The Federal Reserve: Then and Now

0:00It's been two years or so now since the end of the 1980s bull market, and we're now mired into a recession of some unknown length. In this country we have about 10,000 economists, arguably that's part of the problem, but wouldn't you think that some portion of these economists Economists would have a feeling of deja vu, having experienced or at least read the history of the 1920s, where we had a boom of similar length, after which we were mired into the depression of the 1930s. Wouldn't you think that a number of economists would be searching for parallels, and even if not finding exact patterns, exploring differences as well as Well, it turns out that very few, if any, economists are working on that question.

1:09It almost doesn't occur to them. And before I address the question head on, I might say a few words about what's going on in the profession today that spans in the way of looking at this important issue. It turns out that whether we look at the cutting edge, so called, in economic research, or look at what's enshrined in our modern textbooks, we find little or no attention to business cycles in any relevant, meaningful sense. For instance, if we look on the cutting edge of research today, what we find is something is something called the real theory of the business cycle. Not that the theory itself is so real, but that there's an attempt by a number of economists to explain cycles strictly in terms of technological change, supply shocks, oil embargoes, and that sort of thing with no regard whatsoever to the central bank.

2:14They've despaired of looking at the central bank and looking at its activities and trying to find some relation to cyclical activity and have resorted to the so-called real factors. In real business cycle theories, often the Federal Reserve and even money plays no role in cyclical activity. These cutting-edge theorists are not likely to see any parallels at all between the 80s in the 20s. In fact, there's few parallels between their economic theories and macroeconomic realities. But it's an imminently publishable enterprise, and it hasn't peaked yet. If you look at the textbooks, what do the textbooks say about business cycles?

3:05It's a little too early for them to incorporate an account of the end of the 80s boom. I want to say about business cycles in general. I surveyed several textbooks, just principles texts, and one that I found very typical and I can report on this morning is the latest edition, fifth edition, of a text by Baumol and Blinder, very popular text, widespread adoptions over the country. A textbook of some 900 pages, and this is typical what the Out of 900 pages, how many pages would you guess would be devoted to the question of business cycles? Six. And not even six in a row. Six sort of spotily through the book, no more than two consecutive pages.

4:02Okay. So, you don't expect to see comparisons in the textbooks between the current situation and the situation of the interwar period. What I'm going to speak on today, then, is the Federal Reserve then and now. And what I think you'll find, I hope you'll find, is that many of the ideas in my paper will dovetail very nicely with what you heard yesterday. I have not seen the papers in advance that were presented yesterday, but the papers by Professor Fan and Professor Adling in particular reinforce some of my own ideas in ways that are comforting to me, let's say. So we can give a full-scale comparison of the two episodes, and we'll find that whatever the differences, and there are many insignificant ones, we need to pay as much attention to the differences as to the similarities, but whatever the differences, the Federal Reserve's Power to Create Money, figures importantly in both episodes.

5:01So let me review for you in very capsulized form what went on during the 20s and what the plus was about at the end of the 20s. And I'm going to review this in capsulized form just to show you what to look for, okay, just to get an idea of what the relevant points of comparison are. In the 1920s, we saw a central bank for the first time operating in a peacetime economy. It spent its first decade getting organized and financing World War I. But in the 1920s, it had turned to the business of the economy, and it was bent on stimulating growth, raising the economic prosperity to a new plateau, putting an end once and for We saw sustained credit expansion during the 20s, in which the interest rate was kept artificially low.

6:02I like to say that the Fed padded the supply of loadable funds with newly created money, drove a wedge between saving and investment, caused investment in the country to outpace savings dramatically, caused investment in the economy to be much too future-oriented in comparison to the savings available actually to sustain it. And this, of course, is what set up the economy for the fall in 29, for the eventual bust. The artificial boom created by the Fed was inherently unsustainable. Now, if I wanted to summarize, even the capsulized version, I would say that the interest rate during the 20s didn't tell the truth.

6:50This is something you heard from Dr. Ebeling yesterday, it didn't tell the truth, it didn't tell the truth about people's time preferences or savings preferences, didn't tell the truth about how long people were willing to wait for the fruition of the production process. So we want to look for something like that in the current period, but don't expect the similarity to be all that strong. In other words, can we simply retell the story of the 1920s boom and the 30s bust, changing only the dates and a few minor details?

7:35Well, I think not. Fed watchers, who are always watching the pattern of growth in monetary aggregates, watching movements in the federal funds rate, movements in the discount rate and so on, are almost sure to be disappointed. There's a sense in which the Fed never does the same thing twice. If it did, it would be all too predictable and lose most of its In fact, in thinking about Fed watchers, it reminds me of a colleague I had several years ago at Auburn. And he had two sons that were unusually mischievous. On one occasion, he had just stocked his liquor supply in anticipation of his cocktail party that evening. And his His sons decided that the liquor cabinet was a pretty good substitute for a chemistry set.

8:34Well, they broke the seals and they began pouring scotch into gin, gin into rum, rum into scotch, added a little creme de ment all the way around. Well, when their father discovered the misdeed, not in time to save the guests from a few and a few innovative cocktails. He meted out a punishment to his sons in the form of yard duty, lower allowance, and the sons accepted the punishment gracefully and promised never to do that again. My friend sort of wistfully told me, he says, you know, I believe them. He says, they'll never do that again.

9:20The next time it'll be something else. Okay? And so it is with the Federal Reserve. Don't expect it to do that again. It maintains its powers, it maintains its influence from one episode to the other by doing something else. And yet, even though it does something else, we can see a theme, we can see a general pattern of activity. First, let me warn you off even further of the straightforward application of the analysis of the 20s and 30s to the analysis of the 80s and 90s. There's too many differences between the two episodes. For instance, during the 1980s, credit conditions were relatively tight compared to the 1920s.

10:13The 1920s interest rate, the real rate, was incredibly low throughout most of this period. Not so in the 1980s until the very waning years of the boom. Now here we run into some problems raised by Professor Fan yesterday, Secondly, if we look at monetary aggregates, we see that the overall growth rate in the money supply during the 80s actually was a little larger than in the 1920s. But the pattern doesn't fit. The pattern doesn't fit. If you look at the 1920s, what you see is a credit expansion that accelerates near the and the end of the boom for reasons we now all understand that the Fed was trying with increased resolve near the end of 1929 to keep the boom going, inflating at an accelerating rate until finally it could sustain any longer.

11:15In the 1980s, however, the monetary aggregates look at M1 or any of the others for that matter. They peak in mid-decade and then drop to low single digits from about 87 on, okay? So despite the fact that the total decades growth rate was greater than the 20s, the pattern doesn't match, it doesn't allow us to tell our 1920s story. In fact, if we look at different aggregates, look at narrow aggregates, the monetary base, Or I look at broad aggregate, the so-called Divisia Index, which is a measure of total liquidity. Those don't improve the FITS particularly. We can even say it would be surprising, this is just reinforcing the idea that the Fed doesn't do the same thing twice, it would be surprising if in fact the Fed could pull it off again, if they could increase credit throughout the 80s and stimulate a boom that lasted nearly a decade. This was explained as early as 1953 by Ludwig von Mises who anticipated by a decade or so the rational expectations

12:27revolution. Mises understood full well the strategic significance of inflation, of expectations that the Fed couldn't fool the people time after time by using the same old tricks. So it's not a replay of the 1920s, but I think it deserves to be called variation on a theme, okay? And so I can spend some time explaining the theme and explaining a particular variation. I'll make the claim that in the 1980s, unlike the 20s, The Fed actually didn't play the lead role, but it played an indispensable supporting role that I'll have much to say about.

13:13What did play a lead role in the 80s was fiscal policy, in other words, deficits that were measured in the hundreds of billions. You'd be surprised if that didn't figure importantly in the explanation of the 80s and 90s. And also playing a big role was monetary legislation that was passed in the early 1980s under the and the Carter administration, the Depository Institutions Deregulation and Monetary Control Act of 1980, which freed up banks to compete without nonetheless exposing them fully to the discipline of the marketplace. So even at this point, in a broader sense, we see parallels between the two periods.

13:58In other words, what's significant was the unprecedented, the unprecedented. That's what allows people to become fool. What was unprecedented in the 1920s was a strong US central bank operating in a peacetime environment. But what was unprecedented in the 1980s was deficits in the hundreds of billions coupled with banking deregulation that worked in ways that it's taken us 10 years to figure out, okay, and so even here we find strong parallels. Now, let me state as clearly as I can what the variation on the theme is, and then I'll try to make the story stick with institutional details and the story of the 1980s.

14:49In the 1920s, we could say that investment was out of line with time preferences or savings preferences. What I'll claim is true of the 1980s is that investment was out of line with risk preferences. Not savings preferences or time preferences, risk preferences. We would say in the 1920s that investment was excessively long-term, well, reflecting an artificially low rate of interest. In the 1980s, investment was excessively speculative, which is another way of saying too risky, too many risks were being taken for some reason in the private sector. Or to put it in terms that you heard yesterday, the interest rate was telling a lie, but it was telling a different lie in the 80s than the 20s.

15:34In the 20s, it was telling a lie about people's willingness to wait for output. In the 1980s, it was telling a lie about what risks wealth holders were willing to knowingly accept, okay? And this is what gives us both our theme and variation. The boom of the 1980s was just as artificial as the one in the 1920s. The bust was just as inevitable, okay? but for different reasons as I have suggested. When excessive risks eventually turn into excessive losses, booms turn to busts. Now, let's focus then on these excessive risks and see how they were taken in the private sector and why it was that this was allowed to proceed for nearly a decade.

16:30And the story here is, see it's a little bit institutionally complex. Conceptually it's simple, risks taken were out of line with risk preferences. That's simple. But the disparity between the two, risk taken and risk preferences, involves a story that's institutionally complex. and it involves the treasury, issuing treasury bills, running debts at the astronomical levels. And even at this juncture about treasury bills, this involves in a very important way the Federal Reserve, who after all buys treasury bills. Secondly, it involves the FDIC after deregulation in the early 80s.

17:18And thirdly, it involves the Federal Reserve in its capacity of lender of last resort, okay? So those are the three aspects of the dealing with risk that I want to address. Now, in my judgment, the easiest thing to demonstrate is that heavy government borrowing creates tremendous risks in the private sector, okay? The government borrows, but risks are in the private sector. And let me illustrate just with a simple numerical example, you can see how this works. Suppose just to keep the numbers simple, that the government is budgeted to spend a trillion dollars this year.

18:05And suppose that it intends to collect 800 billion in taxes according to well-established tax code. Well, the deficit is the remainder, the 200 billion. It has to get that money too, somehow, in order to spend the full trillion. Now, my numbers are just for illustrative purposes, actually. In reality, right now, the government is spending about a trillion four and is raising something on the order of a trillion. So we've got somewhere between and the three and four hundred billion of the yet to be funded spending, but I'll stick with my example, spending a trillion funding eight hundred billion in taxes and is out looking for the other two hundred billion.

18:53Now in effect, the government is saying to the private sector, we're going to collect eight hundred billion and you know how, you know how, it's going to be according to the Tax Code that's been established and accountants know about and businesses know about. That's how we're going to collect 800. The 200, well, we're going to collect that too, but we're not going to say just how or just when or just whose. You think this creates some uncertainties in the private sector? I suspect it does, because all you have to do is look at the is a possibility and see what it is that the private sector has to worry about and try to hedge against, although hedging is difficult in this area. The Fed could, or the government could hold the line on money, don't increase the money supply, but continue borrowing in private markets. Well, that puts strains on credit markets, that gives you a high real The real rate of interest in the private sector, higher than otherwise would be, if the borrowing

20:00is done from trading partners, it means that our export markets are particularly weak, as foreigners lend money to the government rather than buy goods and services from the private sector. So the private sector might have to cope with high interest rates and Weak export markets, some combination of the two of unknown magnitude. The government of course could begin inflating, begin monetizing the debt at an accelerated rate or monetizing some already. This of course would give us price inflation, in which case there would be uncertainties about which prices would go up, how much uncertainties about whether any given price change reflected Changes in relative prices are simply inflation as a result of debt monetization, but of course the government could increase its taxes, increase the tax take, but new taxes, unlike taxes that are already codified, have uncertainties of their own, what kind of new taxes, which rates will be increased, whether it be value-added tax, sum-tree tax, tax-side tax, what kind Taxes. This creates more uncertainty in the private sector. So what I'm suggesting is that

21:19200 billion dollars of intent to appropriate in some unspecified way looms large over the private sector. And this creates tremendous uncertainties. Now, is there an anomaly here? Here, treasury bills are risk-free, aren't they? Well, they are risk-free to the buyer of the treasury bill. He doesn't have to worry about default, at least. In fact, the reason he doesn't have to worry about default is that the monetary authority is standing by, The Federal Reserve is prepared to monetize debt if necessary. There's no possibility. It's institutionally precluded. Treasury bills can't be defaulted upon.

22:14The government will have the money by Thursday noon, even if the ink isn't quite dry. But don't worry about default. Now, of course, if you've got your money that way, there'd be tremendous inflation, but there would be inflation whether you were holding any treasury bills or not. So your decision of whether to put your money in treasury bills is unaffected by the potential for hyperinflation as a result of debt monetization. There's no default risk on treasury bills. Now, this is where the Fed comes in, in the first instance. In other words, the very potential of monetizing debt is what keeps those treasury bills default risk free.

23:02If it weren't for that potential, if we had no central bank, if we had no possibility of debt monetization, then at some level of borrowing, there would be a default risk premium on treasury bills, just like there was default-risk premium on New York municipal bonds. And what level of borrowing would that take? Well, I would think three or four hundred billion should do it. I would be surprised if there weren't a fairly substantial default-risk premium on treasury bills today if it weren't for the standby capacity of the Fed to monetize debt. Here I can relate my story to remarks from David Phan yesterday. He said that nobody knows what the Fed is doing.

23:48The Fed doesn't know what the Fed is doing. We don't know whether it's trying to keep a constant price level, or we don't know whether it's trying to target unemployment rates or the employment rate. We don't know if it's trying to keep exchange rates stable. We don't know all these things, any of these things, but one thing we do know is that the Fed stands by ready to accommodate the Treasury, all right, whether it's actually accommodating it in any significant degree right now or not. If you look at the typical directive that goes from the Federal Open Market Committee to the trading desk at New York, typically It starts with the clause, while accommodating the treasury, comma, and then the rest of it's pretty subordinate actually, it accommodates the treasury.

24:43It needs a lot of accommodation when it's borrowing $400 billion a year. So we can see two things here. One is that this important potential for debt accommodation doesn't necessarily show up in the current monetary aggregates. It may well be that M1, M2, whatever, are doing a random walk, as Professor Fan says. You can't deduce much from movements, actual movements in monetary aggregates. So you don't see, you don't come anywhere close to seeing the full impact of the Fed by looking at what it's actually doing at any given time. What's important here is what it has the potential for doing, namely monetizing that debt.

25:31And even while the debt is not being monetized, the effect is being felt dramatically in the form of no default risk premium on treasury bills. That's a significant... And we know in our bones, we know, that when push comes to shove, rather than default on treasury bills, the Fed will monetize. If we know that, if we know nothing else about the Fed. Now, when I point this out, it seems, at least to me and I hope to you, to be crashingly obvious, to use an expression of a dear colleague of mine, crashingly obvious that yes, the federal budget is dramatically overextended, that yes, it's nonetheless paying no default risk on its treasure bills and that the reason for that is The Potential for Debt Monetization And yet, it's not difficult to find contrary views One member, one faculty member in our business school at Auburn A named professor Now all professors have names actually, but when they say named professor He's got a spare name of someone who is endowing a chair for him

26:42He's a very important professor, he has a chair Well, we all have chairs, but he has an endowed chair, okay? Now, this professor who will remain nameless both ways, tell you neither one, argues that we actually need more government debt. This is an argument different than the one that astonishes David Fann and astonishes and the rest of us for that matter about deficit spending in order to stimulate the economy. We need more debt, according to this unnamed professor, because government debt is risk-free.

27:28And with all of the riskiness out there in the private sector, we need more risk-free Every death I help offset it. People on opportunity, after all. Maybe that explains why he's a name professor and I'm not. I don't know. Now, what do you think happens to all of this risk? Does it just get extinguished by the Fed? Does it get shunted into the Atlantic or whatever? Or would you guess it gets dumped on the private sector? I suggest the latter. The risk-freeness, in fact, I like to call it artificial risk-freeness, to sort of parallel the business about artificial low interest in the 20s, artificial risk-freeness of treasury bills, the inflation premium is artificially low.

28:20Now what this means, of course, in the private sector is that if people guess wrong about how the deficit is going to be accommodated, they lose big. If you make your investments on your guess that inflation is not far in our future, you might be wrong. You actually might be right in a global sense. In other words, 10-15 years you get wild inflation, but you're not likely to be able to hold out that long. You'll probably go bankrupt before that actuality. So you have to make guesses about the near-term effects of this Deficit Accommodation, okay. So let's look at the private sector and see how these risks get born. Look, if everybody understood this increased riskiness and if the risks were allocated in the private sector in some economically efficient way with people bearing that extra risk to the extent they were willing to do so, that would pretty much be the end of the story.

29:22We'd simply have a riskier economy and that would be it, okay. But what we see is that all sorts of institutional arrangements and policy maneuvers tend to hide those risks, or tended to during the 1980s, to hide those risks so that bank depositors, owners of bank securities and taxpayers were bearing much more risk than they knew. They were bearing it unwillingly because it was unknowingly. So let's see what some of these arrangements were and see how this story actually plays itself out in a fairly convincing way, at least it convinces me, if I'm here this morning to try to convince you. One of the most significant aspects of the story, the story really in its own right, is the operation of the Federal Deposit Insurance Corporation, which of course we've had around since the 30s, but it never quite came into play until the 80s, after bank deregulation so-called.

30:20So beginning in the early 1980s, when banks were allowed to compete with non-bank financial institutions, when capital ratios were allowed to fall to new lows, the deposit insurance was still there on the deposits. The government was still insuring the deposits. And they were doing it at a highly subsidized rate, And more importantly, at a rate that was totally independent of the risks that were being taken. You see, the premium for deposit insurance, and here we're talking about risk, aren't we? What's the premium for this deposit insurance? Is it related to the risks that the banks are taking? No, not at all. It's one-twelfth of one percent of the total deposits of the bank, no matter whether it's an adventuresome bank or a very conservative mom-and-pop bank.

31:141.12 to 1% of the deposit. This created tremendous incentive for banks and savings and loans before them to undertake as much risk as they could. In fact, the legislation at the beginning of the 80s had the effect of privatizing profit-taking while socializing risk. Now, we're all in favor of privatizing profit-taking, that's great, but boy, if you don't privatize the risk-taking along with it, you've got a formula for disaster, that's exactly what we have. Now, all of a sudden, all of a sudden this illuminates a lot of the particulars during the 80s that would otherwise remain a mystery to you, certainly remained a mystery to me until I put it together with this risk-based story.

32:10The first part that's not so hard to understand is that the banks are out, of course, looking for risks to take. And look, there are lots of risks to take. A lend for oil exploration, a lend to third world countries. Who knows whether they can pay it back or not. If they pay back, great. The bank keeps the profit. If the bank goes belly up because of losses to these countries, well, the FDIC takes care of the depositors. So it's a heads-eye-win, tails-you-lose proposition. Loan for land speculation, that's risky, but pays off great. If it doesn't, no, we try. Depositors are taken care of by the FDIC. So there's plenty of investment around that's risky, and just shifting the portfolio of savings and loans and banks to these risky areas is enough to make the story stick.

32:59But what we find is that Wall Street rose to the occasion. It responded to the banks and the SNL's demand for increasingly risky lending. And this is what underlies the whole movement in leveraged buyouts and junk bonds, new terms, the junkification of the bond market, you heard that one. and I think most of you know how junk bonds work but essentially buyouts of companies are accomplished by heavy borrowing in the bond market such that the resulting company has an extremely high debt-to-equity ratio. Now bondholders are of course first in line to get the liquidated value of a failed company, but if there's lots and lots of bondholders, they still may be out of luck.

33:59There's still a high risk in owning those bonds, so they're high-risk, high-yield bonds, and that's why they're called junk bonds, okay, because of the high risk. Some of the yields can be 25 to 30 percent, okay. Now, what you can see here is this provides a vehicle for market participants to bet on inflation. I'm going to tie this story about the deficit spending to the story about the junkifications in the bond market to the story about federal deposit insurance, that the Treasury is in such deep debt that it has market participants guessing about when the debt monetization will begin, when the inflation will come. The banks are buying junk bonds simply because they're high risk and they're protected on the downside by the FDIC.

34:55People are willing to buy junk bonds because if they're betting on inflation and they're right, These companies will have their debt inflated away. So buying in the junk bond market is a way of betting that the federal government will soon turn to debt monetization. It's a way of accommodating the risk-taking in the private sector that's created by all of that physical irresponsibility. Now, it's just fascinating to watch this junk bond market. Mark, you know, sometimes you hear that, oh, well, junk bonds have been around for a long time, while the fuss about junk bonds in the 80s. Well, you see, before the 80s, a junk bond was a bond that was issued as investment-grade bond. When it first came out, it was investment-grade. But But bad luck and mismanagement of the firm put its bondholders in jeopardy until the bonds were eventually downgraded and became junk bonds.

36:04There was still a market for them, but they were junk bonds. In the 1980s, we actually got new issue junk bonds. The stuff was junk from the start, okay? That's what was new in the 80s. And also the massive infusion of junk bonds into the market, okay? and even with junk bonds they can go downhill you know I've just discovered recently that even within the general category of junk bonds there are different ratings okay from the very best that's called quality junk okay down To the worst, that's called toxic waste, okay?

36:50So this shows you what the innovations there are in the marketplace to provide risks for financial institutions to take. I might say at this point that had the government actually resorted to debt monetization in say 87 or so, then most of the companies, certainly a good portion of them, who failed because of their burdensome debt, would have had that debt inflated away. The junk bonds would have become much less risky, okay? And that's what holders were hoping for. That's what they were betting on. And inflation would have been detrimental on the rest of it, but the people holding those bonds would have done just fine. Michael Milton probably wouldn't be in jail today, had we had inflation in the late 80s, okay?

37:39So, we've seen plenty of evidence that Wall Street has responded to provide the risky assets that are demanded by the financial institutions. Now, let's look at then how these risks are ultimately borne, and here I'm talking about the risks of assets owned by commercial banks. And what we'll find is that the risks are unknowingly borne by both market participants who might be subjected to inflation without anticipating it, and by taxpayers who will have to pay for a tremendous bailout of the financial system. So here the Fed plays an important role, it's already played a critical role in keeping those treasury bills default risk-free, which is to say that it took the risk off treasury bills and put it in the private sector.

38:33That's sort of the root of the problem to start with. Now it's playing a second role as lender of last resort, trying to keep the banks liquid as long as possible. And this, of course, sustains the boom for longer than it otherwise could be sustained. Now, this potential debt monetization, of course, can continue indefinitely. The FDIC payoffs to depositors can continue so long as the FDIC is recapitalized out of general tax revenues. But, banking can't be shielded from losses forever. The lender of last resort won't do the trick forever. It will only stave off the coming of the bust.

39:20Forbearance as practiced by FSLIC and now FDIC can only go so long. The doctrine of too big to fail is one that can't be pursued in the final analysis. It all comes crashing down. I might also mention a discovery I made fairly recently at a conference in New York that suggests that the problem is bad and getting worse. I expected that anyhow, but if you look at the rate of bank failures, it started out, you know, 15 years ago, it was down around 10, 12 banks a year might fail in this country and then it got up in the 20s and 30s and 50s and peaked over 100 a few years ago, but then bumped up against 200, 200 banks per year failing in this economy.

40:19But then, happily, refreshingly, the numbers leveled off at about 200, a good sign. And yet, what I've discovered in a conference not too long ago is that this has an explanation that make you feel quite so good, that the administrative capacity of the FDIC to close banks is about four per week. If it's working full force, it can close four banks a week. Okay? 50 weeks, give them two weeks off vacation, okay? 50 weeks times four, that's 200. Okay? So it's not that banks are in better shape or not getting any worse. is that the FDIC has exceeded the capacity to close banks, okay?

41:09Now, what this has done, what this has done is given rise to a large number of banks out there who would have already been closed had the FDIC had more administrative capacity, and they know they're on the list to be closed because their capital is too close to zero, or maybe negative, okay? But they can watch the FDIC and look at the list and say, Well, we'll probably close down maybe a year from Christmas, okay, but we've got time in the interim to take some incredibly risky, incredible risks and try to get back in the black, okay. Now here again, the terminology follows the contact, it follows the substance. You just look at the terminology that's coming out of the banking industry and see that something is wrong.

41:57There's a special name for these institutions now. They're called zombie banks, or zombie SNLs. It's a distinction between the dead and the living dead. So these banks are dead as far as capital goes, but they're still operating because the FDIC hasn't gotten two of them yet. And there's no risk too great for them to take, because they're not risking anything. And if they win, hey, They're back in the black. If they can get back in the black before the FDIC gets to them, they've got it made, okay? So the particularly hideous risk that they're taking, again, has a special terminology that's been attended to it. It's called gambling for resurrection. Does this Does this sound like sound banking? I think there's some risk here.

42:49Now, don't lose sight of the overall claim I'm making that, in telling the stories about the FDIC, the treasury deficit and all the rest, I'm just showing you that it's endlessly risky, highly speculative, much more so than would have been tolerated had the ultimate Wealth Holders understood what risks were being taken by the banking legislation, so it played itself out over a period of nearly a decade before it came crashing down. Now what I can do for you is put this view to a test. Sometimes Misesian economists are accused of not testing their theories.

43:35I'll test this one for you in several different ways. And the kind of tests I have in mind is seeing if the characteristics of the current economy during the post-boom era differ in predictable ways from the economy in the 1930s. You would expect that a boom based on actual credit expansion in the 20s would give rise to a bust and a depression that was substantively different than what we're experiencing now because now it's a risk-based boom and consequent bust. So I'll list about four things that sort of reinforce the story. The first one is that this bust, unlike others before it, certainly unlike in 1929, is a bank-led bust, okay? It was failing banks that led the bust. And this has been noted by any and many number of commentators, financial journalists and so on without any real explanation of why we have a bank led bust this time when before the bust was, well the real bust, shortage of resources at the end of the boom where firms, industries had to close their doors.

44:50And we can see that this is what would happen in a speculative boom. In other words, in the 1920s, look, there was speculation in the 1920s, but the people speculating were incurring the risk of that speculation. The loans that banks were making were loans to industry that were too long-term oriented but weren't otherwise too speculative. When the bus finally came to an end, the capital positions of the commercial banks at the time was relatively good. Now, it turned bad soon enough after the bus was underway, but it was relatively good at the peak. But now, of course, it's the speculative investing by borrowed funds from banks that have eroded Banks Capital and the banks capital have gotten so low that the banks themselves have failed and turned boom into bust. Okay, so the story tests out in the sense that you would expect that if risk and externalization of risk, deviation of risk preferences from risk undertaken, if that were the root problem and you'd

46:12Second, I'll look at the idleness of resources during the thirties as compared to idleness of resources today. Much more idleness during the thirties. But today, probably because the bust is bank led, we get failed companies showing up first as non-performing loans in and the assets of failed banks, all right? And these assets are simply turned over to the RTC, put together in the mid-80s, to oversee the disposition of these bad assets. Turned over to them to do with what they can. Supposedly they'll sell them back to the private sector, although they've done very little of that yet.

47:03But in the meantime, while they have these assets, which are in the form of old hotel chains, Motel chains, condominiums, golf courses, shopping centers, and so on. The RTC actually farms them out to so-called operating companies. In other words, it's quite possible that if you stay in a motel on your way to this motel, I don't think it applies to this one, hope not, but if you stayed in a motel on your way here, it might well have been an RTC-owned motel, run though by some operating company who doesn't have to pay a mortgage. All they have to do is make a variable cost. And by operating it, they save the RTC some maintenance expenses.

47:48And yet, they can profit by running these firms because they don't have a mortgage. I first got onto this, or had it a driven home, the significance of it, when I came through Memphis about a year ago and looked for a Ramada Inn that I'd stayed at a number of times and thought it was a pretty good place. Well, the Ramada Inn was gone, but there was this dimly lit sign in front of what used to be the Ramada Inn. I think it said Airport Inn. And we stopped there. Well, the room rate was about half of what it had been before. And the clerk at the desk was even boasting about it. He says, hey, we don't have a mortgage. We don't have a mortgage. This thing's owned by the RTC.

48:33So we can beat everybody's prize in time. So instead of saying idleness, I've asked Jim Barth at Auburn who is sort of headlong into this topic of FDIC and RTC and he says this operator run RTC owned firm is quite common. He couldn't give me a percentage figure but he says it's quite common, there's a lot of it. So, instead of seeing resource idleness like you saw in the thirties, what you see is RTC owned and otherwise operated firms of that sort, and you might not even know that they're bankrupt, they're still operating. Now, this puts quite a damper on the market's recovery. I think what we can argue is that, see, it'll keep the recession from looking quite as deep as it otherwise would.

49:23After all, unemployment rate hasn't gotten that high. This is a mild recession by conventional measures, which is unemployment rate. Well, some of these people are employed at the Maramada Inn, okay? And yet, it's very likely to trade depth for length. In other words, the recession might be more shallow than most by conventional standards, but it's also likely to be quite long, because it's much more difficult to draw resources away from the RTC than it is to draw them out of idleness. Resources are eager to come out of idleness, not so eager to come out of the RTC. Also, consider the potential market competitors of these firms. If you were in Memphis, would you be eager to start a new motel across the street from this one owned by the RTC?

50:14Would you be interested in expanding your operation, trying to compete with the RTC-owned firm? I don't think so. And in fact, I think it's this kind of thing that explains why the recent desperate attempts to stimulate the economy with monetary injections have had such little success, okay? But you don't inspire people in the market to compete with these RTC-owned firms just by slightly lower rate of interest. So it's not at all hard to understand that the monetary authority is not particularly potent as far as just stimulating the economy in the short run. Third, I'll point out that the pattern of employment in the current situation is dramatically different, and this has been noted very widely, than in the 30s.

51:03It's predominantly white collar now as opposed to blue collar. And people puzzle over this. I've watched C-SPAN and some of them, McNeil, Lair, and a number of them, or the puzzle of them, or why is the pattern so different? But yet, if you take the risk-based explanation that I've offered you, it becomes apparent. In other words, in the 1920s, the overextension of the economy was in long-term projects, which means steel mills and manufacturing. The labor complement to that kind of production is predominantly blue collar, okay? But in the 1980s, the overextension was in speculative developments, which included Many high-rise office buildings in Dallas that included financial services of all kinds and leveraged buyouts and all that.

51:50And the labor complement is predominantly white-collar. So the pattern of unemployment of labor matches perfectly the pattern of misallocation of capital for the two periods. And a fourth difference that I'll point out, which to me is one of the more ominous ones, And that is that with the end of the boom in the 1920s, we also saw the end of monetary growth. Okay? In fact, it was tapering off of monetary growth that triggered the boom, and despite efforts to the Fed, by the Fed the inflation was not rekindled. Monetary aggregates actually fell, you could argue they fell too much, but at least you You didn't have the problem of inflation, of inflationary finance after mid-1929.

52:47But if you look at the situation now and see that the proximate problem in the 1980s was a deficit, hideously out of balance, $200 billion per year, year after year for most of the boom, what you discover is that after the bust, the deficit actually increases. We can understand why it increases, but we should be troubled by the fact that the very situation that caused such instability, such riskiness in the private sector, and eventually gave us a pause at the end of the 80s, is a situation that we're experiencing now in increased magnitude, that deficits will probably reach near $400 billion this year. Well, I think I've pointed out what the problem is. I'll say a few things about how to fix it.

53:37Maybe the fix is fairly obvious. In addition to the obvious things of dealing with the FDIC, we have to deal with deficits, which really, I argue, even though it's a fiscal problem, it has a monetary solution. In other words, we need to attack the central bank and eliminate even the potential for debt monetization. That, after all, is what gives the fiscal authority such a long leash. So let me end by suggesting that even researchers at the Fed are close to this recognition. I argue they're two steps away from it. I say this because of what I think is a very important article that just came out in the Minneapolis Sped, Orderly Review, two researchers, PhD economists, one vice president of research at Minneapolis, Miller Preston, and his cohort, William Robards, who is at the Atlanta Fed.

54:41And let me give you what they conclude about deficits, the effects of deficit policy. Be sure and write this down because we need to know just where they stand on this issue. So here's the concluding section of the paper, the paper that by the way involved looking at a number of very sophisticated econometric techniques and modeling techniques to see just what the effects of the deficit are, okay. Here's our conclusions. Deficit policies may matter, and then again, they may not. Existing studies really don't tell us much Much about the effects. That was the conclusion of the Federal Reserve. Now, when I say that they're only two steps away from understanding the problem, I say this on the basis of their title. And the title of the piece is How Little We Know About the Effects of Deficit Policy.

55:39All right? So let me move you two steps to a healthy understanding. The we, how little What little we know about the effects of deficit policy is intended to mean we economists, we researchers at the Federal Reserve, we economists in general. But surely the important thing is that the we can also stand for, this is step one, can also stand for we lenders, borrowers, savers, investors, hedgers, leveragers, how little So we market participants know about the particular effects of deficit policy in the immediate investing period. So it's not really uncertainty on the part of economists about what deficits do. It's uncertainty in the marketplace about how deficits affect your investment decisions.

56:30That's the first step. The second step is to recognize that we can also apply to we holders of treasury bills, holders of government debt. But here we have to modify the title. How little we know or care about the effects of deficit prophecies, okay? So the fix is to make them care, okay? We want them to care. We want to expose them to the risks that are associated with this, okay? So let me just conclude here with my summary at the end here. Although irresponsible fiscal policy is the proximate source of current macroeconomic imbalance, monetary reform is the ultimate solution. The Federal Reserve's capacity to monetize Treasury debt keeps the default risk premium off Treasury bills and hence leaves the Treasury and Congress free of any effective debt limitation.

57:23In 1932, Franklin Roosevelt was willing to rely on the character of elected officials to solve the deficit problem. He says, let us have the courage to stop borrowing, okay? When it became fully evident that courage was not enough, reformers sought other devices. Let us have a legal debt ceiling. Let us have a Deficit Reduction Act. Let us have a constitutional amendment, okay? All these attempts to legislate physical responsibility have or will fail, so long as the treasury bills are kept artificially risk-free. So, let us have a default risk premium on treasury securities. nothing short of eliminating even the potential for debt monetization will impose deficit, discipline on the federal budgetary process.