My topic is the financial crisis and the death of macroeconomics. The topic reminds me of
an old joke. A Western observer is at a Soviet May Day parade back in the 1980s and the spectacle
is overwhelming. The parade begins with crack divisions of Red Army troops followed by battalions
and the designs of these very mighty tanks, after which come huge long-range field artillery
rows and rows, followed by the nuclear missiles that are gleaming in the sun.
After that, there's a small group of men not in step at all, sort of puny, undistinguished
looking in ill-fitting suits.
And the Western Observer is puzzled and he turns to his Soviet hosts and he says,
Who or what is that? And they respond,
Well, that's our most terrible and destructive weapon. Those are economists.
Well, those are our macro-economists in the United States.
Alright, so I'm here to support Gary North, what he said yesterday, in trumpeting the
silver lining amid the gloom and doom about the financial crisis. After a long and disreputable
history of about 300 years, in my four words, macroeconomics is finally dead. As Gary pointed
Yesterday, its leading proponents simply do not know what to do anymore. And they've said
this in so many words. In fact, as Murray Rothbard, he actually, Murray was always very
insightful. And back in the 1980s, after the short-lived sort of attraction to monetarism
died out because they had misforecast a recession that never occurred in 1984-85.
Macroeconomics was really dead from the neck up, that was Murray's term. Since the 1980s,
macroeconomics has been a zombie discipline and I'm hoping that this crisis will finally
put the zombie in its grave.
So let me just give you a very short paragraph on where macroeconomics came from. Where
did it come from? Most people think it started with John Maynard Keynes. People that are
a little bit better informed talk about Irving Fisher as the true father of macroeconomics.
He first came up with the quantity theory formulated in an equation. But really macroeconomics
Mises is a crackpot doctrine that came to life in 1705 in a very slim book entitled
Money and Trade Considered with a Proposal for Supplying the Nation with Money.
The author of the book was a Scotsman, his name was John Law, he was a notorious character
who was known throughout Europe as a gambler, philanderer, schemer and escaped convict who
had killed a man in a duel in London.
He was also the first central banker, true.
In 1716, Law became the director of the Royal Bank of France and immediately enacted the
principles set out in his book. In four short years, he created a massive inflationary bubble
that left the French monetary system in ruins when it finally burst. That was the first
macroeconomic crisis. There were many more to come. I'm hoping that this one, the current
So now what I want to do is to set out the dimensions, briefly outline the dimensions of the financial crisis and argue that it really is worse than we think because it brought about a great deal of overconsumption, capital destruction, malinvestment and impoverishment that still has not been revealed.
So let me just talk first about the money supply because it always starts with the money supply.
Macroeconomics is simply the policy conclusion that spending more money can cure anything.
It's been put in different language over the past 300 years, but that's the germ of macroeconomics.
So let's sort the dot-com bubble. It burst in early 2000 leading to a recession in early 2001.
2001. The Fed reacted very aggressively by lowering the target Fed funds rate. The events
of 9-11 led the Fed to ratchet up its expansionary monetary policy. From the beginning of 2001
to the end of 2005, the Fed's, one of the Fed's monetary aggregates that I tend to look
at, which is MZM, increased by about $1 billion per week. They were creating $1 billion new
The monetary base, which is completely controlled by the Fed, increased by about $200 billion
over those years, which was a cumulative increase of about 33%.
The Fed funds rate was driven down below 2% and then held at 1% for almost three years.
Yet inflation during this period was very moderate.
The CPI fluctuated between about 1 and 3%.
However, since modern macroeconomists and central bankers tend to narrowly focus on
consumer prices to determine whether there's inflation in the economy or not, they believe
believe that their monetary policy had succeeded in stabilizing the economy after the dot-com
bust. In fact, they congratulated themselves in the journals and papers that were produced
by the various regional central banks. And they did this by claiming that they had achieved
over the past 20 years a great moderation. In fact, what they had really done is to blow
and blow up a huge asset bubble that began in the 1990s and didn't come to an end until 2007, 2008.
So let me just give you some idea of the dimensions of this.
Okay, this is the Fed funds rate, which starting in 2000 was quite high, it was over 6%.
You can see how it was pushed down and we held that 1% there for a long while.
Then, Greenspan allowed it to rise, and that's when we began to get the end of the housing bubble.
And now, it's been pushed down, again, as the recession took place, the gray bar represents the periods of recession.
As the recession took place, it was pushed down to between 0 and 0.25%.
Here are the measures of the money stock. If you notice that both MZM and M2 were just about $5 trillion in 2001 or so.
Today, MZM is between $9 and $10 trillion, M2 representing almost a doubling of the money supply in about nine years.
The massive increase in the money supply.
One thing you should notice is that both of these aggregates
began to flatten out in about mid-2009.
We haven't had much monetary growth during that period.
We've had qualitative easing.
But now they're threatening us with quantitative easing again.
Qualitative easing simply means socializing
the financial system, trading government assets for bad assets,
taking over financial institutions and so on.
Quantitative easing simply means printing money.
Okay, so we're gonna be back to printing money again.
Those lines are gonna start to rise again, very soon.
And then this is consumer price inflation,
which shows that from 1990 or so,
except for short periods,
it fluctuated between one and 3%, you can see the,
and then shot up right as the recession hit.
But for the most part, it was fairly moderate by historical standards.
Now let's talk a little bit about the mortgage market.
As many Austrians pointed out at the time, the wildly expansionary monetary policy
ignited a boom in asset prices, especially in the real estate and stock markets.
Rates on 30-year conventional mortgages fell sharply from over 7% in 2002 to a low of 5.25% in 2003
and then fluctuated between 5.5% and 6% until late 2005.
But this wasn't really the important story.
The important story, and what was more significant, was that one year adjusted rate mortgages,
Their rates plummeted from a high of 7.1% in 2000 to a low that was cut in half of 3.75% in 2003.
And then they rose to about 4% and stayed there, but for 2004-2005.
In addition, and importantly, credit standards were loosened and unconventional mortgages including interest only,
This caused a rapid expansion of mortgage lending and especially of subprime mortgage lending.
The subprime share of the mortgage market rose from 8.62% in 2000 to about 13.5% in 2005.
So, yeah, tremendous increase in subprime loans.
Also, housing prices accelerated to double digit annual increases after a short disinflation that we had during the 2001 recession.
That is, housing prices didn't come down in 2001. They stopped increasing as rapidly as they had been in the 1990s.
The housing boom soon turned into a bubble as people's expectations lost all contact with fundamentals.
People who could not afford houses of certain prices were simply buying them because they knew they could sell those houses
at much higher prices in the future and then move on to an even higher priced house.
By mid-2003, the stock prices began to go up.
We began to get a big bull market.
Let me just again give you some of the figures here, some of the pictures.
This is the 30-year mortgage rate, which was pushed sharply down from over 8% in 2000 and
and then fluctuated around 6% and then went up to around 7% right before the bursting
of the bubble.
Housing prices, as you can see, rose tremendously from January, if you take that as 100, they
They rose by 120% in 10 leading cities, and by about 100% in 20 leading cities, okay?
And just to give you an idea of the rates of change, housing prices were rising in 2004, and running up to 2004, by 15% to 20% every year they were going up, okay?
And again, this is for selected 10 and 20 cities, okay?
And the housing crisis did not affect, the housing bubble did not affect the whole country.
It affected some larger cities and metropolitan areas.
Now, what's important is, what was the effect on household net worth?
Because this is sometimes called a balance sheet recession.
But it was also a balance sheet bubble.
The sharply rising stock and real estate prices boosted household net worth by over $23 trillion during just three years, from 2003 to 2006.
This drove the ratio of household net worth to annual GDP to well over 450%.
Let me just show you that.
This is just the increases in the Dow Jones.
Here's the household net worth.
You can see that in 2002 it's about $40 trillion. That includes all financial assets and real estate assets minus the debts owned by households.
So it went from $40 trillion all the way up to $63 trillion in 2005 and 2006. It's $23 trillion. What did that do?
That gave a tremendous impetus to people to begin using their houses as ATM machines
and to engage in all sorts of luxury consumption and consumption that under more realistic circumstances
and under more realistic calculations they would have never undertaken.
So it set off a huge consumption boom.
Now, historically, the percent of total household net worth as a percent of GDP was about 350 percent.
If you go all the way back to 1992, it fluctuated about 350 percent, between 300 and 350 percent.
Suddenly, notice how it sharply rises with the bubble, the first bubble, the dot com bubble in 1995, rise up to 450,
falls during our recession of 2000-2001 back to almost normal levels, and then shoots up to over 450%, to 475% of income, and then again later crashes, which we'll talk about.
Okay, so I can point out by comparison, for over 40 years, from 1952 until the dot-com
crash began in the mid-1990s, the household net worth to annual GDP ratio had held between
300% and 350%.
After nearly falling back to this range, as I pointed out, in the recession of 2001, the
Fed's monetary expansion drove it up by 100 percentage points in a matter of three years.
created 23 trillion dollars of net worth, all of which was false, all of which was phony,
all of which misled people and misdirected their purchases and caused what we call an
overconsumption boom.
So the enormous increase in net worth was based almost solely on paper profits and phantom
capital gains on households' real estate and financial assets.
People were misled by the inflation bloated balance sheets to cash out some of their home
equity and increase expenditures on consumer goods and services.
As we know in the expression of the day, people began using their houses as ATM machines.
Households financed the increased spending on boats, luxury autos, upscale restaurant
meals, pricey vacations and so on through fixed dollar debt.
This created a huge consumption boom as monthly real expenditures on retail and food services
rose from an average of 160 billion dollars per month between 2000-2003 to 180 billion
dollars through 2008.
Okay, so there's a consumption boom, going from 160 billion, okay, and actually you can
see it going through the 90s, it's a huge consumption boom, okay, and it was intensified
after the recession of 2001 by the Fed pouring a billion dollars a week into the economy.
And by people thinking that they were wealthier than they really were. This is what has occurred
during the boom and the bust. During the boom you had falsification of monetary calculation.
So it's not just capital misdirected, but people begin to misinterpret what prices are telling them.
And as we'll see, it takes a long time to regain faith in the price system after you've had a crash.
After everything you've done, which seemed like the right thing to do given the circumstances, suddenly turns out to be completely wrong.
Here's what happens to a personal saving rate. Why save? If you're gaining trillions of dollars a year in stocks, in your 401k, in your houses, so the saving rate in the U.S. fell from around 4 or 5 percent, even higher if you go back into the 90s, but by 2000 it was around 4 percent. It declined all the way to less than 1 percent in 2005.
Were consumers just being profligate? Were they not worried about their futures? No, they felt their futures were secured by the fact of this huge increase in net worth that they could depend on for their old age.
And fortunately, people came to their senses and began to save much more money out of their current accounts, arising up to 7% and then 8% by the end of the recession.
Household assets rose by over $21 trillion from 2003 to 2007. Liabilities, mainly home mortgages and consumer credit, increased by $4 trillion during the same period.
The year-over-year rate of growth of household debt nearly doubled from 6 percent during 1997 to 11 percent for three consecutive years beginning in mid-2003.
When the boom came to an end in 2007, housing prices, corporate profits and markets plunged.
The capital gains accumulated since the mid-1990s were revealed to be an illusion.
World Net Worth, the value of your house and your financial assets of all Americans, declined
by $13 trillion or 20% during one year alone, 2008. That $13 trillion is a figure exceeding
the sum of the combined annual GDP of Germany, Japan and the UK. That wealth disappeared
into thin air. It was actually never there. People thought it was there.
This brought the overconsumption frenzy, which had begun in the mid-1990s, to a screeching halt.
Let me say a few words about the retail slump.
One of the most important features of the current recession in the U.S. has been the exceptionally severe retail slump.
In the old days during recessions, you didn't have retail stores going out of business.
You had construction companies. You had steel companies laying off workers.
You had interest-sensitive consumer goods like automobiles cutting back.
Chrysler filed Chapter 11 on April 11, followed by GM on June 1, 2009. KB Toys, one of the largest U.S. toy retailers, sought Chapter 11 protection in December 2008 and announced that it was planned to close all of its 460 retail outlets.
CIRCUIT CITY, THE SECOND LARGEST ELECTRONIC RETAILER IN THE U.S. DECLARED BANKRUPSY AND
CLOSED ALL 575 OF ITS STORES THAT YEAR MID SIZE ELECTRONICS RETAILER, COMP USA CLOSED
ALL 103 OF ITS OUTLETS SHARPER IMAGE, A NOVELTY IN ELECTRONICS RETAILER, HAS ALSO DECLARED
BANKRUPSY LENIN AND THINGS, THE SECOND LARGEST HOME GOODS
RETAILER IN THE U.S. FILED CHAPTER 11 AND IS LIQUIDATING ITS 371 STORES
Fortunov's, one of my wife's favorites, a leading jewelry and home furnishing chain in the Northeast,
filed for bankruptcy, as did mid-size furniture retailers Levitts and Bombay, both of which
are liquidating.
Many more retail chains are scrapping expansion plans and proceeding with massive cuts, or
have done that, including Disney and Taylor, Footlocker, and many, many others.
You didn't have these things happening in early recessions, because you didn't have
For December 2008, the year-over-year decline in current dollar sales was 11.1% and from
From January through July 2009, these year-over-year declines fluctuated between 8.5 and 10.5%.
Now what's the significance of that? Well, except for two non-consecutive months during
the recession of 1990-1991, in which monthly retail sales dipped slightly below zero in
a year-over-year basis, one would have to go back to 1960-61 to find declines in actual
$1,000,000 spent on consumption goods during a recession.
Retail sales also took an exceptionally, real retail sales also took an exceptionally sharp
plunge during this recession.
They declined from $180 billion on a monthly basis, which I talked about in 2006, 2007,
to $160 billion.
If you compare the current recession to all recessions, all other recessions beginning
With 1960-61, the monthly percent change in real retail sales from a year ago fell by 8% for only three months.
Out of all the past recessions going back to 1960-61, you had real retail sales falling for only three months,
and that all happened in the mini recession of 1980, and they weren't consecutive.
By contrast, during the current recession, real retail sales on a year-over-year basis have contracted by 8% for nine consecutive months,
which ended in 2009. Overall, they contracted, they were negative for 23 consecutive months.
Let me just jump ahead here. That shows you the dimension of something that no one expected and that was the retail boom and slump.
Okay, now I want to talk a little bit about capital consumption, which I think is the
fallout from all of this.
The extent of capital consumption and malinvestment that resulted from the housing boom is revealed
by developments in the Wilshire 5000 Total Market Index.
This index tracks the total dollar value of all U.S. headquartered equity securities with
with readily available price data.
So it's basically the total capitalization of all the firms headquartered in the U.S.
minus the capital that was invested by bondholders.
So it's using the total stock capitalization.
It's using total stock value as a proxy for the total capital of all our firms.
After reaching a high of $15.5 trillion in 2007,
The index collapsed and fell to a low of $8 trillion in 1997.
So there you have almost $16 trillion and fell all the way to $8 trillion.
It has since recovered and has been languishing around $11 trillion, $11.5 trillion.
Now what does that mean?
The first time that the Wilshire 5000 reached $11 trillion was back in 1997.
What does that tell you?
That there's been no capital accumulation since 1997.
That any capital that was accumulated after that point was destroyed by malinvestment,
investing in wrong lines and overconsumption.
People consuming their capital, consuming their savings.
Now we can talk a little bit about the death of macroeconomics.
It may happen that even the level of wealth and income that we think we have now is based
on false calculations because the Fed and the US Treasury, which is a fiscal agent of
the US government, have used every tool at their disposal and even forged some new ones
in order to prop up housing and financial asset prices.
So we have a bunch of things here, most percent changes in the will show you don't have to
worry about that.
The federal deficit, see it way down there in the corner, you probably can't, the federal
deficit for fiscal year 2009 was 1.4 trillion and is on target for 1.2 trillion dollars
for this fiscal year, with trillions of dollars of deficits each year being forecast down
the road, as Gary North pointed out yesterday.
The gross federal debt has risen from around $6 trillion in 2001 all the way up to nearly
$14 trillion, $10 trillion in addition to federal debt.
Now the gross federal debt, that's the gross federal debt, the amount of the debt held
by private investors, $4 trillion is held by government agencies and we don't have to worry
The Fed's attempt at qualitative easing has resulted in its balance sheet rising from
from $800 billion to $2.2 trillion just in the fall of 2008.
Very colorful here.
So this is all of, see the blue at the bottom is the traditional security holdings, government
securities.
They added lending to financial institutions, this is qualitative easing, liquidity to key
markets, federal, fed agency debt, mortgage backed securities purchases.
So it jumped from under $1 trillion to $2.2 trillion, and the market's not buying this.
This hasn't got us back on track.
Despite all the stimulus programs and the alphabet soup of qualitative easing programs,
TAF, TARP, TALF, PPIP, FASP, AMLEF, and so on, the U.S. economy is mired in a stalled
World Recovery and Regime Uncertainty. Despite the quantitative easing and the qualitative
easing that the Fed has done, and the stimulus programs, the deficit spending, no one is willing
to borrow and invest because they do not know the economic consequences of all these programs
and the other government programs such as cap and trade, Dodd-Frank bill and Obamacare
There's a great graph by Steve Hanke here. I'll quickly describe and give you one more
graph and I'll end. As Hanke points out, the Fed has increased the money supply, so it's
increased its own, the very bottom of this rectangle, the lower triangle is from August
2008. What you can see there is that the Fed has about 800 billion dollars in monetary
base and the money supply measured by M2 is 7.8 trillion dollars. Now that has grown from
August 2008 to August 2010 or to June 2010. The base has more than doubled and the money
supply has increased from 7.8 to 8.6 trillion dollars. However, what has not grown, what
What's had shrunk is borrowing, is the extent to which people are willing to take on new debt.
This is what is stalling us.
So shadow banks, that is the broad financial system, the credit extended by this sector
has fallen from $16 trillion to $13 trillion.
The international positions of banks, those US dollar deposits outside the US, has fallen
from 13.2 trillion to 12.2 trillion dollars, okay, so that's full.
And finally, the derivatives, the over-the-counter derivatives, have fallen from 684 trillion
to 615 trillion.
So the Fed is pushing money out, but the market's not taking it.
The investors, well, let's put it this way, the banks don't trust the investors, they
They don't trust the businesses.
They don't believe that they don't have confidence that that business out there have good plans
for investment.
The investors themselves aren't taking the loans because they don't see profit opportunities
and they don't see profit opportunities because they believe that we're going to have higher
taxes because of all the programs that the government has implemented as well as the
The pending programs that will be implemented in the future, as well as of course the deficit
and the huge debt that we're facing.
So the US credit triangle is shrinking and the market's causing it to shrink.
And that's a good thing because entrepreneurs are stepping back and making sure that before
they do anything, prices and costs are aligned properly, that there are true prospects for
profits.
The government has to step away. They have to allow the adjustment to occur.
This last graph shows us the death of macroeconomics.
As you'll notice, the black line is the federal deficit.
The red line is the Fed funds rate.
As they move down, the deficit gets larger as the black line moves down,
If the funds rate gets lower, as the red line moves down, that means that we have more spending
and more money creation.
But notice what happens to the blue line.
Every time the monetary policy line and the fiscal policy line move down, that is, every
time we get more deficits or greater deficits and lower interest rates, what happens to
the blue line?
The unemployment line goes up, okay?
So everything they're doing is having the opposite effect to their intentions, to their
stated intentions.
In fact, recently in May, in the AER, there was an article by University of Chicago economist
Harold Eulig that pointed out that for every new dollar of government stimulus spending
is the destruction of $3.40 of real output in our economy.
So I'm happy to report that it looks like macroeconomics is on its last legs and that
hopefully it will be put in its grave.
We just have to say we knew this was coming as Austrians.
We told you so.
Here are the reasons and here are the data.
So thank you.