The Source and Workings of the Latest Crisis

0:00Thank you, folks, very much. For some reason, I sort of imagined that it would be slightly creepy here on Jekyll Island, right? Yet it turns out it's beautiful. Of course, that's why they came here, right? You don't come to some dump, obviously. It's a beautiful place. My wife is home with our new baby, and I was trying to think of the most gentle way I could tell her that she's missing out on the best event we could have gone to in the past three years, but all the same, she's doing her good work at home. which also means, by the way, that I'll be leaving a little early. I'll be leaving around two o'clock, so if there's anything you want to ask me about, any sort of fringe question you're afraid to ask, you've got to hurry up and ask it because I've got to head out early today, because the crazy travel schedule starts up again in a couple of weeks for me.

0:47Now, over the past few Mises circles that we've had, where we have these one-day events around the country, In some of them I've had 45 minutes to speak and I've spoken on a specific thing like I spoke on the condition of the US economy in 1920 and 21 and how that was reversed and that has been viewed, I just checked, it's been viewed 72,000 times on YouTube so thank heavens the country is even dorkier than I dreamed. I gave a talk in South Carolina on sound money, generally in 45 minutes the basic case for sound money. In Houston I finagled some extra time because Doug didn't take his full time so of course I used it and I talked about something, a topic, Keynesian predictions versus American history. They don't come out very well. But here I have less time and the topic is far broader. So what I think I'm going to do is really is just make some comments that I think are relevant to rendering a judgment about the financial

1:57crisis and the causes and so on and so forth. We'll start with a couple of the conventional statements that you might hear, let's say, on right-wing radio about the financial crisis. And that's not to say that they're wrong, I just think rather that they're incomplete. And so for example, Fannie and Freddie are talked about a lot. Fannie and Freddie are operating with, in addition to the various tax and regulatory advantages they enjoy, an implicit government guarantee that if these mortgages go sour and Fannie and Freddie are in real trouble, well, the Treasury will extend them what was sort of understood to be an indefinite sort of line of credit, not just the couple of billion that was explicitly, that people knew about.

2:44And this seems to have been generally understood. For example, at Freddie Mac, we have a top executive noting in the wake of the collapse over there, we have this statement. It basically worked exactly as everyone expected. When things got bad, the government came to the rescue. Exactly as everyone expected. Another fellow at Freddie Mac says, the thinking was that if something really bad happened to the housing market, then the government would need Freddie and Fannie more than ever. would have to rescue them and you could multiply quotations of this sort. Now allow me, even though I've been speaking only a couple of minutes, a digression right from the start here. If you look at the major banking crises of the period before the creation of the Federal Reserve, and I'm talking about around the world, if you look at the period let's say 1874-1913. There are four really major banking crises around the world, Argentina, Australia, Norway and Italy. What they all have in common is these governments are all artificially

3:51encouraging real estate. Norway in effect had a Fannie Mae. And more recently when we look at the debacle in Iceland, which is of course blamed on the free market as usual, Iceland had an explicit government guarantee, whereas Fanny and Freddy are only implicit guarantees. The government says they're not going to bail them out, but sort of with a wink, and people kind of suspect they would. In Iceland, this is an explicit government guarantee in the area of real estate. Well, of course, therefore, Fanny and Freddy, because they enjoy this implicit guarantee, as well as other advantages, are able to borrow more cheaply than anybody else could. And so they can borrow cheaply and then go out and buy these high-powered assets and they have a nice spread that they pocket for themselves.

4:43And so they grow bolder and bolder until we hit catastrophe. Now in July 2008, as Fannie and Freddie were heading toward ultimate collapse, Treasury Secretary Hank Paulson calmly observed that quote, their regulator has made clear that they are adequately capitalized. Well, two months later, you know, the whole thing is collapsed and the government has taken them over. And so Hank Paulson was confronted with this statement. I mean, didn't you just tell us in July that they're adequately capitalized? Everything's fine. And here's his reply. This is an exact quote. I never said the company was well capitalized. What I said is, the regulator said they are adequately capitalized.

5:32I read that to my wife on the phone last night. She said, what is this guy, five years old? We've got a real creepasaurus here. Now the other thing we get told a lot about is that lending standards declined. Like this is just some spontaneously occurring thing. Now it's It's true that there were various government policies that encouraged lending standards to go below where they ought to be, perhaps. And in fact, even Alan Greenspan, Alan Greenspan reflects on this. This is the big free market Alan Greenspan said in 2008. He said, I was aware that the loosening of mortgage credit terms for subprime borrowers increased financial risk and that subsidized home ownership initiatives distort market Outcomes. But I believed then, as now, that the benefits of broadened home ownership are worth the risk. Well, I'm glad you're willing to bear that risk, Alan. That's just super.

6:30Thanks a whole lot. But on these lending standards, it is true, as I say, that the central bank and various other institutions and pieces of legislation encouraged lending standards to Fall. But let's also note that when you have a monetary policy, such as the one the Fed pursued in the years of the housing bubble, that policy itself is going to lead to a drop in lending standards. Mises points this out in Human Action. Chapter 20 is the chapter on the business cycle, and he talks about how sometimes we We see the manifestation of this in the fact that loans are made that would not have been made otherwise.

7:16Because now the banks have got all this additional money, well previously they've already lent up to as much as they can go, everybody who wants to borrow is borrowing, but now you've got all this additional money to lend, how are you going to lend it out? You're going to have to lend it out to people you would otherwise not have lent to. And the analogy that I've used is that of a basketball team. Suppose you're picking people for your team from a pool of potential players, and then ten minutes later you get told, oh, by the way, you get to pick two more. Well, where are those two more going to come from? Logically. Of course, they're going to come from the pool of people you'd previously rejected. So there is this element. The Fed itself, its very activity is going to lead to a decline in lending standards. And we should also note that when we talk about Fannie and Freddie and we talk about

8:03Without a Housing Bubble, we should note that again in an atmosphere of stable, sound money, that is to say not the atmosphere that we had during the housing bubble, interest rates perform the role of a break. They put on the breaks. If people are just sort of arbitrarily deciding they all want to buy a lot of houses, like we're all a bunch of zombies and all we can think to do is buy houses, if we just keep If you keep on doing this, the banks ultimately are going to start running low on stuff to lend. Interest rates are going to shoot up and that's going to tend to put a break on things. Because certainly at least speculators will be less likely to want to flip houses when interest rates are so high. They're going to look to go do something else. But when you have what I've started to refer to as a Soviet Commissar in charge of money and interest rates, who can just sort of arbitrarily keep the thing going, just juice it up, keep it going,

8:58Well, you can persist in this artificial boom. You can persist in this bubble. There's additional credit to allow people to keep buying an asset whose price keeps on rising. The interest rate does not rise along with it. It's pushed down. It's kept low, and that, in effect, allows for the financing of more and more purchases of this type of asset. Now, these are points that I think are essential to use to supplement this story about Fannie and and Freddie and declining lending standards, and they involve the Federal Reserve, and they need to be raised. And what typically happens is because up until recently, you really couldn't talk about the Federal Reserve as a contributor to our problems. Really shouldn't talk about the Fed at all if you can get away with it, but if you do, you should speak of it in hushed, reverential tones and get out your incense and wave it in front of the sacred image of the chairman.

9:49But now that we're allowed to talk about it, it, I think, takes some of the heat off the and the Market Economy. Because if you can't talk about the Fed, when the Fed is the precipitating factor of the problem, well naturally the default position will be it must be the free market that caused it. And so by leaving out the elephant in the living room, we get these, well to say the least misleading diagnoses of our problems. Now the Austrian School of course has a business cycle theory that has I think attracted a I've been getting a lot of attention recently because of this particular financial crisis and because of the internet. That even though the gatekeepers are still there, who would rather that we not talk about this, not focus on a theory that points the finger at central banking, as Gary North says, you know, the gates are still up, but the walls are down.

10:43You know, so you still have Newsweek trying to tell you what to think. But meanwhile, you can just walk around Newsweek and get in and talk to the normal people. Well, Austrian Business Cycle Theory, which perhaps you've heard about and know something about, so I won't go into detail on it. There's a lot you can watch on YouTube and read about with regard to it. But what Austrian Business Cycle Theory is going to tell you in the Misesian formulation that you read about in Human Action is it's a story of malinvestment and overconsumption, that these phenomena are going to be evident in the business cycle. Now, by malinvestment, this is a word that's used a lot and often not defined, the Austrians mean something like the following, that we have a structure of production, that is to say when things are produced they don't just magically appear out of thin air. In fact, let me interrupt myself to point out that Rothbard explains this beautifully in something

11:36that we just put up, I say we, I had nothing to do with it whatsoever, it's all Chad Parrish, but we just put up on the website, Introduction to Microeconomics with Murray Rothbard, it's This is a recording of his course that he's teaching to undergraduates in 1986 and I find it very heartwarming not only because it's just wonderful to hear him but also to note the great rapport he has with the students like they laugh at his jokes and even if they don't he's laughing and having a great time like he interacts with them so well he explains things so simply and never once has he led on to them oh by the way you know I'm a genius who's written a huge treatise on this subject but he keeps it simple But yet, insightful, so he's talking about the structure of production that's necessary to produce a ham sandwich that you get down the street, and he's talking about, now, think about how far back this goes, he says, it's going to have to go back years and years,

12:28you're going to raise the pigs, you're going to raise the corn to feed the pigs, you're going to create tires for the trucks, you're going to transport, you're going to have refrigeration, this is just going to go on forever, right, and that's just for the ham, you know, forget about the bread and the butter, I mean, it's just, it's unbelievable, and he says the amazing The interesting thing is that this all comes together without a giant central planner. This just all happens. It all occurs. That's what microeconomics is interested in figuring out is how does it happen? How does this work? How does this all come together? Well, that's in effect what I'm talking about here, that there's a structure of production. It's not just like consumer goods just suddenly appear or there's like a machine and it just churns them out. It goes through a series of stages. You might think of it very, very simply, and they don't all follow this pattern, but, you know, like raw materials and you transform those into something else and go through a manufacturing process and then there are marketers and wholesalers and retailers and finally you get it.

13:24And there's a time dimension in the structure of production, okay, because obviously the raw materials are very, very far away from a finished consumer goods. So they're far away in time, not just conceptually. And so when you interfere with the structure of interest rates, these things that are more time-consuming are going to come to seem more more profitable now than they would otherwise have been. They're the most interest rate sensitive. The longer term a project is, the more interest rate sensitive it is. So when you interfere with interest rates to push them down artificially, you're going to give an artificial stimulus to interest rate sensitive things. So the higher stages of the structure of production, for example, or or housing, for example. Housing is interest rate sensitive. I mean, anybody who's ever been involved in buying or selling a house knows that, that the structure of interest rates is very significant there.

14:12So it's not surprising to see these things artificially stimulated, but it's an artificial stimulus. I mean, there's a reason that the market economy was giving you interest rates that were going to, in effect, discourage you from expanding those stages. It's ultimately that from the big picture point of view, the economy can't really sustain that much expansion in those stages. That's not in line with consumer preferences, ultimately. There isn't going to be a substantial enough stream of saving to support these long-term projects in the long run. And so this is malinvestment. Investment is directed into the wrong lines, basically, where it does not belong. But at the same time, the low interest rates lead to overconsumption by the public. That is to say, I mean, obviously, the interest rates are low. You feel like, well, I might as well blow my money now.

15:01Robert Wenzel, economicpolicyjournal.com

15:31He says, indeed the IPO market ground to a complete halt, not just the housing related sector of the IPO market. Over the last 12 months, this was a couple of months ago, non-construction manufacturing durable goods unemployment has climbed from 6.5% to 13.1%, mining, quarrying and oil and gas extraction unemployment climbed from 2.8% to 10.7% and so on. But as I say, we also have over consumption and we can see that in the fact that a lot A lot of people were buying a lot of things on the basis of wealth that they thought existed but really didn't, on the basis of inflated housing prices, inflated stock portfolios. Everybody feels rich and everybody goes out and the examples I always give, it's sort of unfair, is everybody thinks it's sensible to buy a six dollar cup of coffee or an eight dollar ice cream cone, whatever, hey, sky's the limit, right, I've got a half a million dollar house, next year it'll be three quarters of a million, you know, I mean, I got more

16:30and more, gazebos, you know, I'm lousy with gazebos, I don't know what to do with them all. So people make consumption decisions on this basis, but it's a false basis. And then ultimately they realize, wait a minute, I actually don't have the wealth that I thought I had. And so I think one of my favorite things ever, even though it's, I don't want to celebrate people's misfortunes, but just because of how revealing it is, is that ad with the guy riding around on the power mower and he's talking about how he's got the brand new house Mises in that chapter 20 of Human Action gives the allegory that I've used and some of us have used in the past of the master builder and it's a great allegory because it works for both the malinvestment and the overconsumption aspects of the boom.

17:21He describes the economy, he says, let's imagine the economy as being one guy, a master builder, whose task it is to build a house according to a blueprint, but he doesn't realize that he lacks the number of bricks that he would need to complete this structure. Well, what we conclude from this is that printing up green pieces of paper isn't going to get him anymore. If there are only this many bricks in the world, you can print up all the green pieces of paper you want. He still can't complete the house according to the original blueprint. So of course it's better for him to discover this error sooner rather than later so that he doesn't waste a lot of resources building a house that ultimately can't be finished because of mere physical constraints. He can't possibly finish it. So it's better for him to discover this error later. It would not be good to just keep cheering him on from the side.

18:08No, no, no. Keep on going, man. By the time you get to the end, we'll figure out some way to summon bricks out of thin air. That wouldn't be good, because then by the end, he's wasted his time that he could have devoted to something else. He's going to have to destroy perhaps most or even all of the house, so this would be bad. And the usefulness of this allegory is that, in effect, this is what a recession is. The recession is when the economy figures out there aren't enough bricks, figures out there's been malinvestment. We've been doing the wrong things with the resources we have. We've been over ambitious. We've been trying to start a series of projects that we're not wealthy enough yet to complete. There aren't enough saved resources to make them all possible. So therefore, we better quit doing this as soon as possible and start doing other things. In the same way, the master builder better quit doing what he's doing because he's embarked on something that's over ambitious.

18:56Well, now we think of this in a macro sense. The whole economy has been over ambitious. So now we have to sort out, using entrepreneurial skill and the price system, what's sustainable, what isn't, What lines should this production be going into and what should it not? It works very well because it's a wonderful allegory. If you were to encourage the master builder to keep going, you'd just make things worse. Likewise, with bailouts and with stimulus, we want to stimulate the same patterns of spending we've been having. Again, that just makes it worse because now you're continuing to do the wrong thing for even longer. But this allegory also works for the over-consumption angle as well. Because here we can think of the master builder as being, you know, just some regular American.

19:42And he's trying to buy, he's in effect buying more stuff than ultimately he can support. I mean, he's going to realize he doesn't have the bricks, ultimately. That he's engaged in a structure of consumption, in effect, that is not compatible with his real wealth position. but that he has overestimated because of these inflated asset prices. Now it's often said that what we need therefore is to prevent this sort of thing from happening again is more regulation of the economy. We can't have deregulation, we need more regulation. Now this is tricky because when you have a government system, and I take the Federal Reserve system that we have now as being a government system because the Federal Reserve has a government-granted monopoly on the money supply.

20:29It was created by the government, the whole thing is ultimately backstopped by the government. So when you have a system like this, it's not always clear whether so-called deregulation is the right thing to do. Because let's say you've got a government-granted monopoly of some good, but the government also says that as a condition of holding this monopoly, you can't raise the price above X dollars of your good. Well let's say that in the name of deregulation, we say, okay, never mind, the monopoly can You can charge whatever it wants, but it can continue to be a government monopoly. Well, would that necessarily be a step forward? Okay, so it's tricky when you have the government involved. It could be that either you get rid of all of it, you get rid of the monopoly and the price control, or you don't get rid of any of it, because maybe getting rid of just a portion makes things worse.

21:18It's not always clear. One could make a case that you need some type of regulation to deal with all the rotten consequences of the system we have now. One could at least make that argument. My own opinion of the subject is that regulation, deregulation, though, in this particular case is by and large a red herring, that I don't think that there are things that were going on on Wall Street and with banks that couldn't have gone on in the absence of any of this on the regulation front, I'm suggesting that we're sort of missing the point here, because we look at what the Federal Reserve causes, it causes moral hazard, because everybody knows that there's no physical constraint on how much money it can create, so in the last resort, anybody can be bailed out, or Fannie and Freddie can have its crummy securities purchased in huge, gigantic numbers, because you can just create the money.

22:17Alan Greenspan put when Alan Greenspan was Fed Chairman, people sort of took for granted that, well, you know, old Alan will bail you out one way or another. We have asset bubbles that are accentuated by the current system. We have distortions of the structure of production. We're directing investment spending into an unsustainable pattern. We're artificially encouraging debt finance for business and consumers alike. I mean, when credit can be created out of thin air, it's not a surprise that people use more of it. So we have this totally unstable, crazy system, and what's being recommended to us is, well, let's keep this crazy system, but let's run around like lunatics trying to regulate it. Well, this is sort of missing the point. It's the system itself is the problem. I mean, it would be like having a dam, but the dam is made out of, like, you know, paper mache or something, and saying, gosh, this dam is always springing a leak. We've got to just run around.

23:08Well, you know, why don't you build it out of concrete or something? Then you won't have this problem. Mises in effect put his finger on it when he said that one intervention into the market economy winds up causing problems, supposedly unforeseen problems, and so therefore there are calls for further interventions to correct the problems caused by the first intervention. So you get further and further in and you never consider the prospect that maybe it was the initial intervention that was the problem. In fact, Guido Hulsman, who I think is one of the great intellectuals of the Austrian School, in his book, The Ethics of Money Production, a book I highly recommend, he says this. He begins with a concession. He says, the banks must keep certain minimum amounts of equity and reserves.

23:55They must observe a great number of rules in granting credit. Their executives must have certain qualifications and so on. Yet these stipulations trim the branches without attacking the root. They seek to curb certain known excesses that spring from moral hazard, but they do not eradicate moral hazard itself. As we have seen, moral hazard is implied in the very existence of paper money. Because a paper money producer can bail out virtually anybody, the citizens become reckless in their speculations. They count on him to bail them out, especially when many other people do the same thing. To fight such behavior effectively, one must abolish paper money. Regulations merely drive the reckless behavior into new channels. One might advocate the pragmatic stance of fighting moral hazard on an ad hoc basis wherever it shows up.

24:43Thus, one would regulate one industry after another until the entire economy is caught up in a web of micro-regulations. This would, of course, provide some sort of order, but it would be the order of a cemetery. Nobody could make any potentially reckless investment decisions anymore. Everything would have to follow rules set up by the legislature. In short, the only way to fight moral hazard without destroying its source, fiat inflation, is to subject the economy to a Soviet-style central plan. Now let me leave with one final point on the regulation matter and then just wrap it up. Jeffrey Friedman and Vladimir Krauss are in the process of writing a book on this subject. The subtitle is, How Reasonable Regulation Caused the Financial Crisis.

25:33We just need reasonable regulation. And part of their argument runs as follows, it argues that when you have regulators who say, okay, we have to have capital requirements, and we also want to control the type of investments that these institutions are making. So what they've done, what they did in this case was to privilege a particular type of security. Say, if you're holding a government-supported, sponsored enterprise security, like Fannie Mae, Freddie Mac, with the implicit government guarantee, you only have to hold $2 in capital for every $100 in these AA or AAA GSE bonds. But for regular mortgage loans, you have to hold $5 per $100. And for commercial loans, it's $10.

26:20So you're artificially encouraging this desire to get into this particular type of security. So you are forcing a herd mentality on the economy, and then when this particular type of security turns out to be not so safe after all, well, there's a massive problem. Whereas in the free market, what typically happens is that some people invest in one thing and some people hold other things and they have different assessments and forecasts of what they think is going to happen with each of these, and some lose and some gain. But when we artificially privilege one particular type of asset and then that asset, the bottom If something falls out, we can't stand around and say, Well, gee, I guess the free market just doesn't work. And so, I think that's also a relevant point. Well, I'm very sad, actually, to follow George Selgin and Gary North, because George Selgin gave like the greatest paper I've ever seen in my life, and then Gary North spontaneously comes up with funny things and just knows everything.

27:16So that sort of stinks. But he did say something though, and he said that, Automatically condemned as being right-wing and fringe, whatever, and I wonder what's so right-wing about thinking that maybe the government shouldn't have a magical money-creation machine, I mean, like, if you really want to fight against war, wouldn't that be, like, if you were on the left, wouldn't you want to go after the Fed? I don't know why this would be necessarily just a so-called right-wing thing, but I think now it's not, we're not going to have this problem so much anymore, because thanks to the Ron Paul campaign, the growth of the Mises Institute and the financial crisis itself, people looking around Well, we've got a generation of young economists coming up. I didn't get emails three years ago from people saying, Hey, I want to get a PhD in economics. What should I do? I'm getting these all the time.

28:01I refer them to other people who know more about economics departments than I do. But I'm getting this all the time. So what's going to happen when a quarter of the economics profession is Fed skeptical? Like, what happens then? And then, are you really going to say all these people are crazy? Well, I suppose, well, today I guess we say most of the economists are crazy. So it is possible to say that, but public opinion is changing. It's possible to talk about this issue. You can go on CNBC and ask, should the Fed be abolished? It's still considered a little bit out of bounds, but people talk about it. Smart people talk about it. And a lot of us here at the Mises Institute, we get thanked by you folks. You come up and say, hey, thanks for everything you're doing. But the thanks go in the other direction, and the other direction because you guys are out there spreading the word about this, you guys are listening,

28:48we're all looking for answers and we know where to find them. And I feel like now, for the first time, certainly in my lifetime, I feel like even though, you know, they have all the shills on the payroll and they have the media that supports them in a knee-jerk way, either out of ignorance or more sinister motives, the point is that our numbers are growing, I think theirs are stagnating, And for the first time, I think we can say, we've got them right where we want them. So let's push forward. Thank you very much.