Only the Austrians Understand Interest Rates

0:00Our next speaker is an adjunct scholar at the Mises Institute, a faculty member at Mises University. He's written a number of books for us. He's written the Study Guide to Man, Economy and State, Study Guide to Human Action. He's written the Politically Incorrect Guide to Capitalism, Politically Incorrect Guide to the Great Depression, the New Deal. He's working on a new book for us that's called Lessons for the Young Economist that we think will be a great hit with young people and with homeschoolers. And he's also an instructor in the Mises Academy, which is a program we just started, and he's teaching a course online about the business cycle.

0:57and amazingly he has over 200 students from all over the world so he's the one who's broken ground with that and he's talking about only the Austrians understand interest rates. Please help me welcome Robert Murphy. Thank you, Doug. Thank you, everyone, for being here. It's a pleasure to be here. This is one of the nicer places I've ever stayed. Normally, when the Mises Circle travels around the country, Doug puts us up in a Motel 6, so this is a very pleasant surprise. All joking said, it really is impressive when we go out and do these things and just fill up these rooms of hundreds of people who come out.

1:44I have some family on Long Island, so I got in yesterday and was out with them, and they knew I was in town for a conference. And then when I was talking to them and they realized it was going to be today, they said, people turn up on a weekend to hear that kind of stuff? And I said, yeah, it's interesting. I mean, of course, what they didn't realize is that when you come to these things, you hear Doug French talking about dopamine and financial pornography. So that was the little inside secret that a lot of the outside world doesn't realize. It's not all just about interest rates. So speaking of interest rates, though, that's what my topic is for you today. and it's a bit of a presumptuous title, we'll admit, that only Austrians understand interest rates, but I think by the time I'm done, I hope you at least see where we're coming from, that it's really even, you know, it's a Chicago school type, you watch CNBC and you see certain, you know, Larry Kudlow or whatever, free market guys or you read Thomas Sowell and things like that, free market guys that they would agree with the Austrians on many things, like if it were price controls or deficit

2:48Spending, certainly any aspect of standard Keynesianism, we're both on the same side. But yet when it comes to interest rates, even if we have the same conclusion on something, the reasoning is different. So that's what I want to try to elaborate on right now in this talk. And then later on, Joseph Salerno, when he's going to talk to you about Austrian business cycle theory in relation to the overconsumption boom, you'll see the same lesson applied. So I just want to make sure you understand what the Austrians think of when it comes to interest rates. Let me just give you an analogy. Suppose that on Monday, Ben Bernanke has a press conference and he announces a new Fed policy. He says, you know, I am the other policy makers here. We've been monitoring the situation in the Gulf with this oil spill and we know that people are concerned if that continues, you know, oil prices might go up and that's going to just choke off this recovery in its infancy. And we also know that people are struggling. I've been talking with President Obama. He's very concerned about, you know, the middle class and the poor and how

3:47rising gas prices this summer would really just be devastating to a lot of households who are already struggling and so what we're going to do this new Fed policy is we're going to start buying oil from all the major producers around the world and then we're going to set up arrangements with US oil companies so that we'll sell the oil to them at ten dollars a barrel and we're going to do what we can within limits you know gauge by the the takers we get when we auction it off because presumably we're expecting we're going to have have a A few people show up if we're selling oil at $10 a barrel. That's just our guess. And as much oil as we can get from these producers around the world, they will go up to capacity and pump as fast as they can and then we will just transfer and sell oil for $10 a barrel to select U.S. oil companies so that will, of course, push down the world price of oil significantly.

4:38In particular, it will push down gasoline prices for U.S. consumers. And so that's what the Fed's going to do. You know, everyone's in this together and that's our contribution to help make sure the recovery goes forward. Now, if they did announce that, I mean, you can imagine, some people, of course, are going to think it's great, just because by definition anything Bernanke says is genius, right? But beyond that, you could imagine a lot of the free market type analysts and commentators would say, that sounds like the most insane recommendation I've ever heard in my life. in Life. And they would, you know, the commentators would say, well, why? What's wrong with that? And they say, well, where do you even begin? First of all, that's going to cause massive inflation, right? That, I mean, the Fed's going to have to just print up all kinds of new money or technically just write checks on the Fed to give to, you know, these OPEC countries and other producers to buy the oil from them at what currently is the market price. And again, they'll sell as much as they can if the Fed's willing to buy it.

5:36and then but but suppose that didn't happen suppose they put the plan in place and these OPEC countries and other producers just keep piling up the dollars in their bank account you know they just had accounts with the Fed just get huge you know over a trillion dollars in six months I mean I'm just being crazy that that would never happen you know that the Fed wouldn't just create a trillion dollars in six months but imagine this is a thought experiment okay so suppose that were to happen and then you could imagine people looking at you know, going to the St. Louis Fed's website and looking at the spike in the dollar reserves at the Fed and they say, you know, is the world going to blow up? How can that be possible? But, you know, prices at the grocery store haven't gone up and they say, oh, I guess maybe it's okay. And then you could say, oh, yeah, so maybe massive inflation didn't hit

6:20from this, but still, that's, I mean, just all the corruption that, of course, you know, the Federal Reserve picking certain U.S. companies, the ones to get these sweetheart deals and get oil sold to them at $10 a barrel and, of course, their profits would be going through The Theory of Money and Credit

7:02If you can't trust central bankers and the heads of oil companies, who can you trust? And again, I'm sure everyone but two people in here understands the analogy, but just make sure I'm not losing anyone. Of course, in our time, again, heads of major investment banks or whatever, people in and out of Goldman Sachs, those are the salt of the earth. Sometimes they make mistakes, but it's only because it was an intellectual error and they had our best interest at heart. That would be the 30-second soundbite stuff in terms of the CNBC, but in terms of people writing op-eds or various think tanks, writing longer pieces summarizing just how insane this new oil policy was, I think a lot of them eventually would come around to the fact and the fact that, look, this is supposed to be a market economy and prices actually mean something.

7:55The world price of oil being whatever it was at the time of the announcement, $75, $70 a barrel, that meant something. It had something to do with supply and demand. And if the Fed pushes that down, so maybe the new world oil price after this new policy is put in effect gets pushed down to $40, let's say. And that some companies, of course, are getting it at $10, and other ones aren't, but on average the price gets pushed down to $40. And you say, that's going to screw things up, and maybe gasoline prices get pushed down to a dollar a gallon. And you say, those are the wrong prices, that doesn't accord with supply and demand. And you say, well, so what? What are the consequences? You can imagine someone thinking, you know, I'm driving my car and I like the fact that gas prices are lower, and you warned about inflation, I didn't see that yet at the grocery store, so what's the big deal?

8:39And an economist, you know, a very stuffy economist, could explain, matter of fact, well, no, those prices mean something, and it's screwing things up. For example, we're using far more oil now than we otherwise would have, and the oil's a finite resource, there's only so much of it in the ground, and if we're burning more now, that leaves less available for future use, whereas in a market economy, if the prices aren't interfered with, one thing that the current spot price of oil does is it sort of regulates the use, it rations it, right? And if people expected there to be a shortage in the future, the price would go up now to make us cut back on our current consumption, and so you screw that mechanism up that rationing approach up if you push down the prices in the president makes you use more oil now than you ought to be using so it's not a question of doing a favor for the consumer while you're doing now is

9:28benefiting people now and hurting them down the road because now they're using up too much oil and it has other effects to that the artificially low price of gasoline is going to cause people to buy less fuel-efficient cars than the otherwise would have so people are going to be more likely to buy SUVs and so and so forth than they otherwise would have and if this if it were the correct market price that would be fine but it's not the right market price and in particular what's going to happen eventually the Fed when inflation kicks in or some other reason kicks in the feds gonna abandon this policy and then when prices shoot up people are going to be stuck with these gas guzzlers so to speak and they're going to see gasoline prices a lot higher all right and so you can imagine them just talking through all of the different problems and of course there'd be all the issues of arbitrage and the companies getting the

10:13the barrels at ten dollars and then just selling them to somebody else. You can just imagine, it would be a nightmare. There would be so many economic distortions introduced by this policy. And I think not just Austrians but other free market economists would see that and they would go ahead and and spell these things out. Now the policy might go through it. I'm actually concerned that if the Austrian School gets more popular and this lecture is on YouTube that somebody in Bernanke's staff might say, I just heard a fantastic idea. you know let's let's have a meeting so it's sort of like you know if you're a novelist everyone or that like that like the guys that it like come up with with crime thrillers and they have like ways that serial killers get away with so do you wonder sometimes if they think I don't want to give somebody an idea well that's that's what we have here when we talk about hypothetical fed policy so the

10:59so that would be the problem and then but again this is the same thing carries over with interest rates and yet the Austrians are really among the few people, although I was pleased to see the previous speaker mention that too when he was saying, you know, interest rates at 0%, what does that even mean? And I had a guy call me Bill Barnett, who's an economist down at Loyola in New Orleans, and when the Fed first had pushed interest rates down, you know, between 0 and 0.25 or whatever the official range was, and he was calling me talking about some issue of the Fed's balance sheet, and he just said, you know, Bob, what does that even mean, that interest rates are zero? He said, did they abolish scarcity, you know? And I was like, I don't know, did they? But that's part of it. So what are interest rates? Well, first of all, they're prices. That's a price. In the market, if the Fed didn't intervene, the interest rate, in a sense, in the Austrian view, is a signal, if you will, sort of regulating people's impatience.

12:02Alright, and it has to do with what the Austrians call time preference, meaning the trade-off between being able to consume now or postponing the consumption, but with the reward that you get more down the road, right, so that's what the interest rate serves to regulate, if you will, just like the price of oil controls or rations, how much we consume now versus how much you leave in the ground to be available down the road, the same thing, interest rates do that for capital funds in general. and there's it so it's not just about money and and unit a unit of account that as the previous speaker has mentioned we're sort of we've lost in our age right that I think before back on the gold standard people really thought of money as sort of a metric a yardstick or a ruler whereas now people really don't think that money is anything like it's it's not even real anymore and just like I don't know if you guys notice this but you don't have

13:00After the bailout, the first TARP went through, and jokes would circulate, like you'd hear people say, when do I get my bailout? Or people would say like, yeah, I'm not going to pay my credit cards because I'm going to wait for my TARP. Or there would even be ads on the radio about, you know, it's come down to crazy eddies where the prices are insane to get your own bailout. You know, and that kind of like, that was just the marketing. So it was just sort of like the running joke. And I was talking about bailouts, but I think it was beyond just the humor. I think it really did influence the way people looked at the World, and that when you're running your business or just a normal person trying to do financial planning, I mean, just to see a bunch of guys change the rules in the middle of the game when they were losing, I mean, I think that really shocked a lot of people and makes them

13:43less confident playing this game going forward. And I think the same thing happens with fiat money, that when the government can just, or when the Federal Reserve can just create money out of thin air, you know, quite literally, that that sort of shocks people and they start behaving differently just because that's a different game now that we're playing and it's funny i think even members of congress have just slowly started to realize just how insane this process is i don't know if this is true but the the uh... anecdote going around was that when the uh... when they first bailed out AIG i think the fed came in and stepped in and advanced to eighty five billion i believe and that first injection and they were Bernanke was in a committee meeting with uh... some members of the Congress and Barney Frank I think asked Bernanke well do you guys have 85 billion and I think Bernanke was like what do you mean do we have it you

14:36know and you know and so yeah you guys went into the business where you have to tax people and take their money and spend it we just create it you know so So, in terms of professions, you chose poorly.

14:57That's a good crowd for my anti-Bernanke jokes. So, when it comes to interest rates though, there again, in the Austrian view, if you had a free market When you had a real sound money system based on gold or some market-chosen commodity, what the interest rate would do is sort of signal, and I'm dumbing it down a little bit here, but this is the basic spirit of it, is signaling society's willingness to postpone consumption or their need to have consumption sooner rather than later. And so it's not that there's a good interest rate or a bad interest rate. I mean, the interest rate is what it is based on people's preferences. and so if people really are impatient then the interest rate should be high and it's the Fed isn't doing anyone any favors by pushing it down that's just messing up the signal that's in a sense not allowing people to communicate with each other that's partly what market prices do is it allows people to communicate so Friedrich Hayek has a famous passage when

15:57he's talking about market prices and how they help people in the economy coordinate with each other and he says that you know suppose there's a I don't remember the exact example But there's a tin mine in some other country that collapses, right? And so for a short period, the supply of tin being brought to market is lower than it normally would be. And so Hayek says, what happens in a decentralized market? Of course, the price goes up because the supply gets shifted to the left in the short run. And then what happens? Every business around the world that uses tin economizes on it. They cut back on their production because the price went up. So any business where there's some substitutability, where you can use a little bit less of TIN and more of some other input, that's what they're going to do. Not because they want to make sure the world economy allocates resources effectively, but because they want to make money.

16:45They want to minimize costs and if one of their inputs goes up in price, they cut back on it. And so Hayek's point is that what the price mechanism does in that scenario is it transmits the barest amount of information everyone needs in order to respond to the collapse of the Ten Mind. The people cutting back on their use of tin in Idaho, they don't even have to know what happened. It's not that someone needs to tell them, oh, by the way, the tin mine collapsed and so you guys better use less of it. They don't need to know that. All they need to know is that the price went up. So that's what interest rates do as well. But there, what they serve to regulate is, in the Austrian view, is how much the production Structure is geared towards present consumption versus future consumption.

17:33So in here, the reason Austrians are the only major school of thought to focus on this stuff has to do with the Austrian approach to what's called capital structure, capital theory, meaning when the Austrians look at an economy and make a model of it, if you will, they don't just say, as other schools of thought do, they don't say, okay, well, imagine there's There's a big bunch of labor and this big glob of capital and then they get mixed together and produce output and that at best if other schools of thought want to talk about saving and investment they'll say oh well if society invests more well then next period the glob of capital increases like this year capital was a hundred and next year it'll be a hundred and ten and that's the way other schools of thought typically deal with thinking through issues of capital and savings and investment and interest rates whereas in the Austrian The Austrian approach, it's a lot more realistic. The detail given to the capital structure is a lot more intense.

18:33And so the Austrians picture there being what's called stages of production. And there the idea is the furthest stage from consumption is something like mining, where there's getting the materials from the earth, right, or harvesting raw natural resources. And then those things will move down the stages of production. So if you just think about it, like you go into an electronic store and you see a plasma screen TV, if you went back in time and just looked at the life cycle of that thing, it probably would be years in the making. If you just traced it back and looked at all the materials that went into that particular physical thing on the shelf, you would have to go back years to get the starting point, if you will, and then trace that forward and see how those materials and resources just The Austrian view the economic system, if you could see it from space, then you would just see some people on the earth would be taking resources out of the ground,

19:50and giving it to other people and all these things would just go through really complicated chains of transformation where each person put some more finishing touches on it before it finally comes out as the finished consumer good and that those chains of production or transformation could take years. So what the interest rate helps to coordinate is that whole structure and it's a very complicated thing and so you see it's not just an issue of oh gee well if interest rates get pushed too low well then we might get more or inflation. That's really the one thing, even if a mainstream economist or someone from the Chicago School, for example, if they do criticize the Fed's decision with interest rates, usually all they'll say is, oh, interest rates are too low right now and we're going to get inflation. That's the problem, that they view it merely as interest rates are sort of a governor on total spending. And that's what the Keynesians think of it too, and that's what they want. They're saying right now we're in a recession, people aren't spending

20:48In the Keynesian view, that's what the interest rate does. That's its sole function, is it regulates how much total spending there is. But again, go back to that oil analogy, you'd be missing out a whole lot of what's going on. What you thought of the oil price was that regulates how much people spend when they fill up their car.

21:41Market Rate, let's say it's 8% and then people in the economy decide they want to save more because they want their kid to go to college or something. So what happens is everyone starts saving more, they spend less on restaurants, they spend less on going to the movie, they spend less on Ferraris and so forth, so they're saving money and then they put it in the bank let's say. So in a normal market where prices are correct and they're the market prices, what happens? All those other industries, they see their revenues fall, the theater and the restaurant owners, they see their sales plummet and so they cut back. They have to lay off waiters and lay off the guys who rip your ticket at the movie theater and so forth, and the people who make Ferraris, they have to cut back their production, lay off staff and buy fewer resources, and then the banks have more savings come in so they can afford to lower their interest rate that they charge on loans. And then what happens, so long as the people running the colleges know that that demand is going to be there in the future, well then they can afford to borrow

22:39to borrow more at the lower rates and then build more buildings in their campuses and people who want to go get PhDs can afford to borrow money to get student loans and so forth. And so the idea is it's not that, oh, production fell and now we're in a recession. No, it's just it gets re-diverted. Instead of resources going into making dinners and Ferraris and showing more movies around the country, Those same physical resources and workers get redeployed into making stuff that's not going to yield its fruit until years in the future. So that's the Austrian view of how interest rates serve to coordinate all that stuff. So it's a very complicated thing. Of course, I'm boiling it down for you, but that's the basic idea. And so what happens when the Fed comes along and just pushes interest rates down arbitrarily, that screws all that up.

23:27It makes entrepreneurs start acting as if people had saved more, but there aren't more resources to go around, and so it's a boom period, it seems like there's prosperity because you're getting the same signal as if there's also more capital, but there really isn't. Alright, so that's the Austrian view on interest rates and that's why I and the previous speakers as well are so concerned about the future because for the last two years basically we've been in limbo with interest rates being pushed down to basically zero or certain key interest rates being pushed down that low. What does that mean? The economy has been without a major corrective signal, if you will, without that important to Regulate how much should we invest, how much funds are there available to be borrowed and in particular certain investment banks and other financial institutions they should have gone under, when they make bad investments as they did during the housing boom that caused real physical resources to go to the wrong places, so it really was the case that too many houses were built, that it really was the case too many smart people who maybe should have gone into theoretical physics ended up going into options trades,

24:40Society lost opportunities. Society right now would have been on a much more solid footing had those mistakes not been made during the boom and so the point is you can't just undo that. You can't just take a mulligan by having Bernanke buy everyone's toxic assets and say, okay, okay, let's try it again. The mistakes were made. You can't just turn all those houses now into virgin pieces of wood again and then use them for something else. I mean those mistakes have been made and we now have to suffer the losses. So the point is those losses did happen, someone has to bear them and when the Fed comes in and just buys up all these toxic assets or does other tricks to sort of rescue the banks, it didn't undo the mistakes, it just meant now the people who made those mistakes don't have to eat the loss and it's going to be spread now among everyone else who holds dollar bills.

25:40Price Inflation

26:10The banks legally speaking have the right to advance new loans, but they're not for various reasons. There's this tendency to think that money really hasn't gotten into the economy yet, but in a sense it has. Those banks who sold assets in exchange for checks written from Bernanke, that was real money to them. Those dollars are just as much legal tender as a $10 bill in your pocket. and so that money really has been created but what so when you talk about well so what are the distortions so far everything seems fine well the distortion is prices first of all should have been collapsing that that's normally what happens when there is a boom and then a bust is prices come down and so what like when it comes to the stock market or the housing market I think the conventional wisdom is things were going great and then the market got crazy and crashed and now finally we're pushing you know we're allowing it to recover to where it should be

27:06In the Austrian view, it's no, things were crazy. You got prices pushed way up here in the stock and real estate markets. Then people realized the mistakes and prices started to come down back to a more sane level. And then Bernanke and the federal government came in and then did their best to inflate it back up. And now they're doing their best to keep them up at these crazy levels. And so that's partly why a bunch of us think that another crash is coming in asset prices. And so that's part of it, that the inflation in a sense is already there, it's just the baseline would have been much lower prices. So we already have seen a re-inflation of the asset bubble. But then again, as far as the prices of things in the grocery store and so forth, I personally do think that that's coming. And that's why so many of us are telling people, you know, buy gold and silver and things that are going to at least allow you to get through this.

27:57Not that we're going to be able to avert the coming crash, but at least if enough of us survive, sort of a Darwinian sense, then when we emerge from it, the Austrians will be the only ones left standing. Us and Ben Bernanke. So I'll stop it there. Thanks a lot.