New Eras, Old Fallacies: The Fed and the Coming Recession

0:00Unfortunately, there's not one word of optimism in this title. New Year's, old fallacies, the Fed and the coming recession, it's all pretty grim. The only thing humorous about it is that I get to make fun of Alan Greenspan in the course of this talk. Let me start with the old fallacies that are still current. I'll start with them, and then I'll go on and talk a bit about the events that they've led to, and that we're now living with. We're on the precipice, on the precipice of the establishment of a world or global central bank that will be able to inflate to what Murray Rothbard used to call a fairly well, just inflate as much as they wish.

0:48Let me just talk about some of the fallacies, and at the end of which I will read a statement, testimony, given by Alan Green's fan to Congress last Tuesday, which very nicely embodies these fallacies. Let me begin with one statement we all hear, and we all think we know, or not us as the people who are economically enlightened, but certainly the public at large, unfortunately, and the media. Low interest rates cause economic growth. That's fallacious. It's a lie. Old-fashioned thrift, voluntary savings, postponing present satisfaction and investing the money is what causes economic growth.

1:38It also happens to bring about at the same time, as a necessary part of the process, a lower interest rate. That lower interest rate indicates that people no longer prefer the present as greatly as they did before, that is, present satisfaction. So interest rates are, falling interest rates are a part of the process of economic growth, but they're not the cause of it. In fact, we know the Fed can lower interest rates. The Fed, by simply printing up money, creating money out of thin air as it were, the Fed simply lowers interest rates in that way and it does it all the time. It doesn't cause economic growth. In fact, it wastes scarce resources. It causes businesses to borrow at a lower interest rate that really corresponds to what people feel about the present and the future.

2:24And in the course of this, they create too many capital goods. Okay, we get too few McDonald's hamburgers and too much steel, which eventually, when the trades go back up again, is going to cause a situation of recession. That is, the people in the steel industry that were newly hired to add to the amount of steel or other capital goods in the economy are going to be thrown out of work. And they're going to have to move back to producing hamburgers and other goods that directly satisfy human wants. So for a while, you may see more goods being produced, but eventually, the chickens come home to roost, and those manipulated interest rates go back up to a level that corresponds to people saving preferences, and we get a recession. If, in fact, low interest rates cause economic growth, then the Japanese economy would be booming, instead of shrinking.

3:15It's literally shrinking, it's getting smaller. But the interest rate is 0.6%. It's less than 1%. You or certainly a business can get a loan for less than 1% in Japan. That hasn't caused economic growth. The fact is, we'll see in a few minutes, that's caused a tremendous distortion of the Japanese economy, which is still ongoing. Okay, economic growth causes inflation. This is a complete mistake. Economic growth, if it means anything, means that there's an increase in the supply of goods and services. Our economy is becoming more productive and it's producing more things. When more things are produced, all other things equal, if there are more goods coming onto the market, in order to sell those additional goods, these sellers have to lower their prices.

4:01They have to. We're assuming the government does not increase the money supply, which means the prices will then fall. Economic growth causes falling prices. If you look at economic growth in the computer industry, tremendous economic growth in the 80s, prices of personal computers fell from something like $20,000 down to less than $1,000. I don't see any inflation there. The price of hand calculators fell dramatically in the 70s, from $350 to something like $10 today. And of course, one of the greatest periods of economic growth in the U.S. was from 1880 until 1890. We were growing at 4-5% per year, which is equivalent to what Japan was growing at in the late 80s. Very high rates. And yet, prices were 7% lower in 1890 than they were in 1880.

4:52The economic growth requires an increase in the money supply to finance the purposes of the extra goods that are being produced. That is, if there's more goods, we have to have more demand, right? We're going to get extra demand if we don't have any more money. Well, as I've just mentioned in talking about fallacy number two, you don't need any extra money because prices naturally fall on the market as the supply of goods and services increase, okay? So today your dollar can buy 20 times more computers than it could 15 years ago. A dollar can buy about one thousandth of a computer today, right? A thousand dollars or so. 15 years ago it could only buy about 120,000 of a computer.

5:40So as the course of price is falling, each dollar becomes more and more powerful and is capable of buying off those extra goods. So you never have to worry about having efficient money in the economy. If the money supply could be perfectly constant, that would actually be an ideal situation. It would be constant and prices would naturally fall over time, indicating that all things are becoming cheaper to us because they're becoming less scarce, and that lower scarcity is reflected in the lower prices. A fourth fallacy I want to touch on is that an increase in consumer spending is good for the economy in that it can cause, or will cause, an increase in real output. If consumers spend more, well, businesses will produce more. It's more profitable, okay?

6:28This is a terrible fallacy that came into mainstream economics in the 1930s. In fact, if nothing else changes and people begin spending more on consumption, that means they're saving less. If they save less, there's less money available to be loaned out to business and invested in capital goods. So all that an increase in consumer spending does is to cause losses to occur in the capital goods industries. We will have less steel, less computers produced, and so on, because there's not much money being saved and invested. There will be profits in the consumer goods industries, and resources labeled shift into producing consumer goods. But think about it. After a period of time, as our capital goods, our factories are wearing out and rusting, the supply of consumer goods is going to begin to decrease.

7:21So in the short run, all that an increased consumer spending can do is to increase consumer goods temporarily and decrease capital goods. Five, falling prices hinder economic activity by destroying business profits, that is, that falling prices are bad for business. Well, tell that to Microsoft. Tell that to other industries in which prices have fallen tremendously in the 80s. 35% a year, prices have fallen in the computer industry, and yet, more and more entrepreneurs are entering. Business was booming. Why? Because when you have technological improvement, you have lower costs and greater productivity. So with better technology and more machinery and so on, you can lower your costs. So prices will fall naturally.

8:09In fact, costs have fallen more than prices, and that's why profits stay up. Profits are simply the difference between prices and costs. 6. Estable consumer prices indicate an absence of inflation. That is, if you don't see consumer prices going up, well then there's probably no inflation. That's what we hear all the time, including in more sophisticated financial media like the Wall Street Journal. But in fact, an increase in the money supply has many other effects, many, many other more important effects than merely an increase in consumer prices. and I'll come back to this when I talk about current events, but it artificially lowers interest rates, it increases stock prices, it increases the price of capital goods, it also increases real estate prices and it causes a redistribution of real income and wealth.

9:00In fact, consumer prices increasing aren't even a very important effect, relatively unimportant effect of inflation. and they can be actually obscured or suppressed that is the increase in consumer prices if people increase their demand for money for example or if there's economic growth. Let me give you an example, in the 1920s we had tremendous economic growth, there was a lot of investments and technological improvement, yet at the end of the decade prices did not change. So people assumed, most American economists among them, that there was no inflation. But in fact, as Murray Rothbard has shown in America's Great Depression, the money supply was exploding during the 1920s, increasing at 7% per year.

9:51But that was obscured by the fact that the American economy had become so productive that there were more goods and services flowing forth each year, preventing prices from rising as a result of the increase in the money supply. But that did not stop the distortion of the interest rate and all the other effects that I'm talking about. The same thing happened in the 1980s. From 1982 to 1986, to give you an example, in those four years the money supply increased by about 17% per year of the President Reagan. The Reagan miracle was really a myth. It wasn't caused by these relatively minor tax cuts in 1982-81. It was really caused by this tremendous increase in the money supply. And the consumer prices only rose by about 3% per year during those four years.

10:37Other things were happening. The world economy had gone into a recession. US dollars were being used abroad to finance the drug trade and black market activities. So we had a tremendous increase of demand for money that hit the inflation. But the inflation did exist. There was a tremendous increase in the money supply that worked its other effects. Two more fallacies I want to touch on. Seven, the Fed is an inflation fighter. And President Clinton is a father figure to Monica Lewinsky. The Fed is the only agency that is legally empowered to increase the money supply. Therefore, the Fed is not an inflation fighter. It is the sole cause of inflation.

11:26The Fed causes inflation. It doesn't fight it. Finally, bank failures are the worst thing that can happen to an economy and must be avoided at all costs, including using U.S. taxpayer money, billions of dollars, to bail out Indonesia, South Korea, Thailand, and so on. This is a fallacy and a scary one at that, because now, since this has been accepted and has been voiced out in public, were being asked to bail out these countries that have gotten into difficulties as a result of their own monetary policies and partly as a result of ours, not, of course, the American public, but the policy of the Fed. But in fact, bank failures are a healthy reaction to inflation. That is, banks partake in the inflationary process. They print up money out of thin air and loan it out.

12:19The collapse of banks reverses this process, prevents credit from going to businesses that are wasting resources and aid in driving those businesses out of business. You want those businesses that are producing things that don't suit consumers to go out of business. and bank collapses help this process. There's nothing wrong with them. Now, as I mentioned before, a number of these fallacies are embodied in a testimony given by Alan Greenspan to Congress last Tuesday. I want to read at least part of the report on Greenspan's testimony.

13:08Federal Reserve Chairman Alan Greenspan said the Fed is on hold until it determines that the storm clouds massing over the Western Pacific and heading our way, these mysterious inflationary storm clouds that he has nothing to do with, will damp the momentum of the U.S. economy on the verge of running out of available workers. In other words, somehow we're running out of workers, and this is going to cause wages to go up, and that's going to cause inflation. The key question is whether the restraint building from the turmoil in Asia will be sufficient to check the inflationary tendencies that might otherwise result in the strength of domestic spending and tightening labor markets.

13:59So there are two things going on. Asia is going into a recession. They're not spending as much as they were. That's causing downward pressure on inflation. On the other hand, we're running out of workers mysteriously and therefore it's causing upward pressure. So Alan Greenspan is there watching his gauges and trying to decide whether or not he should act to fight inflation or fight recession. Mr. Greenspan suggested the effects of the Asian financial crisis will suffice to head off an outbreak of inflation. Inflation, so that the Fed would have to act soon. This is crazy. I mean, the Fed is causing inflation, but yet he's playing it on the sidelines, you know, calmly watching as things develop. And then he goes on with more of this, saying, as we suspect, the restraint coming from Asia is sufficient to bring the demand for American labor back into line with the growth of the working age population.

14:54Labor markets will remain unusually tight, but any intensification of inflation should be delayed very gradually, very gradual and readily reversible. And he concludes by saying that, he describes the Fed as caught between finally balanced though powerful forces, which is the contractionary effects of Asia and the inflationary risk of tight labor markets. and that's unable to know whether its next move should be to lift the lower rates, again, the Fed's manipulating rates here, the Fed will do nothing for now, okay, so as Lew referred to Greenspan last night, our bamboos were achieved, you know, this is a fact claiming that the Fed really has absolutely nothing to do with inflation, okay, except to fight it when it breaks out, okay, now these fallacies are responsible for the deepening global economic crisis of the 1970s, which has come to a head with the so-called Asian crisis.

15:55So what I want to do is talk a little bit about three aspects of this crisis, Japan, the US, and then Asia itself, the southeastern Asian countries that are enveloped by the crisis. First, let me talk about Japan, because we're following Japan. Japan is a number of years ahead of us. What happened was, from 1983 to 1986, Japan was increasing the money supply at a rapid rate, about 8% per year. That's fairly rapid, pretty high inflation. They drove interest rates down from about 6.5% or so to about 5%. But consumer prices didn't go up. The Japanese economy is tremendously productive.

16:40So supply of new goods and services was offsetting, the increase in goods and services was offsetting the natural tendencies of prices to rise when you increase the money supply. So prices were only rising during those years by about 1.7%. Their GDP, their real output was growing very rapidly, about 3.7%. And they had a low unemployment rate. Now, let's go from that period, 83 to 86, to 87 to 90. In 1987, the U.S. and other countries put pressure on Japan to increase their money supply to drive the value of the dollar, to stop the value of the dollar from dropping, so we wanted Japan to join our inflation. Japan agreed. They began to increase the money supply at almost 11% per year.

17:28and their interest rates first went down but then shot up because people began to expect inflation but consumer prices again didn't increase much one and a half percent their GDP growth, now for the U.S. 3% is normal, for Japan it shot up to over 5% and a tremendous amount of resources were shifted out of consumer goods industries into investment goods industries industries. The investment now took up about 31% of their GDP rather than the old 28%. Unemployment went down. Finally, last period, 1991 to 1997, Japan panicked. They were fearful of inflation. They cut back the rate of growth of money supply to about 2.5%, very, very for Japan. It went into a severe recession. In fact, the stock prices fell by about 33 percent from 1990 to 1997. The Nikkei collapsed. It was up to 32,000 yen and it dropped to 14,000 yen. So, actually, it was cut in half. So, the stock market collapsed. Consumer prices still didn't rise much but their economic growth fell to about 1.4% per year. Now this is Japan

18:48Incorporated growing at a miserable rate for six years. In fact, in the last few quarters, as I said before, the economy has been shrinking. Okay, now what advice is being given to Japan and what advice would an Austrian economist give? Well, let me tell you what Miller Friedman's advice is, and then I'll also tell you what Alan Greenspan's advice is. Basically the same thing. Japan should go back to increasing the money supply at about 8%, what they were doing in 1983 to 1986. And they should increase government spending. Basically, they should re-inflate to get out of this recession. And at the same time, to increase the amount of money in the Japanese economy, and therefore increase the imports from the Southeast Asian countries that are having problems.

19:38Now, Milton Friedman is not known as an inflationist, so that's his article that he published, actually it was a letter to the Wall Street Journal, published this past December with Starlin. Let me just give you a few sentences of what he says here. He says, So the surest road to a healthy economic recovery is to increase the rate of monetary growth to shift from tight money to easier money to a rate of monetary growth closer to that which prevailed in the golden 80s, but without overdoing it. Now he's asking them to go back to 8% increase in their money supply. Remember, every dollar that is printed means a redistribution of wealth away from the public to the government. and then he's known as a pre-market economist, is pushing this.

20:28That would make much needed financial and economic reforms far easier to achieve. And then he goes on to say, there's no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will always have the same effect. After a year or so, the economy will expand more rapidly and so on. So his idea is to get out of this terrible recession by inflating. Alan Greenspan, not as surprising, of course, says the same thing. He was asked by Senator Connie Mack, is the Japanese Central Bank doing enough? No, I think not, Mr. Greenspan promptly replied, but I have to say that the argument he marked before the Senate panel that Japan needs to be more comprehensive than simply cutting taxes.

21:23Japan must first move conclusively to solve its banking crisis before fiscal policy can have significant effect. Now what he's saying here is this, not only does he want Japan to cut, to increase spending, to increase the supply of money, he also wants Japan to bail out its banks. Japan hasn't completely done that. They're, they're waffling there. Now he wants all this to occur for the following reason, and that is that he doesn't, he's very fearful of some of the Asian countries going under. So he wants Japan to lead a re-inflation in Asia. In fact, the real problem and the Austrian solution is that the fallacy that banks should never fail is being accepted here.

22:11Instead of allowing banks and the bankrupt companies to fail, there are many of them in Japan, the Ministry of Finance has forced the solvent banks and other financial institutions to pay 5 trillion yen, 5 trillion yen and taxpayers to cough up another 680 billion yen to bail them out. So this is being done. And while it's being done, it means that these bankrupt companies are going on wasting scarce resources. If the banks were permitted to fail and credit contracted, these companies would not be able to pay back their debtors. They'd go out of business. There would be a lot of unemployment. There would be a sharp recession. But eventually, the laborers would move back to those productive employments that they were in before the inflation began.

23:01So, middle treatment is all wet here. We should allow the banks to collapse and allow credit deflation to take its course. Let me just say a few words about the US speculative bubble, which began in 1991. Basically, the US began increasing the money supply very rapidly to get out of the recession of 1990. And it was increasing the money supply about 10% per year, very high rate from 91 to 93. As a result, interest rates were pushed down. They were pushing interest rates down, thinking that would bring about economic growth. Commercial paper went from 8% to 3% just in three years. They knocked five percentage points off the interest rate.

23:49And the long-term interest rate on AAA bonds went from 9% to 6.5%, but prices only were going up by 3.5% per year. So people thought, well, inflation isn't quite dead, but it's not terrible. But in fact, 1991 and 1993 saw an incredible economic boom, but it wasn't manifested in consumer prices. What did happen was that it set the stage for the stock market boom that was to follow after 1994. And it caused American businessmen to begin to invest a lot of funds in capital goods. 1994-1995, the Fed stopped increasing the money supply. In fact, it was actually slightly negative those two years.

24:35Interest rates went up during those three years. It went from three to five percent for short-term interest rates, three to five and a half percent. And long-term interest rates went up by about one percentage point. We would have gone through a recession under normal circumstances, but we didn't. What happened was that the stock market boom had begun, the Japanese recession had taken hold, And you found a lot of foreign money pouring into the United States, keeping our boom, artificial boom going for those two years. Finally in 96 and 97, in fact towards the end of 96, the Fed began to inflate the money supply. Part of the reason was that the Clinton administration was putting a lot of pressure on the Fed. Because signs looked like, or signs were pointing to a recession in 94-95.

25:24And Clinton wanted to avoid this because we know that presidents who have experienced a recession in the year prior to an election, sitting presidents, tend to lose that election. They lose a lot of votes as a result of the poor state of the economy. So that was to be avoided. So Alan Greenspan knuckled under, gave him a quasi-inflationary policy, and we were back stoking the fire to the boom. And just to give you an idea of what went on there, the stock market took off in 1994, and it increased in 96 by about 20 percent. Stock prices went up 97 by 32 percent in just the last 12 months, ending in February. So we had a tremendous a stock market boom, we had a lot of increase in investment, and interest rates have begun to fall again, okay, 96, 97, they're tending slightly downward, so we're heading to the top of a boom.

26:24All right, so keeping those two things in mind, let's now turn to the Asian crisis. As it turns out, the so-called Asian miracle that was valued so much by many people and by the media, especially the Wall Street Journal, turns out that it was built on bank credit inflation, which was made in the US, Japan, and in the countries themselves, Thailand, Malaysia, and so on. There was a huge investment boom in Thailand, Philippines, Indonesia, Malaysia and South Korea. The party was due to their own monetary policies to increase the money supply tremendously at tremendously high rates. But also the increases in the Japanese and U.S. money supplies in the 90s pushed down worldwide interest rates.

27:11And as lenders looked around for better investments as interest rates fell in the U.S. and Japan, their money went to Southeast Asia. So the paper boom, the boom not based on economic fundamentals, on economic growth built on genuine saving and investment, but built on paper. And the stock markets went crazy in these countries. In Malaysia, and it was reversed in 1997, I don't have the figures for the increases, but just to give you an idea of the money that poured in first of all, then we'll talk about the collapse of the stock market. In 1996 alone, East Asia, which was China, and Southeast Asia received nearly half of the $243 billion of foreign private investment throughout the world.

28:00So half of the whole total foreign private investment went into these countries. They're fairly small economies. Of course, it set off a tremendous boom. And of course, the boom was reflected in the increase of stock market prices. and so as a result in 97 when this was reversed we found that the Malaysian stock market fell by 48 percent, Indonesia fell by 30 percent, Philippines by 45 percent, and South Korea by 24 percent. The Indonesian currency depreciated by 70 percent in seven months, well 70 percent of its value with regard to foreign Inflated currency in merely seven months. So it shows you how inflated that currency was. Now when the stock price is full, it makes it more difficult for these domestic companies that are indebted to foreign creditors to raise money, to pay off their loans.

28:51And when they're depreciating currencies, they have dollar loans. If their currencies now buy fewer dollars, it makes it even more difficult to pay off foreign debtors. So there's a great risk that arose in 1997 of defaulting on loans to Western banks, and this is why Greenspan and the group of seven nations, that is the industrialized countries, began to put pressure on the IMF to bail these banks out, to bail these countries out. So now we have a spectacle of US taxpayers having to ante up billions of dollars. Now we already have billions of dollars in the IMF. There's a $43 billion bailout plan for Indonesia, $50 billion for South Korea, and $17 billion for Thailand.

29:43I think Lou mentioned these figures last night. In addition, the US is being asked to ante up another $18 billion in contributions to this bailout effort. This is a fiat effort. US taxpayers' money is already being used by the IMF. They already have funds that were extracted from US taxpayers. So this is an additional 18 billion. This has not passed yet. And this also explains now why Alan Greenspan and others have been berating Japan for not increasing their money supply. They're not only worried about the Japanese economy, they also want Japanese banks to begin lending again to these Southeastern countries so they can pay back the Western banks. Banks. Now, what are the solutions? Two sets of solutions here. On the one hand, some economists associated with the World Bank, not the IMF, but former Clinton economists, for example, Joe Stiglitz, has argued that the terms imposed by the IMF on these countries are much too severe. In other words, the IMF wants them to stop running deficits and maybe run a surplus of 1%

30:50They want them to take care of the non-performing loans, bail out their banks. They want them to raise taxes and to cut government spending. Well, people like Stiglitz think that's too severe. They're not against the bailout. The bailout's fine. But they want the bailout on even easier terms. Now, there's another solution that's been proposed. It's very hard getting to Austrian, and that is the fact by someone who is associated with the Mises Institute, Steve Henke, who is an economist at Johns Hopkins University, and is on the board of editors of the QJA, the Court of Journal of Austrian Economics.

31:35He's become an advisor to President Suharto of Indonesia, and he has recommended that Indonesia abolish its central bank and go to a currency board. Basically, it would be a setup in which the Indonesian rupiah would be set at a fixed rate to the US dollar, let's say 10,000 rupiah to a dollar. and the money supply would only be increased when more dollars flowed into the country so that the politicians would now be unable to increase the money supply on their own whim and there would be no more central banks that could simply buy up government securities print up Rupiah and buy up government bonds and increase the money supply that way that wouldn't be the way it would happen the only way it could happen is through foreign trade If Indonesia exports more real goods and services to the U.S. than they import, then extra dollars would flow in and they could increase their money supply.

32:32That would put a very big break on the increase in the money supply in Indonesia. What's interesting is that the whole international establishment has come down on its head. Let me just conclude, just read a slight excerpt from the Wall Street Journal on this. They're all horrified, because this would mean that you really couldn't bail out the banks, that the banks might start collapsing. And if the banks started collapsing, they couldn't pay back Western banks, and then you'd get a domino effect, which for me would be great. For several weeks, Mr. Henke bested the elite economists of the International Monetary Fund and the U.S. Treasury, who considered him a crank, and fervently opposed his prescriptions for Indonesia.

33:20They were caught by surprise when he turned up at Mr. Suharto's side, when Mr. Henke got a February 2nd award for the president, a top treasury official found out only when a reporter mentioned it two days later. That's also a curating thing to a bureaucrat to actually cut out of the loop like that. Alright, now, then the global economic establishment launched a massive counter-strike against the poor, you know, poor little Steve Henk. IMF Managing Director Michelle Kandesu threatened to suspend the $43 billion IMF-led bailout if Indonesia pursued Mr. Henk's plan. They're blackmailing him with $43 billion. Obviously, anybody's going to cave under those circumstances. Why wouldn't they? President Clinton telephoned Mr. Suharto on Friday. Clinton got me involved.

34:09For the second time in a week, the lobby against Mr. Hankey's advice. Leaders of Germany and Japan weighed in as did finance ministers from leading industrial nations at a weekend meeting in London. The campaign, unfortunately, is now showing signs of success. A top Indonesian monetary official said over the weekend that the government has suspended plans to implement Mr. Hankey's idea. and Treasury Secretary Robert Rubin said that would be a constructive step so the bottom line is unfortunately the news isn't optimistic it looks like the bailout is going to go through and that this is going to even give more momentum the plans to have an international lender of last resort that that is to turn the IMF into basically a world central bank.