How the Fed is Retarding Recovery

0:00I was asked to explain, Doug just alluded to the fact that we're developing a high school curriculum. It's actually, I think you would be amazed at what the kids are reading these days and I mean that in a good sense that, you know, I will, at every Mises University that we go to, and for those of you who don't know, Mises University is every summer where typically college undergraduate kids go down to the Mises Institute and we have a week Conference, and every year, the stuff they've read, it gets more and more impressive. In other words, when I was going there, I was one of the few people who had read Human Action, let's say, and other people had read parts of it or they had read easier things, but I was one of the few as a student who had read it from cover to cover, but now there's more and more people that that's just, yeah, of course I read that, why wouldn't I have

0:53read that? It's online, it's free, why wouldn't I have done that? And it really is impressive, and so my point is just that actually I think this curriculum we're working on, we had conceived of it as, you know, for high school kids, maybe homeschoolers, but actually I think it'll be good for precocious seventh and eighth graders. And the announcement that I was asked to relay is that it might not be appropriate for you guys, but if you know people in the area, this coming Friday, the 20th, I guess that would be, they are going to have an event at the Mises Institute for high schoolers and their parents who are

1:54where is talking to high schoolers that they have no idea if what you're saying is right or not so on the other hand you guys presumably won't throw spitballs at me whereas that that is always a danger with the high school kids okay so the uh what i'm talking about today is how the Fed is retarding recovery and what i want to sort of combat is the this conventional wisdom that when you it's true whether you're reading the Wall Street Journal or watching CNBC or you're reading in the New York Times or CNN, let's say, you know, that's the spectrum that we're supposed to have, or Fox News, I guess, from the so-called, you know, free marketeers to the interventionists, that's, we're supposed to be getting the full palette there of possible views, but I mean, every, almost everybody is saying, with the occasional, except there's a few op-ed writers in the Wall Street Journal, but the typical line is, even if you're against what the Fed

2:45is doing, in terms of since the crisis set in, the things the Fed has done, people, they They generally are saying things to the effect that, yes, the Fed rescued us and it prevented another Great Depression, but we think maybe it's time to pull back that emergency measure, to take that medicine away, because now it's done the job and now we run the risk of over-medicating the economy, and that's the threat awards, to put it in more economic terms. They say, yes, the Fed, by lowering interest rates, it has stimulated recovery and it was a much-needed dose of help from the Federal Reserve, and thank God we have the Fed, but The Federal Reserve, fiat money, fractional reserve banking, Human Action and State, The Theory of Money and Credit

3:50that by doubling the monetary base in six months or whatever the exact figure is the Fed has sown the seeds for future price inflation and that's the only downside to be weighed against all the benefits of doubling the monetary base in six months that no, doubling the monetary base in six months in and of itself has been a bad thing and I want to just go through some of the reasons for that in the talk today. Alright, so first and foremost just the very you know the thing that everyone thinks is the help, the benefit of low interest rates. So the idea is that if we didn't have a FED, if we had a purely free market, or if Bernanke had been a mean guy and didn't want to help people, when the crisis set in, what happened, and when I say when the crisis set, I guess largely people have in mind September and October of 2008, but even the rescue measures started well before then, but let's just join the debate the way most people have in mind and talk about things like after the fall of Lehman.

4:50And let me just go on a little bit of a tangent, even right there, the debate is all screwed up when people say that, oh, you know, we had a totally free market and then Lehman fells and, you know, the credit markets are royal, everyone's panicking, it would have been the end of the world financial system, but for the interventions, but I don't think that's true. So for one thing, there was a good article, actually it was in the Wall Street Journal by Zingales and I think John Cochran, I might have had my economist mix up, but there was These two Chicago school guys, and they actually had a great chart showing that the real panic in terms of looking at the spreads between corporate bonds and other types of debt versus what was considered to be really safe debt in terms of U.S. treasuries, those spreads didn't explode the day Lehman failed or the day after, it was only a little bit further after.

5:40If you look at the timeline, when Paulson and Bernanke were telling Congress, we need We need $700 billion for this TARP or else the world is going to end. So that was what really made the panic start. So it wasn't the fall of Lehman per se. You really saw the objective measures of panic or crisis in the system kick in only when Bernanke and Paulson were pointing at the Lehman failure and saying because of this we need $700 billion. The idea is that maybe it wasn't that the system itself was really that precarious. It was that investors wondered, well gee, what the heck does Paulson know that we don't No. In retrospect, what he knew was that this will help Goldman Sachs. You see what I'm saying? So even the conventional story, the way they tell it, isn't quite right. And then even pushing it further, even if it were true that the Lehman collapse, per se, was really where we can point to, oh man, it's a good thing we've had the Fed and the Treasury doing extraordinary

6:36measures since then. Otherwise, the free market would have brought us to our knees. Well no, So part of why Lehman was such a shock is that they had earlier either directly bailed out or the Fed behind the scenes sort of brokered takeovers of Bear Stearns and other things that were in trouble, right? And so part of why Lehman was such a shock was that was an about face from what the government had been doing up until then. In contrast, if, say, way back in the summer of 07, when it was clear that the subprime thing was a problem and that there was a lot of losses that were going to be on the books of these firms that had dabbled in mortgage-backed securities, if at that point, George Bush had said, hey, guess what, I'm supposed to be a free market guy, we're not doing anything to help you, this is a profit and loss system, and if you screwed up, that's tough for you,

7:29and you're going to go out of business and the Fed had said we're not going to do anything special we're going to look at what interest rates should be looking at GDP and looking at inflation expectations we're not going to alter our policy based on the financial system if you screwed up that's tough for you if they had done that consistently since the onset of these problems then the Lehman failure wouldn't have been such a big deal right whereas again the reason it was such a surprise was people had been led to believe no big firm is just going to be allowed to collapse because it's too big to fail because So anyway, the very first step in the argument when people are trying to explain why the Fed has saved us is wrong and that the crisis that they say would have happened had we just followed laissez-faire capitalism, we don't know because they didn't allow laissez-faire capitalism at any stage in this.

8:19but okay what about the idea of bringing interest rates down in here the what they're the people who are for the Fed the people who are saying the Fed rescued us and provided temporary relief perhaps at the risk of long-run inflation they're they're going to say that the idea is pretty simple that you know high interest rates are tough if you're a business person and you have bad loans on your books and you're having trouble getting financing well surely other things equal, if the Fed has low interest rates, it's cheaper for you to borrow money from the Fed, or even if you're the third firm in line, somewhere up the high chain of lending, if they can get money from the Fed at 0% or a quarter percent interest rates, that's got to be a good thing, right? And I want to say that, yeah, it's good from any individual firm's point of view if you want to go borrow, but it's not good from the system as a whole's point of view or the

9:12the economy's point of view, because those prices mean something. So let me just give you an analogy, and a lot of you have studied free market economics and you'll recognize this, that what happens when you try to motivate the problems with price controls, let's say there's a blizzard in some small town somewhere and they're cut off from the outside world, there's a huge blizzard, and a lot of people think, oh well, the way to help those people is to make sure that the local shopkeepers, they don't engage and Price Gouging, right, that they don't, for generators and batteries and canned goods and bottled water, that they don't just jack up the price and take advantage of those poor people because they get hit with the blizzard. But actually, if you've studied economics, you know that that's not true. What happens in that situation is, you know, you've got a fixed supply, the demand goes way up because people are panicked that, uh-oh, the trucks from Sam's or whatever might not

10:03be able to get in here for a few days. And so the inclination is every household runs to the store to clean out the shelves, to stock up their pantry, but you don't want that to happen. You don't want the first ten people who get to the store to clean up the shelves and get six weeks of canned tuna and bottled water, and then the person who's eleventh in line gets to the store and the shelves are empty. So how do you ration the available stockpile so that everybody gets enough to get through the few days until the blizzard gets, you know, the streets get cleared and so on, is you allow the prices to go up. So that's, just to give you an example, so you might think that, isn't it nice isn't it helping the people by checking the evil greedy profits seeking of the merchants who want to exploit them in their time of need in this in this emergency but no actually you're not helping them yet you're helping the people who get

10:52to the store first but you're actively hurting the people who show up after the tuna runs out or whatever it is that the thing that's in short supply okay so that the the broader point there is market prices really mean something and you're not creating more wealth by holding prices below where they should be so then in the context of the financial crisis yeah when when investors realize oh my gosh all these mortgage-backed securities that that these firms are sitting on actually aren't worth what we thought and so now a company that has a lot of these things on its books if it wants to borrow money from me well I'm going to ask them for a much higher interest rate because they're a much riskier proposition right now than I would have thought a month ago and so that's why you see you know the the interest rate on certain corporate Debt, especially for particular companies, started going way up.

11:41And so it's not true to say that by the Fed's interventions, and part of the way they try to measure the effectiveness, they say, look at Bernanke's save the day, is they'll show charts of the spread between corporate debt and treasuries, things like that. So what that means, I know some of you are new to this, you don't have a finance background, I'll try to simplify it. The idea is what investors were demanding in terms of an interest rate to lend money to the U.S. government as opposed to a major financial institution or even just to a regular Fortune 500 company, that the gap between that, because the U.S. government is considered safer, that it's much more likely, even though the way they get their money is a bit dubious to some of us in the room. The idea is that, you know, if you buy a ten-year bond from Uncle Sam, chances are you're going to get that money paid back to you. You know, Uncle

12:39Sam's not going to default to the same probability as even, you know, some other private company. Even if it's a strong company, ultimately the government can just tax people and pay you off, or they can print the money and pay you. So people aren't so much worried about The Treasury literally defaulting on its bonds, although the probability of that event, it's like two, two and a half to three times higher now than it was like 18 months ago. If you look at the prices for certain things protecting you from that event, so even though it's still considered, the US Treasury is still considered a safe investment, it's a lot riskier now in investors' opinions than it was even just 18 months ago. But anyway, the point is, that's one way that they were gauging the fear in the credit markets and what people thought in terms of the stability of the system as they looked at the gap.

13:30The premium investors needed to be paid in order to lend their money to a private institution versus giving it to the safe U.S. government. And so those spreads exploded, as I say, in the fall of 2008 and since then they've come way down. And so that's, again, people are pointing that to say that shows that Bernanke's been and Successful. But no, he hasn't because, again, that's equivalent or analogous to if, right when the blizzard sets in, if the free market price of tuna and bottled water and generators went through the roof and then the government did all sorts of measures, you know, like threatening fines and maybe using tax incentives to bring the price of tuna back down to the pre-crisis level, that wouldn't be a good thing. And so you see something

14:43They run out of dollar bills because Bernanke just you know make it you know spend all you want We'll make more right you see so it's a little bit weird there But that but the principle is still the same to the extent that you think interest rates mean something Then clearly by them pushing them down below where they should be they they've distorted things and in particular what what happens is You know think of what? The mistakes people were making during the credit and the housing boom Part of what was going on there is consumers weren't saving enough right that people in the years 2003, 2004 and 2005, they were getting their paychecks, their salaries, whatever, their normal sources of income and then they weren't putting much of it aside into their 401k or whatever their sources of savings were because their house was going up at double digit rates in some areas and so they quite rationally thought, you know, if that house price rise were legitimate and were going to last, well it's dumb for me to be putting aside 15% of my paycheck in the bank or in the stock market or whatever when my house is appreciating so much.

15:43And so then when the market crashed, the housing market crashed, people in a sense realized they had a lot less saved up than they thought they were going to have in the year 2008, when they were, you know, planning their behavior for earlier years and they thought how much net wealth am I going to have in 08 and 09 and 2010, their plans were totally screwed up by the collapse in the housing market. And so people needed to be saving more. And one of the ways the market would sort of give them a kick in the pants is if interest rates went way up. And so people now, you know,

16:43And we'll get through this. There's no reason to alter your behavior. And we know that that's the case. They're trying to get people to spend more, to go out and borrow more, and stop paying down your debt. That's a bad thing. Okay. So again, lowering interest rate per se is not a good thing if the interest rate should have been really high. Another problem with what the Fed's doing is it's fulfilling or perpetuating what's called moral hazard. There, I'll be brief on this particular point, it's a pretty simple case or simple argument that what the Fed has done, among all the other things it's done, is it's bailed out these large institutions that should have gone bankrupt, or they should have been taken over by rival firms, through various mechanisms, but largely because part of what the Fed has done is, and this morning I didn't check the latest figure, but the Fed has taken onto the Federal Reserve, fiat money, fractional reserve banking, Human Action, Man Economy and State, The Theory of Money and Credit

18:05May and Freddie Mac. Actually, it's over a trillion at this point since the inception of the crisis. So part of what happened is specific firms that made bad bets, that they invested in mortgage-backed securities, for example, they're sitting and then they should have gone under, they should have been taken over, but instead the Fed comes in the night on the white horse and buys them off their books, so the banks clear off their books a little bit and now they're no longer insolvent, but only because the Fed rescued them. So in terms of the system as a whole, that malinvestment is still there. It's not that the Fed undid the mistake. All the Fed did was say, okay, instead of you, the person who made the mistake, instead of you bearing the brunt of it, we'll just basically spread it to everyone who uses U.S. currency.

18:50Because when the Fed creates money out of thin air to absorb that loss, in a sense, it's who loses, it's the people who hold U.S. dollars that now are depreciated. And one way to see that is if the Fed had done nothing, you saw prices, remember prices were falling in the winter of 2008, they would have fallen a lot more if the Fed had done nothing. The Fed, in addition to all the other things, the Fed increased the actual supply of money in people's pockets. So I'm not talking about the banking system, but I mean currency and circulation, people's checking balances, that number went up something like 17% in the second half of 08. And so as much as prices fell anyway, the price fall was being bullied up by the fact that they allowed the money supply to expand.

19:40And so if they had really done nothing and just sat back and let the thing run its course, prices would have fallen a lot more. So you would have seen a lot of firms failing, but people who had nothing to do with mortgage-backed securities, people who were just living on a fixed income, let's say, or other workers who weren't getting laid off, they would have gone to the store and they would have seen

20:29The simple transfer of wealth from people who had nothing to do with the mistakes to giving it hundreds of billions to the people who made these mistakes, the problem is the precedent it sets that to the extent that a lot of the mistakes made during the housing boom years were because managers were incompetent or rather what they were doing is they were being a bit too aggressive during the housing boom. They were making money hand over fist when home prices were rising at double digit rates there was a lot of money to be made in Financial institutions, you know, going around to banks saying, I don't care who you lend the money to, just get people into houses, get mortgages, we'll take them off your books, we'll combine them, slice them and dice them and then sell them off to investors in China and elsewhere, and then we'll earn our commissions, the, you know, people at the time, some people knew that that's risky, what if the housing market collapses? And so the way, if you were a firm that didn't engage in such riskiness, the way you could justify your lower profits to your shareholders is to say,

21:29Don't worry, we think that with these people, they're going to get caught with their pants down and the housing market collapses, we don't know exactly when, but then you'll see why the prudence of our approach is better. That yeah, we're not making the huge returns and our executives aren't getting these multimillion dollar bonuses, but we're looking at the long term. Well that advice now has just been rendered moot, that was a dumb thing for them to do. The ideal strategy is make a bunch of money during the housing boom, pay your investors of Money, The Theory of Money and State, The Theory of Money and State, The Theory The rules are going to change. You don't know what's going to happen.

22:31Tim Geithner could just wake up next week and say, we're going to cancel all these types of loans, or we're going to introduce some new lending program to bail out firms that are getting in trouble. So you see that the incentives have all been changed. Let me move on a little bit here. Another downfall of what the Fed's been doing is it's picking winners and losers. okay so it's a lot of people talk as if it's just lending help to the economy in general and then you know again at the expense of all possible inflation down the road but no the Fed has come in and specifically bailed out individual sectors and we can only assume sectors that you know it's not that they randomly chose them or that they asked a bunch of social workers which areas of the economy should we help you know and they said well I think we you should buy you know debt issued by companies that make baby formula and and you know

23:54Goldman Sachs, Credit Default Swap, so that if AIG went down, Goldman would have been one of the ones hurt. And also the foreign banks that benefited from all these Fed interventions, they also, a lot of them, it's now coming to light over the last few weeks, the positions they were in, the reason they were so vulnerable was because of deals brokered by Goldman Sachs employees. So it's not merely the direct losses that Goldman would have suffered if the Fed The Fed literally did nothing when Lehman failed and AIG was on the ropes, but also a lot of their business partners would have lost billions and they would have blamed that in a sense on the advice and the deals that they got through Goldman Sachs. So again, it's not just Goldman Sachs of course, but the point is if you look at the Fed's balance sheet, it did not just say, oh the economy needs a trillion dollars in liquidity, so let's throw a dart at the board and just start buying stocks to the dart lands.

24:43Art Lands. No, they intervene in specific sectors to the detriment of others. So that's bad on many accounts. Again, it teaches businesses that what you need to do to succeed is not serve your customer, is not make sure you're returning value to your shareholder and watching the assets on your balance sheet, but rather the way to succeed is to make sure you remain in good with whoever's running the Fed. Bernanke right now is incredibly powerful. He's arguably one of the most powerful people on the planet if you assume that he really does you know behind the scenes we don't know exactly how much power he has maybe somebody tells him what to do we don't know but in terms of what the fed chair ostensibly has the power to do that's incredibly powerful he literally could destroy the economy tomorrow he could just say you know we're gonna we're gonna uh... sell everything off the books right you know and that would just cause the markets in turmoil

25:34or he could say we're gonna buy up every mortgage in america and technically he has claimed the right to do that and many of you probably know this but So the Fed had injected, at the time, I think it was about $700-800 billion into the financial markets. This was in December of 2008, so a few months after the rescues really got in a full swing, and Congress called Bernanke before them and said, can you please tell us who you're giving this money to? We're not disputing that you have the right to create hundreds of billions out of thin air and just hand it out to people, can you at least tell us who you're giving it to? And he said, no, that would defeat the purpose of the program. Now, his rationale was it would cause a stigma, you know, if people knew that we gave 13 billion to the Citi group to, you know, take something off their books, then people, you know, and

26:24you don't want the bankers to feel bad. So it's all about self-esteem on Wall Street, right? So, but literally, I mean, if you just think about it, that's shocking that not only does Bernanke walk around literally with the ability to write checks with, you know, it's not like there's a pile of money and every time Bernanke writes a check up, now he has less reserves, He can write as much as he wants. They have a hard time grasping it because it's such a crazy idea, but they've literally added more than a trillion dollars of assets to their books and the only way he gets penalized is on the balance sheet, your assets went up and then your liabilities went up, but there's nothing to stop him from doing that. Like I say, he doesn't even have to tell Congress who he's given the money to. So anyway, that's part of the impetus behind the audit, the Fed bill is just to say, well, at least let us know who you're shoveling these billions into the pockets of.

27:13Okay, let me have a few minutes left here, a few other problems and what the Fed's been doing. The whole, remember the whole ostensible purpose of these interventions in the credit market is we got to get businesses lending, or sorry, banks lending to businesses, right? That they say there's, you know, all these businesses out there that the way they pay their employees is they borrow money every month, right? in which it's crazy that you talk to an actual especially a small business owner and say do you actually use you know borrow money in order to pay your employees and make payroll every month and i talked to a few of them and they said well i'd be in real serious trouble if i did do that right that that that would be a sign of an emergency that that's not a standard operating procedure that you borrow money just to be able to pay your employees that month but anyway that was that was the whole rationale if you remember from tarp and all the things that the fed's been

28:01doing and that's always why they say you know Geithner when he was on his town hall meeting of of CNBC. You know, they never say, oh, we're bailing out the bankers because they made a bunch of losses and they shouldn't have to deal with that. They say, no, it's regrettable. We'd like to let them all fail and eat the results of their past mistakes, but we can't because then the financial system collapses and then you lose that credit intermediation process that you got savers over here, borrowers over here, and the banks are in the middle channeling the savings into the hands of the borrowers. So beyond the problems that we've talked about, that by the moral hazard they've the people in the middle who are responsible are the ones who prove themselves to be incompetent and besides the fact that the price, the terms on which these these borrowings are occurring are not the right prices, besides those two problems you've got the fact that the borrowing is way down

28:53and we don't know in the alternate universe the Fed had done nothing what would the borrowing be like but it's just, I think it's ironic, If you look at the loans to businesses from banks, commercial loans to businesses, they were at an all-time historical high in October of 2008. And since then, they have plummeted something like 17%. So I'll say that again, the thing that we're trying to rescue was at an all-time high right when TARP kicked in, and then since then, it's fallen like 17%. So if you looked at a chart from your point of view, it's like this, and then it's is like this, and the inflection point is right when all these emergency measures to boost lending to small businesses are kicked in, and it's, proponents of it will say, well, if it hadn't been for TARP, it would have fallen even faster, and that perhaps that's true, but again, the people are, you probably wouldn't have known that unless I told you, or if you heard it from somewhere else, if you listen to the conventional wisdom and people justifying the interventions, you would have thought loans to businesses were collapsing, especially real estate loans were collapsing, and then they finally started picking back up,

29:57The so-called credit crunch, when people were worried about it, it was just the rate of increase of loans was tapering off. But it didn't actually start plummeting until after. And one of the specific things the Fed has been doing, and some economists, you know, they can't understand why, is the Fed's paying interest on reserves. So it's a little bit technical, but if you're a commercial bank, you could have reserves, it's basically your checking account with the Fed. In the Fed, which is a relatively new thing, it didn't used to do this, is paying interest to banks to keep their money parked at the Fed. So many of you may have thought, gee, I thought the Fed was doing everything in its power to get banks to make new loans. No, it's not. It's in a sense, literally paying banks to not make loans. And again, we don't know how much loan making would have occurred because it is a bad environment and the banks are, you know, they have huge losses.

30:46My point is just, it's ironic that we think the Fed is trying to promote lending when, no, they're literally paying banks, not to make new loans, but to keep money on deposit with the Fed. Okay, the very last point, I want to make out a minute left here, is, of course, the thing everyone talks about, the inflation concern. But there, people are acting as if, so far it hasn't been a problem, but once price inflation gets to five, six, seven percent down the road, we don't know exactly when, and then we'll see the downside of all the beneficial things the Fed has done up till now. And I want to say, no, right now, the threat of that is retarding recovery. I mean, just think about it, you personally, you haven't been trying to find the best ways to serve customers or to, you know, where's my money going to make the highest rate of return over the next few years in that sense, you know, channeling resources to where they're

31:37going to yield the most fruit for consumers. No, you're wondering, man, is this inflationary time bomb real, and where am I going to put my money? Should I just put it in gold or silver, or should I buy real estate in Asia? So when people are worried about massive inflation, they're not doing what they're supposed to be doing. That sort of, in a sense, takes away the whole benefit of a monetary economy, is when people start thinking in terms of barter, and I've been talking to some of you guys, and you guys are more paranoid than I am, which is saying something, about, you know, we need to get, you know, oh, I got my shit, I got this much, you know, ammunition and this much bottled water and, you know, this stuff, and it's, you know, hybrid seeds, what have you, and that's not good for the economy, you know, in terms of, if those, it would be good if those threats weren't there and people didn't need to worry about stocking up on hybrid seeds but instead could worry about, you know, let me try to get more customers from my business or whatever the issue is, okay? So, my point is just even though the price inflation threat has

32:34the Federal Reserve, fiat money, fractional reserve banking, Human Action, Man Economy and State, The Theory of Money and Credit

33:04600, because it would have kept falling the way oil prices collapsed. People would have been directing their resources and their time into productive things rather than just trying to hang on to their principle in light of this coming inflationary storm. So with that wonderfully chipper note, I will end. Thanks a lot.