The Federal Reserve, Then and Now

0:00I'll start out by saying I feel a genuine sense of power tonight, having been given a slot that has a 7.30, beginning time and no end time. I promise you, though, I won't abuse that power. In fact, academics are programmed to think and speak in 50-minute segments, and so I don't think it would be possible for me to abuse the power. However, I would warn you about tomorrow evening when Congressman Ron Paul has his same time slot. You might want to get a statement from him. Also, as I look at tomorrow's schedule, I see that you're scheduled to hear about the origins of money, the origins of banking, and other related topics, and promise not to steal any thunder from those speakers.

0:51I'll confine myself this evening to the 20th century about the Federal Reserve and leave the prehistory of the Fed as important flashbacks for tomorrow. Let me begin by explaining my title, the Federal Reserve then and now. Then refers to the 1920s, the roaring 20s, the boom during the 20s and of course the bust and depression that followed. that now refers to the bullish 80s, high-flying banks, junk markets, junk bond markets, and so on, of the 1980s and the recession that followed. We'll have a few things to say about the very current period, about Clinton and Greenspan and elections and monetary policy and all such.

1:44Also, to put my talk in some perspective, I can give you the counterpoint right away by referencing Lester Thoreau, Dean of the Business School at MIT, who recently wrote a book entitled Head to Head, talking mainly about the competition between the US and Japan. But in commenting on capitalism in general, he remarked that it's a wonderful thing, capitalism, He said, with capitalism, markets just go crazy every 60 years or so, which seemed to be both the beginning and the end of his analysis of the Federal Reserve, both then and now. I'll promise you a little more analysis than that. I think we can understand something about why markets went crazy in the 20s and again in the 80s.

2:37In fact, I don't intend to save my conclusions for a punchline. I want you to see up front where my argument's going. It helps you to follow it if you see where it's going. Both booms in the 1920s and again in the 1980s were artificial booms in an important sense. They were policy-induced. They were created by government. And as a result of that, they were inherently unsustainable. busts inevitably followed both booms. And secondly, the Federal Reserve had a major role, although a different role, in each episode. It's important to see the differences as well as the similarities. It's impossible to get a fix on the Fed where we can get its modus operandi down once and for all. If that were the case, it would probably lose its power. It maintains its power are partly, if not largely, by being able to adapt to changing circumstances, different policy regimes, and operate accordingly.

3:41I'm reminded several years ago when a colleague of mine was preparing for a cocktail party one evening, and he had done his liquor shopping, buying gin and rum and scotch. Sometime before the evening arrived, his children decided that the liquor cabinet was a pretty good substitute for a chemistry set. And they began pouring one bottle directly into the other, scotch into rum, rum into gin, gin into scotch, little cream to man all around. Well, my friend discovered the problem not before guests that had some innovative cocktails. And he meted out some punishment in the form of yard duties and decreased allowances and the kids promised him never to do that again.

4:31Never to do that again. And my friend told me just sort of despairingly. He said, you know, I believe them. I believe him. He said, they'll never do that again. The next time it'll be something else. And that reminded me of the Federal Reserve. Next time it'll be something else. So, don't try to get a fix on the Fed simply by watching the aggregates or watching even the interest rates or the money supply. You have to look behind the scene, look at the politics, the institutions, the policy regime, to fully understand what it's doing. And that, I think, we can do tonight. Now, to understand the Fed's role in the 20s, we need to know a little bit about the origins of the Fed and about the gold standard that preceded it.

5:17If we could take the political rhetoric at face value, we take it that the Fed was created by two problems, real or imaginary. One was the random variation in the money supply because of its being tied to the gold stock. And two, the slowness of its growth rate in comparison to economic growth. Both problems were captured by the phrase, we need an elastic currency, elastic. The gold standard wasn't sufficiently elastic. It didn't increase to meet seasonal demands, or it didn't increase over time to match secular growth. Looking at these concerns in a more healthy perspective, we see that neither were problems in their own right.

6:08One was a problem actually created by the government, The other, not a problem at all. If the market didn't meet demands for money with new supplies, it wasn't the market's fault. It was the government's. The government had taxed private banking out of existence from the time of the Civil War. And even before the Civil War, it highly restricted banks on the basis of the banks buying government-issued bonds. So had the banks simply been allowed to work, they would have. Secondly, there's no need for the rate of production of money to keep pace with economic output. The demand for money can simply be accommodated by falling prices, where the same amount of money buys more as prices fall.

6:58This is a point that Murray Rothbard never tired of making. But these arguments simply weren't in play at the time that the Fed was originated. What was in play was simply the notion that the central bank could outperform the gold standard, taking my line or paraphrasing it from Annie Get Your Gun, anything gold can do, we can do better. So the rhetoric that surrounded the creation of the Fed had some praise, limited praise for the gold standard, but argued that the Fed could do it even better. could keep the money supply more stable and it could grow it at a rate that would match the economic growth in the country. With centralization, however, we lose the ability even to distinguish between accommodating increases in demand for money, which the market can certainly do, and simply increasing the money supply in spite of no increases in demand.

7:59The Central Bank, in fact, had conflicting goals along these lines. As one wag put it, the slogan of the Central Bank is, what we want is sound money and plenty of it. And if there's a trade-off here, of course, it was always soundness that lost out to plenty. Now, the Fed spent the first few years finding its own feet in financing World War I. The story of boom and bust starts in the early 20s, when we had for the first time a strong Central Bank, Operating in a Peacetime Environment. If I wanted to put it in modern parlance, I would say the central bank set out to grow the economy. This is a term borrowed, as you might recognize, from Bill Clinton, only presidential or president that I know of who used grow in this sense as a transitive verb. In fact, when I introduced these These ideas to my classes back in Auburn, I simply ask them point blank.

9:01Is grow a transitive verb or an intransitive verb? Actually this doesn't work at Auburn because my students don't know the difference between those two. I have to explain, one takes an object and the other one doesn't. If you think it's an intransitive verb, you simply say the economy grows. The economy grows, or at least it does if government stands out of the way. If you think it's a transitive verb, then some thing or one, politician, president, has to grow the economy, right? And in fact, I divide schools of macroeconomics into two broad groups. I call them the transitive school and the intransitive school, okay? And jumping ahead, you can see Bill Clinton as a full-fledged card-carrying member of the transitive school of thought.

9:48He grows the economy and so too did the Fed, or at least it set out to do just that, in the early 1920s. Well, fine. How does the Fed grow the economy? And the answer is pretty simple, by expanding the money supply, by making good on this elastic currency. And if you know money and banking, you know that the Fed has different ways of doing this. In our banking courses, monetary theory courses, back at Auburn, We spend some time explaining all the differences between the different tools that the Fed has to work with. And yet what's important to see is what they have in common. And what they have in common is that they're all ways of pumping new money into the economy through credit markets.

10:37Pumping money in through credit markets, lending money into existence. The reserve requirement that's imposed on the banking system can be changed. If it's lowered, that allows commercial banks to lend more to its borrowers. The discount window, so-called, is the second tool in which the Fed lowers it in order to encourage banks to borrow and in turn lend to their customers, or so-called cryptically The way they named open market operations, which simply means the Fed creates money and lends it to government by buying treasury bills is still another way that the Fed lends money into existence.

11:23The federal open market operations, by the way, began in the 1920s, which is another way to mark the beginning of this important era in Federal Reserve history. Well, I wanted to divert your attention from the differences between these different tools. This is the business of money and banking. This is the nuts and bolts of it all. And learn it if you have to, if you have any occasion to. But more importantly, look at the similarities. Each tool, no matter which, is a means of pumping money through credit markets. The Fed pads the supply of loanable funds, creating new funds to be lent. Another way to say it is it drives a wedge between saving and investment. The market itself, supply and demand working in the loanable funds market, keeps investment in line with people's willingness to save.

12:16You can't invest more than there are savings to finance it. The Fed breaks that link. It destroys that market discipline. And it creates incentives for the economy as a whole to undertake more investments than can possibly be finished. All right, this is the significance of pumping money in through credit markets. And this is why the boom is aptly described as artificial. You can't do that forever. You can do it for a while, but it'll come back and get you. It'll come back and haunt you. That eventually the game is up and the market will crash, which of course happened in 1929. I'm amazed at modern mainstream economists and their ability to deny even these obvious aspects of the Federal Reserve.

13:08I invite you to pick up almost any economic textbook and look for any hint, any clue, that the Federal Reserve did anything wrong during the 20s. No clue of it whatsoever. And in fact, I've gotten on to economists in this respect. I claim that they argue like a lawyer. And this would do apology to any lawyers in the audience. And for those who aren't lawyers, I might have to explain how lawyers argue. The lawyer argues like this. My client didn't borrow your lawnmower. And your lawnmower was already broken when you lent it to him. And it was still in perfect shape when you returned it.

13:55Well, if you can get the jury to go for any one of those things, you've got your client off. Okay, that's arguing like a lawyer. If you look at how modern macroeconomists argue about the Fed in the 1920s, they say interest rates weren't low during the 1920s. Further, the low interest rates had no effect on the macroeconomy. And what's more, the stimulation attributable to those low rates brought us prosperity, you see. So don't look for an insightful theory of boom and bust out of the modern textbooks in macroeconomics. The truth, of course, is the Fed did lower interest rates during the 20s. It caused an artificial boom, which eventually led to the bust. The rates overstimulated long-term capital, overcommitted resources to projects that couldn't possibly be finished because too many of them had begun.

14:48When it finally became obvious that not all could be finished, many had to go into bankruptcy. Many had to close their doors. Many had to shut down. And that was the bust. In fact, at the very eve of the bust, interest rates were high, as businessmen scrambled one with another, trying to outbid for funds in order to complete the project that he or she had started. The economy's industrial structure had become distorted too long-term with respect to people's actual willingness to save, which would have been reflected, of course, in interest rates had it been left alone by the Fed. Now, at the risk of sounding a little defensive, I want to elaborate here a little bit about the business of interest rates being low.

15:37And I've been driven to look into these different arguments precisely because mainstream economists deny this particular aspect of the theory. When the Austrians, if you read Mises or Hayek or Rothbard, when the Austrians talk about the rate being too low, they don't mean hit you in the face low or dramatically low relative to historical trend. And they simply mean low relative to what the market would have had it, below what market forces themselves would have produced. In fact, it is precisely because market participants have no crystal ball to find out what the real interest rate should be that a low rate does so much harm.

16:23If the rate is too low and businessmen are being guided by that rate, they have no reason or no means actually of figuring out what the rate ought to be and no incentive to tailor their affairs to some other rate that would have existed but in fact doesn't because of the acts of the Federal Reserve. And in fact, the very notion that an interest rate can be low, below the market, not dramatically so, not hit you in the face, obviously so, for a period of years is what causes so much damage, okay, that this problem can go for years undetected, the problem festers, and when it finally comes to a head, it's in the form of a crash, a bust, and the following depression in which the capital structure is being restructured.

17:17One way to illustrate this here, just using standard old mainstream tools, if you think about the supply and demand for loanable funds, which the market clears by adjustments in the interest rate, suppose that the government were to simply fix that rate below its market clearing level by decree, by legislation. Starting noon Thursday, the interest rate will be 3%, instead of the four or five that possibly the market would dictate. What would happen? What would be the consequence? Well, it's pretty obvious there would be a credit shortage. There would be more people wanting to borrow money at that low rate than there would be people willing to lend it. It would be a dramatic credit shortage.

18:02It would cause a problem immediately, and the problem would persist until that interest rate ceiling was eventually lifted. That's pretty clear. Sure, mainstream economists have no problem with that part of the analysis. Let me take it a step further now. What if the Federal Reserve were to step in and make good on the shortage? In other words, you announce the rate below the market, and then the Federal Reserve simply creates the money and lends it to all takers at that rate. They paper over what otherwise would be a shortage to avoid the problems that a shortage would cause. What would you say now? Oh, that fixes things. No problem now. Is that right? Surely not. Surely not. Surely what happens is the problem goes undetected, that the problem festers, that the consequences become worse as time goes on.

18:55And if the Fed keeps the thing going for virtually a decade, the problems are monumental. And that, I think, is an apt description of what went on during the 20s. A Fed maintaining artificially low interest rates is analytically equivalent to a price ceiling on credit with the shortage papered over, covered up by money creation. If you have any economic instincts in you at all, and I think all of you do, that's going to cause trouble, okay? And we saw that trouble at the end of the 20s. All right. Well, I've spent relatively little time explaining how the boom of the 20s was artificial. In fact, my authorities here are Mises and Hayek and Rothbard is called the Austrian Theory of the Business Cycle.

19:43Rothbard called it the Mises-Hayek Theory of the Business Cycle. It's alive and well and applicable to some extent even today, as I'll show. In fact, what I want to do is fast forward now to some experience that's within our own memories. And suggesting that the big change from the 20s to the 60s and the 70s and the 80s was simply we've learned a lot more about the Fed. There's an important sense that the 1920s was what I could call an age of innocence. And by innocence I'm talking about the relationship between businessmen and financial planners on the one hand and the Federal Reserve on the other. I'm not talking about the originators and boosters of the Fed.

20:29The Fed. Not much innocence there. In fact, that's why you should read Murray Rothbard's case against the Fed to learn the history of its creation. But people in the 1920s didn't understand the Fed. They didn't know about the Fed. There were no Fed watchers. You didn't see much in the newspapers about the Fed. It was generally trusted to maintain favorable market conditions. And that was about it. And this even extends to the Fed's own perception of itself, or maybe starts with that. I think maybe the telling episode here is a famous interview with Irving Fisher, who was a monetarist before Milton Friedman, talking in the late 20s with Benjamin Strong, who was president of the New York Federal Reserve Bank, which at the time was calling the shots in Federal Reserve policy.

21:27Irving Fisher, being a monetarist, asked Benjamin Strong point blank, Aren't you a little concerned about what's happening to the money supply? And Benjamin Strong replied, Oh, I don't know what is happening to the money supply. You would think that a Federal Reserve president, especially the one in charge of monetary policy, would know that. The reason he didn't, though, is not hard to see. He wasn't watching that. It would have been anachronistic for him to be watching monetary aggregates. He was watching credit conditions. He was watching the interest rate. He was trying to keep it low. And if keeping it low required pumping in still more money, he did it, without much attention to the monetary aggregates.

22:13Financial markets weren't paying attention to it either. Well, guess what? In more recent years, we pay attention. We watch those monetary aggregates. We try to get a line on the Fed, figure out what it's doing, so we can hedge against it, protect ourselves from it. So the big change from the 20s to later decades was simply that we lost our innocence. People are streetwise in watching the Fed. Application of Lincoln's Law is introduced by Ludwig von Mises in this context. You can't fool all the people all the time. They wise up. They see what the policies are. They don't go for those same kind of policies over and over again. But the result is simply that the booms are shorter. Instead of having a boom that lasts a decade, you have one that lasts a year and a half.

23:02Okay? And in fact, that has been such an integral part of our landscape. It's taken on a name. It's called the political business cycle. Okay? It happens about every four years. It starts about 18 months before election day. And to the extent that's the game the Fed is playing, it's fairly predictable. Political business cycles are probably here to stay, get used to them, and we can learn to watch them and make our predictions in accordance with them. And I'll even argue that the proof, that the proof and the notion of political business cycles is found in the notable exceptions. There aren't many in the post-World War II period, but I can name three. And I'll show you three exceptions where the game was either not played or played very badly by different administrations.

23:52And the question to you is what do these three have in common, all right? The first was Gerald Ford, who in 1975, a year before the 76 election, was told by his advisors, it's time to start thinking about the economy. by which they meant, of course, the stimulation has to begin about 18 months before the election if its effects are to be felt close to the election. Gerald Ford had to be explained how this works. He was an admirable person from many points of view, but when he got a glimpse of what he was supposed to be doing, he decided not to do it.

24:38That doesn't sound like the right thing to do. Everybody knew he could have done it. Arthur Burns was still chairman of the Fed. Arthur Burns had done the same thing for Richard Nixon four years earlier with the right effects. But Gerald Ford, for reasons we could all guess about, decided not to do it. He didn't do it. He didn't play the game. We didn't have any political business cycle that time around. A second example was Jimmy Carter, an odd example, an opposite example, and it was opposite in an important sense. If you all remember when Jimmy Carter did win the election, of course in 1976 from Gerald Ford, he held press conferences in Georgia before he ever went to Washington, put his entire cabinet together before ever going to Washington, and announced proudly that his administration was going to hit the ground running.

25:36Now, in terms of monetary policy, that means hit the ground printing, as indeed he did. Jimmy Carter started the game too early, partly because Ford hadn't done it at all. And Carter began increasing the money supply as soon as he took office. So four years later, or I should say two and a half years later, when it would have been time to start the political business cycle, We were beginning to feel the adverse effects. We were beginning to feel the inflation, double-digit inflation that had been caused by the monetary expansion we had already had. There was no scope to play the game there. He tried. The money supply was increasing even after that, but with no good effects, because the thing had already come to its own natural end.

26:26In fact, if you want to credit Jimmy Carter with something, Credit him for reducing the lag to virtually zero. In other words, by the end of the Carter presidency, you might well see headlines in the Wall Street Journal fed to expand the money supply, interest rates rise. And of course, the wisdom is, if you increase the money supply, you lower the interest rate. You pump money out to your credit market and you lower the interest rate. Right, that's the initial temporary effect, after which eventually they rise as inflation proceeds. Okay, so you can push the interest rates down, but they come back in your face. And in fact, it's that very time lag between pushing it down and it coming back in your face that you want to... that's where the timing is important, it's all in the timing.

27:18You've got to push it down, then have the election, then it comes back in your face. Okay, that's the way you do it. But with Carter, he had done it the whole four years, And as a result, it was coming back in his face as soon as he started expanding. So Carter started too soon. I'll give you one more example, and that's George Bush in the election of 92. This is fairly fresh in our memories, and we remember that he won the Gulf War in early 91. And at that point, it was perceived as absolutely unbeatable. He didn't need to play this game. No need to play it. He had the election in the bag. He was unbeatable, so unbeatable that the Democratic Party didn't even want to waste a good candidate. Find somebody from Arkansas or whatever, run against this man.

28:09And yet, he discovered the hard way how short political memories are. What have you done for me lately? First maximum politics. As time wore on, it became increasingly obvious that the Gulf War wasn't going to be enough to see him through. He had to do something. When he finally realized he had to do something, George Bush himself wasn't quite sure what to do. No one ever accused George Bush of being an ideas man, but he knew who the ideas men were, Jim Baker. He brought Jim Baker in to help him out, but he brought him in in the summer of 92, just a few months before the election. Not enough time. You need 18 months. You can't do it with three. And Jim Baker, of course, had the same old ideas that everybody else has, increase the money supply, stimulate the economy.

28:54It was too late. It was too late. He played the game, but he played it too late, increased the money supply. But the election came too soon after that. Of course, the stimulant from that increase in the money supply came in February and March of 93, after the Clinton administration had already taken office. The cycle worked itself out in an economically predictable way, but it was too late. Well, have you figured out what those three episodes had in common? Ford, Carter and Bush? They all lost, that's right, they all lost. That's the way you lose an election, by not doing the political business cycle right. And at this point, it might be worthwhile to comment on Clinton, on this particular point. I'm going to grade Clinton in a different way as we go on.

29:46But right now, let's look at it just in the context of the political business cycle. And I'll predict that he won't fail this part of the test. He'll get this part right. And you can already see it if you watch it. You know, we're 18 months before an election. Less than that. But if you look at the record over the last several months, Once you see the very kinds of activity that you would predict in an administration who is playing the game in accordance with the political business cycle theory, lowering of interest rates, expansion of money supply. And there's two kickers here that I might clue you in on tonight if you haven't already thought of them. One is important to watch what the economist calls the yield curve, which is just to say Let's say the relationship between short-term rates and long-term rates.

30:36Short-term rates are more directly controllable by the Fed. It can push those down, at least temporarily and in the short run, simply by flooding credit markets with new money. The long-term rates are a little more difficult to control, and the long-term rates are the ones that give you your clue about expected inflation. If people expect inflation, those long-term rates will be up. The yield curve will be steep, right? So, if the current Federal Reserve action is perceived as resulting in substantial inflation in the future, then even though the short-term rates are down, the long-term rates are up. But actually, that's not the case right now. What we see is a relatively flat yield curve. So as those short-term rates go down, it hasn't affected long-term rates yet, all right?

31:27And those long-term rates are one of the things that the Fed watches to see if it's getting A flat yield curve is the very thing that will tell you that the Fed hasn't seen its limit, hasn't seen anything that's going to stop it. So that means you're likely to see more reductions in interest rates, more credit expansion, a stronger cyclical boom going into that election next year. The other thing to think about, and this is something I can raise as a question and let you guess along with me about the answers, and that is that Clinton really does need Greenspan as every president needs the chairman of the Board of Governors.

32:14But this time around, Greenspan needs Clinton too, because his term of office expires March of 96. This is going to give an interesting dynamic to the politics of 96. Greenspan would like to be reappointed, I suspect, in March of 96. And Clinton would like full accommodation from the Federal Reserve in his bid for re-election later that year. And so we'll just have to wait and see how that plays itself out. It may play itself out in a way that neither is too pleased with, as I'll suggest in the later part of my talk tonight. Well, what I've suggested is this political business cycle is something that we've learned to live with.

32:59And yet, I want to argue there's something else going on that's much more worrisome. Something else that has in recent times led to a considerably longer boom, namely the big bull market of the 1980s that has a precedent only in the boom of the 1920s in the 1920s, as far as a sustained boom. What is it that explains this long-term rise? And how is the recession in the 1990s connected to it? What I'll argue is that the Fed has begun to play a substantially different role in policy formulation than before. And part Part of this, again, comes from the aftermath of the Carter administration, when the Fed seems to lose its touch as far as increasing the money supply and having even a short run effect.

33:53It seemed to be losing power to a considerable degree. So much so, the drastic measures were taken and starting in October of 79, still under the Carter administration, the Federal Reserve abandoned interest rate targeting. They quit trying to control credit markets, instead tried to control the money supply. Didn't control it very well, it was very erratic, so too were interest rates, but at least their policy goals were stated in terms of money supply targets and not credit conditions. So with the Fed inflating less than it had before, after all we did bring down the inflation from the double digits numbers to into the low single digits, the government needed another source of funds.

34:41And what it discovered was that the Treasury had a much greater capacity to borrow than it ever had imagined. So what I'll show you here is that the boom of the 1980s was debt-financed and not money-financed, But the Federal Reserve, nonetheless, played an essential role, a critical role, indispensable supporting role in the Treasury's issuing Treasury bill beyond anybody's wildest expectations of how much it could actually borrow. I want to argue that the very existence of the Fed, I'm not talking about how much money it creates or what credit conditions it maintains, The very existence of the Fed puts the Treasury on a very long leash that the Fed, in its stand-by capacity to monetize debt, is backing up the Treasury.

35:36It's there to be used in a pinch if the Treasury gets itself in trouble. That very fact allows the Treasury to borrow unprecedented amounts without paying any additional premium for what it borrows. This is literally true, of course, there's no default risk premium on treasury bills. Think about this for a minute. If you're a private firm, there are strict limits on how much you can borrow. If you borrow too much, you have to pay a default risk premium, you have to pay dearly to borrow more, your equity shares fall in value, your credit worthiness is destroyed, you have to clean up your operation in order even to get the credit that you once got before.

36:22There are strict limits imposed by the market on a firm's overextending itself. There are even effective limits on a municipality, as New York City discovered several years ago. Bonds can be downgraded by bond rating agencies. Municipal governments have to get their fiscal house in order in order to avoid paying dearly for the funds that they're borrowing. But this is not true of treasury bills. It's not true of treasury. There is no default risk premium on treasury bills. All right? And the reason there isn't is simply because the Federal Reserve operates in a standby capacity to bail out the treasury if that should become necessary. Now what I argue is that nonetheless there are tremendous risks associated with all this borrowing.

37:15There's simply not risks that are borne by the holders of treasury bills. In fact, quite to the contrary, you know, in managing your own personal finances, that if you don't want to put your money at risk, what do you do with it? Put it in a money market account that is heavily in treasury bills, or you buy treasury bills themselves. That's safe for you as an individual, okay? And yet, that borrowing creates a lot of risk. It's simply risk that has to be dealt with in the private sector. In other words, if the government has borrowed to the tune of four and a half trillion dollars, with deficits 200 billion plus each year, that makes doing business in the private market much more risky, because you have to predict what the government's going to do next.

38:06And they don't have to tell you what they're going to do next. Are they going to monetize? Then you're going to have inflation to cope with. Are they going to borrow domestically or are you going to have high interest rates? Are they going to borrow abroad? You're going to have exchange rates turn on you in a way that you hadn't predicted. The way I like to put it, I like to use some of the terminology from the mainstream and say that the very existence of the central bank has the effect of externalizing risk. Risk is born by the market economy as holders of treasury bills earn their interest on a risk-free basis. Sort of an irony here because people who advocate government intervention are always worried about externality.

38:54So worries about pollution and worried about acid rain and that sort of thing. Well, here's an externality that's much more worthy of our worry. Let's worry about the externality in the form of tremendous riskiness in the market that's attributable to that government debt. Tomorrow I'm going to give a talk on the debt bomb where I'll tell you more of the nuts and bolts of this riskiness. But right now I'll just ask you to realize that the risk associated with borrowing is not shunted into the Atlantic Ocean, This is a view not widely accepted in fact I haven't seen it in print anywhere except in my own articles and in fact quite to the contrary at Auburn University we have an eminent scholar in the finance department who actually argues that the government ought to go deeper in debt it ought to borrow more and the reason it ought to borrow more he says is because as a safe security. And what with all the risk in the private sector, we could use a few safe securities, you see.

40:10Well, this is why he's an eminent scholar and I'm not, I suppose. He's got this figured out. Okay, so at this point I can summarize this parallel, this distinction between the 1920s and the 1930s fairly succinctly. I could say that in the 1920s, In the 1980s, investment was excessively long-term, and by the end of the 20s, the game was up, liquidation took place, capital structure had to be restructured. In the 1980s, investment was excessively speculative, and partly, if not largely, because of the enormous federal debt.

40:57There were other factors, in fact, some that are very much worth mentioning. At the beginning of the 1980s, again under the Carter administration, we had deregulation of banking, which in and of itself is a good thing, except it didn't quite go far enough. Smaller capital requirements, lower entry barriers, more competition in banks, fewer asset restrictions banks could buy, more and more speculative assets than they had before. But all this was done without any attention at all to the Federal Deposit Insurance Corporation. FDIC was maintained in place with the government ensuring the depositors who deposited their money in these risk-taking banks.

41:42And that broke the market discipline, didn't it? It caused banks to be able to behave in a very speculative way without alarming any of its depositors who, after all, were covered by FDIC. In any case, the FDIC insurance was sold at a very low subsidized rate and, more importantly, was unrelated to the risk that the banks were taken. So the more speculative banks tend to win out over the more conservative ones. As it began, it was a heads we win, tails you lose proposition. These kinds of regulations during the 1980s just added to the speculation, speculative orgy, really, of that decade.

42:27And in fact, this is what even gave rise to the whole junk bond market. If you read about Michael Milken and read what an evil person he was and how he was speculating with other people's money and so on and his cause of the problem, he had no cause of the problem at all. He was simply responding to the incentives that were created by these institutional changes and by the huge government debt. He was providing speculative opportunities to banks who were all too eager to take them. Besides, Milken didn't invent junk bonds anyhow. They've been around a long time. He simply escalated their usage as demand dictated. In fact, By the end of the 1980s, you might not realize this, but junk bonds had proliferated to deliver all sorts of gradations within that category.

43:18You had everything from what was called quality junk. If you really want to be speculative, 1,200 some banks failed during the 1980s compared to about 80 in the decade before. One part of the story that's worth mentioning, I think, and it's one where I can actually bring you some good news, is that during the shakeout at the end of the 80s, when over-speculation turned into dramatic losses, where the bull market of the 80s turned into the recession of the early 90s.

44:09Lots of firms were identified as bankrupt firms simply because they were non-performing assets in failed financial institutions. Many of these firms, motels, restaurants, industrial firms, shopping centers and so on, fell into the hands of a special created agency, the Resolution Trust Corporation, the RTC. whose job it was to get rid of these assets, to sell them back into the market. And for a number of years running, this was the biggest nightmare in the administration. Think about it for a minute. They had upwards of $500 billion. We're quite sure what they had actually, but something like that of assets. And they wanted to avoid two things.

44:56They wanted to avoid dumping them on the market Because that would spoil markets, trigger more bankruptcies, more institutions would go bankrupt, and they would receive these assets back. So don't dump them on the market. The other thing they wanted to avoid was holding them. Because if you hold them, this can be called an overhang. That if the RTC is holding on to unfinished shopping centers, golf courses, and restaurant chains and so on, and so on. It's awfully hard to stimulate private industry into building those things, right? First they want to wait and see what's going to happen to the existing ones that are currently owned by RTC. Now the good news is that the assets of RTC have dwindled down now from about $450 billion down to about $15 billion.

45:49So hopefully the RTC at least will be on its way out. Now, let me turn for a minute and look at current conditions and I've already suggested that Jimmy Carter may win the day on the business of political business cycle. But I want to suggest that he's got another test that he has to face that he may not be able to pass. Again, it's all a matter of timing and all of a matter of luck, as we'll see. The stock market, financial markets in general, have been more volatile in recent years when the government deficit has been large. This much seems to be recognized by most economists who watch these things. And in fact, one of the objectives that Clinton stated in his most recent State of the Union address is he wants to try to stabilize financial markets.

46:40That was his third listed objective. I'm not sure he'll be able to do it, especially in light of his first two listed objectives. His first listed objective is balance the budget, which means, of course, decrease government spending and increase taxes. Second listed was stimulate the economy, which of course means increase government spending and decrease taxes. The third objective is stabilize financial markets, which translates into be predictable. Okay, be predictable. Let the Wall Street know what you're doing. Well, in light of the first two objectives, I don't think that's possible. The Federal Reserve to date has had a fairly good track record of dealing with the so-called mini-crashes of 82 or 87, 89.

47:36And the object here has not so much been to stabilize financial markets as simply to keep them from spilling over into the real economy. and the real economy. This has all become almost a slogan to try to build a firewall between the financial sector and the real sector so that Wall Street lives a life of its own and doesn't bother the rest of the economy. Now, that's not the way to financial health. It's not the way to economic health. In fact, the economy depends desperately on signals from the financial sector if it's to do the right thing. Nevertheless, building the firewall seems to be the closest thing they can do to come to stabilizing financial markets. Think about it for a minute. How does the Greenspan maintain the firewall?

48:22Well, simply by providing liquidity when it's demanded. In other words, if there's a liquidity crisis on Wall Street, if people begin selling stocks and bonds and wanting to hold money, he pumps in money through credit markets for them to hold. And then when the crisis is over, he sops it back up as they go back into real securities. Now, this could play itself out in a rather peculiar way in an election year when the political business cycle is at issue. Think about it this way. Clinton leans on Greenspan to increase the money supply still further, which means pump money in through credit markets. Greenspan being the independent sort says, no, it's not the thing to do, it wouldn't be prudent.

49:09And we stand by to watch to see if Wall Street believes him, to see if he'll hold stick to his guns. And it may well be that this sets off a liquidity crisis. In other words, it's a battle of wills, people aren't sure who will win, they're not quite sure what market conditions are going to look like, and therefore there's a scramble for liquidity. Well, to maintain the firewall, that's exactly the time that Greenspan has to pump money in through credit markets, you see. He has to supply that liquidity to the market to quell the fears of people who are worried that he won't stick to his guns. What I'm suggesting is that this story turns pretty unstable pretty fast. It's very difficult. You're going to need some tea leaves to find out whether Greenspan is increasing the money supply because he caved into Clinton.

49:58Or is he increasing the money supply to maintain the firewall and supply the liquidity to investors who believe that he would cave in to Clinton? In either case, you get an increase in the money supply and destabilizing of credit markets. So that's the kind of a scenario that you want to look for in the months ahead, especially in the months approaching March of 96, When again at play is Greenspan's own job and his next term in office, which of course is up to Clinton. So what I'm suggesting is that the whole system of a president who has strong influence with the leader of the central bank in deciding what the money supply will be is inherently unstable, all the more so in an environment of heavy indebtedness of the Treasury, all the more so in a political environment with an election next year, and with the chairman himself up for reappointment.

51:03I would suggest in closing that the answer to all of this isn't some different chairman or even some different president, but rather is a decentralization of banking, a return to hard money, where we can trust the hard money directly and not some person that's managing, where we can have a default risk premium on Treasury bills and have the market itself impose a discipline on the Treasury. Hard money and destabilization, I'm tempted to say that nothing more is necessary and nothing less will do. Thank you.