Monday, March 4, 2019

Wenzel on the Federal Reserve

Last year I appeared on "The Bob Zadek Show" (860AM In San Francisco Bay Area, 1590AM in Seattle and 1380AM in Sacramento), where Charlie Deist was the guest host, to discuss Austrian school business cycle theory. In later shows he interviewed the Keynesian Brad DeLong and the market monetarist Scott Sumner. He has now published the interviews in book form with the title, ABCs of the Austrian Business Cycle: A Primer on Booms and Busts.
Below is the section of the book devoted to my interview.

The Speech Heard Throughout the Fed

Charlie Deist: Let’s start off with the story that became your book, The Fed Flunks: My Speech at the New York Federal Reserve Bank.

First, would I be correct to say that you’re something of a radical libertarian?

Robert Wenzel: Yeah, I think so. Even some of the radical libertarians would think I’m radical beyond them.

Charlie Deist: And that makes you a critic of the Federal Reserve.

Robert Wenzel: Absolutely. I’m with Ron Paul on that — End the Fed.

Charlie Deist: How was it that a radical libertarian and arch-critic of the Fed came to give a speech at, not just any branch of the Federal Reserve, but the central branch – the New York Federal Reserve Bank?

Robert Wenzel: In 2005, two New York Federal Reserve Bank economists wrote a paper saying there was no housing bubble. I replied to that, discussing why they were wrong and pointing out errors in their thinking and analysis. Then I wrote that they were making the greatest error since Irving Fisher said, in 1929 — just before the stock market crash — that stocks were at a new permanently high plateau. Then they went around the country presenting their idea that there was no housing bubble, and put up my quote about Fisher and the crash—saying that they were making the same error—as “an alternative perspective.”

Of course, we all know what happened after that. There was a stock market/real estate crash and it just killed the real estate market. It was clearly a bubble.

Simon Potter, one of the top Federal Reserve officials at that time, wrote a piece admitting that the Fed got it wrong, that there was a real estate bubble, and that many people didn’t see or understand it. He mentioned a couple of names [of people who did see it], and I wrote him and said, “Hey, what about me? Not only did I recognize that it was a bubble but I specifically identified the paper that your two economists wrote and said they were making mistake at the time.”

He forwarded it to two economists there and I got into an email conversation with one of them, Richard Peach. Richard is a great guy — at some point he says, “Why don’t you come over and tell us how you saw this.”

I said, “Sure, absolutely.”

Now I’m completely anti-Federal-Reserve. Anybody familiar with my writings (there may have been a couple at the Federal Reserve) would have known that I’m going to go in there and blast the place up. So I was amazed that he invited me, and I took him up on the offer. He put a notice out, and then they quickly changed and killed the notice and said, “Well, we’re going to do it this way instead of that way,” and all that kind of stuff. But he kept to his word, and set the whole thing up.

He had a place set for about 20 or 30 economists, and it was just a couple of them that showed up. He said that the others were busy — tied up at some other meeting — which did not surprise me.

Once I was in the New York Federal Reserve Bank, I was going to give the speech, even if I had to give it in the in the men’s room. But I didn’t have to do that. McCarthy and Peach were great. We had a discussion after I gave the speech that is now in my book, The Fed Flunks.

Mugger’s Money

Charlie Deist: Let’s talk about the philosophy of the Austrian school.

My understanding is that the Austrian Business Cycle Theory is not just a theory of over-investment or overstimulating the general economy, but it’s about how cheap credit distorts the economy in specific ways. Why was the housing market particularly affected by the actions of the Federal Reserve? What do Austrians say is the role of the Fed in creating something like a housing bubble?

Robert Wenzel: The reason it’s called the Austrian Business Cycle Theory is not because it’s something that only applies to the country of Austria. The original thinkers on this theory came out of Austria. The key people were Ludwig von Mises and Friedrich von Hayek, who won the Nobel Prize in Economics for his business cycle theory.

It’s really a simple theory and I don’t understand why mainstream economists don’t adopt it. Well, I do — it’s for political reasons, but it very clearly explains why.

To describe it in a short manner, the Austrian business cycle theory says that the Federal Reserve (or any country’s central bank) prints money. Wherever that money flows is where you will get a boom in the economy, because you get more money going in, bidding up prices. Generally it’s in the capital goods sector which means the stock market, real estate, etc.

The consumer end is a little more technical. Money printing just sort of revolves stuff around. But when it goes to the capital goods sector, you have the boom. Then at some point the central banks always stop. They have to stop or they’ll start a hyperinflation, such as we’ve seen in Zimbabwe and Venezuela.

I carry what I call “mugger’s money” around with me, which is money from former Yugoslavia. It’s too bad we don’t have a video here, well, I’ll show you, Charlie.

Charlie Deist: Bob is pulling out… what is it, 500 billion or 500 million?

Robert Wenzel: Yeah, a 500 billion dollar note out of Yugoslavia.

Charlie Deist: You’re a rich man.

Robert Wenzel: I actually had to use a couple of these when I was walking in Boston Common fairly late at night. These two guys came up to me and they said, you know, “Can you spare some change?” And they were clearly going to take it from me if I wasn’t going to give them something, so I pulled out a couple 500 million dollar notes, and they were jumping around and all happy. Of course, the problem for them was they didn’t understand hyperinflation. If they got ten cents for each one of those pieces of paper when they got to the bank that would have been a lot.

Central banks always have to stop printing at some point. They can pump, and pump, and pump in one direction, but in a modern complex society (outside of Germany, where they had two major hyperinflations), most of the time they stop well short of a hyperinflation. When we had G. William Miller as Fed chairman in the 1970s, it went its highest, to 15 percent, but usually when inflation gets over 5–10 percent they slam on the brakes. And when they slam it on, there’s no more central bank money flowing into the capital goods sector, the stock market, and real estate, so they crash.

It’s that simple: You pump the money in. It’s going to go up. You stop pumping it and it’s going to crash.

There have been 18 recessions in the United States since the Federal Reserve started operating in 1914....

Follow the Money: Interest Rates vs. Money Supply

Charlie Deist: From 2001 or so Alan Greenspan started lowering interest rates to make sure that that the headwinds the economy was facing didn’t drag it down. Is that correct?

Robert Wenzel: You have to go back to around 1987, when Alan Greenspan had been in power for about seven or eight months. Paul Volcker — who was the Federal Reserve chairman before him — sort of gave him a gift in the end. I’m speaking facetiously here, because Volcker started slowing money supply when he left. He didn’t want to have a legacy of inflation getting out of control, so he slammed on the brakes knowing that it takes a few months for it to kick in . Greenspan would have to deal with the crash.

The crash came in October of 1987, and Greenspan really started pumping after that. He slowed a little bit in 2000–2001 when we had the Internet bubble, and then he just pumped it up again. We had tremendous amounts of money flowing into the capital goods sector because of the way the Federal Reserve works. You had the stock market going up. You had a real estate boom.

Generally, there’s a sector that leads all the others in terms of the capital goods boom, and in this case it was the housing market, because there are a lot of regulations that the government uses to try to push money in that direction. Consequently, it was clearly a bubble, and it burst in 2008.

Charlie Deist: I want to quote from your book. This is Ben Bernanke speaking in 2008, shortly before the recession hit to provide an update on the economy:

“Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly. Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so. Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy.”

What happened next that led to such a huge downturn that we now know as the Great Recession?

Robert Wenzel: What Bernanke is doing is a perfect example of what all the Federal Reserve economists and most mainstream economists do — looking at the data coming in. There’s nothing telling them what’s causing this data or what might be changing that may change the flow of data in the trends.

They’re basically just trend-watchers — they’re doing what anybody can do by just looking out there and seeing if prices are going up or down, what current economic data is showing, or whatever. There’s no theory behind what they’re doing. They talk a bit about aggregate demand but they’re really just looking at whether unemployment is up or down? If it’s up, they think, maybe they’ll continue this way — depending upon what’s going on in other sectors.

But they miss the inflection points. They have nothing that tells them that things will change dramatically. And that’s what Austrian business cycle theory does, because it says, “Look, if you stop printing that money so it’s not flowing into those sectors anymore, it’s going to crash.”

It’s basic stuff, and they don’t get that.

If I can go back to the time when I gave the speech at the Federal Reserve, after I talked to McCarthy and Peach, I was discussing the Austrian business cycle theory with them a little bit. One of them said (I’m not going to mention names on this part), “Well, I know what you guys are—you are the guys that have that formula, M x V = P x T[4]”, which completely shocked me, because not only is that not the Austrian school — that’s the Chicago School formula!

So it taught me that these senior guys at the Federal Reserve are so in the tunnel of Keynesian economics that they don’t even understand University of Chicago school monetary theory. They don’t know anything else, and that’s really not a theory other than “demand is stopping and slow.”

But why is demand stopping? Why are people no longer building the houses, or demanding stocks? That’s where the Austrian school comes in and says, “Look, you’re printing the money, it’s going to go there. You stop printing the money, it’s going to stop going there.”

Charlie Deist: At the risk of getting into too technical of territory, I want to stop for a little bit on this question of Keynesian versus monetarism versus the Austrian school.

The Keynesian model of aggregate demand is that pumping money into the economy increases demand in periods when consumers might otherwise lose confidence.

But in the long term, as the monetarists have pointed out, when you increase the money supply, all you end up with is an increase in prices. Maybe you get a short-term boost in spending, but if you’re not stably increasing the money supply over the long term, then you get these  erratic booms and busts.

One more quote that I found particularly interesting in your book is that as a financial planner you say:

“I find it extremely difficult to give long-term advice when in short periods I’ve seen three month annualized M2 money growth go from near 20 percent to near zero and then in another period to see it go from 25 percent to 6 percent.”

This was during the recession. Can you explain in layman’s terms:

a) how money supply is measured;

b) why you choose money supply as the metric for monetary policy; and

c) what was going on in that period?

Robert Wenzel: First you have to get a full picture of what is actually being used as money to bid prices up. I tweak a little bit with regard to how I calculate money supply.

All economists will grant you that the physical money that you have in your wallet and in your checking account should be considered part of the money supply. Basically, most savings accounts — if it’s not a certificate of a deposit — that you can pull out any time should be considered part of the money supply. I also include money markets, because a lot of people use that as a sort of checking account and pay their monthly rent or mortgage with a money market fund in other accounts.

Charlie Deist: Where does this misconception come from that the Federal Reserve controls interest rates? We can talk about the federal funds rate — the overnight rate at which banks lend to one another — which the Fed can influence through their actions of buying and selling Treasury bonds. But where does this idea come from that it sets the market interest rate, which everyone from banks to borrowers look at when thinking about their long-term decisions. Why might it be mistaken relative to thinking more in terms of the money supply?

Robert Wenzel: Well, the Federal Reserve has some control over the money supply, but it’s not complete. We’ve had four or five interest rate hikes in the last two years, and basically we’ve had a situation where the Federal Reserve is raising that rate — and it does cause an increase in the very very short-term rates.

The long-term rates are a little bit different, because you also have people adjusting for what they think inflation might be in the future, at different places on the on the yield curve — the time schedule of how far out you’re going. So they don’t control all rates but they have a major influence.

This is the key: when an Austrian looks at the business cycle, he doesn’t necessarily look at the interest rate. He looks at the amount of money, or he should. I battled certain Austrians for the last two years — I call them “Austrian Lites”— they sort of get the idea that the Federal Reserve does something, but they panic at the tiniest change in interest rates.

Charlie Deist: Austrian Lite, like Coors Lite.

Robert Wenzel: Right. Right exactly.

Charlie Deist: It’s watered down.

Robert Wenzel: Maybe I should call them Austrian snowflakes, because they thought the stock market was going to crash when the Federal Reserve first started this recent hike in interest rates in December 2015. You had guys writing that the Federal Reserve is going to have to reverse the interest rate hike. They raised it by a quarter point — 25 basis points — it’s a tiny little speck in the ocean, and they thought this was going to dramatically change things.

Well, to understand how the Fed creates money, you also have to factor in the inflation rate. So, let’s just use this as an example — it was lower than this, but let’s say inflation was 2 percent. If the Fed increases the Federal funds rate from .25 to .50, there’s still going to be a lot of willingness to borrow at that rate given that the inflation rate is at 2 percent, just to use a big example. You have to look at how much change there is, and how much money is being printed. You could have a full 1 percent increase in the interest rate but if inflation is starting to heat up by 3 or 4 percent, people are going to still borrow at very very low rates. If the Fed funds rate is at, say, 2 percent, and the inflation rate is 4 percent, they’re going to want to borrow a lot.

So, you have to look at how much the Fed is raising the interest rate, and how much the inflation rate is jumping during that same period, to get a sense for how much it’s going to increase the money supply.

The borrowing occurs through the bank sector — the banks create this money and put it in a corporate checking account, or the Federal Reserve might come in and buy Treasury securities, and that money goes in to the banks. That’s the base: power money and then more loans go out from that.

Charlie Deist: The fractional reserve system is where it gets multiplied.

Robert Wenzel: Correct.

Charlie Deist: All these variables are enough to make my head spin sometimes, and I’m sort of an amateur economist. But for the average person listening, I think the key points to understand are that actors in the economy tend to be rational — they’re receiving price signals from all over.

F.A. Hayek––one of the leading lights of the Austrian school — talks about entrepreneurs as the planners. They’re the ones who are making the long-term economic decisions, and they need to know what resources are scarce, and how much savings there are in the economy to be channeled into long-term investments, like housing, like the stock market — these capital intensive industries.

When the Federal Reserve manipulates this important variable of the money supply, it clouds all of these signals. We’re talking on the radio — some people are maybe listening with a poor radio signal — and you can imagine that the Federal Reserve is mixing up these signals. It’s not just injecting unpredictability, but also a general skew in the direction of cheap credit. It’s incentivizing people to pursue these long-term projects for which there are no underlying resources. Would you say that’s a fair summary?

Robert Wenzel: It is. But I want to be careful about using the term “rational actors,” because Austrians look at the individual and say, “An individual makes decisions based on a value scale of different things he wants to buy at different times.” This is different from mainstream economists who say most actors are rational. We don’t assume that what they’re doing is rational. It could be entirely crazy.

As a matter of fact, buying houses at the top of the bubble was an absolutely insane thing to do in 2006, especially going into 2007. They wouldn’t have bought at the prices they were buying at if they really understood anything. You can have people buying all kinds of crazy things. So it’s not as much the rationality factor.

Some Austrians say, “Well, the signal is distorted.” That’s part of it, because the interest rates are lower for when corporations are planning. But the key is that there’s more money out there. It doesn’t really matter if people are rational or irrational if there’s no money for them to do nutty stuff with — to buy stocks when they’re selling at 300 or 500 times earnings — however crazy it gets. You can have irrational people doing that, but they can only do it if the money is available to continue that buying. The key remains how much money is being pumped...

Charlie Deist: I’m spending the hour with Bob Wenzel author of the economics blog and the book The Fed Flunks: My Speech at the New York Federal Reserve Bank. We’ve been talking about how the Federal Reserve manipulates the money supply and, in doing so, has exacerbated booms and busts in the overall economy, including the Great Recession. Perhaps we’re headed for another one.

Does Austrian economics represent the Red Pill worldview? You be the judge.

Let’s talk about one particular aspect of Austrian business cycle theory that puts it at odds with the Keynesian theory, which grants a special role for sticky wages. It’s hard for wages to adjust downward. You have business owners who are reluctant to cut wages for their employees for a variety of reasons — some are psychological and some are related to other frictions in the economy. But in the Austrian story, wages need to move downward in order for the markets to clear after this period of inflation.

You mention in this book that Herbert Hoover famously tried to shame businesses during the Great Depression for cutting wages. Are you saying that that this wasn’t the right thing to do? Did Hoover not have the worker’s best interests in mind when he was calling for businesses to keep their wages at the same level?

Robert Wenzel: Right. Keynes himself promoted this idea that is wrong at a basic level. When you look at supply and demand, markets clear. There’s no case where markets don’t clear. So if you’re demanding regulations, and trying to prevent companies from hiring outside of unions, and doing all these things that cement above-market wages, you’re going to just log jam the employment market. That’s what you saw in the 1930s and every recession after that. You’ve got governments trying to prop things up, and then you give people unemployment insurance — you actually pay them not to work. That’s going to take a bunch of people out too.

Now, when these wages drop, it doesn’t necessarily mean that people are losing buying power. During the down side of the business cycle, people are fearful. They don’t know what’s going to happen. They don’t know if they’re going to lose their job, so they don’t spend as much money. They keep it in their wallet. They husband it, and they’re careful. You have a deflation in the economy, which is not necessarily good or bad — it’s just a readjustment of wages and consumer prices. Wages drop, but prices are dropping at the same time. People have the same kind of buying power — if you’ve got the people working, they are producing things, and if things are being produced you’re going to have demand for those things, just at cheaper prices.

That’s something you don’t really see mainstream economists pointing out. They’re just saying wages are sticky. Wages aren’t sticky — prices clear; and especially wages. If a guy doesn’t have any job, and he has no money coming in, he’s going to take a lower wage. It’s not sticky. It makes makes no sense.

Charlie Deist: There’s sort of a self-fulfilling prophecy, because the theory says that wages are sticky downward, therefore we must enforce them at the current level — so then they actually do become sticky. Are you saying that the only way that markets don’t clear is if you enforce sticky wages through further government intervention?

Robert Wenzel: Exactly. They’re actually doing the opposite of what they’re saying. They’re saying, “Oh my, wages are sticky so we have to go and enact laws,” but the laws are making them sticky. They’re causing the stickiness. Again, if a wage drops during a downturn, when there’s a general deflation, even if wages drop, the buying power of that wage is going to stay basically the same.

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