How the Fed Fools Some People Much of the Time

0:00In Lew's opening comments this morning, I noticed that he mentioned all of the speakers. Addressing you today were members of the Austrian School, who considered themselves Austrian economists, and that reminded me of an exchange I had in a more eclectic session recently, where most of the participants were, well, we'll say mainstream economists. And one of them asked me after the talk, did I mind being thought of as an Austrian economist? And I assume he meant as opposed to what, mainstream economists or just plain economists or whatever.

0:45To which I responded by recounting the story, true story actually, of the prisoner on death row, serial killer. It turns out, he was awaiting his imminent execution. And he had a priest in his company and was trying to make peace with himself and with the world. And he said, you know, Father, I don't mind if people think of me as a serial killer, as long as they don't think that's all that I am. So, I don't mind being thought of as an Austrian economist.

1:35Although today I will work in a few mainstream ideas, if you'll allow me. I noticed that the topic this afternoon, as announced by Lew, and as was printed in the earlier versions of the program, was how the Fed fools some of the people much of the time. I did notice in the final program, someone had put an S on FED, how the FEDs fool some of the people and I almost wondered if I was supposed to say something also about the IRS and possibly the Bureau of Alcohol, tobacco and firearms, but I think I'll restrict my remarks to the Federal Reserve, but I do want to call your attention to the significance of the title itself, obviously a takeoff on Lincoln's dictum about fooling people.

2:25and would remind most of you if you've read up on economics in the last couple of decades of the rational expectations revolution where economists claim that the Fed can't fool anybody any of the time and I'm pleased to say that Ludwig von Mises was in on the ground floor on the basic idea although he didn't push it to the extremes that the new classical economists have And let me just read a short passage from the third edition of Theory of Money and Credit, which was published in 1953. And in that book, Mises included an epilogue, written in 1953, on inflationary finance, government printing money to finance projects of one sort or another, either in the public sector or through lending and out through credit markets.

3:18And of course when he talked about inflationary finance, he wasn't talking about a general rise in prices, he was talking about inflation of the money supply, padding the money supply whether or not prices have yet risen. But of course he knew, as we all do, that rising price level is the ultimate consequence of increase in the money supply. On inflationary finance, he wrote, Here the famous dictum of Lincoln holds true. You can't fool all the people all the time. Eventually the masses come to understand the schemes of their rulers. Then the cleverly concocted plans of inflation collapse. Inflationism is not a monetary policy that can be considered as an alternative to a sound money policy. It is at best a temporary makeshift.

4:05The main problem of an inflationary policy is how to stop it before the masses have seen through their rulers' artifices. It is a display of considerable naivete to recommend openly a monetary system that can work only if its essential features are ignored by the public. This, by Mises in 53, a full eight years before John Moot wrote his article on rational expectation in nearly 20 years before Bob Lucas and others began to incorporate the idea of rational expectations into macroeconomic literature. Mises, of course, as I mentioned, didn't push this to the extremes that the new Classicals have. And in fact, for that reason, the Austrian School, radical as they seem in many respects, and rightly so, radical in the sense of going to the root of the matter, are very much middle ground on this issue.

5:01They're between the Keynesians who argue as if the central bank can fool all the people all the time and manage the economy and make it behave in ways that it otherwise wouldn't. That's the aim of the demand management policies. The new classicals are at the other extreme, arguing that the Fed can't fool any of the people any of the time, that rational expectations simply undo any damage that the Fed might otherwise cause. The Austrians certainly are in the middle on this issue. Yes, the Fed can fool some of the people much of the time and that gives rise to artificial growth, to a boom or bubble economy as we've heard it called, which ultimately must collapse, hence the Austrian theory of Mises would argue in terms of money as a tool of calculation, and if money prices and particularly the interest rate are distorted by money creation, then the calculations will be incorrect, the economy will be set on an unsustainable growth path.

6:07of Path. Hayek would argue in terms of prices being signals, and particularly especially the interest rate on the issue of unsustainable growth. Jam the signals by pumping money through credit markets. Jam the signals and the economy will be misguided. This does not require that we assume that market participants are actually fools, they're simply reacting to prices that aren't telling the truth. And even knowing, as people will eventually come to know, that the signals are being jammed doesn't necessarily solve the problem. In a phrase, knowing that a signal is jammed is not the same thing as knowing what the unjammed signal would be.

6:54And therefore, the economy is still misdirected, set off on the wrong course that will eventually require an adjustment. We have reason, I think, to believe that the signals are now being jammed. The twist I want to add to today may seem novel to some and obvious to others, but as the market recasts, or I'm sorry, as the market reacts over a period of time to central bank policy, trying to guess what it will do next, and as the central bank reacts to the market's reaction, guess what? The jammer, the central bank, doesn't know what the unjammed signal would be either. This is a point that Mr. Grant drove home this morning by suggesting that Greenspan didn't know what the natural rate or the market rate of interest might be.

7:47We know what the discount rate is. I'll show you something about that in a little bit. We know what the federal funds rate is. But do we know what the market rate would be, the so-called natural rate? What would the natural rate be in the absence of the Federal Reserve manipulations? That we don't know, and Alan Greenspan doesn't know either. So how does the Fed fool much of the people some of the time? Well, the short answer is by fooling himself too. He doesn't know what the interest rate should be. He's struggling like you are and like I am to figure this out. In the long run, and in the absence of central bank actions, the interest rate that clears the market for loanable funds is called the natural rate.

8:42The amount of funds lent at that rate is equal to the amount of funds borrowed at that rate. And in fact, that amount constitutes what Dr. Shostak referred to earlier today as the funding pool. The Funding Pool, the amount of funds supplied and demanded at the market clearing rate of interest and of course the point of his lecture is that if growth, economic growth is based on the funding pool, is based on the amount that savings actually supports then it's healthy, it's sustainable, it works, it gives us increased output but if it's greater than that because of Federal Reserve manipulation, because of credit expansion, then the economy is set out on a on a path of unsustainable growth.

9:30The term itself, natural rate of interest, came from a Swedish economist, Newton Vicksel, but it was adopted by von Mises in putting together his Austrian theory of the business cycle. The natural rate is essentially the market rate, the rate that's undisturbed by a central bank. If business, the business cycle then plays itself out in terms of movements of the rate of interest from that natural rate. And if the rate is too low, then capital will be misallocated, the economy will be set out on an unsustainable growth path, a bubble, as you've heard earlier today, that eventually will collapse. This is the Austrian story of boom and bust.

10:17The forthcoming book mentioned by Lew, I'm starting now to call it my forever forthcoming book, But in that book I set out a framework of what I call capital-based macro and show that macroeconomics fashioned after Mises and Hayek has much to say about a lot of issues including, and importantly including, the business cycle, but much else as well, deficit finance, fiscal policy, tax reform, and a lot of other issues. issue, so I'm generalizing from what Mises and Hayek taught us about cyclical variation. Now at this point I want to depart slightly from the Austrian framework and bring in the unemployment rate, which is the statistics that you most normally see reported in Wall Street Journal and elsewhere.

11:14Ever since the Keynesian Revolution, cyclical movements have been tracked not in terms of misallocated capital structure or as distortion of the interest rate, as the Austrians would have it, but as movements in the unemployment rate, as Keynesianizes the whole view of cyclical variation. Nonetheless, we have a benchmark here that allows us to translate from one framework to another, corresponding to what we call the natural rate of interest, is something that has been called the natural rate of unemployment. And it's telling, I think, that that term, coined by Milton Friedman, was so named precisely to pick up its kinship with Vicksel and his natural rate of interest.

12:06And so without too many qualifications, we could argue that an economy experiencing the natural rate of interest and therefore a funding pool that's consistent with sustainable growth would at the same time experience what could rightly be called a natural rate of unemployment. Or we could say in the long run, in the absence of central bank action, the rate of unemployment experienced by the economy, well, is the natural rate. Unemployment of this sort, the natural unemployment, has the same economic significance as unsold cans of corn or unsold bags of sugar on the grocery store shelf. In other words, inventories. A certain level of unemployment, like a certain level of inventories, is consistent with, even essential to, the functioning of the economy.

12:59Some people in even a healthy economy are just breaking into the job market, looking for a job or between jobs, looking for a better job and so on. This is the unemployment primarily that we consider to be natural and healthy and not symptomatic of anything wrong with the economy. So, if unemployment is at its natural rate, well, the economy is said to experience full employment. This is just the terminology of mainstream economics that I'm sure you've encountered before. If unemployment is above its natural level, well, the economy is experiencing a recession. It's very far above the corner of depression. If unemployment is below the natural rate, we say that the economy is overheated, a term that you've all heard, which really means, translated back into Austrian terms, Unsustainable growth rate, unsustainable levels of employment and output.

13:57Now, at this point, I could be critical of the idea of the natural rate. It's made up of something called frictional unemployment, a term that Mises took exception to. He offered the much more insightful term speculative unemployment, Meaning that if a job seeker speculated that if only he looks further, he might find something better, he will decline current job offers, speculative unemployment, but nonetheless part of the natural rate. But today, at least for the sake of argument, I want to adopt this idea of the natural rate and look at it as simply a sustainable rate that involves no recession and no overheating.

14:47Now the problem comes when we try to quantify the levels. What is the natural rate of unemployment? But according to the mainstream, conventionally and for some time macroeconomics of all persuasions have settled in on five or six percent of the labor force. If no more than five or six percent of the labor force are unemployed, we say the economy is fully employed. That means that it's experiencing unemployment that's not in excess of the so-called natural rate. Now we've noticed that when unemployment gets very far beyond this range, one way or the other, many macroeconomists, Especially the apologists of the administration argue that the national rate itself has changed.

15:36So for instance, during the Ford administration, when the unemployment rate flirted with the double digits between 9 and 10 percent, economists, apologists of the Ford administration argued that the national rate itself had risen. And we really weren't experiencing much of a recession at all. Now, when the unemployment rate is flirting with the 4% level, apologists of the Clinton administration are arguing that the natural rate itself has fallen, and that the economy is not in a bubble at all. So in practice, at least as a politically-charged rhetoric has it, the natural rate itself is something a little different from the natural rate.

16:22It's the thing that keeps changing to make sense out of the current policies. It's certainly true that five or six percent is not chiseled in stone. Followers of Mises and Hayek know this well. There are no economic constants. These things can change with changes in the real factors, productivity and all such. But neither does it change to suit the visions of politicians and policy makers. So, for today's purposes, I'm going to stick with the conventional natural rate and just show you. I've been tracking the rate of employment and a few other statistics for a while now, and I show you here that that band in the middle between 5 and 6 percent involves rates of unemployment that are consistent with full employment.

17:17and anything above that, we identify as recession and anything below that is a bit worrisome because it's a bubble, it's unsustainable unless there are serious arguments that the natural rate itself has changed. Now let's put the unemployment rate over that period, about 10, 11 years is what I'm using to show you what the unemployment rate has actually done. Look at the unemployment rate from 89 through present. What we see is that in 89 and 90, we were within the full employment range. The economy seemed to be doing fine. 91, 92, we slipped into the Bush recession, largely as a result of aftermath of the savings and loan debacle and a few other things that were going on at the time.

18:11We had the Bush recession, something that Bush denied during the campaign. but also something that hit its trough or peak, if you're looking at unemployment rates, in mid-1992, well before the election in November. So we were coming out of the Bush recession at the time of that election, but not far enough to save Bush from defeat. If you look at the 92 to present period, you see the bull market that you read so much about, with unemployment and almost steady decline. and I'll say almost, I'll make this qualification, you'll see the significance in a minute, because there seems to be a leveling off in the full employment range in 1996.

18:56Greenspan seems to have engineered, if you take conventional wisdom seriously, a soft landing of sorts, by coming out of recession without throwing the economy into the unsustainable region. But then look at 97-99 and you see the economy going into the unsustainable region. I might even say that when I first started tracking unemployment on this graph, this particular kind of graph, actually the bottom of the graph was 4.5% and over the last several months I've had to adjust my graph to pick up the new low figures. Now, down as low as 4.2. If it goes any lower, I'll have to redo my graph once again.

19:42But let me raise the issue point blank. Is this new unemployment rate in the low fours flirting with 4% Is that an unsustainably low rate of unemployment or is that a bubble? Now, there are several arguments to the effect that it's a new natural rate of unemployment. I'll consider them briefly, only to reject them. One is that labor unions are more restrained, they're less powerful, their wage demands reflect more reasonable expectations. But we know that labor unions have been on the wane for years, not just since 96, and Their actions affect relative employment in any case, causing less unemployment in labor in unionized industries and more in non-union. That's not a plausible reason. Increased technology, improved technology, particularly the personal computer. Here again, there's a timing problem.

20:47We've had the personal computer from the early 80s, not just since 96. The advocates of this And for this reason, recognize the timing problem and point out that, yes, but during the first decade or so, everyone just played solitary and minesweeper. And now we're beginning to see the real productivity gains. I reject that in part because, well, I still play minesweeper. The third is demographic reasons, baby boomers and women coming into the labor force in greater numbers. Baby boomers reaching their high job security years. Sounds plausible, but those are long-term sweeping trends that would take place over a course of many cycles.

21:37If you look at the graph, you see that what's happened is something during a single cycle. In a single business cycle, we've gone from what used to be called full employment, supposedly to some lower figure. I suggest an alternative explanation, and to show you that, I'll put on a chart that has the discount rate on it as well as the unemployment rate. Now, the Federal Reserve has always been a political animal, but the Greenspan Fed under the Clinton administration, particularly so, asked you to recall the State of the Union address in 1993, when I hardly remember what was said that evening, but I remember what I saw that evening.

22:28And what I saw was Alan Greenspan seated between Hillary Clinton and Tipper Gore. And I don't know how much you know about the planning of State of the Union, but it's not open seating and Greenspan was charted to sit there. He signed on as a team player by agreeing to sit there. The next day you could have read in the papers and seen the pie charts and the bar charts and all the rest explaining what was going on but the seating chart is what told the story. One of my colleagues at Auburn apologizes for Greenspan saying that the symbolic subservience was a way of buying himself substantive independence I don't think it works that way I think that he became a team player now in the interest of time I'm going to summarize what comes next but even though you see a number of changes in the discount rate there's one that stands out if you look at the chart very closely and it's a one where for the first time

23:36What was economically advisable and what was politically advisable were two different things. Coming out of the Bush recession, the discount rate was ratcheted up in several steps, increasing it from 3% to as high as 5.25 and engineering this soft landing which seemed to be working. And then you notice that in January of 1996, Greenspan cut the discount rate. This was the first instance in which there was a dilemma where he could either do the economically correct thing according to mainstream theory or do the politically correct thing in view of the oncoming election.

24:21He cut the discount rate. He did it in January of 1996 when the unemployment rate had popped up from about five and a half to 5.8%, which turned out to be because of a big blizzard in January, more respectable commentaries at the time indicated that the rate change was unwarranted, meaning that he wasn't really trying to fight the January blizzard, but rather was trying to fight the battle of the election for next November and therefore he set the economy off on an unsustainable growth path with that change. And also, significantly, it's dating from that time that you begin to see speculation against the Fed where changes in the unemployment rate will produce perverse reactions in the Dow Jones average. In other words, I can account for several different instances where three-tenths of a percent decrease in the unemployment rate, which would would seem good for the economy, nonetheless cause the Dow Jones Average to plummet as people speculate about whether Greenspan is going to take off his political hat and put

25:34on his economic hat or keep his political hat on. So it's from that point, January of 96, that Greenspan has pursued a policy of what I call dead reckoning. Are you familiar with the term dead reckoning as an old maritime term? It means that if you're in a fog, you can't see the stars, you don't have communications. Your only guide to where you are is what you did in the past, how you set your rudder and how you set your sails, and from that you determine where you are now. Well, I would argue that Greenspan is in a fog, that the signals he's looking at are polluted signals because most of the interest rate, price signals and so on are based mainly on what people He keeps getting criticized for fighting inflation when there are no signs of inflation, according to the critics.

26:37And what I argue is there is a sign of inflation, and it happened in January of 96, that he knew what he did in 96, he knew he was setting the economy off on an unsustainable boom, He knew that corrections had to be made for that at a later time. And so he takes this extremely low unemployment as a sign of a bubble. I might point out here that if we actually had competitive banking, if we had a decentralized banking system, if we had a market-determined interest rate, it would be idle speculation about whether a 4.2 rate was sustainable or not sustainable. Just wait and see, that's all, okay? But if you have a central bank that's trying to make decisions on the basis of these issues then it becomes very critical and what's important is not, or what's important is what Alan Greenspan thinks and he's given us reason to think that he believes it's unsustainable and he talks about over exuberance, he uses the word unsustainable in connection with it, okay?

27:41And now, at the risk of going a minute over my time, let me just show you another graph that will put into perspective recent changes in the interest rate. The political, or the popular press by the way, is not very good at reporting interest rate changes because they blur the distinction between the discount rate, which is what I had on the last graph and it's on this one too, and the federal funds rate, which the The Fed can influence but can't fully control. The last two rate hikes were not in the discount rate, it stayed at 4.5% for some months now, hasn't changed. But the other plot of interest rates on there is the federal funds rate, and it shows the federal funds rate inching up, those are the rates, target rates that the Fed has set for itself in the last couple of open market committee meetings.

28:35And now, I've brought you almost to the brink of a prediction, okay? Lew Rockwell told us that we didn't predict. But I've brought you to the brink of prediction. I've showed the federal fundraising rising significantly above the discount rate. And you might think that I'm going to flout the rules that Rockwell laid down and predict what Greenspan's going to do next, but instead I'll affirm those rules and say that, guess Greenspan doesn't know what he's going to do either, okay? Thank you very much.