The Fed: Recent Episodes
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The Fed includes the founding and operation of the Federal Reserve System and people who played important roles, Greenspan, Bernanke, Yellen, Jeykll Island.
In the global Ponzi scheme, thin air and deceit substitute for sound money. As hedge-fund manager Mitch Feierstein wrote in Planet Ponzi, “You don’t solve a Ponzi scheme; you end it.”
Original Article: "The Coming Collapse of the Global Ponzi Scheme"
While many economists claim that high overall debt levels can lead to economic recessions, irresponsible government spending and money expansion are the real culprits.
Original Article: "Easy Money Is a Much Bigger Economic Problem than Debt"
In this episode, Mark examines Fed Chairman Jay Powell's recent confession that the Fed is "navigating by the stars on a cloudy night." This reveals the fundamental methodological weakness of the Fed's economic policy and mainstream economics in general ("data dependency"). In contrast, it also reveals the strengths of Austrian economics, economic theory, and the self regulation of the free market. Mark suggests that we all be prepared for big negative surprises in the economy and additional Federal Reserve and government power grabs.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Recommended Reading "What the Central Bank Cartel has Planned for You" by Thorsten Polleit: Mises.org/Minor34A
"Transparency or Deception: What the Fed Was Saying in 2007" by Mark Thornton: Mises.org/Minor34B
While the government promotes CBDCs as tools for "inclusion," it is more likely that they will be another vehicle for federal intrusion.
Original Article: "CBDCs: The Ultimate Tool of Financial Intrusion"
Peter Lewin joins Bob to discuss his work with Nicolás Cachanosky on uniting Austrian capital theory with mainstream finance.
Peter's New Book on Capital and Finance: Mises.org/LewinBook
Join us in Nashville on September 23rd for a no-holds-barred discussion against the regime. Use Code "HA23" for $45 off admission: Mises.org/Nashville23
The "2 percent" inflation target is purely arbitrary, and mainstream economists can't agree on the "right" level. It's all folly, and Austrian economics explains why.
Original Article: "What Is the Right Inflation Target for Central Banks?"
In this episode, Mark explains why we need a Crash (or very Hard) Landing in the US economy and the world economy. Specifically, why is a crash landing better to resolve the malinvestments caused by the Fed? Why is a crash landing better in many ways for the productive class of workers and savers? And, how would a crash landing place much of the pain and the overall burden on the rich, politically-connected classes?
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Additional Resources "The Fed's Real Mandate": Mises.org/Minor33A
"Black Hole or Shock Absorber: How Does a Free-Market Economy Respond to Crises?": Mises.org/Minor33B
"The REAL Solution to the Coming Economic Crisis": Mises.org/Minor33C
"Eliminating Economic Crises": Mises.org/Minor33D
"Austerity: A Real Solution to Help Heal the US Economy": Mises.org/Minor33E
"US Labor Market: Help Wanted!": Mises.org/Minor33F
"After the Boom Must Come the Bust" (Radio Rothbard): Mises.org/Minor33G
"Here's What Mounting Corporate Layoffs Tell Us about the Economy" (Radio Rothbard): Mises.org/Minor33H
The recent actions of the Federal Reserve are reminiscent of central bank activities in wartime.
Original Article: "Has World War III Already Begun?"
Will we get a soft landing or a hard landing in the economy? Or, should we hope for a crash landing? Mark Thornton explains.
See also "Soft Landing? Not Likely" featuring Bob Murphy and Jonathan Newman on the Human Action Podcast: Mises.org/HAP407
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Jonathan Newman joins Bob to discuss the argument being put forth by Alan Blinder, James Galbraith, and other progressive economists, who claim that the Federal Reserve's rate hikes couldn't possibly be responsible for the quelling of consumer price inflation.
Jonathan and Bob stress the important role of expectations as a "transmission mechanism" from Fed policy to impacts on prices.
Galbraith's Article on the Fed's 'Soft Landing': Mises.org/HAP409a The Paper on the Forward Guidance Paradox That Mentions Krugman: Mises.org/HAP409b
Join us in Nashville on September 23rd for a no-holds-barred discussion against the regime: Mises.org/Nashville23
While FedNow seems benign, there is the larger problem of the entire banking system itself being built on a foundation of sand. FedNow can only make that problem worse.
Original Article: "FedNow Isn't a CBDC, but It Is Dangerous"
In this episode, Mark updates his early March 2023 episode (Mises.org/Minor11) on the high price of toilet paper. He shows how economic changes, so far, in 2023 seem to have vindicated his forecast of lower toilet paper and paper towel prices. It also demonstrates how the market process works on a minor scale, even when large determinants like Amazon, Covid, and the US home construction industry get tangled up with politicians and bureaucrats.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
In this week's episode, Mark reviews what people have said about Fitch's downgrade of US government debt. Mark sees it as a good thing, but not good enough. The "minor issue" in the latest debt ceiling agreement is ignored by the mainstream media: politicians suspended the debt ceiling into 2025, rather than raising it to some arbitrary, higher figure.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
As Fed staffers no longer predict an impending recession, economists on social media are all assuring themselves that Americans are in store for a "soft landing." Mises Fellow Jonathan Newman joins Bob to explain why the data still support the case for recession and point out the eerie similarity to the calm before the storm in 2008.
Robert Lucas' Nobel Prize Winning Lecture: Mises.org/HAP407a Bob's Eerie Article from 2007 on the Recession: Mises.org/HAP407b 'Bernanke Was Wrong' Compilation: Mises.org/HAP407c 'Peter Schiff Was Right' Compilation: Mises.org/HAP407d
Join us in Nashville on September 23rd for a no-holds-barred discussion against the regime: Mises.org/Nashville23
In this week's episode, Mark discusses the record levels of credit card debt and how it is a major contributing factor to economic pain from the Fed's impact of causing higher prices for consumer goods. This is expected to intensify when the recession officially hits.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
David Brady Jr. discusses his recent article at Mises.org, in which he argues that the newly launched "FedNOW" system isn't a CBDC. Even so, there are dangers from FedNOW, such as exacerbating bank runs. David also explains the new Mises Apprenticeship program, of which he is a member.
David's Article on Mises.org: Mises.org/HAP406a George Selgin Cato Article on FedNow: Mises.org/HAP406b
Join us in Nashville on September 23rd for a no-holds-barred discussion against the regime: Mises.org/Nashville23
George Gammon, host of the popular Rebel Capitalist show, warns that the Fed won't have to force the public to adopt a central bank digital currency (CBDC). Instead, the public might clamor for it, being promised safe, high-interest checking accounts at the Fed, just like Jamie Dimon.
The Rebel Capitalist show: Mises.org/HAP405a
Join us in Nashville on September 23rd for a no-holds-barred discussion against the regime: Mises.org/Nashville23
On this episode of Good Money with Tho Bishop, Dr. Jonathan Newman joins to look at recent headlines on inflation. Tho and Jonathan discuss the larger costs of Fed policy on the real economy and how official government measures can be gamed with techniques such as "shrinkflation."
Good Money listeners can order a special $5 book bundle that includes How To Think About the Economy and What Has Government Done to Our Money? with free shipping using promo code "GoodMoney" at Mises.org/Good
Receive a free subscription to The Austrian magazine at Mises.org/Magazine
How can a bank “create money out of thin air”? We must enter the magical kingdom of “fractional-reserve banking,” where deposits are turned into loans, loans are turned into money, and so on, to find out.
Original Article: "Banks Create Money out of Thin Air. What Could Possibly Go Wrong?"
With each iteration of the banking crisis, the Federal Reserve System and federal regulators gain in power and authority. Maybe the banking crisis isn’t an accident.
Original Article: "Is the Banking Crisis Being Orchestrated?"
On this episode of Good Money with Tho Bishop, Ryan McMaken joins the show to talk about America's debt crisis. Tho and Ryan discuss both the damage done to the economy by runaway government spending, as well as how Federal Reserve policy has incentivized consumption and punished savings, which has resulted in record-high credit card debt.
Good Money listeners can order a special $5 book bundle that includes How To Think About the Economy and What Has Government Done to Our Money? with free shipping using promo code "GoodMoney" at Mises.org/Good
Receive a free subscription to The Austrian magazine at Mises.org/Magazine
In times of banking and financial crises, central banks always intervene. This is not a law of nature, but it is an empirical law of central bank behavior. The Federal Reserve was created 110 years ago specifically to address banking panics by expanding money and credit when needed, by providing what was called in the Federal Reserve Act of 1913 an “elastic currency,” so it could make loans in otherwise illiquid markets, when private institutions can’t or won’t.
The great Victorian banking thinker (as well as private banker) Walter Bagehot proposed that the Bank of England “lend freely” to quell a panic, and the central banks of the world today are all his disciples in this respect. With the post–Bretton Woods, pure-fiat-currency Federal Reserve, the US currency is elastic with a vengeance. That’s how we got a Fed with assets of $3 trillion during the great real estate bust of 2007–12 and then the truly remarkable $8.9 trillion Fed balance sheet in the wake of the covid financial crisis of 2020.
Austrian economists are generally against any central bank intervention at all, but suppose with me arguendo that the case for intervention in a crisis prevails: that the periodic financial crises that do and doubtless will continue to occur should be addressed by the temporary expansion of the compact power and money-printing ability of the government and its central bank—especially the money-printing power, which shifts assets and risks to the government’s balance sheet. The central bank’s balance sheet thus expands to offset the pressured private balance sheets. Even if the crisis was caused by the actions of the central bank itself, as Austrians would point out, and even though the expansion creates moral hazard for the future, the central bank’s elastic currency and balance sheet are handy in midst of the crisis. This is the credo of all modern central banks.
But what happens when the crisis is over?
Note well the essential word temporary in the preceding argument for crisis intervention. The crisis interventions should be temporary. If prolonged, they will tend more toward monopoly and bureaucracy and less toward innovation, growth, and economic well-being than will competitive, enterprising markets. In the extreme, long-term intervention will produce markets characterized by socialist stagnation. How do you get interventions withdrawn when the crisis is over?
Consider a huge and radical intervention of the last fifteen years. The Federal Reserve started buying mortgage securities at the beginning of 2009. The amount of mortgage securities which had been owned by the Federal Reserve until then, from 1913 to 2008, was exactly zero. Then, faced with the shriveling of the vast housing bubble and the panic of 2008, the Fed was led by Chairman Ben Bernanke into a new intervention and started buying mortgage securities to prop up house prices and the housing finance market. This was the opposite of the former Fed orthodoxy, which held that the monetary power of the central bank should not be used to favor any particular economic sector.
Bernanke’s theory was that this radical intervention would be temporary. As he testified before Congress in February 2011: “What we are doing here is a temporary measure which will be reversed so that at the end of the process, the money supply will be normalized, the amount of the Fed’s balance sheet will be normalized, and there will be no permanent increase, either in money outstanding, in the Fed’s balance sheet, or in inflation” (Italics added).
Needless to say, the promised normalization didn’t happen. As of the end of April 2023, the Fed owns $2.6 trillion of mortgage securities. That is larger than what the total assets of the Fed were at the end of 2008. That number and the interest rate risk it represents would have astonished previous generations of Federal Reserve governors. The Fed also experienced a massive mark to market loss on these mortgage securities: a loss of $408 billion as of the end of 2022, or almost ten times the Fed’s total capital of $42 billion.
In the intervening years, the Fed’s mortgage purchases, driving down mortgage interest rates to an unprecedented less than 3 percent, stoked a major house price inflation. By 2021, US national house prices were in a new bubble, their increase rising to an annual rate of over 16 percent. Faced with runaway inflation of house prices, the Fed has unbelievably continued to buy hundreds of billions of dollars of mortgage securities, and never sells any. I know of no one who now defends this far overextended intervention.
In my view, the Federal Reserve should get out of the business of pushing up house prices, and the Fed’s mortgage portfolio should go back to the normal amount of exactly zero.
Emergency interventions, however sincere the original intent that they be temporary, inevitably build up political and economic constituencies who profit from them and want their continuation. When the central bank monetizes government debt, the biggest such constituent is the government itself.
So here is our essential and unsolved problem: How do you reverse the central bank emergency programs, originally thought and meant to be temporary, after the crisis has passed? No one has successfully addressed the issue of how to do this—not even central banking’s most ardent supporters propose an answer.
That the emergency interventions of the crisis should be withdrawn in the normal times which follow I call the Cincinnatian doctrine. The name comes from the ancient Roman hero Cincinnatus, who was called from his plow to save the state and made temporary dictator of Rome. He did save the state, and then, mission accomplished, eft his dictatorship and went back to his farm. Similarly, two millennia later, George Washington, the victorious general and hero who had saved the United States and might perhaps have made himself king, voluntarily resigned his commission and went back to his farm, becoming to the eighteenth century “the modern Cincinnatus.”
But the Federal Reserve does not have the republican virtue of Cincinnatus or Washington, so how do we get the Fed to go back to its farm? The difficulty of ending vast emergency interventions whose day has passed but which have become established and advantageous to their constituencies and have increased the power enjoyed by the central bankers is the Cincinnatian problem. There is no easy answer to the Cincinnatian problem. It deserves our intense focus.
While the faux debt ceiling drama rages in Washington, DC, governments worldwide are defaulting on their debt via inflation.
Original Article: "Default by Inflation Is the Real Drama in the Global Debt Market"
The Mises Institute's Executive Editor Ryan McMaken joins Bob to discuss his latest article, in which Ryan spells out the state of the M2 money supply and possible implications for consumer prices and an impending recession.
Ryan's Mises.org article on M2: Mises.org/HAP402a Ryan's QJAE article on the inverted yield curve: Mises.org/HAP402b
Mises Institute Fellow Patrick Newman joins Bob to discuss a recent tweet from Stephanie Kelton, which argued that the government's "red ink makes our black ink possible." Patrick and Bob point out that these MMT tautologies are very misleading at best. Patrick also lays out the argument in his journal article, saying that MMT's debt monetization won't cause a boom-bust cycle, but will still reduce living standards.
Ryan and Robert Aro take a look at the Fed's unconvincing explanation of why it has chickened out on interest rate hikes. This only makes sense if the economy is much weaker than the Fed claims.
Be sure to follow the Fed Watch Podcast at Mises.org/FedPod.
The usual suspects are "relieved" that Congress gave President Biden what he wanted on the so-called budget deal. Without sound money, however, the borrowing and spending regime will collapse sooner or later.
Original Article: "Sound Money Is Required for Real Budget Discipline"
US trade deficits seem to be expanding, placing pressure on the dollar. However, central banks around the world are just as irresponsible as the Fed, masking the relative devaluation of US money.
Original Article: "US Trade Deficits Are Growing Larger. Or Are They?"
On this episode of Good Money with Tho Bishop, Peter St Onge joins the show to discuss this week's Fed announcement and what it means to normal Americans. Tho and Peter also discuss the political battles in DC over the future of CBDCs and the dangerous trojan horse some Republicans may be creating on the issue.
Find more from Peter St Onge on Substack at StOnge.Substack.com. You can also find him on Twitter @ProfStOnge.
Good Money listeners can order a special $5 book bundle that includes How To Think About the Economy and What Has Government Done to Our Money? with free shipping using promo code "GoodMoney" at Mises.org/Good
Receive a free subscription to The Austrian magazine at Mises.org/Magazine
As the Fed increases interest rates to reverse the inflation it has caused, firms that depended on easy money will face the bankruptcy judge. Stay tuned; there's more to come.
Original Article: "The Bankruptcy Caravan Is Now Arriving: Time to Pay for the Easy Money"
Despite all of the inflation-fighting talk from the Fed, the truth is that the government benefits from inflating the currency. We need to know how to defend ourselves.
Original Article: "Can We Protect Ourselves from Inflation?"
Jonathan Newman joins The Human Action Podcast to discuss his recent Twitter controversy over the claim that market prices can be "wrong" (i.e. in disequilibrium) if they are "sticky."
Jonathan Newman's Twitter controversy on sticky prices: Mises.org/HAP399a Joe Salerno on Mises's Monetary Theory: Mises.org/HAP399b Bagus and Howden on market disequilibrium and sticky prices: Mises.org/HAP399c
We are familiar with the five stages of grief. However, it is not a stretch to apply those stages to what is happening to the banking system. Right now, we are in the second stage: anger.
Original Article: "The Five Stages of Bank Failure Grief"
On this first episode of the Fed Watch Podcast, Ryan McMaken and Senior Fellow Alex Pollock talk about how the Federal Reserve has negative cash flow. The Fed will print money to "solve" the problem.
Be sure to follow the Fed Watch Podcast at Mises.org/FedPod.
Recommended Reading"The Fed’s Capital Goes Negative" by Alex J. Pollock: Mises.org/FW_01_A
"Who Owns Federal Reserve Losses and How Will They Impact Monetary Policy?" by Alex J. Pollock and Paul H. Kupiec: Mises.org/FW_01_B
"Why the Fed Is Bankrupt and Why That Means More Inflation" by Ryan McMaken: Mises.org/FW_01_C
With negative growth now falling to near –10 percent, money-supply contraction is now the largest we've seen since the Great Depression.
Original Article: "The Money Supply Has Plummeted in the Biggest Drop Since the Great Depression"
This episode of Good Money with Tho Bishop features guest Ryan Griggs of Griggs Capital Strategies. During the show, Ryan discusses his work with Bob Murphy on an Austrian understanding of inverted yield curves as a signal for recessions and how it differs from the mainstream analysis. He also discusses Nelson Nash's infinite banking strategy as a means for capital accumulation, in contrast to traditional investment approaches.
Ryan and Bob Murphy on the Austrian understanding of inverted yield curves: Mises.org/GM7aGriggs Capital Strategies: Mises.org/GM7b
By any conventional measures of finance, the Federal Reserve has negative equity. In the long run, cooking the books only puts off the day of reckoning.
Original Article: "The Fed Is Overindebted, Isn’t It?"
In this week's episode, Mark explains why the market for existing homes has been diverging from the market for new houses. The Fed ZIRP, QE and Covid bailouts have locked Americans into their mortgages and low payments, reducing the supply of existing homes. This keeps them off the market and home prices high in an economy that is headed for a recession or crisis. Buyers have been diverted to newly constructed homes where builders have more flexibility to sell and there are no existing homeowners locked into mortgages.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
The most popular measure of economic growth is GDP. However, GDP movement is driven by changes in the money supply, not real economic factors.
Original Article: "Does GDP Present an Accurate Picture of the Economy? Not Likely"
Austrian business cycle theory points out that easy money leads to malinvestments. Once easy money disappears, the crash begins. Time to clean up malinvested assets.
Original Article: "Paying the Piper: Time to Clean Up the Latest Malinvestments"
While the Fed and the Biden administration try to assure Americans that their banks are safe and secure, the numbers tell a different story.
Original Article: "Charles Schwab and Other Big Banks May Be Secretly Insolvent"
After a long series of rate hikes, Fed officials and asset markets are expecting a long series of interest rate cuts. This is based on the tried and hue Phillips Curve analysis. In color theory, "hue" is the technical appearance of color that can be described mechanically as a number. Let's hope interest rate expectations are not being distorted by other factors of reality, and that current Phillips Curve model perceptions of hue are also true.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Dr. Paul Cwik joins Bob to discuss the inverted yield curve's "signal" of an impending recession.
Dr. Cwik's dissertation on inverted yield curves and economic downturns: Mises.org/HAP395a
Bob on the link between inverted yield curves and recessions: Mises.org/HAP395b
Bob's Understanding Money Mechanics: Mises.org/Mechanics
A central tenet of Keynesian economics is that governments must run budget deficits to stimulate economic growth. But government spending actually shrinks the economy.
Original Article: "Government Budget Deficits Cannot Stimulate True Economic Growth"
Even after two years of "transitory" inflation, America's ruling classes insist that prices are falling and that all of this is temporary. We don't believe them.
Original Article: "The Ruling Classes Are Inflation Deniers and the Ship of Fools Sails On"
The current banking crises have deep roots in US financial history. Monetary authorities have engaged in inflationary behavior for more than a hundred years.
Original Article: "A Pyrrhic End to 130 Years of Vicious Bad Money and Banking Crises"
After years of inflationary intervention, the Federal Reserve has no more rabbits to pull out of the hat.
Original Article: "The Failure of the Federal Reserve: The Covid Boom and Unnecessary Intervention"
As markets settle down after the last set of bank failures, political elites claim the crisis is behind us. But it is not over, not by a long shot.
Original Article: "No, the Financial Crisis Is Not Over"
This Audio Mises Wire is generously sponsored by Christopher Condon.
A generation ago, the Berlin Wall fell and the USSR collapsed. Today, US monetary authorities are bringing down our own country.
Original Article: "Role Reversal: The Collapse of the Dollar-Enforced Empire"
This Audio Mises Wire is generously sponsored by Christopher Condon.
This episode explores precious metals. Gold (Au) is the main precious metal, followed by Silver (Ag), Platinum (Pt), and Palladium (Pd). These are distinct from valuable industrial metals such as copper (which served as money historically), nickel, and zinc, which have served as token coins in modern times. There are many different ways and forms you can own precious metals.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Like the arsonist who then heroically fights the fire he set, the Fed is increasing its efforts to bail out banks both at home and abroad. This does not end well.
Original Article: "Is the Fed Trying to Bail Out the World? Sure Looks Like It"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Mark is not fooling around today. He looks back at the history of gold and its price, which some believe is too erratic and too unstable (like Bitcoin) to serve as a basis of a monetary system. Mark shows that it is not gold that destabilizes events in the real world, but rather real world events related to political decision-making that has made the price of gold unstable. The price of gold is a "minor" indicator of what governments are really up to.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
In this episode, Mark looks at the far away minor issue of the impact of hyperinflation in Zimbabwe. Even though they have switched from Zim dollars to US dollars, ordinary people are still suffering. Their government and its inflationary monetary policy is manifesting itself in some interesting ways.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
With commercial banks exposed by the recent bailouts, Americans question whether “their money” is truly safe despite the promises of FDIC insurance.
Jeff and Bob walk through the mechanics of how a full reserve bank could work in a truly free market based on the concepts and taxonomy of Mises’s Theory of Money and Credit.
Mises's A Theory of Money and Credit: Mises.org/TMC
Bob's study guide to A Theory of Money and Credit: Mises.org/HAP388a
John Cochran, 'The Safest Bank the Fed Won't Sanction': Mises.org/HAP388b
This week on Radio Rothbard, Ryan McMaken and Tho Bishop are joined by Peter St. Onge, a fellow at the Heritage Foundation and a regular contributor to the Mises Wire. This episode looks at the political response to the recent turmoil in the banking system and how the Austrian position looks today relative to 2008. St. Onge makes a case for optimism.
Recommended Reading"It Turns Out That Hundreds of Banks Are at Risk" by Peter St. Onge: Mises.org/RR_126_A
"The Fed Backtracks on Future Rate Hikes as Bank Failures Loom Large" by Ryan McMaken: Mises.org/RR_126_B
"Looming Bank Failures Point to More Price Inflation as Real Wages Fall Again" by Ryan McMaken: Mises.org/RR_126_C
Peter St. Onge's Substack: StOnge.substack.com
2023 Libertarian Scholars Conference: Mises.org/LSC23
Be sure to follow Radio Rothbard at Mises.org/RadioRothbard.
The F.A. Hayek Memorial Lecture, sponsored by Greg and Joy Morin.
Recorded at the 2023 Austrian Economics Research Conference hosted at the Mises Institute in Auburn, Alabama, March 16–18, 2023.
The Austrian Economics Research Conference is the international, interdisciplinary meeting of the Austrian School, bringing together leading scholars doing research in this vibrant and influential intellectual tradition. The conference is hosted by the Mises Institute at its campus in Auburn, Alabama, and is directed by Joseph Salerno, professor of economics at Pace University and academic vice president of the Mises Institute.
Even if Powell is sincere in this stated desire to slay inflation with more rate hikes, recent bank failures will put the Fed under enormous pressure to end its rate hikes and to once again embrace easy money to save the banks and Wall Street.
Original Article: "Looming Bank Failures Point to More Price Inflation as Real Wages Fall Again"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Welcome to Whose Economy Is It, Anyway?, where the rules are made up and the dollars don’t matter. Or at least that seems to be the view of the Yellen regime.
Original Article: "A Bank Crisis Was Predictable. Was the Fed Lying or Blind?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
This past weekend saw extraordinary actions by the Fed to address the meltdown of Silicon Valley Bank. Did the central bank break the law by effectively authorizing unsecured loans to banks based on the face value—rather than significantly lower market value—of those banks' Treasury holdings?
Bob's study guide to A Theory of Money and Credit: Mises.org/HAP387a
Jeff on the Fed as the ultimate bank: Mises.org/HAP387b
SVB Bank and Signature Bank failed this week and were bailed out. Mark explains why the banks failed and why it was bound to happen. The minor issue is that the total FDIC bailout fund is actually smaller than either one of the banks.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Get beyond the PhDs running the Federal Reserve or the way people treat the Fed with deference. In the end, it is nothing but a legal counterfeiting ring.
Original Article: "We Are All Counterfeiters Now"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Progressives view all aspects of human life as a struggle against forces of oppression. Earlier this week on BBC, Professor Mariana Mazzucato suggested governments across the West should simply print money not only to help Ukraine, but also to finance other "wars" against climate change, inequality, and more. Should national treasuries essentially adopt a permanent wartime footing and print far more money, as Mazzucato and Warren Mosler recommend? Hint: Jeff and Bob say "No."
Jeff's article "A Permanent Wartime Economy": Mises.org/HAP386a
Bob's debate with Warren Mosler: Mises.org/HAP386b
Bob's article in The American Conservative on the Greenbacker movement: Mises.org/386c
Mark talks about the recent price inflation reports, as well as reports of job openings from private sector job placement companies. Inflation was higher than expected and job openings declined. What will the Fed do? People are making painful adjustments—Domino's reported disappointing sales, because their customers are "eating in".
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Mark uses Intel Corporation, the computer chip manufacturer, as a barometer of the business cycle. He looks at the stock price in recent years, its production capacity expansion, and the company's very recent cost- and dividend-cutting moves.
Check out Mark Thornton's free book, The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century: Mises.org/Curse
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Mark Thornton explains the target as another smokescreen that was originally intended to stabilize monetary policy, currencies, and exchange rates, but has become a justification for inflation and central bank manipulation.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
These days, the Fed and Chairman Jerome Powell are claiming the title of "inflation fighters." The more appropriate moniker should be "inflationists."
Original Article: "Fighting Inflation Really Means Fighting the Federal Reserve"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Mark Thornton takes a look back at US stock markets, the national debt, and Fed policy (ZIRP, money supply, and its balance sheet).
"After the Boom Must Come the Bust" (Radio Rothbard): Mises.org/MI_06_A
Austrian Economic Research Conference: AustrianEconomics.org
Be sure to follow Minor Issues at Mises.org/MinorIssues.
On this episode of Radio Rothbard, Ryan McMaken and Tho Bishop feel obligated to discuss the State of the Union address. Was anything of value learned? Tune in to find out.
Also, join the Mises Institute in Tampa this month for a special event featuring Per Bylund, Jeff Deist, Tho Bishop, and Brett Lindell, on February 25. Learn more at Mises.org/Tampa.
Recommended Reading"Raise the Social Security Age to (at Least) 75" by Ryan McMaken: Mises.org/RR_120_A
"Another Recession Sign: Part-Time Work Is Growing Faster than Full-Time Work" by Ryan McMaken: Mises.org/RR_120_B
"Yes, the US Government Has Defaulted Before" by Ryan McMaken: Mises.org/RR_120_C
Be sure to follow Radio Rothbard at Mises.org/RadioRothbard.
Monetary authorities have come up with numerous clever ways of measuring money. However, they are unable even to define money, much less measure it.
Original Article: "Do Correlations Help Define Money?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Mark Thornton discusses the history of record low unemployment rates and the business cycle.
See "Unemployment Rate" (UNRATE) from the Federal Reserve Bank of St. Louis: Mises.org/MI_04_Chart
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Will the Fed be successful with its "Immaculate Disinflation"? Or, will we still have to "pay an even higher price" for their use of Weapons of Massive Monetary Destruction in 2020-21?
Be sure to follow Minor Issues at Mises.org/MinorIssues.
On this episode of Radio Rothbard, Ryan McMaken and Tho Bishop discuss Jay Powell's exercise in Fed-speak this week. While political pressure mounts at home for the Fed to turn dovish, growing international challenges to the dollar's dominance mount. Ryan and Tho also examine the Saudi's willingness to question the petrodollar and recent rumblings down south of a South American monetary union.
Also, join the Mises Institute in Tampa this month for a special event featuring Per Bylund, Jeff Deist, Tho Bishop, and Brett Lindell, on February 25. Learn more at Mises.org/Tampa.
Recommended Reading"The Fed Is Already Flashing Signs It's Done Raising Rates" by Ryan McMaken: Mises.org/RR_119_A
"How FedGov Destroyed the Housing Market" (Human Action Podcast): Mises.org/RR_119_B
"Why the End of the Petrodollar Spells Trouble for the US Regime" by Ryan McMaken: Mises.org/RR_119_C
Be sure to follow Radio Rothbard at Mises.org/RadioRothbard.
Does cheap money and credit make us richer? Does more money and credit create more stuff, or better stuff? Do they make us happier and more productive? Or do these twin forces actually distort the economy, misallocate resources, and degrade us as people?
These are fundamental questions in an age of monetary hedonism. It is time we began to ask and answer them. Millions of people across the West increasingly recognize the limits of monetary policy, understanding that more money and credit in society do not magically create more goods and services. Production precedes consumption. Capital accumulation is made possible only through profit, which is generated by higher productivity, thanks to earlier capital investment. At the heart of all of it is hard work and human ingenuity. We don’t get rich by legislative edict.
How we lost sight of these simple truths is complex. But we can begin to understand it by listening to someone smarter! The great financial writer James Grant probably knows more about interest rates than anyone on the planet. So we should pay attention when he suggests America’s four-decade experiment in rates that only go down, down, and down appears to be over.
The striking thing about the bond market and interest rates is that they tend to rise and fall in generation-length intervals. No other financial security that I know of exhibits that same characteristic. But interest rates have done that going back to the Civil War period, when they fell persistently from 1865 to 1900. They then rose from 1900 to 1920, fell from 1920 or so to 1946, and then rose from 1946 to 1981—and did they ever rise in the last five or 10 years of that 35-year period. Then they fell again from 1981 to 2019–20.
So each of these cycles was very long-lived. This current one has been, let’s say, 40 years. That’s one-and-a-half successful Wall Street careers. You could be working in this business for a long time and never have seen a bear market in bonds. And I think that that muscle memory has deadened the perception of financial forces that would conspire to lead to higher rates.
—James Grant, speaking to the Octavian Report
Do the brilliant young Ivy League quants working at central banks and investment houses really understand this history? Why should they? The baseline cost of capital has been less than 3 percent throughout their careers. Cheap credit and rising stock markets are all they know. Lots of projects make sense when funded with debt rather than equity; or as we might say, with other people’s money. And when those projects go public, the numbers go up!
Until they don’t.
One fears our under-forty financiers really have little understanding of the basic function of interest rates, a function Mises explained so clearly more than one hundred years ago. Interest rates should act as “prices,” as Mr. Grant states, or more precisely, as exchange ratios. They bring together borrowers and savers, thus performing a critical function of capital markets and allocating resources to their best and highest uses.
Yet, in 2022, interest rates are widely viewed as policy tools. They are economic controls, determined and tinkered with by technocratic central bankers when the economy overheats or chills. We expect central banks to “set” interest rates, an impossibility in the long run but also a perverse goal in a supposedly free economy.
What other prices do we want centrally planned? Food, energy, housing? Should the Fed direct how many cars GM produces in 2022, the price of a bushel of wheat, or the hourly wage for an Amazon warehouse employee? Is this the Soviet Union?
Of course not. But those who view money as a political creation are once again prone to fundamental errors. They don’t understand money qua money. They certainly cannot imagine a world without “monetary policy,” which is plainly a form of central planning.
Austrian economists like Carl Menger and Ludwig von Mises illustrated how money can arise on the market as simply the most tradeable commodity, with the most desired features of “moneyness.” We don’t need state treasuries or public banks to issue it. And we should care about the quality of money, much as we care about the quality of the goods and services we exchanged for it.
But in fiat land, that quality goes down, down, and down. Everything politics touches gets worse; why would we expect money to be an exception?
This four-decade experiment in price fixing of interest rates, described as cyclical by Mr. Grant, not surprisingly corresponds with a dramatic rise in the US M1 money supply. In January 1982, the Fed’s “narrow money” was less than $450 billion. In January 2022, it was more than $20 trillion—roughly forty-four times bigger!
We can call this monetary hedonism: a combination of low rates and ever-growing money supply designed to create an illusion of real wealth. Monetary hedonism is an arrangement which encourages our whole society to live beyond its means, using monetary policy rather than direct tax-and-spend policy. It directly benefits both the Beltway and the banking classes, who enjoy an exorbitant political privilege due to their proximity to newly created cheap money. After all, Congress can service $30 trillion+ of debt with interest payments of less than $400 billion—thanks to a weighted average interest rate of only about 1.6 percent on that debt. And it’s awfully nice for spendy politicians to know the Fed stands ready to create an instant market for Treasurys owned by commercial banks.
To be sure, cheap money and low rates benefit all of us in a shortsighted sense. They make the cost of doing business lower and enable corporations to carry more (tax-deductible) debt. They make house payments and mortgages more affordable. They make college and cars and dinners and vacations purchased on credit cheaper. They make it easy and fun to spend.
Yet there is always a price to be paid for unearned profligacy. The hangover follows the party. We all sense it. A reckoning is coming for the inflationary US dollar. That reckoning will come for entitlements, for congressional spending, for deranged US foreign policy, and for Treasury holders.
But this economic reckoning is not the full story. We must also consider the incalculable but rarely considered social and cultural costs.
What happens to a society when spending is encouraged and saving is for chumps?
Our grandparents understood the power of compound interest rates. They could save 10 percent of their income at, say, 10 percent interest rates, and their nest egg doubled roughly every seven years. They could get ahead simply, if not easily, through sheer thrift. They could follow the most human of compulsions, the deep-rooted desire to put money away for a rainy day. They could leave something for future generations. Even when consumer inflation approached 10 percent in the 1970s and ’80s, they could get 14 percent on a simple CD or money market account!
Compare their experience to that of a hapless young person today, attempting to save up a 20 percent down payment on a modest $300,000 house. In 2022, with inflation at least 6 points above simple savings rates, this seems like a pipe dream.
This is the perversity of our times: with inflation rates higher than savings rates, the overwhelming incentive is to spend and borrow rather than produce and save.
Bitcoiners already understand the problem. The simple economic concept of time preference explains so much: some people are more than willing to forego consumption today to reap a larger reward later—even if that “later” is beyond their lifetimes. Time preference is the only way to make sense of interest rates and their critical function in society; interest rates reflect the relative preferences of borrowers and savers. Manipulation of interest rates by central banks severs this critical mechanism, allowing bubbles to occur in the form of new credit without new saving.
Without interest rates determined by time preference, society’s signals become mixed up. We all understand, axiomatically, why humans prefer something today (certain) over something in the future (uncertain). We may die unexpectedly, our financial positions could change radically due to unforeseen events, or external conditions could influence our desires. We all understand borrowing money to buy a dream home at age forty instead of paying cash at age ninety. We all understand why lenders, given the uncertainty and forbearance that goes with lending, want to be paid interest for their risk.
It is a matter of time.
Everything we do in this corporeal world has a temporal element. When governments or central banks interfere with money and interest rates, they distort the vital information provided by real people’s relative time preferences.
Hans Hoppe, in his infamous Democracy, the God That Failed, goes further—describing time preference as the essential civilizing or decivilizing element in society.
The saver-investor initiates a “process of civilization.” In generating a tendency toward a fall in the rate of time preference, he—and everyone directly or indirectly connected to him through a network of exchanges—matures from childhood to adulthood and from barbarism to civilization.
When lots of people save and invest, across society, we call it capital accumulation. And as Hoppe posits, this is not just economic—it is cultural and civilizational. Thrifty people like our grandparents, generation after generation, bequeathed to us an almost unimaginable world of affordable food, water, habitation, transportation, communication, medicine, and material goods of every kind. They did this out of love and sacrifice, but they also did it because the monetary system rewarded saving.
Today, the opposite is true. Monetary policy across the West is an agent of decivilization. It upends the natural, innate human impulse to save for a rainy day and leave our children better off. It encourages consumption over production, profligacy over thrift, and political promises today that will be paid for by savers and taxpayers tomorrow. Monetary policy degrades and deforms the economy, but ultimately its corrosive effects impact the broader culture.
In short, it makes us worse people.
Does bitcoin fix this? Maybe. In the eyes of many maxis (or “bitcoin realists,” per Cory Klippsten), certainly. But time is running short. We face a toxic mix of high–time preference junkie politicians and central bankers who are only too willing to provide the fix. We are depleting capital and borrowing against the future. We consistently display high time preference, both as individuals and as a society. This cannot end well for our children and grandchildren.
It is past time for all of us to demand better money, not better monetary “policy.” It is time for money to comport with human nature and reward the saving impulse. It is time for us to reconsider our bequest to future generations and make their lives better and more prosperous than ours.
Monetary hedonism, in the form of low interest rates, is coming to an end. The hangover will not be pretty. Readers would be well served to prepare themselves and act accordingly. Politicians and bankers are unlikely to do this for us.
[This article first appeared in the fall 2022 issue of Bitcoin magazine]
Government interference into money creation and production harms the economy in a number of ways, including skewing the organization of division of labor.
Original Article: "Fiat Money Inflation Not Only Raises Prices but Also Undermines Division of Labor"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The Fed is insolvent, and that means that it will bail itself out by printing money. For ordinary people, that means inflation and a rising cost of living.
Original Article: "Why the Fed Is Bankrupt and Why That Means More Inflation"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The Federal Reserve has created a huge boom full of bubbles. But after the boom must eventually come a bust. Ryan and Tho talk to Mises Institute Senior Fellow Mark Thornton about what to expect from the next recession and how we got ourselves into our current inflationary mess.
Recommended Reading"Eliminating Economic Crises" by Mark Thornton: Mises.org/RR_118_A
"The REAL Solution to the Coming Economic Crisis" by Mark Thornton: Mises.org/RR_118_B
"Wholesale Price Inflation Is Slowing as Economy Worsens" by Ryan McMaken: Mises.org/RR_118_C
The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century by Mark Thornton: Mises.org/RR_118_D
"Will the Fed Pop the Everything Bubble?" by Daniel Lacalle: Mises.org/RR_118_E
"The Trillion-Dollar Coin Idea Is Just Another Way to Rip Us Off" by Ryan McMaken: Mises.org/RR_118_F
"The Fed's Real Mandate" by Mark Thornton: Mises.org/RR_118_G
Be sure to follow Radio Rothbard at Mises.org/RadioRothbard.
Government and monetary authorities claim that the worst of the postcovid lockdown disruptions are past and a "return to normal" is just around the corner. It will be a very long corner.
Original Article: "The Chimera of a Postpandemic Postwar Return to Monetary Normal"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Central bankers follow inflation "target" in their pursuit of "price stability." Not surprisingly, they usually miss their targets -- quite badly -- and we now are living one of those moments.
Original Article: "Central Bankers Are Poor Archers: The Problems and Failures of Inflation Targeting and Price Stability"
This Audio Mises Wire is generously sponsored by Christopher Condon.
There is no real housing market in the US. Instead, an unholy trinity of Fannie/Freddie, the US Treasury, and the Federal Reserve Bank operate to distort the market at every turn and drive home prices up dramatically. Mises Institute Senior Fellow Alex Pollock, an economist and former mortgage banker, joins Jeff to describe the reality few Americans know.
Alex Pollock's new book Surprised Again: The Covid Crisis and the New Market Bubble : Mises.org/HAP377a
Alex Pollock on how the Fed became the world's biggest S&L: Mises.org/HAP377b
By all measures, the economic downturn that began in 1920 was worse than what occurred in 1930, yet the economy recovered quickly in 1921. Why the difference?
Original Article: "The Economic Superbowl: 1920–21 versus 1930–31"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Wall Street has convinced itself that the Fed will soon engineer a "soft landing" by bringing down inflation without an accompanying recession. They need to rethink their beliefs.
Original Article: "History Shows High Inflation Can Last Over Ten Years"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Bob and Jeff make their provocative 2023 predictions for the economy, the Fed, politics, world events, and cultural issues.
Only Father Time helps us cut through the policy nonsense and understand interest rates conceptually.
Original Article: "Father Time versus Central Bankers"
This Audio Mises Wire is generously sponsored by Christopher Condon.
This week's show features a bare-knuckle discussion between Jeff and José Niño of "El Niño Speaks" on the biggest political, economic, and cultural events of 2022—and what they portend for 2023.
You don't want to miss Jeff's unvarnished thoughts on the Left, the Right, the economy, and what is sure to be a turbulent New Year.
Read José's Substack: josbcf.substack.com
John Maynard Keynes derided gold-based money as a "barbarous relic," yet it was gold that enabled a long regime of honest money -- and the advance of civilization.
Original Article: "The "Barbarous Relic" Helped Enable a World More Civilized than Today's"
This Audio Mises Wire is generously sponsored by Christopher Condon.
One hardly can imagine a better tool of social control than a digital currency. Not surprisingly, U.S. monetary authorities are moving in that direction.
Original Article: "Digital Currency: The Fed Moves toward Monetary Totalitarianism"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The US monetary system is out of sorts and out of control. The authors show a path back from the inflation brink to monetary soundness.
Original Article: "Fiat and Gold: Two Fixes for a Broken US Monetary Base"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Money supply growth slowed even more in October, and is now back to levels we last saw during the repo liquidity crunch of 2019, and in the days right before the 2007–09 recession.
Original Article: "Money Supply Growth in October Fell to a 39-Month Low. A Recession Is Now Almost Guaranteed."
This Audio Mises Wire is generously sponsored by Christopher Condon.
It is easy to think of the Fed as a good institution that simply lost its way. In truth, it was a bad idea and a bad institution from its beginning.
Original Article: "The Fed Is Not "a Good Idea that Became Corrupt": It Always Was Corrupt"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Federal Reserve officials, for all of their alleged wisdom and education, have a knowledge problem. Hayek and other Austrians could have told them their grandiose plans will fail.
Original Article: "The Federal Reserve's (Permanent) Knowledge Problem"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Many investors forget that when the easy money is flowing, financial mediocrities and even outright frauds can be made to look like legitimate geniuses.
Original Article: "How Easy Money Fueled the FTX Crypto Collapse"
This Audio Mises Wire is generously sponsored by Christopher Condon.
One might assume that new rounds of monetary stimulus will bring new peaks in housing construction, reversing the ongoing housing shortage. That hasn't happened.
Original Article: "The Housing Boom Is Already Over. The Housing Shortage Will Continue."
This Audio Mises Wire is generously sponsored by Christopher Condon.
The Federal Reserve has not only mismanaged the US economy; even its own "portfolio" is underwater.
Original Article: "In the Red: The Federal Reserve’s Portfolio Joins the Rest of the Market"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Jeff and Bob record a special Thanksgiving episode for Money Talk 1010 AM on what it really takes to fix the US economy.
Mark Thornton on the coming economic crisis: Mises.org/HAP371A
Listen to Jeff on Money Talk 1010 every Thursday at 9:00am ET: Mises.org/MoneyTalk
Historians praise the US entry into World War I because it enabled an Allied victory. But it also led to the economic disasters of the 1920s and ’30s.
Original Article: "World War I: The Great War Was also the Great Enabler of Progressive Governance"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The common view of inflation is that it is defined as a general increase in prices. Actually, inflation is expansion of the money supply that results in price increases.
Original Article: "Inflation Is Not Price Increases. Inflation Causes Price Increases."
This Audio Mises Wire is generously sponsored by Christopher Condon. '
While we speak of a desire for honest money, the larger problem is that the Federal Reserve System cannot coexist with an honest money regime.
Original Article: "Honest Money in Dishonest Hands"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
Even with near-record inflation, the US dollar still has gained strength relative to other currencies. This does not mean that the Fed has been acting responsibly.
Original Article: "The Dollar's Global Wake of Destruction"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
In a free market, short-term and long-term rates would move toward convergence. Fed interference with interest rates ensures that won't happen.
Original Article: "Federal Reserve Tampering with Interest Rates Distorts the Shape of the Yield Curve"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
Home price growth of the sort we've seen in recent years simply cannot be sustained without a continued commitment to easy money from the central bank, and it shows.
Original Article: "Without Easy Money from the Fed, Home Prices Will Keep Falling"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
Sponsored by James McMahon.
Recorded at the Arizona Biltmore Hotel in Phoenix, Arizona on October 7th, 2022.
Government inflation makes people’s responses much more delayed, leaving people’s value adding greatly degraded.
Original Article: "Fed Socialist Money Manipulation Cancels Individuals' Better Judgment"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
This year's trio of Nobel winners in economics are short on actual economics and long on government intervention.
Original Article: "The Nobel for Government Intervention: Bernanke and Others Rewarded for Flawed Theories"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
This is the "American dream" the Fed has given us: work more jobs and longer hours to keep paying those bills that are now growing at 8 percent per year.
Original Article: "Thanks to the Fed, You'll Work More This Year to Keep Last Year's Standard of Living"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
Dr. Bob Murphy and Jeff Deist discuss the nauseating elevation of former Fed Chair Ben Bernanke to Nobel Prize winner.
Recorded at the Arizona Biltmore Hotel in Phoenix, Arizona on October 7th, 2022.
Sponsored by Remy Demarest.
Recorded at the Arizona Biltmore Hotel in Phoenix, Arizona on October 6th, 2022.
Sponsored by Tracy and Joe Matarese.
The standard line is that the Federal Reserve System has two mandates, keep unemployment low and create price stability. Mark Thornton notes that the real agenda is found elsewhere.
Original Article: "The Fed's Real Mandate"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
Progressives are fond of telling us that we are under a "social contract" with the government, in effect justifying whatever abuses authorities inflict. Putting up with massive inflation is the latest iteration of this so-called contract.
Original Article: "The Fraudulent Social Contract of Bad Money Regimes"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
The US dollar is not the world's "reserve" currency because of responsibility on behalf of the monetary authorities. Instead, the dollar's "strength" wages from the USA's self-appointed role as the world's protector.
Original Article: "It's All about the Benjamins: Why the Dollar Determines US Policies"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
The current bout of inflation is the latest disaster in a string of disasters caused by government debasement of once sound money.
Original Article: "History Repeats Itself: Abandoning Sound Money Leads to Tyranny and Ruin"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
The Fed claims 2 percent inflation promotes "price stability." However, that policy also causes the boom-and-bust cycle, which is anything but stable.
Original Article: "How the Policy of Price Stability Generates Greater Economic Instability"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
The money supply is on a long and fast downward trajectory. This points toward recession and is just one more indicator of economic weakness in addition to negative GDP and an inverted yield curve.
Original Article: "In Latest Recession Signal, Money-Supply Growth Plummeted to a Three-Year Low in August"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
While officials in the White House, Treasury, and the Fed give the appearance of being in control, but in truth, they cannot undo the damage they have done.
Original Article: "Despite Their Hubris, Monetary Authorities Do Not Have Total Control"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Standard economic theory states that as an economy grows, the money supply should grow with it. Appealing to the Austrian tradition, Frank Shostak shows that belief is mistaken.
Original Article: "Should the Fed Increase the Money Supply in Response to a Growing Economy?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The Fed's entire "strategy" can be summed up as "hike 'til it breaks, cut 'til it inflates." That's the best all those PhDs at the Fed have managed to come up with.
Original Article: "The Fed Is Finally Seeing the Magnitude of the Mess It Created"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Adherents of the famous Phillips curve believe there is a permanent tradeoff between inflation and unemployment. This is mistaken.
Original Article: "The Fed Is Wrong to Make Policies Based upon the Phillips Curve"
This Audio Mises Wire is generously sponsored by Christopher Condon.
On this episode of Radio Rothbard, Ryan McMaken and Joseph Solis-Mullen take a look at brewing debt crises in emerging markets and how the dollar still looks good when compared to other global currencies.
Recommended Reading "How the Fed Helped Create Another Calamity: The Ongoing Emerging Market Debt Crisis" by Joseph Solis-Mullen: Mises.org/RR_99_A
"August's Price Inflation Soared, and That Means Earnings Fell Yet Again" by Ryan McMaken: Mises.org/RR_99_B
"Greenspan Would Be Proud: A Lesson in Fed Speak" by Joseph Solis-Mullen: Mises.org/RR_99_C
"It Just Might Be Time to Listen to the Austrians" by Joseph Solis-Mullen: Mises.org/RR_99_D
"Throwing the Fed's Machinery in Reverse: Fed Interest Rate Policies Continue to Damage the Economy" by Frank Shostak: Mises.org/RR_99_E
Be sure to follow Radio Rothbard at Mises.org/RadioRothbard.
The Fed's suppression of interest rates in the USA didn't just affect this nation's economy. It also drove investors to seek higher interest rates in questionable investments.
Original Article: "How the Fed Helped Create Another Calamity: The Ongoing Emerging Market Debt Crisis"
This Audio Mises Wire is generously sponsored by Christopher Condon.
This is bad news for the administration, which has repeatedly attempted to downplay the relentless increases to the cost of living being inflicted on Americans after years of deficit spending, fueling inflationary monetary policy.
Original Article: "August's Price Inflation Soared, and That Means Earnings Fell Yet Again"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Logical positivism holds that theory is irrelevant to the empirical results. It is the other way around; One cannot understand or interpret economic data until one has a working economic theory in place.
Original Article: "We Cannot Interpret Economic Data Unless We Know Economic Theory"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The Fed’s tampering with market signals undermines the process of wealth generation, thereby exerting an upward pressure on the time preference interest rate and the market interest rate.
Original Article: "Throwing the Fed's Machinery in Reverse: Fed Interest Rate Policies Continue to Damage the Economy"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Paul Krugman recently argued that the Federal Reserve can engineer a "soft landing" for the economy as it tries to deal with inflation. Such a view ignores economic realities.
Original Article: "Looking at the Economic Myth of the "Soft Landing""
This Audio Mises Wire is generously sponsored by Christopher Condon.
On this episode of Radio Rothbard, Ryan McMaken and Tho Bishop look at the rhetoric surrounding the Federal Reserve. A growing chorus of pundits is attacking Jerome Powell for risking a recession, but this misses what has brought the economy to this point. Is it possible to get American attention spans to capture the true cause of our economic instability? Can monetary policy ride the wave of the current culture war? Ryan and Tho address this and more in this week's show.
Recommended Reading "Inflation: State-Sponsored Terrorism" by Jeff Deist: Mises.org/RR_98_A
"Blame the Fed for Both the Inflationary Boom and the Inevitable Bust" by Ryan McMaken: Mises.org/RR_98_B
"Inflation Kills" (Human Action Podcast) with Jeff Deist and Robert P. Murphy: Mises.org/RR_98_C
"We Cannot Interpret Economic Data Unless We Know Economic Theory" by Frank Shostak: Mises.org/RR_98_D
Be sure to follow Radio Rothbard at Mises.org/RadioRothbard.
Biden has declared that the USA has "zero inflation" at present. Austrian economists say, "Not so fast."
Original Article: "Inflation in the USA: Where Do We Stand Today?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Powell isn't a villain for pulling his foot off the money-creation accelerator a little. No, Powell's villainy stems from his role in helping create the boom in the first place.
Original Article: "Blame the Fed for Both the Inflationary Boom and the Inevitable Bust"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The value of the US dollar has risen during the Ukraine war. If peace breaks out, the dollar might be one of its casualties.
Original Article: "The Story of War and Peace in the Currency Markets"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The "official" definition of a recession is a two-consecutive-quarter decline in GDP, but there are problems with GDP measurement in the first place.
Original Article: "Is a Recession Simply a Decline in GDP? What Does That Mean?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Between its political happy talk in the contrast to reality and its broken promises, whatever credibility the Fed had in the past is long gone
Original Article: "How the Public Lost Trust in the Federal Reserve (Which Should Never Have Been Trusted in the First Place)"
This Audio Mises Wire is generously sponsored by Christopher Condon.
When inflation hits, we see higher overall prices for everyone. But inflation hits lower-income people the hardest, and they bear the brunt of this tax.
Original Article: "Inflation Makes People Poorer (And It's the Government's Fault)"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Now that inflation is the highest it has been in four decades, the monetary authorities are trying one trick after another. Only ending artificially low interest rates will help.
Original Article: "Low Interest Rates and High Taxes Won't Help against Inflation: The Economy Needs Savings and Real Investment"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Powell said that moving forward "we think it's time to just go to a meeting by meeting basis." Translation: "Things might go even more off the rails at any time, so let’s just play it by ear."
Original Article: "The Fed Is Making It Up as It Goes, So It Ditched Forward Guidance"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Forget Biden's claim that his government is "fighting inflation." His government is creating inflation, and in so doing robbing people of their savings and earnings.
Original Article: "Inflation Takings Require Just Compensation: Slash Governments!"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Most economists see GDP as a snapshot of the performance of the economy. However, it is better understood as a misleading statistic which fails to accurately describe what really is happening economically.
Original Article: "GDP Provides a False Reading of the State of the Economy"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Mortgage companies and realtors are today's canaries. They're in deep trouble, and so are the rest of us.
Original Article: "The Canaries in the Coal Mines Are No Longer Singing"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Rather than contributing to a "soft landing," raising interest rates will continue to destroy wealth.
Original Article: "Interest Rate Tightening Will Cause Even More Economic Destruction"
This Audio Mises Wire is generously sponsored by Christopher Condon.
June was the fifteenth month in a row during which price inflation outpaced earnings growth. June's gap is also among the biggest we've seen in decades.
Original Article: "Inflation Hits 9.1 Percent after Months of Empty Talk at the Fed"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The Keynesians running our economic life may be reassured that the Fed cannot fail in a technical sense, but the public should be appalled.
Original Article: "The Fed Cannot Go Bankrupt; However, It Can Bankrupt the Country"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Paul Krugman denies that the Fed artificially suppressed interest rates. As usual, Krugman neither understands interest rates nor the effects of inflationary policies.
Original Article: "Krugman Is Wrong (Again): Artificially Low Interest Rates Created Bubbles"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Jeff and Bob discuss the effect of rising interest rates on Uncle Sam's ability to service debt—and promote the increasingly less radical idea that a default on Treasury debt is both inevitable and good.
Jeff's article on rising rates: Mises.org/HAP351-1 House Budget Committee report on higher interest rates and US debt service: Mises.org/HAP351-2 Rothbard on the ethics of debt repudiation: Mises.org/HAP351-3
With his current timid, weak, and prevaricating position on price inflation, Powell is positioning himself as the new Arthur Burns, who did nothing to end 1970s inflation.
Original Article: "Powell Is the New Arthur Burns, Not the New Paul Volcker"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Congress enjoys exorbitant political privilege in the form of cheap deficit spending—but it may soon come to an end.
Original Article: "Rising Interest Rates May Blow Up the Federal Budget"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Tightening the interest rate hurts both bubble and solid businesses. The Fed should just focus on reducing the money supply.
Original Article: "The Fed's Tightening Will Only Drag Out the Economic Slump"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The relative lack of inflation in Japan doesn't mean real wages haven't fallen.
Original Article: "Here We Go Again: The Fed Is Causing Another Recession"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Ben Bernanke once claimed that a monetary gold standard caused economic instability. He failed to mention that his fiat money standard causes the boom-and-bust cycles.
Original Article: "Contra Ben Bernanke, the Gold Standard Promotes Economic Stability"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The Federal Reserve was supposed to prevent recessions that people blamed on the lack of central banking. Not surprisingly, the post-Fed recessions have been worse.
Original Article: "How Bad Were Recessions before the Fed? Not as Bad as They Are Now"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The United States economy may have delivered no growth in the first half of 2022 after the decline in the first quarter, narrowly avoiding a technical recession.
Original Article: "US Household Saving Rate Vanishes, Credit Card Debt Soars"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Inflation is raging and progressives want action. What kind of action? They want to return to the 1970s regime of price controls.
Original Article: "Back to the Future: Progressives Imagine the Good Old Days of Price Controls"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Peter Schiff once joked that Obama should have appointed Bernie Madoff secretary of the Treasury. The government's easy money policies ultimately lead to Ponzi schemes.
Original Article: "From the Eccles Building to Vegas: The Fed Enables the Worst Ponzi Schemes"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Forget Jerome Powell's fanciful "soft landing" or the notion that the Fed can pull another rabbit from its hat. The banking system is headed for a crash and monetary authorities likely will make things worse.
Original Article: "A Perfect Storm Is Brewing in Banking and Finance"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Conventional wisdom says a country should manage its debts, but what if debt has become uncontrollable?
Original Article: "In Defense of Defaulting on the National Debt"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Inflation in Argentina is far worse than neighboring countries. It has only one cause: an extractive and confiscatory monetary policy—printing pesos without control and without demand.
Original Article: "How Money Printing Destroyed Argentina and Can Destroy Others"
This Audio Mises Wire is generously sponsored by Christopher Condon.
When asked to quantify how a 75-point hike is better than a 50-point one, Powell had no answer. And will it work? Powell could only say "we'll know when we get there."
Original Article: 'The Fed Is Winging It: A 75 Basis Point Hike "Seemed like the Right Thing"'
This Audio Mises Wire is generously sponsored by Christopher Condon.
By late 2021, fueled by trillions in newly printed money, gasoline prices had surged to ten-year highs. Now, even in inflation-adjusted terms, gasoline prices are surging to new highs.
Original Article: "No, It's Not "Greed" or "Price Gouging" That's Driving up Gas Prices"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Year-over-year PPI growth came in at over 10 percent for the sixth month in a row. This will put more pressure on the Fed to "do something."
Original Article: "Wholesale Prices Rise More than 10 Percent, Pointing to Continued Price Hikes"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The Federal Reserve is raising interest rates in hopes of reversing some of the inflationary damage it has done for more than a decade. Unfortunately, the Fed already has done incalculable damage to the economy.
Original Article: "Interest Rates Are Rising, but the Fed Continues to Be Reckless"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Forget the notion that the Fed "fights inflation." In fact, the Fed exists to promote inflation.
Original Article: "Even When There Is Inflation, the Fed STILL Fights Falling Prices"
This Audio Mises Wire is generously sponsored by Christopher Condon.
A Google engineer is in hot water for claiming the company's chatbot tech had become sentient. Meanwhile, Jerome Powell presumes to fight inflation technocratically, by raising the Fed Funds rate nearly a full percentage point. So is the engineer correct? Do technology and machine learning portend an end to scarcity and a solution to monetary policy? Jeff and Bob discuss.
Google Engineer Blake Lemoine's interview with LaMDA: Mises.org/HAP348-LaMDA Charles Haywood's on why AI is overblown: Mises.org/348-Haywood Read 'Yes, a Planned Economy Can Actually Work' at Jacobin: Mises.org/348-Jacobin Read Bureaucracy by Mises: Mises.org/Bureaucracy Bob's article on the Socialist Calculation Problem debate: Mises.org/348-Murphy
The Fair Tax is a supposed alternative to the income tax. But the name does not matter, since a tax is still a tax.
Original Article: "The Fair Tax Is the Tax That Will Not Die"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Inflation is at a forty-year high, fuel prices are wreaking havoc, and there's no end in sight. Time for Biden to tell us how good we have it.
Original Article: "Will Punch-Drunk Biden Take America Down with Him?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Since the state is incorrigible and incapable of being reformed, perhaps the best way to deal with government predations is to boycott the elections.
Original Article: "Let's Boycott Them!"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Today, inflation and prices are soaring. We know that Federal Reserve monetary policy is the cause. But why didn't something similar happen after the 2008 financial crash?
Bob Murphy and professor Ross McKitrick discuss the government policies, Fed actions, and banking movements that lead up to the 2008 crisis, and why the current economic situation is different.
Ross McKitrick on inflation then versus now: Mises.org/HAP-McKitrick Bob explains how Keynesians missed the latest bout of price inflation: Mises.org/HAP347-Murphy Bob's book Understanding Money Mechanics: Mises.org/Mechanics
The Great Reset usually is framed as the reestablishment of democratic social principles. In reality, it's an attempt to do away with the last vestiges of classical liberalism.
Original Article: "Covid and Its Statist Legacy: How Did We Get to This Point?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Jeff and Dr. Murphy discuss a recent interview with IMF economist Manmohan Singh in the context of central banks co-opting digital technology for bad ends.
Find Manmohan Singh's Interview: Mises.org/HAP-Singh Janet Yellen, "I was wrong about inflation": Mises.org/HAP-Yellen Kristoffer Hansen on the basics of central bank digital currencies: Mises.org/HAP-Hansen Block and Barnett on Maturity Mismatching: Mises.org/HAP-BlockBarnett
After the 2008 housing bust, the government supposedly set up a fail-safe mortgage program aimed at preventing future bubbles. It failed.
Original Article: "The Fed's Latest Housing Bubble"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The proabortion centralist line of "accept our definition of human rights, or else" is what we'd expect from the imperialists of old who claimed the "savages" in the colonies couldn't be trusted with self-government.
Original Article: "Federal Control of Abortion Laws Is Modern Colonialism"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Recorded at Maggiano’s Little Italy in Orlando, Florida, on May 14, 2022.
Slides used in this talk are available here.
Special thanks to Greg and Julann Roe for sponsoring this event.
Jeff and Bob take a look at the misnamed "World Economic Forum" and its conference this past week in Davos, focusing on their recently published report.
Read the WEF's Chief Economists Outlook: Mises.org/WEF22
While the covid-19 pandemic brought sickness and death, another pandemic raged through Washington: abuse of executive power.
Original Article: "The Pandemic of Executive Overreach Comes to an End. When Will the Next One Begin?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Recorded at Maggiano’s Little Italy in Orlando, Florida, on May 14, 2022.
Special thanks to Greg and Julann Roe for sponsoring this event.
We spend a lot of time on this show talking about central banking. This week we talk about central bankers themselves, from Powell to Brainard to Lagarde to Greenspan. Robert Aro joins.
Money velocity's role in forcing up prices is misunderstood because today's monetary "authorities" fail to consider how new money is injected into the economy.
Original Article: "The Fed Gets It Wrong on Money Velocity, Too"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Last year, Joe Biden and his administration claimed that inflation was "transitory." This year, Vladimir Putin gets the blame. Next year, Biden will blame American businesses. And the beat goes on.
Original Article: "No, It's Not the Putin Price Hike, No Matter What Joe Biden Claims"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Propping up congressional deficit spending, juicing equity markets, and constantly recapitalizing commercial banks are the Fed’s true mandates.
Original Article: "Inflation, Quick and Dirty"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The Fed's reckless behavior has undermined Netflix more than the losses at CNN+.
Original Article: "How Did CNN+ Get Canned by Netflix? Austrian Economists Might Have an Answer"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Paul Krugman recently wrote that the reason we see high inflation is that people mistakenly believe inflation is in our future and act accordingly. This reasoning is false.
Original Article: "Do "Inflationary Expectations" Cause Inflation? Contra Krugman, the Answer Is No"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Jeff and Bob discuss the mechanics—and pain—required to put an end to inflation.
Read Bob's Understanding Money Mechanics: Mises.org/Mechanics
In this episode of Radio Rothbard, Ryan McMaken and Tho Bishop take a look back at previous statements by current members of the Fed. For years, the Fed said the biggest problem was a lack of inflation. Now, with inflation at historic heights, is there any reason to believe the Federal Reserve is prepared for what to do next?
Recommended Reading "The Fed Who Cried Growth" by Jonathan Newman: Mises.org/RR_77_A
"We Still Haven't Reached the Inflation Finale" by Brendan Brown: Mises.org/RR_77_B
"Real Wages Fall Again as Inflation Surges and the Fed Plays the Blame Game" by Ryan McMaken: Mises.org/RR_77_C
"Do Inflationary Expectations Cause Inflation? Contra Krugman, the Answer Is No" by Frank Shostak: Mises.org/RR_77_D
"The Fed Can't Fix the Economy, but It Can Break It" by Jon Wolfenbarger: Mises.org/RR_77_E
"Kashkari Said What?" by Robert Aro: Mises.org/RR_77_F
Understanding Money Mechanics by Robert P. Murphy: Mises.org/BobMoney
Be sure to follow Radio Rothbard at Mises.org/RadioRothbard.
Despite assurances from politicians and the media, the Federal Reserve System is not a collection of geniuses who stand guard against inflation and recession. Instead, think of the Fed policy makers as the Keystone Cops of central banking.
Original Article: "The Fed Can't Fix the Economy, but It Can Break It"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Recorded in Birmingham, Alabama, on April 2, 2022.
Slides used during this talk are available here.
Special thanks to Mark Walker for sponsoring this event.
Recorded at the 2022 Austrian Economics Research Conference hosted at the Mises Institute in Auburn, Alabama, March 18–19, 2022.
The Henry Hazlitt Memorial Lecture, sponsored by Yousif Almoayyed.
The Austrian Economics Research Conference is the international, interdisciplinary meeting of the Austrian School, bringing together leading scholars doing research in this vibrant and influential intellectual tradition. The conference is hosted by the Mises Institute at its campus in Auburn, Alabama, and is directed by Joseph Salerno, professor of economics at Pace University and academic vice president of the Mises Institute.
Jeff and Bob Murphy talk about the state of gross economic ignorance in America today.
Lessons for The Young Economist: Mises.org/YoungEcon
Understanding Money Mechanics: Mises.org/BobMoney
Saifedean Ammous hosts the podcast The Bitcoin Standard where he discusses bitcoin and economics from the Austrian school perspective. He is the author of several books, including The Bitcoin Standard, The Age of Cryptocurrency, and The Fiat Standard.
Saifedean Ammous: We have lots to talk about. First, I’ll begin by saying the Mises Institute is a place to which I owe an enormous debt of gratitude. I was one of the people who stumbled upon this blog, this seemingly innocent blog, in 2007–08 and then just kept digging into the massive, astonishingly large archive of books and articles that are available there and have not stopped digging since then. That has been absolutely life changing.
I was a PhD student at Columbia University learning regular, mainstream economics, none of which made any sense, and then I start hearing about Ron Paul, making all these crazy speeches that make a lot of sense in a world of politics, where politicians are not supposed to make sense. And so, I start digging into this guy and coming across this incredible website where all these economists make sense. Why would an economist make sense? Economists are supposed to write arcane, esoteric math and pretend they’re engaged in some centuries-long struggle to understand the mathematical foundations of how reality works. But the Mises Institute gave me the idea that economics can make sense, economics can actually be something that is helpful to understanding the world. The point of economics, and this is really the culture shock you get from reading mises.org, is that when you’re studying mainstream economics, the point of learning economics is in trying to understand what these economists are saying, and then when you understand what they’re saying, you don’t learn anything useful for the real world. You just learn what those people are saying and then you pass your test and get your degree and get a job. But with the Mises Institute economists, and the economists of the Austrian school, you use the work of the economists in order to understand the world. So, thank you very much for everything that you do with the Mises Institute. Could you tell us a little bit more about the Institute, its history and your role and the milestones in this development over the years?
Jeff Deist: Over the last year in particular, economists and other social scientists have done a very poor job of helping us understand the world, in particular the unseen. The fallout from covid policies is going to be the real story over the next five or ten or twenty years, the alcoholism, the depression, the weight gain, the drug and alcohol abuse. It’s going to be incredible. Social scientists are supposed to help us understand the human world, just as natural or physical scientists are supposed to help us understand that world. Most economists are failing us. They’re stuck in mathematical modeling and statistics, in data. They don’t consider a proper praxeological approach.
But today the Austrian school has a lot of new applications. It has a lot of new proponents and adherents. I think people understand that economics as a profession doesn’t work. It doesn’t really help society. It doesn’t help us understand the world. It doesn’t make us happier or healthier or wealthier. It just does dumb things like failing to predict the housing crash of 2007, for example, and it gives us central banking and minimum wage and nonsensical narratives about inequality. It provides an intellectual veneer and cover for the political class. This gives the Left ammunition to claim economics is merely a pseudoscience. It just provides intellectual support for capital, for the wealthy. It isn’t a real science. And I understand that critique. I think economists have to bear some responsibility for that.
I hope the Mises Institute provides a counter to all that. We are a free school for anybody who wants to avail themselves of it—maybe a little, maybe a lot. Some people only want to consume the occasional tweet or the odd article to improve their understanding. Some people want to really delve in and read nine-hundred-page books and make Austrian economics part of their life. We want to be a full-service organization for both kinds of people. Saif, you know we live in a high–time preference society that’s been created by the political and banking classes. It’s very easy to look at the landscape and say, “Jeff, this is not the time for nine-hundred-page books written by guys from the 1800s. It’s time for activism.” I understand that. But the flipside is: What matters, what lasts, what is timeless, what is true across time and space?
So yes, fewer and fewer people are willing or capable of sitting down and reading those nine-hundred-page books. Will those people matter more or less in the future? I think they will matter more. Because the Mises Institute is not here so we can plant a flag on top of a pile of rubble, some kind of Mad Max scenario years from now, and say, “See? We were right!” That’s not the point or the goal. The goal is to help people learn and reach what Albert Jay Nock called the Remnant—people who are interested in building a world, a civilization, a society that’s real. One with a foundation. That means capital accumulation. There is no other way. And increasingly, in my opinion, we should talk about separation. About finding the Remnant. If you spend time on social media, you know people have gotten a lot crazier. Maybe they were always crazy and now we just know about it because they can spout off on social media all day. I don’t know which is the case, but it’s clear a significant number of people in the West believe enormously illiberal crazy things.
SA: Yes.
JD: And since we have limited time and resources, since scarcity is a fact, how do we spend our time and energy? Do we try to reach everyone? Do we try to win national elections? Do we wonder why “classical liberalism” seems helpless against progressivism? Or do we try to identify and begin to separate ourselves? That can take place in a variety of ways. That doesn’t necessarily mean geographic secession or even geographic concentration of like-minded people. But it does mean separating in a business sense, in a capital sense, in a political sense, in an economic sense. We have to understand we’re trying to build a world, or improve the world, for people who can be reached. That’s not everyone. I think when we jettison the idea of political universalism, political globalism, it’s really very liberating.
I hope the Mises Institute helps people. I know it does on an individual level. It’s much harder to affect things on a societal level. It’s a very anti-intellectual age in which we find ourselves. But we want to be the biggest and best online school that’s free, that’s digital, that’s available instantaneously for anybody. And increasingly we want mises.org to be a gigantic free library. We’re buying up rights to all kinds of books for which we don’t own the copyright and we’re trying to improve our library function. So, a free school is my idea of what the Mises Institute is.
SA: Yes, it’s very much succeeded in that. One of the most common initial criticisms people have about libertarians is that they come at it from the perspective of the political system and then they find out that there’s a libertarian political party that is massively hopeless. Then they think that libertarianism’s clearly hopeless. I think that is completely missing the point because in my mind, a libertarian political party is going to have to be hopeless because it’s like an atheist branch of Catholicism. It’s just not going to make headway in the Vatican if you start off from the premise that there shouldn’t be a Vatican. And this is the contradiction that a lot of the DC libertarians fall into, and this is why in many cases you see their role is to be basically the bastard. They’re there to justify and give excuses to the regime and convince themselves that they are being pragmatic in order to get concessions from the regime. But in reality, they are actually helping the regime further its ends and its goals by convincing young people who have radical ideas about freedom that this is completely unrealistic and you need to get in with the system. You need to fight at the tiny, little margins to get some of these tiny, increasingly inconsequential ideas that people like the Cato Institute fight for.
For instance, my favorite problem with the Cato Institute is their monetary issues. They’re practically indistinguishable now from run-of-the-mill Keynesians and monetarists. They are pretty much monetarists and they view Austrians as too radical, people like Ludwig von Mises and Murray Rothbard as being too radical. That’s why when something like bitcoin comes along, they’re naturally hostile to it. They’ve been enormously hostile because they are conditioned to think of the problem as having to be solved by government and if only we just had the government to put the right people in. If only they would take Cato’s monetary advisors and put them on the Fed, then we’d have a libertarian free market monetary policy, which is an absurd contradiction in terms that’s never going to get anywhere. The whole point of having a Fed is not to have a free market in money, and if you’re trying to push free market ideas within the Fed, you’re not going to get anywhere. All that you do, again, is serve to move people away from promising ideas of change like bitcoin to allying with the regime. This is why there’s a lot of parallels and a lot of confluence between people at the Mises Institute and bitcoiners, that it’s the same approach.
As you said, the best way to have clean water is to separate the clean water pipes from the sewage. You need to make a separate place where we can have these ideas, we can think about them. It’s not about achieving results immediately, it’s about achieving the correct results, no matter how long it takes. There’s always time for nine-hundred-page books and there’s always time to think about these things in the long term. People who are not reading nine-hundred-page books are still reading nine hundred pages of nine hundred different articles in the New York Times repeating the same stupid talking points over and over and over again. So, you could skip these articles and read the nine-hundred-page book and come out with a much better perspective. It’s a multipreference approach.
Coincidentally, within the Mises crowd, there has been some skepticism of bitcoin, but overall, it’s incomparable to the reaction that you get from the DC libertarian think tanks. It’s striking just how reasonable people at the Mises Institute have been. I’ve spoken to Hans Hoppe about it, I’ve spoken to Joe Salerno about it, I’ve spoken to you. I haven’t spoken to David Gordon, but I know Mike Goldstein spoke to him. Most of these people had problems with bitcoin initially. All of us had problems with bitcoin initially. Everybody thinks about it, but then the notion that we’re going to have a money that is separate from the state is something that makes sense. They’re not hostile to it. They might not necessarily get all the technical aspects of it. They might not be enthusiastic about it, but they’re definitely not hostile to the idea that we’re going to separate money from the state and we’re going to have a software program that everybody can audit replace money. And once you go over a few of the technical problems that people have with it, then the reaction is “Yeah, we’ll let the market decide.” Ron Paul, of course, is like that as well. It’s a very different reaction that you get from the regime libertarians, who are coming up with an endless parade of problems that they can’t even defend and state eloquently. They know that it can’t work and it won’t work, and it ultimately comes down to “Well, that’s not politically realistic. We need to aim for something that is politically realistic.”
JD: When you hear someone talking about public policy, so-called, you need to run away from that person. We don’t need public policy. That sounds like a program for cattle. We especially don’t need monetary “policy.” When think tanks talk about this and that monetary policy, how we need some sort of rules-based Fed or some sort of NGDP (nominal gross domestic product) targeting, they are way off base. The minute there’s a crisis or an exigent circumstance, central bankers throw the rules out the window. They don’t follow rules. They’re operating in an ad hoc manner to save their own skins. So much for public policy or monetary policy. Look, the chair of the banking committee (“Financial Services” Committee) in Congress is Maxine Waters. She is a crazy person. The idea that a DC think tank is going to send somebody over to testify before her committee about NGDP targeting is just laughable. She’s just going to say, “Well we need cheaper loans for low-income people.” This is why politics and economics should never mix.
I mentioned nine-hundred-page books, but Mises also wrote Nation, State, and Economy and Liberalism in the interwar years. These were more political tracts about liberalism per se. And people should read these because they are only three hundred pages! For Mises, liberalism meant the wholesale separation of economy and state. Sometimes we lose sight of that. Liberalism, today libertarianism, should not be mistaken for feel-good liberation theology or a rejection of social structures. It’s about the rule of law and property. That’s Mises’s liberalism. It was about a rigid separation of property and state, of economics and state. One paragraph in Liberalism which makes a lot of libertarians squirm distills the entire liberal program—of course, Mises uses “liberal” in the nineteenth-century sense—down to a single word: property. It’s not about living your best life without authority or self-actualization, or accepting a host of left-cultural precepts. All of that is an appendage, with which I don’t particularly agree. I would say people don’t have to agree with this appendage.
SA: It’s tangential at best.
JD: It’s tangential, but more importantly, high–time preference societies tend to devolve very quickly. We want less external governance, but also no internal governance—which strikes me as a crazy proposition. In other words, we ought to support all the intermediary institutions that stand between the individual and the state.
That’s a bit of a detour from your question, but I do think when bitcoin came along, it posed a serious challenge to Austrians and libertarians. My own thinking on it has evolved a lot, albeit gradually, starting with Bob Murphy and then Caitlin Long and then your book. Certainly we support the idea of denationalization of money. We love the idea of competing currencies, but is bitcoin just a particular brand among many? If so, we shouldn’t advocate one brand over another, like Toyota over Honda. That was my facile thinking before reading your book The Bitcoin Standard. I’ve changed my thoughts since then. In Austrian economics circles there has been resistance to bitcoin, certainly. Gold was the ideal alternative to government fiat for so many decades. And to be fair to gold bugs, bitcoin was promoted and sold as a high-tech solution to problems with fiat rather than as a commodity. But algorithms aren’t high-tech per se. They can be very, very complex, but the computing power to solve them isn’t complicated. The image of bitcoin was futuristic money for perpetual travelers who live on islands off Singapore somewhere. I think it should have been sold as a digital commodity. It should have been promoted as a savings vehicle for people worried about inflation. So I don’t want the Mises Institute to be a bitcoin promoter. I don’t view that as our role. But I don’t want us to be a bitcoin antagonist either. So that’s my weaselly answer, Saif.
SA: No, I agree with you. I don’t think it’s a weaselly answer because you do quite a bit of work to educate about bitcoin. But yes, I think you’re absolutely correct in that this is the Mises Institute, it’s not a bitcoin institute. We have the Satoshi Nakamoto Institute, which focuses on promoting the works of Satoshi and on bitcoin, but the Mises Institute is the work of Mises and it has a wider rim, and as powerful as bitcoin is, I think it would be distracting from the overall mission. I know a lot of bitcoiners give me and give you trouble for that, but I don’t particularly see a problem with it. I think your approach has been quite reasonable about it and you’re absolutely correct. For many years I heard about bitcoin and I just dismissed it because I did not think that it had the properties that would make it really replace gold, get us rid of gold. Initially, again, it was promoted as just a faster, cheaper PayPal, that was the main idea. I would say around 2014, ’15, ’16 it becomes clear that this is a pretty powerful monster that is not out there competing with PayPal. This is monetary policy that is set in stone. Nobody can change this, nobody can edit it, and once you start thinking of it this way, then yes, it begins to make sense and that this is going to be a very big deal. That’s the conclusion that you arrive at from this.
Back to the Mises Institute. Tell me more about the history of the Institute. How was it started and what was its initial mission? I know Murray Rothbard played a role in that and Lew Rockwell. Can you tell us a bit more about this?
JD: Well, the Cato Institute was going to be home to Rothbard, and Rothbard intended to create a real viable Austrian outpost there. People don’t know this. The Cato Institute started in San Francisco. Murray Rothbard was out there before it moved to Washington. The idea was to Austrianize free market economics, which was mired in Milton Friedman and monetarism. It was mired in supply-side thinking in the early Reagan years. That was the goal, but Rothbard had a falling-out with the Cato Institute. He felt they were moving away from hard-core or pure Austrian economics. As a result of that, Lew Rockwell got involved and connected with Mises’s widow, Margit. Lew had met Margit and Ludwig von Mises during his days at Arlington House Publishing. Lew and Murray knew Auburn University had a friendly trustee on the board. Auburn also had some friendly professors in the economics department in the early 1980s. So Lew came down to Alabama, and in hindsight that was a stroke of luck. DC think tanks are so bad, and so corrupted, and we need to turn our backs on the whole thing. We need to turn our backs on Washington, and Brussels, and the UN and the IMF (International Monetary Fund), and all of these organizations. So in hindsight, we benefitted enormously from being located outside the Beltway.
Initially, we were involved with the Auburn University economics department. I’d like to point out we actually paid rent to Auburn University. And then Lew started raising some money on his own and we were able to build a building across the street. We’ve expanded that building a couple times since. Over the years we’ve tried to be a place where Austrian economics could be explored in full. Contrary to some of our critics, we are not simply about Mises and Rothbard and Hoppe. You can go through our archives and find vast volumes of work by Carl Menger and Eugen von Böhm-Bawerk and Friedrich von Wieser and lots of other economists in the tradition.
We certainly claim the Misesian strand of pure praxeology, which Rothbard improved upon, and we don’t shy away from the implications of that. Plus Mises and Rothbard wrote about everything. Mises was intimately involved in the Viennese chamber of commerce. We’ve never shied away from considering the full implications of pure praxeology, of pure theory.
We’ve never shied away from considering the implications, as Mises did in Liberalism and Nation, State, and Economy, of secession and breakaway movements and radical decentralization. We’ve never been afraid of the secession word. We’ve never been afraid of openly discussing and considering the ramifications of pure anarcho-capitalism, of statelessness—of how defense, police, and courts could be provided on the marketplace. Do we really need minimal government? We’ve never been afraid to discuss whether democracy is a good thing or whether it’s a bad thing. Is it really the only way to organize society? Is social democracy the final and fullest expression of political organization in the twenty-first-century West? Is it the enlightened end point of liberalism? Well, no, clearly not. Democracy in the West produced several disasters in the twentieth century. So I’d like to think we’ve been uncompromising. I’d like to think we’ve carried on the intransigence, or better yet the courage, of Mises and Rothbard.
SA: I think, obviously, the critics will take any deviation from government propaganda as a sign of “You’re inflexible and you’re dogmatic,” and, of course, that’s all projection. If you don’t agree with the Overton window of DC accepted debate, then you’re considered a dogmatic fanatic. But in reality, the intellectual width of debate within the Mises Institute itself is far wider than the entire politically correct space of everyone in DC. That’s astonishing. Within the Mises Institute, as you said, secession and democracy, these are topics that are discussed, and there are people that are in favor of them and there are people that are opposed to them. And they get together in the meetings and they discuss them, and it’s usually pretty cordial and respectful and intellectual. This is much more than can be said about the broader debate in the general public arena, where there’s a clear idea of what is considered acceptable and it’s a very narrow range between the Republicans and the Democrats.
Immigration is another issue. Within the Mises Institute, there’s a lot of debate on that topic. The topic of immigration makes some people uncomfortable, but the Institute is a place where you get to hear the different perspectives on this issue and how it should be tackled. And the role of the police and the role of the military and the role of the government in terms of national defense. There’s a huge variety of perspectives within the Mises Institute, which you don’t find within general debate. In my mind, it’s just like with economics: the government perspective, the government propaganda perspective, is absolutely limiting and suffocating.
And as you were saying earlier, you’re not sure if people have gotten crazier or the internet has made us realize that people are crazier. People have definitely gotten crazier, particularly in the last twenty months or so, since the whole coronavirus situation started. The world has truly, truly gone mad. Even the most fanatic, hysterical people today, who are still calling for shutdowns and lockdowns, even those people, if you spoke to them in 2019 and you asked them, “Your political opponent wants to do this. What do you think about it?” They would have said, “This is crazy.” And yet a year later they were calling for just that from all across the political spectrum. It’s deeply illiberal in a way that was unimaginable in the vast majority of the world, not just in Western liberal democracy.
It’s all over the world, in Latin American countries, in Asian countries, the idea that your movement from your home needs the permission of your local health czar, and your ability to open your business, and how many people can you accommodate in that business, and what hours you operate. All of that has become the purview of somebody who is unelected and whose only credential is the fact that they have been brought up by the global public health mafia.
All the public health people before 2020, they discussed the possibilities of different pandemics and even in the cases where things were far deadlier than this, this was never a strategy. A total lockdown of the population was never considered a viable strategy. They knew it would be ineffective, and it is ineffective, and it has proven ineffective. They knew that it would be massively destructive in a way that would cause far more harm than whatever the disease can do, and this is exactly what we’re seeing.
It’s to your great credit that from day one, the Mises Institute was very clear on this. You are not taking Bill Gates’s money and not taking the World Health Organization’s money. Everywhere else is being funded by these criminal organizations, and then suddenly, they were getting their marching orders in sync. One day you wake up and everybody wants you to stay home, and then the next day everybody wants you to wear a diaper on your face, and then the next day everybody wants you to not take medicines which are proven to be effective because the science says that we shouldn’t take them and they’re not effective. Everybody’s singing to the same tune. And yet the Mises Institute from day one said, “No, the shutdowns are insane. People can make their own decisions.”
It’s amazing, this basis in the liberal tradition, the old liberal tradition, nineteenth-century liberalism. It’s like a vaccination against brain damage from the media. It doesn’t matter how insane the propaganda gets, it doesn’t matter how many videos of people falling over in China you see on TV. You’ve taken your Mises shots. You’ve read the nine-hundred-page books and it’s not going to fly. And bitcoiners, I should say, bitcoiners from early on were some of the very few people who were calling this out. I personally got abuse from a lot of idiots and I’m very happy about it now because I’ve managed to eliminate an enormous number of deadweight and idiots from my life because of this. But back in March 2020, it was extremely rare for anybody to say, “Nope, I don’t think you should force people to stay home.”
JD: Looking back on March 2020, it reminds me of the period right after 9/11 in America. There was this sinking feeling in our stomachs, but it wasn’t about the virus—it was about what our government might do in response to the virus. And so that was very similar to 9/11. Looking back, I think covid may be worse than the Bush-Cheney- Ashcroft “global war on terror.” Government responses to covid were nearly universal across the globe, so that was unprecedented. We didn’t have that with the Spanish flu, we didn’t have it with two world wars—people in London still went to work during the Blitz! Everything is global now, led by the West. We really should view it as neocolonialism, where the West makes decisions and the rest of the world follows suit. This is not a healthy situation. It is political imperialism. We have some two hundred countries on this planet. They all should exercise internal sovereign decision-making, as far as I’m concerned. I’d like to see a thousand countries or ten thousand countries. Then maybe we would have some alternative approaches to covid.
Covid has been a very scary time. I’m as cynical as anybody with respect to politics and the managerial state, which neither Trump nor Biden managed to control. But the managers have kept the narrative going this long: two weeks to flatten the curve, vaccinations will make life normal again, get your third booster. But in March 2020, everyone thought it would all be over by the end of summer. Surely, we’ll be back to normal by fall. But that didn’t happen. It’s breathtaking, it’s pretty scary.
This world had enough problems with money and entitlements and war prior to covid policies. What’s so remarkable is that economists and social scientists should have been sounding the alarm. Just because someone’s a public health expert, so-called, just because someone’s a doctor, that does not mean they’re equipped to make cost-benefit decisions for society as a whole. That’s crazy. We don’t just allow scientists to run our lives. You know, during the Blitz in London people went to work. During the Spanish flu people went to work, so the idea that we drop everything like children and abdicate our personal decision-making to these medical doctors is unprecedented. Doctors don’t get to decide whether we have restaurants open, or whether we can get on an airplane, or whether our kids stay home from school. Economists were supposed to be out there helping us see the unseen.
What’s the unseen? The unseen is the opportunity cost, the tradeoffs, all the harms which will wash over our society and our economy over the next ten or twenty or thirty years as a result of these lockdowns. Teenagers lost a year and a half … so far. Developing infants see these masked faces. What is that going to mean for early childhood development? How many people gained twenty or thirty pounds, and how do you measure that across an economy, across time, in terms of diabetes, early death, and all the things that come with obesity, all of these unseen things which are very hard to measure? Fauci insinuated there might be millions of deaths—which was not true—but even if it had been true, we still needed to consider tradeoffs. This is where economists failed us. Economists should have been asserting themselves two years ago, saying, “Hold on, we need to talk about the unseen.”
SA: We’ve had one economist from the London School of Economics on our podcast The Bitcoin Standard, Paul Frijters. He’s an empirical economist and very not Austrian, all about numbers. He was shocked that he was an exception. I went to the LSE, to Columbia University, and I studied a lot of empirical economics with a lot of empirical economists, and I know that these people will try and calculate and measure the most obscure and arcane little details and consequences of things. For example, they get hundreds of thousands of dollars to study what is the impact of giving one African village a little bit of extra food for one-year-olds? And then they’ll follow these one-year-olds ten, twenty years down the line and quantify the impact on their income and on their IQ and on their height and on their everything.
There’s an enormous industry of empirical economists out there measuring the impact of all kinds of things. You and I have our problems with that because, ultimately, without theory, this doesn’t tell you anything, and of course, this can be utilized and abused in all kinds of different ways. I still expected that you’d get these stat nerds to speak up and say, “Well, you know, if we’re going to shut down the world for two weeks,” which is what it was initially, “this is the impact. This is how many people are going to die from unemployment and how many people are going to die from poverty. This is how many cancer diagnoses are going to be missed, this is how many malaria cases are going to die, this is how many tuberculosis patients are going to be dying because they won’t be getting their treatment, AIDS patients, etc., etc.” And yet all of these empirical economists, regime bootlickers, they were just trotting out the same propaganda that was being put out by the World Health Organization and all the other organizations. It’s just “Oh, well, yeah, we need to do this because otherwise millions of people would die, according to the model.” And suddenly, these models, these completely nonsensical models of millions of people dying, were just counted as if they were reality. Then the empirical economists went to measuring how many lives we saved based on comparing it to the model. And, of course, ignoring the glaring cases of Sweden and Belarus, which never implemented lockdowns and didn’t see any of this mass devastation and death that everybody else was mentioning.
As I said earlier, it’s a great credit to the Mises Institute and to Austrian economists for being some of the very few economists to speak out against this, without needing to do sophisticated math. I think it’s a damning indictment of this sophisticated math because, even for all of my appreciation of what Paul Frijters has done, this clearly shows that numbers without theory, numbers without a guiding framework, numbers without a praxeological basis, are just basically prostitutes that can say whatever you want. You just focus your analysis on one part of the story and you can make those lockdowns look great, or you focus your analysis on something else and you can make the lockdowns look bad. And that’s why these empirical economists are so easy to manipulate, why they talk nonsense, because you just fund the questions that you want. You fund them to look into the numbers that you want to look at. You make assumptions about how much staying at home has saved lives and then they can go and spend another two years running regression analyses to tell you how many lives were saved. They don’t have to look at the unseen. So, just simply conceptualizing the unseen without any numbers is far more powerful and far more useful than all of the sophisticated mathematics that you could deploy when you are funded to ignore the unseen.
JD: You bring up Africa. There’s this idea in the West that we’re simply rich forever, that this material wealth surrounding us will organize itself regardless of what we do—regardless of incentives. We don’t have to worry about it. So we can shut down big parts of the supply chain for a year or two and tell people they don’t have to work. We can give employers PPP (Paycheck Protection Program) loans to make payroll without producing the goods or services they normally produce. We can tell people they don’t have to pay their rent. These things are just costless. I think the average American at this point thinks these actions are costless because government has the money. The federal government has the unlimited power to issue its sovereign currency as needed, this is what MMT (modern monetary theory) argues. And it’s trickled down to the politicians. We can just create money forever and ever.
Imagine going to a financial planner in your twenties instead of your thirties or forties. If you saved money younger, at least back when we had interest rates, the cumulative effect of compounding interest made you much better off. So when we give up two years of economic output, what does that mean for the world a few decades from now? What does that mean for capital accumulation and future prosperity? How do we measure that over time? We’ll never know, I suppose, but what strikes me is this acceptance by people in the West. The Left loves it because now everyone working those low-wage tough jobs at Subway for eight to ten bucks an hour have newfound bargaining power in the labor-management relationship. Maybe they will never go back to those jobs. The Left loves this idea of a Great Reset, because they think wealth exists perpetually in the West and simply needs to be doled out more equitably. Never mind that billions of people need to get up and produce wealth every day. They think electricity and hot and cold running water, and a Starbucks on every corner, and cars and planes will just materialize without respect to incentives. That is the dangerous mythology behind covid shutdowns: production is assumed.
SA: Yes, I think it’s the Left, but it’s also the fiat world. This is fiat par excellence. This is the world of people who just think that government can dictate those things. The reason we have all of these things working, the reason you walk into a house that is protected from the elements and that has electricity and has all of these amazing devices is because the government passed a law and said houses should be like that. They don’t understand the amount of work that went into it, and for me, the crowning glory of this kind of mental dysfunction is when people tell you, “Well, now what do you bitcoiners suggest to do if we have an economy that was running on bitcoin? How would you shut down the world on a bitcoin economy if you couldn’t print money and hand it out to people?” And “Checkmate, bitcoiners.” As if the fiat allows you to suspend the rules of economics and now the government just hands out money and then we create prosperity. Uber Eats still shows up outside your door and you still keep getting the food, and your economy will continue to work and hum along seamlessly for the next decade because the government is printing money while you’re protected.
Well, in a cruel, hard-money economy, if you had gold or bitcoin and you had those evil Austrian economists in charge, then the government couldn’t protect you by printing money and you’d have to go out and actually work in order to produce those things. It’s such an insane way of looking at the world, but it really is the fiat viewpoint. It’s something I discuss in detail in The Fiat Standard because it’s exactly what fiat allows people to think, because you look around and the government is constantly able to give things for free, take things for free, make things for free. It’s always the case that we can get whatever we want. Do we want to make Afghanistan into a modern democracy? Just print a bunch of money and go to Afghanistan. Do you want to make Iraq into a modern democracy? Same thing. Whatever it is that you want, you can just print money and get it and the only limit, the only restraint is getting the political will to do it. And that’s MMT. This is now a school of thought with a growing number of people, particularly young people, because the younger you are, the more you’ve lived in this clown fiat world where economic reality is dictated from above, rather than a result of work.
It’s easy to poke fun at the Left, of course, and I’m always up for poking fun at the Left, but what’s really amazing is how many people in finance think like that. How many people who work in fiat finance think like this? One of the most remarkable is Nassim Taleb, who’s completely lost his mind on this issue and has absolutely no conception of how an economy works. With this new omicron hysteria, his buddy in the World Economic Forum, Yaneer Bar-Yam, was saying, “Oh, well, new variant means new epidemic. We need all the restrictions reinstated from day one.” And Nassim was retweeting him, saying, “Yup, we’ve learned nothing.” He’s learned nothing from the last two years. We need to go and implement all of this because in his world, and in the world of a lot of people who work in finance, money is just numbers on your Bloomberg terminal. The economy is just you sitting there and gambling on whether you’re going to get a green candle or a red candle, and you make money on that. And of course, in Nassim’s case, he doesn’t even trade; he simply writes books about trading and pretends to be trading and never shows what he does. It’s just a game. It’s like a video game. There’s no actual resources, there’s no capital.
Nobody discusses this issue that you have pointed out, which is the impact on capital accumulation. What’s the world going to look like in five years’ time when the things that we count on today needed to have been invested in today in order for them to serve us in five years’ time? The grids and the airplanes and the transportation and infrastructure, all of those things that we will need five, ten, fifteen years from now needed to have been invested in today, but who’s investing in them today? We are shortening the cycle of production and production is becoming more and more instantaneous, and investment is becoming more and more short term because of inflation and because of the disincentives for work and production.
JD: Inflation means hypothetical little old ladies have to go out and chase yield instead of getting paid 5 percent or 7 percent on savings after a lifetime of thrift. I think the search for yield props up tech stocks to an extent. Yes, there are certainly people in finance (including people on the right) who think economies can just be commanded or engineered. Goods and services can be summoned or legislated into existence. At some point, I don’t know what to say to people who don’t understand that more money and credit does not equal more goods and services and society. At some point it becomes tedious to repeat that production has to precede consumption.
Covid, much like any other natural disaster, a terrorist event like 9/11, or a war breaking out, should have a deflationary effect. Yet in every crisis fiscal and monetary policy immediately shifts into fighting human nature by creating inflation. In your new book (The Fiat Standard) you point out an article from William Hutt called “The Yield from Money Held.” What does it mean when people “hoard” money, when they start holding more cash than usual? Because they always do just that in uncertain times. There was tremendous uncertainty in the world during March of 2020. People didn’t know if they were going to lose their jobs. People didn’t know if millions of people were going to die. People didn’t know what covid really was. Under that kind of uncertainty people immediately begin increasing their cash balances, because cash is the best thing to have during times of trouble relative to less liquid wealth like real estate or stocks.
Hoppe wrote an article called “The Yield from Money Held Reconsidered,” which is about Hutt’s article. Hoppe presents all the socially beneficial things that happen when people hoard money. And a lot of free market economists disagree with this. They think money has to circulate endlessly, we have to worry about velocity. Money needs to move around like a pinball game. Well, no. When people hold more money, it gives them flexibility and options. Maybe they will need to move for a new job or survive without a paycheck for a while. That’s why they naturally spend less and increase cash holdings in a crisis. This increases everybody else’s purchasing power by lowering demand and taking some money out of the purchasing economy, at least temporarily. This is deflationary, and beneficial both for the individual and for society. We want to see prices fall when production falls and savings increase. And yet, everything our politicians do, everything our central bankers do, is designed to fight this natural tendency. We need to stimulate, stimulate, stimulate. We need to create demand. Everything’s about demand and consumption, and so we need to create more money and credit on the monetary side. On the fiscal side we need to flood people with stimulus—so they can pay their rent or pay their employees or go buy a new car. We all need to get brand-new $50,000 Ford F-150s. But if you might lose your job due to covid, it may not be smart to go buy that F-150, worse yet if you have to make payments on it. Your every inclination should be to stop spending and hunker down. But our crazy system encouraged spending in 2020, and so auto dealers in the US had their worst and best sales months on record in the same year. That’s a clown-world example of what happens when you distort the economy and go against people’s natural inclinations during a crisis.
SA: Yes, it’s remarkable. People will say, “Well, the government won’t be printing money in a hard-money economy.” Well, yes. If there is a massive natural disaster or a world war or whatever, yes, a lot of economic destruction will happen. Free markets obviously can’t protect you from earthquakes, but they can ameliorate that because people are going to stop spending money on useless stuff and things that they don’t need. So, if you were planning on buying a new car this year, you won’t do it. You’re going to save your money because who knows, maybe you’ll lose your job. So what happens is that the price of cars falls. What you want to buy, the only thing that you do want to buy, is money. You want to hold on to your money, so the price of money basically rises, so you don’t need the government to print money and hand it to everybody. Everybody’s cash balances appreciate in real terms because everybody’s holding on to their money. At that point, goods become cheaper, and that’s the way in which we ration those goods. Goods become cheaper because there’s no new demand for them, the new cars that have been made already will only go to the people that really, really need them. Everybody else is going to save their money and everybody’s money is going to appreciate, so they can buy more, and that’s how you weather the storm. That’s what you do. It applies on a personal level; it applies on a national level. If you’re in trouble, you stop spending on frivolous stuff and you save. But the fiat world just flips all of this on its head. It’s remarkable.
JD: I think your new book The Fiat Standard is an important one. In many ways it elaborates on themes that Guido Hülsmann presents in his book The Ethics of Money Production. Monetary debasement leads to cultural debasement. Political control of money, political money, serves political interests. That creates high time preference in society, which affects families, work, even one’s own personal integrity and morality. Your book really fleshes that out by going into particular industries like food. It’s a fascinating topic, the cultural implications of monetary policy, and not too many people talk about it. We think of monetary policy as a technocratic set of dials and knobs to be fine-tuned to get optimal production from the barnyard animals. We don’t think of it in cultural terms.
SA: Yes, it’s clearly hitting a nerve for people who can see this clearly. The kind of money that you use in every single trade with the rest of the world and with yourself is going to have an effect. Nobody wants to talk about it among the economists except basically Hülsmann and me and a few other Austrians, which is great because it just means more sales for my books. So, I encourage all other economists to continue to stick to their NGDP targeting models. That’ll surely work out one day when the Fed appoints you and you get to show us how you are actually right with all these equations.
JD: Yes, if we just get the right Federal Reserve chair! This is what Washington, DC, gives us. It gives us this idea we fix things politically. But that’s too far gone now. The money’s too far gone, the politics are too far gone, the entitlements are too far gone. We’re in a car going too fast and there’s a sharp curve ahead with a steep cliff beyond. At some point no amount of braking or countersteering can save you from going over the cliff. I think our focus ought to be on building things rather than trying to save things.
SA: It’s not even that you can actually be the right person in the Fed. There is no right person in that job. The right person in that job is no person in that job. Recently, you and I were both commenting on the St. Louis Fed taking on the role of Betty Crocker and giving the world dietary advice about how to handle their Thanksgiving. This was amazing because it came exactly in the week in which I published my book. There’s a huge chapter on fiat food in the book and how government intervention in the food market has resulted in the degradation of the dietary experience of the average person in the world today and a shift in the Overton window of what is considered food. It’s allowed the inclusion of all kinds of industrial waste into our food supply, pushed and promoted by governments because this helps hide inflation.
I’ve said before, that my North Star in life is the jeering of idiots: when idiots start jeering me, I know I’m on to something important. It happened with coronavirus. It happened with bitcoin. It happened with this discussion of fiat food. When I started talking about this, a lot of people were laughing, “Ah, this is ridiculous. He likes his meat and he’s trying to pass off his diet as being something more profound than just him liking steaks.” I wrote a whole chapter about it, maybe ten thousand words in The Fiat Standard. Then the Federal Reserve chose to give me this amazing gift during the week of its publication. They proclaimed, Instead of eating an actual turkey, make your turkey out of soy. You’ll get more protein per dollar.
It’s amazing. There was a very astute comment about this, which is the more central planning happens in the monetary realm, the more we will inevitably have the central bank have to intervene in all aspects of life.
JD: It’s pretty scary to see the new woke language at the Fed and central banks in general. You pointed out earlier that younger economists at central banks may well be brilliant in terms of pure IQ and mental horsepower. They went to Wharton, they went to Harvard, they went to Stanford. But they’ve never seen a bear market and they’ve never seen real positive interest rates. They really have no conception of the history of economic thought. So they don’t know much about Marx and Keynes and Samuelson, much less the Austrians or Adam Smith or the Spanish Scholastics. It’s very dangerous because these young brilliant people think they can engineer outcomes and make humans respond in the ways they want. That’s what scares me. Now we add the social justice push to the agenda. The Fed needs to fight sexism, to fight racism, to help us achieve justice in society. They need to help us overcome this amorphous idea of climate change. That’s a real shift. That would shock the ghost of Paul Volcker. It’s part and parcel of the world we live in now, where everything has been so politicized they’re able to make this stuff seem nonpolitical. Fighting climate change is just what all good people do to leave the earth intact for future generations. Well, we already had that. Teddy Roosevelt had that. It was called conservation. We don’t need central bankers from Wharton to tell us this. When central banks get overtly political, watch out.
SA: It’s amazing because the statistics constantly show that there is no problem of inflation. All right, there’s a little bit of transitory inflation, maybe, here and there, and it’s because of supply chain issues and the climate crisis and this and that, but it’s reached Soviet levels of propaganda now. People are visibly suffering. Prices are massively going up, supply chains are disrupted because nobody’s working because everybody’s getting paid to sit at home. Economic production is being destroyed, money is being printed and handed out like confetti, and economic production is essentially falling apart. They’re covering it up with their amazing empirical magical statistics. And then, they believe their own bullshit, in the sense that “Well, look, we can manage the pandemic. We’ve saved the world from the virus, we’ve printed all this money and we didn’t cause inflation, so what else can we fix?” This mentality leads them to say, “Well, let’s fix people’s diets by feeding them soy and let’s fix the climate by stopping the production of cows and replacing cows with soy, because grazing animals are ruining the planet and monocropping is destroying the soil. That’s how we take care of the planet.” It’s Soviet levels of delusion and propaganda. And they believe their own nonsense about it being successful and so there’s no limit to how far this is going to go, and I think you’re absolutely correct on the climate change.
There’s another thing that I keep harping on, and people mock me and laugh at me and tell me, “You’re being crazy.” But carbon dioxide is an essential component of every living organism on earth. There are no living things that don’t contain carbon dioxide, and so if you’re able to control carbon dioxide under whatever stupid pretense you come up with, you’re able to control all of life. This is an enormous, enormous step forward for central planners around the world. I think it’s absolutely mind boggling to imagine that they want to control how much carbon dioxide is being emitted all over the world. It’s insane.
To go back to The Fiat Standard, I spent part of the book talking about fiat life. I talk about energy and I talk about food, and I discuss how in the 1970s the central bank’s monetary policy, which led to inflation, also led to central banks and the governments all over the world trying to promote these alternative sources of nutrition and energy because they were cheaper. They were very happy to support and subsidize and promote all kinds of idiotic pseudoscience that tells you meat is bad for you and you should eat soy because that’s how you stay healthy. And that meat is bad for the planet and fossil fuels are bad for the planet and that the future is to eat soy and rely on wind and solar energy. If you do that, there’s no inflation because these things are far cheaper to produce, but of course, they’re far inferior. If you live off solar and wind, you live like your ancestors lived five hundred years ago. It definitely keeps the CPI (Consumer Price Index) down but also makes surviving the winter much harder, and it also means no motor transportation, and it also means you’re going to have to live in a much tinier house to be able to keep it warm. I think we’re witnessing the world heading toward that now.
We’re seeing a revival of these 1970s memes. They never really left us because inflation never left us. But now we are seeing it being pushed aggressively. When you add in the prospect of central bank digital currencies, central banks will have complete control over every dollar of spending and social credit scores. We’re already seeing this with the vax passport. It is a prelude to total centralization. There’s a reason why all of the people who are hysterically afraid of the virus are also hysterically afraid of climate change and also believe that inflation is not a problem.
Inflation is not going to be a problem if you have a social credit score system and a central bank digital currency that limits you to fifty grams of beef a week and three hundred milligrams of gasoline a month or whatever it is. You’re going to have rationing Soviet style done through your iPhone, and you’re entirely dependent on delivery to your house, and you’re not going to be able to afford a big house. Everybody’s going to move into these tiny, little bug pods where they’re going to stay home all the time with Mark Zuckerberg’s headset on their face and experience life through the headset. You’re going to eat the soy, and you’re going to live in the pod, and you’re going to not move, and you’re going to stay cold, and there will be no inflation.
One other thing I want to talk to you about is your Human Action Podcast. I listen to that quite a bit and I really enjoy it. You host Austrian economists, and others, to talk about the great books. Make the pitch for people who haven’t dug into the nine-hundred-page tomes. Why are those books great and why should people read them?
JD: Well, I thought there were too many podcasts. What could I do different to provide value? So we decided to focus on books and use the show to help explain economic theory while promoting some of the great literature of the Austrian school. Sometimes we get into political science, sometimes we get into philosophy, occasionally even fiction or antiwar history, but for the most part we focus on economic theory. Some people do listen pretty religiously. My pitch is this: if you’re not going to read that book, the podcast is the CliffsNotes. It’s like watching the movie instead of reading the book. And it might inspire you to actually go out and read it. For long books we have multiple episodes, so we don’t rush through things. I hope five or ten years from now the old shows will still have value, which I think is not true of a lot of current events podcasts. I always try to ask myself—What has value and what lasts? These books will still be here years from now, and our explanations or elucidations of them will still be here.
Contractionary monetary policy may be necessary to slow the rise of inflation, but the recessionary results of this remind us why the Fed's inflationary policy is so dangerous.
Original Article: "Inflation or Recession? The Fed Faces a Choice."
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Includes an introduction by Jeff Deist. Recorded in Lake Jackson, Texas, on December 4, 2021.
Ron Paul's two campaigns for president (2008 and 2012) were watershed moments for liberty-minded people around the world. The "Ron Paul Revolution"—centered around his undiluted message of peace, property, and markets—changed the way millions thought about the American empire and the American financial system. Dr. Paul's focus on central banking and foreign policy caught politicians and pundits off guard, forcing them to scramble for explanations of our Middle East policy and Soviet-style central planning at the Fed. Politics in America has not been the same since the "Giuliani moment" and "End the Fed." The Ron Paul Revolution was both a political and cultural phenomenon.
Bob provides a running refutation of Stephanie Kelton's recent TED talk on Modern Monetary Theory (MMT).
Mentioned in the Episode and Other Links of Interest: Stephanie Kelton’s TED TalkBob’s review of Kelton’s book explaining MMTBob’s article on opting out of Social SecurityKelton’s intro to MMT, The Deficit MythBob’s interview of a founder of MMT, Warren Mosler. Then Bob’s analysis of that episodeBob’s Mises.org critique of a popular identity (equation) in the MMT literature. For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Google Podcasts, Stitcher, Spotify, and via RSS.
The Fed is backed into a corner. If price inflation continues, the public could demand action and the Fed could be forced to cut back the flow of easy money, which may lead to a depression.
Original Article: "Why the Fed Is So Desperate to Hide Price Inflation"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Unlike the ongoing price inflation that is typically caused by central-bank expansion of the money supply, the price inflation generated by diminished supplies of goods is a one-shot affair.
Original Article: "Is There Such a Thing as Good Inflation?"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Scott Sumner is a monetary economist with the Mercatus Center. He famously argued in late 2008 that the Fed was too tight with monetary policy, and eventually he has convinced many economists of his views. In this episode he explains why interest rates and even monetary aggregates are not good indicators of the stance of monetary policy, whereas NGDP growth is much better.
Mentioned in the Episode and Other Links of Interest: Scott Sumner’s Mercatus page and his blog, The Money IllusionScott argues the Fed through 2012 had been tightScott’s older book The Midas ParadoxScott’s forthcoming book The Money IllusionBob’s review of The Midas Paradox and his assessment of Market MonetarismEconTalk interview with Michael Belongia (which brings up Milton Friedman’s critical comments about NGDP targeting) For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Google Podcasts, Stitcher, Spotify, and via RSS.
Jeff Deist and David Gornoski talk about some of the recent news and relevant topics such as the buying up of homes by Black Rock; the federal reserve’s connection to big corporations; the out of control state of the Fed’s reverse REPO market; and what the average person can do to protect themselves from government interference in the market.
Find more from David Gornoski on A Neighbor's Choice.
In response to a listener request, Bob continues a 3-part series explaining areas where his views have changed. In this episode, he covers government debt and future generations, accuracy in polemical writing, the Fed being a private corporation, whether nice guys finish last, and mainstream utility theory.
Mentioned in the Episode and Other Links of Interest: Bob’s “The Economist Zone” article with links to the original contributions to the Great Debt Debate. Bob’s Mises University lecture on the topicBob’s link for Tom Woods’ Liberty Classroom (which features a lecture on government debt burdens)Bob’s FEE article on the origin of public schoolsBob’s essay on advice for single Christian menBryan Caplan’s “Why I Am Not an Austrian Economist For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Google Podcasts, Stitcher, Spotify, and via RSS.
Rothbard called Mises's The Theory of Money and Credit "the best book on money ever written." But Rothbard himself may have written the best money book for lay readers, namely What Has Government Done to Our Money?
Bob Murphy joins the show to discuss this superb and eminently readable tract: a mini-course on money itself, from its origins and uses to its degradation by kings, politicians, and central bankers. In only 119 short pages, Rothbard gives us everything we need to know about this most critical commodity in society—along with the ruinous development of fully fiat (unbacked) state money. Readers also enjoy a brilliant history of money regimes, from early barter to the classical gold standard and the ultimate collapse of the Bretton Woods agreement.
Read this fantastic book for free in HTML format: Mises.org/WHGD
Bob Murphy's series, "Understanding Money Mechanics": Mises.org/MM
Bob Murphy interviews Fed economist David Andolfatto on the devaluation of money, among other topics: Mises.org/BMS175
Hans-Hermann Hoppe reconsiders Hutt's seminal article, "The Yield from Money Held": Mises.org/HoppeHutt
Dr. Mark Thornton joins the show to discuss what might just be Murray Rothbard's best book on money and banking: The Case Against the Fed. Written not long before his untimely death, this work is nothing less than a master class on the history of money: the sordid players and interests behind the creation of the Federal Reserve bank; the workings of demand deposits and fractional reserve, inflationism, and the monetary mechanics behind it all. The final pages of the short and penetrating book are especially fascinating, as Rothbard lays out a process for unwinding the Fed and paying off its liabilities using the federal government physical gold holding. End the Fed starts with understanding the Fed, and this book is vital for any lay reader.
Find the online version of the book at Mises.org/RothbardFed
Mises's firm anti-inflation view—and his recommendation for a return to sound money (that is, free market money)—rested on his awareness of the disastrous consequences of an inflationary policy.
Original Article: "Inflation Breeds Even More Inflation"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Ron Paul used the fall in purchasing power since the founding of the Fed to argue that the central bank had hurt regular Americans. Fed economist David Andolfatto disagrees, but Bob pushes back.
Mentioned in the Episode and Other Links of Interest: The YouTube version of this interviewDavid Andolfatto critiques Ron Paul’s argument against the FedBob’s rebuttal to Andolfatto“Has the Fed Been a Failure?” by White et alBob’s forthcoming book on Understanding Money Mechanics For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
No matter how bleak the economy may be, the Keynesians are likely to say, “It would have been worse without us.”
Original Article: "The Fed Won't Save Us from the Growing Jobs Recession"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Expect more of the same in 2021. The Fed has no real plan. It is just lurching from one crisis to the next, hoping more easy money will buy some time. It's been doing this since 2008, and there's little chance it will stop now.
Be sure to follow Radio Rothbard at Mises.org/RadioRothbard.
In spite of its relentless public relations efforts claiming the opposite, the Fed remains a leading reason for the impoverishment of working-class and middle-class families.
Original Article: "2021 Would Be a Great Time to Audit the Fed".
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
A single vote on the Fed's policymaking committees wouldn't make any real difference. On the other hand, the Fed will brook no dissent from the official media and academic narrative.
Original Article: "Why Is the Fed So Afraid of Judy Shelton?"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
If the current thinking continues, the world’s central banks will buy whatever paper governments issue. The result by the end of the decade will be a Federal Reserve balance sheet totaling $40 to $50 trillion.
Original Article: "The Fed's Balance Sheet May Be Headed to $40–$50 Trillion".
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Bob reads from an article recently tweeted out by the NEA, which calls for an end to schooling as we know it in order to promote anti-racism. He then discusses what the Fed has been up to since the coronavirus panic began.
Mentioned in the Episode and Other Links of Interest: The YouTube version of this episode (with lots of visuals).Karlyn Borysenko’s YouTube episode on the NEA tweet.Jamilah Pitts’ article on school transformation.Fed article talking about dividend payments to member banks.Total assets of the Federal Reserve System. For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
The Fed plans to keep interest rates near zero, while monetizing debt, financing zombie companies, and pouring new dollars into the market. But that may not be enough.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Original Article: "The Fed Is Planning Another Ultralong Period of Ultralow Rates".
The question is not if the current system will end. The question is how it will end.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Original Article: "The Fed's Brilliant Plan? More Inflation and Higher Prices".
Jeff Deist calls in to talk about deflation, Jeff Booth’s book The Price of Tomorrow, the role of the federal reserve in creating consumerism, liberalism as opposed to Marxism, and more.
Find more from David Gornoski on A Neighbor's Choice.
Kodak's newly announced $765 million loan is just another case of DC picking winners and losers.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Swamponomics: Trump's Fed Pick, a Kodak Moment, and GDP Misinformation".
As a follow-up to his discussion on MMT with Rohan Grey (in ep. 130), Bob goes solo to explain the basic cash balance framework for thinking about money, inflation, and debt. Specifically, Bob will explain why he thinks it's far more important to know how the government finances a deficit rather than knowing what it spends the money on.
Mentioned in the Episode and Other Links of Interest: BMS ep. 130 with Rohan Grey.Bob’s infamous inflation bet: response to Krugman/DeLong and his explanation years later for reason.com.Rothbard’s critique of the “equation of exchange,” MV=PQ.Bob’s QJAE article on the economics of fractional reserve banking. For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
According to Keynesians, wealth effects result from money creation, and they have a beneficial impact. The Keynesians are right that wealth effects exist. But they're wrong about who benefits.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Yes, QE Creates Wealth Effects".
In a very comprehensive discussion, Bob talks with Rohan Grey, Assistant Prof. of Law at Willamette University. Rohan is an expert on the history of US fiscal and monetary legislation, as well as Modern Monetary Theory (MMT).
Mentioned in the Episode and Other Links of Interest: The YouTube version of this interview.Rohan Grey’s CV, and his paper on the history of US coinage.Rohan’s presentation on money as a creature of the law, not the State.Jon Stewart rips Paul Krugman on the trillion dollar platinum coin.Bob’s original book review at Mises.org of Stephanie Kelton’s book on MMT. George Selgin’s response, which in turn prompted this post from Nathan Tankus.Kelton’s book, The Deficit Myth. #CommissionsEarned (As an Amazon Associate I earn from qualifying purchases.)Bob’s older critique of an MMT accounting argument.Bob Murphy Show ep. 18, interview with Warren Mosler.Bob’s critique of fractional reserve banking.Bob on Bob Higgs on World War 2 (a portion of the presentation).Help support the Bob Murphy Show. For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Download the slides from this lecture at Mises.org/MU20_PPT_14.
Recorded at the Mises Institute in Auburn, Alabama, on 14 July 2020.
Bob wrote a lengthy review of Stephanie Kelton's new book on MMT, The Deficit Myth, for the Mises Institute. In this episode he narrates his review.
Mentioned in the Episode and Other Links of Interest: Bob’s original book review at Mises.org.Kelton’s book, The Deficit Myth. #CommissionsEarned (As an Amazon Associate I earn from qualifying purchases.)Bob’s older critique of an MMT accounting argument.Help support the Bob Murphy Show. For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
A no-holds-barred discussion of the economy after the coronavirus shutdown and George Floyd protests. Are we facing another Great Depression? Can there be a V-shaped recovery or is this wishful thinking? What will all the new money and credit created by Congress and the Fed mean for the dollar? What kind of economic mess will Trump or Biden inherit in 2021? How far will Fed chair Powell go to keep markets propped up? And how can you protect yourself and your savings?
Recorded at Avondale Brewing Company in Birmingham, Alabama, on June 6, 2020. Special thanks to Mark Walker for sponsoring this event.
It is in a time of crisis where the leviathan state has the greatest opportunity to grow. The global coronavirus pandemic has given cover to governments around the world to give into totalitarian instincts and implement authoritarian policies against their people. It is in times like this when an uncompromising defense of liberty and markets is needed most. We are grateful that people around the world have sought out the content of the Mises Institute to better understand the environment we find ourselves in, pushing traffic on mises.org to all-time highs.
In this issue of The Austrian, we provide highlights from some of the most important and salient articles we have published during this unprecedented crisis.
The Benefits of a Free Society during Pandemics by Per Bylund
In this time of crisis, many exclaim how impressed they are by the “swift and decisive” actions by the Chinese regime. Instead of recognizing the abhorrent disrespect for human life, the Chinese response is put forth as an exemplar for combatting a pandemic.
These hailers conveniently forget the many weeks of silencing and censorship that preceded the brutal shutting down of the city of Wuhan and the whole Hubei Province. They also turn a blind eye to the nature of hierarchy and bureaucracy, pretending what is needed to choose proper action is simply power and that access to accurate, reliable information is of little concern.
The calls for a strongman solution are misguided at best but have been used to paint the picture of freedom as being impotent. Per the strongman delusion, libertarianism would seem to lack exactly what is needed for “swiftly and decisively“ dealing with a pandemic—centralized power…
But a centralized solution also makes us more vulnerable. An example might illustrate this. Consider the difference between a structured, centralized national defense and an armed populace. Switzerland is the popular example of the latter, but this is not a unique idea. For example, Sweden’s defense comprises both a traditionally structured military and the Home Guard. While you can rather easily cripple the military by taking out a couple of their bases, the decentralized and dispersed forces of the Home Guard are almost impossible to wipe out.
What does this have to do with a virus pandemic? It illustrates the false promises of centralization, which is a costly and inadequate solution that in fact makes a society more vulnerable. The same argument applies whether it is the national defense, centralized education, or the monopoly of the CDC. A centralized command structure offers only a false sense of security.
Libertarian society has exactly the decentralized structure that our present society is lacking. Rather than a pyramid with information selected and repackaged on its way up and orders issued from the top, it would be a collaborative network of individuals and neighborhoods. A neighborhood affected by an outbreak could quickly and easily choose to contain the virus, perhaps in collaboration with adjacent neighborhoods. Others could choose to temporarily quarantine themselves to not get infected.
There would also be little reason for them to not share information. While the Chinese apparently believed they didn’t have to do anything, other than silencing whistleblowers, a government is typically not held responsible for its failures. It’s the other way around: a government agency that fails in its task is not punished, but instead offered larger budgets and more discretion.
In rather stark contrast, a libertarian neighborhood that chooses to suppress vital information about an outbreak could (and would) be held liable for the harm caused to others. They face the same mechanism as the private store owner, who would be liable if s/he welcomed those knowingly carrying a virus to enter the premises and infect other customers. It is thus in their interest not to hide the facts, as is the government modus operandi, but to share the information and get in front of the problem.
None of what is appropriate action during an outbreak or pandemic requires central command. The downsides of centralization in fact make matters worse and are what made us vulnerable to begin with. The many calls for increased centralization, and their outright dismissal of libertarianism and freedom as “impotent,” are fundamentally confused. Rather than being reasonable and rational, these outcries are emotional and contrary to fact. They are but symptoms of the strongman ideology.
Calls for Central Planning in the COVID-19 Panic Are like the Calls for the “War Socialism” of Old by Philipp Bagus
The similarity between the reasoning in favor of war socialism and the arguments that have been brought forward during the corona emergency is striking. Today war rhetoric abounds. Emanuel Macron explicitly stated, “We’re at war,” and sent, as in Spain, the military to the streets. US president Donald Trump similarly speaks of “Our Big War” and invokes the wartime authority of the Defense Production Act. We hear the slogan “We are in this together” all the time.
Mises discusses German war socialism during the First World War in detail. He points out that Emperor Wilhelm II basically lost all powers to the General Staff. General Ludendorff “became virtually [an] omnipotent dictator,” he explains in Omnipotent Government, and subordinated everything to the war effort.
Winning the war was thought to be the outstanding goal, which could only be achieved by centralizing all powers. These powers were given to the military. After all, they were the experts in military matters.
Today, we face a similar tyranny of experts, to borrow a term from William Easterly. In the medical emergency, enormous power lies in the hands of doctors such as Anthony Fauci in the US or Christian Drosten in Germany. These experts advise governments on what to do—for instance, which size of gatherings shall be prohibited (events of 1000, 100, or 3 persons), if and for how long economies shall be locked down, and if the wearing of masks shall become mandatory. And politicians follow the advice of the doctors. After all, they are the experts…
The central medical planning focuses only on measurable variables such as the infection rate. By not taking into account other ends (and not being able to do so), this planning exerts enormous harm from the point of view of voluntarily interacting individuals. In contrast to the central planning approach, which focuses on one end, all ends in human society are taken into account in the market economy through (expected) profits. Production is adjusted swiftly and efficiently toward the changing ends of consumers.
It is entrepreneurial profit seeking that unleashes human creativity and genius and thereby satisfies human needs as efficiently as humanly possible. The right answer to a war, and to the corona war as well, is therefore to eliminate all barriers to entrepreneurship. Mises said:
“For anyone of the opinion that the free economy is the superior form of economic activity, precisely the need created by the war had to be a new reason demanding that all obstacles standing in the way of free competition be set aside.”
In other words, in order to win the corona war, government should cut taxes and regulations vigorously. Unfortunately, governments around the world have opted for the opposite path, namely war socialism. If they do not quickly rectify their responses and end their war, the socialization of our economies will continue. Mises warns: “in the long run war and the preservation of the market economy are incompatible.”
The COVID-19 “Lockdowns” Are What Twenty-First Century Mob Rule Looks Like by Ryan McMaken
As of April 6, forty-one states have statewide “stay-at-home” decrees in place. These orders vary widely from place to place.
In some states, there are long lists of exempted industries including marijuana dispensaries, liquor stores, hardware stores, and of course, grocery stores. In some states with these edicts, public lands, state parks, and beaches remain open. In some states, city parks are more crowded than ever as local residents, with little else to do, attempt to recreate. In other places—such as California—one can be arrested for paddleboarding all alone in the ocean.
Yet in all of these places, the current regime of rule by decree will have—and already has had—a devastating effect on many small and medium-sized businesses and their employees. As governments have created new arbitrary definitions of what constitutes an “essential” business, some businesses find themselves forced to close. Employees have lost these jobs. The owners of these enterprises will likely lose far more as debts mount and business investments are destroyed. As unemployment and poverty increase, the usual pathologies will arise as well: suicides, child abuse, and stress-induced death.
Yet the politicians—mostly state governors, mayors, and unelected bureaucrats—remain popular. In New York State, where the lockdown orders are among the most draconian in the nation, it is now claimed that 87 percent of those polled approve of Governor Andrew Cuomo’s handling of the situation. As Donald Trump’s administration has recommended ever harsher government limits on the freedom of Americans, his poll numbers have only improved.
Meanwhile, among critics there appears to be a misconception of these lockdowns (which are very often only partially imposed or enforced) as being imposed over the howls of the local population, which is being silenced and cowed by jackbooted local police.
If only that were true. In most places, it appears clear that a great many residents approve of the lockdowns. We see this support in the form of all the local scolds who complain on nextdoor.com about neighborhood children who don’t properly engage in “social distancing.” We see it in the people who call the police to report violators of stay-at-home orders. We see it in those who report local businessesfor allowing too many people inside…
Thus, we’re not witnessing a usurper regime imposing unpopular measures on a resistant but helpless citizenry. We’re more likely witnessing widespread mob rule, the central characteristic of which is rule by the majority with no regard for the rights of dissenting minorities. The government may now be ruling by decree, but it is in many places doing so with the hearty approval of the majority. Politicians have calculated that they’re likely to remain popular so long as they cultivate an image of “decisive leadership“ through strong decrees and demands for compliance in the name of safety. As Cuomo’s surging popularity suggests, this may be a safe political move.
Certainly there are those who resist. There are those for whom the rule of law, the Bill of Rights, and basic freedoms actually matter. But for others, principles such as these are quickly forgotten once fear and anxiety enter the picture. The rights of minority groups (such as business owners or old-fashioned Bill of Rights enthusiasts) mean little or nothing once the majority—conditioned by years of public schooling to demand a government solution to nearly everything—decides that such rights are an inconvenient obstacle to “doing something.”
The public demands action. Politicians are more than happy to oblige.
Anthony Fauci, the “Learned Ignoramus“ by Zachary Yost
As the COVID-19 shutdown across the US continues, one cannot but help see the importance of specialization and the division of labor time and time again, as many Americans deal with true shortages of goods for the first time in their lives. Specialization has allowed us to enjoy a much more prosperous life than we would were we all to do everything ourselves. However, as with everything in this imperfect world, specialization comes with certain tradeoffs that are important to understand. As the unemployment numbers continue to rise by millions more every week, as meager savings are eliminated, and as our highly organized society slides into chaos it is important to understand the way in which an unbalanced intellectual specialization has contributed to bringing about the current crisis.
In his 1930 book The Revolt of the Masses, Spanish philosopher José Ortega y Gasset addresses what he considers to be a strange byproduct of the prevalence of specialization in everything, specifically the intellectual sphere. “Previously,” he writes, “men could be divided simply into the learned and the ignorant, those more or less the one, and those more or less the other.” Now, however, a new kind of person has emerged, “an extraordinarily strange kind of man” who cannot be called “learned for he is formally ignorant of all that does not enter into his specialty,” yet at the same time cannot be considered “ignorant because he is ’a scientist’ who ’knows’ very well his own tiny portion of the universe.“ Thus, Ortega y Gasset says that the only fitting name for such a person is a “learned ignoramus.”
There can be no doubt that numerous learned ignoramuses can be found in all parts of society, but most importantly they are very clearly involved in the response to the COVID-19 virus, as sweeping calls for months of lockdown make clear.
Dr. Anthony Fauci, director of the National Institute of Allergy and Infectious Diseases and seen by many as the face of the federal virus response, has perhaps made the most ridiculous assertion, stating at a White House briefing on April 1 that “we could ’relax social distancing’ once there’s ’no new cases, no deaths,’ but the real turning point won’t come until there’s a vaccine.” Similarly, Dr. Zeke Emanuel, an architect of Obamacare and current advisor to Joe Biden, declared that it will be impossible to return to “normalcy” for eighteen months and that no matter the economic cost: “The truth is we have no choice….We cannot return to normal until there’s a vaccine.”
Such ideas are frankly madness, and would take an incalculable toll on the health and wealth of all Americans. Tens of millions of Americans find themselves out of work or with reduced hours or pay. The idea that society could continue to exist in such a state betrays a lack of any understanding of the social order…
The phenomenon of the learned ignoramus can be seen in every field and at all levels of intellectual life and popular punditry. However, the current crisis reveals the damage such “experts“ can wreak upon civilization itself.
Ortega y Gasset fully recognized the important role that specialization has in making modern life possible; however, he calls for a balanced intellectual specialization, in contrast to the unbalanced status quo that he fears threatens the advancement of scientific discovery itself. Two such balanced intellectuals are without a doubt Ludwig von Mises and F.A. Hayek; although economists, they could be more accurately called social thinkers whose work encompassed far more than that of the typical economist today.
Rather than insular, unbalanced specialization, Mises argued that “He who wants to achieve anything in praxeology must be conversant with mathematics, physics, biology, history, and jurisprudence.” Hayek similarly warned that “Unless you really know your economics or whatever your special field is, you will be simply a fraud. But if you know only economics and nothing else, you will be a bane to mankind, good, perhaps, for writing articles for other economists to read, but for nothing else.”
Undoubtedly, the entire situation would look entirely different from the chaotic disruptive mess it is now if our public health officials and social scientists were trained in the mold of Mises and Hayek. Whereas both men stressed the complex and ultimately fragile nature of the social order, and therefore the need for broad understanding of this complexity, the learned ignoramus, in the words of Ortega y Gasset, “believes that civilization is there in just the same way as the earth’s crust and the forest primeval.”
Every time the “experts” demand that life be halted into the indeterminate future, they vindicate Ortega y Gasset’s observation that the learned ignoramuses are ignorant of the very nature of the social order itself and are therefore a menace to its preservation. This crisis demonstrates how prescient Ortega y Gasset’s warning was. Hopefully it is not too late to prevent a true societal catastrophe.
Airline Bailouts Destabilize the Economy and Inflate Asset Prices William L. Anderson
In the end, after all of the political posturing and all of the speeches and exhortations for Congress to “do something,” a $2 trillion “coronavirus stimulus” bill landed on the president’s desk for The Donald to sign. And sign he did, uttering all of the platitudes and everything else that comes with “historic” spending legislation that never should have seen the light of day. Although COVID-19 has helped expose vast weaknesses in public health systems in the USA, it also has shown that with much of corporate America, the emperor has no clothes.
Although tracking where the money goes is not an easy thing, we do know that the airlines will receive about $50 billion in cash and loans, while Boeing will receive a share of $17 billion earmarked for industries favored by Congress. Another $500 billion will go to cruise lines, hotels, and other firms that have lost business because of travel restrictions and the economic shutdowns.
Politicians of both parties heaped praise upon themselves for their “bipartisan” efforts, which in real life only can mean that Congress cleaned out what was left of the IOUs in the till. Rep. Thomas Massie, a Republican from Kentucky, drew attacks from all sides as he tried to force a roll call vote (as opposed to the voice vote that the members wanted) and announced his opposition to the bailout. President Trump called for his expulsion from the Republican Party while Democrats declared him to be an unsavory ideologue.
There is not much to do but to wait for the results, and they will unfold over time. However, much of this bill’s harm is invisible, the way that termites quietly but surely destroy a house when homeowners fail to detect them. The politicians and the pundits, along with corporate executives, are hailing this infusion of public funds to business as a lifeline to the economic system itself, when, in reality, it will weaken these firms in the long run.
This commentary deals mostly with the airlines, but what we say here applies to any firm receiving rescue funds and loan guarantees. While some of these essentially bankrupt firms gain some relief as taxpayers and consumers pony up to pay the companies’ bills, the temporary cash infusion allows them to kick the financial can down the road and not deal with the underlying problems that they are facing, at least for now…
Although most politicians and airline executives want us to believe that airlines are an “essential” industry that is the equivalent of the “thin blue line” between prosperity and a depressed economy, the markets see things differently. First, and most important, with the current situation there is no way that airlines can meet their loan payments, issue stock dividends, or even pay all of their employees at current rates (including their executives). Faced with that situation, the healthier companies would most likely come to terms with their creditors and restructure their finances.
The unlucky firms, however, would go into Chapter 7 bankruptcy, with all assets sold to pay off their creditors. That means massive layoffs, fewer flights—and realistic valuation of their assets. If the economic need for airlines really were as great as airline executives and political pundits claim, then whoever has purchased those assets at bargain prices would be able to put them to use in no time. The industry will have had its necessary cold-water bath, and asset values, along with prices of airline tickets, would settle at true market values, not the bloated numbers that pollute current airline balance sheets.
Because the “bad effects” of allowing airlines to go under would result at first in massive layoffs, bankruptcies, and fewer passengers in the air, the media and political classes would be condemning those who voted down the federal largess. “Bad effects,” not surprisingly, are quite visible and the plight of the newly unemployed and of stranded travelers plays well on the news.
The “good effects,” however, are less visible. By the time airline assets were sold at bankruptcy auctions and new companies hit the airport runways with market-priced capital and market-paid employees, the media would be on another crusade and the resurrection of airlines would not receive the coverage it deserved.
By shoveling out cash to the airlines and more promises to the banks whose unsteady solvency always lurks in the background, Congress and Trump have perpetrated a financial fraud greater than much of the mess we saw on Wall Street more than a decade ago. Yes, they will receive praise in the media and votes from those grateful to have taxpayers pay their wages and salaries, but they have solved no problems and have created a generation of new ones. Almost surely we will be covering the next crisis in these pages.
How to Think about the Fed Now by Jeff Deist
The Great Crash of 2020 was not caused by a virus. It was precipitated by the virus, and made worse by the crazed decisions of governments around the world to shut down business and travel. But it was caused by economic fragility. The supposed greatest economy in US history actually was a walking sick man, made comfortable with painkillers, and looking far better than he felt—yet ultimately fragile and infirm. The coronavirus pandemic simply exposed the underlying sickness of the US economy. If anything, the crash was overdue.
Too much debt, too much malinvestment, and too little honest pricing of assets and interest rates made America uniquely vulnerable to economic contagion. Most of this vulnerability can be laid at the feet of central bankers at the Federal Reserve, and we will pay a terrible price for it in the coming years. This is an uncomfortable truth, one that central bankers desperately hope to obscure while the media and public remain fixated on the virus.
But we should not let them get away with it, because (at least when it comes to legacy media) the Fed’s gross malfeasance is perhaps the biggest untold story of our lifetimes.
Symptoms of problems were readily apparent just last September during the commercial bank repo crisis. After more than a decade of quantitative easing, relentless interest rate cutting, and huge growth in “excess” reserves (more than $1.5 trillion) parked at the Fed, banks still did not have enough overnight liquidity? The repo market exposed how banks were capital constrained, not reserve constrained. So what exactly was the point of taking the Fed’s balance sheet from less than $1 trillion to over $4 trillion, anyway? Banks still needed money, after a decade of QE?…
So monetary “policy” as we know it is dead as a doornail. What central banks and Fed officials do no longer falls within the realm of economics or policy; in fact the Fed no longer operates as what we think of as a central bank. It is not a backstop or “banker’s bank,” as originally designed (in theory), nor is it a steward of economic stability pursuing its congressionally authorized dual mandate. It does not follow its own charter in the Federal Reserve Act (e.g., impermissibly buying corporate bonds). It does not operate based on economic theory or empirical data. It no longer pursues any identifiable public policy other than sheer political expediency. Fed governors do not follow “rules” or targets or models. They answer to no legislature or executive, except when cravenly collaborating with both to offload consequences onto future generations.
The Fed is, in effect, a lawless economic government unto itself. It serves as a bizarro-world ad hoc credit facility to the US financial sector, completely open ended, with no credit checks, no credit limits, no collateral requirements, no interest payments, and in some cases no repayments at all. It is the lender of first resort, a kind of reverse pawnshop which pays top dollar for rapidly declining assets. The Fed isnow the Infinite Bank. It is run by televangelists, not bankers, and operates on faith.
The Destructive Effects of the Coronavirus Relief Package by Thorsten Polleit
Governments and their central banks have put together mega-bailout packages. In the US, President Donald J. Trump has signed off on a $2 trillion “virus relief package” amounting to around 10 percent of the US gross domestic product. It is meant to provide massive financial support—in the form of loans, tax breaks, and direct payments—to large and small businesses as well as individuals whose revenue and income have been destroyed by the politically dictated “lockdown.”
What is more, the US Federal Reserve (the Fed) has provided a colossal “backstop” to financial markets. It injects ever higher amounts of central bank money into the financial system by buying up all sorts of credit instruments—not only government bonds, but also mortgage debt, corporate bonds, commercial papers, etc. The Fed thereby props up financial asset prices, keeping the cost of credit artificially low and, most importantly, avoids payment defaults on a grand scale.
In fact, the Fed is at the heart of all these rescue measures, for the US administration does not have the money to finance all its promises. The US Treasury will issue new bonds that will be bought by the Fed, which thereby creates new US dollar deposits in the hands of the US government. These are then transferred to the bank accounts of entrepreneurs, consumers, and most of all to government beneficiaries (its employees, service providers, and contractors). As a result, the newly created money shows up in people’s bank accounts, increasing the stock of money in the economy.
Beyond that, the Fed purchases credit instruments—bonds and bills (and perhaps even other assets at some stage). As it does business with banks, the Fed ramps up the central bank money supply to the interbank market: banks hand credit papers over to the Fed in exchange for newly created central bank money deposits. As a result, the “excess reserves” of banks increase and credit risk is taken off theirbalance sheets. Equity capital is freed up and can be used to increase lending to corporates, consumers, and, of course, government entities. This also contributes to the increase in the outstanding money stock.
If and when the Fed purchases credit products from, say, hedge funds, mutual funds, and insurance companies, the quantity of money will also be increased: these market players will hand unwanted credit products over to the Fed in exchange for deposits held with commercial banks. These new money balances can, and most likely will, be used to purchase other assets (e.g., stocks, land, commodities, etc.).
It becomes obvious that the mega-bailout package will effectively result in an increase in the quantity of money in the economy. Sound economics tells us what the consequences are: the increase in the quantity of money will result in higher goods prices, thereby lowering the purchasing power of money. In other words: the mega-bailout package boils down to “money printing”—to an inflationary policy. Again, sound economics tells us that inflation is a policy redistributing income and wealth among people: it does not create a win-win situation; it creates winners and losers…
Today, the policy of printing new money to hold up an economic and financial system that cannot last is being pursued again—as it has been in the past, on many occasions. The question is not whether money will lose its purchasing power. It is just a question of how much and how quickly. The best-case scenario is that the economic slump will be overcome quickly and, as a result, central banks will not have to monetize too much debt and issue too much newly created money.
But even then the underlying problem will not be solved; it will merely be postponed, because the government-controlled unbacked paper money system will predictably lead to ever greater amounts of debt on the part of entrepreneurs, consumers, and, most importantly, governments. At some point, debtors will no longer be in a position to service their debt. This is the point at which the unbacked paper moneysystem collapses altogether through payment defaults, or when governments begin to issue ever greater amounts of money in a last-ditch effort to fend off the inevitable. That said, economies that have become addicted to unbacked money will, at some point, be confronted with a “recession-depression” à la 1929 or a German hyperinflation à la 1923.
Meanwhile, however, governments and central banks’ mega-bailout programs may very well succeed in keeping the artificial boom going—that is, in transposing the approaching economic and financial bust into yet another boom, thereby preventing the system from collapsing. One thing, however, is certain: the official currencies—be it the greenback, the euro, Chinese renminbi, or the Japanese yen—will most likely lose their purchasing power. The truth is that they have never been a reliable means to store wealth—and never will be.
From the preface:
"End the Fed!" Three small words became one of the most improbable and powerful political chants in modern politics thanks to the presidential campaigns of Dr. Ron Paul. With the backdrop of a global financial crisis, the congressman from Texas was able to use the microphone of modern politics, forever changed by the internet and social media, to wake up a generation of Americans to the threat posed by central banks and fiat money. Ideological gatekeepers in Washington and the corporate press found themselves forced to recognize and attack a previously obscure school of economic thought that was now being talked about by college students, activists, and even the odd politician.
Of course, no such movements ever truly happen overnight. The seeds of the international Austrian revival were planted when Ludwig von Mises escaped World War II Europe and made a home for himself in America. With positions at New York University and the Foundation for Economic Education, Mises was able to develop a legion of followers in both academia and the public at large. Several students of his NYU seminar, such as Israel Kirzner, Hans Sennholz, and Ralph Raico, became important Austrian scholars in their own right. It was, however, Murray Rothbard who was perhaps Mises’s most significant mentee, with not only significant contributions to economics, history, and political philosophy, but popular writings aimed at energizing a grassroots Austro-libertarian movement far outside the restraints of the ivory tower.
Rothbard’s potent blend of serious scholarship and dynamic popularism became a model for the Mises Institute, which he helped found with Lew Rockwell in 1982. Since the beginning, the Institute has been both an incubator for new generations of Austrian scholars and a fount of education for the public at large.
Anyone who is familiar with the works of Mises, Rothbard, and the Austrian school understands how far removed they are from the progressive-dominated zeitgeist that has long controlled the most powerful microphones of the West. Although this carries with it the curse of limiting the influence that it could have with policymakers in government, it also means that it benefits from times when the public questions the very foundations of the institutions that it was indoctrinated to believe in.
2008 was such a time. Unfortunately, 2020 appears to be one as well.
The purpose of this collection is to highlight the important work of contemporary Austrian economists on the modern financial system. Although the mainstream financial press has been crediting American, European, and Chinese policymakers with upholding the global economy in the aftermath of 2008, Austrians have long been warning that these very same actions have only set the world up for a larger disaster. Promises in 2008 of the ease of normalizing monetary policy—such as by reducing balance sheets and phasing out market intervention—have been proven to be lies, just as Austrians warned.
While the government response to the coronavirus may serve as a catalyst for the next crisis, it is the irresponsible actions of central bankers, governments, and globalist institutions that will make the pain so much more intense. Worse still, the response will be led by individuals who are only versed in the same failed ideologies that brought us to where we are now.
The first section is a look back at major policy decisions that brought us to where we are now. One of the important aims of this collection is to highlight the truly global nature of these failings, not simply critiquing the actions of the Federal Reserve, but their colleagues at the European Central Bank, the Bank of Japan, and elsewhere. It is the coordinated attempt by central bankers around the world to try to bolster markets by hiding and mispricing underlying financial risk that has only served to escalate the fragility of the global economy.
This is followed by a look forward to what we might expect from policymakers as they are forced to respond. The combined fiscal and monetary response to the coronavirus and the government-imposed lockdown has highlighted the degree to which central bankers and modern governments feel completely unhampered by concerns about inflation or government debt. Every attempt will be made to prop up the financial bubbles they have created, and these actions will only compound the fundamental issues we face. Of course, as economic decision-makers become ever more drastic in their thought, we can expect them to resort more to using the full authoritarian powers of the modern state.
Lastly, the book looks at placing the ideas of the Austrian school within the context of the modern world. Although questions of underlying ideology may be dismissed by “practical” individuals who pride themselves on being “independent thinkers,” Mises understood the degree to which our intellectual environment directly guides policy and institutional frameworks. In the aftermath of the challenging times that may be ahead, the only way to build a stronger, more prosperous, and more stable future will be with an ideological revolution.
I hope that you will find this collection of articles enlightening, even if the ramifications of their content mean difficulty in the short term.
Central banks are at the heart of government mega–bailout packages. Their ongoing expansion of the money supply won't end well.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "The Destructive Effects of the Coronavirus Relief Package"
Wouldn’t you feel great knowing that your stock picking is fully insured by the Fed? Billionaires and wealthy hedge fund managers know the feeling.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Why Markets Are Rallying as Millions Become Unemployed"
The Fed is, in effect, a lawless economic government unto itself. It is the lender of first resort, a kind of reverse pawnshop that pays top dollar for rapidly declining assets. This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "How to Think About the Fed Now"
Our guest is economist Ryan McMaken, senior editor at the Mises Institute. He was the economist for the Colorado Division of Housing from 2009 to 2014. He is also the author of Commie Cowboys: The Bourgeoisie and the Nation-State in the Western Genre — a book that reveals his aptitude for analyzing economic events in their broader cultural context.
Additional Reading Thanks to Lockdowns, State and Local Tax revenues Are PlummetingThe Fed’s Balance Sheet Skyrockets As It Doubles Down on Inflating Asset PricesAnother Right Abolished by the Government’s COVID Lockdown: The Right to a Speedy TrialColorado County Says It Will Arrest All Tourists, Including Those Who Own Property ThereThe COVID Lockdowns Are What Twenty-First Century Mob Rule Looks Like
[This article is part of the Understanding Money Mechanics series, by Robert P. Murphy. The series will be published as a book in late 2020.]
The ultimate purpose of this booklet is to give the reader a solid grasp of how money works in today’s world. Yet before diving into the particulars of central banks, repo markets, and LIBOR—all topics that will be covered in future chapters—we should first provide a general framework giving the basic theory or “economic logic” of money and banking.
In short: why do we have money in the first place? Where does it come from, and what determines its form (livestock, metal ingots, coins, paper notes, electronic ledger entries, etc.)? What qualities make for a good money? What role do banks play—is it something other than what money itself does for us?
In this chapter, we’ll answer these elementary yet essential questions. To be clear, we are not here offering an actual history lesson, though we do mention some important historical episodes and illustrative examples. Rather we are providing a mental framework for understanding everything else that follows in the booklet.
The Limits of Direct Exchange To understand the importance of money, let’s first imagine a society without money. In a world limited to barter, or what economists more precisely call direct exchange, there would still be private property and people would still benefit from voluntary trade. Because economic value is subjective—the “utility” of a good is in the eye (or mind) of the beholder—we can have win-win exchanges, in which both parties walk away correctly believing that they got the better end of the deal.
However, if society were limited to direct exchange—in which individuals only accept items in trade that they plan on using personally—then people would miss out on many advantageous transactions. Let’s consider a simplistic example. Suppose there are three individuals: a farmer, a butcher, and a cobbler. The farmer starts out with some eggs that he’s just taken from his hens. He would like to trade his eggs in order to get his tattered shoes repaired. The problem, though, is that the cobbler doesn’t want any eggs—but he would be willing to repair the shoes for bacon.
Unfortunately, the farmer doesn’t currently have bacon. However, his neighbor the butcher does have bacon. Yet the butcher doesn’t want to trade with the cobbler, because the butcher’s shoes are just fine. What the butcher would really like are some eggs. Yet, the farmer himself doesn’t like the taste of bacon, and would rather eat his own eggs.
In a world limited to direct exchange, these men are at an impasse, because no single transaction would benefit any pair of them. Yet all of them could improve their situation with a rearrangement of the goods.
The solution is to introduce indirect exchange, in which at least one person accepts an item in trade that he doesn’t plan on using himself but holds merely to trade away again in the future. In our example, suppose that the farmer has an epiphany: Even though he personally dislikes its taste, he trades his eggs to the butcher to obtain the bacon. Then he takes the bacon to the cobbler, who accepts it as payment for fixing his tattered shoes.
[[{"fid":"87567","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"direct exchange diagram","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"1":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"direct exchange diagram","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"direct exchange diagram","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"1"}}]] After these two trades, all three individuals are better off than they were originally. Remember, though, that the solution relied on the farmer accepting an item in trade—in this case the bacon—that he didn’t plan on using himself. Economists call such a good a medium of exchange. Just as air is a “medium” through which sound waves travel, the bacon served as a medium through which the farmer’s ultimate exchange was effected—namely giving up his eggs in order to receive shoe-repair services.
Media of Exchange and the Origin of Money As our fable illustrated, individuals can often improve their position by trading away goods that are less marketable and accepting goods that are more marketable, even if they don’t personally plan on using the items. As the founder of the Austrian school, Carl Menger, demonstrated in an 1892 essayCarl Menger, “On the Origins of Money,” Economic Journal 2 (1892): 239–55, https://cdn.mises.org/On%20the%20Origins%20of%20Money_5.pdf. (though earlier economists had anticipated some of the explanation), this principle is all we need to explain the emergence of money.
As individuals in the community seek to trade away their less marketable (or less liquid) goods in exchange for more marketable (or more liquid) goods, a snowball process is set in motion: those goods that started out with a wide appeal based on their intrinsic qualities see a boost in their popularity simply because they are so popular. (For a more modern example, the prisoners in a World War II POW camp would gladly trade away their rations in exchange for cigarettes even if they were nonsmokers, because enough of the other prisoners were smokers.The classic article from a trained economist captured by the enemy in World War II is: R. A. Radford, “The Economic Organization of a P.O.W. Camp,” Economica 12, no. 48 (November 1945): 189–201, http://icm.clsbe.lisboa.ucp.pt/docentes/url/jcn/ie2/0POWCamp.pdf.) Eventually, one or two commodities become so popular that just about everyone in the community would be willing to accept them in trade. At that point, money has been born.
A formal definition for money is that it’s a universally accepted medium of exchange. Menger’s explanation showed how such a commodity could emerge from its peers merely through voluntary transactions and without any individual seeing the big picture or trying to “invent” money. (See the endnotes for recent anthropological criticism of Mengerian-type explanations of the origin of money.The most prominent modern critic of the standard “economistic” explanation for money is David Graeber, in his Debt: The First Five Thousand Years (Brooklyn, NY: Melville House Publishing, 2011). For a review of Graeber’s critique and a defense of the Mengerian approach, see Robert Murphy, “Origin of the Specie,” American Conservative, Apr. 11, 2012, https://www.theamericanconservative.com/articles/origin-of-the-specie/.)
The Qualities of a Good (Commodity) Money Money that emerged in the process we’ve described would necessarily be commodity money, in which the monetary good itself is also a regular commodity. (In chapter 3 we will discuss fiat money, in which the monetary good serves no other function than to be the money.) Historically, many types of commodities have served as money in various regions, including livestock, shells, tobacco, and of course the precious metals gold and silver.
What would make a community gravitate towards some commodities but not others? Besides having a wide marketability, an individual would want a medium of exchange to possess the following qualities: ease of transport, durability, divisibility, homogeneity, and convenient size and weight for the intended transactions.
In our fable above, although bacon served as the medium of exchange, it would be ill-suited to serve this purpose generally, as bacon is perishable. Likewise, a shotgun might be very valuable in certain communities, but it’s not divisible; you can’t cut it in half to “make change.” Diamonds might seem like a great candidate for a medium of exchange, but they aren’t homogeneous: one giant diamond is more valuable than five smaller diamonds that (combined) weigh the same amount.
These types of considerations help explain why eventually gold and silver emerged as the market’s commodity monies of choice. These precious metals satisfied all of the criteria of what makes a convenient medium of exchange, and once the community generally agreed, they were money.
Monetary Calculation The emergence of money meant that a single commodity was on one side of every transaction. This greatly reduced the calculations required to navigate the marketplace. For example, consider a merchant whose business required him to closely follow twenty different goods. In a world of pure barter—where each good traded directly against every other good—in principle he would have to keep track of 190 separate barter “prices”For n goods, there are n*(n–1)/2 unique barter price ratios. (meaning the ratios at which one good traded for another). But if one of those twenty goods also serves as the monetary good—maybe it’s silver—then the merchant only needs to keep track of nineteen different prices (all quoted in silver), because each of the other goods is always being bought and sold against silver.
Moving from a state of barter to a monetary economy allows for economic decisions to be appraised in terms of a standard unit. With the use of money, business owners can engage in accounting, where they can easily calculate whether they had a profitable year. Trying to compare revenues to expenses would be much more difficult in a pure barter system. A factory owner could know that her operation used up certain quantities of hundreds of input commodities (including labor hours), in order to produce certain quantities of dozens of outputs, but without being able to reckon these physically distinct commodities in terms of money prices, she would face the same type of problem plaguing socialist central planners.Ludwig von Mises is the economist whose 1920 essay launched what has become known as the “socialist calculation debate.” He stressed the crucial function of economic calculation in guiding entrepreneurs in a market economy, so that they could assess whether their operations were using scarce resources for socially beneficial purposes. For an accessible discussion see Murray Rothbard, “The End of Socialism and the Calculation Debate Revisited,” Review of Austrian Economics 5, no. 2 (1991): 51–76, https://cdn.mises.org/rae5_2_3_2.pdf.
The Function of Monetary Coins (and Tokens) We have seen how a commodity money can emerge spontaneously from a prior state of barter, facilitating exchanges and profit/loss calculations. However, even though a community benefits tremendously from the existence of money, there would still be limitations if the money remained in its “raw” form. It would hamper trade if shopkeepers had to perform metallurgical tests on hunks of metal that customers presented for payment to verify that the hunks were indeed silver (or gold, etc.) of the claimed weight.
The solution to this problem is to coin the raw hunks of metal into recognizable disks of a uniform size and purity (or “fineness”). We should emphasize that a full-bodied coin was not money because of the stamping process; the markings on the coin merely indicated to the community that the hunk of metal in question did indeed contain the specified weight in the underlying commodity that served as money.
In addition to striking full-bodied coins, another possible solution is for reputable outlets to issue token coins, which represent redemption claims on the issuer for a specified amount of the actual money commodity. Note that to perform their function well, even token coins would need to be recognizable in the community and difficult to counterfeit. For a modern example, consider the plastic chips issued by casinos: A Las Vegas casino needs to have chips that are distinctive and “authentic”-looking, and which can’t be easy for outsiders to replicate. Because such chips will be instantly redeemed by the casino, within its walls (and even perhaps in the surrounding neighborhood) they are “as good as money.” But a gambler who travels back home wouldn’t be able to buy groceries with chips issued from a Las Vegas casino.
Just as the money itself can arise without the intervention of political authorities, so too can the private sector handle the operations of turning the commodity money into coins. Indeed, numismatists agree that some of the highest-quality coins (and tokens) ever produced originated in eighteenth-century Britain from private mints.
The full story is too long to tell here,The details of Britain’s coin shortage and the private-mint response are taken from George Selgin, Good Money (Oakland, CA: Independent Institute, 2008), chapters 1 and 2. but the quick version is that the British Royal Mint had utterly failed to provide the common people with coins that could serve their needs for everyday commerce, and regulations prohibited banks from issuing notes in small denominations. As a result, employers resorted to various inconvenient remedies, including paying their workers in waves (so that, say, the first third of the employees would spend their new wages in town, after which the employers could then collect the coins in order to pay the second third of their workers, etc.) and making arrangements with the local tavern owners so that the workers’ beer tabs would effectively reduce the wages they were owed. The shortage of government-produced coinage was so severe that even obviously counterfeit coins were tolerated because bad money was better than no money at all.
In this intolerable situation, Thomas Williams, the principal owner of the giant Parys copper mine, hit upon the bright idea of installing a commercial-scale mint on the premises. He then struck (token) coins out of the copper with instructions on where they could be redeemed for money, and paid his workers—the ones actually mining the copper—with these token coins. Soon afterwards Matthew Boulton, famous for his collaboration with James Watt in the refinement of the modern steam engine, followed suit with the privately owned Soho Mint, where he was the first to implement a process of using steam power to mass-produce exquisite coinage. The following photos exhibit the remarkable craftsmanship of the privately struck coins and tokens from this era.The photos are gratefully used with permission from Bill McKivor, whose website (featuring these and other photos) is http://www.thecoppercorner.com/.
[[{"fid":"87568","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Peck 1075 Coin","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"A Penny from a Soho Mint 1797 pattern striking. Photo Credit: Bill McKivor, The Copper Corner.","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"2":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Peck 1075 Coin","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"A Penny from a Soho Mint 1797 pattern striking. Photo Credit: Bill McKivor, The Copper Corner.","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Peck 1075 Coin","class":"media-element file-image-no-caption","data-delta":"2"}}]] A Penny from a Soho Mint 1797 pattern striking. Photo Credit: Bill McKivor, The Copper Corner. [[{"fid":"87569","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Promissory Half Penny 1791","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"A 1791 token promising a half-penny to the bearer. Photo Credit: Bill McKivor, The Copper Corner.","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"3":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Promissory Half Penny 1791","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"A 1791 token promising a half-penny to the bearer. Photo Credit: Bill McKivor, The Copper Corner.","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Promissory Half Penny 1791","class":"media-element file-image-no-caption","data-delta":"3"}}]] A 1791 token promising a half-penny to the bearer. Photo Credit: Bill McKivor, The Copper Corner. The Function and Origin of Banks Even in a community with a commodity money stamped into high-quality coins, there would still be limitations on commerce. For example, wealthy individuals would be nervous about holding vast sums of gold or silver in their homes where they would be vulnerable to theft, and it would be inconvenient to transport large amounts of coin or bullion for every transaction involving a significant purchase price.
A bank solves these problems by providing a secure location where members of the community can store their excess supplies of money. (The other main function of banks is to serve as credit intermediaries, which act as a conduit between borrowers and savers.) The goldsmith was a logical person to also act as banker, because his business already involved storing stockpiles of gold. It was easy enough for members of the community to deposit coins with the goldsmith in exchange for an official receipt indicating how much of the money commodity they (the depositors) had stored with him.
[[{"fid":"87573","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"Exchange Gold for Promissory Note Diagram","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"7":{"format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"Exchange Gold for Promissory Note Diagram","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Exchange Gold for Promissory Note Diagram","style":"float: left;","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"7"}}]] The reason a booklet on the mechanics of money must also cover banking is that—to put it bluntly—banks enjoy the legal ability to create money. In chapter 5 we will explain this process in much greater detail, but for now let us quote the Chicago Federal Reserve on the historical origins (at least in England) of this practice:
[B]anks can build up deposits by increasing loans and investments so long as they keep enough currency on hand to redeem whatever amounts the holders of deposits want to convert into currency. This unique attribute of the banking business was discovered many centuries ago.
It started with goldsmiths. As early bankers, they initially provided safekeeping services, making a profit from vault storage fees for gold and coins deposited with them. People would redeem their “deposit receipts” whenever they needed gold or coins to purchase something, and physically take the gold or coins to the seller who, in turn, would deposit them for safekeeping, often with the same banker. Everyone soon found that it was a lot easier simply to use the deposit receipts directly as a means of payment. These receipts, which became known as notes, were acceptable as money since whoever held them could go to the banker and exchange them for metallic money.
Then, bankers discovered that they could make loans merely by giving their promises to pay, or bank notes, to borrowers. In this way, banks began to create money. More notes could be issued than the gold and coin on hand because only a portion of the notes outstanding would be presented for payment at any one time. Enough metallic money had to be kept on hand, of course, to redeem whatever volume of notes was presented for payment. [Emphasis added.]Dorothy M. Nichols, Modern Money Mechanics: A Workbook on Bank Reserves and Deposit Expansion, rev. Anne Marie L. Gonczy, rev. ed. (1961; Chicago: Federal Reserve Bank of Chicago, 1994), p. 3, available at: https://upload.wikimedia.org/wikipedia/commons/4/4a/Modern_Money_Mechanics.pdf.
Once the banker (such as the goldsmith) realized that his deposit receipts (“notes”) were treated by at least some members of the community as being “as good as money,” he could lend out some of the coins that his customers had deposited with him, even though the customers still held paper receipts entitling them to immediate redemption. The whole operation was viable so long as the banker always had enough coins on hand to satisfy whoever might show up to demand their deposits back.
[[{"fid":"87574","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"right","field_file_image_alt_text[und][0][value]":"Exchange Gold for Promissory Note Many Diagram","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"8":{"format":"image_no_caption","alignment":"right","field_file_image_alt_text[und][0][value]":"Exchange Gold for Promissory Note Many Diagram","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Exchange Gold for Promissory Note Many Diagram","class":"media-element file-image-no-caption media-wysiwyg-align-right","data-delta":"8"}}]] This booklet will focus on the mechanics and economic implications of the fact that banks have the legal ability to create money, but we’ll wrap up our historical sketch here with a note on the judicial treatment. If someone hands over an item for safekeeping in which the specific article is important—such as a college student placing her furniture in a storage unit for the summer, or a diner checking his coat when entering a restaurant—this is handled under bailment law. In such a situation, the person acting as a warehouser obtains physical possession but not legal ownership of the items in question, and is obligated to act as their custodian until the actual owner wishes to retrieve them. It would be a breach of contract for the manager of a storage facility to rent out the student’s couch, even if he had it safely back in her storage unit when she returned from summer break.
However, when the deposited items are fungible goods, such as wheat or oil, then the relationship is more nuanced. With such an “irregular deposit,” the depositor isn’t entitled to the specific physical items that were handed over for safekeeping, but instead merely expects to receive comparable items back. In the typical scenario, this is the type of deposit applicable to money; the people handing over coins to the goldsmith didn’t care about receiving back those particular coins, they merely wanted to be assured of obtaining the same number of comparable coins when they redeemed their deposit receipts (i.e., banknotes).
As a result of various court rulings, it is now standard to treat the deposit of money with a bank as a loan, so that the depositor becomes a creditor of the bank and the actual ownership of the money transfers to the banker, even for “demand deposits,” which are payable upon notice. Rightly or wrongly,For an elaborate case arguing against the practice of fractional reserve banking on both (traditional) legal and economic grounds, see Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, trans. Melinda A. Stroup, (1998; Auburn, AL: Ludwig von Mises Institute, 2006), available at https://cdn.mises.org/Money_Bank_Credit_and_Economic_Cycles_De%20Soto.pdf. For a defense of the development of the legal treatment of fractional reserve banking, see George Selgin, “Those Dishonest Goldsmiths,” SSRN Working Paper, Apr. 14, 2010, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1589709. it is this legal treatment that allowed the proverbial goldsmith to lend out some of the coins that his depositors had placed with him for safekeeping, and which allows modern banks to engage in “fractional reserve banking.” To reiterate, it is this practice by which banks can create (and destroy) money—a process that we will fully explain in chapter 5.
We will close this chapter with an excerpt from an opinion issued by Lord Cottenham in the 1848 case Foley v. Hill and Others:
The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted.Foley v. Hill and Others, 2 H.L.C. 28, 9 E.R. 1002 (1848), quoted in Murray N. Rothbard, The Case Against the Fed (1994; repr. Auburn, AL: Ludwig von Mises Institute, 2007), pp. 42–43, available at: https://cdn.mises.org/The%20Case%20Against%20the%20Fed_3.pdf.
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[This article is part of the Understanding Money Mechanics series, by Robert P. Murphy. The series will be published as a book in late 2020.]
This chapter will provide a brief sketch of the historical context in which the Federal Reserve was founded, summarize some of the major changes to the Fed’s institutional structure and mandate over the years, and end with a snapshot of the Fed’s current governing structure. (Chapters 2 and 3 of this book cover more of the historical context, while chapters 5 and 7 explain the mechanics of Federal Reserve operations in much greater detail.)
Historical Context After a bitter power struggle,For a fascinating account of Andrew Jackson’s battle against Nicholas Biddle, head of the Second Bank of the United States, from an Austrian perspective, see Dan Sanchez, “The 19th-Century Bernanke,” Mises Wire, Sept. 1, 2009, https://mises.org/library/19th-century-bernanke-0. For a conventional historical discussion, see: https://www.history.com/this-day-in-history/andrew-jackson-shuts-down-second-bank-of-the-u-s. President Andrew Jackson achieved his goal of “killing” the Second Bank of the United States when its charter expired in 1836. The year 1837 is considered the beginning of the so-called Free Banking era in the United States, because the federal government conferred no special privileges on individual banks, while some states — most notably New York — allowed relatively free entry into the banking industry.For two essays on the so-called Free Banking era in the United States written by Federal Reserve-affiliated economists, see Daniel Sanches, “The Free-Banking Era: A Lesson for Today?,” Federal Reserve Bank of Philadelphia Research Department, Economic Insights (Third Quarter 2016): 9–14, https://www.philadelphiafed.org/-/media/research-and-data/publications/economic-insights/2016/q3/eiq316_free_banking_era.pdf; and Gerald P. Dwyer, Jr., “Wildcat Banking, Banking Panics, and Free Banking in the United States,” Federal Reserve Bank of Atlanta, Economic Review (December 1996): 1–20, https://www.frbatlanta.org/-/media/documents/research/publications/economic-review/1996/vol81nos3-6_dwyer.pdf. These two essays in turn cite several works by the two most prominent members of the Austrian “free banker” camp, namely George Selgin and Lawrence White. (It’s important to note that “free banking” in this context merely means that no special charter was required to open a new bank; the label does not mean that banks were unregulated or even that they were treated the same way as other businesses.On this point, see Sanches 2016, p. 9.) The Free Banking era ended during the Civil War, after the National Bank Act of 1863 gave the federal government authority to charter national banks.
However, even the various rounds of National Bank Act legislation during the 1860s did not establish a single, central bank of the kind seen in Europe, the most obvious example being the Bank of England (established in 1694). Indeed, in January 1907, investment banker Paul Warburg — widely considered one of the intellectual architects of the Federal Reserve System — wrote:
It is a strange fact that, while in the development of all other commercial phenomena the United States has been foremost, the country should have progressed to so slight an extent in the form of its commercial paper. The United States is in fact at about the same point that had been reached by Europe at the time of the Medicis, and by Asia, in all likelihood, at the time of Hammurabi. Most of the paper taken by the American banks still consists of simple promissory notes, which rest only on the credit of the merchant who makes the notes, and which are kept until maturity by the bank or corporation that discounts them. …
In Europe … there are scores of banks … which give their three-months’ acceptance for the commercial requirements of trade, or which make it their specific business to indorse [sic] commercial bills. … This banker’s acceptance, or this indorsed paper, can be readily negotiated by the buyer at any time. … The holder will always be able to dispose of it, either through private discounting or, in case of need, by selling … to the Bank of England, the Banque de France, or the German Reichsbank [emphasis added].Paul Warburg, “Defects and Needs of Our Banking System,” New York Times, January 6, 1907, available (with subscription) at https://www.nytimes.com/1907/01/06/archives/defects-and-needs-of-our-banking-system-paul-warburg-of-kuhn-loeb.html.
As Warburg’s discussion indicates, the original justification for the creation of another central bank — one with more power than the Second Bank of the United States had had — did not allude to the modern goals of “full employment” and “price stability.” Rather, the pleas of the time called for an “elastic currency” that would expand or contract according to the “needs of trade.”
Some nine months after Warburg’s essay appeared, a failed bid by speculators triggered a run on depository institutions and eventually swelled into the Panic of 1907. Insolvent banks collapsed, while solvent yet illiquid banks had to go hat in hand to private lenders such as J. P. Morgan. The experience bolstered calls for the creation of a publicly run “lender of last resort,” and conventional histories cite this episode as pivotal in building support for the creation of a new central bank.For an example of the conventional treatment of the Panic of 1907 and its relation to the Federal Reserve, see Jon R. Moen and Ellis W. Tallman’s “The Panic of 1907,” Federal Reserve History, Dec. 4, 2015, https://www.federalreservehistory.org/essays/panic_of_1907. The essay was written for the Federal Reserve, and Tallman works at the Federal Reserve Bank of Cleveland. However, dissenting scholars argue that a group of powerful financial interests had been agitating for a US central bank for years — and Warburg’s essay indirectly confirms this.See, for example, the work of Murray N. Rothbard, The Origins of the Federal Reserve (Auburn, AL: Ludwig von Mises Institute, 2009), https://cdn.mises.org/The%20Origins%20of%20the%20Federal%20Reserve_2.pdf (excerpted from Rothbard’s A History of Money and Banking in the United States: the Colonial Era to World War II).
Much of the structure of what would become the Federal Reserve Act was laid out during secret meetings held at Jekyll Island (off the coast of Georgia) in November 1910. Present at the meetings were Senator Nelson Aldrich (and his secretary Arthur Shelton), Henry P. Davison (a J. P. Morgan partner), PresidentSome libertarian authors state that Vanderlip was vice president of the National City Bank. It’s true that when he originally joined the bank, Vanderlip held the position of vice president, but by the time of the Jekyll Island meeting, he had been elected president. See C. E. Booth, “Biography of Frank A. Vanderlip: A Brief Biography of Rockefeller protege [sic] Frank Vanderlip,” 1914, Modern History Project, accessed Jan. 1, 2020, https://modernhistoryproject.org/mhp?Article=VanderlipBio. Frank A. Vanderlip of the National City Bank of New York (now Citibank), Assistant Secretary of the Treasury A. Piatt Andrew, and Paul Warburg himself.Gary Richardson and Jessie Romero, Federal Reserve Bank of Richmond, “The Meeting at Jekyll Island,” Federal Reserve History, Dec. 4, 2015, https://www.federalreservehistory.org/essays/jekyll_island_conference.
These prominent figures from government and banking knew that they should keep a low profile, going so far as to book their travel to Jekyll Island under assumed names (so that the press wouldn’t begin wondering why such powerful men were meeting clandestinely). Such intrigue has understandably fueled an entire genre of commentary on the Fed. As journalist Roger Lowenstein put it during his Marketplace interview:
You gotta hand it to the conspiracy theorists, because, in fact, there was a conspiracy. … I call it a patriotic conspiracy, but there was a senator from Rhode Island, a guy named Nelson Aldrich. … [L]ate in his career, he decided we needed a central bank. So he organized — now I’m not making this up, it doesn’t come from Warner Bros. studio or anything — he organized a faux hunting trip to an island off the coast of Georgia [Jekyll Island] where there was an exclusive resort where J.P. Morgan was a member. [Morgan] made sure there was no one else in the club. And the senator, three bankers, the assistant secretary of the treasury — who, by the way, didn’t tell his boss — went down there for a week. They were plied with wild turkey, quail, stuffed oyster. They wrote what became the first draft of the Federal Reserve Act.Roger Lowenstein, quoted in Kai Ryssdal and Bridget Bodnar, “How a Secret Meeting on Jekyll Island Led to the Fed,” Marketplace, Oct. 20, 2015, https://www.marketplace.org/2015/10/20/how-secret-meeting-jekyll-island-led-fed/.
The Federal Reserve Act of 1913 On the Federal Reserve’s website, in its About section, the Fed describes its enabling legislation as follows: “The Federal Reserve Act of 1913 established the Federal Reserve System as the central bank of the United States to provide the nation with a safer, more flexible, and more stable monetary and financial system.”“Federal Reserve Act,” Board of Governors of the Federal Reserve, accessed Jan. 8, 2020, https://www.federalreserve.gov/aboutthefed/fract.htm.
The original Federal Reserve Act was signed into law by President Woodrow Wilson on at 6:02 PM on December 23, 1913. (The fact that such a significant piece of legislation was enacted the night before Christmas Eve helps fuel the suspicion surrounding the Fed that we mentioned.) The previous day, the House had approved the final bill by a vote of 298–60, with the Senate approving it on December 23 by a vote of 43–25.Voting record for Federal Reserve Act taken from “The Federal Reserve Act of 1913 – A Legislative History,” Law Librarians’ Society of Washington, D.C.,” last modified August 2009, https://web.archive.org/web/20100324115751/http://www.llsdc.org/FRA-LH/.
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SOURCE: Wikimedia Public Domain [[{"fid":"87173","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"Signing of the Federal Reserve","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"2":{"format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"Signing of the Federal Reserve","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Signing of the Federal Reserve","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"2"}}]]
Wilbur G. Kurtz Sr., Signing the Federal Reserve Act, 1923,Photo of painting courtesy of Woodrow Wilson Presidential Library & Museum, Staunton, Virginia. [[{"fid":"87174","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"The Sun","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"3":{"format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"The Sun","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"The Sun","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"3"}}]]
"New U.S. Banking System Announced," The Sun [New York], April 1914. As is typical, the enabling legislation didn’t specify all the operational details of the new American central bank. As Sandra Kollen Ghizoni of the Federal Reserve Bank of Atlanta explains:
The [Federal Reserve] Act established a Reserve Bank Organization Committee (RBOC) to select locations for Reserve Banks and draw district boundaries.
The RBOC comprised Secretary of the Treasury William G. McAdoo, Secretary of Agriculture David F. Houston, and Comptroller of the Currency John Skelton Williams. The RBOC was charged with designating between eight and twelve cities as Federal Reserve cities and apportioning the country into districts, each of which would contain one Reserve Bank city. Furthermore, the boundaries of each district had to take into account that region’s “convenience and customary course of business.” …
RBOC members spent six weeks traveling 10,000 miles to allow business leaders, bankers, chambers of commerce, clearing house associations, and other representatives to make a case for why a Federal Reserve Bank should be located in their city. Public hearings were held in eighteen cities. … The hearings generated more than 5,000 pages of testimony and covered a wide range of topics. …
Some cities were obvious choices, such as New York, Chicago, and St. Louis, which were designated central reserve cities under the National Banking Act of 1863 and subsequent legislation. Despite the RBOC’s efforts to clarify the criteria used to draw district lines and select Reserve Bank cities, several cities nevertheless sparked controversies over the eventual decisions. …
Of the thirty-seven cities that applied to have Reserve Banks, these twelve were selected: Boston (District 1), New York (District 2), Philadelphia (District 3), Cleveland (District 4), Richmond [VA] (District 5), Atlanta (District 6), Chicago (District 7), St. Louis (District 8), Minneapolis (District 9), Kansas City (District 10), Dallas (District 11), and San Francisco (District 12) [emphasis added].Sandra Kollen Ghizoni, Federal Reserve Bank of Atlanta, “Reserve Bank Organization Committee Announces Selection of Reserve Bank Cities and District Boundaries,” Federal Reserve History, Nov. 22, 2013, https://www.federalreservehistory.org/essays/reserve_bank_organization_committee.
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NOTE: The district boundaries do not necessarily line up with state boundaries.
It is important to understand that originally each of the twelve Reserve Banks exercised considerable autonomy: each Reserve Bank, under the leadership of its respective governor, set its own policies. In contrast to our day, there was no such thing as “the Fed’s” discount rate but instead the discount rate charged by, say, the Reserve Bank of St. Louis or of Dallas.The author (Murphy) encountered this dichotomy when writing his book on the Great Depression. In order to rebut the (now standard) allegation that the Fed’s “tight money” policy caused the economic calamity of the 1930s, Murphy wanted to contrast “the Fed’s” interest rate targets back in the early 1920s with those of the early 1930s. But in fact there was no such target, as the Federal Reserve Banks didn't have a unified policy until the 1935 legislation was enacted. (Incidentally, Murphy made his point using the New York Fed’s discount rates, which were at then record highs in 1920–21, and what were then record lows from 1929–31, making it difficult to reconcile the history of the Roaring ’20s and the Great Depression with standard claims of “tight money” after the stock market crash of 1929.) See Robert P. Murphy, The Politically Incorrect Guide to the Great Depression and the New Deal (Washington, DC: Regnery 2009), pp. 76–80. This would all change in 1935, as we will explain in the next section.
Major Amendments to the Federal Reserve Act Congress has amended the Federal Reserve Act several times since its inception. In this section we will describe two of the most significant episodes.
The Banking Act of 1935
Although sweeping legislation affecting the American banking system was passed in 1932 and 1933 — including the famous Banking Act of 1933 (commonly known as Glass-Steagall) — the most significant changes to the structure of the Federal Reserve System itself came in the Banking Act of 1935.
This new legislation strengthened the overall power of the Federal Reserve System and consolidated it in Washington, DC, away from the Fed’s own Reserve Banks. However, the Banking Act of 1935 also served to make the Fed more autonomous from the federal government. As Gary Richardson, the Fed’s official historian at the Reserve Bank of Richmond, explains in a coauthored essay,
The reorganization included cosmetic and consequential changes. … The leader of the Board of Governors (previously called the governor of the Federal Reserve Board) became the chairman [while] … [a]ll members of the Board (formerly just called members) received the title of governor.
The Board of Governors became increasingly independent from the executive branch of the federal government. The secretary of treasury, who had served as the chairman of the Federal Reserve Board, and the comptroller of the currency, who had served as a member of the Federal Reserve Board, ceased to serve with the Federal Reserve after 1936. The Federal Reserve moved its meetings from the Treasury Department to a new building constructed on Constitution Avenue and consolidated its staff at that location. …
In each Federal Reserve district, the chief executive officer, who had been labeled the governor, received the title of president. …
Changing the titles of the Federal Reserve’s leaders had symbolic and legal significance. Around the world, the final decision-maker in a central bank held the title of governor. … The Federal Reserve Act of 1913 labeled the chief executive officers at reserve banks as governors because the Fed’s founders viewed the system as a confederation of autonomous reserve banks, each operating independently under general oversight of the Federal Reserve Board in Washington, DC. Governors were active executive officers who directed the day-to-day operations of their organization.
The Banking Act of 1935 changed the titles of the System’s leaders to signify the centralization of authority at the Board of Governors and the reduction in the independence and stature of the twelve Federal Reserve District Banks. …
In this rewriting of the [Federal Reserve Act], the reserve banks lost certain legal powers and much policy independence. Originally, each bank directed open-market operations in its own district. Banks decided what securities to purchase at what price for their own accounts. …
The Banking Act of 1935 superseded [the previous interim] arrangement by creating the [Federal Open Market Committee’s] FOMC’s modern structure. … The FOMC directed open market operations for the system as a whole[,] implemented through the trading facilities at the Federal Reserve Bank of New York. Within this structure, the district banks participated in the creation of a coordinated, national monetary policy, rather than pursuing independent policies in their own districts.
Control of the most important tool of monetary policy, open market operations, was vested in the FOMC, where voting rules favored the Board of Governors. The Banking Act of 1935 [also] gave the Board of Governors control over other tools of monetary policy. The act authorized the Board to set reserve requirements and interest rates for deposits at member banks [endnotes removed, emphasis added].Gary Richardson, Alejandro Komai, and Michael Gou, “Banking Act of 1935,” Federal Reserve History, Nov. 22, 2013, https://www.federalreservehistory.org/essays/banking_act_of_1935.
And thus, through the 1935 legislation, the United States created a truly “modern” central bank patterned after the European model. Setting aside the question of the merits of this consolidation of power in Washington, it is safe to say that this version of the Federal Reserve would not have been approved politically back in late 1913. Indeed, the very term federal had been picked in order to assure Americans that this would be a relatively decentralized network of autonomous banks.
The Federal Reserve Reform Act of 1977
The other major reform we will discuss is the aptly titled Federal Reserve Reform Act of 1977. If the legislation of 1935 gave the Fed more autonomy from the federal government, the 1977 act arguably tightened the leash.
The biggest takeaway from the 1977 legislation is its explicit assignment of what is commonly referred to as the Fed’s “dual mandate.” As Joy Zhu of the Federal Reserve Bank of Philadelphia explains:
When the Federal Reserve was first established in 1913, Congress directed it only to “furnish an elastic currency, to afford means of rediscounting commercial paper” and “to establish a more effective supervision of banking in the United States.” In effect, the Federal Reserve’s central founding purpose was to provide a more flexible supply of currency and bank reserves in order to stem banking panics. The original act assumed continued adherence to the gold standard regime, which tended to keep inflation under control automatically over the long run. …
By the 1970s, the gold standard had been abandoned and the worsening inflation and unemployment experience called into question the conduct of monetary policy. The 1977 Reform Act amended the original act by explicitly directing the Federal Reserve to ”maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote the goals of maximum employment, stable prices, and moderate long-term interest rates.”
Although the Reform Act directs the Federal Reserve to pursue three policy goals, the Federal Reserve focuses on employment and prices [emphasis added].Joy Zhu, Federal Reserve Bank of Philadelphia, “Federal Reserve Reform Act of 1977,” Nov. 22, 2013, https://www.federalreservehistory.org/essays/fed_reform_act_of_1977.
Thus, Congress’s so-called dual mandate to the Fed is to promote maximum employment and stable prices. The debates over monetary policy among professional economists tend to focus on which policy tools and/or institutional frameworks are most conducive to achieving these two goals, which — according to those economists who subscribe to the “Phillips curve”The Phillips curve describes an alleged tradeoff between the rate of unemployment and price inflation. See Kevin D. Hoover, “Phillips Curve,” Library of Economics and Liberty (Econlib), Liberty Fund, Inc., accessed Jan. 8, 2020, https://www.econlib.org/library/Enc/PhillipsCurve.html. — are in tension, at least in the short run.
The Current Organization of the Federal Reserve System There are twelve Federal Reserve Banks, one for each district, each located in its respective city. The Board of Governors is located in Washington D.C.
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In terms of personnel, the Board of Governors consists of seven members, each of whom has the title of governor (hence the Board of Governors). Each governor on the Board is appointed for a fourteen-year term, after being nominated by the president of the United States and confirmed by the Senate. The president must also nominate, and the Senate confirm, two members of the Board of Governors to be the chairman and vice chairman. These are only four-year-term positions, however.See “About the Federal Reserve System,” and “Federal Reserve Board,” Structure of the Federal Reserve System, Board of Governors of the Federal Reserve, accessed Jan. 8, 2020, https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-system.htm and https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-board.htm.
As the name suggests, the seven-member Board of Governors is the overarching authority over Federal Reserve actions. However, the specific component of monetary policy known as “open market operations” (analyzed in detail in Chapter 5) is handled by the twelve-member Federal Open Market Committee (FOMC).
The seven members of the Board of Governors are always on the FOMC, and the remaining five members are presidents of the Reserve Banks: one is always the president of the New York bank, while the remaining four are drawn from the other eleven districts, serving one-year terms on a rotating basis.See “About the FOMC,” Federal Open Market Committee, Board of Governors of the Federal Reserve, accessed Jan. 8, 2020, https://www.federalreserve.gov/monetarypolicy/fomc.htm.
To conclude, the following diagram should help illustrate the relationships:
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The Understanding Money Mechanics series by Robert P. Murphy, is a comprehensive overview of the theory, history, and practice of money and banking, with a focus on the United States.
The full book is available at the Mises Store, and free on mises.org in html and pdf versions. Also available on Amazon.
[The table of contents below is from an earlier serialized version of the book]:
TABLE OF CONTENTS Chapter 1: Introduction
Lays out the scope and purpose of the booklet, and the schedule for release.
PART I: THEORY AND HISTORY
Chapter 2: The Theory and Brief History of Money and Banking
Covers Menger’s theory of the origin of money, and briefly mentions the anthropological critique (David Graeber). Explains the attributes of a desirable commodity money. Gives a standard history of the origin and development of modern banking, including some important court rulings. Mentions the history of private mints.
Chapter 3: A Brief History of the Gold Standard, with a Focus on the United States
Explains the US dollar’s tie to the precious metals over time, and some of the major controversies such as William Jennings Bryan’s “Cross of Gold” speech. Explains the operation of the classical gold standard and how it evolved during the World Wars, Bretton Woods, and, finally, the Nixon Shock.
Chapter 4: The History and Structure of the Federal Reserve System
Explains the unusual circumstances of the Fed’s origin, and mentions “conspiracy theory” treatments. Explains how power was consolidated in DC and away from Reserve Banks under FDR, and how the Fed’s mandate again altered in 1977. Concludes with an overview of the modern organization of the Fed, including the number of member banks, how the Federal Open Market Committee (FOMC) is selected, how the chairman is picked, etc.
PART II: THE MECHANICS
Chapter 5: Standard Open Market Operations: How the Fed and Commercial Banks “Create Money”
Explains the “textbook” mechanics of the Fed buying assets to create new reserves, and then how commercial banks create new loans on top. Defines the various monetary aggregates (base, M1, M2, “Austrian true money supply,” etc.).
Chapter 6: Beyond the Fed: “Shadow Banking” and the Global Market for Dollars
Defines the concept of shadow banking and gives a brief history, plus some stats for context. Defines things like “eurodollar,” LIBOR, etc. Explains the Bank of International Settlements (BIS) and the Basel Accords. Explain the basics of the repo market and the difference between capital requirements and reserve requirements.
Chapter 7: Central Banking since the 2008 Financial Crisis
Explains the “emergency” measures that the Fed adopted (Term Auction Facility, QE rounds, interest on reserves) and negative interest rates abroad. Mentions the moves to suppress cash (tied up with negative interest rates, at least rhetorically). Explains how Maiden Lane programs are arguably illegal.
Chapter 8: The Fed’s Policies since the 2020 Coronavirus Panic
Explains some of the major changes implemented in the wake of the pandemic, such as the abolition of reserve requirements, unprecedented asset purchases, and a redefinition of M1.
PART III: APPLICATIONS
Chapter 9: Ludwig von Mises’s "Circulation Credit" Theory of the Trade Cycle
Lays out the basics of Austrian boom-bust theory. Explains that Mises developed it in The Theory of Money and Credit, in which he also said that fiat money was a theoretical possibility (!); this means that Mises clearly didn’t think that boom-bust was restricted to fiat money regimes. Using Mises’s analogy of a master builder running out of bricks, illustrates the difference between “overinvestment” and “malinvestment” theories, and also why continued pump-priming a bad idea.
Chapter 10: Monetary Inflation and Price Inflation
Starts with Friedman’s measures of money stock and (consumer price) inflation, and summarizes cases of hyperinflation (Civil War, Weimar Republic, Zimbabwe, Venezuela). Documents change in how the word “inflation” is used, and explains how “currency boards” are used by some countries to limit the ravages of inflation. Explains the famous equation of exchange (MV = PQ) and why Mises and Rothbard didn’t like it.
Chapter 11: The Inverted Yield Curve and Recession
Documents this surprisingly good forecasting tool, and then shows that it fits quite nicely within the Austrian framework.
Chapter 12: The Fed and the Housing Bubble/Bust
Shows that the textbook Austrian story fits the empirical facts of the housing boom/bust.
PART IV: CHALLENGES
Chapter 13: Does Textbook Explanation Get Money and Banking Backwards?
Is the “textbook” description (covered in chapter 5 above) actually wrong? Deals with the (relatively) recent claims—coming not just from internet critics but also a major UK institution—that bank lending is not reserve constrained. Also addresses that idea that “lending creates deposits” rather than vice versa, as the orthodox economists claim.
Chapter 14: Crying Wolf on (Hyper)Inflation?
Explains that some (including the present author) made erroneous warnings about (consumer price) inflation when QE was first implemented, and asks whether this invalidates the textbook treatment. Is it true that QE was “just an asset swap” and “wasn’t money printing”?
Chapter 15: The Keynesians on the Cause of, and Cure for, Depression
Explains the Keynesian perspective. Contrasts Austrians and Keynesians on the Great Depression. Explains the “liquidity trap” and why Keynesians think Say’s law works in the special case of “full employment” but that we need a general theory of employment, etc.
Chapter 16: The “Market Monetarists” and NGDP Targeting
Gives a brief history of the historical battles between original monetarists and Keynesians (Friedman/Phelps on the Phillips curve, the Robert Lucas critique, and rational expectations framework). Then explains how people like Scott Sumner updated Friedman’s monetarism and now offer the goal of “level targeting” of stable NGDP growth, which some Austrians argue is similar to Hayek’s approach.
Chapter 17: Bitcoin and the Theory of Money
Applies the earlier theoretical framework to Bitcoin, to answer questions such as “Is it money?” Addresses the challenge that Bitcoin violates Mises’s regression theorem.
Chapter 18: An Austrian Reaction to Modern Monetary Theory (MMT)
Reprints Murphy’s 2020 QJAE review of Stephanie Kelton’s popular book explaining MMT, The Deficit Myth.
Dr. Bob Murphy joins the Human Action Podcast to discuss one of the most important issues of all: how money and credit work in today's society. Jeff Deist recently commissioned Murphy to write a series of articles on money mechanics (Mises.org/MoneyMechanics), an exceedingly important topic for critics of the Fed — and today's podcast serves as an introduction to the project. The articles will be compiled into an e-book, with plenty of graphics to simplify the basic process of money creation in a fractional reserve system. If you want to understand how the Fed works, how money and credit come into being, how interest rates arise, and what it all means for you, don't miss this great upcoming series at mises.org.
Additional Resources Jeff Deist on Understanding Fed Money Mechanics
Jeff Snider is Head of Global Research at Alhambra Investments. He talks with Bob about the recent spike in lending rates in the repo markets, and how the Fed’s attempted solution fails to address the real problem. He then relates the repo problem to the global monetary system, which has suffered from major imbalances going back to 2007 that have yet to be corrected.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Economist Nicolas Cachanosky specializes in the overlap between capital theory in traditional economics and the capitalization of cash flows in finance. He explains the relevance of these concepts to understanding the business cycle. Then, Nicolas and Bob have a friendly disagreement over Mises’ views on fractional reserve banking. The conversation closes with Nicolas’ view on central banking policy since the financial crisis of 2008.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Professor Murray Sabrin, author of the new book Why the Federal Reserve Sucks, joins HAPod to explain why ordinary people should care about — and oppose — the Fed. This is a comprehensive look at central bank mythmaking: how money creation benefits wealthy elites at our expense; what Keynesians, monetarists, and supply-siders get wrong; and, why we should understand the sordid history of money manipulation and tyranny.
Subscribe and listen to the Human Action Podcast on iTunes, YouTube, Stitcher, Soundcloud, Google Play, Spotify, or via RSS.
Europe and Asia are awash with $13 trillion in negative yield sovereign and corporate bonds. Alan Greenspan says negative interest rates are coming to America. And the Fed just announced another rate cut, even while Chair Jay Powell and Mr. Trump assure us the economy is better than ever. Economist Bob Murphy joins Jeff Deist to make sense of the nonsensical world of negative interest rates.
ABSTRACT: The extensive debate over fractional reserve free banking (FRFB) has spanned decades and includes volleys from many contributors. Consequently, relative newcomers to the controversy often wish to extend the conversation on several fronts. In this spirit, Bagus and Howden (2010) is a 27-page paper detailing numerous objections to FRFB, which they modestly entitled, “Fractional Reserve Free Banking: Some Quibbles.” The present paper continues in this tradition, elaborating on some of the key critiques of FRFB raised by others earlier in the debate. In particular, I critically explore two key claims of the FRFB camp: that holders of banknotes implicitly lend funds to the issuing bank, and that the historical periods of relatively free banking illustrate the stability of the system.
JEL Classification: B53, E32, E42, E58, G21 Robert P. Murphy (Robert.P.Murphy@ttu.edu) is a Research Assistant Professor with the Free Market Institute (FMI) at Texas Tech University.
I thank Vincent Geloso for references on early Canadian economic data. I also thank an anonymous referee for helpful suggestions on including more of the debate in my discussion.
Quarterly Journal of Austrian Economics 22, no. 1 (Spring 2019) full issue, click here.
I. INTRODUCTION The debate over fractional reserve banking predates the Austrian School. David Hume favorably cites the bank of Amsterdam (Hume 1987 [1742], II.III.4), while Adam Smith explains this famous case of 100 percent reserve banking in The Wealth of Nations.“The bank of Amsterdam professes to lend out no part of what is deposited with it, but, for every guilder for which it gives credit in its books, to keep in its repositories the value of a guilder either in money or bullion. That it keeps in its repositories all the money or bullion for which there are receipts in force, for which it is at all times liable to be called upon, and which, in reality, is continually going from it and returning to it again, cannot well be doubted…. At Amsterdam… no point of faith is better established than that for every guilder, circulated as bank money, there is a correspondent guilder in gold or silver to be found in the treasure of the bank” (Smith [1776] 1904, IV.3.27). In fairness to proponents of fractional reserve free banking, I concede that some later writers have described the bank of Amsterdam as a forerunner of modern central banks. The early 19th century British Currency School was so influential that it achieved a legislative insistence on 100 percent reserves in the issuance of banknotes (though not demand deposits) in the famous Peel’s Act of 1844. (Salerno 2012, p. 98)
Besides some economists in the Austrian tradition, the Chicago School is also known for a streak favoring 100 percent reserves (e.g. Fisher 1935), and in the wake of the financial crisis some prominent Real Business Cycle economists are reconsidering the proposal (Prescott and Wessel 2016). Yet the present paper falls squarely within the Austrian School, critiquing the practice of fractional reserve banking from the perspective of Mises-Hayek business cycle theory. Some representative works in this vein include Mises ([1912] 2009), Hayek ([1925] 1984), Rothbard ([1962] 2001), and Huerta de Soto (2006).
The foil for this paper’s perspective is the framework of “fractional reserve free banking” (FRFB) advanced for example in Selgin (1988), Selgin and White (1996), and Horwitz (2001). The free bankers endorse the Mises-Hayek theory of business cycles, but they deny that fractional reserve banking per se is the problem. Instead, the advocates of FRFB blame various types of government interference with money and banking.
As with Bagus and Howden (2010), the present paper joins this long-standing yet vigorous debate, seeking to address several of the key controversies. Although Bagus and Howden modestly label their contribution as a collection of “quibbles,” in fact their discussion of money demand and credit expansion highlights a devastating flaw in the FRFB position. In this paper, I elaborate on this problem,Selgin himself responded to Bagus and Howden (Selgin 2012), and then they responded in turn (Bagus and Howden 2011 and 2012). I will note in the text when these subsequent exchanges touched on the issues I want to revisit, but in my opinion their further discussion did not flesh out the points I make in this paper. showing that the FRFB claims are demonstrably incompatible with the Misesian approach to money and banking. Beyond that, I show that Selgin’s two highlighted examples of the best historical cases of FRFB (namely, Scotland and Canada) are, if anything, poster children for the Rothbardian warnings against fractional reserve banking.
In Section II, this paper establishes that Mises and Hayek both believed that fractional reserve banking per se is instrumental to the business cycle. Section III extends the Bagus-Howden approach to demonstrating the problem with the FRFB claim that fiduciary media need not disrupt the loan market. Section IV critically analyzes the historical examples of FRFB nominated by Selgin. Section V concludes.
II. MISES (AND HAYEK) THOUGHT FRB PER SE WAS DISRUPTIVE Setting aside the potential legal and conceptual problems with fractional reserve banking in order to focus on the economics, one of the key areas of dispute is whether FRB necessarily leads to an unsustainable boom as described first by Mises ([1912] 2009) and elaborated by his disciple Hayek (e.g. [1931] 1967). It is significant that both of these developers of what is sometimes called “the Mises-Hayek theory of the business cycle” thought that FRB was a central element of the story. To be sure, Mises and Hayek may have been mistaken, but it is worth documenting their position because in the debate over FRB, one often hears (especially in informal venues) casual claims that only dogmatic Rothbardians could find fault with fractional reserve banking per se.
We find an unambiguous statement of Mises’s position in Human Action. Mises defines “fiduciary media” as bank-issued claims to money, payable upon demand, that are not covered by base money in the vault, and then declares:
The notion of “normal” credit expansion is absurd. Issuance of additional fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle. Of course, if the additional amount issued is not large, neither are the inevitable effects of the expansion. (Mises [1949] 1998, 439, n. 17; bold added.)
Regarding Hayek, even the FRFB writers admit that his understanding of commercial bank behavior is inconsistent with their claims. For example, Larry White (1999, 761) writes that Hayek ([1925] 1984, 29) “suggested in one of his earliest writings a radical solution to the problem of swings in the volume of commercial bank credit: impose a 100 percent marginal reserve requirement on all bank liabilities….”
Mises too at some points in his career called for an explicit prohibition on additional issuance of fiduciary media,In the early 1950s Mises wrote an essay (included in later editions of his The Theory of Money and Credit [1912] 2009) titled, “The Return to Sound Money.” In the portion pertaining to the United States Mises explicitly says,No bank must be permitted to expand the total amount of its deposits subject to cheque or the balance of such deposits of any individual customer… otherwise than by receiving cash deposits in legal tender bank-notes from the public or by receiving a cheque payable by another domestic bank subject to the same limitations. This means a rigid 100 per cent reserve for all future deposits, i.e. all deposits not already in existence on the first day of reform. (448) though he also wrote (for example in Human Action) in favor of “free banking” as the best practical way to restrain the issuance of fiduciary media. (Salerno 2012, 96–97) Readers should therefore not misinterpret Mises’s praise for laissez-faire in banking as an endorsement of the modern “free banking” claim that fractional reserve banking, at least under certain conditions, promotes economic stability.
To appreciate the specific problem of fiduciary media in the eyes of Mises, it is very instructive to consider where he placed the business cycle discussion in Human Action. One might have classified the periodic boom-bust cycles plaguing market economies as a result of political intervention, which would mean placing the discussion (as Rothbard did in Man, Economy, and StateSpecifically, in his own treatise Rothbard ([1962] 2009) discusses the business cycle in Chapter 12, which is titled, “The Economics of Violent Intervention in the Market.” (The discussion of inflation and the business cycle is contained in section 11 of the chapter, starting on p. 989.)) in the same section of the book that handled minimum wage laws and taxation. Yet Mises rejects this plausible approach, and his explanation illuminates his broader views on fractional reserve banking:
It is beyond doubt that credit expansion is one of the primary issues of interventionism. Nevertheless the right place for the analysis of the problems involved is not in the theory of interventionism but in that of the pure market economy. For the problem we have to deal with is essentially the relation between the supply of money and the rate of interest, a problem of which the consequences of credit expansion are only a particular instance.
Everything that has been asserted with regard to credit expansion is equally valid with regard to the effects of any increase in the supply of money proper as far as this additional supply reaches the loan market at an early stage of its inflow into the market system. If the additional quantity of money increases the quantity of money offered for loans at a time when commodity prices and wage rates have not yet been completely adjusted to the change in the money relation, the effects are no different from those of a credit expansion. In analyzing the problem of credit expansion, catallactics completes the structure of the theory of money and of interest….
What differentiates credit expansion from an increase in the supply of money as it can appear in an economy employing only commodity money and no fiduciary media at all is conditioned by divergences in the quantity of the increase and in the temporal sequence of its effects on the various parts of the market. Even a rapid increase in the production of the precious metals can never have the range which credit expansion can attain. The gold standard was an efficacious check upon credit expansion, as it forced the banks not to exceed certain limits in their expansionist ventures. The gold standard’s own inflationary potentialities were kept within limits by the vicissitudes of gold mining. Moreover, only a part of the additional gold immediately increased the supply offered on the loan market. The greater part acted first upon commodity prices and wage rates and affected the loan market only at a later stage of the inflationary process. (Mises [1949] 1998, 571–72; bold added.)
The above excerpt from Mises is extraordinarily important in understanding what role he thought the commercial banks played in a typical boom-bust cycle. Yet to correctly parse it, we should first remind ourselves what Mises means precisely by the phrase “credit expansion” (since he is contrasting it with “an increase in the supply of money proper”). Earlier in the book, Mises does not yet explain the trade cycle but defines the terminology that he will later need. He explains:
The term credit expansion has often been misinterpreted. It is important to realize that commodity credit cannot be expanded. The only vehicle of credit expansion is circulation credit. But the granting of circulation credit does not always mean credit expansion. If the amount of fiduciary media previously issued has consummated all its effects upon the market, if prices, wage rates, and interest rates have been adjusted to the total supply of money proper plus fiduciary media (supply of money in the broader sense), granting of circulation credit without a further increase in the quantity of fiduciary media is no longer credit expansion. Credit expansion is present only if credit is granted by the issue of an additional amount of fiduciary media, not if banks lend anew fiduciary media paid back to them by the old debtors. (Mises [1949] 1998, 431; italics in original, bold added.)
Putting together all three of the block quotations from Human Action that we have provided above, we can summarize Mises’s position as follows: The unsustainable boom occurs when a newly created (or mined) quantity of money enters the loan market and distorts interest rates, before other prices in the economy have had time to adjust. In principle, this process could occur even in the case of commodity money with 100 percent reserve banking.
However, in practice Mises believes such a theoretical possibility can be safely neglected, because (a) the quantity of new gold (or other commodity money) entering the economy will likely be relatively small over any short period and (b) whatever the stock of new commodity money entering the economy as a whole, typically only a small fraction of it would be channeled into the loan market upfront.
Thus, even though in principle Mises’s theory of the boom-bust cycle is fundamentally about new quantities of money hitting the loan market early on, in practice the explanation revolves around newly-created fiduciary media being lent into the market. That is why Mises described his explanation as the “circulation credit theory of the trade cycle.” When we understand how Mises thought (in principle) newly mined gold could conceivably set in motion the boom-bust cycle, it becomes crystal clear that he thought any amount of newly-issued fiduciary media—i.e., a credit expansion—would do the same. (Remember, our earlier quotation shows Mises claiming that “[i]ssuance of additional fiduciary media, no matter what its quantity may be, always sets in motion” the processes that cause the unsustainable boom.) Thus there are no caveats or other conditions to consider, on this narrow question. Mises thought fractional reserve banking per se would set in motion the business cycle.
III. EXCHANGING MONEY PROPER FOR A MONEY SUBSTITUTE IS NOT LENDING FUNDS TO THE BANK In contrast to the view of Mises and Hayek, the modern free bankers deny that FRB per se causes a deviation of market and natural interest rates. In a free market with no central bank or government-provided deposit insurance, profit-maximizing commercial banks will—so the free bankers claim—only issue fiduciary media in the case when the public increases its demand to hold bank money, and this is precisely the scenario in which we should want them to do so. The free bankers argue that an insistence on 100 percent bank reserves in the face of a sudden increase in the public’s demand to hold bank-issued money will lead to a period of monetary disequilibrium (in the sense of Yeager 1997).
With this approach, the free bankers apparently turn the 100%-reserve critique on its head. Selgin and White (1996) argue:
We aspire to be consistent Wicksellians, and so regard both price inflation and deflation as regrettable processes insofar as they are brought about by arbitrary changes in the nominal quantity of money, or by uncompensated changes in its velocity, and not by changes in the real availability of final goods or the cost of production of money. It is therefore an attractive feature of free banking with fractional reserves that the nominal quantity of bank-issued money tends to adjust so as to offset changes in the velocity of money. Free banking thus works against short-run monetary disequilibrium and its business cycle consequences. (Selgin and White 1996, 101–02; italics in original.)
Selgin (1988) makes the point in greater detail. He first recognizes that the balance between money supply and demand is conceptually distinct from equality between the market and natural rates of interest, but he claims that under a regime of free banking the two will be synchronized:
As used here “monetary equilibrium” will mean the state of affairs that prevails when there is neither an excess demand for money nor an excess supply of it at the existing level of prices. When a change in the (nominal) supply of money is demand accommodating—that is, when it corrects what would otherwise be a short-run excess demand or excess supply—the change will be called “warranted” because it maintains monetary equilibrium.
This view of monetary equilibrium is appropriate so long as matters are considered from the perspective of the market for money balances. But it is also possible to define monetary equilibrium in terms of conditions in the market for bank credit or loanable funds. Though these two views of monetary equilibrium differ, they do not conflict. One defines equilibrium in terms of a stock, the other in terms of the flow from which the stock is derived. When a change in the demand for (inside) money warrants a change in its supply (in order to prevent excess demand or excess supply in the short run), the adjustment must occur by means of a change in the amount of funds lent by the banking system.
An important question, one particularly controversial among monetary economists in the middle of this century, arises at this point. Are adjustments in the supply of loanable funds, meant to preserve monetary equilibrium, also consistent with the equality of voluntary savings and investment? The answer is yes, they are. The aggregate demand to hold balances of inside money is a reflection of the public’s willingness to supply loanable funds through the banks whose liabilities are held. To hold inside money is to engage in voluntary saving.
As George Clayton notes, whoever elects to hold bank liabilities received in exchange for goods or services “is abstaining from the consumption of goods and services to which he is entitled. Such saving by holding money embraces not merely the hoarding of money for fairly long periods by particular individuals but also the collective effect of the holding of money for quite short periods by a succession of individuals.” (Selgin 1988, 54–55, bold added.)
Steve Horwitz echoes these sentiments, arguing that “demanding bank liabilities is an act of savings” (1996, 299, qtd. in Bagus and Howden 2010, 40). Horwitz explicitly combines the bank function of credit intermediary with fractional reserves when he writes:
Savers supply real loanable funds based on their endowments and intertemporal preferences. Banks serve as intermediaries to redirect savings to investors via money creation. Depositors give banks custody of their funds, and banks create loans based on these deposits. The creation (supply) of money corresponds to a supply of funds for investment use by firms. (Horwitz 1992, 135, qtd. in Bagus and Howden 2010, 39; bold added.)
More generally, the FRFB writers see nothing special about demand deposits, that would make them qualitatively different from other forms of credit instruments. The FRFB writers can ask rhetorically: If Rothbardians do not object to a man lending $1,000 to the bank by buying a 12-month CD, then why do they object to a man effectively lending $1,000 to the bank by keeping it in his checking account for a year? Yes, it is true that if the bank lends out some of the funds and then the man tries to withdraw his money, there could be a problem. But by the same token, there could be a problem if the bank lends out the $1,000 from the CD sale to fund a project that will not be repaid for (say) two years. According to the FRFB writers, all this shows is that commercial banks need to pay attention to maturity matching. It is not fraudulent and it does not cause the business cycle if banks sell (say) 12-month CDs and lend the funds out for 2-year projects (hoping to roll over the CDs when they mature).In the text above, I am paraphrasing a line of argument from the FRFB camp, which presupposes that the typical Rothbardian does not object to maturity mismatching per se. However, some Rothbardians do argue that maturity mismatching is the fundamental problem, of which fractional reserve banking on demand deposits is only the most prominent example. See Block and Barnett (2017) for such a claim, and see Bagus, Howden, and de Soto (2018) for a critical response, which contains citations to the volleys of the running debate. Of course, for those in the 100 percent reserve camp who agree with Block and Barnett, this particular line of argument from the FRFB would fall flat. So by the same token, there is nothing especially risky or distortionary if we look at one end of the spectrum, where savers lend their funds to the bank for a loan that matures in “zero” time even though the bank uses those funds to invest in longer maturity projects. According to the FRFB writers, that is one way to appreciate the benignity of demand deposits or checking accounts: consider them as buying CDs that mature instantly and that the saver continuously rolls over.
As we have seen, it is essential for the FRFB position that people adding “inside money” (i.e. bank-issued claims to money payable upon demand) to their cash balances are engaged in an act of saving and furthermore are lending their savings to the bank. There is much controversy on this point. Some critics of FRFB (e.g. Hoppe 1994, 72) have denied that the accumulation of cash balances is a form of saving. However, I agree with Hülsmann (1996, 34) that the accumulation of cash is a form of (gross) saving. What I deny is that this act of saving, if performed using the vehicle of a banknote or demand deposit, represents an implicit loan to the commercial bank. Thus my position is compatible with Selgin’s (2012) response to Bagus and Howden on money balances and saving (p. 139); savings can take the form of an accumulation of bank notes. But admitting this does not mean that accumulating bank notes is the same thing as lending funds to the bank that issued them. The following thought experiment will illustrate the distinction.
Imagine a young boy who receives a weekly allowance of $10 for his household chores. Each week his parents give the boy a crisp $10 bill, which he promptly stores under his mattress. After eight weeks, the boy buys an $80 video game. Does anyone want to deny that he “saved up for” the purchase? Both plain language and—I would argue—economic definitions must conclude that the boy consumed less than his income for the eight-week period, and engaged in saving. He invested in the accumulation of a very liquid financial asset, namely fiat money.
Things would not change if the boy (week after week) exchanged his fiat dollars for instantly demandable notes issued by a reputable bank. The accumulation of these banknotes would still represent saving and investment on the part of the boy. But they would not constitute a loan to the bank, any more than a man who checks his coat at a restaurant (and receives a claim-ticket) is lending his garment to the establishment. Even though a Martian observer might think the man was engaged in a credit transaction, our understanding of the true situation informs us that the coat-checking process is not a loan.
If our hypothetical boy converts actual money (“money in the narrower sense” in Mises’s terminology, or “outside money” in Selgin’s) into a banknote or demand deposit (“money in the broader sense” for Mises or “inside money” for Selgin), he has not altered his ability to command goods and services immediately in the market. Therefore there is no additional credit transaction, besides the accumulation of money per se. The boy’s saving translates into the “investment” of an accumulation of dollars in his cash balances. If he converts the fiat currency into banknotes, then his prior acts of saving “correspond to” the banknotes now in his possession. It was not his decision to convert the fiat dollars into banknotes that represents saving; that decision merely altered the form in which he holds his savings. There is no “excess saving” on the part of the boy that could accommodate the creation of additional banknotes that the commercial bank then lends out, with the boy’s $80 in fiat dollar deposits serving as the reserves.
Our analysis here exactly mirrors that of Mises. In The Theory of Money and Credit he begins a section titled “The Granting of Circulation Credit” in this way:
According to the prevailing opinion, a bank which grants a loan in its own notes plays the part of a credit negotiator between the borrowers and those in whose hands the notes happen to be at any time. Thus in the last resort bank credit is not granted by the banks but by the holders of the notes. (Mises [1912] 2009, 271)
Those familiar with Mises’s rhetorical style can guess that things do not bode well for the FRFB camp. After some historical references, Mises continues the above train of thought by declaring:
Now this view by no means describes the essence of the matter. A person who accepts and holds notes, grants no credit; he exchanges no present good for a future good. The immediately-convertible note of a solvent bank is employable everywhere as a fiduciary medium instead of money in commercial transactions, and nobody draws a distinction between the money and the notes which he holds as cash. The note is a present good just as much as the money. (Mises [1912] 2009, 272, bold added.)
Now to be sure, just because Ludwig von Mises rejected a particular view, does not suffice to demonstrate its error. Yet when it comes to arguments over FRFB within the camp of economists who all endorse the Mises-Hayek theory of business cycles, it is crucial to study Mises’s own view of fiduciary media and the connection to an unsustainable boom.
Contrary to the FRFB writers, Mises does not think that banknotes are simply a credit instrument with zero maturity. On the contrary, they are a form of quasi-money because of their special nature. Indeed a few pages earlier (p. 267) Mises explains that other types of claims are eventually redeemed; you cannot eat a claim on bread. And this is why a “person who has a thousand loaves of bread at his immediate disposal will not dare to issue more than a thousand tickets” entitling the holder to a loaf of bread. But things are different with instantly convertible claims to money, because these claims (so long as their redemption is not doubted) perform the services of money proper. That is why issuers of these claims can dare to create more tickets than they can redeem.
Early in The Theory of Money and Credit (pp. 50–54), Mises weighs the pros and cons of including fiduciary media in the category of “money” itself. After all, a perfectly secure and instantly redeemable claim to money is itself a commonly accepted medium of exchange. But Mises decides instead to use the term “money-substitute” since he thinks it necessary to distinguish between “money in the narrower sense” and “money in the broader sense” in order to explain his circulation credit theory of the trade cycle.
I have stressed these aspects of The Theory of Money and Credit—and earlier in the paper, I dwelled on the exposition in Human Action—to show that the thesis of Salerno (2012) has firm roots. It is true that Mises has kind things to say about free banking in Human Action, and his section on “The Case Against the Issue of Fiduciary Media” (pp. 322–25) in TMC is ambivalent. My modest point in this paper is that the entire Misesian framework of money and banking denies the alleged ability of fractional reserve banking to enhance equilibration in the loanable funds market.
However, in fairness Selgin could respondIt is awkward that Selgin had a chance to respond to Bagus and Howden on this point and chose not to; I am therefore reduced to suggesting what he could have said (but did not). Also, an anonymous referee disagrees with my attempt to speak on behalf of Selgin; the referee believes Bagus and Howden’s example works as is. In any event, my own thought experiment in the text above perhaps makes the point even more forcefully. that in this case, the commercial bank would not find it profitable to issue more notes than the ones that would be held by the man (who first deposited his gold coins). It is only when the community wants to increase its total money holdings broadly defined (at given prices), Selgin would argue, that the profit-maximizing fractional reserve banks would find it in their interest to issue new loans (or engage in credit expansion, in Mises’s terminology).
Bagus and Howden (2010, 43) proceed along similar lines as the present critique when they imagine an individual who originally holds some gold coins under his mattress, but then—perhaps because of crime—decides to deposit them with a bank in exchange for notes. Bagus and Howden argue that the individual’s newfound willingness to hold banknotes should not be a signal to the bank to issue more loans to the community, because there is no act of net saving here.
Yet we can tweak the thought experiment to shore up Bagus and Howden’s critique. Suppose we have a gold-using community that is at an initial monetary equilibrium (in Yeager’s 1997 sense) and a loanable funds market equilibrium where the market and natural interest rates coincide (in Wicksell’s [1898] 1962 sense). Now suppose every single person in the community becomes more fearful for the future, and desires to increase his or her real cash balances by 10 percent. Under 100 percent reserves, the only way this can happen is through additional mining and/or falling prices (quoted in gold). Yet with FRFB, this sluggish adjustment can be neatly sidestepped: Each individual goes to the bank and takes out a loan, in the form of newly printed banknotes (claims on gold), which he or she then adds to cash balances. The community achieves its desired increase in cash holdings without “wasting” real resources digging up more gold, and without the discoordination of disequilibrium sticky prices.
The only odd thing about this scenario is that when asked to explain how this maintenance of “monetary equilibrium” can avoid disrupting the loan market, Selgin et al. would have to say, “Each individual in the community lent himself the extra money he is now holding.”
IV. THE ALLEGED HISTORICAL SUCCESS OF FRFB Besides the theoretical arguments, the proponents of FRFB claim that history vindicates their position. For example, Selgin (2000) argues:
Episodes of systemwide bank failures and serious bank over- and underexpansion have been less common than is often supposed. The episodes that have occurred can generally be shown to have resulted not from any problem inherent in fractional reserve banking but from central bank misconduct or misguided government regulation or both…. Where fractional reserve banks have operated free of both significant legal restrictions and the disturbing influence of central banks, as in nineteenth-century Scotland, Canada, and Sweden (to name just a few cases that have been studied), serious banking and monetary crises have been rare or nonexistent. (Selgin 2000, 98; bold added.)
In blog posts, Selgin has held up Canada and Scotland as epitomizing the success of his vision of money and banking. For example in a 2018 post Selgin begins:
As all dedicated Alt-M readers know, I am a big fan of the Canadian banking and monetary system that flourished between Canada’s Confederation in 1867 and the outbreak of the First World War. Besides thinking it was a darn good system, I also regard it as the best example, together with Scottish banking during the first half of the 19th century, of a “free” (that is, largely unregulated) banking system. (Selgin 2018; bold added.)
In the above quotation, Selgin’s phrase “I am a big fan of the Canadian monetary and banking system” is hyperlinked to his earlier 2015 post praising the Canadian system, saying it was “famously sound and famously stable.” This claim is in turn linked to an endnote where Selgin informs the reader, “For a very good review of the features and performance of the Canadian system in its heyday, see” R.M. Breckenridge (1895), The Canadian Banking System: 1817–1890, which is a nearly 500-page book on the subject.
Thus we have Selgin himself singling out the two apparently best examples of his brand of FRFB in action: Scotland and Canada, during the appropriately defined years. And yet, as we will see, both examples hardly seem exemplary, and if anything confirm the warnings of the Austrian critics of fractional reserve banking.
Free to Refuse: Scotland During the Free Banking Period
We can quickly deal with the case of Scotland by quoting from Murray Rothbard’s (1988) review of Larry White’s (1984) book on free banking in Britain. Rothbard observes:
From the beginning, there is one embarrassing and evident fact that Professor White has to cope with: that “free” Scottish banks suspended specie payment when England did, in 1797, and, like England, maintained that suspension until 1821. Free banks are not supposed to be able to, or want to, suspend specie payment, thereby violating the property rights of their depositors and noteholders, while they themselves are permitted to continue in business… (Rothbard 1988, 230–31; bold added.)
The fact that the Scottish banks suspended specie redemption for more than two decades and were not forced to close their doors, proves that they were clearly not following the textbook exposition of a “free bank,” which is allowed to maintain fractional reserves but of course is still subject to standard legal rules concerning contract enforcement. As Rothbard goes on to note, the fact that Scottish specie reserves fell to “a range of less than 1 to 3 percent in the first half of the nineteenth century” hardly clinches the case for fractional reserve banking. It is not surprising that “free banks” in Scotland let their reserves dwindle so low, when they were “free” to turn their customers away who demanded specie redemption.
Don’t Blame Canada: Economic Volatility During the “Famously Stable” Era
As we established earlier, besides the celebrated case of Scotland, Selgin also held up Canada during the period 1867–1914 as the best example of FRFB in action, saying its banking system was “famously sound and famously stable.” In this subsection I will offer some evidence to the contrary, relying (in part) on Selgin’s own cited source.
First we can get a sense of Canadian stability by looking at a recent update (using a new method to calculate the GNP deflator) of estimates of GNP per capita. The following figure is taken from Hinton and Geloso (2018), contrasting the standard series by Urquhart (1993) with their slightly revised version:
Figure 1. GNP per capita using different deflators [[{"fid":"84064","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"GNP per capita using deflators","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"2":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"GNP per capita using deflators","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"GNP per capita using deflators","class":"media-element file-image-no-caption","data-delta":"2"}}]]
Note that the period covered in the figure (1870–1900) is a subset of the period Selgin identified. And yet, as the figure indicates, the Canadian economy exhibited nothing like smooth steady growth. Depending on which deflator we choose, per capita GNP had a sharp or modest boom-bust cycle from 1872–78, at which point it soared, rising some 30 percent in a mere four years (1880–84). Then in a single year (from 1884–85), real per capita output fell a little more than 6 percent. (To get some perspective, during the Great Recession—which of course is the worst economic calamity to hit the world since the Great Depression—the biggest year/year drop in U.S. real GDP per capita was 4.9 percent, which occurred in the second quarter of 2009.Data for U.S. real GDP per capita available at: https://fred.stlouisfed.org/series/A939RX0Q048SBEA#0.)
After the trough in 1886, there was another expansion through 1891, followed by another multiyear contraction. Then from 1896–1900 we see the beginnings of yet another massive boom, with real output per capita again rising about 30 percent in four years.
Now in fairness to Selgin, 19th century economic data are notoriously prone to exaggerate the volatility in real output during business cycles, because of imperfect adjustment of the relevant price deflators. (This is why I used a chart taken from a very recent paper, which itself quibbled with the standard reference in the literature.) Yet even if Selgin and other FRFB advocates want to claim that the wild swings in Canadian output were mostly nominal, that still contradicts their claim of stability. Under the classical gold standard, nominal prices rose during booms and crashed during busts, but that was (at least partly) due to fractional reserve banking, where the bankers fed the boom by inflating through credit expansion and then starved the bust by deflating through credit contraction. The figure above—whether we take it at face value or even if we generously suppose it is partially mistaking nominal swings for real ones—is exactly what Murray Rothbard would suppose a FRFB economy would look like. It is not how the FRFB writers describe their vision.
Ironically, even if we turn to the very source Selgin cited—namely, R.M. Breckenridge’s (1895) large book on the Canadian economy—we find decent support for the claim that FRFB fosters the standard Mises-Hayek business cycle.
For example, in the Table of Contents, this is how Breckenridge lays out the topics in Chapter VIII:
Figure 2. Excerpt from Table of Contents of Breckenridge (1895) [[{"fid":"84063","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Banking under the Confederation 1867 to 89","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"1":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Banking under the Confederation 1867 to 89","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Banking under the Confederation 1867 to 89","class":"media-element file-image-no-caption","data-delta":"1"}}]]
Notice that the material in Chapter VIII covers the Canadian banking system for the first 22 years after Confederation—all of this falls under the period that Selgin singled out as epitomizing a sound, stable, fractional reserve free banking system in operation.
Now surely one does not have to be a fuddy duddy Rothbardian to say that the subject headings for Chapter VIII are inauspicious at best for the FRFB camp. We see a six-year “expansion” followed by a five-year “depression,” and a section devoted to the bank losses during the depression. The 100 percent reservists can now add Selgin’s recommended text as further evidence that FRFB fosters the Mises-Hayek boom-bust cycle.
Now to be fair to Selgin, Breckenridge is a fan of the Canadian banking system that he is describing. For example, here is how Breckenridge concludes his discussion of bank failures through 1889:
Here ends, for the present, the account of bank failures in Canada. If any conclusion may be drawn from the study, it is that the disasters have been due to faults of practice, rather than defects in the system. It is clear that legislation, scientifically framed, has not prevented poor management, bad management, or fraud. No one, probably, ever expected it would. It is clear also that it has not saved shareholders from loss. A careful estimate shows that, by reductions of capital, liquidations, failures, and contributions on the double liability, shareholders have sunk at least $23,000,000 in Canadian banking since the first of July, 1867. This sum, more than 37 per cent. of the present paid-up banking capital, is independent of the losses provided for out of profits, or met by reduction of rests [sic]. The security of a group of banks, however, must be judged, not by the losses of their proprietors, but by those of their creditors. We may see now how well the Canadian system has minimized the creditors’ risks. Out of 56 chartered banks, some time in operation in Canada since the first of July, 1867, just 38 survive. Ten of those gone before have failed. But the total loss of principal inflicted during twenty-seven years on noteholder, depositor, government, or creditor whomsoever, has not exceeded $2,000,000, or less than one per cent. of the total liabilities of Canadian banks on the 30th day of last June. (Breckenridge 1895, 314; bold added.)
And so we can see the sense in which Selgin could think the Canadian free banking system was vindicated. After all, the restaurants on a busy downtown strip (say) might be characterized by a high turnover, yet so long as entrepreneurs enter the field with eyes wide open, this could be a healthy example of cutthroat competition and Schumpeterian innovation. A high percentage of restaurant failures in a certain area would not necessarily prove that the market was failing consumers.
However, there are serious problems with such an attempt to rehabilitate the Canadian experience. First of all, in our hypothetical restaurant analogy, we surely would not say, “The disasters have been the fault of the restaurants’ management, not the system.” When you have to use the word “disaster”—as Selgin’s own preferred authority on the Canadian experience did—it is hard to maintain the claimed badges of stability and soundness.
Furthermore, Selgin is moving the goalposts if he thinks loss of customer deposits is the criterion for a desirable banking system. The claim—from Mises and Hayek through Rothbard up to writers such as Salerno in the present day—has always been that credit expansion sets in motion an unsustainable boom. Breckenridge’s historical account confirms that claim beautifully. To put the matter another way: By Selgin’s criterion, we could just as well “prove” that the United States banking system from 2000–10 was perfectly stable and sound. After all, no bank customers lost any deposits in standard checking accounts, and there were no banking panics of the kind witnessed during the 1930s.
As a final note, Breckenridge’s figure of a mere $2,000,000 in creditor losses is misleading. As Breckenridge explains earlier in the book, troubled banks had suspended note redemption, and in the consolidation process some depositors had to sell their notes at a loss, even though those notes would eventually be redeemed at par. This affected the public’s mood—imagine that!—when the bank charters came up for renewal:
The expiry of all bank charters had been set for the 1st of July, 1881. In accord with the policy adopted a decade before, Ministry and Parliament took up… the question of what changes to make in the system at the time of the first decennial renewal of charters.
They were anticipated both by the public and the banks. Among the people, much dissatisfaction had been caused by the bank suspensions of the preceding year. The notes of only one of the failed banks were finally redeemed at less than their nominal value, but at that time liquidation in several cases was still incomplete. To change the notes of failed banks into convertible paper, the holder had to submit to a discount, and the brokers who took the risk exacted ample pay for it. Many of those holding notes at the times of suspension had only the option between this loss and physical want. They were forced to realize at the time when the credit of their debtors was at the lowest ebb. They could not even wait until the fears of the first week were quieted, much less till the day of final payment….
The bankers understood the popular discontent with the security of the currency. They saw their own interest, and the country’s interest, no doubt, in calming it. For them, their privilege of circulation provided an easy, convenient, and useful means of profit; to the country, it gave an elastic currency, increased sources of discount, and through the system of branches promoted by it, widespread and accessible banking faciliites. (Breckenridge 1895, 289–90; bold added.)
Whatever one might say about the block quotation above, it hardly sounds like a description of a smoothly operating free market, bereft of political favoritism, and where customer satisfaction is Job #1. On the contrary, it sounds exactly like the negative picture painted by a Rothbardian critic of fractional reserve banking.
Our brief sketches of Scotland and Canada have shown that the two examples held up by Selgin were plagued by decades-long specie suspension on the one hand, and depression coupled with bank failures on the other. It leads the critic of FRFB to doubt the accuracy of Selgin’s assurances that all major problems with banking in history were the fault of anything but fiduciary media.
V. CONCLUSION The intra-Austrian debate over fractional reserve banking is long and contentious. In the present paper, I have focused on the specific issue of whether fiduciary media per se set in motion the boom-bust cycle. I have shown that even the very definitions Mises chose in his monetary theory underscore this elemental fact. Furthermore, the FRFB attempts to reconcile credit expansion with loan market equilibrium fall apart when subjected to simple thought experiments. Finally, I have shown that Selgin’s two favorite examples of the alleged stability of FRFB—Scotland and Canada—are in fact textbook illustrations of the dangers of fractional reserve banking.
Bitcoin is a shot across the bow at government’s monopoly control of money. While no one in the US appreciates the direction money is going, others are waking up.
Original Article: "Bitcoin, Gold, and the Battle for Sound Money".
Jeff Deist joins David Gornoski to discuss the impending train-wreck of runaway government spending, and why the average person doesn't feel the effects of huge foreign-policy expenditures by government. They also talk about the influence of media outlets during catastrophic events such as the recent terrorist attack in Sri Lanka.
David Gornoski's A Neighbor's Choice Radio airs live Monday 7–9pm and Tuesday–Thursday 8–9pm ET on NewsRadio WFLA in Orlando, 93.1 FM and 540 AM
It will be interesting to see how Trump critics handle Mr. Cain. He has the one quality Elizabeth Warren and other Democrats have chosen to focus on when it comes to a Federal Reserve nominee: he isn’t a white guy.
Original Article: "Will Democrats Rally Behind a Herman Cain Fed Nomination?".
Pundits are hoping that instead of a crisis, we just get a "global economic slowdown." Given the damage done by central banks, a sustained slowdown would be a best-case scenario.
Original Article: "It's Not a Recession, It's a 'Global Economic Slowdown'".
Our great friend Daniel Lacalle, author of Escape from the Central Bank Trap, joins the show to discuss the perilous condition facing central banks after a decade of their own malfeasance.
Daniel and Jeff discuss absurd reactions to the Fed's tiny interest rate hikes, the fragility of central bank policy in the face of enormous sovereign, corporate, and household debt, why expansionary monetary policy always hurts poor people, and what the Fed and ECB might do– realistically– under current conditions. This is a must-listen interview with one of the best and most visible central bank critics.
Bob explains what he means when he tells crowds, "Back in the fall of 2008, as the financial crisis hit, the Fed began paying backs to not make loans to their customers." Specifically, Bob explains the new Fed procedure of "paying interest on reserve balances." As of the Fed's December 2018 meeting, the Fed now pays the banks $40.8 billion on an annual basis—to not make loans to their customers.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Former Dallas Fed official Danielle DiMartino Booth joins the show just as Chairman Jay Powell faces his first major challenge: will he keep raising rates as promised now that autos, housing, employment, and even tech stocks look soft? And if not, will he effectively signal that the US economy is in big trouble?
DiMartino Booth and Jeff Deist discuss Powell's performance to date, the credulity of the financial press, the ugly ticking time bomb of US corporate debt, and whether Austrians and permabears overestimate the Fed's influence on the economy.
What's the biggest and most dangerous financial bubble? Sovereign debt issued by profligate governments. And unlike stocks or corporate debt, government bond bubbles harm millions of ordinary people when they burst.
Economist Daniel Lacalle joins Jeff Deist to figure out the bizarro world of the bond bubble: negative interest rates, anemic rate spreads between government bonds and "high yield" bonds, and central banks as the unseemly buyers of last resort. They discuss the Fed's interest rate hikes, Jerome Powell's focus on data, the US housing market, and why all of us have a stake in seeing central bank balance sheets shrink.
Related article: Daniel Lacalle on the Bond Bubble
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years." This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 2: "And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
From Section 1: "The Skyscraper Curse". This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
Mark Thornton's definitive work on booms and busts. His now-infamous Skyscraper Index theory draws the connection between loose monetary policy, artificially low interest rates, and vanity construction projects.
This audiobook is made available through the generosity of Mr. Tyler Folger. Narrated by Graham Wright.
Download the complete audiobook (27 MP3 files) here. This audiobook is also available on Soundcloud, Apple Podcasts, Google Podcasts, and via RSS.
Even many libertarians dismiss gold and precious metals as irrelevant in the global monetary system. Ben Bernanke famously told Ron Paul that gold is a commodity, not money. So why do central banks still hold so much of it, Ron asked? Good question.
Ronni Stöferle from Incrementum AG joins Jeff Deist to talk about everything related to gold: why it's still money, how it might react to rising interest rates, why the IMF still worries about it, and why so much of it seems to be flowing from West to East. You won't want to miss his analysis of why gold and precious metals are complementary assets with respect to cryptocurrencies, and his call for both camps to join forces and promote Hayek's goal of denationalizing money.
Related: Ron Paul on the Dollar Dilemma.
The Skyscraper Index expresses the strange relationship between the building of the world’s tallest skyscraper and the onset of a major economic crisis. This relationship only came to light in 1999 when research analyst Andrew Lawrence published a report noting the odd connection between record-height buildings and noteworthy economic crises — that is, the skyscraper curse, a relationship that dated back nearly a century. Without a theory to support it, journalists largely dismissed Lawrence’s report as the fun story of the day.
However, from the vantage point of Austrian business cycle theory, or ABCT, Lawrence’s report was important for understanding the business cycle: booms and busts. ABCT is the business cycle theory developed by the economists of the Austrian school during the early twentieth century.
In the 1860s, Austrian financial journalist Carl Menger (1840–1921) began to ponder economic activity that he was reporting on in light of the economics of the classical school — that is, Adam Smith (1723–90), David Ricardo (1772–1823), John Stuart Mill (1806–73), and so on. He found huge gaps in the explanation of many basic concepts, such as supply and demand. To close those gaps he developed some fundamental elements of modern economics, such as marginal analysis and the rudiments of opportunity cost, marginal utility, and subjective value.
His students at the University of Vienna learned from him and built on his insights. For example, Eugen von Böhm-Bawerk (1851–1914), who served as finance minister of the Austro-Hungarian Empire, built on Menger’s work to show that production can be less or more time consuming, or roundabout. From this perspective, we can see that laborers get paid very quickly, while capitalists are paid interest for delaying their rewards until the product is actually sold. Böhm-Bawerk showed that interest was based on the time preferences of workers and capitalists, savers and borrowers. The interest rate is a critical economic factor because it helps determine the size and complexity of an economy’s capital structure. The capital structure is simply the non-natural world around us: all the business assets related to mines, farms, factories, utilities, transportation, warehouses, wholesale and retail businesses, and so on. Austrian economics has been described by Peter Klein as mundane economics.Peter G. Klein, “The Mundane Economics of the Austrian School,” Quarterly Journal of Austrian Economics 11, nos. 3–4 (2008): 165–87.
For example, a market economy populated with individuals with low time preferences and interest rates would, over a long period, be characterized by a large accumulation of savings that is turned into large amounts of “brick and mortar” capital and advanced-technology production processes. The division of labor would be highly specialized. People would be wealthy and have a high standard of living.
Ludwig von Mises (1881–1973) was a student of Böhm-Bawerk who extended Austrian analysis into the area of money, solving the classical school’s problem of how to connect the workings of the real economy with monetary economics. He accomplished this with his regression theorem, which was based in part on Menger’s explanation for the origin of money. Mises also formulated a theory of the business cycle based on the interaction of the interest rate and capital allocation. His approach is based on distortions of the market rate of interest. His student, Friedrich August von Hayek (1899–1992), further elaborated and extended Mises’s theory, a contribution for which he was awarded the Nobel Prize for economics in 1974. Their theory is now known as Austrian business cycle theory. (See Roger Garrison for a technical explanation of Austrian macroeconomics.Roger W. Garrison, “The Austrian School: Capital-Based Macroeconomics,” in Modern Macroeconomics: Its Origins, Development and Current State, edited by Brian Snowden and Howard R. Vane (Aldershot: Edward Elgar, 2005).)
Inspired by ABCT, my reflections about skyscrapers eventually resulted in an academic working paper, “Skyscrapers and Business Cycles.” The manuscript was summarily rejected by several mainstream economic journals. The replies from the journal editors would often include a short or cryptic explanation such as “This paper does not have a testable hypothesis.” The articleMark Thornton, “Skyscrapers and Business Cycles,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 51–74. was eventually published in the Quarterly Journal of Austrian Economics in 2005. It uses ABCT to explain how record-breaking skyscrapers are linked to business cycles and economic crises. In particular I drew on the economic theories of Richard Cantillon (1680s–1734?), the first economic theorist and a proto-Austrian economist, in order to establish causal links between skyscrapers and business cycles.
Cantillon showed how the interest rate and the money supply can create changes and distortions in the economy, a phenomenon now referred to as Cantillon effects. The paper describes three such effects: (1) the relationship between the interest rate, land prices, and building height; (2) the relationship between the interest rate, the size of firms, and the demand for office space; and (3) the relationship between building height and the enhanced incentive for advanced — or premature — technological innovations in both design and construction.
The time period of my research on skyscrapers and business cycles was crucial for my early identification of the housing bubble. In my February 2004 article “ ‘Bull’ Market?” I used a trend-channel technique to define the initial stage of the bubble. Then in June 2004 I wrote “Housing: Too Good to Be True,” a full explanation of how the Federal Reserve’s monetary policy had caused a massive housing bubble. I also began giving presentations on this subject to the general public.
As a result of this publicity, I was invited in 2005 to contribute a chapter to a book, Housing America: Building Out of a Crisis, edited by Randall G. Holcombe and Benjamin Powell. I submitted the resulting chapter, “The Economics of Housing Bubbles,” to the editors the first week of June 2006.
The publisher of the book asked me to remove some text they considered too gloomy and ominous regarding what might happen in the aftermath of the housing bust. I agreed to the changes because the book was to be marketed to people interested in zoning laws, building codes, and urban planning, not economic Armageddon. However, the editors later allowed me to include that removed text, when, after a long publishing delay, the book was finally published in 2009. At that time my gloomy predictions seemed more appropriate. The removed text was placed in a Postscript in the original publication. Indeed the editors were so kind as to mention my chapter prominently at the beginning of their preface:
The timing is noteworthy because most of the chapters were completed in 2006 when the housing boom across much of the country was reaching its peak. One chapter in particular that deserves mention in this regard is Mark Thornton’s, because he was discussing the inevitable collapse of the housing market bubble at a time when many observers were arguing that house prices could continue rising indefinitely. Thornton’s chapter does a good job of explaining the collapse of housing prices in hindsight, and it is worth noting that Thornton’s hindsight was actually foresight: he was talking about the collapse before it actually occurred.Randall G. Holcombe, and Benjamin Powell, eds., Housing America: Building Out of a Crisis (New Brunswick, N.J.: Transactions Publishers, 2009), p. vii.
Between 2004 and 2007 audiences and readers generally scoffed at my analysis. This was a time when the accepted wisdom in mainstream economics and the real estate industry was that “housing prices never go down” and “you can never lose money in real estate.” Mainstream economics refers to what is widely taught at well-known universities and associated with the neoclassical synthesis, which combines neoclassical microeconomics and Keynesian approaches to macroeconomics.
One of my particularly provocative public lectures, circa 2006, “Luxury Game Day Condominiums,” was given to students at Auburn University. As it turned out local building contractors and bankers were also in attendance. The empirical evidence I presented was based on interviews of people who had purchased these game day condos during the housing bubble. The condos had been marketed to football fans of Auburn University who come to Auburn, Alabama, for the six or seven home football games per year. When I did the calculations I discovered that the condo buyers could have stayed at the best hotel in town and eaten all their meals at gourmet restaurants and saved money. I then asked the buyers, “Why buy the condo?” To this the answer would invariably be “I can always sell it for more money later.”
The complete bust in housing had not been recognized yet, but everyone in the audience knew that condo prices were falling and that some local projects had been cancelled. The students in the audience roared with laughter at those responses, but the builders and bankers were none too pleased. Of course it was not just local builders and bankers that wanted to keep the bubble going. By now Federal Reserve officials were publically cheerleading for the housing bubble and denying that it existed.Mark Thornton, “Transparency or Deception: What the Fed Was Saying in 2007,” Quarterly Journal of Austrian Economics 19, no. 1 (2016): 65–84.
They should have known better, or at least reexamined their models. After all, the housing industry as measured by the Philadelphia Stock Exchange Housing Sector Index peaked on June 30, 2005. On August 8, 2005, my short article “Is the Housing Bubble Popping?” was published.Mark Thornton, “Is the Housing Bubble Popping?” LewRockwell.com, August 8, (2005). In the article I presented charts that indicated that home-builder stock prices could be headed much lower and that short-term and long-term interest rates could be heading higher. Both trends, which did continue, were harbingers that the housing bubble would eventually pop.
In 2007, the skyscraper curse struck again, the second occurrence since Lawrence’s 1999 report. This time it happened in the Middle East in the city-state of Dubai. Located in the United Arab Emirates, between Saudi Arabia and Oman and across the Persian Gulf from Iran, Dubai is a fantasy city. Its ruler has transformed his oil wealth into a highly dynamic city with very tall and ornate buildings, hotels, the world’s largest shopping mall, and even man-made islands in the Persian Gulf designed to resemble a map of the world.
It was in Dubai that construction of the Burj Dubai tower began in 2004. It was designed to be a world-record setting skyscraper in terms of all metrics such as height, highest livable floor, the most floors, and so on. The next “skyscraper signal” occurred when construction reached a new record height in late July 2007. In August I reported:
There is a new record setting skyscraper in the making in the United Arab Emirates. The Skyscraper Index predicts economic depression and/or stock market collapses to occur prior to the completion of the skyscraper.Mark Thornton, “New Record Skyscraper (and Depression?) in the Making,” mises.org blog, August 7, 2007.
The tower was renamed the Burj Khalifa and opened in early January 2010. The building was renamed for the ruler of Abu Dhabi who had arranged for billions of dollars in emergency loans to bail out his cousin in Dubai. Clearly the skyscraper curse had hit once again. The media began to take it more seriously. On January 8, 2010, CNN.com’s Kevin Voigt reported:
When the Burj Khalifa officially opened in Dubai on Monday, much of the world press noted the irony of the world’s tallest building unveiled just weeks after the emirate’s debt crash.
But a look at the history of record-breaking skyscrapers and business cycles suggests otherwise — the opening of every single “world’s tallest” building in the past century has coincided with an economic downturn.
One person who wasn’t surprised by the economic woes greeting the dedication of the Burj Khalifa (renamed Monday from Burj Dubai in honor of the sheikh of Abu Dhabi, which recently threw Dubai a $10 billion lifeline) was Auburn University economist Mark Thornton.
He predicted tough times for the emirate two years ago in a blog entitled “New Record Skyscraper (and depression?) in the making.” He noted that economic depression or stock market collapse usually occurs prior to completion of such skyscrapers.Kevin Voigt, “As skyscrapers rise, markets fall,” CNN.com.
So the Skyscraper Index’s “curse” has correctly forecast all major economic crises for over a century. The skyscraper curse has also experienced a good deal of mainstream media coverage; and so it would seem that the Skyscraper Index theory is accurate and alive and well.
That was until March 28, 2015, when the Economist declared the skyscraper curse was dead. In reviewing the current “skyscraper boom” they noted in their unsigned “Towers of Babel” editorial the following:
Does this frenzy of building augur badly for the world economy? Various academics and pundits, many of them cited by The Economist, have long argued as much, but new research casts doubt on it.
As a side note, the majority of major media who write about my work and this phenomenon fail to cite me as a source, although they have clearly been drawing from my publications. Of the “various academics and pundits” most draw from Andrew Lawrence.Andrew Lawrence, “The Skyscraper Index: Faulty Towers!” Property Report, January 15, 1999 and “The Curse Bites: Skyscraper Index Strikes,” Property Report, March 3, 1999. The Economist’s article did not include me explicitly in the text, but at least they did reference my 2005 journal article at the end as a source.Thornton, “Skyscrapers and Business Cycles.” Thank you.
The Economist based its view on a new academic article, “Skyscraper Height and the Business Cycle: Separating Myth from Reality.” The article was written by three Rutgers University economists: Jason Barr, Bruce Mizrach, and Kusam Mundra. It was published in the academic journal Applied Economics in 2015.
Their article demonstrates that skyscrapers do not cause (in a technical economic sense) business cycles as measured by changes in overall economic activity — that is, GDP. Their statistical analysis shows that skyscraper construction and overall economic activity move together, having a common cause or trend. They also found it difficult to find a correlation between the skyscraper announcement and completion dates and changes in GDP.
Let’s be perfectly clear here. Skyscraper construction does not cause business cycles. The statistical evidence presented in Applied Economics actually supports the Skyscraper Index theory.
It should be clear from my “Skyscrapers and Business Cycles” article that there is a third factor at work. Skyscrapers are essentially part of the boom phase of the cycle. The cause of both is artificially very low interest rates and artificially very easy credit conditions. This cause results in new record-breaking skyscrapers, a boom in the economy, and eventually a substantial economic crisis — the skyscraper curse.
Immediately, I wrote a letter to the editor of The Economist to inform them of the error in the 2015 article and to ask them to change the date they printed for my journal article from 2004 to 2005. The letter was never published and the date of my paper was never corrected. I did receive an email three months later that said the magazine had misplaced my letter. I also submitted a comment (with Lucas Engelhardt) on the article published in Applied Economics. Surprisingly, the editors of Applied Economics rejected the comment. Accordingly, this book is dedicated, in part, to the editors of Applied Economics and The Economist.
The main point of the Skyscraper Index and the resulting curse is to give people a tangible, concrete example of what is happening to the economy during a business cycle. ABCT is necessarily vague on some issues and silent on others. For example, it refers to capital, the structure of production, and goods of higher and lower orders without being specific. The theory presents issues, such as interest rates being artificially low relative to market-determined rates, without providing readers with a mechanism to calculate whether and when they in fact apply.
That does not mean ABCT is unrealistic, hard to understand, or difficult to apply. Austrian economists have always striven to be realistic about the economy and the limits of economic theory, but that necessarily puts limitations on the analysis and forces us to introduce significant caveats to our conclusions. For example, Austrian economists cannot “predict” in the strictest scientific sense. We speculate about the future, given the caveat of ceteris paribus — that is, all things being equal — and without illusions that economic theory can help us determine the timing and magnitude of future events. However, we can make “pattern predictions” based on economic theory and an appraisal of the facts.
In contrast, when mainstream economists are faced with the complexities of real economies or with scarcity of data, they resort to unrealistic assumptions, questionable simplifications, and inappropriate data. For most mainstream economists, their sine qua non is predicting the future. However, mainstream theories of the business cycle, such as real business cycle theory and various Keynesian theories, cannot predict anything about the future because in their view, the cycle is generated by economic shocks that cannot be anticipated. They can only predict in the sense that they use historical data in their models, like “back testing” stock market strategies. They practice retrodiction, rarely prediction.
The grand benefit of this book then is to show what Austrian economists see with the aid of the business cycle theory. ABCT shows what causes the business cycle, what happens during the business cycle, and that the boom must inevitably end in a bust or economic crisis. The value of resources is squandered in the process and people are harmed. Austrian theory can also show how to best deal with the bust, what to avoid, and how to permanently fix the problem by ending the business cycle, or at least minimizing its impact.
In section 2, I present evidence that demonstrates the real-world usefulness of ABCT by showing that Austrian economists have correctly forecast almost every major economic crisis for over a century. I also present evidence that mainstream economists have a poor record of predicting business cycles and have made some very bad predictions.
To be fair, there have been some mainstream economists who have made correct forecasts of economic crises, but their numbers are few compared to the Austrian economists, especially considering that Vedder and GallawayRichard Vedder, and Lowell Gallaway, “The Austrian Market Share in the Marketplace for Ideas, 1871–2025,” Quarterly Journal of Austrian Economics 3, no. 1 (Spring 2000): 33–42. have estimated that there are about a hundred mainstream economists for every Austrian-school economist. Obviously, not all predictions by Austrian economists have come true or in a timely manner, including those of this author.
Before leaving section 2, let me be perfectly clear on one key point. Austrian economists have used ABCT to make their predictions about booms and busts since Böhm-Bawerk’s time over a century ago. But since the concept of the Skyscraper Index is a relatively new concept, it has not been a part of the Austrian economists’ toolkit. The idea of the Skyscraper Index was only discovered in 1999, and the theoretical justification for connecting it to ABCT has only been around since 2005.Before ending this introduction, a question arises: what are Austrian economists saying about the current economy and government policy? Austrian economists have spoken out against current fiscal and monetary policy, and many have argued that policy has been unconventional, unorthodox, and extreme even by mainstream standards. Austrian economists have recommended drastic changes to current policies, and they have speculated that the economic consequences of the next crisis will be truly horrible. There are obviously differences of opinion, but the Austrian school is united against the current policy regime.
A skyscraper alert has already been issued, in that a groundbreaking ceremony has taken place and construction has begun on the Jeddah Tower in Saudi Arabia, a prospectively record-setting skyscraper. If a skyscraper signal is issued, it will mean that that project’s height exceeds the current world record.
In conclusion, the book provides a remedy of how to best deal with the next economic crisis.
The author would like to acknowledge the assistance and support of many people and to apologize for no doubt forgetting the assistance of many others over the long course of this project.
First and foremost I would like to acknowledge the support of the officers, members, and donors of the Mises Institute who made this book possible. I would also like to thank Paul Cwik, Harry David, David Gordon, Lucas Engelhardt, Jörg Guido Hülsmann, Roger Garrison, Karl-Friedrich Israel, Floy Lilly, Greg Kaza, Jonathan Newman, Patrick Newman, Shawn Ritenour, Louis Rouanet, Joseph Salerno, Susan Schroeder, Judy Thommesen, Paul Wicks, all the economics teachers I’ve had throughout the years. I would most especially like to thank Robert B. Ekelund, Jr.
Money makes possible the good things in life: our ability to trade with one another and the ability to form groups to work for beneficial purposes, as well as saving, investing, economic growth, and development. Without some form of money, advanced society would not be possible. However, as we saw in the previous chapters, increases in the supply of money, which mainstream economists now view as indispensable, are really the source of many evils of economic life.
Increases in the supply of money result in higher consumer prices, a process now known as inflation. This means that many people with jobs suffer diminishing purchasing power of their wages over time. Economic historians have long agreed that such inflation is the enemy of labor. Free market monies, such as gold and silver, typically increase in value over time, which is beneficial for wage labor and encourages work and saving, as the purchasing power of wages and savings tends to increase over time.
Increasing the money supply causes an unnatural redistribution of wealth. People who receive the money first become wealthier because they spend the money before prices have risen. People who receive the money later or not at all become poorer because they pay the higher prices. In the case of money coming from the Federal Reserve, the biggest winners are the US government; its large contractors, such as weapons manufacturers, big banks, and Wall Street. As a result, the financial sector of the US economy has grown enormously and economic inequality, measured in terms of income and wealth, has increased dramatically since the United States went completely off the gold standard in 1971. The financial-services sector has grown from about 4 percent of the US economy then to over 8 percent now. Thomas PikettyThomas Piketty, Capital in the Twenty-First Century (Cambridge, MA: Harvard University Press, 2014). has famously shown that inequality of income and wealth has increased greatly in the United States and elsewhere. However, the entire increase in inequality has come after 1970 and the abolition of the Bretton Woods gold standard. The period beforehand, when we were on the gold standard, is one of increasing equality.
The big losers receive the money after prices have already risen. The losers would include private-sector workers and people on pensions or fixed income — in other words, the labor class. Inflation also harms savers and bond investors, as well as taxpayers who find themselves in higher tax brackets when wages catch up with price inflation. Simply put, paraphrasing Senator Phil Gramm of Texas, the people pulling the wagon are harmed and reduced in number, while the people sitting in the wagon benefit and increase in number.
Finally, inflating the money supply causes the business cycle, and this is the least well-understood aspect of the Fed’s increasing of the money supply. It is not just natural swings in the economy; it is artificial, squanders resources, and ruins lives. This will be illustrated with the case of skyscraper construction.
Inflating the money supply is directly connected to interest rate manipulation. When the Fed buys government bonds from banks, it gives them dollars, which they can reinvest in more government bonds, mortgages, commercial loans, and consumer loans. This process artificially reduces interest rates. It also completes the movement of government bonds from the US Treasury, to the big banks, to the balance sheet of the Fed. It can sit there until it comes due, at which time the Fed can purchase more government bonds. The Fed is required to return any leftover interest income from these bonds to the US Treasury, so this process is the equivalent of an interest-free loan. Also, as monetary expansion turns into price inflation and lowers the value of the dollar, it effectively reduces the value of the national debt, a process referred to as monetizing the national debt. It is a convoluted process, but you can see why those who benefit do not want to reform it. It is quite a racket for the politicians, the big banks, and their highly paid facilitators at the Fed. This is the process that brings about artificial gyrations in interest rates and creates Cantillon effects and business cycles.
The Cantillon effects that we can see in record-breaking skyscrapers are symptomatic of what is going on in the economy; it is just more difficult to point to some particular project or new technology and claim that it is a malinvestment caused by the Federal Reserve and artificially low interest rates. So remember, skyscrapers themselves do not cause business cycles, the Fed does.
Many people consider the skyscraper a form of art, but their construction is essentially a business that must respond to incentives and constraints. Therefore skyscraper construction can be expected to follow closely even small changes in relative prices. In reevaluating the early skyscraper artistically, Ada Louise HuxtableAda Louise Huxtable, The Tall Building Artistically Reconsidered: The Search for a Skyscraper Style (Berkeley: University of California Press, 1992). noted:
Essentially, the early skyscraper was an economic phenomenon in which business was the engine that drove innovation. The patron was the investment banker and the muse was cost-efficiency. Design was tied to the business equation, and style was secondary to the primary factors of investment and use. … The priorities of the men who put up these buildings were economy, efficiency, size, and speed.
That is not to say that the early skyscrapers were without artistic merit, or that later structures failed to improve artistically; quite the contrary. Nevertheless, post-WWI skyscrapers continued to emphasize profits and technology. The early skyscraper drew from existing technology and was considered an engine of innovation. Even in modern times, design continues to grow and evolve, but for Helmut Jahn,Quoted in ibid., p. 117. the “structural rationale for such a tall structure is technically and economically inescapable.” For Huxtable,Ibid., p. 105. “Architecture simply doesn’t count. … With pitifully few exceptions in the past, New York’s skyscrapers have never reached for anything but money.” Art, technology, government regulations, and even ego must be considered factors, but the skyscraper is essentially captive to economic forces and motives. Therefore when architects are asked what makes for the super skyscraper, economic forces are considered preeminent. Psychological factors related to ego are created in the credit driven boom.
In this context it is important to remember that changes in the price of land, building materials, and the interest rate will have important implications for skyscraper construction. Changes in the rate of interest have three separate Cantillon effects on skyscrapers. All three effects are reinforcing, and all three effects are interconnected to the transformation of the economy toward more roundabout production processes. When the rate of interest is artificially reduced, all three effects contribute to the desire to build taller structures. The world’s tallest buildings are generally built when the interest rate is reduced substantially below the natural rate for a sustained period of time. In contrast, when the interest rate is forced above the natural rate the economic effects reduce the value of existing structures and the demand for tall buildings. Construction can come to a complete standstill.
The first Cantillon effect is the impact of the rate of interest on the price of land. The most obvious cause of this result is that lower interest rates reduce the opportunity cost of borrowing to buy the land and to build structures. As a result, owners of land and real estate experience an increase in their wealth. This relationship is confirmed by Jeremy Atack and Robert Margo,Jeremy Atack, and Robert A. Margo, “‘Location, Location, Location!’ The Market for Vacant Urban Land: New York 1835–1900.” NBER Historical Paper 91, National Bureau of Economic Research (Cambridge, MA, August, 1996). who examined the market for land in New York City during the nineteenth century. Their evidence suggests that land values tended to increase during deflationary periods, when interest rates tend to be low, but less so during inflationary periods, when interest rates tend to be higher because of the inflation premium in interest rates. Paul CwikPaul Cwik, “Austrian Business Cycle Theory: Corporate Finance Point of View,” Quarterly Journal of Austrian Economics 11, no. 1 (2008): 60–68. demonstrates that the interest rate has an impact on the net present value of working capital and longer-lived fixed capital. As a casual observation, when interest rates are artificially low, you tend to see more “land for sale” signs along roads and interstate highways because land prices are higher in general.
A lower rate of interest also tends to increase the value of land, because the interest rate is used by entrepreneurs as a proxy for the discount rate. In evaluating any investment project, entrepreneurs estimate the net present value of a project by looking at the projected income stream from the investment over a long period of time and adjusting it for interest payments over time. The income in the first year does not have to be discounted much at all, that is, just one year’s interest expense, but that same income in year twenty-five has to be discounted by twenty-five years of interest expenses and may be worth nothing in terms of net present value. Net present value of an income stream has to exceed risk-adjusted cost of an investment for the project to be undertaken. High interest rates lead to heavy discounting of income streams, whereas low interest rates lead to less significant discounting, which makes long-term projects seem relatively more profitable.
For example, consider an investment project that is expected to produce $1 million in income above operating costs per year for ten years. In the tenth year of operation, if the discount rate is 4 percent, the calculated net present value of that year’s $1 million net income is $675,000. However if the discount rate is 8 percent then the calculated net present value of that year’s income is only $463,000.
From this we can see that land values rise because lower rates of interest reduce the opportunity cost, or full price, of owning land and drive up the net present value of income streams from using land. Treating the rate of interest as the cause, a reduction in the interest rate will increase the demand for land and result in an increase in land prices. The impact of lower discount rates will tend to favor longer-term investment projects using land, such as skyscrapers.
It has been often said that the three most important things about real estate are location, location, and location. When the rate of interest is falling, the land best suited for the production of the longer-term, more capital-intensive, and more roundabout methods of production will increase in price relative to land better suited for shorter-term, more direct methods of production. As land prices rise, the yield required from any piece of land to make ownership of it profitable must also rise. Combined with a lower cost of capital brought about by a lower rate of interest, land owners will seek to build more-capital-intensive structures, and at the margin, this will cause land to be put to alternative uses.
In the central business district this means more-intensive use of land and thus taller buildings. Higher prices for land reduce the ratio of the per-floor cost of tall vs. short buildings and thus create the incentive to build taller buildings to spread the land cost over a larger number of floors and more leasable space. Thus, higher land prices lead to taller buildings. In my hometown there are a variety of one- and two-story structures currently being demolished to make way for the construction of multifloor structures. These projects are stimulated by artificially low interest rates and the search for yield on investment funds. In this manner, the height aspect of the projects is driven by land prices.
The second Cantillon effect from lower rates of interest is the impact on the size of firms. A lower cost of capital encourages firms to grow in size and to take advantage of economies of scale, such as the example of the dairy industry in transition. Here, companies that expand based on artificially low interest rates benefit, at least temporarily, at the expense of companies that do not and exit the industry. As part of this larger-scale, more roundabout production process, firms develop central offices or headquarters for their accounting, management, marketing, human resources, and product-development departments. This increases the demand for office space in central business districts. This demand in turn raises rents and encourages the construction of taller office buildings within the central business district.The phenomenon of firms growing in size and scope in response to artificially low interest rates can be seen in the history of merger-and-acquisition waves. Mergers between two firms occur when both firms believe they can profit from combining their operations. Acquisitions and takeovers occur when one firm believes it can manage the combined assets of the firms in a more profitable manner. Lower interest rates reduce the cost of the capital to buy out investors of the other firm. Mergers and acquisitions have occurred in clusters or waves during periods of low interest rates and easy credit conditions (the boom), and because they often start operating as a united company during the bust, their record of success has not been great.
SaraviaJimmy A. Saravia, “Merger Waves and the Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 17, no. 2 (Summer 2014): 179–96. shows that waves of mergers and acquisitions that have been experienced in the past are consistent with Austrian business cycle theory (ABCT). Not only do low interest rates help finance mergers and especially acquisitions, but the demand for such business deals is a reflection of the “resource crunch” of ABCT as shown in the previous example of the expansion of the advanced computer-chip industry. Ekelund, Ford, and ThorntonRobert B. Ekelund, George Ford, and Mark Thornton, “The Measurement of Merger Delay in Regulated and Restructuring Industries,” Applied Economics Letters 8, no. 8 (2001): 535–37. show that when mergers are delayed by government “red tape,” the resulting acquisitions and mergers tend to be unprofitable because they are often completed during an economic downturn. ThorntonMark Thornton, “Review of The Synergy Trap: How Companies Lose the Acquisition Game, by Mark L. Sirower,” Quarterly Journal of Austrian Economics 2, no. 1 (Spring 1999): 85–86. has furthered the discussion of why so many mergers and acquisitions turn out to be miscalculations.
The third Cantillon effect is the impact of interest rates on the technology of constructing record-tall buildings. Record-breaking skyscrapers require innovation and new technology in order to be profitable. Buildings that reach new heights pose numerous engineering and economic problems relating to such issues as building a sufficiently strong foundation, ventilation, heating, cooling, lighting, transportation (e.g., elevators, stairs, and parking), communication, electrical power, plumbing, fire protection, and security systems, as well as wind resistance, structural integrity, and even window cleaning. There are also a host of public issues connected with increases in employment density brought about by tall structures, such as transportation congestion and environmental concerns. For example, Sukkoo KimSukkoo Kim, “The Reconstruction of the American Urban Landscape in the Twentieth Century,” NBER Working Paper 8857, National Bureau of Economic Research (Cambridge, MA, April 2002). showed how increases in skyscraper-building and, in particular, improvements in skyscraper technology lead to increases in employment density. Here, advanced technology businesses benefit at the expense of incumbent technology businesses.
Beyond the mere technology it takes to build the world’s tallest building, every vertical beam, tube, cable, pipe, or shaft in a building takes away from leasable space on each floor built, and the more floors in the structure, the greater the required capacity of each system in the building, whether it is plumbing, ventilation, or elevators. So designers, architects, and building contractors cannot simply increase the size of each system to increase capacity. They must come up with new, more efficient systems to reach record heights. Consequently, there is a tremendous desire to innovate with technology in order to conserve on the size of these building systems or to increase the capacity of those systems. Therefore, as the height of construction rises, input suppliers must go back to the drawing board and reinvent themselves, their products, and their production processes.
M. Ali and Kyoung Sun MoonM. Ali, and Kyoung Sun Moon, “Structural Developments in Tall Building: Current Trends and Future Prospects,” Architectural Science Review 50, no. 3 (September 2007): 205–23. describe how designers and engineers have a tremendous need to innovate to conserve on the requirements of building systems. For example, one elevator shaft with a floor size of 2×2 meters would take up the space equivalent of ten efficiency-sized apartments in a hundred-floor building. At standard speeds it would take about ten minutes to get to the top floor of the Burj Khalifa tower, plus the time it took for the elevator to arrive on your floor and any additional stops on the way to your destination. AmesNick Ames, “Elevator Installation Prep Begins at Kingdom Tower,” ConstructionWeekOnline.com, May 10, 2015. reports that KONE Corporation engineers have created a new elevator cable that weighs less than 7 percent of the weight of traditional steel cables, which each weigh over twenty tons for a 400-meter-high building. Obviously, a twenty-ton cable would require an enormous amount of power to operate. Therefore, as building heights rise, technology must be advanced to conserve on the building systems’ footprint.
Another example of this type of technological effect is in heating and cooling systems for especially tall skyscrapers. Record-breaking skyscrapers require a tremendous capacity for heating and cooling; and traditionally, hot and cool air or water would have to be pumped long distances, which is both inefficient and requires a great deal of space for all the ductwork and plumbing. A recent solution to this problem is a system called variable-refrigerant-flow zoning and split-ductless systems. Instead of massive amounts of air or water transported throughout a building, only the refrigerant — for example, Freon — is moved to each zone. It is transported in small copper tubing rather than bulky ductwork or water pipes, which take up horizontal space between each floor as well as vertical space. Each zone can have its own temperature, and the flow of refrigerant is variable according to the needs, rather than just on and off. The total amount of equipment is less, it is easier to maintain, and it is said to be 25 percent more energy efficient. Surely this is a great invention, but one that would not have come along as early as it did in the age of the mega-skyscraper. In other words, enormous amounts of resources were expended to obtain small gains in efficiency due to the artificially high demand to build very tall skyscrapers. When the next economic crisis comes, the demand for these advanced technologies could collapse because either no one is building such skyscrapers or they are only building much smaller buildings.
Construction systems must also be reinvented to tackle new record-breaking construction projects. For example, pumping concrete higher to build taller structures requires innovation in concrete-pumping technology; the same can be said for cranes and moving laborers to and from their worksite on the building. Again, in the economic crisis that follows, these systems and all the capital combinations that support them could either go unused or used at greatly diminished levels.
All three Cantillon effects resulting from lower rates of interest are interrelated and reinforcing. All three are generally recognized by people involved in the construction of large office buildings including architects, bankers, contractors, design specialists, engineers, entrepreneurs, government regulators, often the tenants themselves, and finance specialists such as bond dealers.
Higher interest rates discourage the construction of taller buildings and of construction in general because capital is scarcer and land is less in demand and available at lower prices. Higher interest rates also create financial difficulties for the owners of existing structures because of the decreased demand for office space and condos. Companies engaged in construction and their suppliers face a decrease in the demand for their services, the impact of which falls hardest on those firms that specialize in the production of the tallest buildings and the suppliers of the specialized construction systems and building systems for ultrahigh construction.
In other words, the technologies and industrial capacities that were induced by the artificially low interest rates are now greatly incapacitated and mostly idle. The buildings themselves are likely to have excess capacity, with too few tenants and lower-than-expected leasing rates.
The interest rate is what makes the construction business, in part, such a speculative business. Homebuilders build spec houses and face the risk of finding a buyer at a profitable price. Developers build speculative office buildings, which in contrast to many corporate headquarters are investments that rely on an uncertain flow of rental income. Separating the winners from the losers is not so much a matter of greed as it is a matter of time and calculation. Skyscraper expert Carol Willis explained the difference between normal times and boom times:
In normal times, when costs of land, materials, and construction are predictable, developers use well-tested formulas to estimate the economics of a project. These calculations are based on the concept of the capitalization of net income. This value takes into account the net income for thirty or forty years. … [T]he conventional market formulas and the concept of economic height were widely known and followed in the industry. Most speculative building was not risky, but reserved in its calculations and highly responsive to market desires.Carol Willis, Form Follows Finance: Skyscrapers and Skylines in New York and Chicago (New York: Princeton Architectural Press, 1995), p. 157.
All of these normal calculations that help ensure profit and avoid loss are not, however, reliable during the boom phase of the business cycle.
In booms, the so-called rational basis of land values is disregarded, and the answer to the question “What is the value of land?” becomes “Whatever someone is willing to pay.” Some speculators estimate value on new assumptions of higher rents; others simply plan to turn a property for a quick profit. … But due to the cyclical character of the real estate industry, the timing of a project is crucial to its success, and the amount a property reaps in rents or sale depends on when in a cycle it is completed or comes onto the market.Ibid., pp. 157–58.
Building the world’s tallest building has been a matter of particularly bad timing by entrepreneurs, and even if they were able to successfully steal away enough tenants from the remaining pool of renters, the economic problem for society is that valuable resources are lost in the process of constructing buildings that are bad investments and underutilized. See, Patric Hendershott and Edward Kane,Patric H. Hendershott, and Edward J. Kane, “Causes and Consequences of the 1980s Commercial Construction Boom,” Journal of Applied Corporate Finance 5, no. 1 (Spring 1992): 68. who estimated that there was more than $130 billion wasted in the commercial construction boom of the 1980s. The Empire State Building was nicknamed the Empty State Building because of its high vacancy rates until after World War II.
However, it is not the entrepreneur’s formula that is at fault, but a system-wide failure that has occurred periodically throughout the twentieth century and before, and is known as the business cycle. HoytHomer Hoyt, One Hundred Years of Land Values in Chicago: The Relationship of the Growth of Chicago to the Rise in Its Land Values, 1830–1933 (Chicago: University of Chicago Press, 1933). found the building cycle was a “motion of a definite order” lasting eighteen years, on average, from peak to peak. Willis raised the key issue as it relates to skyscrapers:
Indeed, a key question about cycles is, if their pattern is so predictable, why don’t people foresee the inevitable bust? This conundrum can perhaps be answered by looking more closely at the dynamics of speculation and at a typical skyscraper development.
Hoyt suggested that the cycle is long enough for people to forget the lessons of the previous cycle and thus not be able to apply it to the next cycle. However, the building cycle is much more volatile and unpredictable than this eighteen-year average would suggest. Together with the impact of local economic conditions and government intervention, the combination of factors blurs any usefulness of the simple knowledge that business cycles exist and have an average duration. Indeed, the people who experience one business cycle are often not even the same as the people who experience the next cycle. As Willis noted:
After the collapse of an inflated market, it is easy to look back on the grave errors of judgment that preceded a crash; yet the basic indicators of the twenties economy seemed to promise unimpeded growth. Pent-up demand for office space after World War I, the expanding numbers of the white-collar workforce, and the increasing per-person average for office space all fueled the building industry. Each year, the summaries of annual construction figures reported record numbers.Willis, Form Follows Finance, p. 159.
Willis did correctly identify that “easy financing underlie[s] all booms,” but this does not answer her conundrum, because easy financing and low interest rates are also at the heart of genuine economic growth. The entrepreneur’s problem is that profit calculations cannot show for sure whether interest rates will remain low and projects will succeed (i.e., economic growth), or rates will rise and projects will fail (i.e., the business cycle). Furthermore, it should be made clear that in ABCT, low interest rates and “easy financing” are terms defined not on the basis of their magnitudes, but in relation to their natural rates, which of course are not calculable outside of a free market.
To reiterate, the Austrian business cycle theory (ABCT) shows that artificially low interest rates produce systematic distortions in the economy. The most important of these distortions is the inducement to build longer structures of production and more roundabout production processes involving advanced or premature technologies. It is during the resulting boom when all the mistakes or malinvestments occur in a temporal cluster. The bust or economic crisis is when these errors are later revealed. While ABCT has been under critical internal review,See Jeffrey Rogers Hummel, “Problems with Austrian Business Cycle Theory,” Reason Papers 5 (Winter 1979): 41–53, and Jörg Guido Hülsmann, “Towards a General Theory of Error Cycles,” Quarterly Journal of Austrian Economics 1, no. 4 (1997): 1–23. more recent worksJoseph T. Salerno, “Comment on Gordon Tullock, ‘Why Austrians are Wrong About Depressions,’” Review of Austrian Economics 3 (1988): 141–45. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010), pp. 325–31; William Barnett and Walter Block, “On Hummel on Austrian Business Cycle Theory,” Reason Papers 30 (Fall 2008): 59–90; Mihai Macovei, “The Austrian Business Cycle Theory: A Defense of Its General Validity,” Quarterly Journal of Austrian Economics 18, no. 4 (2015): 409–35. have found that ABCT has a “general validity.”
Although it is very difficult to model ABCT empirically, several empirical investigations have taken place with supportive results.C. Wainhouse, “Empirical Evidence for Hayek’s Theory of Economic Fluctuations,” in Money in Crisis, edited by B. Siegel, (San Francisco: Pacific Institute for Public Policy Research, 1984), pp. 37–71; P. le Roux, and M. Levin, “The Capital Structure and the Business Cycle: Some Tests of the Validity of the Austrian Business Cycle in South Africa,” Journal for Studies in Economics and Econometrics 22, no. 3 (1998): 91–109; James P. Keeler, “Empirical Evidence on the Austrian Business Cycle Theory,” Review of Austrian Economics 14, no. 4 (2001): 331–51; Robert F. Mulligan, “A Hayekian Analysis of the Term Structure of Production,” Quarterly Journal of Austrian Economics 5, no. 2 (2002): 17–33, and “An Empirical Investigation of the Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 9, no. 2 (2006): 69–93. ABCT has also been proven useful in analyzing historical business cycles.A.M. Hughes, “The Recession of 1990: An Austrian Explanation,” Review of Austrian Economics 10, no. 1 (1997): 107–23; Jeffrey M. Herbener, Herbener, “The Rise and Fall of the Japanese Miracle,” Mises Daily, September 20, 1999; Benjamin Powell, “Explaining Japan’s Recession,” Quarterly Journal of Austrian Economics 5, no. 2 (2002): 35–50; Gene Callahan, and Roger W. Garrison, “Does Austrian Business Cycle Theory Help Explain the Dot-Com Boom and Bust?” Quarterly Journal of Austrian Economics 6, no. 2 (Summer 2003): 67–98; Patrick Newman, “The Depression of 1873–1879: An Austrian Perspective,” Quarterly Journal of Austrian Economics 17, no. 4 (Winter 2014): 474–509, and “The Depression of 1920–1921: A Credit Induced Boom and a Market Based Recovery?” Review of Austrian Economics (January 2016): 1–28.
The Austrian answer for the economic crisis is similar to the RBCT’s (real business cycle theory) rejection of the effectiveness of stimulative fiscal policy and monetary policy. However, ABCT does have a “positive” side to it. In general, government should follow a philosophy of laissez-faire. First, stop the inflation, raise interest rates, and achieve market-determined interest rates. Second, do not enact any policy that attempts to reduce bankruptcy or unemployment. Third, do not attempt to interfere with prices, wages, consumption, and saving.
This would allow the market’s corrective process to proceed at a fast pace to end the economic crisis quickly. On the active positive side, government should cut its budget, its taxes, and all types of regulations and prohibitions in order for more resources to be used productively and efficiently in the private sector. Following these policy recommendations would result in an economic crisis that is painful, but short.
The opposite policy approach to laissez-faire, which employs bailouts and monetary and fiscal stimulus, results in economic crises that are much more painful and prolonged. Examples of this include the Great Depression, the stagflation of the 1970s, Japan’s lost decade(s), and the current financial crisis. The Austrian policy approach tends to hurt the wealthy relatively more than the middle and lower income classes, while mainstream policy approaches tend to hurt the middle- and lower-income classes and to help the rich.
When interest in ABCT by the general public increased significantly after the housing bubble burst, it was largely ignored by mainstream economists. Eventually some economists started to make criticisms that were more like witticisms, such as when Nobel Prize–winning economist Paul Krugman labeled ABCT the “hangover theory.” More recently ABCT has experienced multiple attacks by notable mainstream economists. This could be a good sign if you believe in an idea often attributed to Mahatma Gandhi: “First they ignore you, then they ridicule you, then they fight you, and then you win.”
Criticisms of the Hydraulic Version of ABCT The hydraulic version of ABCT is the one described by Gottfried Haberler.Gottfried Haberler, Prosperity and Depression: A Theoretical Analysis of Cyclical Movements (Lake Success, NY: United Nations, 1937). It could be described as a mainstream translation of ABCT as developed by Mises, Hayek, and Rothbard, with several critical divergences. Nevertheless, this version was surprisingly seized upon by economists in order to criticize ABCT.Tyler Cowen, “Paul Krugman on Austrian Trade Cycle Theory,” Marginal Revolution, October 14, 2008; Bradford DeLong, “I Accept Larry White’s Correction.…” Cato Unbound, December 11, 2008; John Quiggin, “Austrian Business Cycle Theory,” Commentary on Australian & World Events from a Social Democratic Perspective, May 3, 2009; Bryan Caplan, “What’s Wrong with Austrian Business Cycle Theory?” EconLog, January 2, 2008.
Their basic point is that if investment goes up in the boom, consumption should go down; and during the bust when investment goes down, consumption will ipso facto go up. They conclude consumption did not go up in the bust — it went down significantly — and therefore ABCT has been disproven by the facts.
Instead of ABCT, what the critics are arguing against is a simple mainstream two-sector overinvestment theory of the business cycle. However, Austrian economists do not embrace an overinvestment theory, but rather a malinvestment theory. During the boom consumption does not go down but goes up for two reasons. First, the lower interest rate discourages savings and encourages consumption, and second, and more importantly, the wealth effect or net-worth effect of higher wages, asset prices, stock prices, and real estate prices encourages people to consume more. Consumers draw down their illusionary wealth because on paper they can afford it.
With people drawing down their true wealth they will actually be consuming their savings and wealth, and this implies that there will likely be less overall investment, not more, during the boom. During the bust phase, consumption will be relatively strong compared to capital investment, but because of unemployment, lower wages, a negative wealth effect and a general malaise among entrepreneurs, there will hardly be a boom in consumption. The fact that some mainstream economists would base their criticisms on an obscure and flawed presentation of ABCT could be an indication of malicious intentions. Salerno gave an in-depth analysis of this criticism of ABCT.Joseph T. Salerno, “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (Spring 2012): 3–44.
The Rational-Expectations Critique — Why Can’t Entrepreneurs Learn? ABCT has been criticized on the basis of rational-expectations theory. The critics argue that rational entrepreneurs could not be continuously fooled by artificially low interest rates. Based on entrepreneurs’ past experience and analysis of current market conditions, the critics ask, why would they be systematically fooled by the central bank?This criticism has already been addressed by several economists, such as Lucas Engelhardt, “Expansionary Monetary Policy and Decreasing Entrepreneurial Quality,” Quarterly Journal of Austrian Economics 15 no. 2 (Summer 2012): 172–94; Anthony J. Evans and Toby Baxendale, “Austrian Business Cycle Theory in Light of Rational Expectations: The Role of Heterogeneity, the Monetary Footprint, and Adverse Selection in Monetary Expansion,” Quarterly Journal of Austrian Economics 11, no. 2: 81–93 (2008); William Barnett II, and Walter Block, “Professor Tullock on Austrian Business Cycle Theory,” Advances in Austrian Economics 8 (2005): 431–43; and Anthony M. Carilli, and Gregory M. Dempster, “Expectations in Austrian Business Cycle Theory: An Application of the Prisoner’s Dilemma,” Review of Austrian Economics 14, no. 4 (2001): 319–30. For a review of these arguments, see Nicolás Cachanosky, “Expectation in Austrian Business Cycle Theory: Market Share Matters,” Review of Austrian Economics 28, no. 2 (2015): 151–65.
As I have emphasized throughout this book, the distortions in credit markets from artificially low interest rates are not something that is obvious to the casual observer, and the amount of distortion between the market rate and the natural rate is not known definitively by anyone. What we do know is that when you leave your ivory tower and investigate the economy, you will find that some entrepreneurs, bankers, and market analysts have the experience to detect the possibilities of such market distortions.
These people could act more cautiously, withdraw from certain markets, or require greater risk premia in their dealings. The problem for these people is that their competitors are acting in a boom market where everyone is seemingly making large profits and capital gains. Either you join the party or you get replaced. I have seen this displacement effect in the construction industry, banking, and even on CNBC.
ABCT shows that as the amount of loanable funds expands, less creditworthy borrowers will enter the market. Several economists have explored this adverse-selection argument at length.Evans and Baxendale, “Austrian Business Cycle Theory in Light of Rational Expectations”; and Engelhardt, “Expansionary Monetary Policy and Decreasing Entrepreneurial Quality.” Austrians see entrepreneurs as rational, but they also realize that the success or failure of a venture is dependent on many factors that cannot be known in advance. Easy-credit policies let more entrepreneurs into the process, the results of which are known not instantaneously, but only as or shortly after these long-term capital projects near or reach completion.
What about Nineteenth-Century Panics? ABCT has also been criticized for blaming the business cycle on the Federal Reserve when in fact there were business cycles in the nineteenth century before the Fed existed. I have already addressed this criticism in chapter 2 on the history of the skyscraper curse. ABCT actually blames the central bank and the fractional-reserve banking system. Even mainstream economists agree that the panics from the time of the Civil War to the time of World War I were caused by the National Banking Acts. The acts’ requirements ensured that bank deposits were structured in an unstable manner. Many also agree that business cycles prior to the Civil War were caused by the First and Second Banks of the United States, which were pseudo central banks.
What about Robert Murphy’s Prediction of Double-Digit Inflation? Critics of the Austrian school of economics have been throwing barbs at Austrians such as Robert Murphy because there is very little inflation in the economy. Of course, these critics are speaking about the mainstream concept of the price level as measured by the Consumer Price Index (CPI).
Let us ignore the problems with the concept of the price level and all the technical problems with the CPI. Let us further ignore the fact that this has little to do with Austrian business cycle theory, despite what the critics would like to suggest. The basic notion that more money (i.e., inflation) causes higher prices (i.e., price inflation) is not a uniquely Austrian view. It is a very old and commonly held view by professional economists and is presented in nearly every textbook that I have examined.
This common view is often labeled the quantity theory of money. Only economists with a mercantilist or Keynesian ideology even challenge this view. However, only Austrians can explain the current puzzle: why hasn’t the massive money printing by the central banks of the world resulted in higher prices?
Austrian economists such as Ludwig von Mises, Benjamin Anderson, and F. A. Hayek saw that commodity prices were stable in the 1920s but that other prices in the structure of production indicated problems related to the monetary policy of the Federal Reserve. Mises, in particular, warned that Fisher’s “stable dollar” policy, employed at the Fed, was going to have severe ramifications. Absent the Fed’s easy-money policies of the Roaring Twenties, prices would have likely fallen throughout that decade.
So let’s look at the prices that most economists ignore and see what we find. There are some obvious prices to look at, such as the price of oil. Mainstream economists really do not like looking at oil prices: they want them taken out of the CPI along with food prices, and Ben Bernanke says that oil prices have nothing to do with monetary policy and that oil prices are governed by other factors.
As an Austrian economist, I speculate that in a free market economy, with no central bank, the price of oil would be stable. I further speculate that in the actual economy with a central bank, the price of oil would be unstable and oil prices would reflect monetary policy in a manner informed by ABCT.
That is, artificially low interest rates generated by the Fed would encourage entrepreneurs to start new investment projects. This in turn would stimulate the demand for oil (where supply is relatively inelastic in the short run), leading to higher oil prices. As these entrepreneurs would have to pay higher prices for oil, gasoline, and energy (and many other inputs) and as their customers would cut back on demand for the entrepreneurs’ goods (in order to pay higher gasoline prices), some of the entrepreneurs’ new investment projects would turn from profitable to unprofitable. Therefore, you should see oil prices rise in a boom and fall during a bust. That is pretty much how things work.
As you can see, the price of oil was very stable when we were on the pseudo gold standard. The data also show dramatic instability during the fiat paper-dollar standard (post-1971). Furthermore, in general, the price of oil moves roughly as Austrians would suggest, although monetary policy is not the sole determinant of oil prices and obviously there is no stable numerical relationship between the two variables.
Another commodity that is noteworthy for its high price is gold. The price of gold also rises in the boom, and falls during the bust. However, since the last recession officially ended in 2009, the price of gold actually doubled. The Fed’s zero interest rate policy has made the opportunity cost of gold extraordinarily low. The Fed’s massive monetary pumping created an enormous spike in the price of gold. No surprise here.
Actually, commodity prices increased across the board. The Producer Price Index for commodities shows a similar pattern to oil and gold. The PPI (Producer Price Index) commodity index was more stable during the pseudo gold standard, with more volatility during the post-1971 fiat-paper standard. The index tends to spike before a recession and then recede during and after the recession.
High prices seem to be the norm. The US stock and bond markets are at, or near, all-time highs. Agricultural land in the United States reached an all-time high. The contemporary-art market in New York is booming, with record sales and high prices. The real estate markets in Manhattan and Washington, DC, are both at all-time highs as the Austrians would predict. That is, after all, where the money is being created, and the place where much of it is injected into the economy.
This doesn’t even consider what prices would be like if the Fed and world central banks had not acted as they did. Housing prices would be lower, commodity prices would be lower, and the CPI and PPI would be running negative. Low-income families would have seen a surge in their standard of living. Savers would get a decent return on their savings.
Of course, the stock market and the bond market would have seen significantly lower prices. Bank stocks would have collapsed, and the bad banks would have closed. Finance, hedge funds, and investment banks would have collapsed. Manhattan real estate would be in the tank. The market for fund managers, hedge fund operators, and bankers would have evaporated.
In other words, what the Fed chose to do ended up making the rich richer and the poor poorer. If it had not embarked on the most extreme and unorthodox monetary policy in memory, the poor would have experienced a relative rise in their standard of living and the rich would have experienced a collective relative decrease in their standard of living.
There are other major reasons why consumer prices have not risen in tandem with the money supply in the dramatic fashion of oil, gold, stocks, and bonds. It would seem that the inflationary and Keynesian policies followed by the United States, Europe, China, and Japan resulted in an economic and financial environment where bankers were afraid to lend, entrepreneurs were afraid to invest, and everyone is afraid of the currencies they are forced to endure.
In other words, the reason why consumer price-inflation predictions failed to materialize is that Keynesian policy prescriptions such as bailouts, stimulus packages, and massive monetary inflation have failed to work and have indeed helped wreck the economy.
In the wake of the financial crisis of 2008, the economics profession suffered a blow to what reputation it had. But unlike most of his colleagues, Mark Thornton was vindicated by 2008. Mark has been a voice of sanity at times when the wild interventions of the Federal Reserve have caused otherwise sensible people to lose their minds.
One rule of thumb I’ve adopted is: whenever the idea that the business cycle may have been tamed forever starts to become mainstream, the bust is around the corner.
After reading this book, you’ll see why. Mark discusses the very different records of Irving Fisher and Ludwig von Mises in the 1920s, with the former saying (in late 1929!) that stock prices had reached a “permanently high plateau” and Mises warning that all the artificial credit creation of the world’s central banks meant a reckoning was coming.
At the end of the 1960s, presidential economic adviser Arthur Okun announced that wise fiscal and monetary policy was making boom and bust a thing of the past. One month after his book on the subject was released, the United States was officially in recession.
The dot-com bubble of the 1990s continued the pattern. Federal Reserve chairman Alan Greenspan even speculated that we had entered an age in which booms no longer necessarily had to be followed by busts.
I trust you know what happened next.
The most recent financial crisis, which was connected to an especially destructive housing bubble, yielded the same kind of crazy commentary: why, real estate prices never fall!I trust you know what happened next.
In fact, Mark Thornton was one of a handful of economists to warn — as early as 2004 — of a housing bubble and its inevitable consequence. That was a lonely position to adopt in those days. Nobody wanted to hear the words “unsustainable” or “bubble” when buying multiple properties and sitting on them seemed to be a path to certain riches. Of course, Mark was the voice that would have done them the most good had they bothered to listen, because they might thereby have limited their exposure to the bust that was surely coming.
But when all so-called respectable voices are assuring everyone that all is well, it is the wise man who appears to be the crank.
Now had Mark been known for nothing more than being a conscientious historian of these earlier business cycles and an accurate prognosticator of the housing bust and financial crisis, that would be ample reason to respect him as a scholar worthy of our attention and respect.
But of course Mark has done much more than this. In this book, for instance, you will encounter Mark’s work on the so-called “skyscraper curse.” I shall not here disclose Mark’s thesis on the matter; the author of a foreword ought to know his place, and stealing the author’s thunder is rather unbecoming.
For now, I can say this: although a correlation between the setting of new skyscraper records on the one hand and plunges into recession on the other had been noted by certain writers, the connection had been generally dismissed as little more than a curious coincidence. Mark, on the other hand, has shown how the two phenomena are connected — not that tall skyscrapers cause the business cycle, of course, but rather that they embody numerous features of the boom period described by Austrian business cycle theory.
Austrian business cycle theory, in turn, is probably the most important piece of economic information and understanding for Americans and indeed the world to understand right now. Again I shall leave the full exposition to Mark. For now, what matters is that according to economists of the Austrian school, the familiar pattern of economic boom and bust is not an inherent feature of the market economy, but instead the product of intervention into the economy by the monetary authority. When the central bank lowers interest rates below what they would have reached on the market, it sets in motion a series of responses by investors and consumers that will prove to be incompatible. The result is the recession, which is the economy’s return to health: the economy’s unsustainable configuration is unwound, and resources (including labor) are reallocated to lines of production that make sense in terms of resource availability and consumer preferences.
In the pages that follow, Mark explains the theory, applies it to various historical (and present) cases, and rebuts the most common objections.
In short, this collection serves the valuable purpose of defending the market economy against the conventional view that freedom has failed us and we need still more controls. We had plenty of rules and bureaucrats on the eve of the financial crisis. A lot of good that did us. Pretty much none of them saw any problems on the horizon, and the sheafs of rules and regulations were aimed in the wrong direction: while the private sector operated in the equivalent of a Kafka novel, the Federal Reserve was able to carry out its mischief unimpeded.
Here’s a crazy thought: maybe this time we might consider a real free market, with sound money and market interest rates, and abolish the giant bubble machine once and for all. Read Mark Thornton and you’ll entertain this and other forbidden thoughts.
Thomas E. Woods, Jr.Harmony, Florida
The skyscraper, that unique celebration of secular capitalism and its values, challenges us on every level. It offers unique opportunities for insightful analysis in the broadest terms of twentieth-century art, humanity, and history. — Ada Louisa Huxtable, The Tall Building Artistically Reconsidered
People have been seeking to discover the cause of the business cycle since the dawn of capitalism. For an even longer time people have sought a magic crystal ball that predicts the future. This book provides some insight for both quests.
The skyscraper is the great architectural contribution of modern capitalism, on par with the canals and railroads that transformed the economy of the nineteenth century. However, no one ever thought to connect it with the quintessential feature of modern capitalism — the business cycle. James GrantJames Grant, The Trouble with Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings (New York: Random House, 1996). did make a clear connection between real estate and skyscrapers on the one hand and the business cycle on the other in The Trouble with Prosperity, and that book could have been an inspiration to Andrew Lawrence.
In 1999, Lawrence published his Skyscraper Index, which purported to show that the building of the tallest skyscrapers coincides with economic booms. Specifically, he showed that the building of the world’s tallest skyscraper is a good proxy for dating the onset of a major economic crisis — the skyscraper curse. His index does not apply to the irregular ebbs and flows of the economy, only substantial economic crises.
Lawrence is an investment analyst whose Skyscraper Index records the history of the world’s record-breaking skyscrapers and major economic crises. According to his index, when there is a groundbreaking ceremony for a new world-record-height skyscraper the economy is booming, but when the record height is achieved a significant economic crisis soon follows. The “curse” is the economic crisis, which is usually self-evident by the time the opening ceremony occurs. The mystery is, how can record-breaking skyscrapers be connected to economic crises?
Does this represent a cause and effect relationship? Can building a skyscraper cause business cycles? Architectural historian Carol Willis describes a very similar empirical conundrum:
In the overheated speculation of the 1920s, as land prices rose, towers grew steadily taller. Or should the order be: as skyscrapers grew taller, land prices rose? The variables that contributed to real estate cycles were even more complex than this “chicken and egg” conundrum.Carol Willis, Form Follows Finance: Skyscrapers and Skylines in New York and Chicago (New York: Princeton Architectural Press, 1995), p. 88.
What is the nature of the relationship between skyscraper building and the business cycle? Surely, building the world’s tallest building does not cause economic collapse. Just as clearly, there are well-known economic linkages between construction booms and financial busts. So what theoretical connections can be made between skyscrapers and business cycles?
Lawrence considered overinvestment, monetary expansion, and speculation as possible explanations for the relationship his index revealed, but he did not explore these issues at length or come to a definitive conclusion. Instead he finished with the notion that his Skyscraper Index was an unhealthy hundred-year correlation. Without an established connection or theory for the Skyscraper Index there are strong reasons to doubt its usefulness.
For example, with the destruction of the World Trade Center and the increased threat of terrorism, the Skyscraper Index may have already lost its usefulness for prediction. However, Edward Glaeser and Jesse ShapiroEdward L. Glaeser, and Jesse M. Shapiro, “Cities and Welfare: The Impact of Terrorism on Urban Form,” NBER Working Paper 8696 (Cambridge, MA: National Bureau of Economic Research, 2001), p. 15. did not find a statistically significant link between terrorism and the numbers of skyscrapers built. They also note that because of government interventions — for example, building codes — as well as psychological reasons such as a builder’s desire for personal fame, the number of skyscrapers may not be market determined.
The business press reported on Lawrence’s Skyscraper Index, but without much fanfare. Investors’ Business DailyInvestors’ Business Daily, “Edifice Complex,” May 6, 1999. seemed somewhat sympathetic to his “impressive” evidence, but asked: “How could something bad come of building the world’s biggest skyscraper? After all, bigger is better. Having the biggest building on earth can be a source of national pride.”
Also positive was Barron’s, which seemed to agree that it was an “excellent forecasting tool for economic and financial imbalance.”William Pesek, Jr., “Want to Know Where the Next Disaster Will Hit? Look Where the World’s Biggest Skyscraper’s Going Up,” Barron’s, May 17, 1999, MW11. Business Week raised the question of how to connect skyscrapers with economic crisis as described by the Skyscraper Index.Gene Koretz, 1999. “Do Towers Rise before a Crash?” Business Week, May 17, 1999, p. 26. The first and most concerned report came from the Far Eastern Economic Review, which noted that China was planning on breaking the record for the world’s tallest building and was constructing three of the ten tallest buildings on the planet to be completed by 2010.Alkman Granitsas, “The Height of Hubris: Skyscrapers Mark Economic Bust,” Far Eastern Economic Review 162, no. 6 (February 11, 1999): 47.
The main reason for the muted response to the Skyscraper Index by the business press is that most economic indicators have eventually failed over time. There have been numerous indicators put forth to help us predict the business cycle and stock markets, but they have not passed the test of time. As Goodhart’s lawCharles A.E. Goodhart, “Problems of Monetary Management: The U.K. Experience,” in Charles A.E. Goodhart, “Problems of Monetary Management: The U.K. Experience,” in Inflation, Depression, and Economic Policy in the West, edited by Anthony S. Courakis (Lanham, MD: Rowman & Littlefield, 1981), p. 116. states: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” This is also a likely fate of the Skyscraper Index.
For example, the Super Bowl indicator predicts that if the championship team from the National Football Conference (the old NFL) beats the championship team from the American Football Conference (the old AFL) in the Super Bowl game it should be a good year for the stock market and ipso facto a good year for the economy. This is a classic case of a “coincidental indicator.” This type of coincidental indicator (with no causal connections) should be differentiated from the traditional type of coincidental economic indicators that track changes in the business cycle. For example, payroll statistics are clearly linked with economic activity over time. If payrolls increase, then there is more economic activity and GDP. There is a real reason why we expect both statistics to change roughly in unison.
When this Super Bowl connection was first noticed in the 1970s by sports writer Leonard Koppett it was nearly perfect.Jason Zweig, “Super Bowl Indicator: The Secret History,” Wall Street Journal, January 28, 2011. Since then it has lost much of its credibility, with an overall record of about 80 percent but only about 50 percent over the last fifteen years. Therefore, the early success of the Super Bowl indicator manifested just a coincidence and a statistical illusion, as Koppett himself professed.
There are also seasonal indicators like the “January effect,” which claims that if stock markets increase in January, then stock markets will increase that year as well. However, this effect has been given multiple justifications, such as year-end bonuses and tax-avoidance strategies. It is also not clear whether the January effect is based on the performance of the stock market during the first week of January or during the entire month. It is also unclear whether it applies only to small-company stocks or the entire stock market. The January effect also suffers from the fact that once everyone is aware of it, it becomes anticipated and therefore no longer offers reliable investment advice or insight into the economy. As a result, such indicators do not have a reliable record for predicting the stock market or business cycles.
Political indicators of the economy are based on the political business cycle theory. This theory maintains that politicians will use monetary and fiscal policy, along with other policy measures at their disposal, to boost the economy, job growth, and the stock market prior to an election in order to enhance the probability of being reelected. Then after the election they will reverse those policies, creating a recession. Despite its intuitive appeal, the political business cycle theory has found little consistent empirical support. This failure may be the result of the difficulty of knowing what ruling coalition is truly in charge of government or how the different levels of government are interacting over their respective election cycles. These and other problems leave the theory with only a weak link between politics and the economy.
According to Paul Cwik,Paul Cwik, “The Inverted Yield Curve and the Economic Downturn,” New Perspectives on Political Economy: A Bilingual Interdisciplinary Journal 1, no. 1 (2005): 1–35. indicators with good causal-economic links to the economy include the inverted yield curve. When short-term interest rates rise above long-term interest rates, the yield curve becomes inverted, and this indicates trouble ahead for the economy. High short-term lending rates may indicate that borrowers are desperate for funds and lenders are reluctant to loan due to the perception of increased risk. The Index of Leading Economic Indicators was once the official crystal ball of the economy. However, in recent years it has had less success predicting changes in the economy. Two other indicators that I use to gauge the global economy are the price of oil and the Baltic Dry Shipping Index, which is a measure of the cost of ocean transportation. When both are high, it is an indication of global economic expansion, a boom, or a bubble. When both are low, it is an indication of economic contraction, a bust, or an economic crisis. However, all of these indicators are error prone and generally only provide a limited advanced notice of cyclical change. Such indicators certainly cannot issue alerts far enough in advance to be helpful for large capital-investment decisions.
Economist Richard Roll explained that economic indicators have only questionable or fleeting value for real-world investing:
I’m not just an academic but also a businessman. … [W]e could sure do a heck of a lot better for our clients in the money management business than we’ve been doing. I have personally tried to invest money, my client’s money and my own, in every single anomaly and predictive device that academics have dreamed up. … I have attempted to exploit the so-called year-end anomalies and a whole variety of strategies supposedly documented by academic research. And I have yet to make a single nickel on any of these supposed market inefficiencies.Richard Roll, “Volatility in U.S. and Japanese Stock Markets: A Symposium,” Journal of Applied Corporate Finance 5, no. 1 (Spring 1992): 29–30.
The problems with stock market and economic indicators are many. Some have a poor track record of predictions, while others have a good track record but no economic rationale and thus offer little confidence that they are not just statistical anomalies.
The Skyscraper Index, in contrast, does have a good record in predicting important downturns in the economy. This index is a leading economic indicator. The announcement of building plans — and in particular, groundbreaking ceremonies — typically occurs during economic expansions long before the onset of an economic crisis.
The most important question about the Skyscraper Index is why it has had such a good record of predictive success. Why does it work? What can it tell us about the structure of the economy over the course of a business cycle? Before we answer those questions, let us first examine the history of the index’s success in predicting the curse.
It was on a weekend during the winter of 2004 and I was getting suspicions of the coming of another Fed-induced bubble like the one of the late 1990s. Social psychology seemed to be becoming more optimistic. However, it was not perfectly clear if it was just a general boom throughout the economy, or a bubble in a particular sector. I decided to take a look for myself.
It would be hard to deny that the American stock exchanges are experiencing bull markets. Last year (2003) the NASDAQ was up over 50 percent while the Dow 30 and S&P 500 had gains of 25 percent, and it seems that everyone is bullish this year. The Dow Theory (which is not much of a theory) tells us that we are in a bull market. If you are a follower of the “January effect,” where the month of January somehow determines the fate of the market for the year, you should also have a bullish outlook because all the stock market indexes ended the month in positive territory.
Only the New England Patriots’ victory would seem to have spoiled the party. The Super Bowl indicator predicts a good year for the stock market if a team from the old NFC wins and a bad year when a team from the AFC wins. Then again the Super Bowl indicator has lost some of its magic in recent years. Maybe we should switch to political indicators, which would suggest big gains in stocks during an election year.
But is the stock market truly showing signs of prosperity, or is it just BS?
I would like to suggest the latter and that it might not be a good time for you to obtain a home-equity loan to invest in hot tech stocks. We are going through a housing bubble, and stock valuations as measured by stock price-to-earnings ratios are at bubble levels. The buy low, sell high philosophy would lead you to sell stocks now, not buy them.
I’m not suggesting that you sell your house or cash in your retirement funds, only that you don’t throw caution to the wind and abandon traditional guidelines. Over 90 percent of stocks are now trading above their two-hundred-day moving average. I usually think of selling stocks, or at least stop buying them, when this indicator approaches 80 percent and then throw the cash back into the market when it gets down to the 20–30 percent level. At a minimum, investors should take the time to evaluate their assets and portfolio allocations between stocks, bonds, cash, and gold — between speculation and safety.
What is the case for a BS stock market based on?
First, the Federal Reserve has pushed short-term interest rates down to historically low levels. This has certainly buoyed stock prices, but it also has stymied savings and encouraged increases in consumption and debt. Americans have low levels of savings and high levels of debt, and this is simply not good for the health of the economy. In fact, statistics indicate that Americans have been taking money out of saving accounts and putting it into the stock market, but are not increasing their overall savings.
Second, the federal government has increased spending and debt at a rapid rate. Both are bad for the health of the economy, but do serve to keep up the appearance of prosperity in economic statistics such as GDP and the unemployment rate. When economic recovery is fueled by government spending, combined with stimulated consumption spending and housing construction, how real can the prosperity be?
Looking backward, we should also remember the decrease in the value of the dollar. Thanks to the Federal Reserve, the US dollar index lost approximately 15 percent of its value in 2003. If you had parked your money in a foreign bank or foreign bonds you could have avoided the loss plus earned interest, making the 25 percent gains on US stocks hardly spectacular in comparison.
Looking forward, we should note that the percentage of investment advisors who are bullish on the market is near the highest level experienced over the last four years. The percentage of investment advisors who are bearish is near the lowest level over the same time period. This psychological indicator is a contrarian indicator in that the larger the number of bulls and the smaller the number of bears, the more likely is a “correction” in the stock market. It is not a perfect indicator — nothing is — but it does line up with economic analysis in finding some trouble ahead in the US stock market.
This takes me to my disclaimer. If investment advisors as a group tend to be wrong about the future of the stock market, then how good can my advice and analysis be? The answer is caveat emptor, and that’s no BS.
What this book has established is that the central bank causes a variety of economic problems and that Austrian business cycle theory (ABCT) shines a scientific light on what otherwise is a highly complex phenomenon. I have shown that the Skyscraper Index has predicted most of the important economic crises for over a century. I have also shown that Austrian economists have predicted those crises using ABCT.
Now the question arises: what are the problems and what can be done about them? The two most obvious problems with central banking and the monetary inflation that flow from them are the boom/bust business cycle and inevitable price inflation. Embedded in the process of monetary inflation and price inflation is a degenerative process of economic inequality that is so apparent today. This effect on economic inequality and the channels through which it flows are described in further detail by Hülsmann.Jörg Guido Hülsmann, “Fiat Money and the Distribution of Incomes and Wealth,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno, (New York: Springer, 2014), pp. 127–38.
Monetary inflation depends on who gets the money and credit first and who gets it last. As fiat money is created by central banks, private banks are in a position to expand the amount of loans they make. The wealthy have established relationships with the banks, and they have the real estate and assets to provide collateral for the loans. Large, established companies and wealthy individuals are in favorable positions relative to small businesses and people with low or average incomes. The loans allow big companies and wealthy individuals to invest in capital goods during the boom phase of the business cycle. Central banks thereby create artificial inequality and poverty. This is the primary Cantillon effect of redistributing wealth.
We have rarely had a true “free market” in money and banking. The American colonies were controlled by English mercantilist policies. The antebellum era experienced the business cycles created by the First and Second Banks of the United States, which were essentially primitive central banks. Between the end of the Second Bank of the United States and the National Banking System was the era of “free banking.” This period best approximates a free market in money and banking because gold and silver coins served as money, entry into the banking business was relatively easy, and bank reserves were kept relatively high compared to demand deposits. Government spending and government intervention were historically very low. This period experienced the highest rates of economic growth in US history, but it was not perfection, as many state free-banking laws contained poisonous provisions that undermined the stability of banking.
The National Bank Acts were passed during the Civil War and “regulated” money and banking until the Federal Reserve Act was passed in 1913. The Fed and WWI effectively ended the classical gold standard and replaced it with the gold exchange standard. In 1933 all privately held monetary gold was confiscated by the federal government, and the nominal book value of gold was changed from $20.67/ounce to $35/ounce. The post-WWII Bretton Woods gold standard allowed other central banks to convert $35 into an ounce of gold, but it also freed the Fed to essentially print gold. This arrangement eventually became untenable when other central banks began converting dollars into gold. President Nixon closed the “gold window” on August 15, 1971.
Since that time the world has been on a fiat monetary system where currencies are not convertible and exchange rates between currencies are “flexible.” The power and authority of central banks has continued to expand over time. The money supplies and central bank balance sheets have continued to expand, and the value of currencies has continued to decline. For example, in mid-2008 the total assets of the Federal Reserve were less than $900 billion. By mid-2014 their total assets were over $4,400 billion. The Fed acquired these additional assets of government bonds and mortgage-backed securities by printing electronic dollars. As a reference point, measured in gold, the dollar is currently worth less than two cents of the pre-Fed dollar. The Bank of Japan, the People’s Bank of China, the European Central Banks (ECB), and other central banks around the world are pursuing similar policies in an undeclared currency war.
MurphyRobert Murphy, “Ben Bernanke, the FDR of Central Bankers,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 31–42. shows that the Fed’s responses to the financial crisis were overwhelming, unprecedented, and of dubious statutory authority. These responses were so egregious that Murphy labels Ben Bernanke the FDR of monetary policy. Despite the Fed’s efforts, Murphy concludes the policies have not worked. The ECB has also overstepped its statutory authority from the European Union in response to the European debt crisis, to no avail.
Have these policies worked well? There has been a constant debate since 2008 over whether the economy has recovered and is growing, or whether it is mired in a lingering recession. There are supporters of both views from across the political and economic spectrums. The real dividing line depends on the relationship the person has with the establishment. Supporters of the establishment contend that the economy survived and recovered, while opponents of the establishment generally consider the economy to be broken and regressing.
The battle between these two views is generally undertaken with contending sets of statistics regarding GDP, unemployment, and price inflation. Austrian economics settles the issue by looking at things such as the big increases in government spending, deficit-financed spending, and the questionable value of investments financed with artificially low interest rates since 2008. Austrians argue that the real market value of increased government spending and malinvestments is far less than the dollars expended. Thus the resulting GDP statistics are very dubious. This analysis suggests that the US economy is regressing on a long-term basis and that we are much deeper in debt as a result.
In fact, EngelhardtLucas Engelhardt, “Unholy Matrimony: Monetary Expansion and Deficit Spending,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 139–48. and others have argued that a central bank facilitates the process of deficit financing and the accumulation of a large national debt. A central bank can always print money to pay for the national debt, or print money to buy up the national debt, as the Fed is doing today with its various quantitative-easing policies. The US government had a debt of around $370 billion to begin the 1970s. At the end of 2007 the national debt was $9.3 trillion, and it more than doubled before the end of 2015 to a debt of $18.9 trillion and it continues to grow. In 1970 the national debt was the equivalent of 34 percent of GDP. In 2015 the national debt as a percentage of GDP was more than 100 percent. A large national debt is a negative drag on the economy and can even result in hyperinflation. SalernoJoseph T. Salerno, “War and the Money Machine: Concealing the Costs of War beneath the Veil of Inflation,” Journal des Economistes et des Etudes Humaines 6 (March 1995): 153–73. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010). has shown that central banks also facilitate unnecessary and expensive wars because the central bank can conceal the true costs of war from the citizens.
However, as a best-case scenario, let us make the heroic assumption that all that government spending was really valuable — that is, a dollar of additional government spending produced a dollar of consumer value — and that all those investments made between 2008 and the present will turn out great. If we take the government’s measure of the economy (i.e., GDP) and adjust for the government’s measure of price increases (i.e., the GDP deflator) and then adjust that figure by the increase in population, we find that the US economy grew at less than 4 percent over the entire period from 2008 to mid-2016. Compare that to the years during the free-banking era (1837–62) when inflation-adjusted, per capita GDP growth was 3 percent or even higher per year. That is a stark contrast.
It is not a mystery as to what has caused economic malaise in the US economy. In this, we note three important factors. First, the amount of debt that has accumulated in the US economy is enormous. The amount of debt of government, businesses, and consumers has soared over the last forty-five years, and this is no doubt linked to suppressed–interest rate policy and a depreciating currency generated by the Fed. Traditionally, the total amount of debt in the United States was about 1.5 times GDP or less. Today it is about 3.5 times GDP. In other words the debt burden is too high. Second, the personal savings rate in the United States has fallen dramatically. Prior to 1971 the average personal saving rate, as measured by the government, was over 10 percent. Since 1971 the personal saving rate has declined to as low as 2 percent during the housing bubble, although it has recovered to an average of over 5 percent since the financial crisis. The Fed’s suppressed–interest rate policy and depreciating currency are the major, but not the only causes of the low personal savings rate. Third, the regulatory burden in the US economy has increased enormously over the last half century, and the amount of and burden of regulation has only accelerated since the financial crisis in the form of Dodd-Frank financial regulation and the Affordable Care Act.
The reduction in savings and the increase in regulatory burden have caused the reduction in productivity growth. A lack of productivity growth explains the stagnation in wages and the lack of high-wage job growth. Any remaining income growth has been absorbed by the increased cost of financing debt, higher taxes to finance government debt, and mandated job benefits, such as medical insurance. All of this comes on top of the fact that family incomes have been stagnant or declining for a decade and a half. Meanwhile, billionaires thrive.
With the Fed passing one hundred years of age in 2014, there have been many retrospectives on the general value of this institution. There have been some favorable and encouraging reviews from inside the Fed, but most outsiders have taken an entirely negative stance on the very existence of the Fed and the place of central banking in a healthy and free society.
White,Lawrence H. White, “The Federal Reserve System’s Influence on Research in Monetary Economics," Econ Journal Watch 2, no. 2 (August 2005): 325–54. for example, questions the influence and impartiality of the Fed. The Fed spends vast resources on economic policy research, particularly on money, banking, and macroeconomics. This funding, as both carrot and stick, has no doubt produced a status quo bias in academic research on subjects that are the concern of the institution of the Fed. According to White:
The Fed employed about 495 full-time staff economists in 2002. That year it engaged more than 120 leading academic economists as consultants and visiting scholars, and conducted some 30 conferences that brought 300-plus academics to the podium alongside its own staff economists. It published more than 230 articles in its own research periodicals. Judging by the abstracts compiled by the December 2002 issue of the e-JEL, some 74 percent of the articles on monetary policy published by US-based economists in US-edited journals appear in Fed-published journals or are co-authored by Fed staff economists.Ibid., p. 235.
White puts the size of the Fed’s research staff into perspective by noting that the Fed’s staff of economists in 2002 was 27 percent larger than the number of macroeconomists and experts in money and banking employed by the top fifty PhD-granting economics departments in the United States combined. The Fed has numerous research journals that publish an enormous number of articles, but the articles that are published are vetted by the staffs at both the regional Fed banks and the Board of Governors in Washington, DC. This no doubt creates a tremendous bias against criticism of the Fed itself.
White also found that the Fed dominates the editorial boards of the leading academic journals specializing in money, banking, and macroeconomics. At the time of his research, one of the two main editors of the Journal of Monetary Economics and eight of the nine associate editors (82 percent) had one or more affiliations with the Fed. At the Journal of Money, Credit, and Banking, all three of the main editors and thirty-seven of the forty-three associate editors (87 percent) had Fed affiliations. Therefore not only does the Fed dominate the profession in terms of carrot-and-stick resources, but it also nearly acts as a universal gatekeeper at both the Fed and non-Fed academic journals dealing with money, banking, and macroeconomics. Not only is the Fed political in defense of its institutional power, but DiLorenzoThomas DiLorenzo, “A Fraudulent Legend,” in The Fed at One Hundred edited by Howden and Salerno, pp. 65–74. has shown that the “independence” of the Fed from the political process is a complete myth.
Selgin, Lastrapes, and WhiteGeorge Selgin, William D. Lastrapes, and Lawrence H. White, “Has the Fed Been a Failure?” Journal of Macroeconomics 34, no. 3 (September 2012): 569–96. examined the Fed’s track record and found it lacking in comparison to the National Banking system. With the exception of the Fed’s role in regulating banks, they examined its roles in controlling inflation and deflation as well as volatility of output and employment; the role of the Fed in the Great Moderation; and the frequency and distribution of recessions, banking panics, and lender-of-last-resort lending. They then evaluated the results against prior monetary experience using standard empirical techniques and published research.
They showed that prior to the Fed, the purchasing power of the dollar had long-term stability. In comparison, the Fed has produced powerful bouts of both inflation and deflation and greatly degraded the value of the dollar over the long term. There has also been a trend of increased volatility and decreased predictability of the changes in purchasing power of the dollar, making long-term plans and contracts more difficult. They found that the declining rate of inflation that occurred during the Great Moderation should be attributable to other factors than the Fed’s monetary policy. Finally, they showed that the Fed has not reduced panics or improved on its function as lender of last resort. In other words, the Fed has failed to match or exceed the results of the previous monetary regime. Historian Thomas WoodsThomas E. Woods, “Does U.S. History Vindicate Central Banking?” in The Fed at One Hundred, edited by Howden and Salerno, pp. 23–30. confirms that the problems of the pre-Fed money-and-banking system were the result of various government interventions, but that it was still better than the Fed. KleinPeter G. Klein, “Information, Incentives, and Organization: The Microfoundations of Central Banking,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 149–62. and IsraelIsrael, Karl-Friedrich. “The Costs and Benefits of Central Banking,” PhD dissertation, Department of Law, Economics, and Business Administration, University of Angers, France, 2017. show that the institutional features of a central bank are inherently destabilizing.
ThorntonMark Thornton, “Transparency or Deception: What the Fed Was Saying in 2007,” Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 65–84. investigated the role of transparency in the conduct of the Fed’s monetary policy. Transparency is the notion that central banks reveal information about the concerns, intentions, and policies to the general public and particularly to specialists in markets and other central banks so as to not unintentionally shock markets with negative news. Generally, transparency by central banks has expanded over the last twenty-five years. Research on transparency has shown that increased central bank transparency has produced either positive or negligible effects on things you can measure with numbers, such as stock markets and interest rates. Instead of a statistical examination, Thornton reviewed the public statements prominent Fed officials made to groups of market specialists during 2007, the year between the housing bubble and the beginning of the financial crisis. He found that in these prominent public addresses, Fed officials consistently made misleading statements that often verged on deception. Economist Shawn RitenourShawn Ritenour, “The Federal Reserve: Reality Trumps Rhetoric,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 55–64. has confirmed that the Fed has consistently used its rhetoric to promote the incorrect view that the Fed solves economic problems, it does not create economic problems.
Given the current scenario and the above analysis, what changes have to be made in order to create an economic environment that produces a stable economy without artificial redistribution of wealth? It would seem that the economic mess might be a web of problems too large and too tangled to solve, but that is not the case.
Let us begin with what are the ultimate goals. It should be clear that given the economic and historical analysis in this book that the goal here is to reestablish genuine markets for money and banking without government regulations and privileges. Market forces alone should regulate money and banking, just like the markets for aspirin, shoes, and cell phones. The following recommendations, couched in this respect, should not be considered a matter of mere opinion.
This seems like a tall task, but the process can begin on day one. The first thing to do is to disband the Federal Open Market Committee (FOMC) and allow the interest rate in the federal-funds market — the federal funds rate, which banks charge other banks for short-term loans — to be determined by market forces. The FOMC consists of the seven members of the Board of Governors in Washington, DC (political appointees), the president of the New York Federal Reserve Bank, and four rotating Federal Reserve District Bank presidents from the remaining twelve Federal Reserve District Banks. Their job is superfluous at best. This central-planning committee is the source of all the problems described in this book. It should be disbanded and its interest-rate–setting authority abolished.
The entire Federal Reserve System should be shutdown. Its legitimate functions, like check clearing, should be privatized. Gold on its balance sheet should be used to redeem Federal Reserve Notes for “gold dollars” equal to some established weight of gold. The Fed’s holdings of US government bonds should be cancelled and other assets should be turned over to the US Treasury. Howden and SalernoDavid Howden, and Joseph T. Salerno, “A Stocktaking and Plan for a Fed-less Future,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 163–69. offer a similar plan, and SalernoJoseph T. Salerno, “Will Gold Plating the Fed Provide a Sound Dollar?” in The Fed at One Hundred, edited by Howden and Salerno, pp. 75–90. finds that most of the other types of plans to return to a “gold standard” do not work and that a “gold plated standard” does not stabilize the dollar or the economy.
All taxes on capital gains on gold and silver should be eliminated along with taxes on anything else that might emerge as a new type of money — for example, Bitcoin and copper. Legal tender laws should also be repealed so that people are not forced to use any particular type of money. Currently it is possible to deposit dollars into gold banks and make payments using a variety of media, such as checks or debit cards, but you have to pay capital gains taxes if a payment generates a capital gain.
Federal insurance of demand deposits should be eliminated. This would be replaced with banks complying with laws regarding other deposit-taking institutions, such as grain warehouses. They would be forced to use their own capital or money raised by selling bonds to make loans. By charging fees on the use of demand deposits (i.e., checking accounts) and offering interest on bonds, banks would reduce the amount of demand deposits and increase their long-term bonds. This would help solve the perennial problem of banking — borrowing short term, but lending long term. Banks would effectively be 100 percent reserve institutions. Banks would probably receive a great deal of deposits and bond purchases from the now largely irrelevant investment demand for gold, as hoarders of gold would have no reason to hold gold and more reason to invest in gold bonds in order to earn interest, instead of hoarding gold. The personal saving rate would no doubt increase. See Askari (George Washington University) and Krichene (International Monetary Fund)Hossein Askari, and Noureddine Krichene, “100 Percent Reserve Banking and the Path to a Single-Country Gold Standard,” Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 29–64. for a full explanation of the nature and history of 100 percent–reserve gold standard reform and the impressive list of noteworthy economists who support it.
None of this would be easy or free of disturbance. The highly leveraged economy would likely face a painful deleveraging process, concentrated in industries that benefitted most from the fiat-money central bank regime. There would probably be a massive wave of bankruptcies, foreclosures, defaults, and other legal and entrepreneurial solutions. The national debt would be in precarious shape and would have to be openly repudiated rather than the current process of default by inflation. The national debt could be put under the control of a legal custodian who would make payments from sales of government assets. If Obamacare, Medicaid, Medicare, and Social Security were significantly reformed and replaced with market institutions, the federal government appears to have enough assets to pay off the national debt and to meet its obligations. The federal government would probably not be able to draw additional credit, but forcing future generations to pay for past mistakes is an abhorrent practice. Massive budget cuts would have to be passed in order to balance the budget and to reestablish a market economy free of government intervention. The more government intervention that can be removed, the better the process of economic adjustment and the faster the economy will adjust and grow.
This process would involve deflation or falling prices. Mainstream economists have an unwarranted phobia of deflation. They think that deflation causes economic crises from which an economy cannot ever escape. Austrians have shown that deflation is actually the corrective process by which asset prices and wages fall relative to consumer goods, thus creating profit opportunities for entrepreneurs to reorganize and employ such resources.
With the United States moving to a 100 percent reserve gold standard, the value of the gold dollar would be fixed as a weight of gold. The exchange value would increase relative to other world currencies, and Americans would be made richer by the fact that their incomes and savings would buy more. It would be increasingly difficult to import goods into the United States. This would put pressure on other countries to follow the United States’ lead in adopting the gold standard and other monetary reforms. With the United States also cutting back on military and regulatory spending and selling vast amounts of resources to the private sector, the standard of living would quickly recover and the economy would experience high rates of economic growth.
Most people would not want to take the risks imagined by these recommendations. Politicians know this and exploit it. They and mainstream economists have plenty of horror stories to scare everyone else. However, SalernoJoseph T. Salerno, “The 100 Percent Gold Standard: A Proposal for Monetary Reform,” in Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2014), pp. 333–63. has shown that the standard criticisms of the gold standard are baseless.
The truth is the alternative of not reforming the system is much, much worse. As the dollar status as a reserve currency for other central banks worsens, the likelihood that some other government embarks on such a reform process increases. The government is too big, the national debt is too large, savings are too low, the money supply has been expanded too much, and the extent of artificial inequality threatens the fabric of cooperative society. These problems will only get worse over time and will end in hyperinflation, where that fabric is finally set ablaze on a bonfire of worthless paper money and government bonds.
The events in Washington, DC, today in 2018, represent a stalemate between President Trump and the establishment. This stalemate sustains the status quo at a time when there is radical rumbling on both left and right. Despite marginal reforms in taxation and regulation and despite the Fed’s announced reversal of policy, nothing remotely has changed to address the calamity that lies ahead, and that I’ve discussed throughout this book.
In the wake of the financial crisis of 2008, the economics profession suffered a blow to what reputation it had. But unlike most of his colleagues, Mark Thornton was vindicated by 2008. Mark has been a voice of sanity at times when the wild interventions of the Federal Reserve have caused otherwise sensible people to lose their minds.
This collection serves the valuable purpose of defending the market economy against the conventional view that freedom has failed us and we need still more controls. We had plenty of rules and bureaucrats on the eve of the financial crisis. A lot of good that did us. Pretty much none of them saw any problems on the horizon.
Maybe we should consider a real free market, with sound money and market interest rates, and abolish the giant bubble machine once and for all. Read Mark Thornton and you’ll entertain this and other forbidden thoughts.
From the Foreword by Thomas E. Woods, Jr.
Section 1 of this book has been about the Skyscraper Index, which was created by Andrew Lawrence in 1999. The index chronicles the puzzling connection between the building of record-breaking skyscrapers and the onset of severe economic crises. The resulting crises are dubbed skyscraper curses.
The skyscraper curse refers to the major economic crises that follow in the wake of record-breaking skyscrapers. In retrospect, curse is a poor choice of words. One use of curse indicates an irritation or annoyance, like psoriasis or a trouble-making daughter, distinct to the individual. A second use refers to being afflicted, at a much higher level of negativity, by a mystical being or worldly but religious person, such as a voodoo doctor. The third use refers to the use of swear words by one individual who is complaining about someone or something. The central contribution of section 1 has been to explain that the skyscraper curse is neither self-inflicted nor related to the use of curse words. It is also not about mystical beings or religious figures. The modern curse is about the imposition of severe economic harm imposed by the worldly beings at the Federal Reserve.
The Skyscraper Index has a remarkable record of showing a very close correlation between world-record-breaking skyscrapers and the onset of major economic crises. This section has extended that history back into the nineteenth century and forward in time since the index’s creation in 1999. It has also shown that the original exception to this historical record, the Woolworth Building, was not an exception at all, but simply an accident of history. We also can see that the index can be used to analyze this phenomenon at lower levels of aggregation, such as the state level and the urban level (the problem of urban sprawl).
Of course, if you had not read this section, you might have doubted the reliability of the index. As I have reiterated several times, the use of the Skyscraper Index as a forecasting tool is not highly recommended. Just as canals are no longer a central component of the economy’s transportation network, skyscrapers could easily lose their key position in the economy in the future. Another reason for caution is that major economic crises can be initiated by other causes than central banks, such as wars and pandemics. Plus, there is no precise mechanism to employ for forecasting, so there remain good reasons to be doubtful or at least skeptical in this regard.
Most promising indicators eventually fail, especially those that seem whimsical and have no fundamental basis, while others are of little use to guide long-term capital-investment expenditures. This section has provided the grounding or fundamental basis for the Skyscraper Index in economic theory and Austrian business cycle theory (ABCT). An artificially low-interest rate monetary policy pursued by central banks distorts capital-investment plans of entrepreneurs. This monetary policy follows the path from the interest rate setting policies of the central bank to open-market operations between the New York Fed and big banks. This eventually hits Main Street and results in more debt and misguided investments. We compared the natural process of economic growth and development driven by real savings with the disastrous results when apparent growth and development is driven artificially by central banks.
Most mainstream economists do not have an economic theory of business cycles. They see the economy as a simple machine that works just fine at the macro level as long as there are no technological or psychological shocks. These shocks are random and cannot be known in advance. Therefore they cannot be predicted or prevented. ABCT incorporates both technical and psychological change. Plus, ABCT theorists expect those changes to happen and can form expectations about when and where those changes will take place in the presence of artificially low-interest rate monetary policy.
By embracing the complexity of the economy with the aid of concepts such as the structure of production and the roundabout production process, ABCT can even provide insight into where the crisis will most likely be the most severe. The analysis of Cantillon effects is also helpful here because this is where the distortion causes malinvestment in product-specific capital goods. Austrian economists have disdain for magic wands in their economic analysis, whereas such wands play a crucial role in mainstream economic analysis.
We now turn our attention to the forecasting ability of Austrian economists regarding economic crises and compare that with the forecasting ability of mainstream economists. Hint: it has nothing to do with skyscrapers.
The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century By Mark Thornton
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Preface During the 1980s Japan was feared as an economic and technological powerhouse. Most observers attributed their stock market bubble and high growth rates to easy monetary policy, management style, and government managed technological development. Since 1990, the Japanese government has been fighting price deflation with monetary inflation and trying to increase growth by government deficit spending. By all accounts it has not worked. Their economy remains mired in low growth, they have by far the highest ratio of government debt to GDP in the world, and they face a dramatic demographic crisis as their population continues to age. This chapter is the lesson of what NOT to do and who not to listen to for advice.
Business cycles and bubbles differ from one another, but the technical similarities between the Japanese and US bubbles are striking. The Japanese bubble began in the early 1970s, the US bubble started in the early 1980s. Both stock markets grew rapidly for thirteen years and then went parabolic to form bubbles, which peaked in Japan at the end of 1989 and in the United States during early 2000. Both stock markets lost about a third of their value eighteen months after their peaks. The Nikkei Stock Index has since lost as much as three-quarters of its peak value, while the Dow Jones Industrial Average has been down 40 percent and the NASDAQ Composite down by 75 percent of its peak value. The real estate bubble continued in Japan for some time after the stock market began its meltdown, and likewise, real estate — particularly housing — experienced (two) bubbles since the initial breakdown of the US stock market in 2000.
The surprising thing is that in the United States the lessons of the Japanese bubble seem to have almost gone unnoticed. Japan experienced fourteen years (now more than twenty-five years) of economic stagnation since its bubble popped. Most troubling, the United States not only failed to heed the warnings of the Japanese bubble, it has thus far mimicked Japan’s failed attempts to stimulate its economy with extremely low interest rates and large government budget deficits. Both countries have opted for a slow, agonizing “recovery,” rather than a sharp correction of past errors that would quickly reallocate resources and return the economy to sustainable growth. Experts tell us that the Japanese and their economy are very different from the Americans and their economy and that the Japanese bubble and Japan’s policy response to its crash were likewise different, but while there certainly are many important differences between the US and Japanese bubbles, the technical features and new-age thinking are strikingly similar in both bubbles.
For example, there is no doubt that technology and new-era thinking played a major role in the Japanese bubble. During the bubble, Japan took over leadership of high technology in the areas of consumer electronics, the automobile industry, manufacturing, and even robotics, and was perceived as a major threat to dominate all technological development around the globe — just as the United States is today. The threat posed by Japan’s growing technological prowess can be seen in the titles of books published during the bubble era: Japan’s High Technology Industries, edited by Hugh Patrick and Larry Meissner (1986); The Technopolis Strategy: Japan, High Technology, and the Control of the Twenty-First Century, by Sheridan Tatsuno (1986); A High Technology Gap?: Europe, America, and Japan, edited by Andrew J. Pierre (1987); The Science and Technology Resources of Japan: A Comparison with the United States, by Maria Papadakis (1988); Created in Japan: From Imitators to World-Class Innovators, by Sheridan M. Tatsuno (1990); Japan as a Scientific and Technological Superpower, by Justin L. Bloom (1990); Japanese Technology Policy: What’s the Secret? by David W. Cheney and William W. Grimes (1991); and Japan’s Growing Technological Capability: Implications for the U.S. Economy, edited by Thomas S. Arrison et al. (1992).
Writing near the pinnacle of the bubble in the stock market, Fumio KodamaFumio Kodama, Analyzing Japanese High Technologies: The Techno-Paradigm Shift (London: Pinter Publisher, 1991), p. 171. explained that the Japanese takeover of technological progress was a result of a new Japanese paradigm that was ushering in a new era:
Japan is becoming one of the frontrunners in industrial technology, which means that prominent science and technology policy researchers all over the world now pay more attention to Japan. Considering this change more deeply, one can understand the reason for the researcher’s academic interest: the paradigm of technological innovation is shifting.
KodamaIbid., p. 172. found that in Japan the innovation of high technology “seems to be different from that for conventional technologies,” and therefore studies focused on Europe and the United States would not lead to a “new scientific framework for analyzing innovation of high technologies.” He suggested that we break away from the inadequate linear model of the past to the unlimited model experienced under the unique “social and cultural context” of Japan. KodamaIbid., pp. 173–74. even ended his book with the suggestion that it was the Japanese cassette-tape recorder, VCR, and fax machine that made the Iranian revolution, Philippine revolution, and Tiananmen uprising possible. This is classic new-era bubble thinking.
Another component of modern new-era thinking is the belief that the so-called scientific management of the economy creates perpetual prosperity. Here the Japanese experience epitomizes this phenomenon because the Japanese economy was said to represent a new “third way,” positioned between the free market economy and that of the centrally planned economy. In Japan, government and corporations act cooperatively in both their self-interest and the general interest of the nation. Bureaucracies help plan and coordinate the economy. They provide incentives, such as financing and tax breaks, in order to channel investment in profitable directions. Corporations, in turn, participate in joint research programs with their competitors, but share the results among participating firms, with each choosing what technological advances to employ in their firms. Production planning is facilitated by an overlap of ownership between final-good producers and their input suppliers. Japanese management, especially during the bubble, was said to spur innovation, enhance product quality and reliability, and create large market shares in export markets for Japanese industries. Alas, none of this could prevent a meltdown of the Japanese stock market and well more than a decade (now more than a quarter century) of stagnation in the Japanese economy.
New-era thinking about the scientific management of the economy was never more prominent and bold than during the Japanese bubble of the 1980s. It was often said that the Japanese system would lead to economic dominance and threaten the preeminence of the US economy. Laura D’Andrea Tyson, who would later become chairman of President Clinton’s Council of Economic Advisors, outlined (at the apex of the bubble) the “threat” of Japan’s technological superiority:
Certainly Japan continues to obtain technology wherever it is available and to translate it into commercial advance, as the United States itself did for so long. However, now talk has begun of a new, “technoeconomic” paradigm emerging in Japan, a new trajectory of technological development. That trajectory emerged from a pattern of industrial catch-up shaped by policies of import substitution and export promotion. As Japan reaches industrial maturity in a broad range of industries, its government is exerting substantial efforts to build a Japanese position in advancing technologies. Agencies such as the Ministry of Trade and Industries (MITI), which have become familiar names in policy discussions in the United States, are involved.Laura D’Andrea Tyson, John Zysman, and Giovanni Dosi, “Trade, Technologies, and Development: A Framework for Discussing Japan,” in Politics and Productivity: The Real Story of Why Japan Works, edited by Chalmers Johnson, Laura D’Andrea Tyson, and John Zysman (Cambridge, MA: Ballinger Publishing, 1989), p. xiv.
In Japan, the government channeled research and development efforts, directed financing, and protected markets for business. This new, third way of government management of the economy was thought to be Japan’s source of economic strength and was to inevitably place it in a position of economic preeminence. As Tyson and ZysmanLaura D’Andrea Tyson, and John Zysman, “Preface: The Argument Refined,” in ibid., p. xiv. confidently asserted:
A generation from now, Japan will almost certainly have created its own mechanism for advancing the technological frontiers in a range of domains. Now the continuing pace of productivity increase suggests that Japan may indeed be on a growth trajectory different from that of the United States. As Japan ascends, America frets about its decline.
Tyson and her coauthors, Dosi and Zysman,Ibid., pp. 4–5. questioned the validity of traditional economic thought, as all new-era thinkers must. They justified Japan’s “often flagrant and self-aware violations of the nostrums of traditional economic thinking” because when “technological change is a key determinant of market outcomes, standard economic models that treat such change as exogenous are a poor guide to understanding the dynamics of market competition and the effects of policy on such competition.” They argued that the “nostrum” of economic efficiency should be abandoned in favor of the less constraining and poorly defined notions of growth efficiency and technological efficiency.
Leaving the anchor of economic efficiency and traditional economic thinking behind, Tyson, Zysman, and DosiIbid., pp. 14–15. were able to justify a variety of noneconomic policies such as “beggar thy neighbor” protectionism. She heralded the concept of growth efficiency, which is essentially a Keynesian idea that rests on the assumption “that there are always unutilized resources that can be mobilized to meet growing demand. … It is exactly this kind of thinking that led the Japanese to target industries whose products were perceived to have high income elasticities as a foundation for rapid economic growth.” Ignoring the economic condition of scarcity and grasping at the concept of an economy of perpetually unutilized resources is a precondition for new-era thinking, as well as a quintessential mistake of freshman college students taking their first course in economics. If resources are perpetually available then an unlimited amount of all goods and services can be produced and there are no economic problems to solve. This would seem to be the most basic of economic errors and a particularly grievous one to make in analyzing resource- and land-poor Japan.
Naturally Tyson also had to offer a rationale for why markets do not work, and she concluded that entrepreneurs will pass up more profitable long-run investments in order to pursue short-run profits under certain conditions. Tyson, Zysman, and DosiIbid., p. 17. even admitted that their argument was simply a variation of the long-discredited infant-industry argument for protectionism:
Under conditions of nondecreasing returns there is simply no way that markets can relate the varying future growth efficiencies of various industries to relative profitability signals facing individual producers. Basically, this argument is a variant of the infant-industry argument. Because of increasing returns, current market signals can be misleading indicators of future profitability. Consequently, government policies to promote a domestic industry with high future growth potential can improve economic welfare in the long run.
It would seem from the perspective of Tyson, Zysman, and Dosi that modern-day entrepreneurs might invest in the production of black-and-white television sets or mechanical typewriters made out of jute if not for the prodding and oversight of government bureaucrats.
In their justification of Japan’s new-era thinking, Tyson, Zysman, and Dosi viewed technology from the historical rather than economic perspective. In an age of information and communication technology, their “path dependent” and “sticky” processes of technological development seem odd and not entirely appropriate for new-age theorists, who often view technology as “spontaneous,” perfectly flexible, and ever present. Nevertheless, they clearly are new-era philosophers of the Japanese bubble and its new technological paradigm:
The expression technological paradigm … involves a new set of best practice rules and customs, new approaches to how to relate technology to market problems, new solutions to established problems. The notion of a major industrial transition, of a second industrial divide, of a shift from “Fordist to flexible” manufacturing that has become a fad in some debates points to just such a shift in technological paradigm.Ibid., p. 31.
In retrospect, the new-era thinkers of the Japanese bubble economy seem conceited and hopelessly naïve, but that is the power of bubbles to deceive. One of the few observers to correctly identify and characterize the bubble was Christopher Wood,Christopher Wood, The Bubble Economy: Japan’s Extraordinary Speculative Boom of the ’80s and the Dramatic Bust of the ’90s (New York: Atlantic Monthly Press, 1992), p. 255. who wrote that Japan “became so arrogant in the late 1980s because it really believed it was immune from the natural laws of the marketplace. This really was one of the most astonishing acts of mass delusion ever, and future historians … will marvel at it.” The Japanese people might be particularly susceptible to the delusions of a stock market bubble because their culture has so long emphasized honesty and respect for authority, and the government has carefully maintained the isolation of its people, both of which could contribute to herd-like behavior and which make them ripe for what Charles Mackay famously called “the madness of crowds.” The Japanese also have characteristics in their social psychology, as well as their well-known emphasis on precision and details, that might make them more susceptible to new-era delusions. The truth is that all these psychological characteristics are unimportant in terms of the cause of bubbles.
In the wake of the bubble and bust, Japan experienced a long series of corruption scandals, a procession of failed prime ministers, the ousting of financial ministers, the conviction of bureaucrats for corruption, and the breakup of its one-party system. However, the Japanese have failed to truly recognize the cause of their bubble and to liquidate their economic mistakes. Instead they embarked on a post-bubble course of easy credit, public works, and deficit spending that has only served to condemn the Japanese economy to continuing economic doldrums.
Postscript The success of Japan after WWII was due entirely to the free market economy, small government, low taxes, an appreciating currency, and a very high personal savings rate. That all changed when the bubble was born in the late 1980s because of overly stimulating monetary policy. A quarter century after the stock market meltdown Japan is still mired in an economic slump. At the prodding of mainstream economists, such as Paul Krugman, Japan has embarked on massive amounts of public works projects, enormous amounts of government borrowing, and extreme levels of monetary stimulus and quantitative easing. None of this has worked. It has left the country with the largest national debt relative to GDP in the world. It has also diverted the attention of the Japanese people and thus prevented the country from addressing its demographic crisis. In fact, it might have made the demographic crisis worse. After all, why get married and have children when the children will have to bear the enormous burden of the national debt?
Foreword by Thomas E. Woods, Jr.
Introduction
Section 1: The Skyscraper Curse
Chapter 1: What Is the Skyscraper Curse?
Chapter 2: The History of the Skyscraper Curse Reexamined
Chapter 3: Do You Have a Theory?
Chapter 4: How to Get Milk
Chapter 5: Cantillon Effects
Chapter 6: Cantillon Effects in Skyscrapers
Chapter 7: The Curse Misses New York. Is Auburn, Alabama, Next?
Chapter 8: When Will the Next Skyscraper Curse Come?
Chapter 9: It Is Not the Skyscraper’s Fault
Chapter 10: Should I Stay, or Should I Go?
Chapter 11: Razorbacks and Wolverines
Chapter 12: The Curse of the Federal Reserve
Section 2: And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years
Chapter 13: Who Predicted the Great Depression?
Chapter 14: The “New Economists” and the Depression of the 1970s
Chapter 15: The Return of the Austrians
Chapter 16: Bubble-Bust in Japan
Chapter 17: Who Predicted the Bubble? Who Predicted the Crash? Bubble Predictions Conclusions Appendix: Some Other Predictions
Chapter 18: “Bull” Market?
Chapter 19: Housing: Too Good To Be True More Greenspan The Housing Bubble Price Inflation Follows Monetary Inflation The Dirty Secret Do Housing Bubbles Burst?
Chapter 20: The Economics of Housing Bubbles What Causes Housing Bubbles? What Goes Up ... ... Must Come Down Summary and Conclusions Postscript — August 8, 2009
Chapter 21: Is the Housing Bubble Popping?
Chapter 22: Making Depressions Great Again
Chapter 23: String Theories
Chapter 24: What Is Wrong with ABCT? Criticisms of the Hydraulic Version of ABCT The Rational-Expectations Critique — Why Can’t Entrepreneurs Learn? What about Nineteenth-Century Panics? What about Robert Murphy’s Prediction of Double-Digit Inflation?
Chapter 25: Summary and Conclusion: End the Fed
Bibliography
Index
Razorbacks are wild pigs that are bulky, strong, fast, and ferocious. They inhabit a very large range in large numbers and are omnivorous and highly adaptable. Wolverines are the largest species of weasel, about the size of a small bear. This fast, muscular carnivore has a well-deserved reputation for strength and ferocity. Do these creatures have anything to do with the skyscraper curse?
No, they don’t, but they did inspire an important article by Greg Kaza.
When I give public lectures on the skyscraper curse, I am inevitably asked whether it can be applied on continental, national, and state levels, rather than just a global scale. For example, would a national-record-breaking skyscraper result in a national curse? My answer to those questions is yes, but that is only based on anecdotal evidence.
Greg KazaGreg Kaza, “Note: Wolverines, Razorbacks, and Skyscrapers,” Quarterly Journal of Austrian Economics 13, no. 4 (Winter 2010): 74–79. examined the Skyscraper Index evidence at the state level in the United States. He chose the states of Arkansas and Michigan. Greg is from Michigan and earned his master’s degree in international finance from Walsh College, in Michigan. He has served as executive director of the Arkansas Policy Foundation since 2001. The team names for the University of Arkansas and the University of Michigan are respectively the Razorbacks and Wolverines.
He used the National Bureau of Economic Research’s (NBER) estimates of economic expansions and contractions in the US economy. He compared that data with data on the tallest buildings in both states. What he found was confirmation of the Skyscraper Index at the state level. According to Kaza:
Michigan’s tallest skyscrapers in the early 20th century, Detroit’s Dime Building and Penobscot Annex, were completed in 1913, a recession year. Detroit’s Guardian and Penobscot buildings were finished in 1928–29 on the Great Depression’s eve. Today, Michigan’s tallest building is the Detroit Marriott at the Renaissance Center, completed in an expansion (1977). Its final tower, however, was finished in the July 1981–November 1982 contraction.Ibid., p. 76.
So the experience in Michigan would seem to confirm the Skyscraper Index. It should also be pointed out that with regard to the Detroit Marriott, the American automobile industry, centered in Detroit, Michigan, was still a vital force relative to the rest of the economy in the 1970s, although that would soon change.
The results were similar in the state of Arkansas. The state is largely an agricultural economy, although that has changed some with the rise of Wal-Mart, which has its headquarters in Bentonville, Arkansas. According to Kaza the state followed the familiar pattern:
A similar effect can be observed in Arkansas. Little Rock’s Pyramid Life Building (1907), Union Life Building (1913), Donaghey Building 2 (1926), Tower Building (1960), Bank of America Building (1970) and Region’s Bank Building (1975) were all completed around NBER contractions. The lone exception, Metropolitan Tower (formerly the TCBY Building) was completed in 1986, a year of expansion.Ibid., pp. 76–77.
The Metropolitan Tower might have been completed during a national expansion of the economy, but such was not the case in Arkansas. As the building was being built, the state of Arkansas was entering a very strong economic contraction. According to Henderson, Gloy, and Boehlje:
U.S. agriculture could not sustain the 1970s prosperity and, similar to the 1920s, U.S. export activity collapsed during the 1980s. After peaking at $96 billion in 1980, real U.S. agricultural exports fell sharply. A weak global economy, world debt problems, a strong exchange value of the dollar and trade barriers — including a Russian grain embargo — cut U.S. agricultural exports (Drabenstott 1983). In 1986, agricultural exports bottomed at $47 billion, half the levels posted five years earlier.Jason Henderson, Brent Gloy, and Michael Boehlje, “Agriculture’s Boom-Bust Cycles: Is This Time Different?” Economic Review (4th quart. 2001): 88.
So the lone failures of the Skyscraper Index in Arkansas and Michigan are really about the difficulties that can arise using national statistics on state-level phenomena.
Kaza raises two other important points. The first point is that the tallest buildings in twenty states were completed in years of NBER contractions. It might be interesting to examine the other thirty buildings to see whether their record-breaking dates, in contrast to completion dates, might have occurred during an economic expansion. The second point is that he found, using NBER dating, that the Woolworth Building, which opened in April 1913, did so in a twenty-three-month-long contraction in the US economy between January 1913 and December 1914. This was a long and severe contraction. However, it was not long enough or deep enough to gain a moniker achieved by other skyscraper-cursed buildings.
While Lucas EngelhardtLucas Engelhardt, “Why Skyscrapers? A Spatial Economic Approach.” Unpublished manuscript, 2015. shows that the skyscraper-curse analysis can be integrated into the microeconomic analysis of labor markets and location theory, KazaKaza, “Note: Wolverines, Razorbacks, and Skyscrapers.” has shown that it can also be situated into lower levels of geographic analysis.
In 2014, there should have been a skyscraper alert issued for China. Groundbreaking ceremonies took place on what was expected to be the world’s tallest skyscraper, called Sky City tower. This project was noteworthy not just as an attempt to build a record-breaking skyscraper of 2,749 feet in height, but also because of the remarkably short construction schedule due to the construction company’s prefabricated construction process. Initially, on-site construction was delayed until April 2014. Later, the government cancelled the project due to environmental concerns over nearby wetlands. That reversed the need to broadcast a skyscraper alert.
The confluence of regional skyscraper signals in Europe, North America, and China, along with a skyscraper alert clearly suggested the possibility of a burgeoning world-wide economic crisis. This pattern would be very much like previous episodes of skyscraper records including the panic of 1907, the Great Depression, the stagflation of the 1970s, the Asian contagion ∕ dot-com bubble, and the housing bubble. In line with these skyscraper-based predictions, a fundamental case can be built around the notion of a looming world economic crisis. Most of the world’s major economies are facing pressing economic difficulties, including the United States, Europe, Russia, Brazil, Japan, and China. Additionally, central banks have been engaged in a worldwide currency war since the housing bubble, on a scale that has never been experienced in human history. It should not be surprising that super tall buildings are being built at an astonishing rate.
Not only is the world teeming with real estate speculation and skyscraper-building from China, to New York, to London and the Middle East, there is a new world-record-setting skyscraper being constructed in Jeddah, Saudi Arabia. The Kingdom Tower is designed to be over one kilometer in height, or more than eleven football fields. It is scheduled to be completed in 2020. As designed, the Kingdom Tower will exceed the height of the Burj Khalifa by more than 500 feet, although only a few floors of inhabitable space. If events proceed as the skyscraper curse predicts, the beginning of construction of the Kingdom Tower signaled a crisis alert, as a new record-breaking skyscraper has had its groundbreaking ceremony. This will change to a skyscraper signal when a new record height has been achieved between now and 2020.
The skyscrapers can sometimes tell us about the geography of world economic bubbles. The last bubble occurred in the oil-rich Middle East, and the next one would also be in the Middle East. Both bubble projects were begun when oil prices exceeded $100 a barrel.
It is interesting to note that according to Television Post,Television Post, “Prince Alwaleed Sells 5.6% Stake in News Corp for $188 Million,” March 2, 2015. Prince Alwaleed, the owner of the Kingdom Tower project, recently and unexpectedly sold most of his large stake of stock in News Corp., Rupert Murdoch’s media conglomerate, to raise nearly $200 million. The move was said to have been part of an overall review and rebalancing of the prince’s $20 billion portfolio. This is probably a smart move given the collapse of oil prices and the hefty price tag of $1.2 billion for the prince’s Kingdom Tower.
With more financing in place, the next world’s tallest skyscraper project is moving forward. The final piece of financing that is necessary to bring the $1.2 billion Kingdom Tower project in Saudi Arabia to record heights has been obtained. Media reports also show that the structure has risen to more than seventy-five meters (246 feet), and construction is proceeding at an uninterrupted pace, although there remain many concerns about the project’s viability. (Subsequently, the project experienced more delays.)
For example, above-ground construction on the long-delayed Kingdom Tower, now called the Jeddah Tower, started in September 2014, but there was considerable doubt that the financing for the one-kilometer (3,280.84 feet) tower could be obtained, given the shaky financial conditions in Saudi Arabia.
But the Jeddah Tower is only the latest phase in an enormous boom that began setting new records in 2014. As I reported in February 2015:
Super tall buildings, or skyscrapers, are being built at an astonishing rate. Ninety-seven buildings that exceed 200 meters (656 feet) high were constructed in 2014, setting a new record. The previous record was eighty-one buildings completed in 2011. The total number of skyscrapers in existence now is 935, a whopping 350 percent increase since the year 2000.Mark Thornton, “Where Is the Skyscraper Curse Today,” Mises Daily, February 24, 2015.
If completed as planned, Jeddah Tower will be the tallest building in the world. Jackie Salo, in the International Business Times, reports:
Saudi Arabia’s Kingdom Tower in Jeddah is slated to become the world’s highest skyscraper when it is erected in 2020, knocking Dubai’s Burj Khalifa tower from its perch as tallest building at 2,716 feet. The new tower will claim the title if it reaches its planned height of 3,280 feet. …The 200-floor Kingdom Tower will be part of a reported $8.4 billion project to construct Jeddah City. Construction of the skyscraper will entail 5.7 million square feet of concrete and 80,000 tons of steel.Jackie Salo, “World’s Tallest Skyscraper Is Saudi Arabia’s Kingdom Tower? Jeddah Building Projected to Break Height Records,” International Business Times, December 1, 2015.
In other words, the Tower could be the next record-breaking skyscraper, which is just part of an even more massive project. That means it’s time for a new skyscraper alert (as of January 1, 2016).
Remember, a skyscraper alert is an indicator that suggests a significant economic crisis will occur in the near future, even though economic conditions currently appear good. This alert could have been issued earlier, because an alert is defined based on the groundbreaking ceremonies of a world-record-breaking skyscraper, not the initial announcement of the project, which in this case occurred in August 2011. At that time there was still considerable doubt the project would be completed as planned.
Skyscraper alerts indicate significant looming danger in the economy, but the danger is not necessarily imminent. The next pivotal date for the Jeddah Tower project is when it reaches the height to break the old record and a skyscraper signal is given. That date is difficult to estimate given the uncertainty of construction. Media reports indicate that the project will be completed in 2020 without indicating whether that date is the completion date or the opening ceremonies.
So, will this latest frenzy of new construction tip us off to the next bust? The Skyscraper Index is silent on the issue of timing, so the dating of when the skyscraper curse becomes apparent is just guesswork. It seems that the boom reaches its peak around the time the new record height is set, and this is when a skyscraper signal should be issued. The skyscraper signal means that economic danger is looming. In most episodes, record-breaking skyscrapers generally have their completion dates and opening ceremonies when the economic crisis is readily apparent.
The important thing to remember is that skyscrapers do not cause economic crises. Rather they are just very noticeable examples of the distortions taking place throughout the economy when interest rates are kept artificially low by the central bank. This point will be thoroughly reinforced in the next chapter.
As of November 2013, it was official. New York City had won the title of having the nation’s tallest structure. The heated controversy between New York and Chicago was settled when the Council of Tall Buildings and Urban Habitat, based in Chicago, decided that the 408-foot spire sitting atop One World Trade Center could be included in the total height of the building.
The revised height of 1,776 feet made One World Trade Center the tallest structure in the United States. We are told that One WTC is more than a building. It both serves as a monument to those murdered on 9/11 and honors our Declaration of Independence. Not to disrespect those who died, but this “record” is a sham because the useable, productive height of the building is only 1,368 feet. The remaining 400-odd foot difference is just uninhabitable window dressing.
This dubious record should nonetheless be a kind of warning to us that the skyscraper curse, the forerunner of economic crisis, is lurking near.
The Shard Building, in London, broke ground in 2009 and was completed in 2012, becoming the tallest building in Europe. This was a clear signal of the European economic crisis, the PIIIGS fiscal disaster — in Portugal, Italy, Ireland, Iceland, Greece, and Spain — and the grave and ongoing concerns over the long run viability of the euro. Japan joined the fraternity with the Tokyo Skytree broadcasting tower, which was completed in 2012 and is now the tallest structure in Japan. Not to be outdone, China set a new national skyscraper record with the Shanghai Tower, which opened in 2014. China also broke ground but suspended construction on Sky City tower in part because of fear of the skyscraper curse. It too would have set a new world record.
World-record-breaking skyscrapers are a signal of economic crisis. Like world-record-breaking art prices, such as the $142 million selling price of a painting by Francis Bacon of his friend Lucian Freud at Christie’s in New York in 2013, such records are signs of economic excess. Just remember that such excess usually occurs in markets manipulated by central banks.
These are the spectacular results associated with the skyscraper curse, but you also might be able to see signs of it at work in small-town America. For example, there are no true skyscrapers being built in Auburn, Alabama, home of Auburn University and the Mises Institute. But there has been a great deal of building big and tall for this small city in eastern Alabama.
Luxury student-apartment building leads the way, followed by high-end restaurants and retail space. Recently two student-apartment buildings were torn down to make room for yet bigger buildings. The city government is also spending truckloads of money on street improvements and a state-of-the-art high school. More recently, old single-floor buildings have been demolished downtown to make room for multistory high density apartments.
What are people thinking? Don’t they realize we are in one of the weakest recoveries on record and headed for another recession? Has no one in Auburn realized there is an enormous amount of student debt and that the job market for holders of college degrees is weak? Is it greedy bankers and construction companies run amuck? Is it out-of-control architects and chefs that are to blame? Or is it the spoiled rich college kids who demand luxury apartments and locally grown veggies at the high-end restaurants they frequent?
The rush to build bigger, taller, and more luxurious buildings actually has little to do with any of these groups, but it has divided us as a city. On the one hand, there are many people upset because all this construction is changing “the loveliest village on the plains.” Local residents are seeing “Keep Auburn Lovely: Save Our Village” signs popping up all over town. They oppose the building spree.
On the other hand, construction workers, cement dealers, building-supply companies, and heavy-equipment operators must love the fast-paced business and full-time jobs with overtime. They love it while heavy dump trucks and cement trucks rush their loads through town.
The problem actually starts in Washington, DC, in an unremarkable building at Twentieth Street and Constitution Avenue NW that houses the Board of Governors of the Federal Reserve. The board, along with the president of the New York Fed, and a rotating selection of regional Federal Reserve Bank presidents, forms the Fed’s Open Market Committee (FOMC), which sets the policy targeting the interest rate that banks charge other banks for very short-term loans — the federal funds rate.
When the Federal Reserve’s Open Market Committee sets the target lower, it sets off a tendency for interest rates to fall across the economy. When it raises the target for the federal funds rate, interest rates tend to rise across the economy. For the last seven and a half plus years they have kept the target under a quarter of 1 percent. This type of policy has never been pursued before. This explains the ultralow rates on your savings account and home mortgage over the last several years.
It also explains the luxury-building mania. When the Federal Reserve first lowered rates, bankers who were burned by bad mortgages after the collapse of the housing bubble, along with luxury game-day condo builders, would not take the bait. Once bitten, twice shy. However, eventually low interest rates become too tempting to resist, especially as new bankers and construction companies come onto the scene.
Lower rates have several effects, including less saving and more spending. Low rates also increase stock market prices because lower rates increase the value of corporations, reduce the cost of borrowing, and induce individuals to move money from bank accounts to stock market accounts and to be more fully invested in stocks. When the policy is successful at increasing stock prices, people reduce savings further and spend more on luxury goods. Lower rates also boost borrowing and investment.
If you think that the combination of reduced savings and increased luxury spending sounds contradictory and dangerous, you are correct.
In any case, lower interest rates also tend to increase the price of land, particularly in the central business district. In contrast, higher interest rates encourage land and real estate owners to part with their properties at lower prices. Higher land prices make development deals harder to generate profits. The solution is to build more intensively and to make buildings taller. A $1 million piece of land could be made profitable by building just one story, but if that same lot is $2 million then you might have to build three stories to make it profitable. A one-story building is relatively inexpensive to build compared to a three-story building, which requires stairways, elevators, and sturdier construction techniques. However, the three-story building also produces two and a half times more rentable space.
Is it better to just build something, even if it is the wrong something? Well, even if interest rates could stay near zero forever, it would still mean we are deploying our resources incorrectly. The things we are building will not be as profitable as originally projected, and the excess capacity means that long-existing projects will also become less profitable. In other words, eventually, their economic values will be less than the amount invested in them. It will also make it more difficult to pay back the loans, especially if you reduce savings and increase your borrowing and luxury spending.
These circumstances are in no one’s long-term best interest. But apparently, eliminating the cause in Washington is currently beyond our collective ability.
Economists understand very little about how technological progress occurs. — Alan Greenspan, “Testimony of Chairman Alan Greenspan”
Before we leave the topic of the problems and blessings of roundaboutness of production and the structure of production, it will be very useful to see a natural, concrete example of it in action. It then will become easier to understand the unnatural cases involving malinvestments and the skyscraper curse.
Making production processes more roundabout results in greater production in terms of the quantity produced and a lower cost on a per-unit basis. Entrepreneurs would not want to make production processes more roundabout unless they thought they would create more profits as a result. More roundabout production takes more time, more steps, and a more extensive division of labor. It also uses new technology.
Entrepreneurs do make mistakes, of course, but the only systematic errors they make are when they are fooled into rearranging production because of artificially low interest rates and easy credit conditions. When the central bank lowers its target interest rates it also makes credit conditions easier in that banks will make a larger volume of loans, which means they weaken their lending standards in order to facilitate the larger volume of loans.
A good example of a very direct production process, in contrast to a more roundabout one, is a farmer who goes to the barn, milks a cow, and then returns to the house and feeds the milk to his family.
An example of a more roundabout, although still very direct, production process comes from my childhood. We lived on the edge of a small town. Just beyond our house were fields and barns. Dairy cattle would feed on the grass in the fields. Later they would return to the barns to be milked. The milk would then be transported a short distance — a couple miles — in a small tanker truck to one of three small dairies in my hometown. There the milk would be processed and packaged. Early the next morning a dairy man in a white suit would arrive at our house and place several quart-size glass bottles of milk in an insulated dairy box outside of our back door and pick up any empty bottles we had placed there. If we wanted an ice cream sundae, we had to go to the dairy during retail hours.
By the time I graduated from high school the entire system had changed. The small dairy farms had been largely replaced with larger farms. The small four-wheel tanker trucks had been replaced by large eighteen-wheel tankers. An eighteen-wheel tanker truck brought the raw milk from the farms to the dairy factory about thirty miles from our house, and a different eighteen-wheel refrigerated truck brought cartons of milk and ice cream as well as boxes of butter to the supermarket. All three of the small hometown dairies eventually went out of business. They were replaced by much larger, factory-size dairies many miles from our home. Instead of having the milk bottles delivered directly to our house, we now purchased dairy products at the local supermarket, an institution that was also a relatively new phenomenon.
The dairy factory system is a much more roundabout production process. It takes more time. The milk travels a round-trip journey of more than sixty miles instead of the less-than-four-mile journey in the old days. There is a greater amount of capital as well as advanced technology involved and there is also far less labor per unit of milk. The overall cost of milk is lower, and with competition between large dairy wholesalers and supermarkets, so is the price.
In order to attain a more roundabout production process there are several requirements. It requires entrepreneurs with a vision of the most profitable action among all possible actions. It requires investment in more capital goods and new technology. Of course, all of this rearranging of production is going to take a great deal of time and even more time for it to be profitable.
Therefore, the entrepreneurs need to have access to savings. They need to have either their own savings or someone else’s savings on a long-term basis in order to proceed. Hence there must be more overall savings in an economy in order to achieve more roundabout production and all the benefits it entails. Savers must have lower time preferences and be willing to delay some consumption in the present. Savers will be rewarded with interest income, with which they will be able to make a greater number of purchases in the future and at lower prices because of the increase in production of goods. The whole process is regulated by the rate of interest, the price system, and the system of profit and loss.
This process is sometimes referred to as creating economies of scale. But notice that while there are economies of scale in this example, everything about the production process changed. The most successful approach was not preordained or known in times past. The entire recipe or technology of production has changed. All the capital goods — including the milking machines, the trucks, and the machinery inside the dairies — are different. Notice further that the change in the dairy industry is going to induce changes in other industries, including technology and investment in the mechanical milking machines industry. All of this requires a careful synchronization process, which is obviously beyond the scope of central planning. The process is driven by the rate of interest. So we will now see what happens when the interest rate is misleading and results in an economic bust and, in severe cases, the skyscraper curse.
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In 1993, Milton Friedman proposed his famous “plucking model”Milton Friedman, “The ‘Plucking Model’ of Business Cycle Fluctuations Revisited,” Economic Inquiry 31, no. 2 (1993): 171–77. of the business cycle. To understand this theory, imagine a string or straight rising line on a graph that represents the potential growth of the economy. Also on the graph is another string that represents actual economic growth and follows the potential growth line except for when the second string is “plucked” downward by policy mistakes or external forces. In Friedman’s model, after the economy has been plucked economic growth quickly returns to the potential growth string. For Friedman it is important to explain the pluck and economic bust, but not the boom because in his model the boom is normal.
Friedman would recommend no special polices regarding the business cycle other than avoiding policy errors. If monetary policy is too tight, loosen it. In particular, money mattered for Friedman and the monetarists, and Friedman argued that a mistakenly restrictive monetary policy and high real interest rates were responsible for the Great Depression. GarrisonRoger Garrison, “Friedman’s ‘Plucking Model’: Comment,” Economic Inquiry 34, no. 4 (1996): 799–802. provides an effective critique of the plucking model.
In the Friedman context, you could try to make an argument that policy makers made an error that brought on the financial crisis, but this would conflict with Friedman’sMilton Friedman, Interview on Charlie Rose, December 29, 2005. own vision. He appeared on the Charlie Rose show on December 29, 2005, the zenith of the housing bubble, and summarized his view of the US economy: “The stability of the economy is greater than it has ever been in our history. We really are in remarkably good shape. It’s amazing.”
He went on to praise Alan Greenspan and the work being done at the Federal Reserve. Not only did Friedman fail to see the housing bubble, but his recommended policy response of loosening the supply of money and credit did not solve the problem. In fact, a loose monetary policy of zero interest rate policy (i.e., ZIRP) and quantitative easing (i.e., QE), have all failed to get the economic-growth string back to the potential-economic-growth string thus far.Ryan Murphy, “The Plucking Model, the Great Recession, and Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 18, no. 1 (Spring 2015): 40–44.
Another string theorist is Ben Bernanke. The former chairman of the Fed was a student of the Great Depression and Friedman’s work on that subject. More generally he is considered to be in the camp of the New Keynesian school, which assumes that people have rational expectations about the future but live in an economy with imperfections and market failures. Extending Friedman’s work, Bernanke found in his research that the collapse of the banking sector in 1933 was the main reason that the depression was “great.” The stock market crash and ensuing economic crisis weakened banks, and many of them failed. After FDR’s bank holiday in March 1933 the normal channels of credit turned into a market failure that held back the economy for many years to come. The bank failures were like a weight hung on the actual-economic-growth string preventing it from reconnecting to the potential-economic-growth string. Therefore Bernanke places a great deal of emphasis on protecting the large, systemically important banks and the credit-industry infrastructure. However, he also believes that loose monetary and fiscal policies are necessary for controlling the business cycle.
On the occasion of Milton Friedman’s ninetieth birthday, Bernanke delivered extensive remarks on Friedman and Schwartz’sMilton Friedman, and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963). work on the Great Depression, holding it in the very highest regard. Although some of his conclusions do differ from Friedman and Schwartz, BernankeBen S. Bernanke, “Remarks by Governor Ben S. Bernanke,” Speech at the Conference to Honor Milton Friedman, University of Chicago, November 8, 2002. closed his remarks on the Great Depression with the following apology and promise: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
Bernanke was working at the Fed as vice chairman and then chairman during the housing bubble. He repeatedly denied the existence of the housing bubble and often suggested that if a bubble did exist and did pop, he would just lower interest rates. When it became evident that there was trouble in the housing market Bernanke moved aggressively in terms of monetary policy. He used both policies along traditional lines, such as reducing the federal funds rate and the discount rate, and aggressive, untried nontraditional policies, such as quantitative easing and zero interest rate policy. The overall policy response included radical decreases in interest rates, radical increases of liquidity in banks, a bailout of the systemically important banks and industries, and an enormous fiscal stimulus from the federal government, including multiyear trillion-dollar deficit spending. Bernanke soon began speaking of his ability to see “green shoots” in the economy, but many years later the actual-economic-growth string continues to lag badly behind the potential-economic-growth string.
Paul Krugman will here represent the Keynesian school of economics. The Keynesian view of the business cycle is based on social psychology. In the Keynesian view, periods of investment euphoria give way to periods of panic, retrenchment, and depression. If the actual-economic-growth string veers even slightly down from the potential-economic-growth string, then this sets up a potential scenario of dashed expectations, cutbacks, and diminished investment that can lead to layoffs, high rates of unemployment, and a significant decline in aggregate demand. This scenario is caused by what Keynes himself referred to as “animal spirits,” which is the irrational fear associated with investment.
When aggregate demand does not keep up with aggregate supply, this leads to lower prices, or price deflation. This can plunge an economy into what Krugman describes as an economic “black hole” from which the economy will never recover. As such, Keynesian economists and mainstream economists more generally have a phobia of deflation, or “apoplithorismosphobia,” which is the irrational fear of price deflation. However, much has been written about why deflation is not to be feared.See Philipp Bagus, In Defense of Deflation (New York: Springer, 2015); Jörg Guido Hülsmann, Deflation and Liberty (Auburn, AL: Mises Institute, 2008); Greg Kaza, “Deflation and Economic Growth,” Quarterly Journal of Austrian Economics 9, no. 2 (Summer 2006): 95–97; Mark Thornton, “Apoplithorismosphobia,” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 5–18; Joseph T. Salerno, “An Austrian Taxonomy of Deflation—with Applications to the U.S.” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 81–109, and “Deflation and Depression: Where’s the Link?” Mises.org, August 6, 2004.
Krugman has been very vocal since the financial crisis, calling for aggressive fiscal stimulus — that is, for the government to borrow vast amounts of temporarily unused savings and spend it. What the government spends the money on is less important than how much it spends beyond its means. It is important that consumers get money in their pockets, that businesses are put back to work doing something, and that the spending has the biggest possible impact on increasing aggregate demand. Certain important industries should receive bailouts if necessary, and public works programs should be begun in hard-hit areas. In order to guard against the possibility of deflation Krugman also recommends a stimulative monetary policy. Krugman has even argued that a Martian invasion hoax would fix the economy:
If we discovered that space aliens were planning to attack and we needed a massive buildup to counter the space alien threat and really inflation and budget deficits (concerns) took secondary place to that, this slump would be over in 18 months. And then if we discovered, oops, we made a mistake, there aren’t any aliens, we’d be better off.Paul Krugman, “Krugman Calls for Space Aliens to Fix U.S. Economy?” Global Public Square, August 12. 2011.
Krugman even later congratulated Japan for adopting the “moral equivalent of space aliens” in the form of Abenomics (i.e., aggressive monetary and fiscal stimulus), and for rejecting the “austerian orthodoxy” (i.e., balanced budgets).
The problem for Krugman is that with the exception of the fake Martian invasion, all of these policies have been implemented in the United States at unprecedented levels since 2008. In Japan, they have been implemented at higher levels for a longer period of time, to no good effect. Of course Krugman might object that these policies were still not large enough or quick enough to solve the problem. However, that just means his approach is untenable: Keynesians cannot predict a crisis in advance, because their analysis of the economic crisis starts with an unpredictable shock to social psychology; similarly, in the case of RBCT (real business cycle theory), the analysis starts with an unpredictable technological shock, or some other exogenous change.
These theories of the business cycle start with stylized facts that describe business cycles. From this, economists develop a hypothesis concerning what causes the business cycle. From this hypothesis, they develop a policy recommendation that agrees with their ideological perspective. Conservative economists — for example, those of the Chicago school — typically recommend no or limited remedial policy actions when faced with an economic downturn, while liberal economists from Ivy League universities are much more likely to recommend significant government intervention when faced with the same crisis. The most general problem with these approaches is that all of these recommendations have been tried since the beginning of the financial crisis and they have all failed.
In 2010, I argued in “America’s Second Great Depression”Mark Thornton, “America’s Second Great Depression: A Symposium in Memory of Larry Sechrest,” Quarterly Journal of Austrian Economics 13, no. 3 (Fall 2010): 3–6. that the US economy was in an economic depression and that it would likely continue for some time until economic policy was reversed. This was one of six papers organized as a symposium in honor of the late Larry Sechrest at the Southern Economic Association’s 2009 convention. While this assessment is a matter of debate, there are plenty of important mainstream economists that agree that current conditions have much more in common with an economic depression than normal economic growth.
An economic depression is a multiyear contraction of economic activity noticeably below the economy’s potential. Great depressions are even longer and deeper and can be interspersed with periods of contraction and expansion. There is nothing in economic theory that can determine whether an economy is in a recession, depression, or great depression. These labels are a matter of assessment, opinion, and professional standards and are subject to change.
Instead of addressing how “great” current economic conditions are, this chapter examines theories of the business cycle and how well they appear to perform in light of economic policies that have been enacted since 2007 in the United States and the global economy.
The Great Depression was clearly a great depression in both its length and depth. In addition, it was a worldwide phenomenon. As Professor HiggsRobert Higgs, “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s,” Journal of Economy History 52, no. 1 (March 1992): 41–60. has shown, the United States never really recovered from the Great Depression until after World War II in terms of inflation-adjusted per capita consumption.
I have also suggested that the stagflation of the 1970s (1970–82) was an economic depression. It was certainly long enough, and it was not confined to the United States. Statistically, it might not have been as bad as the Great Depression. There were economic expansions during the period, but the economy failed to keep up with its potential. However, in contrast with the past, it did inflict both high inflation and high unemployment — that is, stagflation — on the population, simultaneously, really for the first time.
It might surprise you to learn that great depressions are not purely monetary phenomena. Throughout this book great attention has been paid to the phenomenon of central banks’ artificially low interest rate monetary policy causing a business cycle. However, business cycle expansions and contractions are typically of a much shorter time span than a great depression.
Depressions begin with a considerable period of monetary expansion followed by an economic crisis. RothbardMurray Rothbard, America’s Great Depression, 5th ed. (Auburn, AL: Mises Institute [1963] 2000). shows that there was a considerable period of monetary expansion prior to the stock market crash in 1929. Rothbard’s calculation of the money supply in the 1920s has been challenged by Timberlake.Richard Timberlake, “Money in the 1920s and 1930s,” Freeman (April 1999): 37–42. However, SalernoJoseph Salerno, “Money and Gold in the 1920s and 1930s: An Austrian View,” Freeman (October 1999): 31–40. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010), pp. 431–49. has shown that even if you remove the “offending” categories from calculations of the money supply — for example, the cash value of life insurance policies — monetary policy in the 1920s was still highly expansionary.
Turning the crisis into a depression or great depression requires a significant and sustained effort on the part of the government to use various policies in an attempt to stop and reverse the corrective market process — that is, the economic crisis. In other words, the dominant ideology is some variation of Keynesianism, and the government’s response to the crisis involves, among other things, an expansionary monetary and fiscal policy. RothbardRothbard, America’s Great Depression. showed that President Hoover’s policies were intended to keep wages and prices high. This turned an ordinary economic crisis into the Great Depression. Hoover’s “New Deal-like” policies included maintaining high prices and incomes, stimulating the economy with public works projects, loans, bailouts, protectionism, and currency devaluation. HerbenerJeffrey Herbener, “Fed Policy Errors of the Great Depression,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno (Springer, 2014), pp. 43–45. shows that the Fed was interventionist, with a low interest rate monetary policy until 1937. Ohanian and ColeLee E. Ohanian and Harold Cole, “New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis,” Journal of Political Economy 112, no. 4 (August 2004): 779–816. and OhanianLee E. Ohanian, “What—or Who—Started the Great Depression?” Journal of Economic Theory 144 (October 2009): 2310–2335. empirically verified the Rothbard hypothesis. Hoover’s and later Roosevelt’s policies became the basis of what would become Keynesian economics.Arthur Okun, The Political Economy of Prosperity (Washington, DC: Brookings Institution, 1970). Keynesian ideology was also the dominant force during the stagflation of the 1970s and in the Japanese economy from 1989 to the present.
The alternative approach to business cycle contractions is espoused by the classical economists, the Austrian-school economists, and the real business cycle theorists. This “do nothing” approach involves shrinking government and balancing the budget, expanding resources in the private sector, and a nonexpansionary monetary policy. This was employed by Presidents Woodrow Wilson and Warren G. Harding during the fifteen-month-long depression of 1920–21. This period was one of the most severely deflationary in US history, and yet it is hardly mentioned in history textbooks.
James GrantJames Grant, The Forgotten Depression: 1921: The Crash That Cured Itself (New York: Simon & Schuster, 2014). found that the reason this depression was so short was because it largely cured itself before government meddling could begin. Thomas WoodsThomas E. Woods, “Warren Harding and the Forgotten Depression of 1920,” Intercollegiate Review (Fall 2009): 22–29. shows that Harding was really a “do something” liquidationist in the sense that he wanted to reduce the size of government and raise interest rates to actively stamp out the inflation from World War I. There has been some quibbling regarding the timing and effect of various policies and policy changes, but Patrick NewmanPatrick Newman, “The Depression of 1920–1921: A Credit Induced Boom and a Market Based Recovery?” Review of Austrian Economics (January 2016): 1–28. has decisively shown that a liquidationist policy was dominant before the recovery began.
In the chapter to follow, I will present a simplified version of business cycle theories and discuss what those theories would recommend as policy remedies for economic crises, and how well those remedies worked in the wake of the financial crisis. See BagusPhilipp Bagus, “Modern Business Cycle Theories in Light of ABCT,” in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, edited by Jörg Guido Hülsmann (Auburn, AL: Mises Institute, 2012), pp. 229–46. for a more in-depth Austrian critique of modern mainstream business cycle theories.
[This chapter originally appeared as “The Economics of Housing Bubbles,” in Housing America: Building Out of a Crisis, edited by Randall G. Holcombe and Benjamin Powell (New Brunswick, NJ: Transactions Publishers, 2009), pp. 237–62. Reprinted with permission from the publisher.]
Nothing better illustrates government failure and the housing crisis than the housing bubble. While the housing bubble is being created by government, homes become increasingly expensive and beyond the economic reach of first-time home buyers. Then as interest rates rise and housing prices fall, many home buyers find themselves with bad investments that they can no longer afford. What started as a grand federal-government effort to improve homeownership for all Americans through a policy of “easy money” will have unintended consequences that will leave many Americans economically scarred for the rest of their lives. An easy-money policy involves the central bank (the Fed) setting low interest rates and expanding the money supply so that it is easier to get credit (loans), and it also involves government-sponsored credit organizations such as Fannie Mae and Freddie Mac that make getting home mortgages easier.
When an economic bubble pops, many people are harmed economically. In the case of a housing bubble, this will be especially true of homeowners, particularly new homeowners who buy homes during the peak phase of the housing bubble. However, the harm also consists of unemployment of labor and a loss of value to owners of capital, particularly in housing-related industries. At the individual level many people are forced into bankruptcy. On the macroeconomic level the bursting of the housing bubble can send the overall economy into recession or depression. Housing bubbles concentrate their impact in the home-building, materials and furnishings, real estate sales, and mortgage businesses.
On top of all that, people suffer psychological consequences as well. The people most involved in the bubble are confident, jubilant, and self-assured due to their apparently successful decision making. When the bubble bursts they lose confidence, go into despair and lose confidence in their decision making. In fact, they lose confidence in “the system,” which means they lose confidence in capitalism, and become susceptible to new political “reforms” that offer structure and security in exchange for some of their autonomy and freedoms.
The reason economic crises create fear and concession of liberty is that people do not generally know what caused the bust or economic crisis and generally do not even know that there was even a bubble in the first place. In fact, as the bubble bursts many people deny that there is a problem and believe that the whole situation will quickly return to what they consider normal. The average citizen thinks very little about what makes the economy work, but simply accepts the system for what it is, and tries to make the most of it.
The purpose of this chapter is to show how “the system” works, how it generates bubbles, why they eventually burst, and the macroeconomic effects of bubbles. Here we apply the economic understanding of bubbles derived from Austrian business cycle theory, or ABCT, to the current 2006 case of the housing bubble and show that this aspect of the housing crisis is the result of government failure — the inevitable failure of a government bureaucracy (i.e., the Fed) to manage the money supply and interest rates in an economically rational manner. However, the same reasoning can be applied to historical bubbles, from the tulip mania in seventeenth-century Holland to the dot-com tech bubble of the late 1990s, as well as to future bubbles.
What Causes Housing Bubbles? There are three basic views of bubbles that are held by economists and the general public. The dominant view among the general public and modern mainstream economists, including the Chicago school and proponents of supply-side economics, is to deny the existence of bubbles and to declare that what are thought to be “bubbles” are really the result of “real” factors. The second view, which is espoused by Keynesians and by proponents of behavioral finance, is that bubbles exist because of psychological factors such as those captured by the phrase “irrational exuberance.” The third and final view is that of the Austrian school, which sees bubbles as consisting of real and psychological changes caused by manipulations of monetary policy. This view has the advantage of being forward looking and identifying an economic cause of bubbles. By identifying an economic cause it also directs us to policy choices that would prevent future bubbles.
Most people agree with the majority of economists that there is no such thing as a housing bubble — housing prices, they say, “never go down.” Supply siders and Chicago-school economists seem to view the declaration of a bubble as an affront to homo economicus — economically rational man — because they view it as an assertion of some psychological flaw in people that requires government intervention.Homo economicus is the model of the rational economic person that economists use to build their models and theories about the economy. This assumption asserts that people are rational and will always attempt to maximize their utility. This is a source of contention and misunderstanding among economists and between economists and other social scientists. They note that if there were a rational cause or causes of housing bubbles, or any type of bubble for that matter, then even if only some people believed it was a bubble, they could profit by selling homes at inflated prices and deflate the bubble long before it ever became overinflated and burst. Furthermore, if housing bubbles had irrational foundations, then certainly an economically rational man could profit enormously by shedding light on the erroneous psychological motivations that were causing the bubble.
Although there is much diversity in this camp, it is well illustrated by two economists from the Federal Reserve Bank of New York who examined concerns about the existence of a speculative bubble in the US housing market. While McCarty and Peach did find that a housing bubble could have a severe impact on the economy — if it existed and were to burst — they ultimately concluded that such fears were unfounded:
Our main conclusion is that the most widely cited evidence of a bubble is not persuasive because it fails to account for developments in the housing market over the past decade. In particular, significant declines in nominal mortgage interest rates and demographic forces have supported housing demand, home construction, and home values during this period.Jonathan McCarthy and Richard W. Peach, “Are Home Prices the Next ‘Bubble’?” FRBNY Economic Policy Review (December 2004): 2.
Furthermore they find “no basis for concern” for any severe drop in housing prices. They found that when the United States has gone into recession or experienced periods of high nominal interest rates, any price declines have been “moderate”; and they found that significant declines can only happen regionally such that they would not have “devastating effects on the national economy.”
This is essentially the view of Alan Greenspan and Ben Bernanke. In particular, Greenspan was aware of the possibility of a housing bubble, but he offered every possible reason why it did not exist, and how if one did exist it would not be a major problem. The chairman is usually difficult to interpret and at times so incomprehensible as to be almost misleading. His testimony before Congress has been labeled “Greenspam.”Mark Thornton, “Surviving GreenSpam,” LewRockwell.com, February 16, 2004. However, on the topic of the housing bubble he is clear and direct and worth quoting at length:
The ongoing strength in the housing market has raised concerns about the possible emergence of a bubble in home prices. However, the analogy often made to the building and bursting of a stock price bubble is imperfect. First, unlike in the stock market, sales in the real estate market incur substantial transactions costs and, when most homes are sold, the seller must physically move out. Doing so often entails significant financial and emotional costs and is an obvious impediment to stimulating a bubble through speculative trading in homes. Thus, while stock market turnover is more than 100 percent annually, the turnover of home ownership is less than 10 percent annually — scarcely tinder for speculative conflagration. Second, arbitrage opportunities are much more limited in housing markets than in securities markets. A home in Portland, Oregon is not a close substitute for a home in Portland, Maine, and the “national” housing market is better understood as a collection of small, local housing markets. Even if a bubble were to develop in a local market, it would not necessarily have implications for the nation as a whole.Alan Greenspan, “Monetary Policy and the Economic Outlook,” Testimony before the Joint Economic Committee of the US Congress, April 17, 2002.
As the bubble approached its peak, GreenspanAlan Greenspan, “Mortgage Banking.” Speech to the American Bankers Association Annual Convention, Palm Desert, CA, September 26, 2005. did admit that there was some “apparent froth” in some local housing markets, but overall he found that conditions in the housing market were “encouraging.” In his first speech after leaving office Greenspan said that the “extraordinary boom” in the housing market was over, but that there was no danger and that home prices would not decrease.Joe B. Bruno, “Former Fed Chair Says Housing Boom Over,” Associated Press, May 19, 2006. The new Fed chairman, Ben Bernanke,Ben Bernanke, “Reflections on the Yield Curve and Monetary Policy.” Remarks before the Economic Club of New York, March 20, 2006. admitted the possibility of “slower growth in house prices,” but confidently declared that if this did happen he would just lower interest rates. Bernanke also believed that the mortgage market is more stable than in the past. Bernanke noted in particular that “our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. In particular, real estate appraisal practices have improved.”Ben Bernanke, Speech to the Independent Community Bankers of America National Convention and Techworld, Las Vegas, NV, March 8, 2006.
A second view of housing bubbles and bubbles in general is that they exist, but that they are fundamentally caused by psychological factors. Many people and many important economists subscribe to this view of bubbles, including Keynesian economists and proponents of behavioral finance, such as Robert Shiller. From this perspective the business cycle is seen as the ebb and flow of mass consciousness and emotions. Real factors may play a role, but the important causal factors for deviations in the business cycle are psychological. Booms develop because people become confident and then overconfident in the economy. Investors likewise are confident and increase their tolerance for taking risk. Rising profits and asset prices lead to “speculative” behavior where economic decisions are no longer based on old rules and procedures, but on the bravery instilled by a “new era.”All of our actions involve some speculation about the future. Here “speculative” behavior refers to actions that involve great risks which are unwarranted based on the normal or known fundamentals of the economy. For example, betting on a round of golf with your friend involves some speculation and uncertainty, but past experience provides some guidance to the risks you are taking. Here, betting on a round of golf with Tiger Woods would be “speculative.” As the investment mania sets in, the bubble expands. Then, for whatever reason, people begin to lose faith and new investments are exposed as disappointing. Economic reports and statistics turn sour, and stories of scandal begin to appear in the press.It is a common misconception that corporate scandal is the source of bubbles and that it was companies like Enron and WorldCom that tricked investors during the late 1990s to bid up the stock markets to such high levels. It is true that scandal is a common feature of bubbles, but scandal could never account for more than a small percentage of bubbles, and in reality scandal is caused by the same source as the bubble itself — the existence of cheap and abundant credit that must be allocated to increasingly risky and suspect investments. Many investors remain determined in thinking that this turn of events is only temporary, but results grow worse, prices continue to fall, and investment projects are postponed, halted, or cancelled. The mood of the market is one of gloom or even doom. The economy enters a depression.
Representing the behavioral-finance camp is Professor Robert Shiller of Yale University, who is the author of Irrational Exuberance, the first edition of which correctly predicted the stock market bubble; the second edition predicted the housing bubble, whose “ultimate causes are mostly psychological.” Like the Keynesians to follow, ShillerRobert Shiller, “Are Housing Prices a House of Cards?” Project-Syndicate.org. September 2004. does not deny the existence of real factors; he simply downplays them in order to emphasize psychological factors. With the case of the housing bubble he finds three important factors. First, the increased risk and chaos in the world since the technology bubble and the terrorist attacks of 9/11 have caused a flight of investment into quality and safety — your own home. Second, the explosive growth in global communications has increased the glamour appeal of living in one of the world’s leading cities such as Paris, London, New York, or San Francisco. The third psychological factor is “the speculative contagion that underlies any bubble.” Here one higher price begets another, and higher prices in one city lead to higher prices in another city, and the process of higher prices simply builds on itself. Shiller declared that the first two factors will remain in effect, but the third factor cannot last forever. Once prices begin to drop, the contagion works in the downward direction and can last for years before the process is reversed again.
Representing the Keynesian camp is Paul Krugman, who is an economics professor at Princeton University and a writer for the New York Times. Krugman did not predict a housing bubble, but he did finally realize that we were in one and that it presented a big problem for the US economy. Commenting on the hectic pace of housing construction and the “absurd” housing prices Krugman drew parallels to previous investment manias: “In parts of the country there’s a speculative fever among people who shouldn’t be speculators that seem all too familiar from past bubbles — the shoeshine boys with stock tips in the 1920’s, the beer-and-pizza joints showing CNBC, not ESPN, on the TV sets in the 1990s.”Paul Krugman, “Running Out of Bubbles,” New York Times, May 27, 2005.
It is also correct to connect the phenomenon of day traders of technology stocks in the late 1990s to the house flippers of the housing bubble. The real question is: what causes this irrational behavior? Krugman suggested that, with the housing bubble, the bubble builds on expectations of capital gains:
So when people become willing to spend more on houses, say because of a fall in mortgage rates, some houses get built, but the prices of existing houses also go up. And if people think prices will continue to rise, they become willing to spend even more, driving prices still higher, and so on. … [P]rices will keep rising rapidly, generating big capital gains. That’s pretty much the definition of a bubble.Paul Krugman, “That Hissing Sound,” Ocala Star-Banner, May 22, 7, 2004. New York Times, August 8, 2005.
Notice that Krugman placed his emphasis on a supposedly unfounded change in taste or demand (“when people become willing to spend more on houses”) but downplayed the actual cause of the change in the demand for housing (“say because of a fall in mortgage rates”), as if anything might have ignited the bubble. The more Krugman tried to provide an economic rationale for the bubble the more he sounded like the Austrian economists who dominate the third and final view of the housing bubble. Another possible example of this is Baker and Rosnick,Baker and David Rosnick, Will a Bursting Bubble Trouble Bernanke? Evidence for a Housing Bubble (Washington, DC: Center for Economic and Policy Research, November, 2005). who demonstrate the case for a housing bubble and do so in a manner similar to Austrian economists; and even though they date the beginning of the bubble to 1997 they ignore the real factor that tax-law changes in that year were a catalyst to housing and higher housing prices. In fact, KrugmanKrugman, “Running Out of Bubbles.” cites fellow Keynesian Paul McCulley, who did correctly predict the housing bubble and did so in the manner typical of Austrian economists, where interest rate cuts lead to higher home prices, a construction boom, and higher consumer spending all based on increased debt — and he explicitly placed the blame for the bubble on the Fed. The problem with Keynesians such as Krugman and McCulley is that their cures — discretionary monetary and fiscal policy — usually make matters worse. Even if they could be made to work perfectly it would create a conundrum for Keynesian economists because a highly stabilized economy desensitizes investors to risk and makes them “irrationally exuberant” and thus creates the prerequisite for bubbles. Even Alan GreenspanAlan Greenspan, “Reflections on Central Banking,” speech given at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, WY, August 26, 2005. has warned, in his own convoluted way, that “history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”
As you can see, the first view wishes to dismiss psychological reasons for bubbles to focus only on real factors, while the second view wishes to downplay real factors in order to emphasize psychological causes. The third view believes that there are changes in both real factors and market psychology during bubbles and that both are driven by the cause of the business cycle — policy manipulations by the Federal Reserve. This view of bubbles is based on Austrian business cycle theory. This is a minority view held by Austrian-school economists and some fellow travelers of the school.A fellow traveler is someone who sympathizes with or supports various tenets of the Austrian school without being an acknowledged member or embracing all aspects of Austrian economics.
According to ABCT, if the Fed does not pursue a loose monetary policy then bubbles like the technology stock bubble of the late 1990s or the one in housing that we are now experiencing would not develop. If the Fed does follow a loose monetary policy, then a bubble can develop somewhere in the economy, whether it be in tulip bulbs, stocks, or real estate. If the new money is directed toward housing, a bubble will develop in housing. Austrian economists further emphasize that the additional resources allocated to housing are resources that are not available elsewhere in an economy, so that while more resources than normal are allocated to housing construction, fewer resources are available to other areas of the economy such as manufacturing, which will experience higher costs for its inputs such as labor and materials and will produce a proportionately smaller output. It is this mismatching of resources across industries and sectors that has to be resolved — painfully — in the inevitable bust or correction.
In a real estate bubble the price of existing homes rises. The bubble also fuels the construction of new homes so that the wages of construction workers rise and labor reallocates itself into construction and related industries. The bubble also increases the price of construction materials and land. Construction and construction-related industries are also where the most unemployment occurs and where the biggest price and wage declines occur in the inevitable bust. Another unique feature of the Austrian approach is that they do not see a need for prices to increase uniformly across markets, or for prices to increase to extreme levels in all markets. Many doubters of the housing bubble point to the smaller price increases in the center of the country compared to coastal regions, but price is only one dimension of bubbles — quantity can also increase beyond sustainable levels. In fact, one could conceptualize a bubble where prices stayed the same and all the bubble adjustment occurred only in the quantity dimension. If we doubled the number of houses and prices barely budged, we would be left with too many houses for the population and all the labor and materials that went into the production of those goods (i.e., houses) would be tied up and unavailable to serve more urgent needs after the bursting of the bubble revealed that the superfluous houses were bad investments.
Among the Austrians who identified the housing bubble is economist Frank Shostak, who defined a bubble as any activity that “springs up” from loose monetary policies: “In other words, in the absence of monetary pumping these activities would not emerge.” As a result of this pumping, a misallocation of resources develops whereby nonproductive activities increase relative to productive activities — something that seems to clearly characterize the US economy since he wrote in early 2003: “The magnitude of the housing price bubble is depicted … in terms of the median price of new houses in relation to the historical trend between 1963 and 1979. In this regard the median price stood at 73 percent above the trend in December 2002.”Frank Shostak, “Housing Bubble: Myth or Reality?” Mises Daily, March 4, 2003.
The only “problem” with his warning is that it came too soon. A year later Shostak warned that there “is a strong likelihood that the US housing market bubble has already reached dangerous dimensions.”Frank Shostak, “Who Made the Fannie and Freddie Threat?” Mises Daily, March 5, 2004. While early warning maybe a problem for investors in home building stocks, the problems of predicting the timing and magnitude of bubbles and business cycles affects all forecasters, and Shostak’s warning was primarily for the purpose of judging public policy. In effect he was noting that policymakers have made a mistake that they should correct immediately and not make the situation in the housing market any worse.
Also from the Austrian camp is banker Christopher Meyer, who noted that there is always a bubble in the making in a world of fractional reserve banking and fiat currency, and that housing has often been impacted by bubble conditions in the United States and elsewhere. In the summer of 2003 he identified the current housing bubble:
The strong housing market has all the makings of being the next bubble — in particular high leverage and unsustainable price increases. While the larger economy seems to sputter along, the housing market continues to run a hot race. Low interest rates have propelled refinancing, freeing up $100 billion last year alone, according to the Wall Street Journal. Not surprisingly, the low interest rates have increased buying power and supported housing prices.Christopher Mayer, “The Housing Bubble,” Free Market 23, no. 8 (August 1, 2003).
In early 2004 I pointed investors to the on-going housing bubble and specifically that it might not be a good idea to increase your mortgage: “It might not be a good time for you to obtain a home equity loan to invest in hot tech stocks. We are going through a housing bubble.”Thornton, “Surviving GreenSpam.” I followed this up later that year with a more detailed examination of the housing bubble and found:
Signs of a “new era” in housing are everywhere. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the east and west coasts. Booming home prices and record low interest rates are allowing homeowners to refinance their mortgages, “extract equity” to increase their spending, and lower their monthly payment! As one loan officer explained to me: “It’s almost too good to be true.” In fact, it is too good to be true.Thornton, “Housing: Too Good to Be True.”
The problem with the “new era” diagnosis is that it ignores the historical fact that the housing market, and the construction of structures in general, has experienced regular cycles of boom and bust, with prices rising and falling for residential, commercial, industrial, and agricultural real estate. Likewise occupancy and lease rates, new construction, and the fate of construction firms and land speculators point us to the history of real estate bubbles. In fact, statistically, housing starts are a leading indicator of the business cycle and home construction is procyclical (i.e., home construction is positively related to changes in the overall economy, but more volatile). The Skyscraper Indicator even shows that historically the building of a record-setting high skyscraper foreshadows severe negative changes in the economy.Mark Thornton, “Skyscrapers and Business Cycles,” Quarterly Journal of Austrian Economics 8, no. 1 (Spring 2005): 51–74.
What Goes Up… ABCT demonstrates that monetary inflation has different effects depending on who receives the new money first and how it is spent. Is the new money introduced into the economy in the areas of banking and investment, consumer loans, or directly to a group of consumers or producers? Do the people who receive the money want to save it or spend it? If they save it interest rates will go down, and if they spend it interest rates will go up as entrepreneurs borrow money in order to increase production. If the money is spent, it depends on who is spending it. The economy will experience different changes if the money is given to welfare recipients instead of military generals. If the money is saved the economy will experience different changes than if it is invested in stocks rather than housing. The point here is that monetary inflation can cause bubbles and booms in the areas of the economy where it is first introduced. This foundation of ABCT comes down to us from Richard Cantillon, the founder of economic theory, who wrote in the aftermath of the Mississippi Bubble circa 1720s. Tracking the flow of monetary inflation through the economy is very difficult, and most mainstream economists just assume away the problem and declare that money is neutral on the economy.
By the end of the eighteenth century the world had converted from free banking to central banking, with the United States being the last major nation to establish a central bank in 1913. In the first treatise on monetary theory in the modern era, Ludwig von Mises produced the foundations of ABCT.Ludwig von Mises, The Theory of Money and Credit (Indianapolis, IN: Liberty Classics [1908] 1981). With central banks established for the purpose of producing monetary inflation, Mises could now establish a general theory of business cycles rather than the case-by-case basis of Cantillon. By integrating the contributions of Carl Menger, Eugen von Böhm-Bawerk, and Knut Wicksell he was able to show that when the central bank — the Fed — increases the supply of money, it causes the market rate of interest to fall below the natural rate of interest that would have existed in the absence of Fed intervention. This would cause investors to borrow more money, to expand their investments, and to undertake riskier projects and more roundabout production processes. As these borrowers compete for assets, resources, and goods, price inflation inevitably occurs and the rate of interest will increase. This in turn will negatively affect the economy, and some of the riskier and more roundabout investment projects will be discovered to be bad investments. Bankruptcies can also impact previously existing investments and production processes that are caught in the wake of the bust. Mises student F. A. Hayek expanded ABCT to include capital theory and its integration into the structure of production.
According to ABCT, when a central bank makes loans or purchases government bonds from banks it is injecting bank reserves into the economy. Banks now have excess reserves that they can loan, but the existence of excess loanable funds means that banks must reduce the interest rate they charge, reduce the credit-quality requirements of borrowers, or both. The result is a greater quantity of borrowing and investing, particularly in projects that “pay off” over a long period of time. Lower interest rates also discourage savings because the return from savings is lower. In this manner the Federal Reserve drives the market rates of interest below the natural rate of interest that would have existed in the absence of Federal Reserve intervention.
Ever since the Depository Institutions Deregulation and Monetary Control Act of 1980 and Paul Volcker’s (chairman of the Fed from 1979 to 1987) war on inflation of the early 1980s, interest rates have been on a downward path. This culminated with the large reductions in the federal funds rate that followed in the aftermath of the 9/11 terrorist attack in 2001. Under Greenspan the rate was reduced from 6.5 percent in November 2000 to 1 percent in July 2003. The federal funds rate remained at 1 percent until June 2004, coinciding with the launching of the final phase of the housing bubble. The Philadelphia Housing Sector Index peaked at the end of August 2005. At this low level, interest rates were negative when price inflation is taken into account.
The federal funds rate, which is the rate that banks can borrow from other banks in order to meet their reserve requirements imposed by the Fed. The Fed “targets” this short-term rate and injects reserves into this market by purchasing government bonds from banks, thereby freeing up reserves in the banking system. This essentially is the engine of inflation because the Fed simply makes a bookkeeping entry in the bank’s account with the Federal Reserve — modern inflation is essentially an electronic bookkeeping entry. The low rates of the 1960s resulted in no recession and a booming economy, but those low rates also caused the stagflation of the 1970s, where both price inflation and unemployment were very high. This culminated in Volcker’s war on inflation of the early 1980s. By greatly reducing expectation of price inflation and deregulating the banking system, the Fed has been able to reduce interest rates and ignite a giant boom in financial and asset markets throughout the 1980s and 1990s, as well as the housing bubble of the early 2000s when rates were clearly pushed below their natural levels and when rates were negative, when adjusted for inflation.
When banks have access to bank reserves from the Fed at low rates they can offer their customers lower rates on loans. The impact of changes in the federal funds rate has a direct impact on mortgage rates: increasing during the 1970s and peaking during Volcker’s war on inflation at 18 percent, and then generally declining throughout the 1980s and 1990s and then reaching historical lows during the early 2000s. During the housing bubble interest rates on thirty-year conventional mortgages were at their lowest levels ever during the post–gold standard era. When interest rates fall, asset prices and real estate prices tend to rise, and vice versa.
Naturally, lower rates for home mortgages have stimulated borrowing for real estate purposes. Total real estate loans first exceed $1 trillion in early 1995, reached $2 trillion in late 2002 and reached $3 trillion in early 2006 (the maximum for the bubble occurred in mid-2009 at $3.8 trillion). In addition to the Fed, there were other factors that helped direct all this new credit money into real estate. First, in 1997 homeowners were given a $250,000 exemption ($500,000 for couples) for capital gains that resulted from the sale of their house, adding greatly to the tax benefits of homeownership. This tax break could be said to have lit the fuse of the housing bubble. Second, government-sponsored credit corporations such as Fannie Mae and Freddie Mac, which can acquire capital at a subsidized rate because of the implicit assumption that the federal government will bail them out, began to collateralize home mortgage debt on a grand scale so that lenders could quickly and easily resell the loans they make. These government-sponsored agencies have helped stimulate the flow of credit to riskier borrowers who might not otherwise have access to credit, and have therefore helped to lower the credit standards of lending institutions. The problem with these institutions is so large that even Alan Greenspan has publically scolded them.Kathleen Hays, “Greenspan Steps Up Criticism of Fannie: Fed Chief Says Company and Freddie Mac Have Exploited Their Relationship with the Treasury,” CNN.com, May 19, 2005. In truth, the original problem lies with Alan, not Fannie or Freddie.
The artificially low rates generated by the Fed also have the effect of discouraging people from saving money and encouraging them to borrow more for consumption and speculation. The impact of monetary pumping by the Fed has driven down the personal savings rate throughout the 1980s and 1990s, and during the early 2000s it has driven the rate to zero — and even below — which means people are spending more than they earn. Contributing to the problem of the low personal savings rate are the artificially inflated asset and real estate prices which naturally make people feel wealthier and allow them to “cash out” equity from their homes when they refinance their home mortgages. During the housing bubble many Americans used their homes as a kind of giant ATM to withdraw cash from the equity in their homes. Others used the “magic checkbook” from second mortgages to spend the equity they had in their homes.Carol Lloyd, “Home Sweet Cash Cow: How Our Houses Are Financing Our Lives.” SFGate.com, March 10, 2006.
At this point one should be wondering — how could borrowing be going up and savings going down? One answer to the question is that America was borrowing money from overseas in the form of the trade deficit, but the main answer is monetary pumping by the Fed. By artificially lowering rates via increases in the money supply the Fed created a giant gap between borrowing and saving. MZM (money of zero maturity) is a relatively new measure of the money supply and one that is close to the Austrian-school definition of money, which is that it is immediately redeemable at par. MZM includes currency, demand deposits — that is, checking accounts — traveler’s checks, savings deposits, and deposits in money market mutual funds. During the period from January 1959 to August 1971 (11.7 years), when Nixon took the United States off the gold standard, the money supply grew by 82.2 percent for an average annual growth rate of 5.26 percent. Between August 1971 and 1984, when complete decontrol was established from the Depository Institutions Deregulation and Monetary Control Act of 1980 (13 years), the money supply increased by 180.4 percent for an average annual growth rate of 8.25 percent. Ever since 1984 (16.6 years) the money supply as measured by MZM grew by 390.1 percent, or an average annual growth rate of 10 percent. It would seem that all this new money first went into the New York Stock Exchange, especially during the 1980s, then the NASDAQ stock market during the late 1990s, and finally into the housing market after the dot-com bust in 2000.
A large part of the increase in the money supply found its way into the market for home mortgages. Since the recession of 2001 the increase in mortgage debt was about equal to the increase in MZM. This one stylized fact probably best illustrates the housing bubble and its cause. Another measure of the housing bubble is the amount of real private residential fixed investment. Investment in housing was low during the Great Depression and WWII, but beginning in the mid-1940s investment in housing, adjusted for price inflation, has shown a positive trend, which is based on economic and population growth over that same period. The cycle in housing investment was less severe before we went off the gold standard, more severe on the fiat standard, and even more severe after monetary deregulation in 1980. Most noteworthy is that investment in housing hit a boom high during the dot-com bubble of the late 1990s and then “jumped higher off the historical trend” during the recession of 2001, when historically it would have retreated back toward recessionary trend levels. It therefore seems clear that in terms of investment value there has been a housing bubble since at least the recession of 2001.
ABCT does not rely on measuring the cycle or bubble, but empirical measures do often help illustrate the approach. The next such measure is the number of homes built (apartments and other multiunit structures are not included here). Typically there are sharp downturns in the number of housing starts often coincide with the beginnings of recessions and that the sharper the drop the longer the recession. For example, in the late 1970s the number of housing starts fell from an annual rate of over 1.5 million to a rate of barely 0.5 million in the early 1980s, which was a severe recession. Since the recession of 1991 the trend in new housing starts has been steeply upward, and there was no noticeable downturn in housing starts during the recession of 2001 — the only recession on record where that did not occur. Instead housing starts continued to increase and have set several new records over the last few years. In terms of this quantity dimension the United States has been in a housing bubble since the early 2000s.
The final dimension of the housing bubble presented here is the price of houses. Doubters of the housing bubble claim that housing prices are rising on the East and West Coasts, but are not rising by bubble proportions in much of the center of the country. Of course housing prices have increased faster in the West and Northeast compared to the Midwest and South, but ABCT theorists would be shocked if home prices were rising uniformly across the country — after all the whole theory is based on changing relative prices, not uniform increases or decreases in a price level. There are microeconomic and public policy reasons why home prices rise more dramatically and are always at a higher level in, for example, California than they are in Alabama. These issues are explored in many of the other contributions to Powell and Holcombe.Holcombe and Powell, Housing America: Building Out of a Crisis. However, the same could be said about stock prices during the technology bubble — rare stocks in tight supply (e.g., dot-coms) did much better than widely held stocks (e.g., stocks in the DJIA). The same was true of tulip bulbs during the tulip mania that happened in seventeenth-century Holland — rare species were affected more by monetary conditions than ordinary species, but they all went up in price.Douglas E. French, “The Dutch Monetary Environment during Tulipmania,” Quarterly Journal of Austrian Economics 9 (Spring 2006): 3–14.
ABCT expects prices in general to rise, but not to rise uniformly. The extent of the rise depends on both where the money is being injected and the flexibility of the supply side of the markets where the injections are taking place. However, if we look at the national price index for the typical 1996 one-family house between 1998 and 2005 we find that prices have increased by 45 percent, which is a 125 percent larger increase compared to the increase in the Consumer Price Index. According to the Bureau of the Census, the price of the average house, as opposed to the “typical” house, has been increasing even faster, which indicates that people are buying bigger, more expensive homes as well. The price dimension — while muted somewhat by the economy’s ability to produce greater quantities of housing — still indicates a large increase in the real price of housing. We should also remember that new housing is generally built on lower-priced land, that house-building technology has reduced building costs, and that the large influx of labor from Mexico has also helped hold down costs.
… Must Come Down ABCT shows that it is government failure that started the housing bubble in the first place. This is where resources are allocated in an incorrect and ultimately unsustainable fashion. In a housing bubble too many houses are built, houses of the wrong sort are built, and houses are built in the wrong locations based on the underlying fundamentals of the economy and people’s real desires for housing not artificially stimulated by monetary inflation by the Fed. While most people are very happy during boom times, the Austrian economists view the boom as the real problem because this is where resources are misallocated. This is also when people become financially overextended and engage in excessive luxury spending.Thomas Kostigen, “Skewed Views: If the Rich Are Doing So Well, How Much Worse Off Are the Rest of Us?” MarketWatch, May 23, 2006. Inflationary periods tend to be when the rich get richer and the poor get poorer.
The bubble must come to an end because it is based on an irrational allocation of resources caused by the Fed’s misleading interest rate policy. Money that is tied up in an asset bubble initially prevents monetary inflation from being revealed as price inflation as measured by the Consumer Price Index. However, if the monetary pumping is used to purchase assets like stocks, bonds, or real estate then the inflation is revealed in the price of those assets, which will rise even though the underlying earnings of the assets have not improved. When money begins to leak out of asset bubbles into consumption, then the price of goods that are used to determine price indexes will begin to rise. The asset bubble is popped or deflated when interest rates rise. This can occur when either the market raises rates due to rising inflation premiums on loans or when the Fed tries to curtail increases in the Consumer Price Index by preemptively raising rates.
The bursting of the bubble reveals the cluster of errors in the housing market and related industries and begins the process of reallocating resources to their best uses by changes in prices, buying and selling, relocation, bankruptcy, and unemployment. The macroeconomic effect of deflating the bubble is that it causes the economy to go into recession or depression. However, the effects of the bubble will also be concentrated as it deflates. Note that the bubble in employment in the construction industry began in 1997 when it rose above a trend level, which dates back to the end of WWII. Note too that the trend in construction employment has always been negative during recessionary periods — even the recession of 2001 — and that the negative trends often extend beyond the periods identified as recession. Given that the trends in construction employment have been so strong for so long during the housing bubble, it would not be surprising that the negative impact of the bubble would take on a similar but negative effect on construction employment and spending, and that these effects would spread beyond to the construction-materials industry, mortgage lending, real estate sales, furniture, appliances, and household-goods items.
Another natural concern about the bursting of the housing bubble is the indebtedness of the average American. As we previously have shown, the personal savings rate of Americans has been declining for many years, in part because Americans have felt wealthier due to the rising price of their real estate properties. This is then coupled with the rising debt of the average American household. Total household debt was less than $500 billion when the United States went off the gold standard in 1971. It first exceeded $5 trillion in 1996 and $10 trillion in 2004. In October 2005, the last reported period, total debt exceeded $11.5 trillion. Certainly these figures could be adjusted for inflation, population, and economic growth, but that does not negate the fact that Americans have taken on a large amount of debt, but have not set aside a similar amount of savings to offset this debt or to insulate themselves from periods of economic distress.
As the economy goes into recession and unemployment increases, homeowners with large mortgages will have a difficult time making their monthly payments and may face the possibility of bankruptcy. This “squeeze” will be compounded by the fact that many homeowners have taken equity out of their homes in recent years, increasing the size of their mortgage. Further difficulties are presented by the fact that a large percentage of borrowers have taken out variable-rate mortgages rather than fixed-rate mortgages, which means that their monthly payment will rise and will rise substantially when interest rates increase. There are variable-rate mortgages where the payment stays the same, but this entails the principal on the loan increases when rates rise, which could place these borrowers “upside down” or “underwater” on the homes, which means the mortgage would be much larger than the value of the home. Lenders have also been providing mortgage loans based on much smaller down payments, in percentage terms, with some lenders even providing loans that exceed 100 percent of the price of the house. All of this points to the likelihood of a large number of foreclosures and bankruptcies. This in turn points us to the stability of the banking and mortgage-lending industries and the likelihood of a taxpayer bailout of banks and government-sponsored institutions such as Freddie Mac that buy mortgage loans from lenders.
Summary and Conclusions There are three views of the housing bubble. The mainstream view does not believe in bubbles and attributes such changes in the economy to real factors such as technology shocks, and believes there is nothing the government can do to solve such real problems. The Keynesian view is that bubbles exist because of psychological instabilities in the economy, not real factors, and that countercyclical policies of the government should be used to tame the business cycle. ABCT incorporates real and psychological changes into a view where bubbles are caused by the policy manipulation of the Federal Reserve.
The housing bubble that began in the late 1990s is a classic example of government failure as applied to the housing crisis. Inflation of the money supply that accompanied the Fed’s cheap-credit policy led to a borrowing and building binge of an unprecedented scale. The number of new homes built, the price of new and existing homes, and the total amount of real estate investment all indicate that the Fed policy, combined with a favorable tax policy and taxpayer-subsidized lending practices, created the housing bubble.
The bubble is not just a bunch of hot air. Real resources are involved, which have been misdirected during the bubble and which will cause painful adjustments in the aftermath of the bubble. This will involve unemployment, foreclosure, and bankruptcy for many people, especially those in the construction and construction-related industries. The macroeconomy will be sent into a recession or depression, which could be of a lengthy duration because of the slowness of the housing market as compared to the stock market, which can process very large changes in value within the period of one market day.
The lesson of the housing bubble is that what at first appeared to be the government’s trying to help improve homeownership for Americans has been a giant government failure and will have the unintended effect of economically scaring many homeowners, particularly those who bought houses at the peak of the bubble. Others have been fooled into extracting equity from their homes, increasing their mortgages, and taking loans, such as variable-rate loans, that they believed were necessary to qualify to buy houses at inflated prices. Similar trends in housing have occurred in countries around the world as many of the world’s central banks have been engaged in monetary pumping that has been injected into their housing sectors.
The policy lesson of the housing bubble, as provided by ABCT, is that the Fed is responsible for the housing bubble as well as the normal booms and busts in the economy, that it must be relieved of its authority to set what are in effect price controls on interest rates, and also be relieved of its control over the money supply. Furthermore, all federal policy toward housing should be guided by the principles of neutrality, laissez-faire, and do no harm.
Postscript — August 8, 2009 The housing and financial crisis discussed in this chapter is now well underway and we may well have entered the worst global economic crisis of this generation. The question of how economic policy will address these problems has also been revealed in that the Federal Reserve and the US Treasury have initiated aggressive and unprecedented policy responses. Under the cover of preventing a financial market meltdown, these policy responses are really attempts to bailout the owners of large financial business. They will do little to help the housing market and will increase the overall economic harm of the housing bubble.
Will policy responses continue to be aggressive and unprecedented in the direction of greater government centralization and power as the economic crisis worsens? The importance of this question goes beyond any measure of economic harm because it can result in fundamental changes in society. It could of course result in correct economic reforms such as the abolition of the Federal Reserve, the restoration of the gold standard, and the abandonment of Federal government subsidies to housing, but as I wrote in the initial draft of this chapter in June of 2006, which the editors asked me to remove:
On top of all that, people suffer psychological consequences as well. The people most involved in the bubble are confident, jubilant, and self-assured by their apparently successful decision making. When the bubble bursts they lose confidence, go into despair and lose confidence in their decision making. In fact, they lose confidence in the “system,” which means they lose confidence in capitalism and become susceptible to new political “reforms” that offer structure and security in exchange for some of their autonomy and freedoms.
In this manner, great nations of people have given away their liberties in exchange for security. The Russians submitted to Communism and the Germans submitted to National Socialism because of economic chaos. In 20th century America, economic crises — and fear more generally — provided the justification for the adoption of “reforms” such as a central bank (i.e. the Federal Reserve), the New Deal, the Cold War, and even fiat money during the economic crisis of the early 1970s.Robert Higgs, Crisis and Leviathan: Critical Episodes in the Growth of American Government (New York: Oxford University Press, 1987) shows how crisis (such as war or depression) lead to large increases in the size of government that were only partially offset by cutbacks after the crisis was over. On the final page of the book Higgs correctly predicted that future crises would include terrorism in addition to war and depression.
Fear of terrorism after 9/11 resulted in a massive transfer of power to government at the expense of individual liberty.Robert Higgs, Resurgence of the Warfare State: The Crisis Since 9/11 (Oakland, CA: Independent Institute, 2005) correctly predicted (in the days immediately after 9/11) that among other things that government would greatly expand its power “particularly surveillance of ordinary citizens.” Submission of liberty and individual autonomy in exchange for security and the “greater good” is now often referred to as choosing the dark side.A crisis is a crossroad or turning point where the decision maker can make the correct or incorrect choice. The wrong, fear-driven choice is now often referred to as choosing the “dark side” à la Star Wars movies. See Mark Thornton, “What Is the ‘Dark Side’ and Why Do Some People Choose It?” Mises Daily. May 13, 2005.
The reason economic crises create fear and submission of liberty is that people do not generally know what caused the bust or economic crisis and generally do not even know that there was even a bubble in the first place. In fact, as the bubble is bursting many people will deny that there is a problem and believe that the whole situation will quickly return to what they consider normal. The average citizen thinks very little about what makes the economy work, but simply accepts the system for what it is, and tries to make the most of it.
Increased government intervention in housing markets and the virtual socialization of the Government-Sponsored Entities (GSEs such as Fannie Mae), and the risk of mortgage-backed securities indicates that this dangerous trend will continue.
[The original version of this chapter was published as “Housing: Too Good to Be True,” Mises Daily, June 4, 2004.]
Signs of a “new era” in housing are everywhere in 2004. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the East and West Coasts. Booming home prices and record-low interest rates are allowing homeowners to refinance their mortgages, “extract equity” to increase their spending, and lower their monthly payment! As one loan officer recently explained to me: “It’s almost too good to be true.”
In fact, it is too good to be true. What the prophets of the new housing paradigm don’t discuss is that real estate markets have experienced similar cycles in the past and that periods described as new paradigms or new eras are often followed by periods of distress in real estate markets, including foreclosure sales, bankruptcy, and bank failures.
The case of Japan’s real estate bubble is instructive. Japan had a stock market bubble in the 1980s that was very similar to the US stock market bubble in the 1990s. As the Japanese stock market started to bust, Japan’s real estate market continued to bubble. One general index of Japanese real estate shows that prices rose for almost two years after the stock market crashed, with prices staying above pre-crash levels for more than five years. The boom in home construction continued for nearly six years after the stock market crash. Prices for commercial, industrial, and residential real estate in Japan continues to fall and are now below the levels measured in 1985 when these statistics were first collected.
It has now been three years since the US stock market crash. Chairman Greenspan has indicated that interest rates could soon reverse their course, while longer-term interest rates have already moved higher. Higher interest rates should trigger a reversal in the housing market and expose the fallacies of the new paradigm, including how the housing boom has helped cover up increases in price inflation. Unfortunately, this exposure will hurt homeowners, and the larger problem could hit the American taxpayer, who could be forced to bail out the banks and government-sponsored mortgage guarantors who have encouraged irresponsible lending practices.
More Greenspan Once again, Fed chairman Alan Greenspan“Testimony of Chairman Alan Greenspan.” Federal Reserve Board’s Semiannual Monetary Policy Report to the Committee on Banking, Housing, and Urban Affairs, US Senate, February 12, 2003. has created a new-age economic panacea, and earlier this year he applauded his contribution to the economic recovery: “Very low interest rates and reduced taxes, have permitted relatively robust advances in residential construction and household expenditures. Indeed, residential construction activity moved up steadily over the year.”
The key to this panacea is the process of equity extraction that occurs when people refinance their homes; they take equity out and spend it to increase their standard of living. However, because variable-rate mortgages are so low, their payments actually go down, so they have more of their monthly income to spend or they can upgrade to a more expensive house. As Greenspan explained:
Other consumer outlays, financed partly by the large extraction of built-up equity in homes, have continued to trend up. Most equity extraction — reflecting the realized capital gains on home sales — usually occurs as a consequence of house turnover. But during the past year, an almost equal amount reflected the debt-financed cash-outs associated with an unprecedented surge in mortgage refinancings.Ibid.
As is the norm, Greenspan hedged his statements. He also considered some of the potential drawbacks and pitfalls on the horizon for the new paradigm in housing, but in the end he concluded that we really have nothing to worry about. Low interest rates, rising home prices, and lower financing costs mean that we actually can have our cake (i.e., our homes) and eat it too (i.e., equity extraction for consumption):
To be sure, the mortgage debt of homeowners relative to their income is high by historical norms. But as a consequence of low interest rates, the servicing requirement for the mortgage debt of homeowners relative to the corresponding disposable income of that group is well below the high levels of the early 1990s. Moreover, owing to continued large gains in residential real estate values, equity in homes has continued to rise despite sizable debt-financed extractions. Adding in the fixed costs associated with other financial obligations, such as rental payments of tenants, consumer installment credit, and auto leases, the total servicing costs faced by households relative to their incomes are below previous peaks and do not appear to be a significant cause for concern at this time.Ibid.
The Housing Bubble I first reported on the housing bubble in the United States at the beginning of this year (2004) when the bubble was already well under way, if not in full bloom. As the chart “Real Private Residential Fixed Investment” in chapter 18 indicates, real residential investment has jumped far above both its historical trend and even its cyclical trend channel. This indicates to me that there is a bubble in residential real estate. The data for this chart originally stopped at the beginning of 2003. We now know that investment in housing increased by 8.8 percent last year. This is a historically high rate of construction, but far from a record rate increase. However, 2003 marks the ninth year in a row that housing investment was positive, the first time that has ever occurred since the statistic has been collected. Frank ShostakFrank Shostak, “Housing Bubble: Myth or Reality?” Mises Daily, March 4, 2003. and Christopher MayerChristopher Mayer, “The Housing Bubble,” Free Market 23, no. 8 (August 1, 2003). have also written very informative articles on the housing bubble.
Recently I came across a piece of anecdotal evidence of a housing bubble. Last Sunday afternoon, a friend of mine put a “For Sale by Owner” sign on the front lawn of a small rental house he owned on a side street. It wasn’t listed with a real estate agent or in the newspaper, but he nonetheless had a couple of calls that afternoon, with many more to follow, and within a couple of days he had multiple offers before he finally accepted a bid that was substantially over his original asking price.
Mainstream economists who discount the possibility of a housing bubble would dismiss such evidence. But they also ignore all the macro evidence of the current housing boom and see it as a positive development. For example, the number of new homes being constructed is at an all-time high, despite a “soft” labor market. The annualized rate of new home construction has surpassed the two surges of the 1970s when inflation was out of control.
The prices of houses are also up circa 2004, but mainstream economists have generally ignored this development as well; and as noted above, Greenspan sees this as a positive development. Some economists can even point to the Consumer Price Index, which shows that the housing component in the CPI is steady or falling. And yet reports are coming out nearly every day saying that housing prices are up dramatically and setting records all across the country. Record prices have been recently reported in the San Francisco Bay Area, Denver, Boston, Las Vegas, the State of Washington, and even Buffalo, New York.
Nationally, the price of a median family home was up 15 percent between 2001 and 2003, with regional increases of 30 percent in the Northeast, 8.5 percent in the Midwest, 14.4 percent in the Southeast, and 20.4 percent in the West. Over the last year, increases have been reported as 18.7 percent in the Northeast, 1.9 percent in the Midwest, 3.8 percent in the Southeast, and 10.7 percent in the West, or 6.5 percent for the nation as a whole. Interestingly, the median price has actually dropped 7.2 percent in the Midwest and 7.3 percent in the South since peaking in the third quarter of 2003, while prices have been generally flat in the West. Statistics from the last couple of quarters might therefore suggest that the housing bubble may have topped out, or at least temporarily cooled down, in much of the country.
Why have home prices been increasing? David Lereah, chief economist with the National Association of Realtors, explained to Inman News (2004): “It’s a simple matter of supply and demand. … We continue to have more home buyers than sellers in most of the country, which results in tight housing inventories and higher rates of home price appreciation.”David Lereah, “Real Estate Prices Post Double Digit Gains,” Ocala Star-Banner, May 22, 7, 2004. Of course the cause of higher home prices is that the Federal Reserve has kept interest rates, and thus mortgage rates, at historically low rates such that people find it easier to finance homes. In fact, despite an 18 percent increase in home prices since 2001, the median monthly payment remained the same at $789/month and the median payment as a percentage of income has actually fallen. This is the magic of monetary inflation, courtesy of Alan Greenspan.
Price Inflation Follows Monetary Inflation The price of just about everything I buy is going up these days. Gasoline is higher, dairy products are higher, paper products and just about everything else — higher. Mainstream economists have sounded surprised by the recent upturn in price inflation, and they have offered us every excuse to ignore signs of inflation: Ignore rising oil prices. Ignore rising food prices. Ignore rising health care costs. Ignore higher taxes and government fees. And then there is their dirty little secret about housing prices.
Higher price inflation should not have been a surprise given that the Fed has increased the money supply by 25 percent during the period 2001–3. In addition, the price of basic commodities has been rising for many months, and these higher commodity prices eventually turn up in the price of goods and services. One leading indicator of higher commodity prices is the Dow Jones Commodity Index, which represents the stock prices of major commodity producers. It has been rising since the fourth quarter of 2001 and has doubled in value since that time. This stock index is now higher than it has ever been, outside of the blip that occurred in mid-2002.
Only recently have commodity prices begun influencing government price indexes like the Producer Price Index and the Consumer Price Index. For the first four months of 2004 CPI inflation increased at an annual rate of 4 percent, which is a higher rate than we have experienced in the last few years. The Producer Price Index actually decreased in 2001, but has increased in 2002 and 2003. During the year ending June 2004, prices for finished producer goods increased 3.7 percent, while at earlier stages of production the prices for intermediate goods increased by 5.1 percent and the prices of crude materials surged 20.4 percent. This would suggest that there is potentially plenty of price inflation still in the pipeline. The experience of the 1970s would suggest that price inflation adds fuel to housing bubbles because tangible assets such as homes serve as a hedge against inflation.
The Dirty Secret While this price inflation did not surprise me, the delay in its arrival did — that is, until I came across the dirty little secret in the CPI. With prices increasing all around us, there is one thing in Auburn, Alabama, that seems to be in abundance with stable, if not declining, prices. This “good” is now being advertised on most streets throughout the town, whereas in the past it did not require much, if any, advertising over the twenty-plus years I have lived in this college town. This abundant good is housing.
It is a truly odd market when houses and apartments move in opposite directions. After all, houses and apartments are just different products in the same market for housing. In Auburn, it is nearly impossible to find the kind of house you want to buy despite frantic building by construction companies, and yet rental properties, which include many smaller houses, seem to be readily available in all shapes and sizes. Has the population changed? Have people become antirent? Or are we just in a “new housing paradigm”? Is this a “new era” of homes?
Greenspan’s low interest rates have driven renters to become homeowners and knocked the market out of equilibrium. Underneath this Fed-inspired distortion rests the dirty little secret of how the cost of housing has served to limit increases in measured inflation. The Consumer Price Index has underreported price inflation because the government uses the rental value of housing, rather the actual price of houses, in its index.
In the basket of goods used to calculate CPI, the goods that have increased slower than housing include food and beverages, recreation, and education, which add up to about 30 percent of the weight in the CPI basket of goods. Housing accounts for 42 percent of the basket, with housing prices representing almost 25 percent of the entire basket. However, housing prices are calculated with “owner’s equivalent rent,” which is an estimate of the rent that people would have to pay for their houses. With home prices rising and rental rates stagnant, the CPI underestimates the real rate of price inflation over the last year (circa 2004) by about 50 percent.
Do Housing Bubbles Burst? Housing prices never, or rarely, go down. That is the conventional wisdom, and the conventional wisdom is correct. Housing is always a good investment, isn’t it? It’s an inflation hedge and it’s an investment that you get to use every day, plus you get a great tax break. And the home, after all, is a big part of the American dream, right?
Government can screw up just about anything. Given enough power and time it will screw up everything. Housing and real estate in America is just the latest example. The Federal Reserve and the Mac-Mae family of government-sponsored enterprises that facilitate various kinds of debt (i.e., Freddie, Fannie, Sallie, etc.) have conspired to create a housing bubble in the United States, and as the old saying goes, “What goes up must come down.” It’s only a matter of time.
Housing bubbles typically do not pop like a balloon; they don’t even crash like stock markets. Rather, the air in housing bubbles tends to leak out slowly — painfully slowly — while in commercial real estate markets there is a more noticeable hiss. We really don’t know the current value of our homes until we sell them. They are not traded on a daily basis, like shares of stock in Walmart. Some never get exchanged in the market, but are passed on within a family from generation to generation. The market value of a home may drop 20 percent and the owner might never realize it.
Worse yet, when the market for real estate collapses, prices are less likely to collapse because when buyers fail to make offers houses simply don’t sell. Sellers often resist cutting their prices in favor of just leaving the house on the market or taking it off the market. Traditionally the market adjustment to a collapse in real estate markets has come from the quantity side, not the price side — fewer houses are sold — while price reductions tend to come gradually. This doesn’t mean that housing bubbles can’t exist or that the bust is any less painful, only that it doesn’t make the same noise as a crash.
It is difficult to predict how long bubbles will last and when they will go bust. The best indicator is interest rates, because when the Fed forces rates down it tends to create bubbles, and when rates are forced upward bubbles tend to pop. My guess is that Greenspan will raise rates after the election.
Prior to this spike, interest rates had been falling since the early 1980s. As mentioned above, lower rates have coaxed people into refinancing their homes and extracting equity from their homes to spend on other purchases, such as cars, boats, renovations, vacations, or even investments in the stock market. As a result, owner equity as a percentage of real estate value is now at an all-time low.
Here is the unmentioned problem with Greenspan’s panacea. What happens to all these “equity poor” homeowners if the return of monetary inflation establishes a new trend of higher prices and higher interest rates over the coming years?
An ever-increasing proportion of mortgage financing has come in the form of variable-rate mortgages, where the payment increases as interest rates increase. In my experience, variable-rate mortgages come with a “cap” that only allows the variable rate to increase by a certain amount. Even with the cap, however, your mortgage payment could increase by around 50 percent. I have recently learned that many variable-rate loans are now offered without a cap. If rates were to explode upward, mortgage payments for these folks could double or triple. And if this did happen, the housing market would collapse with sellers swamping buyers.
Given the government’s encouragement of lax lending practices, home prices could crash, bankruptcies would increase, and financial companies, including the government-sponsored mortgage companies, might require another taxpayer bailout.
Of course inflation might not materialize. Interest rates could stay low. I reported on a new book Deflation: What Happens When Prices FallChris Farrell, Deflation: What Happens When Prices Fall (New York, 2005). that even predicts that deflation will rein in our financial future. Greenspan has suggested that his economic panacea has given American homeowners greater economic “flexibility.” I would suggest that it is not flexibility he offers, but the shackles to an economic nightmare. Stick with the fixed-rate mortgages, keep the equity in your homes, or go get one of those cheap apartments.
Science is prediction. — Motto of the Econometrics Society
Those who have knowledge, don’t predict. Those who predict, don’t have knowledge. — Lao Tzu
Predicting economic behavior is inherently difficult. As Niels Bohr joked, “Prediction is very difficult, especially if it’s about the future.”
Originally published “Who Predicted the Bubble and Who Predicted the Bust?” Independent Review 4, no. 1 (Summer 2004): 5–30. Excerpted here and reprinted with permission.
Quotation at http://www.brainyquote.com/quotes/quotes/n/q130288.html
People’s economic actions are subject to choice and change, unlike the subject matter of the physical sciences, which has fixed properties. Therefore, the future must remain uncertain. Predicting the economy as a whole is fraught with additional dangers and complications, and all leading indicators of economy-wide change either do not have or eventually lose the capacity to predict the future accurately. As Paul Samuelson once quipped, “Wall Street indices predicted nine out of the last five recessions.”Paul A. Samuelson, “Science and Stocks,” Newsweek, September 19, 1966, p. 92. In light of these difficulties, economists have taken widely divergent positions on prediction.
Many modern mainstream economists, like their colleagues in the physical sciences, view prediction as the essence of science. If you cannot predict with a high degree of accuracy, then you are not being scientific. You must put your science to the empirical test and pass that test. The dominance of positivism in economic methodology encourages economists to worry less about the logical consistency of their models and to concentrate more on the development of models that exploit historical data in making predictions. Government and business economists then use the models to forecast variables such as gross domestic product, interest rates, unemployment, company sales, stock prices, housing starts, and demographic changes.
There is also substantial support for the position that we cannot predict and that economists have a terrible forecasting record. With respect to the technology bust in 2001, Mike Norman put this view of economists in perspective:
I’m an economist. Big deal, right? Until last year, economists got even less respect than Wall Street analysts; now, we’re just a notch above. Admittedly, this reputation is well-deserved, because it comes from our less-than-stellar ability to get economic forecasts right. With all of that data and plenty of powerful computing ability, you’d think we could produce better forecasts. Heck, even the local weatherman puts us to shame.Mike Norman, “Dismal Science May Get a Little Sunnier,” Special to the Street, April 21, 2003.
“The Street,” having witnessed countless forecasts go wrong, is naturally suspect. As Lindley Clark once noted in the Wall Street Journal, “Economists have a great deal of trouble predicting the future, and it’s unlikely that this unhappy situation ever will change.”Lindley H. Clark, Jr., “Housing May Be in for a Long Dry Spell,” Wall Street Journal, January 19, 1990. Indeed, some economists think that forecasts are akin to “magic” and that such magic is contradicted by the very essence of economic science. Deirdre McCloskey has expounded on this view of economic forecasts:
Economics is the science of the postmagical age. Far from being unscientific hoobla-hoo, economics is deeply antimagical. It keeps telling us that we cannot do it, that magic will not help. Only the superstitious think that profitable forecasts about human action are easily obtainable. That is why economics, contrary to common sneer, is not mere magic and hooblahoo. Economics says that forecasts, like many other desirable things, are scarce. It cannot be easy to know what great empire will fall or when the market will turn. “Doctor Friedman, what’s going to happen to interest rates next year?” Hoobla-hoo. Some economists allow themselves to be paid cash money to answer such questions, but they know they cannot. Their very science says so.Donald McCloskey, “The Art of Forecasting: From Ancient to Modern Times,” Cato Journal 12 (Spring–Summer 1992): 40.
Though agreeing in the main that forecasting has questionable value, Michael BordoMichael Bordo, “The Limits of Economic Forecasting,” Cato Journal 12 (Spring–Summer 1992): 47. claims that forecasting has some scientific and practical value and is not all just snake oil and magic. He notes that not all economists have been such dismal failures as forecasters: Richard Cantillon made correct predictions about John Law’s Mississippi Bubble system based on economic theory, and he made a fortune as a result.
Others, following the famous Chinese philosopher Lao Tzu, are skeptical about the prospects for prediction but do not altogether reject the possibility of accurate prediction. They merely restrict themselves to hypothetical and qualitative prediction. Foremost among this group are the Austrian-school economists, who reject the notion of fixed relations between human-controlled variables and even the idea that data can be used to “test” an economic theory. Austrian economist Ludwig von Mises rejected the general notion of forecasting and claimed that economics can provide only qualitative predictions about particular policies:
Economics can predict the effects to be expected from resorting to definite measures of economic policies. It can answer the question whether a definite policy is able to attain the ends aimed at and, if the answer is in the negative, what its real effects will be. But, of course, this prediction can be only “qualitative.” It cannot be “quantitative” as there are no constant relations between the factors and effects concerned. The practical value of economics is to be seen in this neatly circumscribed power of predicting the outcome of definite measures.Ludwig von Mises, The Ultimate Foundations of Economic Science: An Essay on Method (Princeton, NJ: D. Van Nostrand, 1962), p. 67.
The problem of predicting (with the goal of preventing) stock market bubbles and crashes is especially important, not just because busts result in huge financial loses for some investors, but because many of these extreme financial cycles can disrupt the financial system and lead to real economic contractions.Frederic S. Mishkin, and Eugene N. White, “Stock Market Bubbles: When Does Intervention Work?” Milken Institute Review: A Journal of Economic Policy 5 (2nd quart. 2003). Unfortunately, economists have yet to develop a generally accepted view of bubbles and have little to offer in predicting them.
Bubble Predictions If you can look into the seeds of time, and say which grain will grow and which will not, speak then unto me.— William Shakespeare, Macbeth
Responsible economists and economic analysts should have been warning the public about the prospects of a market crash and its implications for both the economy as a whole and their personal fortunes. However, few economists were issuing such warnings.— Dean Baker, “Dangerous Minds? The Track Record of Economic and Financial Analysts”
One person who did issue warnings regarding the stock market bubble and the problems a stock market crash might generate was Dean Baker of the Center for Economic and Policy Research. In the aftermath of the technology bust in 2001, he made the following observations:
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It should have been very simple for any competent analyst to recognize the bubble as the ratio of stock prices to corporate earnings hit levels that clearly were not sustainable in the late nineties. … The failure to recognize the bubble and warn of its consequences stems in part from a misunderstanding of the stock market and its role in the economy. …
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While there were some economic analysts who did warn of the market bubble, their views were almost completely excluded from the media. …
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Due to their failure to recognize the stock market bubble, official forecasters, like the Congressional Budget Office (CBO) and the Social Security Administration (SSA), made projections that were implausible on their face. …
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Most managers of large investment funds, including public and private pensions, and university and foundation endowments, failed to see the bubble and its inevitable collapse. … While the failure to recognize and warn of the stock bubble amounted to an enormous professional lapse, few economic or financial analysts seem to have paid much of [a] price for their mistake.Dean Baker, Dangerous Minds? The Track Record of Economic and Financial Analysts (Washington, DC: Center for Economic and Policy Research, 2002), p. 3.
I myself presented such warnings and analysis in public lectures, radio broadcasts, and newspaper articles and on the internet, but with little or no effect. In a public lecture in Houston on July 15, 1999, I addressed an audience about Alan Greenspan’s “luck” in increasing the money stock without price inflation, and I warned that the Fed’s actions inevitably would have negative economic consequences, especially for stocks and the dollar. I appeared on the Financial Sense News Hour on April 3, 2000, and April 4, 2001, and on a radio show called Credit Bubble.See http://www.financialsense.com/Experts/Thornton.htm On the Barstool Economist list on January 5, 2001, and January 7, 2001, I issued warnings that the dollar (then near its peak) would probably weaken over time. I also wrote several letters to newspapers, such as Investor's Business Daily, during this period, none of which was printed.
The Wall Street Journal’s semiannual survey of economic predictions indicates that forecasters have had difficulties in understanding the stock market bubble. The survey released on January 4, 1999, found forecasters to be concerned about the economy and forecasting low rates of economic growth, the majority expecting higher inflation and a 30 percent chance of entering a bear market in stocks. The survey released July 2, 1999, found those same economists raising their forecasts of the GDP growth rate by 50 percent for the remainder of 1999 in response to higher-than-predicted growth rates in early 1999. Even though they remained personally bullish on the stock market, they expressed greater concern about a bear market beginning in 1999. After the Y2K crisis passed, the survey released on January 3, 2000, found economists to be euphoric about the prospects for 2000. “There is no end in sight to the expansion,” said Allen Sinai, an economist at Primark Corporation. The group remained bullish on stocks, and 95 percent of the forecasters attached a probability of less than 30 percent to the onset of a recession. Only longtime bear Gary Shilling forecast a recession based on the stock market’s crashing. After a decline of more than 30 percent in the NASDAQ index, the survey released on July 3, 2000, found economists confident that the Federal Reserve (the Fed) would engineer a “soft landing”; the optimists believed in the Fed’s perfect soft landing, whereas the pessimists foresaw a soft landing but worried that the Fed would not do enough to fight inflation. However, the group finally was starting to express more concern about the future of the economy and the stock market. These forecasters’ record seems extremely weak. Even as reported by the Wall Street Journal, their record is poor: they seemed to have no clue about changes in the economy’s short-term outlook, instead simply projecting the historical trends forward.
The record of government economists mirrors that of Wall Street analysts. I compare forecasts from the Congressional Budget Office (CBO) and the White House with those from Wall Street in table 1. Under each group’s heading, its annual forecasts for the period 1992–2002 are compared with actual economic growth rates. From 1992 through 1996, the forecasts were accurate as the economy followed the trend line. From 1996 through 2000, forecasters from all three groups underestimated economic growth rates as the economy and the stock market went into the bubble phase. Then, from 2000 to 2002, they all overestimated economic growth rates, following the trend and failing to anticipate the meltdown in the stock market and the economy. The mean absolute error for all three groups was approximately one percentage point, so their average forecast for growth rates was off by approximately 20 percent.
Two of the most famous predictions concerning the stock market came from James K. Glassman and Kevin A. Hassett in their 1999 book Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock MarketNew York: Random House. and from Robert J. Shiller’s Irrational ExuberancePrinceton, N.J.: Princeton University Press. in 2000.
Some traditional investment advisors were quick to warn against Glassman and Hassett’s recommendations. In particular, Charles Murray of the American Institute for Economic Research noted that such books are often a harbinger of disaster:
At the time (October 25, 1999), we said that books such as Dow 36,000 seem mainly to make their appearance at or near market tops. In fact, investors had their choice among Dow titles in the past year: David Elias explained why the Dow will reach 40,000 in Dow 40,000; whereas Charles W. Kadlec and Ralph J. Acampora predicted (although wouldn’t guarantee) that the Dow will eclipse 100,000 in — you guessed it — Dow 100,000.Charles Murray, “Bubble Trouble,” Research Reports 67, no. 11 (June 12, 2000): 63.
Murray’s traditional approach led to the conclusion that the market was in a bubble and to a prediction that a crash or bear market was imminent. Readers could have protected themselves against the crash by acting on Murray’s advice:
Readers of these Reports know that for some time we have noted that the market’s valuation of common stocks has been markedly high in relation to most measures used in security analysis — cash flow, book value, earnings, etc. However, the historical record does not tell us what the “right” valuation is, only that the current valuations are exceptional. We have also observed that the current bull market is of unprecedented duration and magnitude and that at some point a genuine bear market or even crash can be expected. Again, at what point this valuation becomes unsustainable is far from clear.Ibid., p. 64.
Murray noted that the traditional valuation methods have shortcomings and that for larger purposes, such as the prevention of bubbles, valuation techniques do not tell us what causes bubbles in the first place.
Another good foil to Glassman and Hassett is economics and financial writer Christopher Mayer,Christopher Mayer, “The Meaning of Over-valued,” Mises Daily, March 30, 2000. who investigated and wrote about their book during its heyday. He concentrated on the meaning of the term overvalued — not so much on how to determine when something is overvalued numerically, but on the cause, meaning, and effect of overvalued stocks. Specifically, he criticized the notion of perfectly rational and efficient markets and showed how markets can, in a sense, lose their rationality. First, Mayer introduced the general mindset of the new paradigm that dominated the view of the market during the bubble, and he linked Glassman and Hassett to this mindset:
Are stocks overvalued? One answer is that it depends on whom you ask. Those who are buying and holding apparently think that they will be able to sell them at higher prices. Maybe they believe in a new paradigm where the old yardsticks of value are useless. James Glassman and Kevin Hassett recently wrote a book called Dow 36,000 in which they maintain that the stock market is currently undervalued.Ibid.
Next, he made his own prediction, linking Glassman and Hassett with the hapless Irving Fisher. More important, he explained specifically why a bubble existed, rather than arguing simply that the market was overvalued by some historical yardstick:
Looking back, future financial historians will likely relate the Glassman/Hassett thesis to Irving Fisher’s famous proclamation in 1929 that “stock prices have reached a permanent and high plateau.” James Grant likes to say that there are three common features of a bubble: one part fundamental (i.e., a technological revolution), one part financial (i.e., a surge in money and credit) and one part psychological (i.e., a suspension of belief in traditional valuation measures). All the ingredients would appear to exist in the current bull market.
As is often said, only time will tell. Unfortunately, no theory of cycles or bubbles can tell us precisely when it will all end. Maybe twenty years from now, we will be able to definitively state whether these prices were reasonable or whether the boom time of the 1990s ended in a bust. From where I sit, heeding the teachings of the Austrians, I’ll place my bet on the latter.Ibid.
One of the earliest prognostications regarding the boom and bust was certainly the one mentioned by analyst James Grant, the editor of Grant’s Interest Rate Observer. Grant closed his book The Trouble with Prosperity, written in May 1996 “at what may or may not prove to be the ultimate peak of the speculative frenzy,” with the following conclusions:
Predictably, the risks to saving are the greatest just when they appear to be the smallest. By suppressing crises, the modern financial welfare state has inadvertently promoted speculation. Never before has a boom ended except in crisis. In anticipation of just such an outcome, a skeptical Seattle investor, William A. Fleckenstein, founded a hedge fund in 1995 to buy cheap stocks and to sell dear ones. He named it The RTM Fund, the initials signifying “reversion to the mean.” They may be the financial watchwords for the millennium.James Grant, The Trouble with Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings (New York: Random House, 1996), pp. 314–15.
Grant continued to warn investors about the stock market bubble in his investment newsletter, to provide detailed explanations of the cause of the bubble, and to chronicle the relevant statistics.
Another early analysis came from Tony Deden (1999) at Sage Capital Management, who identified the bubble and its causes and predicted a crash:
We fully expect a decline in securities prices and the almighty dollar over the next years. … There is no new paradigm. Economic sins have consequences. Hopefully, perhaps even economists will learn that inflation is measured by the growth in money and credit rather than in an idiotic index of consumer prices. They might even learn that growth achieved with smoke and mirrors ultimately leads to ruin.
Is the incredible rise in securities prices since 1995 a reflection of real value created or is it merely a bubble? Is this really a second Industrial Revolution that changes our very basic economic assumptions or is it not? Is it a “new paradigm”? A world of fast growth, record (low) unemployment and no apparent inflation? Have economic laws been suspended? And if not, how could so many people be so wrong?Anthony Deden, “Reflections on Prosperity,” Sage Chronicle, December 29, 1999.
Writing near the peak in the bubble, Deden declared with regard to the size and magnitude of the distortions:
Let there be no doubt, that what we are witnessing is, indeed, history’s greatest financial bubble. The indescribable financial excesses, the massive increase in debt, the monstrous use of leverage upon leverage, the collapse in private savings, the incredulous current account deficits, and the ballooning central bank assets all describe the very severe financial imbalances which no amount of statistical revision nor hype from CNBC can erase.Ibid.
He was equally clear and unequivocal about the cause of the bubble and related distortions in the economy:
Their cause is not the fault of capitalism as it has been suggested, but an excessive amount of money and credit created by central banks. Yet, this seems to escape the understanding of those who will, in one day, convene congressional hearings to determine what caused this destruction. The culprit is, as it always has been, the same organization, which professes interest in bringing about price stability and low inflation: The Federal Reserve Bank and its policies of money market intervention, credit creation and loose money.Ibid.
Economist Jörg G. Hülsmann, writing in August 1999, provided an analysis and prediction of the stock market bubble based on the post-1980 monetary regime in the United States. He concluded that the market boom had been created artificially and that it was doomed to fail:
You do not need a rocket scientist to predict the bitter end of this evolution. … Just as any other state of affairs that has been artificially created and maintained by inflation, the present system bears in itself the germs if its own destruction. It will experience a flat landing of which even the most recent crises in South-East Asia, Russia, and Latin-America only give a weak foretaste.Jörg Guido Hülsmann, Scöne neue Zeichengeldwelt (Brave New World of Fiat Monies). Postface to Murray Rothbard, Das Schein-Geld-System (Gräfelfing), p. 140.
Hülsmann discussed the alternative courses of action that the Fed might take to deal with the boom and bust in the stock market. The first is to continue inflating money and credit, the second to stop that inflation. However, he concluded: “In any case the crisis is therefore inevitable. It breaks out as soon as the price-enhancing effect of the inflation is no longer neutralized through currency exports or other factors. (And of course the crisis accelerates when the inflationary currency streams back from abroad).”Ibid., p. 147. From these arguments, he concluded that the system of boom and bust based on national fiat currencies must eventually come to an end and that either path of economic policy will entail extreme changes in our political economy:
It is but a question of time until North-America and Europe also reach the dead end of an economy built on fiat money. At that point, however, there will be nobody to extend the life span of this shallow game through further credits and further inflation. Either the western economies will then be under total government control, as it has already been the case in German National Socialism, or we are expecting a hyperinflation. It may take some more years or even decades until we reach this point of time. It can be further delayed through a currency union between Dollar and Euro (and Yen?). But it is and remains a dead end street, at the end of which there is either socialism or hyperinflation. Only radical free-market reforms — in Rothbard’s words: return to a commodity money such as gold on a free currency market and a complete ban of government from monetary affairs — lead us out of this.Ibid., p. 154.
If Hülsmann is correct, not just about the end of the bull market but about the economic and political consequences of the bust, then the issue of stock market bubbles, their cause, and their consequences takes on a critical importance for our understanding of the future course of the overall political economy.
Hülsmann is not the only economist who traced this business cycle back to the post-1980 monetary regime of deregulation. At the height of the bull market, allies of the Austrian school of economics held a conference at which most participants emphasized the role of the Fed in creating the boom. In particular, Frank Shostak highlighted the impact of the central bank’s policies:
Today’s prevailing view is that central banks and other policy makers are knowledgeable enough to pre-empt severe economic slump. … Notwithstanding the popular view, the US economy is severely out of balance. The reason for this is the prolonged loose monetary policies of the US central bank. The federal-funds rate which stood at 17.6% in April 1980 fell to the current level of 5%. At one stage in 1992 the rate stood at 3%. The money stock M3 climbed from $1824 billion in January 1980 to $6152 billion at the end of June 1999. In a time span of less than a decade it grew by over 200%. Another indicator of the magnitude of monetary pumping is the Federal debt held by the US central bank. It jumped to $465 billion in the first quarter of 1999 from $117 billion in the first quarter 1980, a 300% rise. Obviously the sheer dimension of the monetary pumping and the accompanied artificial lowering of interest rates has caused a massive misallocation of resources which ultimately will culminate in a severe economic slump.
The intensity of the misallocation of resources was further strengthened with the early 1980’s financial de-regulation. The idea of financial deregulation was to free the financial system from the excessive controls of the central bank. It is held that freeing financial markets will permit a more efficient allocation of economy’s scarce resources, thereby raising individual well being. It was argued that the overly controlled monetary system leads to more rather than less instability. Nonetheless, rather than producing more stability, the “liberated” system gave rise to more shocks.
The 1980’s financial de-regulation resulted in a reduction of the central bank supervisory powers. The weakening in the central bank controls gave impetus to a greater competition in the financial sector. This in turn through the fractional reserve banking sparked the unrestrained creation of credit and money out of “thin air.” The money out of “thin air” in turn has been further processed by creative entrepreneurs, who have converted this money into a great variety of financial products, thereby contributing to a wider dissemination of the monetary pollution.Frank Shostak, “Inflation, Deflation, and the Future,” Mises Daily, October 5, 1999.
On the basis of his analysis of the then-current economic utopia, Shostak concluded that the economy was poised for bad times ahead: “It seems therefore that the chaotic state of world financial markets will continue to get worse, unless gold is allowed to assume its monetary role. Notwithstanding that[,] there is very little reason for being optimistic in the current economic climate.”Ibid.
The most forceful prediction of both a stock market bubble and a stock market bust came from bearish economist George Reisman in an article published on August 18, 1999, at the height of the stock market bubble. He began with the observation that the conditions of reality were clearly askew, an observation that most market commentators made only in hindsight:
Clearly, something is wrong. It simply cannot be that we can have a society in which everybody lives by day trading in the stock market. While the stock market does make an important contribution to capital accumulation and the production of wealth, it is far from an unlimited one, and its contribution is not enlarged by hordes of essentially ignorant people dabbling in it on the basis of tips and hunches. Yet such an absurd outcome of practically everyone being able to live by means of buying stocks cheap and selling them dear is what is implied by an indefinite continuation of the bull market. As a result, it is inescapable that the bull market must end.George Reisman, “When Will the Bubble Burst?” Mises Daily, August 18, 1999.
For Reisman, predicting stock market bubbles and crashes is not a matter of measurement, but of cause and effect. He made the common sense observation that to understand the cause of a stock market bubble is to understand its ultimate effect: “To understand precisely how and when this will come about, one needs to understand what has been feeding the current bull market. Then one can understand what will put an end to it — what will constitute pulling its foundation out from under it.” He found the ultimate cause of extreme movements in the economy in general and in the stock market bubble in particular to be government intervention in connection with the money supply and interest rates: “The only thing that explains the current stock market boom is the creation of new and additional money. New and additional money, created virtually out of thin air, has been entering the stock market in the financing of corporate mergers and acquisitions and of stock repurchases by corporations.”Ibid. Shunning issues of technological change and psychology, Reisman concluded not only that excess financing for the stock market was the cause of the bubble, but that this money ultimately finds its way throughout the economy, spreading higher prices and bringing the stock market back to reality. He therefore separates technology and normal economic growth from inflation-financed bubbles in stock prices. Obviously, both phenomena occurred simultaneously and mingled during the 1990s:
The increase in the quantity of money exerts its favorable effect on stock prices only when, as in the last few years, the increase is concentrated in the stock market and has not yet sufficiently spread throughout the rest of the economic system. When it does spread throughout the economic system and begins substantially to raise commodity prices, the effect on the stock market becomes negative.
The application to the stock market is that the market will stop rising as soon as the Federal Reserve becomes sufficiently alarmed about the inflationary flooding of the economy as a whole that emanates from the stock market bathtub so to speak. When the Federal Reserve is finally moved to turn off the water — the new and additional money — flowing into the stock market, its rise will be at an end. Indeed, not only will the stock market stop rising, it will necessarily suffer a sharp fall.
The inescapable implication is that sooner or later, the stock-market boom must end. The bubble must break.Ibid.
Reisman, it appears, made an accurate analysis of the stock market, identified the cause of the bubble, and accurately predicted that the stock market would crash.For an updated analysis, see George Reisman, “It May Be Bursting Now, and Faulty Economic Analysis May Cost Investors Dearly,” Capitalism.net, February 26, 2000.
Economic and stock analyst Sean Corrigan also provided well-timed prognostication of the bubble and deep insight into its cause. He compared conditions during the fall of 1999 to those during the late summer of 1987, the Japanese bubble of the late 1980s, and the Roaring Twenties in the United States. He dismissed the idea that technology and a “new paradigm” could have been responsible for the run-up in stock prices in the late 1990s. In his view, debt of all kinds was expanding at high rates at a time when the saving rate was plummeting. The solution to this economic paradox was straightforward for Corrigan. He blamed Alan Greenspan for overly generous provision of high-powered money, and he then proceeded to explain the impact of this highly expansionary monetary policy:
Monetary pumping on this order, as the Austrians will tell you, leads to serious distortions in the price structure of an economy which cannot be captured in crude, aggregate, index numbers. These distortions between the value of goods, present and future, lead to mal-investments and a clustering of false decisions. Factories built and productive processes put in train based on a market rate of interest artificially lowered by the effulgence of fiduciary media are not backed up by real savings and thus become misaligned with a propensity for consumption which has, if anything, intensified.Sean Corrigan, “Will the Bubble Pop?” Mises Daily, October 18, 1999.
What effect do these distorted prices and investments have? Corrigan went on to make a bold and far-reaching prediction:
A raft of “entrepreneurial errors” lies ahead. This means not only the prospect of half-finished malls, hotels and offices, but also completed, now distinctly sub-par undertakings: businesses and plants which cannot possibly earn the returns projected at inception. Less visible, though more widespread, such an overhang will depress returns on capital where they do not wipe it out completely. The credit expansion, once it draws to its inevitable end, will impoverish everyone, everywhere.Ibid.
Writing at the end of the boom, bearish economist Hans Sennholz described both the direct cause (credit creation by the Fed) and its effects in creating the boom in both the stock market and the general economy, taking special note of the explosion in the use of derivatives:
Surely, the American economy looks very dynamic and the value of the stock market is the highest in U.S. history, but the private economy is incurring the biggest financial deficits since the Second World War. The country is suffering record current account deficits with net external liabilities now exceeding 20 percent of GDP and rising.
Wall Street may be celebrating the decline in government deficits, but other debts continue to grow by leaps and bounds. According to the Fed’s Flow of Funds, household debt (mainly home mortgages) is growing at an annual rate of 9.25 percent, total household debt as a share of personal income now exceeds 103 percent. Business debt is soaring at a 10.5 percent rate. Corporate debt of non-financial firms is rising at a 12 percent rate, the fastest in more than a decade.
While some of these debts are going into new investments, much is spent on share buybacks. In short, corporations are going into debt to boost their share prices. Margin debt in the stock market is growing faster than any other type of credit. In 1999 it soared by 46 percent, now exceeding $206 billion, which is the highest in U.S. history. Unfortunately, if this growth of debt should come to a halt, or merely slow down, it may break the fever of the boom and usher in the readjustment.Hans Sennholz, “Can the Boom Last?” Mises Daily, July 31, 2000.
Sennholz went on to describe the precarious position of the economy and the stock market. He described the contraction in the market as an inevitable consequence of the credit-induced boom and as something the Fed had no power to fix:
The American economy is in its 10th year of cyclical expansion, which is the longest on record. A grave risk in this setting is a sudden fall in share prices, a bear market, which would evoke a dramatic fall in consumer confidence and demand. Since consumption is driving more than two-thirds of American production and growth, a sharp decline of consumer demand would soon lead to a decline in production, which may trigger an international run from the dollar. In order to stem such a run and attract enough foreign capital to cover the current account deficit of more than 4 percent of GDP and carry external liabilities of more than 20 percent of GDP, the Federal Reserve would have to raise its rates. But such a raise at a time of falling stock prices and falling output would soon aggravate the decline and lead to a painful recession. The present pleasant scenario of rising productivity and income, high stock prices and a strong dollar would soon turn into the opposite — falling productivity and income, falling stock prices and a weak dollar, declining imports, rising inflation, rising interest rates, and rising unemployment. The longest economic boom in history would give way to a long recession.Ibid.
Just as clearly, the cause of the credit creation and therefore the boom is the Fed and the policy of central bankers:
The economic maladjustments due to many years of monetary manipulations by the Federal Reserve System are the prime source and mover of the inevitable readjustment. Once the market structure no longer reflects the unhampered choices of all participants, the readjustment is unavoidable. In the end, the laws of the market always prevail over the edicts of political controllers and regulators. They even reign over the wishes of a few central bankers. Surely, government officials and central bankers have the power to lessen or aggravate the stresses of readjustment as they have the power to interfere with the economic lives of their nationals.Ibid.
At a time when many were still unsure about the causes and consequences of the initial features of the bust, others such as William Anderson clearly saw the “beginnings of the end” and emphasized that this big cycle of boom and bust was nothing new to US economic history:
We have, supposedly, learned our lessons since the 1970s. Alan Greenspan knows more than previous Federal Reserve chairmen, Robert Rubin was a brilliant Secretary of the Treasury, the internet is providing new ways of doing business, and Bill Clinton has marvelously orchestrated the whole thing. The stock market is rising, and the government (or at least the current regime, according to Al Gore in his stump speeches) knows how to continue the prosperity. This time, we really are experiencing the New Economy.
Pardon me if I dissent. If history tells us correctly, we are in our third “New Economy” in the last 80 years. The first episode of “prosperity forever” came in the late 1920s, as the bull market, low unemployment numbers, and general good times led newly-elected President Herbert Hoover to declare, “In no nation are the fruits of accomplishment more secure.” We know the rest of that sorry story.William Anderson, “New Economy, Old Delusion,” Free Market 18, no. 8 (2000): 5.
Anderson was careful to distinguish the cause of the boom from the normal or natural features of economic growth. He also distinguished between a potential catalyst of the bust (the Microsoft trial) and its underlying causes:
But for all of the high-technology wonders and the gains made from deregulation, the one substantial part of the New Economy consists simply of an economic boom in all that the phrase implies. The engine behind the boom is also the locomotive behind the inevitable bust: the Federal Reserve and its inflationary policies.
As things stand currently, the once-vaunted bull market is in flux. This is partly due to the government’s arrogance in believing it could attack Microsoft without harming other high-technology firms that have been the most visible in the current economic expansion. That the NASDAQ has lost much of its value since Janet Reno’s Department of Justice [DOJ] won the first round of its attempt to dismember Microsoft bears testament to this administration’s foolishness regarding economic matters.
But even without the DOJ’s Microsoft follies, the high-technology sector of the economy faces real problems. First, the bubble that pushed so many of the “dot-com” initial offerings into the stratosphere had burst even before Reno’s pyrrhic victory. Second, the malinvestments as described by Ludwig von Mises and Murray Rothbard that occur as the result of wildly expansive monetary policies by the Fed have been centered in the high technology sector. The growth of new money that is the signature of inflation can come only through the fractional-reserve banking system in the form of loans, which, as noted earlier, have found their way into high technologies, real estate, and the stock market.
Should a large number of high technology investments go bust, or if profit rates disappoint potential investors, the new money will stop pouring into that sector. By that time, we will be seeing an increase of commodity prices, and inflation will be recognized as a serious problem. The next stage will be the beginning of the recession, as the malinvestments that grew willynilly during the period of monetary expansion will have to be liquidated.
The US economy the past five years has been able to absorb a large amount of new money, much more so than it could have done two decades ago. That does not mean, however, that it is inflation-proof or is impervious to malinvestments. The Misesian theory of the business cycle is a comprehensive theory. It has not lost its explanatory power in 2000 any more than it was irrelevant in 1969 or 1929.
While we may be currently celebrating a record boom, we have not overturned the laws of economics. No doubt when it happens, the usual Keynesians in the halls of academe and in the media will blame high interest rates and the Fed’s refusal to expand credit. In truth, there will be another explanation, one that people are ignoring now and will ignore then.Ibid., p. 6.
Supply-side economist Jude Wanniski (2000) attributed the bust in the stock market during April 2000 to tax liabilities accrued from capital gains in the late 1990s. Investors who had capital gains in 1999 had to pay taxes on those gains on April 15, and Wanniski suggested that investors selling shares in order to pay their taxes ignited the decline in the prices of the stocks composing the NASDAQ index. Although this observation provides insight into what might have initiated the bursting of the bubble, Wanniski himself did not believe in financial bubbles and encouraged his clients to jump back into the market after tax season was over.Jude Wanniski, “Letters to Clients,” March 30 to April 19, 2000.
Another important prediction came from economists Stan Liebowitz and Stephen Margolis, who were considering questions of competition and antitrust policy in high-technology markets. They correctly described these markets as displaying a speculative bubble near the apex of the bubble: “This is not to imply that a speculative bubble, which seems the proper description for Internet stocks as this book is being written [spring 1999], is required to assure sufficient financing.”Stan J. Liebowitz, and Stephen E. Margolis, Winners, Losers, & Microsoft: Competition and Antitrust in High Technology (Oakland, CA: Independent Institute, 1999), p. 115. Liebowitz later provided a more detailed examination (published after the bubble had burst) of why the bubble happened:
The book … focuses on understanding why financial events went so awry. … Many of the prognostications about the internet — rapidly increasing number of users, rapidly increasing advertising revenues, rapidly increasing sales — fertilized wildly optimistic prognostications for the performance of Internet firms, as if a virtual cornucopia of wealth would come streaming down upon investors in those companies [and it did for those lucky enough to get in early]. … But even if all the prognostications of users and revenue growth had been true, as some of them were, that would not have assured the rosy financial scenario that so many investors and analysts anticipated.Stan J. Liebowitz, Rethinking the Network Economy: The Real Forces That Drive the Digital Marketplace (New York: Amacom, 2002), p. 2.
Conclusions Such is the exuberance on Wall Street that only a brave man insists that the American stock market is overdue for a crash. Down the long history of bubbles ready to burst, it was ever thus. — Economist, March 25, 2000
The foregoing survey of predictions regarding the stock market bubble of the 1990s was conducted against a background condition that economists do not agree on either the role of prediction in economic science or the causes of stock market bubbles. The purpose was to identify who correctly ascertained the existence of a stock market bubble and who correctly predicted a stock market crash. The appendix at the end of this article provides a timeline of additional quotes reflecting insight, unawareness, or confusion regarding the macroeconomic contours of the bubble and the crash. More important, however, this survey has examined how the boom was identified and what its cause was. These issues are important because stock market booms and busts entail massive transfers and financial losses in the economy, and when associated with severe downturns in the business cycle, they can cause significant economic costs, distortions, and inefficiencies. Economic crises have often provided the occasion for a ratcheting upward of the size, scope, and power of government (Higgs 1987). In extreme cases, such radical changes in financial and economic conditions may give rise to social upheaval and political instability.
In general, the correct predictions fall into two categories. Those in the first group were based on the analysis of valuation. Using standard measures of stock market value, such as the price-to-earnings ratio, economists such as Robert Shiller and a small number of market analysts who were bearish in 1999 concluded that the stock market had become extremely overvalued and therefore was experiencing bubble-like conditions and was fated to decline steeply. Unfortunately, most of these forecasters did not provide detailed economic analysis of their predictions. The use of valuation measures is indeed helpful, but such measures are essentially only tools of historical analysis for comparing ratios and percentages from one time period to those from another period or to historical averages. In the recent bubble, most bulls always found a way to adjust the valuation measures to account for modern conditions and to make the stock market appear undervalued.
The second group of correct predictions came from outside the mainstream of the economics profession. Most came from economists associated with the Austrian school of economics, including academic economists, financial economists, and fellow travelers of the school. These predictions began to come forth in 1996 and continued until after the downturn in the stock market, but most of them occurred close to the peak in the stock markets. Austrians tend to have a negative view in general, and they are quick to emphasize the negative aspects of economic conditions, but they also distinguish bubbles and business cycles clearly from other economic phenomena and trends. Given that the Austrian economists are both relatively few in number and marginalized in the profession, their dominance in making correct predictions seems to be something of an elephant in the soup bowl, especially in light of their general disdain for forecasting and for the mainstream’s requirement of accurate prediction. In my survey, I tried to avoid the inclusion of “permabears,” or analysts who are perpetually bearish on the stock market. It should be noted, however, that James Grant is a self-admitted permabear and that his prediction came too early in terms of market timing. The predictions are summarized in table 2.
It is especially noteworthy that all the Austrian predictions provided an economic explanation of the bubble and that their explanations were relatively consistent across the group. To generalize, the Austrians perceived the Fed to be following a loose monetary policy that kept interest rates below the rates that would have prevailed in the absence of that policy. Individual writers emphasized the Fed’s willingness to bail out investors consistently during the 1990s, thereby desensitizing investors to risk. As a result, a period of “exuberance” and wild speculation took place, culminating in the hysteria of a stock market bubble. If the Austrian analysis is correct, the Fed has been a significant source of financial and economic instability. This analysis also suggests that the Fed’s bias toward keeping rates as low as possible may cause significant economic losses and that a better policy might be to let market forces determine interest rates without intervention.
Those who discovered the “boom” in the economy and the “bubble” in the stock market and who predicted either a “bust” in the economy or a crash in the stock market work within an analytical tradition dating back to Richard Cantillon, whose Essay on the Nature of Commerce in General was published in 1755. The Cantillon tradition was carried forward and extended in the works of Turgot, Say, Bastiat, Menger, Wicksell, Böhm-Bawerk, Mises, Röpke, Hayek, and Rothbard, and it is now a hallmark of the modern Austrian school of economics.
At the core of this mode of analysis is an emphasis on entrepreneurship and the study of what causes prices to rise and fall, encompassing wages, rents, profits, interest, and the purchasing power of money. With respect to the business cycle, the Cantillon tradition shows that disturbances in the supply of money and credit, especially when a monetary authority expands the supply of paper money, changes relative prices. Artificial reductions in interest rates encourage investment and increase the valuation of capital assets, longer-term assets increasing in value more than shorter-term ones. The resulting changes in the structure of production (buildings, technology, and the pattern of industrial organization) are called Cantillon effects. They occur during the boom, a phase when resources are misallocated, both to malinvestments and to misdirected labor. As relative prices correct themselves in the bust, resources are reallocated by mechanisms such as bankruptcy and unemployment. Capital-asset prices are extremely volatile during this process.
Although Austrian ideas have received more notice and attention in the financial media and in academic publications in recent years, a survey of economic textbooks at the undergraduate or graduate level would find hardly a word about Austrian business cycle theory or about Cantillon effects. It may be too early for a complete revision of economics textbooks and too much to ask that economics professors rewrite their class notes, but it certainly is time at least to introduce these concepts in classrooms and textbooks so that students can consider an alternative paradigm and evaluate its merits.
Appendix: Some Other Predictions Jerry Jordan: “The problem may … be … in asset [stock] markets, as suggested by historical episodes in this country, notably in the 1920s, and in Japan in the late 1980s.”Jerry J. Jordan, president of the Federal Reserve Bank of Cleveland in the minutes of the Federal Open Market Committee meeting, November 11, 1997. As a voting member of the Federal Open Market Committee, Jordan, president of the Cleveland Fed, voted unsuccessfully five times to raise interest rates, starting in 1998.Victor Zarnowitz: “The arguments in favor a [sic] new Golden Age are generally not persuasive.”Victor Zarnowitz, “Theory and History Behind Business Cycles: Are the 1990s the Onset of a Golden Age?” NBER Working Paper 7010 (Cambridge, MA: National Bureau of Economic Research), abstract. Zarnowitz is aware of the Austrian theory of the business cycle and considers it in his analysis.Lew Rockwell: “At some point, and nobody knows when, the stock market is going to reverse its climb. It may even collapse.”Llewellyn H. Rockwell, Jr. “Stock Market Bailout,” Free Market (November 1999): 4.Greg Kaza: “There is talk on Wall Street of a ‘New Economic Paradigm,’ that has repealed the business cycle. But surface appearances can be deceiving. … Eventually a recession will occur.”Greg Kaza, Greg, “Downsizing Detroit: Motown’s Lament,” Chronicles: A Magazine of American Culture (November 20, 1999), p. 20.Holman Jenkins: “The claim by Glassman and Hassett to have found a new value for the Dow is a wonderful marketing gimmick, but it is the least important part of their book. The authors are certainly right that Americans have gotten over their fear of the stock market — because the stock market works better than it used to. For investors, it has become safe to buy, hold, and forget.”Holman W. Jenkins, Jr., 1999–2000. “Of Bulls and Bubbles,” Policy Review 98 (1999–2000).Alan Greenspan: “I recognize there is a stock market bubble problem at this point,” and “I guarantee if you want to get rid of the bubble, whatever it is, [increasing margin requirements] will do it”.Alan Greenspan, minutes of the Federal Open Market Committee meeting, September 24, 1996.William McDonough: “I think the banking system is functioning just about where I would like it to be — that is, appropriate willingness to take risk but with good, sensible judgments in general being demonstrated.”William McDonough, president of the New York Federal Reserve, quoted by Reuters, September 26, 1999.The Economist: “Such is the exuberance on Wall Street that only a brave man insists that the American stock market is overdue for a crash. Down the long history of bubbles ready to burst, it was ever thus.”The Economist 2000, p. 84.Alan Greenspan: “It is very difficult to definitively identify a bubble [in US stock markets] until after the fact.”Alan Greenspan, speech at the Federal Reserve Bank of Kansas City’s annual conference at Jackson Hole, Wyoming, August 20, 2002.Nicholas Brady: “The present market collapse is different; it was caused by vastly overblown valuations. The stock market has been in a colossal bubble, a delusion born in the late 1990’s that reached its zenith in 2000. While not uncommon, bubbles have always been a fact of market life, a byproduct of runaway human emotions.”Nicholas F. Brady, “Every Market Collapse Is Different,” New York Times, August 11, 2002.Laurence Mayer: “There was a sense of frustration that we couldn’t deal better with the asset-price bubble. … But I don’t think anybody has come up with a strategy that people felt would have gotten the job done.”Federal Reserve governor Laurence Mayer as quoted in Carol Vinzant, “Two Schools of Thought on Economics,” Chicago Tribune, September 3, 2002.Matthew Spiegel: “The difficulty with declarations claiming that large stock price moves are ‘bubbles’ or ‘panics’ is that they rely on perfect hindsight, typically generated only a few months or a year following the event. But investors do not have that luxury. They must price securities based on the information they have at the time they make their decisions.”Matthew Spiegel, “2000 A Bubble? 2002 A Panic? Maybe Nothing?” Yale School of Management (New Haven, CT., 2002), p. 5.Robert Shapiro: “If not technology shocks or market pricing failures, what’s driving the current business cycle? It’s not terrorism or war. Terrorism doesn’t exact sufficiently large direct costs to drive the economy; and it’s hard to argue that its psychological effects have slowed growth, when the economy turned around in the quarter immediately following 9/11 and turned in its best performance in years in the quarter after that. Nor is there hard evidence that the prospect or reality of the war with Iraq punctured business investment and consumer spending.”Robert Shapiro, “Spin Cycle: Why Has the Business Cycle Gone Topsy-Turvy?” Slate.com. April 15, 2004.James Grant: “In the boom cycle, people are not so much interested in a message that says: a bust is simply a necessary part of the business cycle. In a false prosperity, good economic ideas are marginalized. That’s why Austrians should prepare right now to offer the best explanation when the tide turns, as it always does. Who knows? Maybe we’ll find ways to make the bust intellectually profitable. In time, Austrian economics could be again seen as the mainstream theory. It should be.”James Grant, “The Trouble with Prosperity: An Interview with James Grant,” Austrian Economics Newsletter 16 (1996): 8.
The 1960s and 70s were precarious times for the Austrian school. Ludwig von Mises was very old, retired, and would die in 1973 at the age of ninety-two. Friedrich Hayek was also retired and ensconced at the University of Salzburg in Austria from 1969 to 1977. He called his move to Salzburg a mistake. He had not worked on business cycles and monetary policy for many decades and his research interests at this time were very different. Henry Hazlitt retired from Newsweek in 1966 at the age of seventy-two. Murray Rothbard was a young man and was marginalized and isolated, with little institutional support. There were precious few other Austrian economists in the entire world, and the next generation of Austrian economists had not left graduate school or had not even entered graduate school.
Mises at the age of eighty-nine continued to lecture during the critical 1968–70 period, and make public appearances. Some of his more important lectures included: “The Problems of Inflation” (April 3, 1968); “On Money” (April 3, 1969); “The Balance of Payments” (May 1, 1969); “A Seminar on Money” (November 8, 1969); “The Free Market Society” (February 21, 1970), where he discussed the problems arising from increasing the supply of money; and “Monetary Problems” (June 23, 1970), where he discussed why the return to the true gold standard was so important and essential for economic growth and stability and why the Bretton Woods system was so problematic. Sampling these lectures makes it obvious that Mises in his elder years was completely attuned to the monetary-policy problems and their potential consequences and was doing his best to alert others of the looming dangerous outcomes.
Henry Hazlitt was hardly retired either. After leaving Newsweek in the fall of 1966 he began writing for the Los Angeles Times, and between the fall of 1966 and June 1969 Hazlitt published 177 articles in the Times.Jeffrey A. Tucker, Henry Hazlitt: A Giant of Liberty (Auburn, AL: Mises Institute, 1994). Almost all of the articles discussed the dangers looming because of current monetary and fiscal policy. He clearly saw that the Bretton Woods gold standard was the core problem because it led to too much government spending and a loose monetary policy. For example, he wrote articles such as “Budget Out of Control” (February 12, 1967), “People Want Gold” (February 22, 1967), and “Currency Crisis Ahead” (March 29, 1967) in early 1967. In 1968 he wrote “What a Gold Reserve Is For” (February 3, 1968), “The Most Irresponsible Budget” (February 11, 1968), and “The Dollar Crisis: A Way Out” (March 17, 1968). Hazlitt wrote in 1969 on topics like “The Coming Monetary Collapse” (March 23, 1969), “Pretending That Paper Is Gold” (May 4, 1969), and “Good-Bye to the ‘New Economics’” (June 8, 1969). Hazlitt clearly saw the critical fault in the Bretton Woods System: that the US government would overspend — for example, spending on the Vietnam War, the space mission to the moon, and the War on Poverty — and pay for it by printing dollars. He clearly saw early on that the Bretton Woods–style gold standard would collapse, which it did in 1971.
Murray Rothbard was also keenly aware of what was happening to the US economy in the late 1960s. He published a small pamphlet on the subject of business cycles in 1969 — Economic Depressions: Their Cause and Cure. This was just prior to the end of the longest expansion in US history and the beginning of thirteen years of stagflation and depression. It is very similar to Mises’s book The Causes of the Economic Crisis published the year before the stock market crashed in 1929. Rothbard would continue writing about the looming crisis and the role of the Austrian business cycle theory:
In the sphere of economics the Nixon Administration had been highly touted among conservatives. It was supposed to herald a return to the free-market and a check upon galloping inflation through monetary restriction. Again, nothing has happened. The much publicized monetary tightening has been half-hearted at best, and provides no real test of the effectiveness of monetary policy. For the Administration has been doing precisely what its spokesmen had been deriding the Democrats for doing: trying to “fine-tune” the economy, trying to cut back ever so gently on inflation so as not to precipitate any recession. But it can’t be done. If restrictionist measures were ever sharp enough to check the inflationary boom, they would also be strong enough to generate a temporary recession.Murray N. Rothbard, “Nixon’s Decisions,” Libertarian Forum 1, no. 8 (July 15, 1969): 1.
Rothbard continued his assault on Nixon’s economic policies:
The phenomenon of inflationary recession cannot be understood by Establishment economists, whether of the Keynesian or the Milton Friedman variety. Neither of these prominent groups has any tools to understand what is going on. Both Keynesians and Friedmanites see business cycles in a very simple-minded way; business fluctuations are basically considered inexplicable, causeless, due to arcane changes within the economy, although Friedman believes that these cycles can be aggravated by unwise monetary policies of government.Ibid., p. 4.
In contrast, Rothbard was keenly aware of this political dilemma, the “inflationary recession,” because he attended some lectures by his then thesis advisor Dr. Arthur F. BurnsDoug French, “Arthur Burns: The Ph.D. Standard Begins and the End of Independence,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno (Heidelberg, New York, London: Springer, 2014), pp. 91–102. at Columbia University in 1958. Rothbard recalled the incident with his professor and later chairman of the Federal Reserve:
I remember vividly a prophetic incident during the 1958 recession, when the phenomenon of inflation-during-recession hit the country for the first time. I attended a series of lectures by Dr. Arthur F. Burns, former head of the Council of Economic Advisers, now head of the Federal Reserve Board, and someone curiously beloved by many free-market adherents. I asked him what policies he would advocate if the inflationary recession continued. He assured me that it wouldn’t, that prices were soon leveling off, and the recession would soon be approaching an end; I conceded this, but pressed him to say what he would do in a future recession of this kind. “Then,” he said, “we would all have to resign.” It is high time that we all took Burns and his colleagues up on that promise.Murray N. Rothbard, “The Nixon Mess,” Libertarian Forum 2, no. 12 (June 15, 1970): 1–3.
Rothbard is directly confronting the “new economists” and their beloved Phillips Curve analysis with the phenomenon we now call stagflation, which Rothbard called an “inflationary recession.”
Rothbard also attacked the Nixon administration’s labor guidelines and income policy. He correctly predicted that such policies would likely lead to wage and price controls, which they did the following year:
While we can firmly predict accelerating inflation, and dislocations stemming from direct controls, we cannot so readily predict whether the Nixonite expansionism will lead to a prompt business recovery. That is problematic; surely, in any case we cannot expect any sort of rampant boom in the stock market, which will inevitably be held back by interest rates which, despite the Administration propaganda, must remain high so long as inflation continues.Murray N. Rothbard, “Nixonite Socialism,” Libertarian Forum 3, no. 1 (January 1971): 1–2.
Rothbard went on to show that Keynesian and Friedmanite economists cannot understand this phenomenon and have no way to address such problems. In contrast, he showed how Austrian economists can understand this phenomenon through price theory and capital theory and that they do have policy recommendations on how best to address the problems of stagflation. Interest rates must be raised in order to flush out malinvestments and price inflation from the economy.
F. A. Hayek was awarded the Nobel Prize in economics in 1974 for his work building on Mises’s writings on business cycle theory. Hayek had been working in isolation in Austria and concentrating on his research in entirely different directions for some years. However, when the crisis hit in the early 1970s he rushed back into action. Hayek’sF. A. Hayek, “The Outlook for the 1970s: Open or Repressed Inflation?” in Tiger by the Tail: The Keynesian Legacy of Inflation, edited by Sudha R. Shenoy (Washington, DC: Cato Institute, 1972). first publication on this issue was put together by Sudha R. Shenoy, the daughter of the great Indian economist B. R. Shenoy. She seamlessly strung together materials from Hayek’s early writings on money and business cycles into a coherent monograph. To this 1972 book, Hayek contributed the essay “The Outlook for the 1970s: Open or Repressed Inflation?” He also published three monographs — Choice in Currency: A Way to Stop Inflation (1976), Denationalization of Money: The Argument Refined (1977), and Unemployment and Monetary Policy: Government as Generator of the “Business Cycle” (1979) — that sought to address the problem of the monetary crisis and economic depression.
The Austrians of the time were few but they turned out to be very vocal and correct about the threat of economic crisis. In fact their emphasis on raising interest rates and stopping the money printing might have been very influential in the form of the interest rate policy adopted by Fed chairman Paul Volcker (1979–87). It did cause a severe contraction, but it did end the monetary and price inflation and set the stage for a robust recovery.
It should also be noted that Dr. Ron Paul, an advocate of Austrian economics, decided in 1971 to run for a seat in the House of Representatives because Nixon had taken the United States off the gold standard. He has helped build a worldwide movement for Austrian economics. Also, the Cato Institute was founded in 1974 by Ed Crane, Murray Rothbard, and Charles Koch. The Cato Institute in 1982 published the monographs by F. A. Hayek, as well as The Case for Gold: A Minority Report of the U.S. Gold Commission, by Ron Paul and Lewis Lehrman.Ron Paul and Lewis Lehrman, The Case for Gold: A Minority Report of the U.S. Gold Commission (Washington, DC: Cato Institute, 1982), which was based on the research of Murray Rothbard. Finally, the Ludwig von Mises Institute was founded in 1982 by Llewellyn H. Rockwell, Jr.; its premier mission is to educate people about the benefits of a true gold standard as described in the Gold Commission’s minority report. The monetarist-packed US Gold Commission won the battle to maintain fiat money, but Ron Paul, the Cato Institute, the Mises Institute, and the Austrian school have all grown enormously in influence since then.
During the 1960s, when Keynesian economics came to completely dominate the economics profession, there was a large influx of the so-called new economists into government service. The disastrous results included the “Keynesianization” of the economy and what is best described as an economic depression that lasted throughout the 1970s and into the early 1980s. The long economic expansion of the 1960s came to a screeching halt just as 1 and 2 World Trade Center started to impact the Manhattan skyline.
Like the 1920s and 1990s, the decade of the 1960s was a period of remarkable prosperity in the United States as measured by statistics such as GNP and the unemployment rate. In contrast, the 1950s included several periods of stagnation and mild recessions. During the 1960s the economy grew at a brisk pace, and employment and wages grew as well. America was able to fight the Cold War, the Vietnam War, the War on Poverty, and win the space race, simultaneously. The only noticeable negative effect was a mild uptick in price inflation toward the end of the decade.
According to academic economist Arthur OkunArthur Okun, The Political Economy of Prosperity (Washington, DC: Brookings Institution, 1970), p. 57. the economic expansion was the result of two primary factors. The first was scientific management of the economy by the “new economists” who were brought to Washington to help fine-tune the economy with fiscal and monetary policy — that is, Keynesian economics. The second was the new technology that was introduced in the economy — particularly computer technology, consumer electronics, and technological advances related to space exploration.
Okun was the chairman of President Nixon’s Council of Economic Advisors from 1968 to 1969. Right before the crash he described the economic expansion as “unparalleled, unprecedented, and uninterrupted.” Okun believed that the economy was on a new “dramatic departure” from the past. According to Okun:
The persistence of prosperity has been the outstanding fact of American economic history of the 1960s. The absence of recession for nearly nine years marks a discrete and dramatic departure from the traditional performance of the American economy.Ibid., p. 31.
After declaring the business cycle dead, he went on to demonstrate that research on the business cycle was now a thing of the past and that a “new” approach to the economy had replaced it. In fact, he even took the precarious step of ridiculing those who stubbornly stuck to the old economics, where business cycles were viewed as an inevitable feature of the market economy. In fact, he charged this old school with viewing recessions in a positive light for correcting past excesses, just as Dr. Pangloss, a character in Voltaire’s play Candide, preaches optimism: everything, including negative things, is for the best, and we have the best of all possible worlds. Here I believe he is referring to Austrian economists, such as Ludwig von Mises and F. A. Hayek. Okun’s “latter-day Machiavellis” probably refers to political-business-cycle theorists who at this time were political scientists:
When recessions were a regular feature of the economic environment, they were often viewed as inevitable. Indeed, the Doctor Panglosses saw them as contributors to the health of our best of all possible economies, correcting for the excesses of the boom, purging the poisons out of our productive and financial systems, and restoring vigor for new advances. And the latter-day Machiavellis saw potentially great political significance in the timing of turning points. They spun out fantasies, suggesting or suspecting — depending upon whether their party was in or out of office — that the business cycle would be controlled so that the inevitable recession would come between elections and would be replaced by a vigorous economic recovery during the campaign period.Ibid., p. 32.
Okun confidently declared that the death of the business cycle was “proof par excellence” that economic controversies can be solved. How was the business cycle killed? Okun found that the slayer was not new theories or policy tools, but simply a more confident and scientifically rigorous implementation of existing tools, which resulted in efficient scientific management of the economy — that is, Keynesian economics:
More vigorous and more consistent application of the tools of economic policy contributed to the obsolescence of the business cycle pattern and the refutation of the stagnation myths. The reformed strategy of economic policy did not rest on any new theory.Ibid., p. 37.
For Okun, the New Deal had employed fiscal stimulus, which would later be espoused by Keynesian theory.Ibid., p. 43. He believed the old canard that WWII got us out of the Great Depression. As far as he was concerned those two episodes provided evidence of the success of countercyclical fiscal policy. He also viewed the old “fiscal religion” of limiting the size of government and keeping its budget in balance as nothing more than myth and superstition. Overthrowing those fallacies of the past and embracing scientific management of the economy had allowed economists to fully apprehend and subdue the business cycle: “The activist strategy was the key that unlocked the door to sustained expansion in the 1960s.”Ibid. All remaining errors could be dealt with by fine-tuning of the activist strategy.
It was unfortunate for Okun that the publication of his book, The Political Economy of Prosperity, occurred just one month before the next economic recession began. Civilian unemployment increased from well below 4 percent to just over 6 percent by the end of 1970. The rate then retreated to 5 percent in 1973 only to skyrocket to 9 percent in mid-1975 — the highest rate since the Great Depression. The unemployment rate remained above the “natural rate” of 5 percent for the next two decades, including ten months of double-digit unemployment during 1982–83.
The experiment of the new economists also resulted in higher price inflation, as would be expected from the “stimulating” fiscal and monetary policy of the 1960s. From the beginning of 1946 to the beginning of 1965 — twenty years — the Consumer Price Index increased by 71.4 percent, but it then increased another 20 percent by the end of the 1960s. From 1965 — when the experiment began in earnest — to the end of 1980 the CPI increased by 176.6 percent. The grand experiment greatly increased the price inflation experienced by consumers.
More importantly, revolutionary changes occurred in money and banking. The US Treasury stopped issuing silver coins in 1964, and Gresham’s law ensured that Americans were soon using nothing but “clad” coins that only looked like the old silver coins. Silver-certificate notes were recalled in 1968 in exchange for Federal Reserve Notes. Then, in August 1971, Nixon initiated a “new economic policy” that closed the international gold window (where foreign central banks could still redeem dollars for gold), the last vestige of the pre-1913 classical gold standard.
The United States had printed too much money during the 1960s and had caused a “run” on the dollar by foreign central banks, which sought to cash in their dollar holdings for gold. Despite US promises to the contrary, Nixon also instituted comprehensive wage and price controls in an attempt to block the rising price inflation before his reelection campaign. The Bretton Woods system, where currencies had fixed values in terms of gold, inevitably collapsed. Thus the last links between gold and money were broken and a completely fiat monetary system was established.
The bubble of the 1960s and the subsequent collapse have been well chronicled by John Brooks in his book The Go-Go Years. The “go-go ’60s” refers to the market for technology stocks during the 1960s, when the “Nifty Fifty” emerged as a list of “one decision” stocks that could be bought and held forever. This list of stocks included Coca-Cola and IBM as well as troubled companies of the future, such as Kodak and Polaroid. Like the investment trusts of the 1920s, mutual funds were touted as the fastest path to riches for the common man. As the bubble expanded, investment gurus such as Gerald Tsai used aggressive investment techniques to generate huge increases in the value of their mutual fund shares, while others made millions building the conglomerate corporations that spanned many industries and nations.
John BrooksJohn Brooks, The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60s (New York: Allworth Press, 1973), pp. 137–39. well captured the euphoria that emanated from this new-era stock market: “As mutual-fund asset values went up, new money poured in. Tsai and others like him seemed to have invented a money-making machine for anyone with a few hundred or several thousands of dollars to invest.” He even labeled Tsai “the first big-name star of the new era.” Unfortunately, Brooks was unable to properly diagnose the cause of the mania, attributing it largely to greed and irrationality:
Where were the counsels of restraint, not to say common sense, in both Washington and on Wall Street? The answer seems to lie in the conclusion that in America, with its deeply imprinted business ethic, no inherent stabilizer, moral or practical, is sufficiently strong in and of itself to support the turning away of new business when competitors are taking it on. As a people, we would rather face chaos making potsfull of short-term money than maintain long-term order and sanity by profiting less.Ibid., p. 187.
Brooks noted that “man’s apparent capacity to learn from experience is an illusion.” Man is able to benefit from experience, but our collective ability to learn and pass knowledge on to future generations depends on our ability to formulate correct theories regarding our experiences. Like many others, Brooks seems oblivious to the usefulness of economic theory in this regard, although his analysis regarding experience and lack of a stabilizer does reflect favorably on Austrian business cycle theory.
However, Brooks is correct and quite methodical in showing the similarities between the 1920s and the 1960s. In each case there was a new era and a new way of economic thinking. Both episodes had their investment stars that fell into disgrace. In both cases there were charges of corruption and malfeasance that led, after the fact, to attempts at reform via legislation. At the heart of both eras — the vehicle of mania and deception — was technology. By the history of Wall Street, Brooks was able to show that the collapse in the stock market was actually much worse than the Dow Jones stock index indicated. Many of the best-performing stocks of the decade turned into the worst-performing stocks of the next decade, but were not in the Dow index. This spelled trouble for many investors for years to come.
An even better indicator of trouble in the stock market can be found in the fact that in May 1970, a portfolio consisting of one share of every stock listed on “the Big Board” was worth just about half of what it would have been worth at the start of 1969. The highfliers that had led the markets of 1967 and 1968 — conglomerates, computer leasers, far-out electronics companies, franchisers — were down precipitously from their peaks. Nor were they down 25 percent, like the Dow, but 80, 90, or 95 percent. This was vintage 1929 stuff, another economic depression, with all the economic pain and emotional hardship that mired both stock markets and the economy for years to come.Ibid., p. 4.
The stock market as measured by the Dow did decrease 25 percent between 1969 and 1971 and then, after the publication of Brooks’s book, lost another 20 percent by mid-1975. However, the inflation-adjusted losses in the stock market were larger and longer lasting than an ordinary price chart of the Dow might suggest. The inflation-adjusted or “real” purchasing-power measure of the Dow indicates that it lost nearly 80 percent of its peak value during this time period. When Brooks drew out the similarities between 1929 and 1969, he stopped short of declaring a second Great Depression. However, while the economic pain of the 1970s and early 1980s may not have matched the Great Depression of the 1930s, it could easily qualify as an economic depression.
The decade began with recession and the abandoning of the gold monetary system and saw the emergence of “stagflation” — that is, stagnation and inflation. It ended with the highest monthly misery index in 1980. The index is calculated by adding the inflation rate to the unemployment rate. The 1970s is not generally recognized as a depression by economists. However, it certainly was part of a twelve-year period of economic pain and uncertainty compounded by price controls, the gasoline shortages, Watergate, and defeat in the Vietnam War. It should also be noted that mainstream economists have changed the meaning or application of terms such as depression, panic, and crisis, substituting milder-sounding terms such as recession and correction.
Statistical evidence clearly demonstrates that the 1970s was a turning point in the wrong direction for the American economy. The Bretton Woods gold standard was abandoned, prices increased, and the dollar rapidly depreciated. Unemployment and underemployment increased, and they set post-WWII highs in the early 1980s. The federal government abandoned a longstanding tradition of balanced budgets for the current regime of ever-increasing deficits and a skyrocketing national debt. The personal saving rate of Americans — which had been on an increasing trend until 1971 — flattened out and began its current declining trend toward a zero savings rate.
It was the 1970s when the trade balance first destabilized, and then began the trend of escalating trade deficits. Naturally when the people are saving less and the government is borrowing more, the new loans have to come from foreigners. Going back to the 1930s, net exports of goods and services hugged the zero line. Then in the 1970s it broke below the zero line and continued to head lower. For the fifteen years leading up to 2010, the trade deficit averaged over $500 billion. The stability of the past had been replaced with the instability and erosion that fiat paper money inevitably brings.
Another crucial factor is the impact of the monetary regime on income distribution, one of the most glaring issues of our times. Money is one important factor that is largely ignored by those both on the political left and the political right. It is also largely ignored by mainstream economists, such as Thomas Piketty (2014).Thomas Piketty, Capital in the Twenty-First Century (Cambridge, MA: Harvard University Press, 2014). However, the choice of monetary system and monetary policy does have predictable and historically validated effects on economic inequality.
A monetary system that is dominated by a central bank, such as the Federal Reserve, and uses fiat money, as in our current monetary system, can expect to benefit certain people, such as bankers, financiers, and people with debt. Likewise, because such a system is inflationary, it tends to hurt wage workers and savers. Such a system can be expected to hurt the lower- and middle-income classes and enrich those in the financial industry and the upper-income class.
A gold standard has historically had a tendency for prices to be stable or slightly deflationary. This means that wage rates, cash balances, savings, and bonds tend to gain purchasing power over time. This type of monetary system rewards the hard-working and frugal classes, which leads to an expansion of the middle-income class and the economy.
This graph from the Pew Research Center provides enticing evidence of the differential impact of gold versus fiat paper money.
The graph shows that economic inequality declined in the United States from 1917 to the early 1970s, when Nixon took the United States off of the Bretton Woods gold standard. The darker shaded areas of the graph represent the 99 percent, while the light area at the top represents the percentage of total income of the upper 1 percent. Economic inequality increased during the inflationary 1920s, but the lower-income classes rapidly improved versus the 1 percent when the gold standard was restored after WWII. The graph shows both marginal improvement and stability in economic inequality from the late 1940s to the early 1970s. Since going off the gold standard in 1971 the trend has been for much greater economic inequality.
All of these problems were not due to the laziness of the American people. Females moved into the workforce in record numbers, and the two-income family was established, mostly to try to maintain standards of living. Unfortunately, the 1960s and 1970s were two decades when government employment expanded the most, so that much of this increased labor effort produced little of value. Working for government can even be a net negative for the economy in the sense that government employees can do actual harm to the production of useful goods and services. The “new economists” in the service of the state are a good example of that.
If I go there will be troubleAnd if I stay there will be double.So you gotta let me knowShould I stay or should I go? — The Clash, Should I Stay or Should I Go
The decision of where to locate your residence is difficult to make. Most of the factors that play a role in your decision-making are basically economic factors. So might this kind of decision-making process be somehow involved in the skyscraper curse? Economist Lucas Engelhardt thought so and wrote an insightful paper about it.
I have reiterated throughout this book that record-breaking skyscrapers and the skyscraper curse are merely symptomatic of what is going on throughout the economy when it is influenced by artificially low interest rates for a long period of time. We have already seen that it causes such things as local-record-breaking building heights in places such as Auburn, Alabama, advanced construction technologies, and advanced architectural innovations.
Many factors come into play with respect to the choice of the location of your residence. A big factor is that the cost of your house or apartment is one of your biggest expenses. Rent or mortgage payments are typically the largest single payments in your monthly budget. Once you have paid off your mortgage your standard of living can increase significantly.
Another big factor is that the decision is a long-term choice. If you plan to buy a house or condominium, then there are transaction costs such as moving expenses, realtor commissions, and attorney fees. You can reduce some of these expenses by placing a greater work burden and risk burden on yourself, but you cannot make them go away. Such costs occur every time you move.
These cost considerations also impact decision-making on the choice of apartments. If you sign a lease, then you are obligated to pay rent over the length of the lease. You also have moving costs, whether you pay a moving company or do the moving yourself. The upshot is that people typically spend time and effort acquiring information to make such decisions and typically do not make thoughtless and abrupt choices. So when you ask yourself, “Should I stay or should I go?” remember that there is a significant cost of moving.
Some of the factors that people consider when contemplating moving are housing prices and the amount of the monthly payment; the amount of property, income, and sales taxes; local amenities; the quality of local schools and shopping opportunities; crime rates; and commute time. The location of churches will also affect some people’s choices. There are trade-offs among all these factors. For example, people with young children will tend to put up with higher taxes if the local schools are good and crime rates are low. Another example is that some people would be willing to put up with long commute times if housing prices and taxes are low, local amenities and schools are good, and crime is low.
Lucas EngelhardtLucas Engelhardt, “Why Skyscrapers? A Spatial Economic Approach.” Unpublished manuscript, 2015. made a contribution to our understanding of the Skyscraper Index by providing a fuller theoretical explanation of why we should expect an uneven increase in land prices, rather than a general, even increase in land prices. By using location theory, Engelhardt shows theoretically why we should focus on very high skyscrapers rather than just tall buildings in general. In other words, he does not reject the notion that lower interest rates increase land prices and the height of buildings, but he provides theoretical support for the idea that land prices will increase relatively more in central business districts.
Of the three Cantillon effects, his focus is on the first effect, where artificially low interest rates change land prices, which leads to taller buildings. In my 2005 paperMark Thornton, “Skyscrapers and Business Cycles,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 51–74. the justification for taller buildings in this first effect was not really based on economic theory, but on real estate economics. However, I did provide some theoretical support for the uneven increase in land prices in the second Cantillon effect, where low interest rates caused an increase in company size, which in turn caused an increased demand for office space in central business districts.
Engelhardt uses William Alonso’sWilliam Alonzo, Location and Land Use: Toward a General Theory of Land Rent (Cambridge, MA: Harvard University Press, 1964). bid-rent model with a purely residential city where all employment opportunities are in the central business district. While not realistic, these assumptions are reasonable. In the model, each household budgets part of its income to pay rent and commuting expenses, and part of its time to cover the commute. The further you get from the central business district, the higher the commuting costs, which diminishes the amount you are willing to pay for rent. As you get closer to the central business district, your commuting time and expense decreases and your willingness to pay higher rent increases.
This trade-off is pretty familiar to many people: do you live near your job and pay higher rent, or do you live in the suburbs and endure substantial commuting cost and time? It is a trade-off between housing costs and commuting costs.
If commuting costs are very high, rents will be very high near the central business district (i.e., a steep trade-off), but if transportation costs are very low (e.g., free, ubiquitous high-speed trains), then rents will be similar near the center to what they are on the periphery (i.e., a shallow trade-off). But what determines the steepness of the trade-off? The quality of transportation services is obviously important, but also very costly to manipulate. For example, Dana RubinsteinDana Rubinstein, “Where the Transit-Build Costs Are Unbelievable,” Politico, March 31, 2015. reports that government transportation projects are notorious for being long delayed and over budget, with some projects exceeding $2 billion per mile. Engelhardt chose to focus on wage rates and interest rates, which pertain more generally across cities.
Here he employs Murray Rothbard’sMurray N. Rothbard, Man, Economy, and State (Auburn, AL: Mises Institute, 1962). concept of the discounted marginal revenue product of labor. Normally the difference between this and the mainstream concept of marginal revenue product is negligible, but Rothbard’s concept does introduce the interest rate and time preference into our theorizing about decision-making by adding time discounting to the mainstream concept.
When interest rates are very low you are less concerned with when you are paid because you lose very little interest. If interest rates are very high, then you want to receive your wages very quickly. Likewise, people who are paid daily are unconcerned about the interest rate, but people who are paid monthly or annually could be very concerned about changes in interest rates.
With respect to the skyscraper curse, when interest rates become artificially low, the discount rate on future sales of products decreases and thereby creates an increased demand for products; and this creates an increased demand for labor and higher wages rates. For example, if the interest rate on inventory paid by an automobile dealership falls from 10 percent to 1 percent, the dealer will want to carry a much larger inventory to better approach maximal profits. This increased inventory, reflected across the economy, will cause higher levels of production, employment, and wages.
What impact will these higher wages have on choice of location? Higher wages will have two distinct effects. First, higher wage rates will result in larger household budgets and a larger budget to pay for rent and commuting costs. Second, the higher wage rate makes a person’s commute time more expensive in terms of opportunity costs. For example, a lawyer who makes $500 per hour serving clients would have to consider a move from a 60-minute commute per day to a 120-minute commute per day as increasing their opportunity cost by $125,000 per year! Likewise, a lawyer who moved and reduced commute time from 60 minutes per day to living in his office and having no commute time would potentially increase their revenue by $125,000 per year.
Engelhardt finds that falling interest rates have an unambiguous impact on higher-wage individuals and the land closest to the central business district, although with lower-wage individuals and land near the periphery the effect is ambiguous. This means that artificially low interest rates induce people to want to move closer to the central business district. This in turn tends to increase land prices and causes taller buildings to be built. So during an artificial boom we would expect things like very tall condominium buildings to be built in central business districts.
If you relax the model and allow for office buildings the results are even stronger because businesses want to minimize travel costs for their employees, customers, and input suppliers. Therefore, they want to locate in the central business district, thereby driving land prices even higher. Engelhardt’s findings provide additional evidence for the Skyscraper Index and the skyscraper curse and his research highlights how artificial interest rates can influence our lives on a very personal level.
It has often been claimed that Austrian economist Ludwig von Mises predicted the Great Depression, but that is not quite true. He did predict in 1924 that a large Austrian bank would eventually fail, and he turned down a prestigious job at another large Austrian bank in 1929 because he did not want his name associated with its failure. Mises was clearly expecting a severe economic crisis, but as Murray RothbardMurray N. Rothbard, America’s Great Depression, 5th ed. (1963; Auburn, AL: Mises Institute, 2000). has shown, what made the Great Depression “great,” in that it was both severe and long lasting, were the policies implemented in response to the original crisis. Austrian business cycle theory (ABCT) is generally silent with respect to the timing and magnitude of the economic crisis.
The most important consideration here is that Mises published a thorough theoretical critique of existing monetary policy in the United States and elsewhere in 1928. That book is Monetary Stabilization and Cyclical Policy. Now we will look at opposing views regarding the business cycle of the late 1920s, most notably contrasting the views of Ludwig von Mises and his American counterpart, Irving Fisher.
The first “new era” of the twentieth century took place during the 1920s. People started to believe that this period of extended economic growth was actually one of self-sustaining growth and perpetually increasing prosperity. World War I had ravaged the developed world, central banks had been established across the globe, and the United States had become a leading economic and military power. The Progressive Era had reinvented America largely through constitutional change. Women now had the right to vote, there was a new federal income tax, and alcohol was prohibited across the nation. America also had joined the rest of the developed world by establishing a central bank with the passage of the Federal Reserve Act in 1913. The world was at peace and with a series of federal tax cuts in place, the United States had a very prosperous, although unstable, economy during the 1920s.Robert B. Ekelund, Jr., and Mark Thornton, “Schumpeterian Analysis, Supply-Side Economics, and Macroeconomic Policy in the 1920s,” Review of Social Economy 44, no. 3 (December 1986): 221–37.
There was also a technological revolution as important as the world has ever experienced. This was the decade when the airplane and automobile went into mass production. In communication, it was the onset of mass availability of the telephone and radio. Motion pictures were invented, along with household appliances such as the dishwasher, electric toaster, and refrigerator. The use of petroleum products and electricity increased dramatically while the use of manual power decreased significantly. Assembly line production became ubiquitous and was seen as the key to industrial progress.
The period of economic boom and stock market bubble during the 1920s is often referred to as the “Roaring Twenties.” Few people seemed to think it was unusual that the world’s three tallest buildings were being built either on or close to Wall Street, in New York City. However, it was far from a utopian time given all the crime, corruption, and violence created by alcohol prohibition, and there were clearly imbalances and instability in the economy. None of this, however, could discourage or dissuade the optimists that this was indeed a “new era.”
Edward AnglyEdward Angly, Oh Yeah? (New York: Viking Press, 1931). compiled quotations from newspapers and public records to chronicle the “new era” thinking during the bubble and its aftermath. A prime example of this thinking came from Herbert Hoover in his speech accepting the Republican Party nomination for president, where he proclaimed on August 11, 1928:
Unemployment in the sense of distress is widely disappearing. … We in America today are nearer to the final triumph over poverty than ever before in the history of any land. The poor-house is vanishing from among us. We have not reached the goal, but given a chance to go forward with the policies of the last eight years, and we shall soon with the help of God be in sight of the day when poverty will be banished from this nation. There is no guarantee against poverty equal to a job for every man. That is the primary purpose of the economic policies we advocate.Ibid., p. 9.
Not surprisingly Hoover believed the prosperity of the 1920s owed itself to the economic policies of his Republican Party, but his future policies to save jobs would be responsible for turning the economic crisis into the Great Depression.
Industrialists also saw a new era. Magnus Alexander, the president of the National Industrial Conference Board, said in 1927: “There is no reason why there should be any more panics.” The president of the Pierce-Arrow Motor Car Company, Myron Forbes, claimed on New Year’s Day, 1928, that there “will be no interruption of our present prosperity,” while Irving Bush, the president of the Bush Terminal Company proclaimed in November that “we are at the beginning of a period that will go down in history as the golden age.”
Charles Schwab, the chairman of Bethlehem Steel, noted in March 1929 that “I do not feel there is any danger to the public in the present situation” and in an October speech to the American Iron and Steel Institute reassured members that “in my long association with the steel industry I have never known it to enjoy a greater stability or more promising outlook than it does today.” As is typical of new-era philosophy, in October 1931, he blamed the depression on psychological factors: “The overliquidated prices of many securities are a sign of too short perspective and too excitable temperament.”
The financial press was similarly intoxicated with the economic bubble, with the Wall Street Journal reporting on October 26, 1929, “Conditions do not seem to foreshadow anything more formidable than an arrest of stock activity and business prosperity like that in 1923. Suggestions that the wiping out of paper profits will reduce the country’s real purchasing power seem far-fetched.” Syndicated columnist Arthur Brisbane reported four days later that “those that foolishly talk about a national panic, will please remember that the income of this nation is one hundred billion dollars per year.” In November he reported that “business is good, money is cheap” and that “it ought to be a good year.”
Shortly thereafter he encouraged his readers by reporting that “all the really important millionaires are planning to continue prosperity” and that “if every man would learn to talk about the country’s progress and future as a young mother talks about her new baby, there would be no danger of hard times.” On New Year’s Day, 1930, he declared the economic crisis was over, noting: “Now that the ‘big wind’ that swept through Wall Street, blowing away paper profits, has died down, there are sad hearts, but no real losses.” And one week later he wrote, “It is safe to say that the peak of idleness has about been reached, with better conditions coming.” As the economy worsened and unemployment continued to mount, Brisbane’s assurances became increasingly bizarre and macabre. On January 2, 1931, he wrote: “Sometimes when things go wrong, it is a comfort to be reminded that nothing matters very much. If the earth fell toward the sun, it would melt like a flake of snow falling on a red-hot stove.”
Politicians were big promoters and defenders of new-era thinking. Secretary of the Treasury Andrew Mellon told the American people near the peak of the boom that there “is no cause for worry. The high tide of prosperity will continue.” After the stock market crashed and unemployment began to rise, he reassured Americans on New Year’s Day of 1930:
I see nothing, however, in the present situation that is either menacing or warrants pessimism. During the winter months there may be some slackness or unemployment, but hardly more than at this season each year. I have every confidence that there will be a revival of activity in the spring and that during the coming year the country will make steady progress.Ibid., p. 23.
Republican officials continued to report throughout 1930 that the economy was fine, that conditions were satisfactory, that the worst was already over, that things would improve in a couple of weeks, and that signs of recovery were everywhere. However, by the end of 1930 some panic and confusion had entered into Republican ranks. On October 15, 1930, Simeon Fess, the chairman of the Republican National Committee, complained:
Persons high in Republican circles are beginning to believe that there is some concerted effort on foot to utilize the stock market as a method of discrediting the administration. Every time an Administration official gives out an optimistic statement about business conditions, the market immediately drops.Ibid., p. 27.
This statement is a sign of both alarm and paranoia and, if true, indicates that the “market” had finally entered a phase of disbelief in the pronouncements from the White House because of a large number of past inaccuracies.
Irving Fisher was the most prominent American economist of the period and is still considered by mainstream economists to be one of the greatest economists of all time. He was an enthusiastic supporter of Herbert Hoover and believed that the great economic prosperity of the 1920s was attributable in part to alcohol prohibition, which he championed, but more importantly he felt the prosperity was based on his theory concerning the “scientific” stabilization of the dollar that had been undertaken by the Federal Reserve. Naturally, with both alcohol prohibition and dollar stabilization firmly in place, Fisher was completely blindsided by the Great Depression. On the eve of the great stock market crash of September 5, 1929, Fisher reassured investors that he foresaw no problem in the stock market:
There may be a recession in stock prices, but not anything in the nature of a crash. Dividend returns on stocks are moving higher. This is not due to receding prices for stocks, and will not be hastened by any anticipated crash, the possibility of which I fail to see. A few years ago people were as much afraid of common stocks as they were of a red-hot poker. In the popular mind there was a tremendous risk in common stocks. Why? Mainly because the average investor could afford to invest in only one common stock. Today he obtains wide and well managed diversification of stock holdings by purchasing shares in good investment trusts.Ibid., 37.
Unfortunately, while Fisher continued to preach that stocks had reached a “permanent high plateau” throughout October 1929, stocks lost one-third of their value. Diversification via investment trusts, which were like the mutual funds of today, might have encouraged people to invest in stocks, but it did little to protect their wealth. The market value of investment trusts fell 95 percent over the two years following his prediction, and the Dow Jones stock index lost nearly 90 percent of its peak value.
Well after the fact, Irving Fisher identified in his 1932 book Booms and Depressions: Some First Principles most precisely and perceptively what he meant by a new era. In trying to identify the cause of the stock market crash and depression he found most explanations lacking. What he did find was that new eras occurred when technology allowed for higher productivity, lower costs, more profits, and higher stock prices:
In such a period, the commodity market and the stock market are apt to diverge; commodity prices falling by reason of the lowered cost, and stock prices rising by reason of the increased profits. In a word, this was an exceptional period — really a “New Era.”Irving Fisher, Booms and Depressions: Some First Principles (New York: Adelphi Company, 1932), p. 75.
The key development of the 1920s that clouded Fisher’s perception was that monetary inflation did not show up in price inflation as measured by price indexes. As FisherIbid., p. 74. noted: “One warning, however, failed to put in an appearance — the commodity price level did not rise.” He suggested that price inflation would have normally kept economic excesses in check, but that price indexes have “theoretical imperfections”:
During and after the World War, it (wholesale commodity price level) responded very exactly to both inflation and deflation. If it did not do so during the inflationary period from 1923–29, this was partly because trade had grown with the inflation, and partly because technological improvements had reduced the cost, so that many producers were able to get higher profits without charging higher prices.Ibid., p. 75.
Fisher had stumbled to a near-correct understanding of the problem of new-era thinking. Technology can drive down costs and increase profits, creating periods of economic euphoria, where economic signals would otherwise inject greater caution and clearer thinking. In other words, the Fed had kept interest rates artificially low, stimulating investments in technology beyond normal levels and thereby creating deflationary pressures in commodity prices.
However, he never lost his faith in scientific management of the economy or his devotion to the idea of a stable dollar, despite the implication that his stable-dollar policy had caused the Great Depression. Fisher’s detailed analysis and painstaking investigations of the crash also did little to improve his economic forecasting:
As this book goes to press (September 1932) recovery seems to be in sight. In the course of about two months, stocks have nearly doubled in price and commodities have risen 5½. European stock prices were the first to rise, and European buyers were among the first to make themselves felt in the American market.Ibid., p. 157.
He attributed this “success” to reflationary measures by the Fed that were of deliberate “human effort more than a mere pendulum reaction.”Ibid., p. 158. Unfortunately, not only was his prediction wrong, the world was only at the end of the beginning of the Great Depression and the “human effort” that he thought was the tonic of recovery was actually the toxin of lingering depression. He scoffed at the “mere pendulum reaction” of the market economy that can correct for the excesses in the economy by liquidating capital and credit, a concept that he clearly opposed. However, James GrantGrant, James. 1996. The Trouble with Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings (New York: Random House). and Tom WoodsThomas E. Woods, “Warren Harding and the Forgotten Depression of 1920,” Intercollegiate Review (Fall 2009): 22–29. have shown that this type of “pendulum reaction” worked extremely well during the short depression of 1920–21.
Was the Great Depression predictable? Was it preventable? The failure of the market economy to “right itself” in the wake of the Great Crash is the most pivotal development in modern economic history, and its impact has continued to shape mass ideology and to determine public institutions and policy. Unfortunately, few saw the development of the stock market bubble, understood its cause, or predicted the bust and the resulting depression.
In Austria, economist Ludwig von Mises apparently saw the problem developing in its early stages because of his theoretical insight concerning institutional and ideological changes. The world economy was controlled by central banks instead of the classical gold standard, and artificially reduced interest rates were widely considered to be a good thing. Mises forecast to colleagues the crash of the large Austrian bank Credit Anstalt as early as 1924. In a eulogy for his teacher Eugen von Böhm-Bawerk, Mises wrote in August 1924:
And no citizen of this country [i.e., Austria] shall forget the minister of finance, the last Austrian minister of finance [i.e., Böhm-Bawerk], who, in spite of all obstacles, earnestly aimed at balancing the public budget and preventing the upcoming financial catastrophe. (emphasis added)Ludwig von Mises, “The Economist Eugen v. Böhm-Bawerk, on the Occasion of the Tenth Anniversary of His Death,” translated Karl Friedrich Israel, Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016): 170. Originally published in Neue Freie Presse, Vienna, August 27, 1924.
As mentioned at the beginning of this chapter, Mises published a book-length critique of Irving Fisher’s ideas on monetary policy in 1928, titled Monetary Stabilization and Cyclical Policy. There he targeted Fisher’s “stable dollar” policy and its reliance on the price index as a key vulnerability that would bring about the economic crisis, concluding: “Because of the imperfection of the index number, these calculations would necessarily lead in time to errors of very considerable proportions.”Ludwig von Mises, “Monetary Stabilization and Cyclical Policy [Geldwertstabilisierung und Konjunkturpolitik],” in The Causes of the Economic Crisis: And Other Essays before and after the Great Depression, edited by Percy L. Greaves (1928; Auburn, AL: Mises Institute, 2006), p. 82.
Mises found that Fisher’s attempt to stabilize purchasing power was riddled with inherent technical difficulties and was incapable of achieving its goals: “In regard to the role of money as a standard of deferred payments, the verdict must be that, for long-term contracts, Fisher’s scheme is inadequate. For short-term commitments, it is both inadequate and superfluous.”Ibid., p. 84. He then demonstrated how Fisher’s type of monetary reforms cause booms and that these booms inevitably result in crisis and stagnation. He attributes the popularity of Fisher’s scheme to political influence and bad ideology:
The fact that each crisis, with its unpleasant consequences, is followed once more by a new “boom,” which must eventually expend itself as another crisis, is due only to the circumstances that the ideology which dominates all influential groups — political economists, politicians, statesmen, the press and the business world — not only sanctions, but also demands, the expansion of circulation credit.Ibid., p. 128.
Mises had addressed the same problems in a 1923 work, but named Fisher and his scheme in 1928. In addition to demonstrating the inevitability of the crisis, he clearly identified its cause, where most others could not:
It is clear that the crisis must come sooner or later. It is also clear that the crisis must always be caused, primarily and directly, by the change in the conduct of the banks. If we speak of error on the part of the banks, however, we must point to the wrong they do in encouraging the upswing. The fault lies, not with the policy of raising the interest rate, but only with the fact that it was raised too late.Ibid., p. 131.
He showed that the central bank’s attempt to keep interest rates low and to maintain the boom only makes the crisis worse. Despite the tremendous odds against the adoption of Mises’s own solution — that is, the traditional gold standard — he ended his analysis with a prescription for preventing future cycles:
The only way to do away with, or even to alleviate, the periodic return of the trade cycle — with its denouement, the crisis — is to reject the fallacy that prosperity can be produced by using banking procedures to make credit cheap.Ibid., p. 153.
Mark SkousenMark Skousen, Economics on Trial: Lies, Myths, and Realities (Homewood, IL: Business One Irvin, 1991). notes that in addition to Ludwig von Mises, Mises’s student F. A. Hayek is said to have predicted the collapse of the American boom in early 1929 (but probably not in written form). Felix Somary, who like Mises was a student at the University of Vienna, issued several dire warnings in the late 1920s; and in America economist Benjamin Anderson also warned that the Federal Reserve’s policies would cause a crisis, but like Somary, they were largely ignored. Mises and followers of his business cycle theory clearly had the upper hand over Fisher and the proponents of his stable-dollar policy.
Members of the Austrian school of economics were uprooted by WWII, with Mises in New York and Hayek in London and others scattered in academic posts at other prestigious universities. Despite the Austrians winning the prediction game against Fisher, Keynesian economics would soon rise to control economic thought as the Austrian school went into a general decline. Politically this was tied to the rise of fascism, Nazism, and FDR’s New Deal.
Fortunately, in the wake of WWII, the world returned to a Bretton Woods–style gold standard, and free market economies were established in Germany and Japan. The world quickly recovered from the war and the fascist-style economics that dominated prior to WWII. It would be a quarter century before the next economic depression hit the United States.
The notion that a record-breaking skyscraper can cause economic crises sounds ridiculous, and it is very much absurd. There is no causal relations between skyscraper construction and the skyscraper curse.
The causality that does exist is between artificially low interest rates causing both record-breaking skyscrapers and economic crises. Artificially low rates also cause distortions throughout the economy. Very low rates over extended periods of time are what bring about the record skyscrapers and the economic crises. The skyscraper itself is merely an identifiable manifestation of what is happening throughout the economy.
There are distortions, also known as Cantillon effects, directly tied to the skyscraper, such as what happened with the new lightweight elevator cable. Resources had to be diverted to research and development of the new elevator cable from other investment possibilities. A new production facility and production process had to be designed to produce the cable in a profitable fashion. Distribution could probably take place with existing company facilities, but certainly the marketing aspect of the product would have to be built from scratch. When the economic crisis comes, all these resources could have very low value. What happened to the elevator cable company is taking place in all areas of the economy, although it is not universal.
This type of distortion is occurring throughout the economy as entrepreneurs succumb to the lure of artificially low interest rates and embark on investments in more roundabout and advanced production techniques. These investments will later be discovered to be malinvestments in what has been described as a cluster of entrepreneurial errors, a phrase first used by British economist Lionel RobbinsLionel Robbins, The Great Depression (London: Macmillan, 1934). in his description of the Great Depression of the 1930s.
Much of the interest in the Skyscraper Index can be linked to its ability to forecast the business cycle and to predict the business cycle. In my view, its primary and best use is not to be able to predict the future, but to be able to describe the types of real changes that occur in an economy exposed to artificially low interest rates. Those changes can then be linked to the troubles we experience in the economic crises that follow. Thus, it helps us to understand the business cycle. Unfortunately, many economists ignore the business cycle or do not believe in economic causes of the business cycle. I am afraid that if this situation is not rectified soon, Karl Marx might turn out to be right about business cycles. He argued that business cycles will intensify over time and bring about the demise of capitalism.
In what follows I review an editorial from The Economist“Towers of Babel: Is There Such a Thing as the Skyscraper Curse?” March 28, 2015. that was published March 28, 2015, under the title “Towers of Babel.” The editorial was based on an academic article published by three Rutgers University economists. Unfortunately, the editorial staff of The Economist accepted the wrong, naïve understanding of cause and effect when it comes to skyscrapers. They did not refer to me by name in the editorial, but they did reference my 2005 article as a reference for what, in their minds, is the wrong point of view.
The editorial begins by noting that the world is in a major skyscraper boom and that such booms have often been an ominous signal of tough economic times ahead — the skyscraper curse. The Economist had long reported on and agreed with the Skyscraper Index,Jason Barr, “Skyscrapers and the Skyline: Manhattan, 1865–2004,” Real Estate Economics 38, no. 3 (2010): 567–97. but they were no longer sure:
Does this frenzy of building augur badly for the world economy? Various academics and pundits, many of them cited by The Economist, have long argued as much, but new research casts doubt on it.Ibid.
They then explain the economics of skyscrapers, noting that taller buildings mean more potential revenues. However, they correctly note that the marginal costs of construction also increase with taller buildings. This part of the editorial is a great capsule summary of my 2005 paper, although the role of the interest rate is not introduced. They then mention Jason Barr’s 2010 article, which seems to provide some support for the Skyscraper Index.
Then they turn to the paper, “The Skyscraper Curse: Separating Myth from Reality.”Jason Barr, Bruce Mizrach, and Kusam Mundra, “Skyscraper Height and the Business Cycle: Separating Myth from Reality,” Applied Economics 47, no. 2 (January 2015): 148–60. Two sets of evidence from that paper are presented. The first set examined the question of why the biggest towers are built near the peak of the business cycle and whether that relationship could help you predict changes in Gross Domestic Product (GDP). They found that the time between announcement date of record setters and business cycle peaks is very long and that only half of the skyscraper opening dates occurred during a downward phase of the business cycle: “In other words, you cannot accurately forecast a recession or financial panic by looking at either the announcement date or the completion date of the world’s tallest building.”
The problem with this is that no one familiar with the Skyscraper Index would use the announcement dates and completion dates as a consistent forecasting tool. The World Trade Center towers were announced in the early 1960s, nearly a decade before the first tower opened. Also, many announced record-breaking buildings never get off the drawing board or off the ground, or are not built as planned. The better dating method for identifying the existence of a bubble and future trouble would be to look at groundbreaking ceremonies. Such ceremonies are an indication that plans have been approved, financing and permits have been obtained, land has been purchased, and any necessary testing has been started or completed.
When looking for signs of trouble — that is, the skyscraper curse — a better date would be when the project has actually beaten the old record, or is approaching that point. The Burj Khalifa tower broke the old record in the summer of 2007, when economic conditions seemed good, but it was two and half years before it was completed and opened to the public. As a word of caution, none of these dating processes are some kind of exact, precise, or magical process; they are just rules of thumb based on experience. However, by using announcement and completion dates, the Barr, Mizrach, and Mundra study exaggerated the amount of error that actually exists. Plus, as The Economist notes, it is based on a very small sample size of fourteen. The role of clusters or cycles of record-breaking skyscrapers should also not be ignored.
To rectify the small sample size, the study’s authors turned to a second set of data that includes the tallest building completed each year in four countries, which expanded the number of data points to 311. They compared data on tall but not necessarily record-breaking buildings to changes in local per capita GDP, not severe economic crises. As a result, they found that skyscraper construction and per capita GDP were cointegrated. When two time-series data sets are cointegrated it means that they move, in general, in the same direction and are thought to be the result of the same causal forces. For example, national income and national consumption will tend to move in the same direction, with small variations. You can think of a dog owner walking the dog on a leash as being cointegrated. The dog might be out front and then move behind the owner, but they are both following the same basic path. The fact that Barr, Mizrach, and Mundra found that skyscrapers and GDP are cointegrated means the two data sets move in the same general direction and implies, in other words, that skyscraper construction does not cause the business cycle, and that both statistics are caused by some other factor or factors.
One major problem with this data is that the Skyscraper Index is not based on general skyscraper construction, but instead on record-breaking skyscrapers. As we have seen before, because of the technology requirements and economic constraints, building two, hundred-story buildings is not the same thing as building one 200-story building. Another problem is that the skyscraper curse involves an economic crisis, not the ordinary ebbs and flows of the typical business cycle.
But let us ignore these fundamental problems with their evidence. The evidence that skyscraper construction and per capita GDP are cointegrated and move together with a common cause is exactly what is predicted by the Skyscraper Index! Both statistics move together and have the common cause of artificially low interest rates. The Skyscraper Index tells us that artificially low interest rates cause record-breaking skyscrapers, usually in clusters, as well as a bubble in the economy and eventually an economic crisis — the skyscraper curse. In other words, none of their evidence undermines the Skyscraper Index; it supports it.
Stunned by the editorial, I wrote The Economist a letter to the editor to try to clarify the meaning and status of the Skyscraper Index. That letter of March 30, 2015, is reprinted here verbatim:
Dear Editor of The Economist:
Thank you for discussing my research and referencing my journal article from the Quarterly Journal of Austrian Economics. (“Is there such a thing as a skyscraper curse?” March 28th) I would note that Mr. Barr, Bruce Mizrach and Kusum Mundra’s research actually supports my thesis that misaligned interest rates cause both record setting skyscrapers and economic crisis. The fact that skyscraper height and GDP are cointegrated is no surprise and actually supports the case for a skyscraper curse. Also, I claim no precision with respect to the exact timing of events, especially with respect to “announcements” and “completions.” Groundbreaking and record achieving dates are actually more relevant, yet are still imprecise. They say a picture is worth a 1000 words and I think you’re graphic of the timing of record setting skyscrapers and economic crisis says it all.
Mark Thornton, PhD.Senior Fellow (economist)Ludwig von Mises InstituteAuburn, AL 36830 (USA)
Unfortunately, they did not print my letter. I was contacted more than three months later and they explained that my letter had been misplaced.
Based on discussions with Lucas Engelhardt, we decided to go back to the original academic journal article and reexamine their findings. Based on that examination, we determined that a comment should be written on the article. Once a common practice, the comment is not nearly as common today, but it still exists at many academic economic journals, including Applied Economics, where the original Barr, Mizrach, and Mundra article was published. Originally, we thought the title of the comment should be “Skyscraper Height and the Business Cycle: Separating Data from Reality,” but we chose instead to go for the conventional approach. The comment is reproduced below.
Skyscraper Height and the Business Cycle: Separating Myth from Reality, a Comment In a recent paper in this journal (Applied Economics), Jason Barr, Bruce Mizrach and Kusum Mundra test for the existence of a Skyscraper Curse, which Lawrence (1999) states is the “eerie correlation” between the building of record-breaking skyscrapers and economic crisis. Thornton (2005) shows the theoretical connections between record-breaking skyscrapers and economic crisis. However, the evidence that Barr et al. (2015) presents brings into doubt the existence of the Skyscraper Curse. Based on their evidence the Economist declared: “you cannot accurately forecast a recession or financial panic by looking at either the announcement or the completion dates of the world’s tallest building.”
Here we reexamine Barr et al. (2015) and come to a completely different conclusion. Their evidence does not refute the Skyscraper Curse and most of the more rigorous evidence actually supports it. With the Skyscraper Curse, output and height should be cointegrated and output should Granger cause height. Their evidence here is not only strong, but is more broadly applicable beyond the more narrow issue of record-breaking skyscrapers and once-in-a-lifetime economic crises.
Barr et al. (2015) use Granger causality and cointegration tests to analyze the relationship between skyscraper height and output. They use annual time series data for the tallest building completed each year and real per capita GDP for the United States, Canada, China, and Hong Kong as their measure for output. Their evidence shows that both height and output have a common trend indicating a cointegrated relationship. Granger causality tests show that output causes height, but height does not cause output.
The evidence from Granger causality and cointegration tests actually supports the theory of the Skyscraper Curse. No one believes that simply building a record-breaking skyscraper actually causes an economic crisis. The record-breaking skyscraper is more of an illustration of the types of microeconomic and technical changes to the overall structures of production that take place throughout the economy in response to artificially low interest rates.
Thornton (2005) clearly describes the Skyscraper Curse theory in terms of a third causal factor, artificially low interest rates, that cause both record-setting skyscrapers and unsustainable economic booms and, eventually, economic crisis. There have been several studies such as Barr (2012) that have suggested that such a third factor is responsible for the building of record-setting skyscrapers, such as builder competition, social status, and ego. However, in contrast to these psychological factors, artificially low interest rates provide an economic explanation for 1. Record-breaking skyscrapers, 2. The boom-bust cycle, and 3. Changes in social psychology. Therefore the results of the Granger causality and cointegration tests are completely in line with the expectations of Thornton’s (2005) model.
In contrast to their Granger causality and cointegration test results, the evidence in Table 1 of Barr et al. (2015) does strongly bring into question the existence of the Skyscraper Curse. They use the dates that record-setting skyscrapers were publically announced and the dates that those buildings were opened to the public and find little correlation with either of these dates and the business cycle.
However, there are multiple problems with their evidence. First, neither of these dates would be expected to be well correlated with the business cycle and especially with major economic crises, except in one sense. Announcement dates should generally occur during the boom phase of the cycle. They did find that 10 of 14 announcements did occur correctly in an expansion and 1 occurred at the very peak of the cycle. The 3 remainders occur because the “nearest US peak” is arbitrarily used, placing the 3 announcement dates after a previous peak. Additionally, using NBER peak and trough dates is not a true test of the Skyscraper Curse which is restricted to major economic crises.
Thornton (2014) suggests that announcement dates should be ignored and that instead, ground-breaking dates should be considered “skyscraper alerts” indicating that bubble-related investment opportunities exist, but danger is ahead. Furthermore, the date of record-completion, in the sense that the record-breaking height has been achieved, is a “skyscraper signal” suggesting that economic danger is imminent. Opening dates may be many months or even years in the future from record-completion dates and record-breakers often open in the midst of an economic crisis.
Barr et al. (2015) also downplay the Skyscraper Curse by noting that “the range of months between the announcement and peak is tremendous, varying from 0 to 45 months.” However, this variation is the result of using the announcement date so that, for example, the World Trade Towers was announced in January 1964, but the ground-breaking date for construction began in August 1968. They also use US cycle dating for two foreign records, Petronas Towers and Taipei 101. These record-breakers are normally connected to the Asian Financial Crisis of 1997–98 and also to the Tech Bubble-Bust (1997–2001), but these events bear little relationship with either the announcement or opening dates.
There remain several anomalies in Table 1. The Woolworth Building was announced in July of 1910 and opened in April 1913, but there is no economic crisis of note connected to it. However, the economy did peak and began contracting in the first quarter of 1913 and continued to contract until the fourth quarter of 1914. This contraction included the third worst quarterly decline in real GNP between 1875 and 1918, and was worse than any quarterly performance between 1946 and 1983. The founding of the Federal Reserve System in 1913 and the coming of World War I in Europe in 1914 provided stabilization for the American economy as exports to Europe soared. These 2 exogenous factors prevented the Woolworth Building from being associated with the Skyscraper Curse because the intervention of World War I reversed the deepening economic slump and prevented a historical label (e.g., “Depression of 1913–15”) from being created.
Table 1 also lists the Pulitzer (1890) and Manhattan Life (1894) buildings, which along with the Masonic Temple in Chicago (1892) and Auditorium Building (1889) represent a wave of record-breaking skyscrapers that preceded the beginning of the largest contraction in US history, culminating in the largest quarterly decline in real GNP in US history, which was then followed by the Panic of 1893 and 6 years of double-digit unemployment.
With these clarifications, 13 of the 14 buildings listed by Barr et al. (2015) come into agreement with the Skyscraper Curse model. The Park Row Building, which was announced in 1896 and opened in 1899 does not seem to fit the model, but is in synch with the emergence of the then new steel frame construction technology. If you take skyscraper waves and historical context into account, record-breaking skyscrapers are indeed associated with major economic crises and the Skyscraper Curse does add to our ability to foresee macroeconomic risks, even if the complexities of history prevent predictions of timing from being precise. We agree with Barr et al. (2015) and the Economist that the Skyscraper Index and its Curse is of little value in forecasting the normal ebb and flow of the macroeconomy.
We were quite surprised to learn many weeks later that our comment had been rejected by Applied Economics. The editor sent us two referee reports. Neither of the reports dealt directly with our primary comment, and both were defensive of the Barr, Mizrach, and Mundra paper. We noticed that in one of the reports, the referee identifies himself as one of the authors of the Barr, Mizrach, and Mundra paper, writing, “It is hard to reject a comment that agrees with your paper.” However, he managed to fight that urge and did reject our comment. It is not unheard of to send an author of an article a comment on their paper to referee, but it does seem odd to give them veto rights without the editor having read the paper and comment, which seems obvious in this case.
It is no embarrassment for a journal to publish a flawed paper. It happens on a regular basis. It is part of the academic process. For example, new econometric techniques have brought into question many early empirical papers. Hundreds of papers have been written on the Phillips Curve, and no doubt many are mistaken and now irrelevant. In the case of Barr, Mizrach, and Mundra, their paper is actually not wrong per se; they just came to the wrong conclusions based on their evidence. Even their secondary evidence could be salvageable. This experience provides a clear window into the messy world of academic publishing.
We expanded the comment into a paper with additional empirical evidence, and this paper was accepted for publication at the Quarterly Journal of Austrian Economics. There are other important developing lines of research on the Skyscraper Index, two of which I will report on next. One study looks at the Skyscraper Curse at the state level, the other examines the microeconomics of the Curse at the city level and helps explain the old real estate adage that what matters is “location, location, location.”
It makes very little difference how new money is injected. — Scott Sumner, TheMoneyIllusion
In previous chapters, I described economic growth and development as a process whereby lowering time preferences leads to an accumulation of savings that are invested in more-roundabout production processes, which in turn increase future consumption possibilities, labor productivity, and wages and incomes.
We now turn our attention to what happens with an increase in the money supply, rather than an increase in savings. This is critically important. The mercantilist idea that increasing the money supply increases prosperity was exposed as an error centuries ago by Richard Cantillon.Richard Cantillon, Essai sur la Nature du Commerce en Général, translated and edited by Henry Higgs (1755; London: Cass, 1931), chap. 1. However, modern mainstream economists, including the monetarists, Keynesians of various sorts, and the now-fashionable market monetarists, fully embrace the idea that printing money is necessary for prosperity.
In fact, the major central banks of the world have embarked on an unprecedented policy of monetary expansion both before and after the financial crisis of 2008. These central banks are led by people with advanced degrees in “economics,” and they have large research staffs of people with PhDs in mainstream economics. The result is a world currency war whereby each currency is printed in an effort to implement an economic expansion by a beggar-thy-neighbor policy, another widely discredited idea.
The beggar-thy-neighbor policy involves printing money to reduce the value of your domestic currency vs. foreign currencies. Reducing the value of your currency reduces the relative price of your exports and makes foreign products relatively more expensive so that you increase exports and domestically produced goods and reduce imports. The problem is that you also increase the price of imports and decrease efficiency. Ultimately this policy does not work: in the end you are worse off.
What happens when the supply of money increases? One of the first to examine this question was Richard Cantillon, writing in the 1730s in the wake of the Mississippi and South Sea Bubbles. Murray Rothbard wrote that Cantillon should have the premier honor among economists:
The honor of being called the “father of modern economics” belongs, then, not to its usual recipient, Adam Smith, but to a gallicized Irish merchant, banker, and adventurer who wrote the first treatise on economics more than four decades before the publication of the Wealth of Nations. Richard Cantillon (c. early 1680s–1734) is one of the most fascinating characters in the history of social or economic thought.Murray N. Rothbard, Economic Thought before Adam Smith: An Austrian Perspective on the History of Economic Thought (Brookfield, VT: Edward Elgar, 1995), vol. 1, p. 345.
I have written elsewhere about looking at Cantillon’s contributions through a modern and contemporary lens.Mark Thornton, “Richard Cantillon and the Origins of Economic Theory,” Journal of Economics and Humane Studies 8, no. 1 (March 1998): 61–74.
The Essai sur la Nature du Commerce en Général was completed shortly before Cantillon was murdered in 1734. Due to French censorship laws it was not published until 1755, and under mysterious circumstances. The book was initially very influential. It is believed he wrote Essai to explain the Mississippi and South Sea Bubbles, but he ended up creating an entire theoretical apparatus and what we now call Cantillon effects.
Cantillon investigated several possible causes of an increase in the domestic money supply including money’s importation from foreign countries and the discovery of new gold and silver mines. His important insight was that the effect of this new money depended on who had control of this new money and where it was injected into the economy. New money has a disruptive impact on an economy and can cause what we now call the business cycle.
Mainstream economists typically limit the discussion of Cantillon effects to the redistribution of wealth that accompanies an increase in the money supply.Andreas Marquart, and Philipp Bagus, Blind Robbery! How the Fed, Banks, and Government Steal Our Money (Munich: FinanzBuch Verlag, 2016). The first recipients of the money experience an increase in wealth, while those who do not receive it experience a decrease in wealth.Mark Thornton, “Cantillon on the Cause of the Business Cycle,” Quarterly Journal of Austrian Economics 9, no. 3 (Fall 2006): 45–60. Rouanet provides extensive empirical evidence of the Cantillon effect in terms of changing the distribution of income.Louis Rouanet, “Monetary Policy, Asset Price Inflation and Inequality.” Master’s Thesis, School of Public Affairs, Institut d’Etudes Politiques de Paris, 2017. However, this redistribution of wealth is only the first step in Cantillon’s much deeper analysis of the effects of an increase in money.
For example, if the increased money came from new silver mines, then the money would be in the hands of the owners of the mines and the miners themselves. Cantillon speculated that these now-rich people would consume more meat and wine, instead of bread and beer. This would in turn increase the price of meat and wine and decrease the price of grain. As a result, these price changes would lead farmers to increase the land devoted to raising cattle and vineyards, rather than grain. These are structural changes to the economy, and obviously the mine owners and miners are better off. The peasants who lived on bread and beer would be worse off because the decreased production of grain would mean higher bread and beer prices. Cantillon further theorized that money flows, prices, and the structural changes that were built on them could be reversed and that various businesses would be ruined as a result.
Mainstream economists dismiss all of these real changes in an economy as first-round effects. They do not believe there are any important real-economy impacts from an increase in the money supply, and if minor alterations did occur, it would only lead to temporary, inconsequential changes in the structure of production and income distribution.
To emphasize the importance of where the new money is injected into an economy, Cantillon noted that if the new money came into the hands of entrepreneurs, the rate of interest would fall, but if the new money came into the hands of consumers, the rate of interest would rise. If entrepreneurs found themselves with twice the amount of money they previously had, then they would have less demand for loans to finance their purchases of raw materials and to pay their labor. Therefore the rate of interest would be lower. If instead the new money were to double the amount of money that consumers possessed, then they would increase their purchases of goods. This would cause entrepreneurs to borrow more in order to supply the increased demand for goods, which would result in a higher interest rate. Either channel of increased money would put upward pressures on prices. In both cases, the group that receives the money first benefits, while those who receive it later, or not at all, are harmed by the higher prices.
Furthermore, Cantillon was the first to develop the theory of the price-specie-flow mechanism. This theory shows that a country that receives a bounty of new money will eventually experience higher prices. Some types of goods can be produced either domestically or imported from other countries. As the new money causes domestic prices to rise, there is an increased tendency for people to buy imported goods, and therefore money is sent to other countries. In this way, Cantillon showed that domestic industries that benefit and expand because of the increased supply of money will eventually be ruined because their expanded capacity will no longer be profitable in the face of low-priced foreign competition.
The general form of a Cantillon effect is that there is increased money coming into an economy from somewhere. The first recipients benefit. They spend it according to their preferences, and this causes certain prices to go up. The sellers of those goods benefit from the new money, while others who only face higher prices are hurt. Entrepreneurs respond to the higher prices by increasing their capacity to produce those goods by acquiring specific capital goods, raw materials, and labor. As the economy moves toward monetary equilibrium, the industry-specific capital goods are exposed as unprofitable, and if it is difficult to repurpose them for alternative uses, the adjustment process threatens those entrepreneurs with bankruptcy. The main point of Cantillon’s broader analysis is that changes in money result in changes in relative prices, which will change production plans and result in a different pattern of fixed investment such that new money changes the real economy and results in winners and losers.
Cantillon’s analysis regarding injection of new money has been adopted and extended by Ludwig von Mises and F. A. Hayek as a foundation of Austrian business cycle theory (ABCT). In the modern theory the increase in the money supply is usually restricted to an expansion of bank reserves by the central bank and an expansion of bank loans. In ABCT, this reduces the interest rate below the natural rate and initiates a boom in the prices of capital goods as well as company stocks and real estate. This, in turn, leads to the production of fixed capital goods that will later be revealed as malinvestments, in turn leading to bankruptcies, if not a skyscraper curse.
We don’t really know what starts the speculative bubbles. — Jesse Abraham and Patric Hendershott, “Bubbles in Metropolitan Housing Prices”
The Skyscraper Index was based on the most noteworthy business cycles of the twentieth century and can be explained using Austrian business cycle theory (ABCT). In contrast, there is no consensus within mainstream economics about business cycle theory. The Keynesians have several versions, but all are driven by psychology and changes in aggregate demand. This would include behavioral-finance economists such as Robert Shiller who believe that stock markets are irrational. There are also debt-cycle theories put forth by Irving Fisher, Hyman Minsky, and Joseph Schumpeter. There is the real business cycle theory (RBCT), which is associated with the Chicago school and embraces the role of external shocks, such as technological change. There is a political business cycle theory based on the election cycle, and there are even Marxist theories.
The problem with most business cycle theories is that they are really just descriptions of business cycles rather than economic theories of business cycles. Each description emphasizes particular features that are then elevated to the status of causal forces. Each stage of the business cycle is characterized by several features — for example, speculation, unstable supply of money, changes in aggregate demand, changes in social mood, and external real factors, or shocks. As a result, business cycle theories could be characterized as perspectives in which the economist has identified particular features of the economy to blame, along with their preferred remedies.
As such, business cycles are reoccurring sequences of varying length of expansions, downturns, contractions, and upturns in many types of economic activities such as production, employment, income, sales, housing starts, money, credit, and prices. Interest rates, inventories, fixed capital, and loans outstanding tend to be procyclical. Keynesian theories emphasize that business cycles must be fought with aggressive government policies, such as deficit spending, bailouts, public works projects, and monetary stimulus. Real business cycle theorists take the opposite approach and recommend a passive policy of letting the government and economy absorb the impact of external shocks.
Austrian business cycle theory has significant advantages over mainstream theories:
First, whereas mainstream theories find the cause of business cycles to be either psychological or technological, ABCT identifies a cause of the business cycle that is economic in nature — namely, artificially low interest rates, which start a chain of events that can be understood using simple economic tools, such as supply and demand.
Second, mainstream theories assume away the complexities of the real-world economy, while ABCT incorporates complexity in its analysis.Third, ABCT incorporates the psychological and technological features of mainstream theories and shows them to be predictable rather than random and unexpected shocks.
Fourth, by identifying an economic cause of the business cycle, ABCT reveals a solution for ending the business cycle and the endless cycle of psychological and technological shocks and wasted resources.
For ABCT, the cause of the boom and subsequent bust is when the central bank reduces the market rate of interest below the natural rate of interest by increasing the supply of money and credit. The natural rate of interest is the market rate of interest set by savers and borrowers in the absence of intervention by the central bank and is adjusted for both risk and price inflation. This rate, therefore, signals the general time preference of society. Artificially low interest rates are not calculable because we cannot know what the natural market rate would be except by indirect measures such as the amount of open-market operations conducted by the Fed — that is, its net government-bond purchases. However, we can understand the impact of artificially low interest rates by looking at another, more straightforward, example of a government price control — in this case, a price ceiling set by rent-control laws. Such laws keep the rental rates on apartments artificially low. These laws lead to shortages of apartments, physical depreciation of apartment buildings, and misallocation of apartments. For example, with rent-control laws, you might find a large family occupying a one-bedroom apartment and a single individual living in a three-bedroom apartment due to the shortage of apartments. The key difference with artificially low interest rates in the loanable-funds market is that the Fed can make up for any deficiencies and prevents a shortage by printing money out of thin air.
Prior to Fed involvement, the amount of savings and borrowing are equal at the market-determined interest rate. Actual loan rates of interest vary from loan to loan based on the combination of the base rate, risk premium, inflation premium, and processing costs. After the Fed has reduced this rate to artificially low levels it creates a shortage of loanable funds, which it then corrects by buying government bonds from banks for cash. Banks now have more cash, which they can use to make loans. The direct consequences of this policy are to reduce savings, increase lending and debt, and lower lending standards so that individuals with lower credit ratings obtain loans and individuals with higher scores can obtain a larger amount of loans.
For consumers this means a greater debt burden and a reduction of future income because of less saving and interest income. For entrepreneurs this means a larger amount of borrowing. The lower interest rates also make longer-term investments appear more profitable relative to shorter-term investments. For example, low rates might induce a farmer to switch from growing corn, an annual crop, to growing apples, a multi-decade-length project. Lower interest rates induce foresters to let their trees grow longer, winemakers to let their wine age longer, and publishers to have larger print runs of their books. It also induces entrepreneurs to make production structures more roundabout.
The simplest example concerning roundabout production is of an isolated person who catches fish by hand and obtains one fish per day. If that person spends one day not fishing, but instead makes a net, that person could obtain three or four fish per day. Fishing by hand is direct production, while making the net and then fishing is more roundabout.
For a more modern example, let us examine the alternative ways we can communicate with each other. The most direct way of communicating with someone is to walk over to them and begin talking. A more roundabout method would be to first run a telephone line between your location and their location and use telephones to communicate. Using phones to communicate implies the prior existence of a vast variety of capital goods for the production of wires, phones, telephone poles, and so on. The amount and complexity of capital goods for cellular phone service is even more astounding. Phones are therefore more roundabout than the “walk and talk” method, but are much more productive. Austrian economists focus on this process of technological change. Investment in more roundabout production processes means that investors are investing in new ways of doing things that were previously on the shelf but were not feasible or in general use. Spending money on research and development is investment in new technologies to be available in the future. These technologies generally involve even more-roundabout production processes. In this manner, ABCT shows how the interest rate plays a direct role in the so-called technological shocks of the RBCT.
ABCT also tries to deal with the complexity of the economy rather than assuming it away. Mainstream theories generally have a mathematical model manipulating aggregate statistics such as consumption, investment, and government spending. The mainstream approach treats capital as a homogeneous factor of production that can be retooled and relocated with a wave of a magic wand.
In contrast, ABCT examines structures of production that span from the discovery of raw materials to the final product available for sale in retail stores. There are many stages of production in every structure of production, and each stage employs specific and nonspecific labor and specific and nonspecific capital goods. For example, an oil refinery contains a multitude of capital goods that are very specific to refining oil, but also capital goods such as pipelines and tanker trucks that are nonspecific capital goods because they can be used to transport many different things. To these, the entrepreneur adds very specific labor (e.g., petroleum engineers), nonspecific labor (e.g., truck drivers), and other inputs from previous stages of production (e.g., crude oil) in order to produce gasoline, a consumer good. Therefore, ABCT can show that nonspecific capital and labor can more easily be reallocated if conditions in the gasoline market deteriorate, but highly specific capital and labor are much more difficult to reallocate. Either the market value of oil refineries and the salaries of petroleum engineers must fall dramatically or they must remain unemployed.
The structure of production of all goods and services is highly complex. It is so complex that mainstream economics assumes it away. Even being complex, we can know some things about it and some things that affect it. The structure of production of a new product begins with a very short and direct structure. For example, with the invention of the automobile hundreds of small companies started making their own hand-fitted parts and assembling cars one at a time.
My first “portable” computer was built just for me by a computer technician using purchased parts, and it was the first one in town. This “portable” was the size of a suitcase that would barely fit in the overhead compartment of an airplane and weighed almost twice as much as a fully packed suitcase. Over time structures of production tend to get longer and the number of companies that sell the final consumer product often decreases.
For example, mass-produced interchangeable parts and the assembly line production technique for automobiles were introduced and quickly adopted. These technologies made production more efficient and increased the specialization of labor. They also made the structure of production more roundabout: machines had to be created to make interchangeable parts and assembly lines, technologies had to be created to replicate those machines, and so on. Today we find the structure of the automobile industry incredibly complex, with thousands of firms spanning the globe. These firms provide everything from computer graphics software to design new automobiles to the caps for the air valves on tires. Parts are transported to assembly factories, and then automobiles are shipped to auto dealerships. For mainstream economists the idea of perfect competition is the initial chaos of thousands of individual automobile companies, while for Austrians the whole process of the initial chaos evolving over time into a small number of mega-sized automobile manufacturers is competition. Mainstream economics’ ideal market form requires a large number of buyers and sellers, perfect information, a homogenous product, and several other conditions. For Austrian economists the only requirement for competition is no government barriers for entrepreneurs entering or exiting an industry.
Another difference between Austrians and mainstream economists concerns the role of money. For the mainstream economists money is neutral and is similar to their view of capital. Money can be injected into any point in the economy and it will not cause disruptions, distortions, or redistributions of wealth. In other words, new money does not affect the real economy or relative prices. For them it only raises the so-called price level and reduces the purchasing power of money. In the mainstream view, new money seamlessly seeps throughout the economy without resulting in any relevant changes in demands, relative prices, or production.
In contrast, Austrians base their analysis on the real impacts money can have on the economy. Let us contemplate a doubling of the money supply in the economy, as Richard Cantillon did in 1730. He concluded that new money could not possibly be neutral and then gave several examples of new money and how it would disturb an economy and cause redistributions. His examples included the discovery of silver mines and a large number of wealthy immigrants moving into a nation with their money. He showed that new money changes prices and production to meet the new demands of wealthy mine owners, miners, and new immigrants.
Our example is a central bank that wishes to try an experiment with newly printed money. After carefully acquiring the names of all pickup truck and NASCAR enthusiasts in the economy, it credits each of their bank accounts with $10 million. Austrian economists would expect to see ticket prices for the Daytona 500 increase dramatically, and they might speculate about the introduction of a Daytona 1000, but mainstream economists would expect no change. Austrian economists would expect that the price of the Ford F-450, the most expensive pickup truck in the market today, would increase and that Ford would produce a larger quantity of such trucks and might even build a new assembly plant or even design more expensive versions of its line of pickup trucks.
The pickup truck and NASCAR enthusiasts, the Daytona 500, and the pickup truck producers would all gain relative to everyone else. However, when all the money was spent, what would happen to the new capital that the Daytona 500 and Ford have invested? Mainstream economists tell us that there would be no effect on incomes, wealth, production, and new products or that any such disturbance would only be short lived and unimportant.
In recent years, the Fed’s use of zero–interest rate policy (ZIRP) and quantitative easing (QE) has made it possible for hedge fund managers, Wall Street bankers, and bond dealers to become extraordinarily wealthy. As a result of this immense wealth, real estate prices in Manhattan have increased dramatically and many new luxury-condo skyscrapers have been constructed. The experience at art auctions also tells a similar story. The price of artwork of artists of the currently fashionable contemporary-art genre, such as Jean-Michel Basquiat, Christopher Wool, and Jeff Koons, has skyrocketed to millions of dollars, while the minor works of such famed artists as the impressionist Pierre-Auguste Renoir can be purchased for perhaps less than $100,000.
In reality, with conventional monetary policy there are some straightforward ways in which the economy is distorted by artificially low interest rates. There is more lending and investment and entrepreneurs tend to favor longer-term, more roundabout means of production. For example, in the current environment of extremely low interest rates, especially for large corporations, Amazon has found it profitable to use robots rather than employees to fulfill orders from customers, despite the low-wage environment. The most direct way to fulfill orders is to have employees read orders, retrieve products, and package the products for delivery. A more roundabout method would be to design and build robots to replace the employees; create software for the robots to fulfill orders; reorganize warehouses and order-fulfillment centers to operate with robots; and train some employees to maintain and interact with the robots.
To watch the robots move around Amazon facilities, one might get the feeling that the company is somehow cheating on its various competitors. Additionally, when one looks at the price of Amazon stock one might guess that the company is earning huge profits, akin to a worldwide monopoly. Sales in 2015 were an enormous $35.7 billion, up 22 percent over 2014. Profits were also up a staggering 125 percent at $482 million in 2015. However, that means they are only making about 1 percent profit on sales. Amazon has a market capitalization of $300 billion and a price-to-earnings ratio of over 500.David Goldman, “Amazon Shares Plummet as Profit Disappoints,” CNN.com, January 28, 2016. In other words, investors cannot imagine anything going wrong for the company. WilsonDavid Wilson, “Cisco, Apple Fail to Reach $1 Trillion. Is Amazon Next?” Bloomberg.com, May 9, 2016. reports that one analyst predicts the company will be worth $3 trillion in less than ten years.
Some of the conventional disturbances caused by an increased money supply include a redistribution of wealth from savers to borrowers because borrowers obtain loans at lower rates, savers get a lower return on their savings, and the value of savings and debt is diminished by price inflation. The biggest beneficiary of this redistribution is the federal government, which has trillions of dollars of debt. The other primary redistribution from an increased money supply is the redistribution from people working for wages or living on fixed incomes to people with variable incomes, primarily but not exclusively in the financial sector.
Keynesian business cycle theories are based on psychological factors while real business cycle theory rests on external shocks such as technological change. ABCT incorporates both psychology and technology. With artificially low interest rates the economy will experience more investment and consumption. The price of assets will increase and unemployment will fall, even below the so-called natural rate of unemployment. Wages, incomes, and profits will all increase. During this boom Austrians expect the psychology of investors and entrepreneurs to be highly positive. Retirement stock accounts will increase substantially, variable-income workers in the service economy, such as waiters and massage therapists, will earn higher incomes, and novices will earn windfall incomes by endeavors such as flipping houses and day trading stocks. Given the above story about Amazon, it would also not surprise Austrians that a great deal of new technology would come about; in fact with ABCT it would be expected. The very nature of making an economy more roundabout implies new recipes for production and the introduction of new technologies. So there is a built-in rationale for a technology shock during a boom.
Every boom eventually peaks, and then the economy enters into a corrective phase, or bust. The reasons for transition are important and will be discussed, but for now let’s stick to our example of the bust phase; in light of the mainstream business cycle theories, this is largely just reversing aspects of the boom phase. The price of assets will fall, and the unemployment rate will increase above the natural rate. Wages, incomes, and profits will fall, and the incomes of service workers will decline. House flippers will flop. Naturally the positive psychology of the boom will disappear and the social mood will turn gloomy. Austrians expect this to happen. We would be very surprised if it did not happen.
In terms of technological change, it is hard to undo technology once it is introduced, so Austrians generally expect large losses where there had been the largest investments in new technology, the real estate related to that new technology, and the people who financed that new technology. Some RBC theorists argued that the financial technology used in the housing bubble was responsible for both the bubble and the bust. They blamed the new financial instruments, such as collateralized debt obligations, mortgage-backed securities, and asset-backed securities. For RBCT this financial technology was both a positive shock up to 2007 and then a negative shock. Indeed, the financial technology is the primary, but not only, reason why it was, after all, a housing bubble. Without these new financial products, Fannie Mae, Freddie Mac, the Community Reinvestment Act, and the tax advantages of homeownership, it would have been simply a generalized bubble throughout the economy, rather than specifically a housing bubble.
For now let us look first at the process of economic growth and contrast it with the business cycle in light of ABCT. It is important to know that true economic growth is dependent on the existence of increased savings. When people spend less of their income on consumption goods and save their money, they leave more resources in the economy to be used by others. As compensation, they will have more savings and interest income so that in the future they can increase their consumption beyond their income, or even forgo working altogether.
Entrepreneurs need savings, whether it is acquired through bank loans, the sale of stocks and bonds, or retained earnings from their companies. They need money to acquire capital goods, to hire labor, and to pay other expenses. Companies will use savings to maintain their capital from physical depreciation and they will invest in new capital goods that present better profit opportunities because of technological advantages. This will make the production structures more roundabout, efficient, and productive. More savings makes it possible to pay for things such as more employee payroll and inventories prior to the consumer ultimately paying for the final product. In other words, all the resources hired and used from the acquisition of raw materials to the final assembly and sale of consumption goods have to be financed in some way. More savings results in greater productivity and production.
Now let us contrast economic growth with the business cycle. Instead of an increased preference for saving and future income, now the lower interest rate and source of new loanable funds comes as a result of the monetary policy of the central bank. At the lower interest rate people will save less, not more. They will consume more. Investment will increase, particularly in longer-run, more-roundabout production technologies, but also for consumption purposes.
Reducing saving and increasing consumption and debt makes consumers less wealthy and puts them in a more precarious economic position. Investing in more-roundabout production processes also puts entrepreneurs in jeopardy. For example, instead of two entrepreneurs developing two new factories for the production of new advanced computer chips, four such projects are proposed and financed at the artificially low rates. The entrepreneurs study their projects, which are not identical but are very similar, in order to determine where to construct such factories and what are the best places to find construction workers, engineers, scientists, and factory workers. Also, what are the best sources of the very-specific capital goods, such as chip-making machines and clean-room technology? With existing chips selling better than expected due to increased consumption in the economy and promises of a new advanced chip on the way and financed at low interest rates, the stock price of these companies goes much higher. With such activities happening in many industries, the economy is booming.
Now we turn our attention to supply and demand issues as the entrepreneurs start running into some unforeseen circumstances. With twice the normal number of factories under construction, the price of land best suited for the factories is higher than expected. The availability of labor — first construction workers, but eventually the engineers, scientists, and factory workers — is less than anticipated and therefore wages and benefits are higher than were projected. The demand for the advanced chip-making machines and clean-room technology is also much higher than anticipated, so their prices are also higher than expected. Because there are four factories instead of two, the cost of all four projects will be higher than anticipated. Some components of the projects could be ordered in advance to avoid such cost increases, but not all them.
As the factories come online and start producing, other problems arise. The industry-wide supply of advanced computer chips is much greater than the entrepreneurs originally anticipated. As a result, the price of such chips falls and is lower than anticipated when the projects were initiated. The result of having undertaken four projects instead of two is that prices and revenues are lower than anticipated. Computer chips can be sold in advance too, but such hedging provides only short-term protection.
The overall demand for such an advanced computer chip is also likely to be adversely affected by the artificial interest rates. Recall that artificial rates increased consumption and reduced saving. This means that consumers were busy buying things such as the previous generation of smart phones and other chip-containing products, but now they have less savings and more debt. If half of your intended consumer base now has $10,000 in credit card debt and only $100 in their checking accounts, there is going to be a reduced demand for new chip-containing gadgets. This means fewer chips sold and even lower prices. The central bank can try additional doses of artificial credit, but it cannot print resources. It can only create more malinvestments and greater consumer debt. Notice that if there is a general glut of production capacity in an economy the result could be price deflation, the bogie man for mainstream economists.
With market-determined interest rates, an increase in the demand for loans by chip-making companies and entrepreneurs more generally would result in higher interest rates. When the interest rate is determined by the central bank, there is nearly a perfectly elastic supply of loans at the policy interest rate.
You can see the impact of artificially low interest rates today in the boom in higher orders of capital goods: the record-setting stock markets and general weakness in goods of the lowest order, consumption goods. Central bankers have feverishly used their one tool of money printing, but that has only created asset bubbles, malinvestments, and relative weakness in the Consumer Price Index, which is what ABCT expects. Once central bankers give up and put away their tool, asset prices will crash, malinvestments will be revealed, and consumer prices will be relatively strong.
Some might wonder here about the Austrian view of entrepreneurs. How can the same people who can figure out such amazing ways of improving the economy and its structures of production be fooled, repeatedly, by the Fed? Yes, Austrian economists do view the entrepreneur as a critical player in the economy, but entrepreneurs are not omniscient and we expect them to fail on a regular basis, constrained and controlled by competition, the system of profit and loss, and their capitalist backers. Engelhardt shows how easy credit conditions provide low-quality entrepreneurs access to credit that they would not have access to under tighter credit conditions.
In a nutshell, ABCT warns that artificially low interest rates create malinvestments and a boom or bubble in the economy. This necessarily sets the stage for a recession, bust, or economic crisis when the cluster of entrepreneurial errors is revealed. This is an economic business cycle theory, although it anticipates and incorporates the technological shocks and psychological instability of the competing mainstream theories. ABCT shows us how the biggest policy errors by the central bank result in economic crises and skyscraper curses and more entries in the Skyscraper Index.
[The original version of this chapter was published as “Is the Housing Bubble Popping?” LewRockwell.com, August 8, 2005.]
Friday, August 5, 2005, was a bad day for housing stocks and this could be a sign that the housing bubble may have sprung its first leak. This is what the Philadelphia Stock Exchange Housing Sector Index looked like this week — losing about 5 percent for the week.
Investors have made around 50 percent on their money since I first reported on the housing bubble,Mark Thornton, “Housing: Too Good to Be True,” Mises Daily, June 4, 2004. and there could very well be more bubblingto come. In this graph of high-flying Toll Brothers (TOL), one of the largest home-building companies. The stock has increased by over 50 percent in the last year. Optimists point to the company’s price-to-earnings ratio of “only” fifteen, which is below the market average.
The pessimist’s case for a bursting or deflating of the housing bubble is the issue of rising interest rates. As Greenspan increases short-term interest rates it causes problems for those who have variable-rate mortgages tied to short-term interest rates. Energy prices and a slowdown in the economy can also dampen enthusiasm in the housing sector.
The larger problem may be for long-term rates because they are the foundation for fixed mortgage rates. As Greenspan increases short-term rates the thinking goes that he is reducing inflation expectations and thus reducing the likelihood of increases in long-term rates. However, if long-term rates rise, this is an indication that short-term rates are not rising fast enough to dampen inflationary price pressures.
Long-term interest rates are rising and there was a big increase in the interest rate on ten-year Treasury bonds on Friday, August 5th that coincided with the fall in home-builder stocks. Over the last summer this interest rate made a “double bottom” at about 3.9% which is almost the lowest it has been in my lifetime. It is now 4.4% and probably headed higher. [Note: it was 5.25% a year later.]
A double bottom is a term from technical stock analysis that is a bullish indicator, which in this case predicts higher long-term interest rates. Higher rates spell trouble for the home builders and give some indication the housing bubble might be coming to an end.
Hopefully, Alan Greenspan will know the correct lever to pull next. He did in the 1960s.Ron Paul, “Ron Paul vs. Alan Greenspan.” Testimony before the House Financial Affairs Committee, July 20, 2005.
Postscript If you look at a long-term chart of the Philadelphia Stock Exchange Housing Sector Index (symbol HGX) you will see that this was indeed the exact turning point for home-builder stocks, which typically lead the actual housing market. The Taylor rule, a guide to monetary policy, can also be said to have predicted the housing bubble ∕ financial crisis. WoodsThomas E. Woods, Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (Washington, DC: Regnery Publishing, 2009). is the best analysis of the housing bubble, financial crisis, and the policy response to it.
You could probably go back in history and find examples of the skyscraper curse in structures such as the Egyptian pyramids and medieval cathedrals. Here the review is confined to modern buildings, but we will expand our time horizon to examine records prior to and after the original Skyscraper Index (1907–99). We will also reexamine the one record-setting building, the Woolworth Building, that Andrew Lawrence considered a failure of the index because no curse occurred. As a result of this reexamination, the Skyscraper Index appears more reliable than previously thought.
This reexamination will consider modern buildings with steel-frame construction. The primary criteria for record-breaking projects are the number of floors of livable space and building height, not counting features such as antennas and spires. Those types of adornments are not costly or technologically challenging, compared to difficulties of building taller buildings with more livable space, which have requirements for such things as elevators, plumbing, and temperature control.
The two important inventions that made skyscraper construction feasible were the elevator and the steel-frame construction technique. Prior to the introduction of elevators in the 1850s, construction was typically limited to four-story buildings. Before the introduction of elevators, the lower floors were more highly valued and the higher floors were less highly valued because of the added time and effort of climbing more stairs. This limited the demand to build higher. With elevators, the higher floors became more highly valued, with the exception of first-floor retail space. The introduction of steel-frame construction in the late nineteenth century made it much more cost effective to build taller structures. Steel-beam construction bears the load or weight of taller buildings, and construction can proceed at a faster pace. In contrast, masonry construction requires an ever-larger base to carry the load of taller buildings.
The Equitable Life Assurance Building in New York City is considered by many to be the first skyscraper. Construction was completed in early 1870 and the building opened on May 1. It served as the home of the Equitable Life Assurance Society and was the first office building to feature hydraulic passenger elevators. It had seven floors and set a new record height at 130 feet.
Prior to its opening and approximately when it set the record height, the first Black Friday occurred on September 24, 1869. Jay Gould and James Fisk were attempting to corner the gold market in New York City, but US Treasury officials broke up their plot by selling large amounts of gold. Nevertheless, the economy was adversely affected as the price of gold first skyrocketed and then collapsed. In the aftermath, stocks fell by 20 percent and agricultural exports, the key output of the US economy, declined by 50 percent. According to Robert Kennedy,Robert C. Kennedy, “Gold at 160, Gold at 130,” Harper’s Weekly, October 16, 1869. there were several bankruptcies of brokerage firms “and a severe disruption to the national economy for months.” The aftermath has been labeled both a panic and a depression, but not a significant one.
The Home Insurance Building was completed in 1884 in Chicago. It rose to a height of ten floors and 138 feet. Interestingly, two more floors were added in 1890. This building is connected to the panic of 1884 and the depression of 1882–85. While the financial panic was real, the depression that occurred was mostly about deflation and the railroad bubble. According to Victor Zarnowitz,Victor Zarnowitz, Business Cycles: Theory, History, Indicators, and Forecasting (Chicago: University of Chicago Press, 1992), pp. 221–16. his measure of economic activity indicates that the depression was less severe than the panics of 1873 and 1893 and the depression of 1920–21.
The Auditorium Building in Chicago set a new record of seventeen floors and 222 feet to the top floor in late 1889. Meanwhile the New York World Building, also known as the Pulitzer Building, was completed in 1890 with sixteen to twenty floors (depending on how it is measured) and was 309 feet high, setting a new height record.
This cluster of new-record skyscrapers can be linked to the panic of 1890. Also known as the Baring crisis, it involved the near insolvency of Barings Bank in London. The crisis was international in scope, but the most severe impact did not involve the US economy. It should be kept in mind that the United States was becoming the world economic powerhouse, transforming itself from a largely agricultural economy into a manufacturing and service economy. As farmers went to the cities they often took jobs not only in manufacturing, but also in service sectors, such as insurance and sewing machine salespersons. The service industries were a significant component of the demand for office space and hence skyscrapers.
The Manhattan Life Insurance Building was completed in 1894 with eighteen floors and 348 feet in height, setting a new record. Also completed at this time were the American Surety Building with twenty floors and 303 feet in 1895 and the Masonic Temple with nineteen floors and 302 feet in 1892, but they are not widely considered clear record-breaking skyscrapers. Nevertheless, this cluster of skyscraper construction coincided with the largest contraction in US history, culminating in the largest quarterly decline in real GNP in US history and included the panic of 1893, which is thought to have begun six years of double-digit unemployment, although those statistics are still open to debate among economic historians.
The Park Row Building was completed in 1899. It was twenty-six full floors and is at least 309 feet in height: if the three-story cupolas are included its height is 390 feet, which would make it the world’s then-tallest skyscraper. The opening of the building was preceded by the fourth-largest quarterly decline in real GNP over the period of 1875–1918.
The next skyscraper cluster took place between 1904 and 1909. This is the cycle where Lawrence begins his documentation of the Skyscraper Index. It included the Singer Building, which, at forty-seven floors and 612 total feet in height, became the world’s tallest skyscraper when completed in 1908. The Metropolitan Life Insurance Company Tower set another new record in 1909 with fifty floors and 700 total feet in height. Both projects were begun prior to the panic of 1907 and were reaching record heights when the panic occurred. The panic occurred at a time when seasonal factors relating to fall harvests coincided with cyclical factors in credit markets. It ignited in October when a bank regulated under the National Banking Act refused to clear funds for the Knickerbocker Trust Company, an unregulated bank. The result was widespread runs on banks and one of the sharpest downturns in US history. This episode is historically important and of continuing relevance because it is widely considered to be the key event that led to the passage of the Federal Reserve Act in 1913.
It is worth noting that the panic of 1907, like many nineteenth-century panics, is now widely considered to have been caused by the regulatory structure imposed by the National Banking Acts (1863 and 1864). According to Howden,David Howden, “A Pre-History of the Federal Reserve,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno (New York: Springer, 2014). the financial instability during this period was not the result of a lack of regulation or unfettered capitalism. According to Michael Bordo, Peter Rappoport, and Anna J. Schwartz,Michael D. Bordo, Peter Rappoport, and Anna J. Schwartz, “Money versus Credit Rationing: Evidence for the National Banking Era, 1880–1914,” in Strategic Factors in Nineteenth-Century American Economic Growth, edited by Claudia Goldin and Hugh Rockoff (Chicago: University of Chicago Press, 1992), p. 189. the National Banking Acts created a system that was “characterized by monetary and cyclical instability, four banking panics, frequent stock market crashes, and other financial disturbances.” The poor performance of the subsequently adopted Federal Reserve has led many economists to call into question the suitability of a central bank for solving the problems caused by the National Banking Acts.
The Woolworth Building was the world’s next record-breaking skyscraper in 1913. When completed, it stood fifty-seven floors and 792 feet tall. Lawrence saw the Woolworth Building as an exception to, or error in, his Skyscraper Index because there was no curse in the sense that there was no major economic crisis that coincided with the building. There is no famous panic or depression in the history textbooks. Therefore it seems like the Skyscraper Index failed in this case.
However, it would be wrong to consider the Woolworth Building as evidence against the Skyscraper Index. The Woolworth Building project was announced in March of 1910, but at first it was planned to be a modestly tall building. In November 1910 its projected height was increased, but it was still only slated to become the third-tallest building in the world. In January of 1911 the building was re-planned to become one of the tallest buildings in the world at 750 feet, but this figure was later raised still higher to more than 792 feet high.Sara Bradford Landau, and Carl W. Condit, Rise of the New York Skyscraper: 1865–1913 (New Haven, CT: Yale University Press, 1996), pp. 382–84. The opening ceremonies for the Woolworth Building were held on April 24, 1913, although it was not fully completed until later.Ibid., p. 390.
In fact, the US economy peaked and began to contract in the first quarter of 1913, ahead of opening ceremonies. The economy continued to contract until the fourth quarter of 1914. This contraction included the third-worst quarterly decline in real GNP between 1875 and 1918, and was worse than any quarterly performance between 1946 and 1983. KazaGreg Kaza, “Note: Wolverines, Razorbacks, and Skyscrapers,” Quarterly Journal of Austrian Economics 13, no. 4 (Winter 2010): 74–79. reports that the building’s opening ceremony occurred during a twenty-three-month-long contraction between January 1913 and December 1914. This would clearly qualify this period as a severe recession.
The only reason that American history textbooks do not refer to the depression of 1913 or something else was that World War I was already brewing in Europe and hostilities would break out in mid-1914. WWI was the largest conflagration in human history, resulting in over twenty million casualties of all types. However, in the United States the war created a tremendous increase in demand from Europe for US agricultural products, metal production, and armaments, as well as labor. This event singlehandedly provided stabilization for the American economy and pulled it into an expansion, not an ordinary recovery. While economic historians now know that World War II did not get America out of the Great Depression,Robert Higgs, “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s,” Journal of Economy History 52, no. 1 (March 1992): 41–60. WWI appears to have prevented the United States from falling into one.
Therefore, it would seem that the Woolworth Building should not be viewed as an exception to or error in the Skyscraper Index. It was simply that World War I in Europe did not provide enough time for the economic slump in the United States to deepen and to justify a historical label such as the depression of 1913.
A reexamination pre-Index of the evidence suggests that the Skyscraper Index is an even better forecasting tool than first presented by Lawrence. First, we have shown that the skyscraper curse occurred several times in the late nineteenth century. Second, the only example of an error of the original Skyscraper Index, when the curse did not happen, has a simple explanation. Our examination of this early period also makes clear that the causes behind both skyscrapers reaching new heights and economic crises emerging are related to government intervention in credit markets.
The next cluster of the world’s tallest buildings occurred at the onset of the Great Depression. Three record-breaking skyscrapers were announced during the late 1920s, when the stock market boom was being matched by booms in residential and commercial construction, as well as in manufacturing. In May 1930, the skyscraper at 40 Wall Street (now the Trump Building) was completed at a height of seventy floors and 927 feet. This was followed by the Chrysler Building in 1930 at seventy-seven floors and a height of 899 feet (925 feet to the roof and 1,046 to the top of the spire). The Empire State Building was completed a year later in May 1931 at 102 floors and 1,224 feet. Clearly, there was a capital-oriented boom in the construction of ever-taller buildings before the Great Depression.
Economists have offered many different explanations for the Great Depression, and Robert LucasRobert E. Lucas, Jr., Models of Business Cycles (New York: Basil Blackwell, 1987). has even claimed that it defies explanation. What is clear is that there was a significant increase in the money stock between the founding of the Federal Reserve and the stock market crash, a significant restructuring in banking and bank regulation, a significant decline in the supply of money after the crash, despite the Fed’s best efforts to stop it,Joseph T. Salerno, “Money and Gold in the 1920s and 1930s: An Austrian View,” Freeman (October 1999): 31–40. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010), pp. 431–49. a significant number of bank failures, and a variety of other important factors that contributed to the initiation and duration of the depression, including the Smoot-Hawley tariff and President Hoover’s and President Roosevelt’s New Deal policies.Murray N. Rothbard, America’s Great Depression, 5th ed. (1963; Auburn, AL: Mises Institute, 2000).
It is also worth noting that Ben Bernanke,Ben S. Bernanke, Essays on the Great Depression (Princeton, NJ: Princeton University Press, 2004). Milton Friedman and Anna Schwartz,Milton Friedman, and Anna J. Schwartz, The Great Contraction, 1929–1933 (Princeton, NJ: Princeton University Press, 1965). and Murray RothbardRothbard, America’s Great Depression. all place the blame for the Great Depression on the Federal Reserve, but for different reasons. Bernanke believes the problem was that the Federal Reserve failed to bail out systemically important banks in the 1930s. Friedman and Schwartz believe the problem was that the Fed failed to prevent a drop in the stock of money in the 1930s. Rothbard, using ABCT, found the cause to be the Fed’s expansionary monetary policy in the 1920s. These three theories will be reexamined later in the book.
The next major cluster of skyscraper records occurred in the early 1970s. Once again the economy was coming off a strong and sustained boom in economic activity during the 1960s. At the peak of the 1960s boom, construction workers in New York and Chicago were busy building the next group of the world’s tallest buildings. They would break records set back in the early days of the Great Depression. The World Trade Center was completed in 1972 and opened in April 1973. Both of the Twin Towers were 110 floors, with 1 World Trade Center at 1,368 feet in height and 2 World Trade Center at 1,362 feet in height. Then in Chicago, the Sears Tower was completed in 1974, which also had 110 floors but reached a height of 1,450 feet.
The economic downturn of early 1970 marked the beginning of a slump more than a decade long with the then-rare confluences of high rates of both inflation and unemployment. The breakdown of the Bretton Woods monetary system, abandoning the last vestiges of the gold standard, wage and price controls, gasoline shortages, and several recessions occurred between 1970 and 1982. There were several straight months in the early 1980s where unemployment was double digits and interest rates exceeded 15 percent. The US stock market declined in value between 1970 and 1982 by an inflation-adjusted 50 percent. The skyscraper curse for this period is known as the stagflation of the 1970s. This indicates that there was a general depression in the US economy between 1970 and 1982. The experience thoroughly discredited the then-dominant Keynesian school of economics, at least temporarily.
The next skyscraper cycle ushered in the 1997 Asian financial crisis and the dot-com bubble. The Pacific Rim countries, such as Hong Kong, Malaysia, Singapore, Vietnam, and South Korea, experienced significant economic growth during the 1980s and 1990s. Japan was the region’s leading economy, but it was in recession for much of the 1990s. Observers named the smaller regional economies the Asian Tigers. They were considered miracle economies because they were strong and durable despite being small and volatile. The bubble in East Asia was rooted in technology and export manufacturing, but it was fueled by an expansion of money and credit, much of it foreign money seeking high returns for “investors without borders.” This influx of foreign-investment money led to large increases in domestic money supplies and bank lending.
The Petronas Towers were completed in Kuala Lumpur, the capital of Malaysia, setting a new record for the world’s tallest building. They are only eighty-eight floors, but 1,483 feet in height, which breaks the old record by 33 feet. The two Petronas Towers were completed just months before the skyscraper curse hit in mid-1997. It marked the beginning of the extreme drop in Malaysia’s stock market and those around the region, rapid depreciation of local currencies, and even widespread social unrest. Financial and economic problems spread to economies throughout the region, a phenomenon known as the Asian contagion or, more generally, the Asian financial crisis. The ensuing credit crunch increased bankruptcies and created panic-like conditions.
At the same time, with increased US interest rates and a stronger dollar, the United States became a more attractive investment environment relative to East Asia. Starting in early 1996 this began to hurt Asian exports into the United States. These events essentially transferred the tech bubble from Asia to the United States and to a lesser extent Singapore and Taiwan, which were initially insulated from the crisis.
The next record breaker’s planning began in 1997. Construction began in 1999 on Taipei 101 in Taiwan City, the capital of the Republic of China (a.k.a. Taiwan). The 101-floor building set a new world record if you go by the height of livable space of 1,671 feet. This height surpassed the Petronas Towers, and Taipei 101 became the first skyscraper to exceed one-half of a kilometer. The roof was completed in June 2003, but we are not sure when the new record was set. However, its construction closely paralleled the dot-com ∕ tech bubble’s bursting. This was the first skyscraper cycle to occur in the developing world and the first in which one record, the Petronas Towers, was broken at the beginning of a crisis and the other, Taipei 101, was completed at the end of the crisis — that is, the dot-com ∕ tech bubble. A wild card here is the tech bubble, which was essentially transferred from the Asian-contagion countries to the United States and non-Asian-contagion countries, such as Taiwan and Korea. Taipei 101 is the first addition to the Skyscraper Index after Lawrence.Andrew Lawrence, “The Skyscraper Index: Faulty Towers!” Property Report, January 15, 1999.
The next world-record-breaking skyscraper was the Burj Dubai tower, which began construction in 2004 in Dubai, in the United Arab Emirates. At this time, it was clear to me that in the United States there was what would come to be called the housing bubble. The tower set a new record in the summer of 2007 just as the housing bubble ended and a financial crisis started to become apparent. The building opened to the public in January 2010 in the depths of the financial crisis, with Dubai bankrupt and needing a multibillion-dollar bailout from a neighboring emirate. The bailout resulted in the name of the building being changed from the Burj Dubai to the Burj Khalifa tower. This is another addition to the Skyscraper Index after Lawrence.Ibid.
These skyscraper cycles reliably contain common features. A cycle begins with a long period of easy money and credit. This leads to an expansion of the economy and a boom in the stock market. In particular, the relatively easy availability of credit fuels a substantial increase in capital expenditures. Capital expenditures start to flow in the direction of new technologies, which in turn create new industries and transform existing industries. This is when the world’s tallest buildings are begun. At some point afterward there is a necessary reversal. Many things could initiate the reversal. The reversal often gives the appearance of panic and mass psychological disorder, but people are being scared by real things such as not meeting profit expectations and projections, increases in interest rates, and problems with meeting sales projections, controlling costs, and retrieving accounts receivable. Finally, unemployment increases, particularly in capital- and technology-intensive industries. While this analysis concentrates on the US economy, the impact of these crises often has international implications.
The skyscraper has many of the characteristic features that play critical roles in various business cycle theories. These features make skyscrapers an important marker of the twentieth century’s business cycles, that is, the recurring pattern of entrepreneurial errors in a boom phase that are later revealed during a bust phase to be malinvestments.
It would be very easy to dismiss the Skyscraper Index as a predictor of the business cycle, just as indicators and indexes of other major entrepreneurial advances like canals, railroads, and factories were. The twentieth century skyscraper replaced the factories and railroads, just as the information and service sectors have replaced heavy industry and manufacturing as the prominent sectors of the present US economy.
It should not be surprising that the skyscraper, an important manifestation of the twentieth-century business cycle and indicator of modern global capitalism and commerce, will itself be replaced in the same way by an unknown new capital and technologically intensive investment in the future.
This chapter has demonstrated that Lawrence’s Skyscraper Index can be extended backward and forward in time and that the one instance where the Skyscraper Index was thought to have failed because the skyscraper curse failed to materialize has a perfectly logical explanation. Next we turn our attention to the question of what makes the Skyscraper Index work.
Daniel Lacalle joins Jeff Deist to discuss how and why central banks are trapped, stuck with ultra-low interest rates and expansionary policies that produce astonishingly little real growth. This is a hard-hitting and sober look at what rising interest rates will mean, why academics and bankers are so clueless about the monetary side of financial markets, and why Austrians need to offer real-world solutions instead of ideology.
Danielle DiMartino Booth worked at New York investment houses before joining the Dallas Bank of the Federal Reserve. Her years working with (relative) Fed Hawk Richard Fisher led to the publication of Fed Up: An Insider's Take on Why the Federal Reserve is Bad for America, a full-throated expose of how the Fed benefits elites at the expense of ordinary people. Recorded in Fort Worth, Texas, on 2 June 2018. Includes an introduction by Jeff Deist.
Nomi Prins is a Wall Street veteran and expert on central bank mischief. Her books All The President's Bankers and Collusion: How Central Bankers Rigged the World detail the cronyism and secret dealing of central banks, making the case against unchecked power in the hands of an elite class of bankers and their revolving-door clients at the Treasury and Fed. Recorded in Fort Worth, Texas, on 2 June 2018. Includes an introduction by Jeff Deist.
Jeff Deist welcomes guests to the Mises Circle in Fort Worth: "Will the American Economy Survive in 2018?" Recorded in Fort Worth, Texas, on 2 June 2018. Includes an introduction by Ryan Griggs.
Danielle Booth, a veteran of the Dallas Fed and author of Fed Up: An Insider's Take on Why the Federal Reserve is Bad for America, joins the show to consider whether—or if—the Fed can ever return to "normal" monetary policy. Raising interest rates might slow or even crash equity markets, while causing US debt service to spike. But leaving rates low keeps the US economy in zombie status, punishing savers and preventing bad debt and malinvestment from clearing. It's a no-win situation for new Fed Chair Jay Powell.
Nomi Prins previews her talk at our event in Ft. Worth this weekend, based on her new book Collusion: How Central Bankers Rigged the World—a damning indictment of how the Federal Reserve bullied other central banks and bailed out Wall Street in the wake of the 2008 financial crisis.
Join us in Texas this Saturday to meet Ms. Prins and receive an autographed copy of Collusion!
Hosted by the Mises Institute in Nashville, Tennessee, on 14 April 2018. Special thanks to an Anonymous Donor for making this event possible.
Hosted by the Mises Institute in Nashville, Tennessee, on 14 April 2018. Includes an introduction by Jeff Deist. Special thanks to an Anonymous Donor for making this event possible.
At last month's Austrian Economics Research Conference, we were honored to be joined by Kevin Dowd, an Emeritus Professor of Economics at Nottingham University. Dowd presented a blistering critique of modern central bankers and their mania for monetary stimulus. In this excerpt from his talk, he explains how policies like negative interest rates not only reflect bad economic thinking, but also pose a danger to the civil liberties. What will the Fed and European Central Bank do next, if ersatz economic growth cools in a period of rising interest rates? Don't miss this masterful explanation of how central banks destabilize and distort every aspect of the economy.
With stock markets in turmoil earlier this week, the Mises Institute's resident expert on booms and busts joins Jeff Deist to make sense of it. Will new Fed Chair Jerome Powell do everything possible to prop up markets, or will he be more hawkish than Janet Yellen? What kinds of indicators does Mark look for to predict trouble (hint: it's not the VIX). Why does the volume of margin loans matter, and why is the Russell 2000 Index a better predictor than the Dow or Nasdaq? Are cryptocurrencies now bound up with macro trends? And is Austrian business cycle theory necessarily incomplete as a tool to help investors?
See Mark Thornton's 2004 article "Housing: Too Good to be True".
Narrated by Jim Vann. Published in 1982, this is Ron Paul's revolutionary book on monetary reform.
The Case for Gold covers the history of gold in the United States, explains that its breakdown was caused by governments, and explains the merit of having sound money: prices reflect market realities, government stays in check, and the people retain their freedom.
Narrated by Jim Vann.
Download the complete audio book (11 MP3 files) in one ZIP file here. This audiobook is also available on Soundcloud, Google Podcasts, and via RSS.
Narrated by Jim Vann. Published in 1982, this is Ron Paul's revolutionary book on monetary reform.
Narrated by Jim Vann. Published in 1982, this is Ron Paul's revolutionary book on monetary reform.
Narrated by Jim Vann. Published in 1982, this is Ron Paul's revolutionary book on monetary reform.
Narrated by Jim Vann. Published in 1982, this is Ron Paul's revolutionary book on monetary reform.
Narrated by Jim Vann. Published in 1982, this is Ron Paul's revolutionary book on monetary reform.
Narrated by Jim Vann. Published in 1982, this is Ron Paul's revolutionary book on monetary reform.
Narrated by Jim Vann. Published in 1982, this is Ron Paul's revolutionary book on monetary reform.
Narrated by Jim Vann. Published in 1982, this is Ron Paul's revolutionary book on monetary reform.
Quarterly Journal of Austrian Economics 20, no. 2 (Summer 2017)Sebastian Mallaby is the Paul A. Volcker Senior Fellow for International Economic Relations at the Council on Foreign Relations. One can be sure, then, that his new comprehensive book, The Man Who Knew: The Life and Times of Alan Greenspan, reflects an Establishment point of view. As if this were not enough to tell us where the book is coming from, Mallaby informs us that he had Greenspan’s full cooperation in writing it. “This book is based on almost unlimited access to Alan Greenspan, his papers, and his colleagues and friends, all of whom were generous in their collaboration.”
Professor Lucas Engelhardt, a popular lecturer at Mises University, joins Jeff Deist to discuss the monetary policy landscape. Janet Yellen makes jokes about $20 trillion in federal debt, but what about the trillions the Fed added to its own balance sheet since the Crash of '08? What will happen to the extraordinary amount of bank reserves parked in no-man's land, not being lent by banks? Can Mises's work help us understand what happens when the supply of money increases much faster than demand for it? How does new money and credit flow into the economy unevenly, benefiting those closest to the government and central bank troughs? And is there an ugly endgame scenario, where rapid asset price inflation (i.e. equity and real estate markets) devolves into rapid consumer price inflation?
THE AUSTRIAN: As Austrians, we’re often noting that we seek to explain and describe economic cycles, and not necessarily predict what’s going to happen next week. So, how would you describe and explain the state of the economy right now?
MARK THORNTON: That is right. Austrian economics enlightens you about what will happen but not when and how much. Right now all the headline numbers are very good. The unemployment rate and the consumer price index (to the extent that you can believe them), along with the stock market all look remarkably well. However, we have had nearly nine years of historically low interest rates and that signals trouble ahead.
Not surprisingly, as a result of Fed policy, total household debt (mortgages, credit cards, auto and student loans) is fast approaching a record-breaking $13 trillion. Investment in real estate and elsewhere is also at or close to bubble levels. There has been an enormous transfer of wealth from the middle class to the very wealthy as well. So, all the facts seem to line up with the Austrian business cycle theory.
TA: How do you think the economists at the Fed view things? Do they have an endgame in mind, or are they just trying to weather each crisis as it comes up?
MT: There are the public statements that Fed officials make to increase, or at least maintain consumer and investor confidence. They have a “confidence game” approach. Retired Fed officials have admitted that they cannot make public forecasts of recessions. According to the Fed the economy only gets better over time and we are never headed into a recession.
Of course they would like to normalize interest rates and their balance sheet, but they know that would create enormous problems. For example, the Fed’s monetary policy has created an enormous number of zombie companies, so if interest rates and expenses increase, then these companies would be forced to restructure and lay off workers. They continue to talk of “green shoots,” “normalizing interest rates,” and “selling off the balance sheet,” but they have not achieved any of this yet. Don’t hold your breath.
TA: At this point, we’ve literally been hearing from the Fed since 2009 that they’ll be normalizing monetary policy any day now. What do you think is the biggest reason that they’ve been so afraid to normalize? In other words, why hasn’t the current recovery been enough for them?
MT: When you look below the headline numbers, you see problems. I mentioned the zombie companies above. If interest rates go up they will start to show bigger losses. The auto industry has used low rates and subprime auto loans to sell cars. Now the manufacturers see growing inventories at all time high levels. Auto lenders have also hit an all time high in terms of the average length of loans, now close to six years. Auto dealers are bombarding the airwaves with deep discounts and zero financing. Throw in higher interest rates and the implications for manufacturers, employees, and consumers are all very negative. There are similar scenarios throughout the economy.
Also, dependency on government and private welfare is at a very high level in America, so is economic fragility in terms of employment and savings. The Fed knows all this and is therefore very leery of igniting a recession.
TA: If you look for them, it’s always easy enough to find perma-bears saying somewhere that the economy is about to crash. We’ve been hearing that for years, but things continue along fairly evenly, even if weakly. Our sense, though, is that the Fed seems more concerned now than before, and that maybe they’re backed in a corner. Is this just our imagination?
MT: No it’s not your imagination. This cycle is different because of all the unorthodox and unprecedented monetary policy. I was bearish going into the financial crisis, but the economy got hammered with QE and then again with QE2. I thought a zero federal funds rate was as far as they would go and that they would normalize their policy as past Fed leadership had done. So that was a big surprise. I consider the Fed’s policy to be irresponsible because of what it has done to the American people and to the structure of the American economy. In addition, their interest rate policies have allowed Congress to double the national debt (in absolute terms and as a percentage of GDP) in a very short time. A doubling of interest rates would now cause interest payments by the federal government to roughly double from $500 billion to $1 trillion.
TA: 2017 is nearly over. Have there been any big surprises for you in terms of central banks this year, or have things proceeded much like you thought they would?
MT: Things have proceeded pretty much like I thought they would. Central banks do not like surprises, except the positive surprises of printing more money and reducing interest rates such as QE and QE2. They try to manage expectations. They claim one more rate hike in 2017 (probably in December) and three more in 2018. That is when things should start to get interesting whether they hike rates or not.
The story I am watching from my vantage point in Auburn, Alabama, is the expansion of capacity in terms of commercial and retail space and apartments. Some of it has already come online while more is under construction. All this new capacity means more debt, but will it also result in lower prices and profits? Auburn University has also undergone a mega building program in recent years. The City of Auburn is also building and upgrading infrastructure, schools, parking, and city hall. We have never seen anything like it.
Of course I am also watching the construction of the Jeddah Tower in Saudi Arabia. It is planned to be built to a new record height and according to the Skyscraper Index could bring about a “Skyscraper Curse” or economic crisis in the near future.
TA: You stated above that the bubble economy has transferred wealth from the middle class to the wealthy. This reminds us that bubbles affect different groups differently. When the bubble finally bursts, which groups stand to lose out the most and why?
MT: The general pattern is that capitalists gain from cheap credit and labor is hurt by price inflation on the upside of the cycle. On the downside capitalists and the wealthy lose the most as asset values, like stock prices, collapse, while labor is relatively better off from lower price inflation or even deflation, e.g., lower home prices. This past cycle was different because of the bailout of the wealthy (which helped cause Donald Trump to be president). Those bailouts could happen again, but those bailouts distort the correction process which requires a complete adjustment of relative prices.
Mark Thornton is a Senior Fellow at the Mises Institute and the book review editor of the Quarterly Journal of Austrian Economics. He has authored seven books and is a frequent guest on national radio shows.
In the eyes of many people, the Federal Reserve (Fed) is an indispensable institution. We are told it supports growth and employment, fends off the negative shocks, and fights inflation. Nothing could be farther from the truth. The Fed’s fiat money regime is economically and socially highly destructive — causing far-reaching societal and political consequences that extend beyond what most people would imagine.
Fiat money is inflationary, it debases the purchasing power of money; it benefits a few at the expense of the many; it causes boom-and-bust cycles that hurt many people economically; it makes people run into too much debt, leading to over-indebtedness; it corrupts society’s morals; it makes government grow at the expense of individual liberty; it encourages the state’s aggressiveness and fuels its war machine.
Tragically, however, people consider falsely the Fed as their “knight in shining armor” coming to their rescue in times of trouble rather than what the institution really is: the very source of economic and societal grievance. People do not blame the Fed for the trouble it causes, but instead welcome Fed action for overcoming the damage it has caused in the first place. That is why many people keep their fingers crossed that the Fed’s latest “exit plan” will succeed.
The Fed’s Exit PlanIn the course of the financial and economic crisis of 2008–2009, the Fed lowered interest rates to basically zero. It also increased its balance sheet from $879.4 billion at the end of 2007 to $4.5 trillion in September 2017. It did this by purchasing US Treasuries and agency mortgage-backed securities (MBS) in the amount of $2.4 trillion and $1.7 trillion, respectively, thereby having injected additional ‘base money’ into the US banking system.
Recently, the Fed has changed course. It has raised its target interest rate from near-zero to a still-tiny rate slightly above 1 percent. What is more, the Fed has decided to start shrinking its balance sheet beginning in October 2017 by gradually reducing the reinvestment of principal payments from its security holdings. Specifically, it will reinvest each month’s principal payments only to the extent that such payments exceed gradually rising caps.
The cap will be set at $10 billion per month in October 2017 and stepped up each quarter, reaching a maximum of $50 billion per month a year later. This will bring the Fed’s balance sheet of US dollars down by an estimated $1.7 trillion to $2.8 trillion at the end of 2020 — which would still be $1.9 trillion above its pre-crisis level seen at the end of 2007.
The Fed’s exit plan has spooked some investors.
It is feared that the Fed’s draining of liquidity from the banking sector could result in an overly restrictive effect on credit markets. This, in turn, could push borrowing costs upward, sending the economy — and financial markets in particular — down, even potentially paving the way toward a new full-blown crisis. So what is to be made of the Fed’s plan to unwind its balance sheet in the years to come?
Reducing the Money Supply Could Lead to a BustThe Fed’s envisaged reduction in reinvesting maturing bonds in its portfolio will affect the quantity of credit and money.
The Fed, however, is proceeding with extreme caution, afraid that any sizable change would cause the interbank interest rate to spike and bring down the entire economy and financial system.
In practice, the Fed will thus have to keep sitting on a significant part of its bond holdings and buy new bonds once they mature. A true and final exit from the Fed’s active role in the credit market — and thus an end to long-term interest rate manipulation — is therefore nowhere in the near future.
Whether or not the Fed’s plan will actually result in a contraction in the quantity of money will depend on two conditions: The banking sector’s willingness and ability to expand its balance sheet and investor appetite for agency MBS (or other credit products).
The Safety NetTo make the unwinding of (part of ) its securities holdings run smoothly, it should be clear that the Fed has to continue to cater to the needs of banks and fixed income investors. Perhaps most importantly, the Fed will have to hold up its ‘safety net’ — a tacit promise that operates already in the shadows: to stand ready at any time to prop up the economy and financial markets from collapsing.
This is, in fact, exactly what investors have learned from the last crisis: the Fed, in its determination to keep the fiat money regime going, has made all too clear that it is willing, and has the capacity, to take recourse to manipulative policies (in the form of suppressing interest rates) and raising inflation (that is expanding the quantity of money through credit expansion) to keep the economy afloat and prop up financial market prices.
If and when investors remain confident that the Fed’s safety net remains in place whatever comes, the (partial) winding down of the Fed’s bloated balance sheet is unlikely to cause disruptions in the smooth functioning of financial markets and the continuation of the monetary policy induced expansion of the economy. The truly critical factor in all this is, however, the level of market interest rates.
The Great DistortionFor the latest economic recovery has been, first and foremost, fueled by artificially low interest rates. Exceptionally low borrowing costs have encouraged firms to invest more, private households to consume more, and the public sector to spend more — and so growth seems to have returned. If interest rates rise, however, the monetary policy induced economic upswing (“boom”) will come to a shrieking halt, most likely to fall back into recession (“bust”).
But not only is the continuation of the Fed’s low interest rate policy required to keep the current boom going. By no means less important is the corollary of the Fed’s safety net. For it has created among investors the illusion of stability, encouraging investors to lose sight of unavoidable uncertainties and vagaries of real life; it has put to rest investor default concern, thereby artificially reducing credit premia and lowering borrowing costs.
It is fair to say that the economy and financial markets in particular have become, more than ever before, dependent on the Fed’s monetary machination: By having distorted interest rates and prices on the grandest scale, the Fed has actually established a “hall of mirrors”: a mirage of returning economic and financial prosperity. Nor will the Fed’s destructive policy be ended by the planned unwinding of its balance sheet.
Rather than look to the Fed for the solutions, a more practical and honest approach is to demystify the Fed’s damaging effect on the economy sooner rather than later.
The material liberation has liberated our spirits and has allowed us to live more fulfilling lives than before. So, I don’t want to hear the “money can’t give you happiness” thing. If this doesn’t make you happy — that people are free to do these things and pursue things they love — then there ain’t no satisfying you.
Thorsten Polleit is chief economist of Degussa and macro-economic advisor to the P&R REAL VALUE fund. He is honorary professor at the University of Bayreuth a nd an Associated Scholar of the Mises Institute.
The biggest winner of the Trump presidency is also the most surprising: Federal Reserve Chairman Janet Yellen.
After all, Yellen was a constant target for criticism by Candidate Trump, going so far as to accuse her of being “more political than Hillary Clinton.” Beyond Mr. Trump’s barbed rhetoric, pundits such as Paul Krugman predicted that Trump’s ascendency would be disastrous for the US economy and the stock market in general, which would have wiped out the modest recovery that Yellen’s legacy depends on.
Almost a year after Trump’s election, the world looks quite different. Not only has Wall Street toasted the Donald’s victory, but the president continues to keep open the possibility of re-nominating Janet Yellen for a second term. Of course, given Trump’s surprisingly strong understanding of how current Fed-policy was a positive for the administration, perhaps this reversal should have been as predictable as Paul Krugman being wrong.
For Yellen, more important than Trump’s willingness to compliment her performance is what his presidency has done for the reputation of the Fed. Prior to this year, the Fed had been constantly forced to backtrack on planned interest rate hikes and downplay talk of balance sheet normalization due to economic stagnation.
For example, in 2016 the Fed was only able to hit one of its projected four interest rate hikes during the year, and that one came after the market surged following Trump’s election. Still, many traders were skeptical of the Fed’s forecast of three interest rate hikes. Earlier in the year, Yellen was even forced to admit that forward guidance, a communication tool that was favored by Ben Bernanke, no longer worked because people simply stopped taking the Fed’s projections seriously.
2017 has been a better one for those in the Eccles Building. The Fed is on schedule with its rate hikes and feels comfortable enough following through on its plans to slowly — very, very slowly — unravel its balance sheets that ballooned from various rounds of quantitative easing. While we are still years away from anything resembling normal pre-crisis monetary policy, at least the Fed has been able to make the appearance of trying to get there for the first time since 2008.
Why the change?
Well in spite of the Trump administration’s public frustrations in achieving legislative victories, it has seen success at one of the stated goals of former strategist Steve Bannon: the (partial) deconstruction of the administrative state.
As the Completive Enterprise Institute reported earlier this month, the Federal Register is at 45,678 pages — less than half of the 97,110 pages that existed during the Obama administration. While that is still an extraordinary amount of government red tape (the equivalent of over 50 copies of Human Action), it is a significant step in unraveling one of the most underreported disasters of Barack Obama’s tenure in DC. Further, executive orders made during Trump’s first weeks in office required agencies to eliminate rules prior to writing new ones, which has helped stymie the rate in which new rules are being written.
Not only has this led to saving tens of billions in regulatory compliance cost, but — coupled with continued hope for tax reform — it has been a major boon to business confidence. IECONOMICS finds business confidence at the highest it's been in 10 years.
Data: United States Business Confidence provided by IECONOMICS Meanwhile, NFIB has finally found recovery from post-crisis lows.
Data: NFIB Small Business Trends Survey, September In short, Trump hasn’t needed Congress to do some real good for economic activity — he just needed to not govern like Barack Obama.
The results from this renewed optimism in America’s economic landscape has been increased investment and employment — which have been routinely referenced by the Fed this year while announcing their policy decisions, over the objections of Minneapolis Fed Chair Neel Kashkari and other more dovish critics.
To their credit, in spite of their toxic advocacy for even easier-monetary policy, there is substance in Kashkari’s criticism. In spite of increased business confidence — itself partially grounded on inadequate tax reform that quite possibly may not come to fruition — wages outside of the financial sector and technology still lag — in no small part due to consequences of the very monetary policy hyper-doves are advocating. Meanwhile, while reduction of the regulatory code is a very important step, nothing has been done to address other systemic issues, such as Washington’s complete inability to curb its hedonistic addiction to debt — that too being subsidized by the Federal Reserve’s own policies. Not to mention the ever looming threat of a trade war being just a tweet away. And, of course, these gains have all been assisted directly by the Fed's accommodative monetary policy — a bubble is still a bubble, even if the resulting boom is a historically modest one.
In spite of these very real dangers to the US economy, it’s understandable why the economy is second only to his IQ in topics he enjoys bragging about. As such, with reports swirling that he will soon be making an announcement about next year’s Fed chair, it wouldn’t be surprising to see Trump maintain the status quo and re-nominate Janet Yellen. After all, it's one thing to attack the swamp from the outside, but quite another when you're in charge. Trump's campaign rhetoric made it clear that he understands what will happen when the Fed truly changes course, he's not going to want to be there when that "big fat bubble" pops.
Federal Reserve Chair Janet Yellen announced the bank would begin selling assets it has relentlessly bought since the Crash of '08. The financial press, including the Wall Street Journal, dutifully praised Yellen for her steady hand. But our guest Dr. Mark Thornton has a different take on what it all means for stock markets, investors, and the US economy. Can quantitative easing—a roundabout form of monetizing debt—actually work? Can monetary policy make us rich? Or, are Fed officials just groping in the dark, putting off a day of reckoning? Jeff Deist and Mark Thornton unwind the narrative.
Today the Federal Reserve announced that it will finally begin the process of reversing quantitative easing. Following the process it outlined earlier this year, the Fed will start allowing assets (Treasurys and mortgage-backed securities) to mature off its balance sheet, rather than re-investing them as had been its prior policy. The current plan is to start with a $10 billion roll off in October, and increasing quarterly until it reaches $50 billion by October of next year. Considering the Fed’s balance sheet currently stands at $4.5 trillion, the Fed is envisioning a slow, multi-year process. As Philadelphia Fed president Patrick Harker described it earlier this year, the goal is for it to be “the policy equivalent of watching paint dry.”
Of course the old saying about the “best laid plans of mice and men” also applies to central planners, and as Janet Yellen once again noted today, “policy is not on a pre-set course.” Should markets react negatively, as they did when Bernanke hinted at reducing their purchases in 2013, the markets have reason to expect the Fed to act. In fact, when asked, Yellen kept the door open to both lowering interest rates and stalling its roll off should market conditions worsen. In fact, it appears that markets are already betting on the Fed to not follow through on its projected December rate hike.
As the Fed has been signaling for months now that a taper was in the works, the mainstream narrative suggests that tapering has been priced in (though stocks dropped on the news.) There are still major questions left unanswered.
One of the biggest questions going forward is who will step up to replace the Fed’s purchasing power in the US Securities market? In the past, the US has been able to count on China to purchase US debt. Even before the Trump administration threatened the country with sanctions, China was selling off Treasurys in order to help prop up its struggling economy. With other nations also backing off from US debt, the hope is that investors will fill the gap. While the continued actions of the ECB, BOJ, and other central banks may make US debt more attractive in comparison, increased investments in bonds is likely to come at the expense of other assets.
Of course the noise of the Fed’s actions only serves to distract from the real issue, which is the continuing economic stagnation of the US economy. While Yellen continues to boast about modest employment gains, full-time employment remains lower than it was prior to the recession. Meanwhile, American’s personal debt has reached record highs — following the example of their government. How much of these gains are being fueled by credit and the false prosperity of inflated stocks and other assets? We’ll see.
For what it’s worth, the Fed itself — which is regularly overly-optimistic — doesn’t seem to have much faith in the future. It is now projecting long-term growth below 2%.
Fed vice-chair Stanley Fischer’s surprise announcement of early retirement triggers the obvious question as to whether this could be the fore-runner to a serious market and economic deterioration ahead. Monetary bureaucrats, even if signally bad at counter-cyclical fine tuning, sometimes have a reputation for intuition about how to time their own career moves ahead of crisis. In this case, such suspicion may be wide of the mark given the personal circumstances. Even so, the exit of a Fed Vice-Chair, who in many respects has been the pioneer and the dean of the prevailing doctrine in the global central bankers club, is pause for thought.
The Early Years When Professor Fischer published his famous paper “On Activist Monetary Policy with Rational Expectations” (NBER working paper no. 341, April 1979), the fiat money world was well into the third stage of disorder following the collapse of the international gold standard in 1914. But things were at a temporary resting point where the skies seemed to be getting clearer. After the violent terminal storms of the gold exchange standard (early 20s to early 30s), and then of the Bretton Woods System, it seemed to many that the “monetarist revolutionaries” had found a better practical monetary navigation route. The Bundesbank, the Federal Reserve, the Swiss National Bank, and even the Bank of Japan were pursuing an ersatz gold rule of low percentage increases in the monetary base or a related aggregate.
Fischer vs. the Monetarists Despite the optimism at large, Fischer issued a challenge. The monetarist rules (x per cent growth of the chosen monetary aggregate) were doomed to fail when the underlying demand for money and monetary base in particular was so unstable.
Fischer rejected the new popular view (in the late 1970s) of the fashionable “classical economists” (for example Robert Barro) who argued that under market rationality monetary policy was powerless to influence the real economy. All the various trade-offs hypothesized by the Keynesian economists of the previous decade and pursued in part had been based on a view that central bankers could take the public by surprise (who would not realize what they were “up to” until later on). But once the public knew all Keynesian manipulations could not be effective.
In contrast, Fischer purported to demonstrate that if wages were rigid (most likely due to the existence of long-term contracts), then even given rational expectations, monetary policy could stimulate the real economy.
And so Professor Fischer, on the basis of his pioneering neo-Keynesian creed, preached that, yes, central bankers could and should pursue activist contra-cyclical strategies, especially when shocks were large and obvious. But yes, he also recognized that fine-tuning had its dangers and could morph into a long-run rising inflation rate, and so he recommended that policy be bound by the setting of a low inflation target. These ideas were in turn taken up and worked on by leading disciples (students) of Stanley Fischer, including Ben Bernanke and Mario Draghi.
The Birth of the 2% Inflation Standard And so the fourth stage of fiat money disorder was born — what we may describe as the “global 2% inflation standard”. The prior monetarist experiments faded away in the decade following publication of Fischer’s paper (Paul Volcker abandoned monetarism by 1982, and the Bundesbank was the last hold-out in the year before the launch of the euro). At a stretch we could call this fourth stage the “Fischerian age of monetary policy”. Even though its author is now retiring, the outlook is for this stage to move eventually into a much more vicious sub-stage in which inflation rises far above the levels which the central bankers are purporting to target and the forces of rationality greeted by the classical revivalists have been completely trumped by powerful irrational forces which typify asset price inflation..
And all of this does not depend on who exactly President Trump decides to nominate in Fischer’s and Yellen’s place in coming months, even though there are reasons to speculate that the choice is likely to be pro-3% growth with the near-term target of avoiding defeat in next year’s mid-term elections. The bigger issue is that the so-called 2% inflation target belongs to a collection of fables under the title of the Emperor’s New Clothes. In today’s monetary environment where monetary base has been totally dislocated from the pivot of the monetary system (e.g., there's no stable demand, distinctive qualities of base money are virtually eradicated, and both supply and demand are boated by QE) there is no basis – other than expectation inertia – to view prices of goods and services as anchored.
At the best of times no one knew the precise relationship between monetary aggregates and prices — and indeed under the gold standard or monetarism no one pretended to have the price path under control; at best money was under control and that should foster some long-run tendency for prices to return to the mean, but there was no assurance of this. Strikingly the “Fischerians” have lost all sight of the natural rhythm of prices as responding to fluctuations in the pace of globalization, productivity growth, and of course the business cycle.
There is every reason to believe that expectation inertia will snap at some point in the future. And the root combination of monetary disorder — a Federal budget deficit of 4-5-6% of GDP at a cyclical peak, a Federal Reserve determined to hold down rates and manage the government bond markets, an administration favoring a weak dollar — there are grounds for fearing a lurch of the monetary train towards high inflation, albeit possibly beyond the next business cycle trough. And all of that despite the pride of Stanley Fischer in his resignation letter to President Trump:
During my time on the Board, the economy has continued to strengthen, providing millions of additional jobs for working Americans. Informed by the lessons of the recent financial ciris, we have buildt upon earlier steps to make the financial system stronger and more resilient and better able to provide the credit so vital to the prosperity of our country’s households and businesses.
Power corrupts, and Washington corrupts absolutely. How can anyone pretend to have learnt the lessons and achieved the results until at least one long business cycle under the given monetary regime has been completed? Only then can all the mal-investment be counted and the financial quake or hurricane damage assessed.
Fed Vice Chair and Yellen ally Stanely Fischer announced his unexpected resignation today, citing “personal reasons.” His term as a Fed governor wasn’t to be over until 2020 and his vice chairmanship was to end June of next year.
Fischer was one of the three most important Fed members, the other two being Yellen herself and the New York Fed’s William Dudley. The WSJ reports:
Mr. Fischer came to the Fed in 2014 a luminary in central banking, having taught many leading policy makers during a more-than two decade career as a professor at the Massachusetts Institute of Technology specializing in international economics. His students included European Central Bank President Mario Draghi and former Fed Chairman Ben Bernanke.
Mr. Fischer also ran a central bank—the Bank of Israel—from 2005 to 2013, held a senior post at the International Monetary Fund and served as a Citigroup vice chairman.
In terms of the insider status of these central bankers, Mr. Fischer was “Mr. Establishment.” Well educated in the machinations of how to control an economy from the top, Fischer was an expert bureaucrat. On paper, Fischer was among the most qualified in the world to be tasked with impossible role of making us more prosperous by diktat.
In reality, Fischer, to the extent he had a marked influence on central bankers like Draghi, Bernanke, Yellen, and so many others, was a key player in the boom-and-bust system of modern monetary economics. Under his watch, we had two major and devastating recessions— the cause of which was not Fischer’s failure individually, but the inflationary framework that pervades them all.
Fischer was considered to have leaned “hawkish” by the financial press. In the old days of Paul Volcker, a hawk was one wary of dangers of rising inflation. This was juxtaposed to a dove, who would downplay the dangers of inflation and advise greater monetary expansion. But in the post-crisis era of the so-called “new normal,” where interest rates are to remain absurdly low and inflation must be targeted at 2%, the hawks have long gone extinct. Fischer was no hawk, he was a cheerleader of the quadrupling of the Fed’s balance sheet, an advocate of unprecedented credit creation, and a hater of sound money.
It remains to be seen where Fischer will go next. But his undying advocacy of the use of central banking to tinker with and manage the economy will live on.
See also:
"The Fed Wants to Test Drive Negative Interest Rates" by Joseph Salerno "Stanley Fischer's Eureka Moment" by C.Jay Engel
And then there were three.
Today Stanley Fischer submitted his letter of resignation from the Federal Reserve’s Board of Governors, effective next month, the second such resignation of Donald Trump’s presidency. While Fischer’s term as Vice Chairman of the Fed was set to end next year, he had the ability to serve as a governor through 2020. Along with Trump’s decision next year on whether to replace Janet Yellen as the Fed’s chair, this means Trumps will have the opportunity to appoint five of seven governors to America’s central bank.
Given that the position holds a 14-year term, it is unusual for a president to have the opportunity to make so many appointments. As Diane Swonk of DS Economics noted, “It’s the largest potential regime change in the leadership of the Fed since 1936.”
Of course the question is now whether a change in personnel will lead to a change in policy.
Trump has already taken steps to fill one of the vacancies, nominating Randal Quarles earlier this year. Quarles, a former Bush-era Treasury official turned investment banker, will be taking the specific role of Fed vice chair of supervision. As a vocal critic of Dodd-Frank, and the Volker Rule in particular, Quarles may help relieve some of the regulatory burden on financial institutions, but his views on monetary policy are less clear. He has also voiced his support for rules-based monetary policy, though he has distanced himself to the specific proposal of the “Taylor Rule.” Given the growing consensus building for NGDP-targeting, and Republicans in Congress advocating for rules-based Fed reform, Quarles could become a supporter from within the central bank. All in all though, Quarles is seen by many observes as a bland Fed-appointment.
More concerning are the views of Marvin Goodfriend, who has been reported to be a front runner for one of the Fed vacancies. An economics professor at Carnegie Mellon University and former director of research at the Richmond Fed, Goodfriend has a traditional central banker background and the dangers that comes with it. In 2016, Goodfriend made an impassioned plea for the Fed to consider negative-interest rates:
The zero interest bound is an encumbrance on monetary policy to be removed, much as the gold standard and the fixed foreign exchange rate encumbrances were removed, to free the price level from the destabilizing influence of a relative price over which monetary policy has little control—in this case, so movements in the intertemporal terms of trade can be reflected fully in interest rate policy to stabilize employment and inflation over the business cycle.
Since negative interest rates usually coincide with greater use of cash (and personal vaults), Goodfriend went so far as to suggest the Fed should consider devaluing the value of printed bank notes. A $10 bill would buy less than a $10 debit card transaction, opening up a new front in the ongoing war on cash.
Given his radical views on monetary policy, it’s not hyperbole to suggest that Goodfriend’s nomination would represent a genuine danger to the economic wellbeing of every American citizen – or at least those outside of the financial services industry.
Unfortunately, even if Goodfriend doesn’t get the nod, it’s unlikely Trump will nominate anyone who understands the negative consequences of our artificially low interest rate environment. Though Candidate Trump demonstrated remarkable savvy when it came to how the actions of Bernanke and Yellen hurt Americans, as President Trump he has consistently indicated a desire to keep the “big fat bubble” going. Such a desire obviously fits the self-interest of the White House, but with long-term consequences for the base that elected him.
The only hope for a change in direction from the Administration is for Trump to stop listening to his Goldman Guys and instead lean on the team that helped get him to the White House. As Tommy Behkne noted last November, Trump had managed to surround himself with a number of Fed skeptics during his campaign, and even considered Austrian-friendly John Allison for Treasury Secretary.
Given the historic opportunity he has with the Fed, if Trump chooses to return to those roots, he could do severe damage to the swamp — all without passing a single piece of legislation through Congress.
The Federal Reserve tries and tries and just can’t muster up some price-tag ripping price inflation. Blowing up its balance sheet from $900 billion to $4.5 trillion would have seemed to send us to Zimbabwe, but no, prices just won’t cooperate with the monetary masterminds toiling away in the Eccles Building.
MarketWatch’s Caroline Baum says Fed Chairs used to call these things conundrums. However, “Conundrums are a thing of the past. Nowadays, Fed Chairwoman Janet Yellen has an explanation — an excuse, really — for almost anything, from the atypical behavior of asset prices to inconsistencies in economic relationships,” writes Baum.
We’re told by President Trump that we’re at full employment, yet prices (the way the Fed measures them anyway) can’t get to the 2 percent increase level Yellen et. al. considers nirvana.
Baum writes that the Fed called price changes “transitory” then they were “definitional challenges” followed by “idiosyncratic factors,” such as “a precipitous drop in the price of wireless telecommunications services this year.”
It’s in all the economic textbooks: Nothing stops inflation like a drop in cell phone fees.
This summer, private economists are pointing to drops in hotel rates as depressing CPI and whatnot. However, Ms. Baum knows, “Inflation is a monetary phenomenon. When the Fed expands its balance sheet through asset purchases, it has no control over where that newly created money will go: toward the purchase of goods and services; or into financial assets, such as stocks, junk bonds or housing.”
She continues, “The Fed’s asset purchases lower risk-free Treasury rates, encouraging investors to reach for yield and buy riskier assets.
“Because asset prices aren’t part of official inflation measures, and because identifying an asset bubble is beyond their scope, central bankers eschew using monetary policy to respond to them.”
The Fed is not alone in its bubble enabling. A Bloomberg Businessweek headline screams, “Even the Junkiest Sovereign Debt Now Pays Less Than 6%.” with the subtitle naming the culprit, “Central bank buying has distorted the market and reduced yields on the lowest-rated debt.”
It’s not just those cranky Austrians calling central bankers on the carpet for their monetary mischief these days. Everyone knows, is holding their breath, and hoping for the best.
Natasha Doff explains,
The junkiest emerging-market bonds yield less now than U.S. Treasury bills did as recently as 1999. Yields on state debt of Mongolia, Ukraine and Belarus -- at seven levels below investment grade, among the world's lowest ranked -- have dropped under 6 percent in the past two months.
It is as Ms. Baum writes, “Asset prices are a symptom; excessive credit growth is the cause.”
William White wrote in a 2009 paper that bubble episodes have the following in common: leverage, speculation and declining credit standards.
For instance money losing Tesla looked to sell $1.5 billion of junk bond debt and ended up selling $1.8 billion because the demand was so high for it's B- rated paper.
"I won't call it a bubble," said Andrew Feltus, co-head of high yield and bank loans at Amundi Pioneer Asset Management in Boston told Reuters. "The (market) fundamentals are pretty good."
Some would disagree. According to ValueWalk, “Tesla, Inc. is an over-hyped, lousy company, from a financial perspective, that is destined to go bankrupt.”
Famed Short-seller Jim Chanos said last year the announced $2.6 billion merger with SolarCity Corp. will make Tesla Motors Inc. a "walking insolvency."
A “walking insolvency” can borrow more than it wants at 5.3%; now that’s a conundrum.
Douglas French is former president of the Mises Institute, author of Early Speculative Bubbles & Increases in the Money Supply, and author of Walk Away: The Rise and Fall of the Home-Ownership Myth.
The Power and Independence of the Federal ReservePeter Conti-BrownPrinceton University Press, 2016xiv + 347 pages
Peter Conti-Brown, a legal historian who teaches at the Wharton School, would sharply dissent from Ron Paul’s wish to End the Fed. He never cites Mises or Rothbard, and the only Austrian work that he mentions, hidden away in an endnote, is Vera Smith’s The Rationale of Central Banking and the Free Banking Alternative. Nevertheless, Austrians will find Conti-Brown’s book of great value. He has, with considerable scholarship, exposed many grave problems with the Fed in a way that strengthens and supports the anti-Fed case.
The paramount concern of Austrian criticism of the Fed has been the vital role of that organization in expanding the money supply. Doing this, as the Austrian theory of the business cycle explains, drives the money rate of interest below the “natural” rate, primarily determined by people’s rate of time preference. This leads to an artificial boom and eventually proves unsustainable, resulting in a depression. Murray Rothbard classically applied this analysis in America’s Great Depression (1963), which emphasized the expansionary monetary policy of the 1920s, pursued by the Fed at the behest of Benjamin Strong, the Governor of the Federal Reserve Bank of New York, in causing the 1929 crash.
Conti-Brown tells us that this view of the Fed’s role in the 1920s was shared by none other than Herbert Hoover, who figures in Rothbard’s book as a principal villain for his futile interventionist efforts to cope with the depression. Hoover “blamed the Fed generally (and the New York Fed in particular) for causing the Great Depression. This orgy [of speculation] was not a consequence of my administrative policies, he wrote, but of the ‘mediocrities’ at the Fed” (p. 24). “Hoover further complained that the Fed (under Benjamin Strong) turned American optimism into ‘the stock-exchange Mississippi Bubble’ ” (p. 283, note 19).
The Fed continued its expansionary course during the 1930s, and here the influence of the banker Marriner Eccles was paramount. Eccles shaped the modern Fed through proposals that Congress enacted in the Banking Act of 1935, which “abolished the Federal Reserve Board created in 1913 and replaced it with the Board of Governors of the Federal Reserve System”(p. 27). Once ensconced in power at the Fed, “Eccles’s clear policy ... was to use all policy instruments at the government’s disposal to do for the economy what consumers could not do: spend their way out of the depression” (p. 32). Eccles greatly admired Franklin Roosevelt and was careful to coordinate his policies with him. “ ‘Coordinate’ may even suggest more separation than Eccles intended: he meant for monetary policy to be administration policy” (p. 32). His ideas resembled those of Keynes, but Eccles had developed them independently. “Though they had never met, the millionaire Mormon from Utah had anticipated the dapper Cambridge don’s worldview” (p. 26). Eccles and Keynes eventually met at Bretton Woods in 1994 but did not like each other.
Conti-Brown, as we will see, views such policies with favor; but he aptly describes the consequences of a monetary expansion that fails: “What looks like economic growth is, in fact, a monetary mirage. It’s not more jobs, goods, and services that we see; it’s just more money. And when more and more money chases the same (or shrinking) number of jobs, goods, and services, the prices of everything go up. These inflationary pressures threaten to undermine the economy’s stability and consumer confidence in the level of prices and wages” (p. 133).
If we turn from the 1930s to the recent past, we find that the Fed has continued on its reckless ways. After the Panic of 2008, Fed Chairman Bernanke assumed extreme power to meddle in the economy. “Invoking emergency lending authority that had been unused for almost eighty years, the Fed picked up its ‘lender-of-last-resort’ function and proceeded to deploy it throughout the economy ... [this] started with the investment banking giant Bear Stearns and in time extended to money market funds, traditional banks, and insurance companies” (pp. 154–55).
The extent of the Fed’s power to intervene is difficult to fathom. “When Bernanke and Secretary of the treasury Henry Paulson approached Congress in the fall of 2008 about the need to inject $85 billion into the insurance giant AIG, [Barney] Frank asked if the Fed had that kind of money. Bernanke responded that he had $800 billion. Frank was stunned. ‘He can make any loan he wants under any terms to any entity or individual in America that he thinks is economically justified’ ” (p. 155).
The Fed under Bernanke did not confine itself to aiding particular firms but aimed at a general monetary expansion. His policy came as no surprise. “In one speech in 2002, Bernanke, then a member of the Fed’s Board of Governors (but not the chair), alluded to a helicopter drop of cash on the general public as a way of getting growth and inflation back to desirable levels. In light of subsequent events, and with that precedent in mind, his critics have sometimes called him ‘Helicopter Ben’ ” (p. 143).
Once he became Chair, Bernanke followed through in a bizarre fashion, in what was called “forward guidance.” This “binds the central bank to a mast of its own in an eff ort to convince participants in the economy that the Fed will honor its policy for a certain period of time. ... [T]he central bank must commit that its monetary policy ‘will in fact be effective if the central bank can credibly promise to be irresponsible, to seek a higher future price level’ ” (p. 143, quoting Paul Krugman).
By no means does this exhaust the material a critic of the Fed can draw from Conti-Brown’s book. He points out that the Fed finances its own activities by issuing money: it is not dependent on Congressional appropriations to keep it going. “That the Fed funds itself largely from the proceeds of its substantial assets, taken together with the nature of the Fed’s ability to create money in pursuit of its monetary policy objectives, means that the Fed’s funding is unique in government. ... [T]he Fed conducts monetary policy by, among other options, creating money with which it can buy government — and more recently, nongovernment securities. These interest-bearing assets generate money that the agency can subsequently use to fund itself ” (p. 207).
If the Fed is an arbitrary and irresponsible agency in the fashion so far described, is there not an excellent case for doing away with it? Conti-Brown does not agree at all. He fears the “devastation of expected deflation” (p. 143) that might ensue were the economy on a strict gold standard and thus largely supports Bernanke’s policies.
Conti-Brown’s focus differs entirely from criticism of monetary expansion. He believes that critics of the Fed are in a grip of a false picture of how it operates, which he calls the Ulysses/ punch bowl view. “Ulysses” refers to the incident in The Odyssey in which Ulysses had himself tied to the mast of a ship so he could hear the sirens’ song; and the “punch bowl” to a comment by Fed Chairman William McChesney Martin that the Fed’s role was to withdraw the punch bowl when the party was getting interesting. “The subjects of the metaphors differ by millennia, but the idea is the same: the partygoers and Ulysses alike want something in the near term that their best selves know is bad for them in the long term. Central bank independence is the solution” (p. 3). Conti-Brown maintains that this view rests on an oversimplified view of how the Fed operates, and that “independence” is not an analytically useful concept in understanding the Fed. He may well be right on both counts; but although he repeats the metaphor interminably, he has not at all made his case that the bulk of criticism of the Fed rests on acceptance of the misleading picture he condemns. To confront criticism of the sort advanced by Ron Paul and Rothbard, Conti-Brown would have to respond to Austrian monetary theory. He instead bypasses monetary theory almost entirely, a great pity owing to his gifts of clear exposition. To do this in a book about the Fed is to offer us Hamlet without the Danish prince.
Ever since entering the Senate, Rand Paul has continued his father’s work in advocating for an audit of the Federal Reserve. This week, writing for the Daily Caller, Senator Paul renewed his efforts, illustrating how the recent era of unconventional monetary policy has made an audit all the more important:
In 2009, then-Fed Chairman Ben Bernanke was able to refuse to tell Congress who received over two trillion in Fed loans, and it took congressional action and a Bloomberg lawsuit to force the Fed to reveal the details of what it did in more than 21,000 transactions involving trillions of dollars during the 2008 financial crisis. A one-time audit of the Fed’s emergency lending mandated by Congress revealed even more about the extent to which the Fed put taxpayers on the hook.
When pushed to defend the lack of transparency for the Federal Reserve, officials like Janet Yellen and Treasury Secretary Steve Mnuchin point to the myth of the Fed independence — a position that requires outright ignorance of the history of America’s central bank and the executive branch. Of course it’s quite usual for the Senate to base the merits of legislation entirely off of fallacious arguments, so they have continued to be the legislative body holding up a Fed audit with little indication they are prepared to move.
Given that reality, it is time for Senator Rand Paul to change his approach and introduce another piece of legislation from his father’s archives: the Free Competition in Currency Act.
While not as catchy as “End the Fed”, this piece of legislation – inspired by the work of F.A. Hayek – was perhaps Ron Paul’s most radical pieces of legislation. The idea was quite simple: eliminate legal tender laws mandating the use of US Dollars and remove the taxes Federal and State governments place on alternative currencies — such as gold and silver. While the original legislation did apply to “tokens,” an updated version should explicitly include the growing market of cryptocurrencies as a good with monetary value that should not be taxed.
What this would do is create a more even playing field between the dollar and alternative currencies, allowing an easy way for Americans to safeguard their wealth if they ever have reason to doubt the wisdom of the Federal Reserve’s policies. Just as Senator Paul advocated for the ability of Americans to be able to opt-out of the failing Obamacare system, this bill would grant Americans a lifeboat should the weaknesses inherent with the Fed’s fiat money regime expose themselves.
Unlike most examples of monetary policy reforms, which tend to be the products of ivory tower echo chambers, competition in currency would reflect active political trends. In recent years, states like Texas, Utah, and – in 2017 – Arizona have passed laws allowing the use of silver and gold for use in transactions. Meanwhile, other countries have looked to embrace the potential of cryptocurrencies for their monetary regimes. This makes this not only an idea that is good on paper, but one whose time has come.
As alluded to before, simply because a policy makes sense does not mean the Senate will act on it. That doesn’t mean the conversation and debate isn’t worth having. While it may still be on the horizon, there has been a steady drumbeat in Washington for the Federal Reserve to face some sort of reform. For two Congressional sessions in a row, the House has passed legislation explicitly calling for the Fed to embrace a “rules-based monetary system.” While this approach may sound better than today’s PhD standard, it doesn’t solve the problems inherent with central banking and fiat money.
Monetary rules such as “NGD Targeting” – which has the support of a rare coalition including the Cato Institute, Mercatus Center, Christina Romer, and Paul Krugman — should never be seen as a “reasonable compromise” for those skeptical about the Fed. Instead it’s simply another way of disguising central planning in a way to make it more palpable to the public, and therefore more difficult to stop. By putting this bill out there, Rand Paul can help frame the debate and bring a real solution to the table. Something that wouldn't force the Fed to change a single thing, only making them compete on the market like the producer of other good or service.
After all, as is the case with healthcare, or shoes, the best sort of “monetary policy” is competition on the market. Not one dictated by government.
Sin City’s projected 5,000 new apartment units for this year makes no noise nationally in the latest real estate craze. “In 2017, the ongoing apartment building-boom in the US will set a new record: 346,000 new rental apartments in buildings with 50+ units are expected to hit the market,” writes Wolf Richter on Wolf Street. That is three times the number of units that came on line in 2011.
Richter continues, “Deliveries in 2017 will be 21% above the prior record set in 2016, based on data going back to 1997, by Yardi Matrix, via Rent Café. And even 2015 had set a record. Between 1997 and 2006, so pre-Financial-Crisis, annual completions averaged 212,740 units; 2017 will be 63% higher!”
I’ve written before about the high-rise crane craze in Seattle, but that’s nothing compared to New York and Dallas, that are adding 27,000 and 25,000 units, respectively. Chicago is adding 7,800 units despite a shrinking population and rents decreasing 19 percent.
Not surprisingly, Fannie Mae and Freddie Mac are financing this rental housing boom. I wrote recently, the GSEs made 53% of all apartment loans in 2016, down from their combined 68% market share in 2012. “So, their conservator, The Federal Housing Finance Agency (FHFA), recently eased the GSE’s lending caps so they can crank out even more loans.”
Mary Salmonsen writes for multifamilyexecutive.com, “Currently, Fannie and Freddie are particularly dominant in garden apartments [and] in student housing, with 62% and 61% shares, respectively. The two remain the largest mid-/high-rise lenders but hold only 35% of the market.”
Mr. Richter warns us, “Government Sponsored Enterprises such as Fannie Mae guarantee commercial mortgages on apartment buildings and package them in Commercial Mortgage-Backed Securities. So taxpayers are on the hook. Banks are on the hook too.”
But, for the moment, it’s build them and they will come; first renters, then complex buyers. Wall Street giant “The Blackstone Group acquired three Las Vegas Valley apartment complexes for $170 million, property records show,” writes Eli Segall for the Las Vegas Review Journal. “Overall, it bought 972 units for an average of $174,900 each.”
Sales like this has developers going as fast as they can. I heard an apartment developer say Vegas has at least four more good years left in this cycle and is scrambling for new sites. In the land of Starbucks, Microsoft and Amazon, it’s thought the boom will never end. Richter writes, “the new supply of apartment units hitting the market in 2018 and 2019 will even be larger. In Seattle, for example, there are 67,507 new apartment units in the pipeline.”
However, while no one was paying attention, “the prices of apartment buildings nationally, after seven dizzying boom years, peaked last summer and have declined 3% since,” Richter writes. “Transaction volume of apartment buildings has plunged. And asking rents, the crux because they pay for the whole construct, have now flattened.”
As usual, cheap money entices developers to over do it, and the fall will be just as painful.
Douglas French is former president of the Mises Institute, author of Early Speculative Bubbles & Increases in the Money Supply, and author of Walk Away: The Rise and Fall of the Home-Ownership Myth.
When Janet Yellen testified before the House Financial Services Committee last month, she faced grilling on a topic that hasn’t received enough mainstream attention: the interest being paid on excess reserves at the Fed. While the topic has come up occasionally since the program began in 2008, it is worth noting that Yellen was pushed by both Jeb Hensarling, the committee chairman, and Andy Barr, the chairman of the Monetary Policy Subcommittee. While ending this taxpayer subsidy to Wall Street is important, it’s also important to understand the dangers posed by allowing these excess reserves to be lent out of major financial institutions.
RELATED: "Who Benefits from the Fed?" by David Howden
To understand what is at stake, recall back to 2008 when many Fed observers were concerned about the inflation dangers posed by the policies of the Bernanke Fed. In a six year period, the base money supply increased over four-fold. Understandably, this sparked grave fears about the devaluation of the dollar — fears that, to date, have yet to really present themselves in the CPI. While stock prices, real estate prices, and other types of asset-price inflation are likely being fueled by this monetary policy, the Fed isn’t facing political pressure from inflation concerns — but rather being grilled by misinformed legislators for not reaching their (unfortunate) 2% inflation target.
This is, in part, due to the fact that a lot of this new money has been kept sterile by being parked within the Fed itself as excess reserves. Today, more than $2 trillion worth of these reserves are parked at the Fed, which means that only two thirds of the newly created money has actually been pumped into the “real economy.”
RELATED: "Central Banks Should Stop Paying Interest on Reserves" by Brendan Brown
Now this policy should rightfully puncture the narrative that the Fed was at all concerned with providing liquidity to businesses on Main Street (i.e., not big banks). After all, if the aim of the various rounds of QE was to get banks to loan, then paying them not to is irrational. Instead, the Fed was using taxpayer dollars to subsidize the very same banks that they just bailed out. We are continuing, to this day, to pay banks to not make loans.
While Bernanke repeatedly dismissed the problem of incentives posed by paying 25 basis points on these reserves, the reality is that this was a risk-free investment at a time of great market volatility. Considering that several important banks had issues passing the Fed’s stress tests — tests are designed to exaggerate the stability of the financial sector — it doesn’t require a great logical leap to suggest that the Fed misrepresented this program to public in the name of “stabilizing” the financial sector. In 2016, this policy paid $16 billion to big banks, a number that will likely rise as the interest rate payments go up with every increase in the federal funds rate (we are now paying 1.25% interest, higher than the public can receive from their own banks.)
While both the public and Fed critics on Capitol Hill should be outraged at this clear example of cronyism, simply ending it is not enough. After all, the danger of refusing to pay ransom money is that the ransomer will follow through on their threat. If the Fed was to simply stop payment on these funds, and banks decided to lend it out — then $2 trillion would be injected into credit markets. Given the amplifying effects of a fractional reserve banking system, it’s easy to see how quickly this could unleash severe inflationary pressures.
So this is the true policy issue going forward, how do you stop the taxpayer subsidy to Wall Street while avoiding lighting the fuse to Bernanke’s inflation bomb? One way would be to increase reserve requirements. Currently banks with over $115.1 million in liabilities have to keep 10% at the Fed, by raising that number up you will not only serve to keep this expansion of the monetary base “sterile,” but will make the banking sector as a whole more stable.
The Federal Reserve (Fed) is widely expected to continue to tighten its monetary policy this year. According to a latest Reuters Poll, the Fed is likely to start shrinking its US$4 trillion balance sheet in September and, moreover, raise further its key interest rate, which is currently standing in a range of 1.0 to 1.25 percent, in the fourth quarter this year.
According to mainstream economic wisdom, the time has come for the US economy to return to a more normal level of interest rates. Industrial output is expanding at a decent clip, official unemployment has declined markedly, and prices in the stock and housing market show a sustained upward drift. Considering these circumstances, the US economy can now shoulder a tighter monetary policy, it is said.
It should be understood, however, that there will be side-effects, even unintended consequences, if and when the Fed hikes interest rates further. Most importantly, the Fed doesn’t know where the “neutral interest rate” is. If it does too much, the economy will collapse. If it does not do enough, it will only prolong the artificial boom, causing ongoing malinvestment and, ultimately, another crisis.
Admittedly, this is nothing new: The Fed has always been a cause of boom and bust. It sets into motion an artificial boom by issuing new fiat money through bank credit expansion. Such a boom, however, must sooner rather than later collapse and turn into a bust. It is, therefore, strongly advised to expect nothing good coming out of Fed interventions.
Going Through the Numbers This of course holds true for the Fed’s plan to start selling securities it has bought during the financial and economic crisis to prop up the economic and financial system. Back in 2008 and 2009, the Fed provided the US banking system with an enormous cash infusion by granting loans to and purchasing securities from banks.
The Fed ramped up banks' cash holdings from US$ 24,9bn to US$ 2,398.1bn from September 2008 to July 2017. It did so by buying Treasuries and mortgage-backed securities (MBS) amounting to US$ 1,908.9bn and US$1,770.3bn, respectively. In the meantime, however, banks have repaid most of the loans provided by the Fed.
This, in turn, has reduced banks' cash holdings to US$ 2,398.2bn. As a result, it has become impossible for the Fed to sell all the bonds it has purchased. Simply put: The US banking system does currently not have enough base money to pay for the Fed’s crisis-related bond purchases of US$3.755.8bn.
If the Fed were to shed just 64 percent of its current bond holdings, the base money supply in the US banking system would be completely wiped out, making the banking sector effectively illiquid. In this process, US interbank interest rates would presumably spike, sending shock waves through the economic and financial system, not only in the US but worldwide.
Three Options It is safe to assume that the Fed and the banks would want to avoid such a scenario. This leaves the Fed with three options. Option 1: The Fed sells only a (small) part of its current Treasury and MBS to avoid a liquidity shortage in the interbank money market. In other words: The Fed would have to keep sitting on a significant part of its bond holdings and buy new bonds once they mature.
Option 2: The Fed sells off its bond holdings and, at the same time, runs liquidity providing operations to keep banks sufficiently equipped with cash. It purchases, for instance, consumer and/or corporate loans from banks issuing new base money. As a result, the Fed’s assets in its balance sheet would see Treasuries and MBS go down, and consumer and corporate loans go up.
Option 3: The Fed swaps its Treasury and MBS holdings into short-term maturities and sells these papers over time, thereby reducing the base money supply in the banking system as far as possible. This way, the Fed would reduce its active involvement in the credit markets somewhat, confining it mainly to the short-term end of the market.
Interest Rates will Remain Distorted That said, it will be enlightening to see which option the Fed will ultimately choose. Option 1 and 2 would be indicative of the Fed wanting to retain its powerful grip on the price action and consequently the yields in fixed income markets. Option 3, in turn, would suggest that the Fed allows interest rates in the long-term end of the market to normalize at least to some extent.
Whatever option it chooses, however, the Fed will, one way or another, keep distorting interest rates. By issuing new quantities of fiat money through credit expansion, the Fed inevitably wreaks havoc on the economy's price system. It manipulates the perception of risk and flatters the value of future cash flows.
This, in turn, causes many economic and social problems. Most importantly, the Fed’s actions debase the purchasing power of the US dollar, thereby destroying much of peoples' life savings. What is more, the Fed’s policy coercively redistributes income and wealth, and it also brings about costly boom and busts.
Just to be on the safe side: The Fed is not the solution to all these problems. It is the actual cause. Whatever the US central bank will do: Be assured it will remain on course to trouble. And trouble there will be – and unfortunately so, whatever the Fed will be doing in terms of setting interest rates and dealing with the bonds it has purchased against issuing new fiat dollars.
While this is certainly a gloomy message, it might help investors to make wise decisions. Because if the Fed causes another round of trouble, it will most likely resort to even lower interest rates and issuing even more fiat money. So whatever happens short-term, there is good reason to expect that the fiat dollar — and this holds true for all fiat currencies — will lose value.
Dr. Mark Thornton joins Mises Weekends to explain the "business cycle" for what it really is: a series of booms (credit expansion) and busts (debt de-leveraging) engineered by central banks.
There's nothing natural, real, or sustainable about the current Yellen boom—so stay tuned for Mark's explanation of how it can all unravel.
On Wednesday, Janet Yellen testified before the House Financial Services Committee. Though the hearings lost much of their appeal when Dr. Ron Paul retired from Congress, the House Republicans have maintained a reputation for being far more hostile to the Federal Reserve than their colleagues in the Senate — managing to generate some worthwhile moments. While little news was made, with Yellen maintaining her support for generally low interest rates, there were some points made today worth noting.
1) Republicans Continue to Push on the Fed’s Subsidy to Wall Street Starting in 2008, the Federal Reserve has paid interest on excess reserves parked at the Fed. While this had never been done prior to the financial crisis, this policy has now become a vital tool for the Fed in setting short-term interest rates. As the Fed has increased the Federal funds rate, so too has it increased its “Interest On Excess Reserves” (IOER), now paying 1.25% on the over 2 trillion banks hold at the Fed.
This policy has drawn increasing criticism from House Republicans, and Yellen faced criticism from both Committee Chairman Jeb Hensarling and Rep. Andy Barr, who hold Dr. Paul’s old position as chairman of the monetary subcommittee. Accurately, both men highlight that this policy means the Federal Reserve – and by extension the US Treasury that would otherwise receive these interest payments – are directly subsidizing large Wall Street and foreign banks. Considering these IOER payments are projected to be $27 billion this year, it’s good to more attention be brought to this obvious example of Wall Street cronyism.
2) Higher Interest Rates for Wall Street, not for Main Street Continuing on the subject of IOER payments, Rep. Barr also highlighted that average consumers are not seeing any payoff from higher interest rates. Interest payments on CD’s remain historically low, with many consumers unable to get the 1.25% the Fed is giving their financial institutions.
As the Wall Street Journal documented, a reason for this is the way a decade of low interest rates have changed the consumer-bank relationship. All of this is simply another demonstration of how policies by the Federal Reserve are benefitting Wall Street at the direct expense of the rest of the country.
3) Maxine Waters Wants to Make Poor People Poorer Maxine Waters may be best known these days for being one of Donald Trump’s most vocal critics, but she is also the leading Democrat on the Financial Services Committee. On Wednesday, Waters questioned Yellen on why mainstream inflation measures have been constantly undershooting the Fed’s 2% inflation target, and voiced her disagreement with the Fed’s minor increases in the Federal funds rate.
The way politicians like Ms. Waters discuss inflation makes it clear that they don’t truly comprehend how it presents itself in real life. After all, as someone who constantly fundraises off the dangers of income inequality and the plight of low income Americans, surely the last thing Ms. Waters would want to see is for the purchasing power of the dollar decline for the very people she claims to want to help.
4) Hensarling References Marvin Goodfriend Earlier this week it was reported that President Trump will nominate former Treasury official Randal Quarles Fed Vice Chairman. During the hearing, Chairman Hensarling quoted another economist who has been connected to another Fed vacancy: Marvin Goodfriend. As a Treasury Secretary finalist who has worked with the Administration on banking regulation, Hensarling evoking Goodfriend is being taken by some a sign that his nomination is now simply a matter of when.
Unfortunately Goodfriend’s surname is misleading, as he has been a vocal advocate of negative interest rates. His nomination would be a devastating betrayal by Trump of his blue-collar base, for the reasons he himself articulated as a candidate.
5) Yellen still hates Audit the Fed Thanks to Dr. Paul, the head of the Fed now knows to expect one question about Auditing the Federal Reserve. This time it was Rep. Bill Posey, who tried to push Yellen away from her default defense of mythical Fed independence. Mr. Posey repeatedly asked Ms. Yellen to name a single instance where the Fed would have been negatively impacted by a full audit.
The Fed Chairwoman was unable to provide an answer.
There are a number of things you don’t want to hear a central banker say. One of those things just popped out of Janet Yellen’s mouth – “I don’t believe we will see another financial crisis in our lifetime.” That has to be up there with Irving Fisher’s deathless observation from 17 October 1929 that "Stock prices have reached what looks like a permanently high plateau" or John Maynard Keynes’ comparably adept forecast from 1927 that "We will not have any more crashes in our time."
So far, so anecdotal. How about some data to back up the thesis that, as Thorstein Polleit puts it, the super bubble is in trouble ?
First, define your Super Bubble. We can do this in two ways. One relates to longevity (how long has the bull run lasted ?), the other to valuation (how expensive is the market now ?). The global bond bull began back in 1981, when 30 year US Treasury yields peaked at 15.2%. Now, over 35 years later, long bond yields are below 3%.
Polleit expresses it a little differently, citing the p/e ratio of bonds so that they might more fairly be compared to stocks. To calculate the p/e ratio of a government bond, he divides 1 by the 10 year government bond yield. His results are shown below.
Source: Thomson Financial / Thorstein Polleit
¹For bonds, calculated as 1 divided by the 10 year government bond yield
In his words,
You do not need to be a financial market wizard to see that especially bond markets have reached bubble territory: bond prices have become artificially inflated by central banks’ unprecedented monetary policies. For instance, the price-earnings-ratio for the US 10-year Treasury yield stands around 44, while the equivalent for the euro zone trades at 85. In other words, the investor has to wait 44 years (and 85 years, respectively) to recover the bonds’ purchasing price through coupon payments.
Meanwhile, however, the US Federal Reserve (Fed) keeps bringing up its borrowing rate; and even the European Central Bank (ECB) is now toying with the idea of putting an end to its expansionary policy sooner rather or later.
Those of us who are hostile to central planning are doubly hostile to governmental interference in the price mechanism, which is what the misguided policies of QE and ZIRP effectively are. The definitive text on this topic is Forty Centuries of Wage and Price Controls. Spoiler alert: government attempts to rig prices always fail, sometimes catastrophically.
The problem facing the likes of Janet Yellen, Mark Carney [makes sign of the cross and looks urgently for garlic] and Mario Draghi is that, having now weaponized short term lending rates, the nukes can’t be put back in their silos. How can interest rates be raised meaningfully above zero without crashing the financial system ? Perhaps they can’t. Perhaps unelected monetary bureaucrats should never have been allowed to take them there in the first place. But we are where we are. Any commentary surrounding monetary policy can now only echo that tired old joke about the lost traveller who, when seeking advice, is told that he shouldn’t start from here.
Federal Reserve Chair Janet Yellen recently predicted that, thanks to the regulations implemented after the 2008 market meltdown, America would not experience another economic crisis “in our lifetimes.” Yellen’s statement should send shivers down our spines, as there are few more reliable signals of an impending recession, or worse, than when so-called "experts" proclaim that we are in an era of unending prosperity.
For instance, in the years leading up to the 2008 market meltdown, then-Fed Chair Ben Bernanke repeatedly denied the existence of a housing bubble. In February 2007, Bernanke not only denied that “sluggishness” in the housing market would affect the general economy, but predicted that the economy would expand in 2007 and 2008. Of course, instead of years of economic growth, 2007 and 2008 were marked by a market meltdown whose effects are still being felt.
Yellen’s happy talk ignores a number of signs that the economy is on the verge of another crisis. In recent months, the US has experienced a decline in economic growth and the value of the dollar. The only economic statistic showing a positive trend is the unemployment rate — and that is only because the official unemployment rate does not count those who have given up looking for work. The real unemployment rate is at least 50 percent higher than the manipulated “official” rate.
A recent Treasury Department report’s called for rolling back of bank regulations could further destabilize the economy. This seems counterintuitive, as rolling back regulations usually contributes to economic growth. However, rolling back bank regulations without ending subsidies like deposit insurance that create a moral hazard that incentivizes banks to engage in risky business practices could cause banks to resume the unsound lending practices that were a major contributor to the growth, and collapse, of the housing bubble.
The US economy is already faced with several bubbles that could implode at any time. These include bubbles in student loans and automobiles sales, and even another housing bubble. The most dangerous of these bubbles is the government bubble caused by excessive spending. According to a 2016 study by the Mercatus Center, at least four states could soon join Puerto Rico and Illinois in facing bankruptcy.
Of course, the mother of all government bubbles is the federal spending bubble. Despite claims of both defenders and critics of the president’s budget, neither President Trump nor the Republican Congress have any plans for, or interest in, reducing spending in any area. Even the so-called cuts in Medicare and other entitlement programs that have generated such hysterics are not real cuts, but “reductions in the rate of growth.”
Some fiscal conservatives are praising the administration’s proposal to finance transportation spending via government bonds. However, the people will eventually have to pay for these bonds either directly through income taxes or indirectly through the inflation tax. Government-issued bonds harm the economy by diverting investment capital away from the private sector to the “mixed economy” controlled by politicians, bureaucrats, and crony capitalists.
If Congress continues to increase spending and the Federal Reserve continues to facilitate that spending by monetizing the debt, Americans will face an economic crisis more severe than the Great Depression. The crisis will likely result from a rejection of the dollar as the world’s reserve currency. Those of us who know the truth must redouble our efforts to ensure a peaceful transition away from the Keynesian system of welfare, warfare, and fiat currency to a society of peace, prosperity, and liberty.
Reprinted with permission.
Dr. Ron Paul joins Jeff Deist to talk about his decades as a congressman fighting the Fed, his efforts to legalize the use of gold and silver as untaxed currency, and his involvement with sound money initiatives in states like Arizona and Wyoming. Plus, Dr. Paul shares some great anecdotes about Reagan's Gold Commission, Alan Greenspan, and Paul Volcker.
Here are this week's events relating to the Fed. All times Eastern.
Monday, June 26
Chicago Fed National Activity Index. 8:30amDallas Fed Manufacturing Survey. 10:30am Tuesday, June 27
San Francisco Fed President John Willaims will speak at The Economic Association of Australia on "The Global Growth Slump: Causes and Consequences" in Sydney, New South Wales. 4:00amRichmond Fed Manufacturing Index. 10:00amPhiladelphia Fed Reserve President Patrick Harker will speak on the economic outlook and international trade at the European Economics & Financial Centre. 11:15amFed Reserve Chair Janet Yellen will discuss global economic issues at the Conversation between Chair Yellen and Lord (Nicholas) Stern, President of the British Academy in London. 1:00pmMinneapolis Fed Reserve President Neel Kashkari to participate in a townhall in Houghton, Michigan. 5:30pm Wednesday, June 28
San Francisco Fed President John Williams will speak on The Global Growth Slump: Causes and Consequences at the The Economic Association of Australia, Eminent Speaker Series 2017 in Canberra, ACT. 3:30am Thursday, June 29
The third estimate for first-quarter GDP. 8:30amSt. Louis Federal Reserve Bank president James Bullard to deliver a presentation on the U.S. economy and monetary policy at the Official Monetary and Financial Institutions Forum (OMFIF) City Lecture in London. 1:00pm
The economic arguments against central banks are numerous to say the least. Through the writings of Ludwig von Mises and Murray Rothbard we have a wide variety of critiques that explain the many ways the central banks distort economies, cause booms and busts, punish savers, and chose winners and losers through monetary policy.
But, even if confronted with these arguments, and one remains supportive of central banks, other non-economic arguments must still be addressed.
For example, it is becoming increasing important — in our current age of "non-traditional" monetary policy — to take note of the fact that central banks, and especially the Federal Reserve, are essentially unrestrained by law.
Economists themselves often defend this total unmooring from legal or political accountability, saying it is necessary for the Fed to have "independence" from elected officials.
In reality, however, this "independence" is best described as "total lack of accountability."
Writing in today's Dallas Morning News, Texas Tech economist Alexander William Salter writes:
A phenomenal amount of time and money is spent trying to anticipate what the Fed will do and, afterwards, what the ramifications will be. The reason it takes so many experts to weigh in on Fed behavior is because the Fed's actions are fundamentally unpredictable. This is a huge defect in an organization of such public importance in a nation whose founding principles include the sanctity of the rule of law.
"Rule of law" does not merely mean "according to some official procedure." In order to be truly lawful, the behaviors of government entities must adhere to a more general framework of rules, so that these behaviors are not arbitrary. The more general rules must be more or less fixed, known in advance, and — most importantly — not subject to reinterpretation by those whose hands the rule is supposed to bind. This concept of the rule of law is central to classically liberal constitutionalism and jurisprudence, which underlies the American experiment in ordered liberty.
The behavior of the Fed fails to meet any of these criteria.
Fed activities are more or less unpredictable on any given day, as indicated by the need for various financial houses to devote significant resources to Fed-watching. Congress has almost entirely abdicated its responsibility in holding the Fed accountable, so Fed's actions are not in conformity with any general rule other than what the Fed Board of Governors thinks is expedient. This means the Fed is a judge in its own cause and a law unto itself.
In recent years, some observers — Robert Higgs, for instance — have focused on "regime uncertainty" which is a problem arising from "a pervasive lack of confidence among investors in their ability to foresee the extent to which future government actions will alter their private-property rights."
Much of the focus in this research has been on the presidency and the Congress and the courts while ignoring the central role of the Fed itself in promoting this uncertainty.
As Salter notes, the Fed is now unpredictable, and it's anyone's guess what policy change might be coming down the road at any given time. Needless to say, this isn't great for economic growth for all the reasons laid out in the regime-uncertainty research.
Of course, the Fed has always essentially been unaccountable to any outside institutions. Nevertheless, both political ideology and prevailing views among many economists helped to restrain Fed action over the past century. Since World War II, another important factor has been the fact that the US economy has often been relatively strong, and there rarely appeared to be ample justification for the sorts of radical monetary policy now routinely being discussed among Fed policymakers.
As a perfect example of how radical monetary thought has become might be the discussion surrounding Marvin Goodfriend, who was recently revealed to be a leading candidate for appointment by Donald Trump to the Fed's board of governors. According to the Financial Times, Goodfriend possesses "a radical willingness to embrace deeply negative rates."
As a member of the Fed's board, would Goodfriend push for negative rates under the "right" conditions? Who knows?
But if he was successful in winning over a majority of voting members to such a position what could anyone do about it? More importantly, what documents, guidelines, or statutes would indicate for us ahead of time what the "right" conditions would be for implementing negative rates?
There are none. Whether or not the "time is right" for negative rates is completely up to the whims of Board members.
This situation is, as Salter points out, the complete opposite of "the Rule of Law" and has no place in a legal or political regime that claims to respect such a concept.
Moreover, the situation that now prevails at the Fed is exactly the sort of thing F.A. Hayek warned about in The Road to Serfdom when Hayek outlines the incompatibility between the rule of law and an economy controlled by government planners.
Hayek writes:
...stripped of all its technicalities, [the rule of law] means that government in all its actions is bound by rules fixed and announced beforehand — rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one's individual affairs on the basis of this knowledge.
Serious problems begin to arise, Hayek continues, when "ad hoc actions" on the part of government planners prevent market actors from planning for their own economic futures.
Unfortunately, "ad hoc" would appear to be one of the most apt phrases for describing how the Fed functions in today's world.
The Fed's defenders will tell us that this unrestrained capriciousness must be tolerated or else the Fed will no longer have its precious "independence."
Of course, applying this logic to any other political institution — and the Fed most certainly is a political institution — would be immediately denounced as absurdly authoritarian.
And rightly so.
But the Fed's lack of accountability continues to be sacrosanct among many in power — and it continues in spite of a decade of lackluster economic performance under the Fed's "leadership. Salter is forced to conclude:
But when money is governed by the arbitrary rule of central bankers, things become much more uncertain. Trade slows. The economy stagnates, jobs are hard to come by, and the gains from trade mostly accrue to politically connected financial elites. The Fed bears no small responsibility for the past 10 years of anemic economic performance.
Is the Bank of Canada going to raise its overnight benchmark rate?
Since rising interest rates are decreed by the central bank, the real scarcity of capital in which major financial institutions can borrow and lend out overnight amongst themselves is unknown. Disconnected from any real savings, we expect the Bank of Canada to manually raise rates when the going gets good.
This is flawed thinking. Clearly, the rag-tag team at the BoC has confused cause and effect once again.
Through experience and logic, the idea that central banks can provide a free lunch is rebuffed by a hefty dose of reality. You need capital to have capitalism. Savings and production come before consumption. This is a priori true.
That’s why the Fed-induced casino reacted to BoC’s Number 2 Carolyn Wilkins’s recent speech. Her words were interpreted in such a way that had a discernible effect on the Canadian loonie, and it surged.
It’s easy to imagine a financial system where this is not the case. Where “monetary policy” is returned to its rightful owner — the individual buying public.
When the No. 2 at the BoC says, “We are seeing the economy pick up,” and hints at raising rates, this means that the central bankers believe they can make everyone’s debt more expensive without bankrupting everyone in the process.
Since the economy seems to be doing well, how would a quarter-point or two fare?
Former BoC governor and now Bank of England head star Mark Carney succeeded with this back in September 2010.
America’s housing bubble had already burst, the effects were international, but the whole house of cards didn’t come crashing down. The Fed had some wiggle room, the end was near but it wasn’t set, and Canada happened to weather the storm quite nicely.
After all, we had been running federal budget surpluses since the 1990s, and we had yet to import all the finer details of the Southern real-estate easy-money craze.
With propaganda about our large “stable” banks (who have since been downgraded), there was enough global and domestic confidence for Clown Carney to nudge interest rates to 1%.
Ho, hum.
Gains were lost when his successor cut rates in 2015 due to the crash of Alberta oil.
Current BoC governor Stephen Poloz, or Simple Steve, couldn’t let that wild card spill over into other sectors of the economy. Steve told us to go back to buying land since they ain’t making any more of it. Use the low rates to pay back debts while also taking on more, he said. Grow the economy by borrowing to invest and remodel your house. Don’t look at me for the details, I just work here.
Meanwhile, Wilkins’s speech is “preparing markets” for the eventual crawl back to rate hikes.
The Bank of Canada has created a monstrosity of a monetary system. Insomuch that central banks will be around for the foreseeable future, may I suggest rediscovering some of former BoC governor James E. Coyne’s economic speeches?
Originally posted at mises.ca.
With last week's FOMC meeting over, which means Fed members are speaking once again, reflecting on the June meeting and looking forward to future decisions. Here is a breakdown of the content given by the five Fed members who appeared publicly this week so far.
William Dudley
New York Fed President Dudley stated that inflation, which is closer to 1.5% than 2% as measured by the PCE, is on the low side but he is happy with the progress made on the headline employment numbers. Given the low inflation, future rate hikes are not as certain as they were a few months ago.
Charles Evans
Chicago Fed President Evans was focused on the "low inflation" as while, wanting to emphasize the alleged importance of making sure the public knows that the Fed is going to be doing something about the low inflation problem. Apparently, the "public" is worried that their costs of living aren't going up fast enough and needs confidence that the Fed will sweep in to the rescue in such a dire situation. “We have to assure the public that we recognize the new low-inflation environment and that we are not overly conservative central bankers who see our inflation target as a ceiling,” Evans said, according to Bloomberg. Of course, the opposite is the truth. The Fed has been overly extreme in its monetary expansion and reckless interest rate suppression.
Stanley Fischer
Fed Vice Chair Fischer focused on the steps that must be done to prevent another financial crisis. His focus, naturally, was on government regulation including oversight of lending practices and bank stress tests. As always, there was no mention of the danger to financial stability caused by artificial expansion of the money supply and the suppression of interest rates, which encourages speculation and diverts resources into "investments" which otherwise would not have been funded if it wasn't for the Fed's easy money regime in the first place.
Eric Rosengren
The Boston Fed President almost stumbled onto the right track when he said that persistently low interest rates may raise concerns about financial stability. Unfortunately, all he meant was that the Fed needed to be prepared to "act" (which of course means print more money) in response to possible negative shocks. It seems there was no realization about the reality sitting right under his nose: the Fed's previous course of action is what led interest rates so low in the first place!
Robert Kaplan
Dallas Fed President pointed to the low yields on the 10 year Treasury as a sign that investors were anticipating slow growth in the years ahead. Because of this, Kaplan warned about being too hawkish on monetary policy and moving to remove "accommodation" too early. That is, the Fed's quadrupling of the balance sheet over the last decade hasn't actually provided for a robust economy and now the Fed is stuck having to prop it up with easy money.
They’re back. Subprime mortgages. And loan brokers are needed to start making them. Kirsten Grind, who, by the way, wrote a wonderful book about Washington Mutual (WaMu) entitled The Lost Bank, writes for the Wall Street Journal, “Brokers willing to learn the lost art of making risky mortgages are in demand again.”
Home values are up, flipping is back in vogue, and more than a little subprime sauce is needed to keep the party cooking. Putting a face on the subprime broker demand Ms. Grind features a former Calvin Klein salesman who admits he didn’t know much about housing finance. “‘I knew a mortgage was a loan for a house,’ said Mr. Boyd, who was recruited by his boss, Jon Maddux, after selling him a Calvin Klein suit at a local outdoor mall. ‘I came in just a blank slate.’”
Mr. Maddux now owns Drop Mortgage. But at the depths of the crash his business was “YouWalkAway.com between 2008 and 2012. The site charged homeowners on the brink of foreclosure $995 to learn how to leave their debt behind.”
Of course there’s a good market for loans to folks who don’t fit in the Dodd-Frank box and lenders can earn 6% to 10% from borrowers sporting credit scores of 660 and below. But fresh-faced originators can’t figure out how to make the loans.
“A lot of (the brokers) are timid and scared and don’t know where to start with the nonprime type loans,” Steve Arnold, who is based in West Palm Beach, Fla. told Ms. Grind. Mortgage lenders have succumbed to Stockholm Syndrome and can’t figure out how to make anything but a drop-dead lead pipe cinch conforming mortgage.
Krista Donecker, an account executive at Irving, Texas-based Caliber Home Loans Inc. tells Grind, “It’s been a hard battle” against the stigma of subprime lending. She gives presentations on originating subprime loans and remembers a broker asking her, “Are you sure this isn’t illegal?”
Ironically, subprime is making a comeback while European banks fight “the same kind of heavy-handed rules for banks’ mortgage holdings that have been adopted by their American counterparts,” reports Bloomberg.
“‘By and large, Germans pay their debts’ and are nowhere near as risky as American lenders and home-buyers have been in the past,” says Deutsche Bank AG chief John Cryan. Ouch.
This is all about measures that are “part of the completion of Basel III, effectively [to] increase the capital backing mortgages held on banks’ balance sheets to ensure that lenders can weather another economic downturn,” writes Matt Scully for Bloomberg.
In the conventional loan market, “Interest rates fell last week to the lowest level since November, and the seasonally adjusted mortgage volume jumped accordingly, up 7.1 percent, according to the Mortgage Bankers Association,” reports Diana Olick for CNBC.
"Purchase application volume increased to its highest level since May 2010. Refinance activity bumped up as well in response to moderating rates, but remained generally subdued," said Joel Kan, an MBA economist.
Rreprinted from DouglasinVegas. Douglas French is former president of the Mises Institute, author of Early Speculative Bubbles & Increases in the Money Supply , and author of Walk Away: The Rise and Fall of the Home-Ownership Myth.
Last week, the Federal Reserve announced an increase in the Federal Funds rate to 1.25 percent. The last time the target rate reached so high was in September of 2008, when the rate was 2.0 percent. In October of that year, the target rate fell to 1.0 percent, and was moved down to 0.25 percent in December. It remained at 0.25 percent for the next 83 months.
This week's rate increase was the third increase since December 2016, when the Fed increased the rate from 0.5 percent to 0.75 percent.
Compared to the last seven years, this policy looks hawkish by comparison. On the other hand, compared to the 1990s — which were at the time seen as an era of low rates — current policy remains remarkably accommodative.
Other central banks, however, continue to take no action.
For example, the Bank of England recent voted to keep rates at a record low 0.25 percent. Meanwhile, the Bank of Japan is making no change and keeping rates near zero. Last week, the European Central Bank kept is target rate at negative 0.4 percent. In the wake of this week's Fed decision, the People's Bank of China elected to take no action either.
If we look at all these central banks together, the Fed does appear to be the odd man out:
Perhaps the most notably development is the Fed's announcement of plans to "normalize" its balance sheet and reduce in size the huge $4.4 trillion balance sheet it has accumulated since 2009. According to CNBC:
On top of the rate hike, the committee said it will begin the process this year of reducing its balance sheet, which it expanded by buying bonds and other securities in order to fight the housing crisis. Minutes from the May meeting indicated officials already had begun discussion about putting a set limit each month on the amount it would let run off as it conducts its policy of reinvesting proceeds...
"The committee currently expects to begin implementing a balance sheet normalization process this year, provided the economy evolves broadly as anticipated," the post-meeting statement said.
According to information released Wednesday, the roll-off cap level will start at $6 billion a month for the level of principal payment proceeds from Treasurys it will let run off without reinvesting. The remainder will be reinvested.
The Fed will increase that cap level at a pace of $6 billion each quarter over 12 months until the cap reaches $30 billion a month.
For agency and mortgage debt, the cap will be $4 billion a month initially, with quarterly increases of $4 billion until the level reaches $20 billion a month.
Once both targets are met, the total runoff per month will be $50 billion. Several Fed officials have said publicly they expect the runoff program to continue until the balance sheet declines to about $2 trillion to $2.5 trillion.
If the Fed manages to implement this plan, we're still only looking at a reduction to 2010 levels, and 2010 was not exactly an age of tight money at the Fed.
Moreover, it's rather unlikely we'll ever see this actually happen. Bill Gross, for example, remains doubtful:
I think that the Fed can't follow through with their ... plan and I think that the Fed can't follow through with what they're suggesting in terms of the sell-backs in the Treasury market."
And why won't the Fed follow through?
Well, as Jason Schenker points out at Bloomberg, reducing the balance sheets requires a robust economy, and it's not clear the US has that right now. Moreover, recent history has not provided much hope in this respect:
The ECB’s attempt to reduce its balance sheet was a complete failure, and it almost resulted in a recession. Policy makers were forced to reverse course, and it necessitated the massive quantitative easing program the ECB has since been implementing since, putting the current size of the ECB balance sheet at 4.1 trillion euros ($4.57 trillion) -- more than double the level at the end of its reduction program. In other words, a one-third reduction in the ECB balance sheet subsequently necessitated its doubling from the newly reduced level. This shows how difficult balance sheet “normalization” could be for the Fed.
For all its talk of balance sheet normalization, the Fed may similarly struggle. After all, once hooked on the sauce of cheap money, financial markets don’t want to see the punch bowl taken away. If the ECB offers a lesson, it’s that shrinking the balance sheet can necessitate a rather quick, and even more drastic, expansion.
The Fed's state itself notes its plans depend on "the economy evolv[ing] broadly as anticipated.
At this point, the Fed is clearly in a mine field. It has been seeking to raise rates for some time, to give the Fed some room to move if the economy does fall back into recession. At 1.25 percent, matters have improved, but rates are no where near where they were in 2007 (above 5 percent) at the beginning of the last crisis. However, given the weakness of the economy, it's not at all clear that current markets could ever survive an attempt to raise rates even halfway to the five percent rates we saw a decade ago. In any case, even some minor tightening of policy is can be dangerous, as Thorsten Polleit recently explained:
To keep the boom going, the central bank must keep interest rates below their natural levels. It cannot raise them back to “normal.” First and foremost, higher interest rates would make the boom collapse. The credit market would collapse, stock and housing prices would tumble, and the financial system and the economy as a whole would go into a tailspin.
One may ask: Why is the Fed then raising rates then? Perhaps the Fed’s decision-makers think that the US economy has overcome the latest crisis and higher interest rates are economically justified. Others might wish to tighten policy for getting the short-term inflation adjusted interest rate out of negative territory.
Be it as it may, the disconcerting truth is this: Fed rate hikes will close the gap between the natural interest rate and the actual interest rate level. This, in turn, amounts to putting a brake on the boom, bringing it closer to bust. It is impossible to know with exactitude at what interest rate level the US economy would fall over the cliff.
One thing is fairly certain, though: The US economy, and with it the world economy, is caught between a rock and a hard place. Maybe the Fed’s current rate hiking spree will bring about the bust. Or the Fed refrains from raising rates further and keeps the boom going a little bit longer.
Just two days ago the FOMC decided once again to raise the target range for the Fed Funds rate, with Yellen expressing optimism about 2% inflation and therefore (in the Keynesian framework), the economy itself. While Dallas Fed President Robert Kaplan voted with everyone else (except Neel Kashkari) to hike rates, he today made it clear that the inflation trend is worrying him. If the inflation rate continues to move away from 2%, his opinion is that rate hikes should be suspended.
The June decision was therefore tougher for him to make. Reuters reports:
"In this job you make trade-off decisions; I think the fact that inflation of late has been more muted, for me, made me weigh those trade-offs much more carefully," Kaplan told reporters after a meeting of the Park Cities Rotary Club in Dallas. While he is comfortable with where rates are now, he said, "before I’d be comfortable taking the next step in raising the fed funds rate, I’m going to want to see more evidence that we are making more progress" toward the Fed's 2-percent inflation goal.
His concern about inflation is also the very reason that Neel Kashkari dissented on the rate decision. On his own blog, Kashkari referred to the alleged tradeoff between inflation and unemployment (known as the Phillips Curve) and noted that he believes the slowing inflation is sending a warning to the labor market. That is, since inflation was slowing, the employment numbers may soon reveal a scenario that is less rosy than their current trend. He writes:
On the other hand, unfortunately, the data aren’t supporting this story [that falling unemployment numbers are congruent with rising inflation--CJE], with the FOMC coming up short on its inflation target for many years in a row, and now with core inflation actually falling even as the labor market is tightening. If we base our outlook for inflation on these actual data, we shouldn’t have raised rates this week. Instead, we should have waited to see if the recent drop in inflation is transitory to ensure that we are fulfilling our inflation mandate.
Both Kashkari and Kaplan are worried that inflation trends are slowing and therefore don't want any rate hikes to impede the glorious path toward 2%. Of course, Kashkari is already talking about inflation beyond 2%, stating that an "overshoot of 2 percent... shouldn’t be concerning since we say we have a symmetric target and not a ceiling." When it comes down to it, don't think that a 2% devaluation of our purchasing power will stop the Fed's reckless ways.
Arguments for a "rules based" Fed are gaining momentum on both the political Left and Right — and even among some libertarians. Would the adoption of ideas like NGDP targeting and the "Taylor Rule" really make the Fed less dangerous? Would they be an improvement on the Fed's current discretionary approach? Can monetary "rules" really contain booms and busts, or would Yellen and company simply break them at the first sign of the next crash? Professor Peter Klein joins Jeff for a discussion.
Read Rothbard's What Has Government Done to Our Money? here.
June's FOMC meeting concluded today and the meeting announcement revealed an interest rate hike of .25% to bring the Federal Funds target to between 1 and 1.25%. Additionally, we also learned that the FOMC anticipates one more rate in 2017, 3 more in 2018, and the beginning of a balance sheet reduction effort starting this year. Of course, the balance sheet reduction is actually just a taper in the amount of reinvestment. Since they are simply slowing down how much in assets they are buying every month, the balance sheet will still be increasing.
There are still concerns at the FOMC (and in monetary officialdom in general) that the devaluation of our purchasing power (colloquially known as "inflation") is not occurring rapidly enough. From their own statistics, which exclude things most important to consumers such as food and energy, price inflation dipped a bit to 1.7%. This, of course, is an utter outrage to the experts.
We also got more specific detail about the balance sheet plan, which as we have said all year is going to be the primary narrative of the second half of 2017 in place of interest rate hike talks. Bloomberg reports:
In a separate statement on Wednesday, the Fed spelled out the details of its plan to allow the balance sheet to shrink by gradually rolling off a fixed amount of assets on a monthly basis. The initial cap will be set at $10 billion a month: $6 billion from Treasuries and $4 billion from mortgage-backed securities.
The caps will increase every three months by $6 billion for Treasuries and $4 billion for MBS until they reach $30 billion and $20 billion, respectively.
Officials didn’t reveal the exact timing of when the process will begin this year, as well as specifically how large the portfolio might be when finished.
On the interest rate decision it was Minneapolis Fed President Neel Kashkari who once again dissented, preferring no change. He is one of the more dovish members of the Fed, preferring to see the core inflation rate (according to Fed-preferred statistics) solidly above 2% before additional rate hikes.
The next FOMC meeting is at the end of July, but no rate hikes are expected again until September.
While the Federal Reserve has an explicit dual mandate to keep prices stable and maintain full employment, they have unofficially taken on new goals like maintaining financial stability. Bernanke, Yellen, and other officials have noted how traditional monetary policy is a limited and blunt tool to accomplish this goal, which is why the Fed has, in recent years, exercised and flexed its regulatory muscle.
The Minnesota District Bank president, Neel Kashkari, recently wrote an article about the dilemma the Fed faces regarding asset bubbles and whether or not they should be met with raising interest rates. He summarizes in five points:
It is really hard to spot bubbles with any confidence before they burst. The Fed has limited policy tools to stop a bubble from growing, even if we thought we spotted one. The costs of making policy mistakes can be very high, so we must proceed with caution. What we can and must do is ensure that the financial system is strong enough to withstand the inevitable bursting of a bubble. And finally, monetary policy should be used only as a last resort to address asset prices, because the costs to the economy of such a policy response are potentially so large. In an addendum to his article, he admits that it is possible artificially low interest rates increase the probability of asset bubbles forming: “low rates ... could make bubbles more likely to form in the first place.” He laments that there is no economic theory to back this up, to the unending frustration of Austrian economists everywhere. Indeed, F. A. Hayek won a Nobel Prize in economics in part for his work on a business cycle theory that blames central banks for causing, among other things, bubbles.
ABCT Isn’t So Controversial Despite the lack of representation in Federal Reserve and government offices, the theory is not as controversial as it is made out to be. Just a week before Kashkari’s post, Bloomberg.com published an article on a bubble in the automobile industry that singled out the cause of increased subprime auto loans: “While caution may be good for banks’ balance sheets, it doesn’t offer much relief for automakers, who relied on cheap credit to fuel a seven-year stretch of booming sales.”
In fact, artificially low interest rates and expansionary monetary policy have the explicit goal of stimulating borrowing and spending. This is no secret, as Kashkari explains: “we lower interest rates to try to stimulate economic activity by reducing borrowing costs.”
Now take Kashkari’s first and second points in view of this. If central bank policy is responsible for creating bubbles, then how could a central bank official say that spotting and preventing bubbles is “really hard”? It’s like a detective admitting he’s stumped about who is starting all of these fires around town, while he’s holding a container of fuel, a matchbook, and a book titled Arson for Dummies.
Broken Clocks and Broken Records While Hayek certainly deserved his Nobel Prize, it is well-known that he was following Ludwig von Mises and his work on business cycles. Together, they constructed the framework for what we know today as Austrian business cycle theory, expounded and expanded more recently by Murray Rothbard, Joseph Salerno, Roger Garrison, Jesús Huerta de Soto, David Howden, Philipp Bagus, and many others.
Kashkari referred to those who try to identify bubbles as broken clocks. This characterization is unfortunate. Broken clocks do not explain why. If Austrian economists were only accidentally right some of the time, then they would not be able to point to the specific causes of the business cycle.
A broken clock, for example, would not explain, pre-1929 crash, the causes of the “inevitable crisis”:
Government agencies responsible for financial policy, directors of the central banks of issue and also of the large private banks and banking houses ... failed to recognize the fundamental problem. They did not understand that every increase in the amount of circulation credit (whether brought about by the issue of banknotes or expanding bank deposits) causes a surge in business and thus starts the cycle which leads once more, over and beyond the crisis, to the decline in business activity. In short, they embraced the very ideology responsible for generating business fluctuations. (Ludwig von Mises, Monetary Stabilization and Cyclical Policy, 1928)
Perhaps a broken record is a more apt analogy for modern central bankers (even a broken clock is right occasionally). After every financial crisis, in the midst of every recession, we hear the same line: “Let us stimulate the economy with expansionary monetary policy.” There is no adequate explanation of where the crises keep coming from, except for vague accusations against unregulated financial markets. And there is always another crisis on the way. The booms and busts are taken as a given, it seems. The Fed doesn’t try to solve the problem of the business cycle. They have given up on that task — they just try to make them smaller and smoother when they do come. Kashkari admits this in his article (point four): “What we can and must do is ensure that the financial system is strong enough to withstand the inevitable bursting of a bubble.”
The High Costs of Artificial Credit Finally, Kashkari’s remaining words of warning in points three and five, that bad monetary policy is very costly, are the same as Mises and Hayek’s words of warning. The only difference is what counts as a “policy mistake” and where to look for the costs of wrong-headed policy.
For Mises and Hayek, the policy mistake involves any creation of credit out of thin air. If the Federal Reserve decreases interest rates below what would prevail on an unhampered credit market, then an artificial, unsustainable boom is set in motion. If any central bank increases the money supply through the financial system, it means that borrowers have the privilege of being the first to bid up prices as the new money ripples through the economy.
It means that nominal incomes, employment, consumption, the prices of capital goods, and other asset prices will increase. It means that capital will be directed into new, longer, and riskier lines of production, beyond what would have happened at the prevailing levels of real saving. These lines of production will turn out to be unprofitable as the increasing scarcity of capital becomes apparent and the costs of production become prohibitively high. Incomes, employment, consumption, and stock prices plummet as laborers and capital owners seek productive and profitable employment. The bust is made up of all of the necessary corrections for the errors made during the boom. Additional artificial credit will only delay this process and make it more painful when the day comes.
Contrast this view with that of Kashkari or this supportive Business Insider article: “the main, unspoken reason for pushing interest rates higher was to tame runaway stock and credit markets, which have broken all sorts of records under the Fed’s zero-rate policy ... [Kashkari] makes a solid case in an essay this week as to why this is a terrible idea.” They seem to understand that fiddling with interest rates and flooding the economy with artificial credit has numerous unintended consequences and potentially high costs.
Why is it such a stretch to posit that the bubbles, recessions, and depressions created by these policies are too high a cost? Why is it so controversial to suggest that we should leave interest rates and credit markets alone? Perhaps monetary policy is not a blunt tool, but a dangerous weapon — one that should be confiscated from those who have wielded it for too long.
It's a slow week for the Fed as they gear up for next week's FOMC meeting and subsequent announcement. In the days ahead, there will be much commentary about whether or not the Fed is going to raise rates.
For example Tim Duy, who is always happy to support the Fed's inflationary excesses, is worried about the strength of the economy in the case of "excessive monetary action." What he means by this phrase is not the quadrupling of the Fed's balance sheet since 2008, but rather a small tick upwards in the Federal Funds target rate. He doesn't want the Fed to continue "tightening" and refers to this as excessive action.
This framework of the Fed's letting interest rates rise (by not expanding the money supply by as much as previous) as being excessive action implies that it is somehow less excessive (more "normal") for the Fed to keep interest rates low. This is the exact opposite of the reality of monetary policy in light of monetary theory. In a world without monetary interventionism in which a central bank can simply buy assets (with money created out of thin air) and suppress interest rates, the money supply would tend to remain relatively stable. Interest rates would rise and fall in accordance with the time preferences of lenders and borrowers on the market.
It is the central bank's intervention ("monetary action") that causes interest rates to be forced artificially low. If the Fed let go and stopped "acting," if they let the money supply correct to its natural levels, if they let the malinvestments liquidate, interest rates would likely spike. It is not "excessive monetary action" that characterizes rising interest rates in a recessionary scenario but rather it is the suppression of those interest rates that is the example monetary action.
The Fed letting go of the economy's reigns, the opposite of monetary action, is recessionary because it was the Fed's monetary interventionism which created an artificial economic boom in the first place. Of course, this is not a case against the Fed letting go, for the recession is badly needed so that prices and the capital structure can properly adjust.
The Fed keeps interest rates low by continuing to intervene in the market. That is where the true excessive monetary action lies, and this is the source of our true economic woes.
There are currently three open Federal Reserve Board of Governors positions and the New York Times reports that Trump is ready to nominate the following two:
The expected nominees include Randal K. Quarles, a Treasury Department official in the George W. Bush administration, and Marvin Goodfriend, a former Fed official who is now a professor of economics at Carnegie Mellon University.
In picking Mr. Quarles and Mr. Goodfriend, President Trump is seeking to install conservative counterweights to the Fed’s chairwoman, Janet L. Yellen. Both men have expressed reservations about the Fed’s aggressive efforts to revive economic growth since the 2008 crisis.
Importantly for the discretionary vs. rule-based policy debate, it seems that Trump and those advising him are specifically picking two people who have been outspoken in defense of rule-based (such as the famed Taylor Rule) decision making. This is in contrast to Stanley Fischer and others at the current the Fed who have been firm in defense of discretionary policies.
We still await a formal announcement from Trump.
The Fed's economists are always coming up with deranged new ideas and when they fail to reach their goals the first time, they double down. In the recent decade they picked the completely arbitrary inflation growth rate of 2% (as calculated by the misleading PCE) and stated that for the economy to be on a strong trajectory, 2% inflation was a necessity. And of course, they directed all their stimulus toward Wall Street and capital markets (including housing) which has seen substantial gains since the crisis, but neither are calculated in the PCE.
At any rate, the Fed can point to the failure to hit 2% as an excuse why the economy isn't exactly strong 9 years after the crisis. The silly goal of trying to cause a rise in consumer prices will now be addressed with new "solutions." According to their models they haven't consistently hit 2%, though main street grocery shoppers dissent from the academic models.
At any rate, the Fed is determined to succeed. And so, San Francisco Fed President John Williams presented the idea of "flexible price-level targeting." This new excuse for monetary expansion will allegedly allow the Fed to adjust interest rates and monetary base growth in accordance with what is needed to hit a certain price level. In other words, the Fed wants the ability to overshoot the 2% goal as necessary to make up for lost time or to more effectively deal with years of "too low inflation."
The whole idea of trying hard and failing to hit their inflation goals is a massive underlying theme that continues to justify more monetary intervention. The Fed could hit 2% or more anytime it wanted to. For one thing, they could stop paying interest on excess reserves and therefore remove the incentive to keep money stocked at the Fed. This whole dramatic presentation is just an excuse to keep feeding cheap debt into the capital markets and the US Treasury.
What the United States economy needs is not a Fed that is more successful at hitting its currency devaluation schemes. We need the opposite: we need the Fed to walk away from the business of managing the economy so that prices can adjust, bad debts can be liquidated, and the economy can accumulate a healthy level of savings.
San Francisco President John Williams spoke last Sunday, reiterating his position that the Fed would hike 3 times this year. Looking only at the inflation rate (as measured by the PCE) and the unemployment levels, the Fed considers its dual mandate as having been met. On the surface this justifies a rate hike, according to mainstream economic orthodoxy.
However, Williams also expressed concern about the long-term prospects of slowing economic growth. CNBC quotes Williams:
"I personally view that the biggest challenges the U.S. faces are really longer run challenges, not about next month, next year. They're about the fact that productivity growth is very slow, we have a shortfall of infrastructure in the U.S.," he said.
"We have a lot of longer term challenges that really revolve around needing more investments in education, job training, infrastructure, research and development, all the things that propel an economy over the longer term."
The fact of the matter is the last 3 decades have seen a central bank-induced false prosperity in which the true capital stock of the United States (and the global economy) has been depleted. By artificially lowering interest rates and expanding the money supply worldwide, the central planners have brought consumption spending forward, neglecting the necessary savings required for long term economic growth.
Williams mentions several areas requiring increased investment, which allegedly propel an economy over the long term. The problem is that the world has far less capital to actually invest in the long term-- and the central bankers falsely believe that the creation of more money and the suppression of interest rates will suffice. But money is not the same as savings, as capital. Frank Shostak:
Money can be seen as a receipt, as it were, given to producers of final goods and services that are ready for human consumption. Thus when a baker exchanges his money for apples, the baker has already paid for them with the bread produced and saved prior to this exchange. Money therefore is the baker’s claim on real savings. It is not, however, savings.
The only way that the economy can be prepared for investment in various areas for the long term is by first accumulating a large capital stock. But the Fed's entire academic framework rests on the opposite of this; namely, to keep interest rates basically at all time lows and to encourage spending and consumption. With this the goal in mind, growth rates simply can't recover.
It seems that this theme of "rate hikes immediately but concern about the long term" could be a sign that the Fed is hiking now so that it has room to slash them in a future recession. Watch for this theme to become more prominent toward the end of the year.
I hate to be the bearer of bad news before a three day weekend, but St. Louis Fed President James Bullard informs us that "U.S. prices are now 4.6 percent below the price level path established from 1995 to 2012, when inflation was growing near the Fed's target of 2 percent each year."
This lower than expected price level is deeply "worrisome," for Bullard.
The delight that the average main-streeter feels upon observation of a store sale, or the general falling of the price of all kinds of electronic devices, is not an emotion shared by our well-educated bureaucrat monetary overlords. Instead, evidence of prices falling below their price level path expectations, is of serious concern.
Now, given the above tragedy, it appears to Bullard that the Fed's rate hike expectations are "overly aggressive." That is, in order to save the United States from the haunting specter of falling costs of living, the Fed may need to remain "accommodative," ever ready to flood more debt into the system. How original.
May's FOMC minutes were released at 2:00 eastern today and included the same self-confidence about the strength of the economy, the progress on inflation, and the good employment numbers. Any sign of weakness, especially in the GDP numbers were waved away as being "transitory."
Besides these things being used as justification for further rate hikes, we also received more detail about their balance sheet plans. In short, so as not to scare the markets, they are aiming merely to taper back on the dollar amount of reinvestment of the maturing debt. That is, rather than selling their debt holdings to shrink the balance sheet back to normal levels (which are not actually going to be at "normal" levels), they are going to start by halting their reinvestment program. However, before quitting cold turkey on the reinvestments, it appears that they are aiming to agree on a certain dollar amount of holdings that will be allowed to run off.
The WSJ summarizes:
They want to avoid a rerun of the 2013 “taper tantrum,” when investor concerns over the Fed’s decision to slow the pace of those asset purchases roiled markets, leading to a large spike in Treasury yields and capital outflows from emerging-market economies.
Under the emerging scenario Fed officials have outlined in public speeches and interviews, the central bank would raise short-term interest rates two more times this year and then pause rate increases later in the year when they announce plans to set their balance-sheet wind-down into motion. A pause would allow the Fed to watch for any ill effects before resuming rate increases in 2018.
For the past year or so, the Fed has come across as more or less "hawkish;" preferring to position themselves as ready to tighten monetary policy via continued interest rate hikes. Following the recent several hikes, the Q1 GDP numbers came in terribly low and the Fed's anticipated source of "economic growth," consumer spending, hasn't been up to par either. The economy, quite frankly, looks sick despite the Fed's best efforts to increase the cost of living (what they refer to as inflation).
Thus, it makes sense that two recent Fed speeches have included a tone of caution about further interest rate hikes. Last Friday, St. Louis Fed's James Bullard noted that the economy is showing signs of weakness and argued that earlier months' rate hike expectations were too aggressive [per CNBC]:
On balance, the U.S. macroeconomic data have been relatively weak since the March...meeting.
As such, Bullard argued that the rate hikes estimates were "overly aggressive relative to actual incoming data on US.. macroeconomic performance."
On Tuesday, Minneapolis Fed president Neel Kaskari echoed this same sentiment, arguing that the lack of a clear inflationary trend was troubling. In his mind, the rate of inflation needs to be higher in order to justify higher interest rates. Kashkari emphasized that there was no real inherent need for interest rates to be rushed back to normal levels (as if a .25% hike is a Draconian move).
As we approach the June Fed meeting, we will pay close attention to whether the FOMC follows through with their rate hike estimates. Dr. Thorsten Polleit may have been on to something when he wrote that "the Fed will likely chicken out on planned rate hikes."
Politicians, bureaucrats, and media talking heads specialize in saying one thing but meaning something else. In Fed world, something referred to as "balance sheet normalization" would be thought to be a return of balance sheet levels to pre-crisis numbers (roughly $850 billion). But common sense does not prevail. Instead, as it turns, normalization doesn't mean a return to normal. CNBC:
Interviews with Fed officials, and public statements they've made suggest the Fed's new normalized balance sheet could end up being three times as large as it was before the financial crisis. And it could be bigger than that.
Of course, this was the almost inevitable, given the Fed's irrational fear of monetary deflation and their unwillingness to do anything that might make Wall Street think the punch bowl of easy money was being whisked away. Not to mention the political motivations of remitting profits back to the Treasury and artificially suppressing the US Government's cost of borrowing.
The CNBC article states:
A bigger Fed balance sheet on a more permanent basis is potentially good news for long-term interest rates. It means the Fed will have fewer bonds to unload, and so exert less upward pressure on interest rates. But if the Fed's calculations are wrong, it could mean higher inflation and higher rates.
"Good news for interest rates" does not, of course, mean good news for the economy as a whole. The economic role that interest rates play is to coordinate the use of scarce resources across time in accordance with the time preferences of human beings. So an interest rate that is kept lower due to central bank policies interferes with the market process. Resources are consumed in a way that varies with the desires of people acting in the free economy.
The article sums up opponents of a large balance sheet as follows:
Opponents of a large balance sheet say the Fed should reduce it as much as possible so it doesn't become a victim of politics, where Congress or the executive branch could mandate that the balance sheet be used to buy certain types of securities to solve fiscal problems. They also worry that such a large balance sheet is potentially inflationary.
Contrary to the mainstream press and what has become of "orthodox" economics, "inflation" (by which they mean rising consumer prices) is not the primary threat of suppressed interest rates. Economic depressions themselves are caused by the malinvestment that takes place during the era of too low interest rates. The healing process of liquidating these malinvestments is the pain of higher interest rates and the falling of asset prices. This healing process is what the Fed actively works to prevent by refusing to actually normalize the balance sheet.
Following the 2008 financial crisis, many observers were surprised by how much many Americans began saving. From 2009 to 2012, total household debt fell considerably, dropping by more than 12 percent from 2008 to 2013.
According to the Wall Street Journal, that drop was described by Fed researchers as “an aberration from what had been a 63-year upward trend reflecting the depth, duration and aftermath of the Great Recession.”
Since 2013, though, household debt has again marched upward. And now, according to the New York Fed, household debt in the US has now topped its previous pre-crisis level. According to the Fed:
The CMD’s latest Quarterly Report on Household Debt and Credit reveals that total household debt achieved a new peak in the first quarter of 2017, rising by $149 billion to $12.73 trillion — $50 billion above the previous peak reached in the third quarter of 2008. Balances climbed in several areas: mortgages, 1.7 percent; auto loans, 0.9 percent; and student loans, 2.6 percent. Credit card balances fell 1.9 percent this quarter.
If we look at all the components of debt since 2009, we can see that most components remains near or below the former peak levels. What's pushing total debt up is student debt and auto loan debt.
In this next graph, in which I index all debt levels to the 2008 3rd Q peak, we find that most debt components are near or below the old peak levels. Total debt (the black line) has just now risen above the old peak, with mortgage debt (the light blue line) still below the old peak (represented here by the value of 1). But, if we look at student debt and auto loan debt, we see that debt is well above its old peak. Student debt is now more than double what is was in 2008, and auto loan debt is almost 50 percent higher than the old peak.
Things are only slightly different if we account for growth in the working age population (ages 15–64). When we divide total debt by the working age population over time, we find that the per capita debt (which is $61,800 as of the first quarter this year) is still down 3.9 percent from the peak in 2008.This per capita figure is calculated by dividing the total debt level by the number of working-age persons in the US.
Nevertheless, either way you look at it, the old debt-cutting ways of the population that prevailed in the wake of 2008 appear to now be over, and debt is mounting back to old peaks.
Not surprisingly, the largest components of total debt tend to benefit greatly from government interventions and subsidies. Mortgages are subsidized by a plethora of programs including loose monetary policy and a secondary market for loans dominated by government-owned Fannie Mae and Freddie Mac — not to mention the benefits of the too-big-to-fail FHA. Many student loans, of course, are directly subsidized by the federal government, and auto loans continue to be helped along by rock-bottom interest rates made possible by quantitative easing.
Thus, as auto loans and student loans become larger and larger parts of total household debt, we see it's more than just mortgage housing, this time around. Jonathan Newman addressed some of these implications in March:
[T]his is more of an intended feature than a flaw of the Fed’s monetary policy since the housing bubble popped. Expansionary monetary policy can only replace bubbles with new bubbles. Malinvestments are not totally liquidated, but shift from one sector to another. Consumer debt is not directly paid off, but transferred from one type to another.
The redirection is mostly guided by new government interference in markets. Pre-2008, federal government programs to encourage new housing and mortgages, along with the low interest rates and new money from the Fed, created the housing bubble. Since 2008, programs like Cash for Clunkers, auto manufacturer bailouts, and income-based student loan repayment have funneled spending, borrowing, and increasing prices into education and autos.
Moreover, as with home loans in the late stages of the housing bubble, auto loans are seeing a rise in the total number of loans being made to customers with lower credit scores. Thus, it perhaps should not surprise us that serious delinquencies in auto loans are now near a six-year high:
With the exception of student loans, however, delinquency rates are not exceptionally high, and the current boom — while weak by historical standards — appears to be continuing.
The trouble will come when consumers can no longer keep up with debt payments and money begins to disappear from the fractional-reserve banking system, setting in motion deflation and recession.
It's a correction that's badly needed, but as of the first quarter of this year, at least, the money continues to flow, and debt is enabling many Americans to keep expanding their spending for now.
2016 was supposed to be the year that the Federal Reserve "normalized" its policies. As much as two years ago — after years of a near-zero target rate — the Fed was swearing that it would begin to raise rates back to "normal" levels and cut its balance sheet.
That never happened.
Yes, the Fed has increased its target rate from 0.25 percent to 1 percent over the past 19 months. But if we look at this in context, it would be absurd to declare a target rate of 1 percent as anything other than an easy-money stance. Remember that throughout the 1990s, the Federal Funds rate was usually between 5 percent and 6 percent.
After December 2008, though, the target rate remained at 0.25 percent for seven years. Now that we're nine years into this "recovery" the Fed is talking about hiking rates, but we're in a strange world indeed when a 1 percent target rate looks like a central bank "tightening."
Moreover, we're still hearing precious little about the Fed normalizing its balance sheet, which remains heavy with assets purchased in the wake of the financial crisis to prop up asset prices.
We keep hearing about how the the economy is showing signs of strength, but nearly a decade after the last financial crisis, central banks — the Fed included — are still treating the economy as if it is extremely fragile and may fracture if upset in the slightest.
This becomes all the more evident when we look at other central banks around the world.
After all, the Fed is the odd man out when it comes to central banks, and is the only major central bank that's raising rates.
Looking at the central banks of Australia, the EU, Canada, Japan, China, and the UK, we find no tightening at all. Since 2012, with the exception of the Fed, it's been nothing but cuts in the target rate. Excluding the Fed, the last time we saw central banks move was when the Australian central bank and the Bank of England lowered their target rates in August 2016.
Meanwhile, the European Central Bank and the Bank of Japan continue to sit in negative territory.
The Bank of Japan has been saying it's going to get serious about shedding its massive balance sheet, though — in the future. Last week, the Bank of Japan's governor Kuroda said he might even release a report on the impact of unwinding the BOJ's balance sheet. But talking about scaling back monetary stimulus and actually doing it are two different things.
The balance sheets at the big central banks of the US, EU, and Japan are so big that Bloomberg last month called the balance sheet issue, "the $13 trillion gorilla in the room." It's a combined total that's so huge it's "greater than either China’s or the euro region’s economy."
Like Japan, the ECB is doing nothing at all right now, and "any discussion on when to start shrinking [the balance sheet] appears to be some distance away."
Moreover, the Bank of England left its rock-bottom 0.25 percent rate unchanged and lowered its 2017 forecast. Earlier, the B of E had used Brexit as an excuse to ramp up the stimulus, and in spite of a stabilizing economy, has done nothing since.
And lest anyone think the smaller economies may be doing fine, we find that Moody's is downgrading Canada's six largest banks over fears the housing market there is too frothy. The Bank of Canada's last move was to cut its target rate to 0.5 in 2015.
The cumulative effect of all of this is to drive home, yet again, that the central banks are simply too frozen with fear about the true state of the economy to take any hawkish action on interest rates.
If things are progressing so well, where are the rate hikes of a mere 0.25 percent?
We're not seeing any, because the banks know that without a constant infusion of easy money, demand would likely collapse, and recession would follow soon after.
But, with the Fed the only major bank tightening rates, the world's central banks are driving home yet again that we're in a race to the bottom. Yes, the US is in the midst of an inflationary regime, but the ECB, BOJ, and others appear to have no qualms about keeping their own money spigots wide open. And thus, the dollar, for now, looks not so terrible by comparison.
The great Austrian economist Friedrich Hayek celebrated a birthday earlier this week, while the prominent monetarist (and Fed historian) Allan Meltzer passed away the same day. Joining us to discuss monetarism is our friend Bob Murphy, who lays out the central tenets of the Chicago school and its godfather Milton Friedman. At its heart, Bob explains, monetarism is a cousin of Keynesianism—one advocates fiscal stimulus, the other monetary stimulus. Both go astray when it comes to money, and both fail to see the trees in the macro forest. Bob explains why in this great discussion of the differences between the Austrian and Chicago schools.
Chicago Fed President Charles Evans spoke on Friday, expressing his fear that there was risk to the downside on the inflation outlook. These people! Unlike the Austrians, who define inflation and deflation in terms of the supply of money and fiduciary media, the mainstream defines them in terms prices. Thus, when Evans and others like him consider there being risk of too low inflation, what they are saying us that they fear the cost of living either falling or not rising fast enough (2% annually). No wonder the average person can't stand the pompous "let them eat cake" attitude of the global bureaucrats. Who except an overpaid government academician would praise rising price levels?
For this reason, Evans is on the "dove" side of the FOMC's spectrum, stating that one rate hike instead of two seems more prudent. If inflation isn't up where it should be, then we ought to avoid raising interest rates and instead keep the monetary juices flowing. Of course, there's no real difference between one or two .25% rate hikes, especially on the meaningless Fed Funds rate.
Evans also indicated that he thinks the Fed's balance sheet could return to normal levels ($800 billion) if it was trimmed once per month over the next 3-4 years. This is ludicrous if he thinks this can happen without pension pain, market toil, and even massive problems at the Treasury. It took 8 years to quadruple the size of the balance sheet up to $4.5 trillion. And Evans thinks it'll just be wound down in half that time? Yeah right.
The supply of US dollars has slowed during early 2017 with March's year-over-year percentage increase hitting a 103-month low of 5.9 percent. The last time the year-over-year growth rate was lower was during September of 2008, when the growth rate was 5.2 percent. Monthly year-over-year growth rates in the money supply have been falling each month since October. (All the numbers used here were posted in mid-April 2017.)
Over the past eight months or so, money supply growth rates have become somewhat volatile with the growth rate surging from 6.7 percent in late 2015 up to 11.3 percent by late 2016, and down again to March's multi-year low.
The M2 measure also showed a downward turn in recent months, although not to the same extent as the "Austrian" measure. The year-over-year change in M2 during March was 6.3 percent which put M2 growth near a 12-month low. M2 movements were otherwise unremarkable, however.
In fact, the measure has now dropped below that of M2, which has not happened since the period of 2005 to 2008. A similar phenomenon occurred from 2000 to 2001. In both cases, sizable declines in the Austrian measure below M2 signaled brewing economic troubles.
Two factors that may be contributing to a decline in money supply are the drop in Treasury Deposits at the Fed, and a relative lack of new loans being made in the banking sector.
In March, growth in commercial and industrial loans began to fall to multi-year lows, with April's totals showing the smallest amount of growth in loan activity since 2009. As Frank Shostak explains here, the money stock tends to shrink when banks cut back on loans:
Another factor at work may be the ongoing decline in treasury deposits at the Fed, which in March dropped to a nearly 18-month low.
March's large decline in money supply growth partially reflects a collapse in treasury deposits at the Fed. Indeed, March's year-over-year decline in treasury deposits was the largest decline recorded in 29 years, with treasury-deposit totals dropping by 72 percent.
The "Austrian" money supply measure (also known as the "true money supply") used here is a measure of the money supply pioneered by Murray Rothbard and Joseph Salerno and is designed to provide a better measure than M2. The Mises Institute now offers regular updates on this metric and its growth.
The "Austrian" measure of the money supply differs from M2 in that it includes treasury deposits at the Fed (and excludes short time deposits, traveler's checks, and retail money funds).
Nota Bene: Given a large number of confused comments by readers to these money-supply articles in the past, it may be necessary to clearly state that a measure of the money supply is not a measure of price inflation, and movement in money supply growth should not be interpreted as an index of index of price changes in the general economy. As Frank Shostak explained in a recent article:
[I]ncreases in the money supply need not always to be followed by general increases in prices. Prices are determined by both real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant, prices might display low increases.
... If the growth rate of money is 5% and the growth rate of goods is also 5% then there will not be any increase in the prices of goods. If one were to follow that inflation is the increase in the CPI then one will conclude that despite the increase in money supply by 5% inflation is 0%.
Last Friday featured a handful of Fed speeches, and this week began the same.
Cleveland Fed President Loretta Mester warned against "moving too slow" on interest rake hikes, implicating that she would prefer that the Fed hike faster than the Fed's current "gradual" approach. Mester is not a voting member, and one of her statements was particularly interesting. She said that if the delay in rate hikes was too long, recession could loom. This is not Keynesian orthodoxy, which teaches inflation and recession are mutually exclusive. This is why, for the Keynesians, inflation is always and everywhere the remedy for recession. It is odd to hear a Fed President argue for rate hikes on the basis that not raising them will lead to recession.
Minneapolis Fed President Neel Kashkari spoke optimistically on the prospects for the blockchain. As we mentioned in a previous post, there is much incentive for central banks to adopt and monopolize blockchain technology for the sake of increased control. As the New York Times observed:
For the central banks, the promise of the technology is that it would allow them to track every pound or renminbi on every step of its travels through the financial system in real time — something that is impossible now. The goal would be to make the financial system more transparent, fast, efficient and secure.
So naturally, Kaskari sees great promise in adoption of the technology.
Finally, Boston Fed President Eric Rosengren expressed worry that the economy would overheat unless the Fed moved faster on rate hikes. If the unemployment continued to move too low, this would be a sign of overheating (per the economically fallacious Phillips Curve). That is, Rosengren seemed to argue in the opposite way of Mester, though both support hiking rates at a faster pace than current. Yet, he also expressed his belief that the Fed would someday hit a zero rate of interest and a further expanded balance sheet once again to deal with a future recession.
This gives credence to the idea that the Fed is really pushing to shrink the balance sheet and hike rates so that it can have lots of room to move when the next official recession comes. Such is the state of our "healed" economy.
Fed Vice Chairman Stanley Fischer spoke first on Friday morning and made it clear that the Fed's discretionary approach to monetary policy was to be preferred over a "rules-based" approach. That is, the flexible judgment calls of the economists at the helm of the economy are going to be more accurate than a mathematical model. Such arrogance, thinking that one can run an economy from the top, is typical of those in power positions. Of course, we should be as equally quick to point out that a mathematical model, which naturally originates in the mind of some other academician, is not any better. Central planning is central planning, whether we are told we ought to put faith in the model or in the discretion of the Central Planner.
Fed Chair Janet Yellen chose a politically popular topic: gender issues and discrimination in the workplace. She expressed frustration that discriminatory tendencies were holding back women's pay, apparently unaware that she could help by not being so adamant about increasing their cost of living. If one wonders what this has to do with monetary policy, it must be remembered that the Fed has to play the PR game, just like everyone else in bureaucratic positions.
John Williams of the San Francisco Fed came next. He was enthusiastic about the falling unemployment levels, not once mentioning either that people are taking on more part time jobs to stay afloat or that the employment participation rate itself is terribly low (the denominator in the employment calculation).
However, he expressed concern that job growth was actually growing too fast, as in Keynesian land too many people employed could be a sign of an overheating economy that should be slowed. Here is a piece by Christopher Casey challenging this alleged "Phillips Curve" conundrum.
Finally, St. Louis Fed's James Bullard touched on the balance sheet issue, opining that the Fed should start to roll back its holdings later this year. Whereas other Fed members want one more rate hike before touching the balance sheet, Bullard indicates that the interest rate levels are fine. The balance sheet is ready for "normalization!"
Bullard, however, is not a voting member of the FOMC so it remains to be seen whether any of the others will share his strategy.
At 2:00 pm Eastern, the FOMC made their policy announcement as their meeting came to an end. As expected the Fed did not raise the Federal Funds rate target at this May meeting.
Two items are in focus now, however. The first is the possibility of a June hike. As always, the Fed wants be clear that such a move is “on the table.” Prior to the meeting, the June hike probability was around 70% and have now jumped to 90%. These odds will adjust over the rest of the week in response to the FOMC statement and the plethora of Fed member speeches this Friday. While the Fed doesn’t want to stick hard and fast to a timetable of their hikes, they do seem to be dedicated recently to appearing reliable. They said they’d aim for 3-4 hikes this year. Though of course as Thorten Polleit points out this morning, they will likely chicken out. FOMC on rate hikes:
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
The second is the balance sheet issue. This has been the theme recently as the Fed is giving the impression that policy normalization is on the horizon. That is, the Fed alleges that it has the wherewithal to actually trim its $4.5t balance sheet. Normalization would take it back below $1t, at least. Yeah right. Nevertheless, the minutes of this May meeting will be released on May 24th and we will have a better idea at that time as to how in depth they covered this issue. Here is the FOMC on the balance sheet:
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
These policy decisions come on the back of the lowest GDP growth rate in 3 years. And yet, the FOMC announcement did reveal they are positioning the GDP situation and other "soft data" weakness as "transitory." This means that it is not the mark of new economic problems, just sort of an outlier. But knowing the Fed, when push comes to shove, the only thing they know how to do is suppress interest rates and increase the money supply.
In sum: nothing new here!
The Atlanta Fed's final projected Q1 GDP growth rate was 0.2%. That was down from over 3% earlier in the year. Q1 GDP's actual ("advanced") number ended up being 0.7%, so the 0.2% was pretty close.
But now, the second quarter has begun and the hilarity begins immediately. The forecast has jumped from the 0.2% to a 4.3% forecast for Q2, in a matter of days. Call it a forecast of hope.
The BEA's "advance estimate" release of Q1 GDP came in today at a very low 0.7%, indicating severe slowdown of growth. The growth rate was attributed to slowed consumer spending, downturn in inventory investment, and a slowdown among state and local spending.
Of course, this exposes one of the problems with GDP in the first place: it relies on government spending and consumption qua consumption. That is, it pays little attention to the health of the capital structure and artificial credit expansion. Further, it does not take into account the fact that government expenditures are not necessarily connected to true market demand. As Rothbard noted:
Spending only measures value of output in the private economy because that spending is voluntary for services rendered. In government, the situation is entirely different ... its spending has no necessary relation to the services that it might be providing to the private sector. There is no way, in fact, to gauge these services.
Thus, a high GDP number doesn't imply a healthy of the economy in the first place. Nevertheless, the fact of the matter is that the econometric establishment claims GDP is a good reading on the progress of the economy. And therefore their own models are challenging their claim that their central planning is doing the trick! Will the Fed hike rates into the lowest GDP reading in 3 years?
Finally, this low number points to the superior accuracy of the Atlanta Fed's GDPNow forecasting model (final estimate was 0.2%) than the New York Fed's Nowcast model (2.7%).
Atlanta Fed:
New York Fed:
The Atlanta Fed's GDPNow model has steadily dropped from above 3% growth forecasted for Q1 2017 down to just barely positive as of today: 0.2%. Here is the reasoning from the Atlanta Fed:
The forecast of first-quarter real consumer spending growth fell from 0.3 percent to 0.1 percent after yesterday's annual retail trade revision by the U.S. Census Bureau. The forecast of the contribution of inventory investment to first-quarter growth declined from -0.76 percentage points to -1.11 percentage points after this morning's advance reports on durable manufacturing and wholesale and retail inventories from the Census Bureau.
The Fed has been saying that since the economy was so grand (supported of course by consumer spending — oops), it was time to up the monetary "tightening" efforts. In addition to fed funds rate increases, they are anticipating adjustments to the balance sheet. But this was all dependent on a cooperative economy, which now looks like it's not doing so hot. Which may, to the the dismay of politicians, Wall Street gamblers, and central bankers everywhere, "require" them to keep the monetary juices flowing. Aw shucks.
Paul-Martin Foss has put together a great overview of possible Fed appointees should Trump replace Yellen upon expiration of her term as Fed Chair. One individual who has come to the surface since Foss' article is former Goldman Sachs CEO and quintessential Wall Street establishmentarian Gary Cohn.
CNBC:
Speculation is building on Wall Street that a likely replacement to run the central bank would be Gary Cohn, director of the National Economic Council and Trump's closest economic advisor.
"The buzz among those who claim Cohn confides in them is that he would like to eventually replace" Yellen, assuming Trump decides to move in a different direction when the chair's term ends in early February, Beacon Policy Advisors said in its daily report for clients Tuesday.
Taken in the context of Yellen's recent determination to raise interest rates and Trump's sudden though unsurprising comments on the "need" for a weaker dollar and low interest rates, this could be Trump's move to avoid a tightening monetary environment. No one wants to be in a position of power when the bubble pops.
At any rate, choosing someone like Cohn to lead the Fed would be a long step along Trump's post-election path of base betrayal. Cohn is the epitome of what is wrong with Wall Street's relationship with Washington — and represents exactly what Main Street and rural America were trying to avoid with a Clinton presidency.
Minneapolis Fed President Neil Kashkari spoke on Monday and came out against the idea that infrastructure spending was going to lead to economic growth. No, this doesn't mean he has been keeping up to date with David Stockman, or cracked open Mises's Theory of Money and Credit. Rather, the Central Planner from Minnesota figures that it is "investment" in the education system rather than infrastructure spending, that is going to grow the economy. As if he could possibly know.
Of course, this is just a surface level skirmish between central planners about what centrally planned projects should be focused on. There is nary a hint of conviction that only market actors, guided by the market's wondrous price mechanism, can properly allocate resources in the most productive manner. If the economy (which is in fact just a metaphor that doesn't have an existence of its own) is to be grown at all, such growth must be driven by the market, not the academics at the Eccles Building.
Below is the outline for this week's events and speeches of importance relating to the Fed and its members. All times Eastern.
Monday, April 24
Minneapolis Fed President Neel Kashkari will be speaking at UCLA in CA on opportunity and growth. –11:30amKashkari also has a second speech Monday, this one at Claremont College in CA. –3:15pm Tuesday, April 25
Richmond Fed's Manufacturing Index: released at 10:00am Thursday, April 27
Kansas City Fed's Manufacturing Index: released at 11:00amThe Fed's Balance Sheet update will be released at 4:30pm. Friday, April 28
Fed Governor Lael Brainard will be speaking on "fintech" (financial technology) at the Kellogg School of Management at Northwestern University conference in Evanston, Illinois. –1:15pmPhiladelphia Fed President Patrick Harker will speak at the X-STEM Symposium in Washington DC. –2:30pm
Dallas Fed President Robert Kaplan weighed in on the rate hike storyline Thursday, endorsing the "three rate rises" view. He also qualified it, saying that if the economy outperforms, more than three is possible; and if it is weaker, less than three is possible. Thanks Bob.
He also stated that he was paying particular attention to price inflation trends. It's going the right direction, in his view (prices are rising), but unfortunately there are factors such as "technology-enabled disruption of business [that is] exerting downward pressure" (Reuters). This is unfortunate, of course, because rising prices are desirable and economic advancement challenges their efforts. Sarcasm aside, it is in statements like these that we get a peak into the anti-consumer mindset brought forth by the world's most eminent economists.
Beyond the tired rate hike issue, there is of course the new balance sheet theme. Kaplan informs: "As soon as later this year or maybe early next year, we should begin the process of letting the balance sheet roll off." The balance sheet has grown over 400% since the financial crisis, and now stands at $4.5 trillion compared to the $800 billion level where it stood in 2007. Yes, from the Fed's inception in 1913 to 2007 –almost a hundred years– it racked up an $800b balance sheet. And yet, in the 9 years since the crisis, it launched up to $4.5t.
So how much of this can actually be scaled back? Kaplan's answer: the balance sheet "[is] going to be bigger than the $800 billion we used to run." Clearly.
Regarding the Fed's balance sheet shrinkage narrative, one of the concerns is an unfavorable market response. The bond market (to the extent an actual market even exists) in 2013 panicked when the Fed began to taper it's asset purchases. While many are concerned the markets could panic, Fed Vice Chair Stanley Fischer on Monday denied this as a true concern. After all, they've been talking about this for some time — even in the FOMC minutes — and the bond market has hardly shrugged.
Said Fischer:
My tentative conclusion from market responses to the limited amount of discussion of the process of reducing the size of our balance sheet that has taken place so far is that we appear less likely to face major market disturbances now than we did in the case of the taper tantrum.
However, he also stated it was something that needed to be monitored closely:
But, of course, as we continue to discuss and eventually implement policies to reduce our balance sheet, we will have to continue to monitor market developments and expectations carefully.
So, does this mean that the Fed actually submits to the will of traders on Wall Street after all? To this, Fischer is quick to save face:
During a question-and-answer session, Fischer dismissed concerns that the Fed was providing too much information and therefore fueling too much trading.
“I don’t think we’re engaged in a game where they are leading by us the nose,” he said.
Of course he has to say that. No one is supposed to admit that the Fed doesn't do things on the mere science of dispassionate monetary policy. They cater to those whom they subsidize: both the Federal Government and Wall Street. And in the end, despite Fischer's dismissal of a market tantrum, can we really expect Wall Street's traders to smile and carry on as if they truly realize the Fed is no longer buying what they want to sell?
Below is the outline for this week's events and speeches of importance relating to the Fed and its members.
Monday, April 17
Fed Vice Chair Stanley Fischer speech in New York at Columbia. The topic is "Monetary Policy Communication." –5:00pm Tuesday, April 18
Kansas City Fed President Esther George to speak at 26th Annual Hyman P. Minsky Conference at the Levy Economics Institute of Bard College in Annandale-on-Hudson, N.Y. –9:00am Wednesday, April 19
Boston Fed President Eric Rosengren is also speaking at the Minsky Conference at Bard College, N.Y. – 12:30pmThe Fed's Beige book will be released at 2:00pm here. Thursday, April 20
Fed Governor Jerome Powell is having a Q&A with European Commission VP Valdis Dombrovskis in Washington DC at the Global Finance Forum. The topic is "Capital Markets, Growth & the Economy of Tomorrow." –8:00amThe Philadelphia Fed's Business Outlook Survey, which looks at trends in the manufacturing industry, will be released at 8:30pmThe Fed's Balance Sheet update will be released at 4:30pm. Friday, April 21
Minneapolis Fed President Neel Kashkari will be talking about the health of the economy and "community development" at the Hamline University Community Economic Development Symposium in St. Paul, Minn. –9:30am
Audit the Fed recently took a step closer to becoming law, when it was favorably reported by the House Committee on Oversight and Government Reform. This means the House could vote on the bill at any time. The bill passed by voice vote without any objections, although Fed defenders did launch hysterical attacks on the bill during the debate as well as at a hearing on the bill the previous week.
One representative claimed that auditing the Fed would result in rising interest rates, a stock market crash, a decline in the dollar’s value, and a complete loss of confidence in the US economy. Those who understand economics know that all of this is actually what awaits America unless we change our monetary policy. Passing the audit bill is the vital first step in that process, since an audit can provide Congress a road map to changing the fiat currency system.
Another charge leveled by the Fed’s defenders is that subjecting the Fed to an audit would make the Fed subject to political pressure. There are two problems with this argument. First, nothing in the audit bill gives Congress or the president any new authority to interfere in the Federal Reserve’s operations. Second, and most importantly, the Federal Reserve has a long history of giving in to presidential pressure for an "accommodative" monetary policy.
The most notorious example of Fed chairmen tailoring monetary policy to fit the demands of a president is Nixon-era Federal Reserve Chair Arthur Burns. Burns and Nixon may be an extreme example — after all no other president was caught on tape joking with the Fed chair about Fed independence, but every president has tried to influence the Fed with varying degrees of success. For instance, Lyndon Johnson summoned the Fed chair to the White House to berate him for not tailoring monetary policy to support Johnson’s guns and butter policies.
Federal Reserve chairmen have also used their power to shape presidential economic policy. According to Maestro, Bob Woodward's biography of Alan Greenspan, Bill Clinton once told Al Gore that Greenspan was a “man we can deal with,” while Treasury Secretary Lloyd Bentsen claimed the Clinton administration and Greenspan’s Fed had a “gentleman’s agreement” regarding the Fed’s support for the administration’s economic policies.
The Federal Reserve has also worked to influence the legislative branch. In the 1970s, the Fed organized a campaign by major banks and financial institutions to defeat a prior audit bill. The banks and other institutions who worked to keep the Fed’s operations a secret are not only under the Fed’s regulatory jurisdiction, but are some of the major beneficiaries of the current monetary system.
There can be no doubt that, as the audit bill advances through the legislative process, the Fed and its allies will ramp up both public and behind-the-scenes efforts to kill the bill. Can anyone dismiss the possibility that Janet Yellen will attempt to "persuade" Donald Trump to drop his support for Audit the Fed in exchange for an “accommodative” monetary policy that supports the administration’s proposed spending on overseas militarism and domestic infrastructure?
While auditing the Fed is supported by the vast majority of Americans, it is opposed by powerful members of the financial elite and the deep state. Therefore, those of us seeking to change our national monetary policy must redouble our efforts to force Congress to put America on a path to liberty, peace, and prosperity by auditing, then ending, the Fed.
Originally published by the Ron Paul Institute.
JP Morgan CEO Jamie Dimon and Minneapolis Fed's Neel Kashkari recently had a bit of a clash over the health of US banks, with Kashkari rebutting Dimon's claim that there's no longer a risk of taxpayers having to bailout banks in a financial crisis. Bloomberg summarizes:
In an essay published on Medium and republished on the Minneapolis Fed website, [Kashkari] challenged Dimon’s assertion in his annual letter to shareholders that 1) there’s no longer a risk that taxpayers will be stuck with the bill if a big bank fails, and 2) banks have too much capital (meaning an unnecessarily thick safety cushion).
Kashkari responded to this with: “Both of these assertions are demonstrably false.”
As Bloomberg explains, the conflict is over the acronym TLAC, which stands for total loss-absorbing capacity. That is, in the case of a sudden swarm of losses, how much capital does a bank have to have to absorb all these losses? The more capital, the safer the bank. Kashkari believes that banks are not as safe as Dimon says they are. Their disagreement is over who would absorb the losses (that is, where the capital to absorb the losses would come from). Here is the difference:
Dimon operates on the assumption that the unsecured bondholders of the bank will simply be forced to take a loss and they no will longer receive their interest payments. Thus, unsecured bondholders will aid in the loss absorption rather than, say, taxpayers.Kashkari does not include these bondholders because if one bank announced a default on its debts, bondholders across the financial system who own the debt of other banks would panic. Financial contagion would ensue. Thus, the regulators (i.e., Kashkari) need to protect the bondholders. Kashkari, then, is emphatic that the TLAC should not be thought of as including bonds. Because according to him, the financial regulators, at the end of the day, are going to do everything they can to prevent financial contagion. Bloomberg:
[W]hen push comes to shove, bondholders will absorb few if any losses. Taxpayers will be forced to step up and make sure they keep getting paid.
In a free market, taxpayers wouldn't even be part of the equation. Bondholders take risks and earn the profits or suffer the losses accordingly. But the much bigger point is that if our system wasn't predicated on the crony assumption that the taxpayers and the Fed (lender of last resort) would be there to save investors, these banks wouldn't be nearly as concerned about their health in the first place. The Federal Reserve system and its explicit rejection of sound money has spawned the very challenges it seeks to overcome.
Danielle DiMartino Booth is a former Dallas Fed staffer and author of the new book Fed Up: An Insider's Take on Why the Federal Reserve is Bad for America. She joins Jeff Deist to talk about her years watching Ivy League PhDs make gross and fundamental errors in an almost comically cloistered environment.
Have Fed economists even read Mises and Hayek? Do they recognize malinvestment as a byproduct of interest-rate setting? Do they know anything about their own institutional history, or at least enough to recognize how mission creep has turned the Fed into a central planning Politburo? And how will Janet Yellen deal with the inherent tension between raising interest rates and keeping the cost of US debt service in check?
Echoing the thoughts of Yellen and other Fed members, the Dallas Fed's Robert Kaplan indicated that the $4.5 trillion balance sheet should begin the scale-back process this year. "Gradually and patiently" was the phrase used, as they are ever wary of a tantrum on Wall Street. Reuters reports:
"My view is we could start that process as soon as later this year," Kaplan said in Fort Worth at the Cornerstone Credit Union League Annual Meeting, adding that he would prefer the Fed phase in the reductions to its portfolio so as to manage the impact on markets.
The last time the Fed signaled a change of course on the balance sheet, in 2013 under Fed Chair Ben Bernanke, yields shot up quickly, delaying the central bank's plans for returning monetary policy to a more normal setting.
Consider this a reminder that Wall Street's overreaction to slowing of easy money heavily weighs on the Fed's "objective and scientific" monetary management style. If Wall Street doesn't like it, then the Fed will give in. At any rate, right now the balance sheet normalization narrative is going full steam ahead.
As Yellen and the rest of the Fed cohorts talk rising interest rates and balance sheet shrinkage, Trump makes it clear: the dollar is too strong. As such, he opposes the Fed's recent efforts on interest rate policy. He likes low interest rates. This makes sense — politicians love cheap debt — though it is a sad deviation from his more critical stance on financial bubbles during his candidacy years.
What is interesting though, as he very clearly takes on the Fed's normalization narrative, he states that he has yet to decide whether Yellen should stay as Fed chair. WSJ:
He left open the possibility of renominating Federal Reserve Chairwoman Janet Yellen once her tenure is up next year, a shift from his position during the campaign that he would “most likely” not appoint her to another term.
This seems more like polite posturing than anything, given that Yellen's Fed is obviously on an opposite track than a weak dollar policy, at least in the short term. With the two board vacancies at the Fed, the power is clearly in Trump's hands. If Yellen too forcefully challenges the Trump "weak dollar" stance, she could find herself without the chairmanship when her term expires.
He even goes so far as to say: "I like her, I respect her."
Whatever the case, Trump obviously is gunning for a weaker dollar and lower interest rates. This is a stark aberration from the Fed's budding 2017 narrative. The Trump-Yellen showdown continues, even if it remains behind the vocal niceties.
One of the great Federal Reserve scandals in recent history seemed to resolve itself last week as Jeffrey Lacker of the Richmond Fed resigned for his role in the Medley Leak. But as Pedro Nicolaci da Costa, (perhaps the best reporter on this story) points out, the finely scripted statement from Lacker shows that he was not Medley’s original source for the market-moving information.
Lacker’s statement reads:
During that October 2, 2012 discussion, the Analyst introduced into the conversation an important non-public detail about one of the policy options considered by participants prior to the meeting. Due to the highly confidential and sensitive nature of this information, I should have declined to comment and perhaps have ended the phone call. Instead, I did not refuse or express my inability to comment and the interview continued.
When Medley published a report by the Analyst the following day, October 3, 2012, it contained this important detail about one of the policy options and I realized that my failure to decline comment on the information could have been taken by the Analyst, in the context of the conversation, as an acknowledgment or confirmation of the information.
As da Costa points out:
What Lacker admitted to was unwittingly confirming key information about deliberations on whether and when the Fed should purchase large quantities of government and mortgage bonds to keep long-term interest rates down.
That means "the Analyst" at Medley actually obtained the market-moving details about the Fed's decision-making from someone else.
The identity of the initial source remains a mystery.
While laws against insider trading should be abolished, there is an obvious difference between dealing with non-public information about private companies and central bank officials tipping off a select group with valuable information. In spite of such behavior undermining institutional credibility, the Fed has seemed disinterested in properly investigating it. They did conduct an internal investigation which largely cleared itself of any wrongdoing, but the the FBI and Congressional oversight disagreed with those findings. In fact, this decision to handle the matter internally, rather than working with outside organizations, has raised more questions than answers.
Whether the original source of the Medley leak is found, the entire episode should plainly illustrate the need for greater oversight and transparency at the Federal Reserve.
On Monday, Yellen took the opportunity during a public event at the Ford School of Business to reiterate her position to Congressional attempts to increase Fed transparency, her own actions during the Medley scandal validate the need for changes to be made. The Fed’s utter inability to conduct a credible investigation into blatant mishandling of public information demonstrates that mythical “Fed independence” shouldn’t be enough to prevent public transparency over the Fed’s monetary policy. Especially, as Jonathan Newman noted last week, considering the truly radical nature of the Fed's post-crisis policy.
It’s also worth pointing out that Lacker’s resignation, correct or not, is a significant loss for those skeptical of the Fed’s post-crisis action. Lacker was perhaps the strongest inflation hawk among the members of the FOMC, and has claimed that if he had full control of the Fed he would have never attempted Quantitative Easing in the first place. He has also publicly questioned whether QE has made unemployment worse.
Lacker’s replacement will not be decided by President Trump, but does represent yet another open seat in the FOMC. Who ends up filling these seats will be very important as the Fed seeks to normalize interest rates and unwind its balance sheet. Hopefully Lacker’s successor will share his sensibilities while Trump’s own Fed appointees resemble his campaign rhetoric more than his emerging tax plan does.
After eight years of extremely loose monetary policy, the economy is great again and we are to enter into a post-stimulative era of monetary policy. So said Yellen at a recent discussion at the University of Michigan. In her words, the Fed had given the economy all the "oomph [they] possibly could" and it was time to "allow" the economy to coast along.
Paying no attention to their own econometric constructs such as the GDP, the Fed has declared that the economy is fantastic. After all, the unemployment rate has leapt downward over the last several years (just don't look at the denominator — the labor participation rate) and the Fed's inflation measures are right around their arbitrary 2% level. Allegedly, these two pieces (and the unrelenting stock market) means everything is great!
According to the WSJ's summary: "Fed officials plan to continue gradually raising interest rates unless the economy begins to deteriorate." So the financial system, after eight years of balance sheet expansion at the Fed, is stable, unless it's not. Then what? Well, then the rate-rising narrative will quickly reverse and we'll be back where we were — more stimulative monetary policy!
Yellen couldn't resist a hearty slap on her own back as she praised the Fed as doing well at — get this — keeping inflation low. Seriously. They run around with their hair on fire in panic that deflation is a great threat and that the Fed's balance sheet needs to be quadrupled in order to Save the World. Then they express pride at their ability to keep inflation low. Of course, last year they were frustrated because they just could not hit the 2% inflation target! Amazing. Every data point is either an excuse for more Fed intervention, or otherwise a reason to bow to the cheering media.
Naturally, even despite claiming that the economy is doing well and that we can return to normal, there is still the qualification that there has been some "long-term changes to the US economy" that are going to require a "lower for longer" interest rate mentality. That is, we aren't really returning to normal. The proper interest rate in the Fed's mind is much lower than it was historically.
As if they could know what the proper rate of interest should be. As if their models, which ignore the capital structure and human action, can replace the insight offered by humans acting in the market according to their own consumption and saving preferences.
We end with this, from Yellen: “Evidence suggests that the population roughly expects inflation in the vicinity of 2%." Well, perhaps that's because the Fed and it's financial media lapdogs have been screaming for 2% inflation for years. To the extent that the population pays attention to how much they are being scammed by the central bankers, it seems reasonable that they "expect" an inflation rate comparable to what is blared on television.
Is this the end of stimulative monetary policy? Only until the Fed and the academicians realize their Goldilocks economy is sham and they have to double down to prevent another recession. Because stimulus is all they know how to do. And they reject completely the benefits of a healthy, healing, old-fashioned depression.
The minutes from the March FOMC meeting were released yesterday and we discover that the balance sheet theme is really coming together. The massive portfolio held by the Fed is allegedly going to be reversed over the coming years. The way to initiate this shrinkage in the balance sheet is to first stop reinvesting the return that it is making on all the bonds it holds. In the minutes, we learn that they are considering two options for how to do this:
An approach that phased out reinvestments was seen as reducing the risks of triggering financial market volatility or of potentially sending misleading signals about the Committee's policy intentions while only modestly slowing reductions in the Committee's securities holdings. An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet.
Option 1: "gradual" phasing out of the level of reinvestment. Option 2: immediate halting of any reinvestment whatsoever.
These are going to be the debated options moving forward in the coming FOMC meetings and Fed members speeches. The Fed tends to prefer "gradual" approaches to things, keeping at the forefront of their mind the possible reactions (temper tantrums) by stock and bond market participants. If they decide to begin phasing out reinvestment, it will be much later this year. This gives them two quarters in the meantime to conduct two more rate hikes.
The FOMC minutes give the suggestion that, as they try to get back to "normal" interest rates and balance sheet levels, they will be going back and forth between their two methods: Fed Funds rate hikes and slowing reinvestment. While watching paint dry has been more exciting than their rate hike progress, it seems that the Fed is going to be another two years before they get the Fed Funds rate into the 2% range (if they can make it that far) if they alternate between a reinvestment policy change and a Fed Funds hike.
Of course, all this could come unraveled by a single poor employment report. The wizards determining the direction of our economy, are actually as blind as anyone else. They are walking on eggshells, unsure what to do and where to go next. How does one reverse an 8-year 400% increase in the central bank's balance sheet without causing a commotion? That would be impossible.
Sebastian Mallaby is the Paul A. Volcker Senior Fellow for International Economic Relations at the Council on Foreign Relations. One can be sure, then, that his new comprehensive book, The Man Who Knew: The Life and Times of Alan Greenspan, reflects an Establishment point of view. As if this were not enough to tell us where the book is coming from, Mallaby informs us that he had Greenspan’s full cooperation in writing it. “This book is based on almost unlimited access to Alan Greenspan, his papers, and his colleagues and friends, all of whom were generous in their collaboration.
Though the book is hardly a panegyric to Greenspan, Mallaby views his subject with considerable favor. Nevertheless, the book contains ample material for a more severe verdict: Greenspan abandoned the free market convictions he effectively defended early in his career as an economist. To uphold economic truth was not the path to the power and influence Greenspan sought; and he readily adjusted his beliefs to fit with his ambitions.
Greenspan attached himself to Ayn Rand’s inner band of disciples; but his adherence to free-market economics did not stem from his alliance with Objectivism. Greenspan learned economic theory from Arthur Burns at Columbia University. For Greenspan, like his mentor Burns, statistics had primary importance: economic theory emerged from discerning patterns in the data and was strictly subordinate to its empirical sources. “Burns was the chief heir to Wesley Mitchell’s empiricist tradition, and his influence restrained any enthusiasm that Greenspan might have felt for the new trends that had begun to stir in economics. ... Even the cleverest econometric calculation was limited because yesterday’s statistical relationships might break down tomorrow; by contrast, finer measures of what the economy is doing are more than just estimates — they are facts.”
From his studies of the data, Greenspan arrived at an important conclusion. Financial markets played a crucial role in the genesis of the business cycle: “Squarely confronting the notion that financial markets are merely a casino of meaningless side bets, he laid out an insight for which Nobel laureate James Tobin would later capture the credit. Stock prices drive corporate investments in fixed assets. ... In turn, these investments drive many of the booms and busts in a capitalist economy.”
Greenspan applied his insight to Fed policy in a way that resembles the Austrian theory of the business cycle. During the 1920s, “the Fed’s key error was to underestimate its own contribution to the stock bubble. The rise in the market had set off a rise in investment and consumer spending, which in turn had boosted profits and stoked animal spirits, triggering a further rise in the stock market. The 1920s Fed had been the enabler of this feedback loop — in order for investment and consumer spending to take off, companies and consumers needed access to credit. Faced with a jump in the appetite to borrow, the Fed had [wrongly] decided ‘to meet the legitimate demands of business,’ as Greenspan put it.”
Greenspan drew from his analysis “a radical position: the United States should return to the gold standard of the nineteenth century. By tying money and credit to a fixed supply of gold, the nation could prevent toxic surges in purchasing power.” ... “‘The pre-World War I gold standard prevented speculative “flights from reality” — with their disastrous consequences,’ “Greenspan insisted.”
Nor was this the only area where Greenspan adopted a radically free-market stance. Defying the mainstream, “Greenspan followed up with an attack on government efforts to rein in monopolies with antitrust laws. ... He pointed out that it was not just corporate managers who would want to challenge monopolists; the financial system would demand that they do so. If a monopoly extracted fat rents from its customers, its share prices would soar; that would give entrepreneurs an incentive to create rivals to the monopoly, and it would give financiers an incentive to ply those rivals with abundant capital.” Mallaby views this “crude” view with evident distaste, noting that both Friedrich Hayek and Milton Friedman adopted a more “nuanced” position.
What then became of this free-market radical? Unfortunately, his desire for “power and pelf,” in Murray Rothbard’s phrase, led him to alter his views. A firm commitment to freedom would never gain him entry to the inner sanctum of government, and Greenspan soon learned to temper his views.
In his radical days, Greenspan had opposed government bailouts to failing firms: the discipline of failure was essential to the operation of the free market. In 1971, he defied his teacher Arthur Burns, who favored bailing out Lockheed. “Testifying before the Senate, Greenspan refused to back his mentor. ‘I am in fundamental disagreement with this type of loan guarantee,’ he began. Government-directed lending ‘must inevitably lead to subsidization of the least efficient firms,’ damaging productivity and therefore living standards. ... What the economy really needed was for weak companies to go bust, so that capital and workers would move to better-run establishments.”
Once close to the levers of power, matters were different. He wished to become Paul Volcker’s successor as Fed chairman, and he knew that firm opposition to Fed policy would hurt his chances for the job. Going against his earlier analysis, he supported the “largest bank bailout in U.S. history,” the rescue in 1984 of the Continental Illinois National Bank. He admitted the dangers of the bailout, but it was, as Mallaby summarizes his position, “necessary and appalling.” Appalling, one suspects, because of its effects on the free market; but necessary to advance Greenspan’s career. By the time he became Fed Chairman, the transformation was complete. By 1989, his “libertarian rejection of bailouts was long gone; what he wanted above all was the space to fight inflation.”
Greenspan wanted to fight inflation; but the best way to do it was no longer acceptable. A gold standard, he had long ago recognized, would bring with it monetary stability; but to replace the Fed with a commodity standard not subject to control by the government would erode his power. Accordingly the gold standard had to go.
He cast aside the gold standard with a transparent sophism: “A necessary condition of returning to a gold standard is the financial environment which the gold standard itself is presumed to create. ... But, if we restore financial stability, what purpose is then served by a return to a gold standard?” (quoting Greenspan). Why a gold standard cannot help create a stable financial environment, but instead presupposes it, Greenspan left unclear. Even less clear was how the Fed was supposed to preserve stability in the absence of the gold standard. Evidently we were to rely on his supreme powers of judgment in steering the economy.
Greenspan in his long career as Fed chairman gained the power and acclaim he coveted; but the crash of 2008, two years after the end of his tenure in office, led to a sharp decline in his reputation.
In their attitude toward compromise, Greenspan is the polar opposite to Murray Rothbard. Rothbard could have tailored his views to win the favor of Arthur Burns, who was a family friend, but he refused to do so. He never abandoned his principles, and he took the measure of Greenspan. Writing about him in 1987, Rothbard observed: “Greenspan’s real qualification is that he can be trusted never to rock the establishment’s boat. He has long positioned himself in the very middle of the economic spectrum. He is, like most other long-time Republican economists, a conservative Keynesian, which in these days is almost indistinguishable from the liberal Keynesians in the Democratic camp.”
In looking over Greenspan’s fall from free-market grace, the melancholy first lines of Browning’s The Lost Leader, addressed to Wordsworth, come to mind: “Just for a handful of silver he left us,/Just for a ribbon to stick in his coat. ...”