 --> 00:36:40.620 Monetized debt, you're going to get inflation, and this time, a leveraged inflation, because 325 00:36:40.620 --> 00:36:46.680 if we start seeing debt monetization in this country and start seeing inflation like we 326 00:36:46.680 --> 00:36:54.220 had back in the late 70s and early 80s, then I'll guarantee you that those foreign dollars 327 00:36:54.220 --> 00:36:55.220 are going to come home. 328 00:36:55.220 --> 00:36:59.120 And when they come home, that's going to put a lot of leverage on that inflation. 329 00:36:59.120 --> 00:37:05.440 So, if I want to make one prediction today, and I'm not big on making predictions, but 330 00:37:05.440 --> 00:37:11.360 I'll make one, and that is that we won't have just a little bit of inflation, okay? 331 00:37:11.360 --> 00:37:15.040 We won't have just a little bit, if we have it, it'll be a lot. 332 00:37:15.040 --> 00:37:19.040 A borrower abroad that's going to give you weak export markets and all the problems that 333 00:37:19.040 --> 00:37:24.900 causes, raise taxes, you're going to get dampened market activity all around, and do nothing 334 00:37:24.900 --> 00:37:29.040 but continue debating, you're going to get market uncertainties, that's what we see now, 335 00:37:29.040 --> 00:37:44.040 The whole investment sector is sitting back because they don't know what the climate is going to be in the coming years because nobody has been willing to set a course and stick with it because they don't want to choose from this short list of bad options. 336 00:37:44.040 --> 00:37:53.040 Okay, well let me leave you with a look at the debt. This is debt, not deficit. This is accumulated debt. And look at the recent upturn. Pretty sharp, right? 337 00:37:53.040 --> 00:38:02.040 Now, how many are optimistic and think that what might happen between now and 2010? 338 00:38:02.040 --> 00:38:08.040 If you're optimistic, pay. You know, pay that sucker off, be that free. 339 00:38:08.040 --> 00:38:12.040 Do I have any takers? Okay. 340 00:38:12.040 --> 00:38:18.040 Who's pessimistic? Okay, if it's going that way, we're in trouble in any number of ways. Thank you.