The Current Crisis in the Light of The Theory of Money and Credit

0:00My assigned talk this afternoon, it is just a talk. I don't even have pictures. I think we can make do without them. The assigned topic is the current crisis in the light of the theory of money and credit. Yeah, I want to talk about that, but I actually want to compare several crises since the origin of the Federal Reserve system, which I think will shed more light on the current crisis. But before I do that, I guess I have a caveat or confession. I don't read German, okay? And so I listen to Guido, and I have to confess that George Selgin and myself and others have been wallowing around for years in this English Edition of Theory of Money and Credit, so take that into account when you listen to my talk.

1:01I do want to point out before I begin, though, that there's only a small, small section in the English version, and I would guess the German too, although the words are longer, maybe it took more pages. There's only a very small section in the Theory of Money and Credit that deal explicitly with the business cycle. And there they are, that's them, okay? That's ten pages. Near the end of the book, actually this is the revised edition so it has the added essay on monetary reconstruction, but in the original book it was very near the end and only a few pages. So I think it's something of a remarkable thing that we can look at that now and say, This gives us insight even to the current monetary crisis in the U.S.

1:57That relevant material is in the final two chapters of the final part, part three of the book, and it spans ten pages, which almost justifies this last talk which we just heard of not taking into account the business cycle. It's just a very small part of it. You look at the basic concepts of monetary theory. Well, in looking at those few pages though, I can pick out several aspects of the business cycle that are with us today in one form or another and that have to come together to make a good story about the current crisis and other recent crises. I list a half a dozen and I'm hesitant to mention this This first one in light of the earlier panel this morning, but the subsistence fund, okay?

2:53And I'd like to give my own view on how that fits into the theory by saying that, you know, this was 1912, and the terminology of the classical school was still in circulation, And Mises himself used classical concepts throughout the book, including the one of the subsistence funds. It goes back to, someone said earlier, Boehm-Bawerk, well, it goes back to David Ricardo, who talked about the subsistence fund, and by that he really meant it. In other words, Ricardo had a pretty dismal view of where the economy was headed.

3:38When it would finally reach long run equilibrium, he thought, the workers would be operating at a very much of a subsistence level, hand to mouth, trying to make do day by day. So subsistence really was what he meant. And by fund, Ricardo always wrote about an agricultural Even though he wrote so much later than Smith and the Industrial Revolution was off and running, he thought in terms of agriculture and the time period he was dealing with was governed by the growing season. And so workers had to make do somehow between the time they planted the crop in the early part of the year and harvested it in the late.

4:29and during that time they needed enough corn to stay alive and therefore the subsistence fund had a much more literal meaning and application then than it did later. What the concept does for Mises is point to the inherent temporal element in the production process. In other words, it takes time to produce. You start now, and how much later depends on, well, how much you can borrow to fund your enterprise, how much capital goods you can create over that time and so on. And so he was introducing, if I put it in modern terms, he was simply introducing the time element as an endogenous variable in our theory of macroeconomics.

5:26And I think that was the purpose that it served. But he also has a notion of heterogeneous capital, and he's talking about capital goods, which is another way of indicating this important time element. The production process takes time, and over time you go through a number of stages. He didn't use the term stages, that's Hayek. But the point is the same, that the capital goods you put together, the things you do during the production period, determines the time profile of the output. And you want that time profile to match the preferences of consumers, all right? And so the heterogeneity of capital might give you a circumstance where halfway through Through the process, you see that you're not going to be able to complete, or it turns out to be unprofitable to get the remaining resources to complete the capital process.

6:26That's what gives you the downturn. So I don't see any inconsistency between the notion of the subsistence fund, understood as Mises did, and the heterogeneity of capital, and they're both in that slim 10-page span of theory of money and credit. That was two, subsistence fund and heterogeneity of capital, and the third one I mentioned is the relationship between saving and investment. If they're equal, and I'm putting this in more modern terms, S and I, saving and investment. If they're equal, you get sustainable growth. If savings is short of investment, you get unsustainable growth, which takes the form of the boom and bust, the business cycle. That's in theory of money and credit in those pages.

7:13The notion of a natural rate of interest, this comes from the Swedish economist Newton Vicksel, but it's critical to Austrian theory and is virtually ignored in macroeconomics today. Interest rate today is considered a policy tool, all right? But in the Austrian theory, it's an important price signal that allows entrepreneurs to to undertake projects that can actually be finished, because they have enough savings to work with and so on. So that comes into effect. In fact, I'm going to focus on that a little more after I get through the other couple of points. There was the understanding again from Newton Vicksell that interest rates can be pushed below their natural level by credit expansion.

8:07And in fact, that's what causes the trouble. that causes investment projects that, to be started, that are actually too long, given the willingness of people to save in the economy. So you can push the interest rate down, the market rate below the natural rate. That causes trouble. That causes a misallocation of resources. And my last point, number six, is that it inevitably ends in a bust, booms end in bust if they're triggered by credit expansion and a falsified interest rate where the market rates below the natural rate. If you have increased saving, you can get a boom, it's a genuine boom, it doesn't go bust, but a credit-induced boom does go bust.

8:58Now I want to look back then at several business cycles, booms and busts, starting with the The Great Depression, not going to spend much time on any of them, because we don't have that much time. But we'll see how it goes. And recognize, as Mises did, that the natural rate of interest can change. And there's a subjectivity in Mises, that the people have time preferences, that the demographics change, and that can cause the natural rate to rise to follow. Technological advancements can affect the natural rate of interest. If there's more opportunities to take advantage of, investors are willing to pay more to borrow and take advantage of them, believing, maybe correctly, that they will pay off in the future. So the natural rate of interest can change.

9:56One of the things Mises says, and maybe you have to be a little careful in reading it until you pick up exactly what he's saying, is that what's important is not whether the interest rate actually changes. Here I'm talking about the market rate, the rate governed, sort of, influenced by the Federal Reserve. It's not so important that it literally fell, what's important is whether it falls relative to the natural rate. All right? And this gives us several possible scenarios, all of which we can find examples of in the sequence of booms and busts. Let me start out with the simple one, and that would be what I think of as the public choice view from the Buchanan-Tullock School.

10:49and it corresponds to a book by Buchanan and Wagner called Democracy and Deficits and so on. In that book they acknowledge an Austrian style business cycle. And this is an instance where the natural rate doesn't change. It doesn't have to change. Sometimes it doesn't. You have a natural rate that is what it is and it stays that way for a while. Well, that reflects people's subjective preferences about consuming now and consuming later. But now suppose that the Federal Reserve starts pumping money in, drives the interest rates down, and does it, and here it's public choice, for political reasons, for political advantage, for winning elections, right?

11:35Well that certainly causes the business cycle in sort of standard form, that's the easiest application of the business cycle, and it corresponds to episodes in history where, for instance, In this instance, Arthur Burns helped Richard Nixon get re-elected by goosing up the money supply and dealing with the aftermath post-election. Or for another one, Alan Greenspan helped Bill Clinton get re-elected in 1996 by doing the same sort of thing. I might add that we think about this theory when we think of Alan Greenspan in 1992, I guess it was, 1990, you tell me the year, who didn't help George Herbert Walker Bush get re-elected, and Bush hasn't forgiven him yet.

12:35Okay, but those instances where you can or you might be able to help or you refuse to help or whatever, we can understand in terms of relationship between the rate of interest on the market and the natural rate of interest that doesn't have that Federal Reserve influence. Other episodes come to our attention where technology, enhancements in technology are important. And here I think both of the 1920s, tremendous decade, it was a wonderful place, a wonderful time to be alive. I wasn't, I mean, you know, it would have been a good time to have been alive. A lot of technological innovations, lots of great profit opportunities.

13:22Increase in the demand for credit would cause the interest rate to rise to take advantage of the technological advancements. But they could actually take advantage of them only to the extent that the increased interest rates brought forth more saving, you see. Now, things didn't quite work out that way because the Fed, guess what, accommodated the increased demand for credit. In fact, that's what they took to be their mission. We accommodate the demand for credit. Which means that the interest rates didn't change, didn't change, all right, when they should have. So there's an instance where the rate of interest was held below a natural rate, which had just risen because of the technological innovations.

14:13This is a particularly significant episode in my own view because several years ago I had some give-and-take by mail with Milton Friedman after I'd published an article critical of some of his stuff, critical of his so-called plucking model. If you've ever heard of that, I won't go into it. But I used the business cycle theory to base my criticism on. And he wrote back, we wrote back and forth a few times, but he wrote and said, and actually sent me a printout of interest rates during the 20s. He says, what are you talking about? The interest rates didn't change.

14:58They didn't change. They can't, nothing can depend on the interest rate. We can't explain anything in terms of interest rate because it didn't change. And of course, Friedman, first and foremost, is an econometrician. He's empirically oriented to the hilt, all right? And all of you, all of you, I don't know, have studied econometrics, some of you, most of you, I don't know. A lot of you have studied econometrics. And you know that if an independent variable doesn't change, you might as well not put it in the And so that's why interest rates weren't seen as being particularly important. For the Austrians, they were important.

15:45In fact, Hayek described that particular instance as, in terms of the job of the economist, he said the job of the economist is to look for aspects of the economy that are hidden from the untrained eye. In other words, you have to see that the factors were there to cause demand for credit to rise and hence the interest rate to rise, but it didn't. Why not? Because of the accommodation. What does that cause? Guess what? Boom and bust. Called the Great Depression, which was made a whole lot worse, of course, by all the ways the government tried to deal with the Depression. Similar boom and bust was during the dot-com era. The dot-com boom was triggered in large part by technological innovation.

16:36And so we got the same kind of a replay there. We got increased demand for credit and accommodation by the central bank. The interest rates not changing particularly much, but still gave us boom and bust. Now, I'd like to mention those two episodes, I could mention others, but mention them to give you a stark comparison with the recent crisis. And recognize that, say, the dot-com boom and bust, or the technology during the 20s, those were real and positive aspects of the economy. economy. That actually gave us some real growth, and the Federal Reserve just caused an artificial boom to piggyback on top of that growth. But we had some real growth there that we can make use of when we had to deal with the bust. Not so in the last crisis, because once again the Fed was piggybacking on something else going on, but what was going on was a misallocation of Resources in the Housing Market, which was not a wealth-enhancing situation.

17:47It was not a real positive development, a very negative development. And then look at it in terms of interest rates. And here we could go beyond Mises because he wouldn't have imagined such a thing in 1912, but there's other ways that interest rates can be lowered other than the Fed. And one of those ways is what we call risk externalization. In other words, if the federal government in some way takes the risk away from a certain kind of lending, let's say in housing markets, then it stimulates the housing industry. You have what looks like a low interest rate, but it's simply an interest rate stripped of its risks.

18:38And the federal government is pretty powerful that way. They can't actually shunt that risk off into the Atlantic Ocean. If they could, we'd all be better off. But they can externalize it and hide it as they did. And of course the culprits here are Fannie Mae, Freddie Mac, and Barney Frank. And there's your risk externalization. Now does this get the Federal Reserve off the hook? Well, not really. Because had the Fed not chimed in with its own expansion, then any extra borrowing in the housing market would have had to come at the expense of loanable funds in other parts of the economy, where loans would be more scarce there because they'd gone to housing.

19:28But the Federal Reserve did kick in, but now instead of offsetting an increasing interest Interest Rate, it compounded a falling interest rate. And that's how you got the interest rate, or you didn't do it. That's how the Fed got the interest rate down to 1% in 2003 and 2004, a period that almost every economist of every stripe says that that interest rate was too low for too long. And Anna Schwartz, a monetarist, who tends not to look at interest rates, said that. So the monetarists, at least at that point, started paying a little bit of attention to interest rates. Now look at it in the post-bust era.

20:17One percent sounds kind of high these days, doesn't it? It's got it down to zero. And we have an understanding here based on this. of why this recession is so bad and why it takes so long to get out of it, because you have the distorted housing markets as a result of Fannie Mae and Freddie Mac, and you have the distorted credit markets as a result of infusion during that 2003-2004, and now you have further distorted credit markets because the Fed is holding the interest rate down the Fed Funds Rate, since December of 2008 and into the foreseeable future through 2013, according to Bernanke.

21:07So, all of this though, it's amazing, all of this can be deduced from Mises' Theory of Money and Credit. Those factors are all either there or implied in those pages by the interest rate. So let me leave you, though, with a warm feeling and a warm thought, is that look at the current situation. We have the interest rates at zero. People are saying the economy is picking up or whatever little. No, no, we're suffering from the recovery. The economy is on life support. If you have to have an interest rate of zero to get anything at all going, then the economy is on life support.

21:56In addition to that, you've got the Federal Reserve, which has expanded high-powered money so much that the reserves and the bank are astronomical. And in fact, have you all heard the term? I'm sure you have, you pay attention. They talk about Bernanke and his so-called exit strategy. It means, how is he going to get back all those reserves when the banks start expanding? And I've heard him say several times that he's confident in his exit strategy. And at a recent conference where several federal reserve bank presidents were, I asked one of them. I said, so we're in uncharted waters. The interest rate is zero.

22:42Reserves are astronomical. How is he confident in his exit strategy? And this president of one of the feds looked at me and he says, being confident is in his job description. He has to be confident. Okay, so I think we need to reword what he really means, that his strategy is to pretend to be Confident. And that's where we are today. Okay, thank you.