Does Bernanke Have an Exit Strategy?

0:00I was a little bit nervous out there. There's a few reasons. One was the line, you know, the men in here with the line out the bathroom was pretty long and I was worried that I was going to be still in line when Doug was making the introductions. Fortunately, I've heard all those jokes three times already, so that was, you know, I didn't have to worry about missing that. I was remarking to Tom Woods, you know, the one benefit of being a guy is you're not supposed to have to wait in line to go to the bathroom, and now we don't even get that one. The other reason I'm nervous is that my in-laws are actually here today. My father-in-law, his job moved and so they live in Aiken, but he has a job here in Greenville. And so they're here now. Of course, you know, I married their daughter so they know that I'm an economist. I think they also had some inkling that I was kind of a weird economist. But I think

0:39until today they had no idea just how weird, in fact, I am. And so I was glad I was looking at the roster and realized, thank God Walter Block's not on the schedule today because, you know he he tends not to sugarcoat things for the for the newcomer alright so what am i talking about today it's uh... does Bernanke have an exit strategy so if you had asked me six months ago i would say yes he has an exit strategy and it's not going to work if you ask me today does Bernanke have an exit strategy i would say no he doesn't have an exit strategy so let me clarify so you know both answers are bad but let me just talk you through here and i'm going to warn you this talk it's going to be more technical than some of the other ones i'll do my The Federal Reserve, The Theory of Money and Credit

1:47or the potential problem. So, the first thing we need to realize is, what do we mean when we talk about bank reserves with the Fed? And so here, again, let me just start very basically. I know some of you, as Doug mentioned originally, were brought here against your will. You maybe didn't realize what you were getting into, so let me try to make this as easy as possible. When you go to a bank and you make a deposit, let's say you give them $100, they don't take that $100 and go put it in a drawer with your name on it, right? So what happens, of course, it's a fractional reserve banking system, and what that means is the banks, they go ahead and lend out, just rounding here, of course, of the $100, let's say they lend out, when all is said and done, $90 of it are out there, it's a form of new loan, so at any given time, the money that's in the bank's vaults, or also it's called on deposit,

2:46with the Fed. So it's as if your bank itself is a customer of the Federal Reserve and so your bank in a sense has a checking account with the Fed. So your bank can write checks that the Fed is ultimately cashing, if you will. So that's kind of the way to think about it. So a given bank, when it looks at how many outstanding deposits do our customers have that each of you has what you think, oh, I've got $1,100 in the bank. And there's other customers of your same bank who think they look at their checkbook and they say, The Theory of Money and Credit either isn't cash, you know, in the vault or in the drawers of the tellers, has to have 10% of that number of the total that its customers in theory could show up on a Tuesday at 10 and say we want our money, or there's another way to satisfy the legal requirement. They don't actually have that all in cash sitting in the vault on hand. They can have deposits with the Fed itself, right? So your bank, it satisfies its reserve requirement, the cash on hand, but also its own checking account with the Fed, if you will.

4:13All right, so one way to gauge how expansionary is the Federal Reserve being is you look at reserves. So again, I'll try to make this not very painful. This is the kind of thing when I wanted to punish my students, I would go and give this lecture, but I'll break it down. So typically, forget the crisis, just normally, you know, five years ago, if you asked somebody, how does the Fed stimulate the economy, what happens when the Fed lowers interest rates, what does it mean? It's not merely that the Fed chief just announces some number and then everybody goes ahead and starts transacting at that new number when the Fed cuts interest rates the way the press would report it. The way they actually lower interest rates is they pump new money into the credit market so the supply of loanable funds goes up so the price goes down.

4:59So what happens is the Fed goes into the market and it used to be it would buy government securities. It would buy treasury debt that the federal government, you know, loans the federal government takes from the private sector, so there's pieces of paper floating around saying, Uncle Sam will give you, whatever, $10,000 10 years from now, and that's if you hold this piece of paper, and then people buy and sell that piece of paper, and so the Federal Reserve would buy some of those from the private sector, and how does the Federal Reserve pay for it? It's not that Greenspan or Bernanke says, well I can babysit your kids for you for the next three months, and then in exchange you give me some of those, they don't offer to to cut your lawn. They don't give you a house. What do they do? They write a check on the Fed. So you say, oh, well, how much money does the Fed have saved up to be able to write

5:43these checks? It has an infinite amount of money, not saved up, but it's just when the Fed writes a check, it automatically clears because they write it so they buy whatever, a million dollars worth of government bonds from some private owner. They write a check for a million dollars payable to that bank or that institution and they give it to them.

6:32and, you know, Tom DiLorenzo's talk, if you're in on that, that's kind of a neat system, isn't it? You know, I mean, it's even easier than typically we try to think of it in terms of running the printing press, but that's actually kind of a pain because you've got to go buy the paper, there's ink, you know, you ever get, you know, when you're printing off $100 bills and you get the ink all over your hands and stuff, I mean, it's annoying. This, you just type some things in, change the numbers in the computer and there you If the Fed didn't inject money into the credit market, suppose when the Fed wanted to increase the money supply, what it did was it went out and bought, you know, cars, let's say. It went to used car dealers and just started writing checks for $5,000, $7,000. We were buying used cars and putting them on the balance sheet of the Fed. They could do that, in theory, and they could have big warehouses. They could do that, in theory, and they could have big warehouses.

7:27the Federal Reserve, fiat money, fractional reserve banking, Human Action, man economy, keep buying until they see the price get within the range they want and they would stop buying. And if the price falls a little too low, they start buying some more. So they could target the price of used cars if they wanted to. And that's the way the Fed targets the interest rate of certain types of maturities and risk. So that's how they do it. But then the consequence, of course, what happens is when they're doing in the banking sector and targeting interest rates, what they're

8:53If the Fed stopped writing checks to used car dealers to buy Hondas, right, that that would be awful. They would think of all the people would be thrown out of work, right. So they would, of course, there'd be huge interest groups and it would be so forth. But they would screw up the economy, obviously, if you're not being richer because the Fed's taking possession of used cars, that's just redistributing resources. So the same thing here. The Fed is just redistributing resources from everybody else into the hands of the elites who run the banking system. but in general the the downside is you see prices start to go up so the way that happens and again I know this gets really complicated but let me just try to give you the basics of it there's there's two different things going on and people conflate the two a lot when the Fed directly buys things in banks reserves go up that per se is not going to make the price of milk or eggs the

9:45grocery store go up right because the banks aren't using their reserves on The way that ultimately raises prices that everybody can see that is typically what's called inflation in the press and what the average person thinks determined inflation means is that you're a bank now you have all these access reserves and so remember the whole point is you're allowed to lend those out up until you hit that minimum ratio that the law requires and so if ultimately you know one of your customers is a someone who owns bonds, the Fed comes and buys bonds from them, gives them a check for a million dollars, they deposit it with you if you're just a regular commercial bank, and now you have those extra reserves, so now you're allowed to lend out more. So if someone needs a home or wants to buy a car, some business person wants a loan to expand their factory, that bank now has more available, they have room on their balance sheet, if you will, to legally make those loans. So that's another part where money gets created out of thin air, in a sense, right? That the bank says, okay, here you want a loan for $10,000,

10:49The Federal Reserve, fiat money, fractional reserve banking, Human Action, Man Economy and State, The Theory of Money and Credit

11:19People are worried but yet we haven't seen disaster strike is that starting I guess it was last September and then especially in October what Bernanke did one way he tried to rescue the economy was he engaged in a massive expansion of the Fed's balance sheet so just to give you an idea in August of 2008 the amount of reserves that banks had on deposit with the Fed was about 45 billion

12:18And then, like that. Everyone see that? That's what the chart looks like. And I'm not exaggerating. The chart really does look like that. It's crazy. So most of the stuff we talk about, we say, not since the 1930s has the government done such and such. And it's funny that even there you wonder, well, wait a minute, the last time the government did these policies we had a 10-year depression. Why are they doing them again? So that seems kind of odd. But we can say in terms of what the Fed's doing now that the Fed has never done this. During the Depression, they didn't, they weren't this crazy. Okay, so that's what people are worried about, but again, obviously, you know, it's not like the price of gasoline or milk or eggs has gone up by a factor of 17. And so you wonder, well, it's, you know, is Bernanke doing something magical? Well, what's, the reason that you haven't seen that is because the banks are just sitting

13:07on those reserves. So normally, the access reserves, the amount of reserves banks have that they legally would to have the ability to lend out, but they're just holding sort of spare reserves, that's typically pretty low. Whereas now that's the bulk of what Bernanke has injected in, has just been sitting there now as excess reserves. So why are banks doing that? Why are they sitting out and not making new loans? There's a few reasons. One that Doug mentioned in his talk is that they're very uncertain. Times are frightening and if you're a bank and already you know that without this lifeline from the Fed, we would be insolvent, you're going to be afraid to go out and make new loans to people just because that's riskier, puts you in an even worse position. Another contributing factor is that back in October of 2008, the Fed instituted a new policy where they started paying interest on excess reserves.

14:02So before, it used to be that if you're a bank and you had reserve, you have your cash in your vaults and you've got reserves that you're just keeping sort of like in your checking The Fed pays you 0% interest on that if you're a bank, and now they're paying 0.2%, something like that. So they're paying a little bit, but the idea is, in a sense, they're bribing banks to not make loans to people, which is a little bit odd if you think about the conventional wisdom that we've all been taught. There was this huge credit crunch but fortunately Henry Paulson and Ben Bernanke back in September and October of 2008 saved the day with the $700 billion TART package and then Bernanke doing all these unprecedented new things and that's we averted the credit crunch and now markets are healing themselves.

14:49What's funny is if you look at the data in terms of business loans, they were at an all-time high in October 2008 and they had been steadily rising and then since all these new rescue Rescue Measures were put in place, they're down about 12%. So it's, again, from your point of view, the business loans look like this, they hit an all-time high, and then right at the part where all these rescue measures kick in, the amount of loans goes down like that. So it's not necessarily the case that it's because of all the things the government's doing, but again, it's the same story that the data tell the exact opposite story of what you would have expected listening to the people on CNBC explain it. Okay, so let me, let's see what time we got here. Okay, let me, now that we've sort of laid the groundwork and you understand what the problem is, so the idea is these times are strange, but if Bernanke just did nothing else and just tread water and the conditions returned back to normal and then banks started lending that out, in a sense, you know, rough figures, there's a room for the money supply to go up by a factor of 17, right, because of what earlier thing I talked about.

15:59If a gallon of gas is $2, well, then maybe it would be $34 when things all settle down, right? So that's the kind of thing that's a potential time bomb sitting there, and that's what people are worried about. So that's what they mean when they say, does the Fed have an exit strategy? Let me tell you something that's sort of humorous. There's a guy, his name's Scott Sumner. Some of you know him. He's a very smart guy. I'm not saying he's stupid by any stretch, but he bought brought into Milton Friedman's explanation of the Great Depression and Friedman said the Fed was too timid. And so Sumner has been saying that the reason we're having this trouble is the Fed has been too tight with money. And so he had a blog post one time said, does the Fed have an entrance strategy? Meaning in his mind, the Fed needs to do some more, right? So that's, you know, this, when economists are crazy, they get an idea in their head

16:47and no matter what, they'll say, well, no, we're still in this recession. So clearly the Fed hasn't pumped in enough, even though they pumped in 1700% increase in 12 months of Reserves. So, in any event, let's get back to, so what's the Fed's exit strategy? Before, six months ago, if you asked Bernanke, what do you plan on doing, because you've certainly done a lot, and isn't this a little bit dangerous? The answer was, no, no, a lot of these programs are self-liquidating, they will unwind naturally, meaning a lot of this, the other thing I don't have time to get into, but it's another difference between what Bernanke's doing now versus typical

17:54I'll tell you what, we'll, and I'm simplifying, why don't you lend it to us for 30 days, 90 days, what have you, and we'll give you reserves with the Fed, which are, I was going to say as good as gold, but I don't want to make you laugh, but they're unimpeachable from a legal point of view in our financial system right now, so we'll give you those, and we'll value these things that, I don't know exactly how much, but they certainly value them above the market value. So they're being like this rich uncle who bails people out by doing Bankers are doing short-term swaps of things. So that's another reason, too, that the banks are kind of in a precarious position is that at any moment Bernanke could just change strategy and say, you know, we're letting all these things unwind tomorrow and all these, once the contract expires, a lot of this stuff, these toxic assets on the Fed's books are going to revert to you guys and then you'll instantly be insolvent again. So I think that's another reason that the banks are just completely under the power now of Ben Bernanke. So the question is, or Bernanke used to say, okay, we'll just let these

18:54The problem with that, and so that's what I would have said, yeah, they have an exit strategy, but it's a bad one, they'll stop coming to the Fed to borrow at what are, you know, unreasonable terms once the market improves. The Fed's terms are good right now because they're the only one willing to even deal with you guys, but once conditions improve, people won't look to the Fed, they'll look elsewhere, and so these things, so the Fed's balance sheet will just naturally shrink back down. Now, the problem with that, and so that's what I would have said, yeah, they have an exit strategy, but it's a bad one, so let me just very quickly tell you what the problem with that is. That sort of assumes, so he's sort of imagining that, you know, the Fed inhales and sucks in all these assets onto its books and pumps in the reserves, and then it's just a matter of undoing everything once conditions improve. The Fed will be able to sell off those assets, shrink its balance sheet and suck reserves out of the system and everything will go back to the way it was before the crisis.

19:48But the problem is, what if when the Fed starts selling those things off, so let's say price inflation starts kicking in and the Fed needs to unwind, what if the market value of those things on the Fed's books is a lot lower than what the Fed paid for it? for it. So let's take, you know, the government securities. The Fed was buying a lot of government debt when long-term interest rates are very low, meaning the price of those securities is high. So the Fed's paying a lot of money, it's writing checks that are boosting up the reserves banks has for these things. What happens if China all of a sudden says, you know what, we don't trust the dollar anymore, we're unloading everything, and long-term interest rates go up to 40 percent? Well, then if the Fed, even if it wants to unwind, is all prices are getting out of control let's sell off these things and suck liquidity out they're gonna get a lot less per government security than they

20:36paid for it so even if they did everything there's still extra reserves still sitting out in the system that they can't suck back out because they're not able to sell them for the same price they paid for them okay so that's one issue and then another thing is they've got hundreds of billions of mortgage backed securities on their books as well and so again if the housing market If the Fed recovers, that's fine, they'll just unwind, but suppose the housing market doesn't recover, suppose there's another 5% drop over the next year, well then those mortgage-backed securities would drop in price, and even if the Fed then wanted to unwind, they couldn't get the same price as what they paid, so even if they undid everything, you'd still have all these hundreds of billions, potentially, of excess reserves out there that the Fed would be literally incapable of sucking back in. Okay, so that's why I would have said six months ago, they have an Exodus plan, but it won't work.

21:25I don't even have an exit plan. Lately, what Bernanke and other Fed officials have been stressing when people say, you know, how are you going to get out of this? They say, no, no, don't worry, because now we have this new tool. We're going to be able to, and you might think, oh, Timothy Geithner? No, that's not the tool. The tool is... The tool is paying interest on reserves. All right, so, and we talked about that a little bit before. What their plan is, or what their defense is, when they say, don't worry, this isn't going to be a problem, is they say, look, the only way that those reserves get out in the economy and start raising prices is when banks start lending it, and so that real people have in their checking accounts more money now so they can go to the store and write checks and push up the prices of apples and bread and so forth.

22:14So as long as the banks continue to sit on those reserves, there's no problem. And so even when the economy recovers, if mortgage rates go back up to 6-7% and other interest rates start rising so that now the Fed paying whatever it is, 0.25% interest on loans is not attractive and the banks say, well rather than earning that at the Fed, why don't we lend out some of those reserves and earn whatever, 8% from, sure a borrower is a little bit riskier than the airtight Fed, but nonetheless I'm earning 8% instead 0.25%. The Fed can just increase the interest it pays. That's the idea. So they can, you know, they can pay as much as they want because again the Fed has an unlimited amount of money and that's what they say. And that's where the discussion ends. And I kid you not, I am the only economist I have ever seen raise the obvious question, okay, but isn't that a bit like, you know, a household's in trouble, the guy doesn't earn that much from his job

23:09and you know, they're spending too much money month after month, they keep getting deeper into debt and they're saying, what are we going to do? We really have to either, you We have to get more money, or we have to cut our spending, and the husband says, no, no, honey, our problems are solved, I just got a new credit card. In a sense, the guy's right, that that does buy them some more time, that they can postpone the day of reckoning, but you can see how that's not really fixing the problem. So the same thing here, if the problem is you've got too many reserves out in the system, and banks want to start lending that out, and so what do you do? You need to suck those reserves back, destroy them, and instead of saying, okay, how are we going to do that? Now Bernanke and his lieutenants are saying, don't worry, we will just let the reserves grow exponentially, because we will start paying banks more to not lend those reserves

23:55out. But again, remember, how do they pay a bank? That means whatever the bank's deposit is with the Fed, it starts growing at a higher rate more quickly. And so it's like the Fed writing checks to the banks now not to buy assets, which is to say, don't make loans. and the bank says, no, but it's really profitable, I'll make loans. Well, here's a billion dollars, okay? And that's what he's doing. But again, that pile of reserves now is just going to keep growing exponentially. And so I'm not kidding. I have never seen any other person ask, well, what do you do if we're in a stagflationary period and, you know, that you do that for a year, and now the problem is whatever it is, 2% worse, because you just, you know, had to pay banks 2% to keep them bottled up. and no one has ever even asked that question let alone has Bernanke and friends given a good response so all this stuff the last fun comment I'll leave you with or observation is all of this material the underlying premise is and you see this from Fed officials you see it from Wall Street Journal writers and you see it from you know bloggers is they say well there's no problem there's no threat of price inflation right now because there's so much excess capacity with unemployment this high you can't have price inflation right when of course you can in the 1970s

25:05I thought the one good thing about the 70s was that was supposed to have slayed the Keynesian beast about the Phillips curve that you can either have unemployment or high inflation, but you can't have both at the same time. I thought that was the one thing that we were supposed to have learned from the 70s, and no, it wasn't. That wasn't the one thing. And then you also have, in modern times, the Zimbabwe. They had very high unemployment, and you may have heard that their inflation problem was a little bit out of hand. So this idea that we can't have rising prices when unemployment is above 6%, that's just not true. We can look at U.S. history, we can look at current history, and theoretically, it doesn't make sense either. Think of it this way, what's price inflation caused by too much money chasing too few goods? That's why the unit price goes up.

25:50So during a recession, what happens? You have less real output, there's not many people working, so they're producing fewer are things, and you've got either the same amount of money, or in our time, 17 times as much money, and people are saying, but don't worry, it's impossible, prices can't go up. That just doesn't make any sense, and I think we're going to learn that lesson the hard way. All right, well, thank you very much.