 I first met Roger in June of 1974, 20 years ago. The Institute for Humane Studies had arranged what was probably the first conference on Austrian economics since the Second World War. And the first evening, a group of people were sitting around talking about Austrian economics, and I believe in the circle was Murray Rothbard and a few other people. And I was somewhat brash and young and petuous and not always careful in watching my tongue. And someone had asked me, have you seen this monograph that this fellow Roger Garrison has done on Austrian macroeconomics? And I said, yes, yes, I've seen this paper. It's terrible, it's terrible, it's terrible. He's trying to build this macro model of Austrian economics. He doesn't understand that you can't do this. This fellow doesn't understand what Austrian economics is about at all. And I turned to this fellow sitting next to me and I said, well, what do you think of it? And he calmly says, I'm Roger Garrison. But in spite of that, Roger and I have known each other now for 20 years, run into each other periodically at conferences, and I can honestly say that in all attempt to embarrass him, I consider him one of the best of the Austrian economists of this generation that began their graduate studies in the 1970s. His works on Austrian monetary theory, capital theory, business cycle theory, Austrian approaches to understanding unemployment as a government-caused monetary phenomena are not only original but have added to and enriched the understanding of the Austrian point of view in many ways. He has contributed to a number of works, one of which I can gladly say is that this past April, April 94, he was at Hillsdale College participating in our annual Ludwig von Mises lecture series on the theme of economics in the classroom and he delivered an excellent paper on the continuing unfortunate legacy of Keynesian macroeconomics in academia and in the classroom. That book will be available from Hillsdale College by the end of this year with his contribution. He's also contributed to Austrian economic schools of economic thought, Friedrich Ahayek critical assessments, and he is presently working on a book called Time and Money, the Macroeconomics of Capital Structure. It is with great pleasure that I give you our afternoon speaker, Dr. Roger Garrison on the case against central banking. Okay, thank you, Richard. First thing I have to do is try to dig myself out of the hole that was created by Doug Casey. He mentioned to you at noon that people who actually have a degree in economics don't know any. Now, I could stand up here and try to defend my profession, defend the economics profession as a whole, but oh, that would be too big a task. I won't try that. I will point out instead that my undergraduate degree is in electrical engineering, okay? And so that will give me at least as much insight into economics as Casey's physicist might have had, okay? And in fact, the engineering degree is what underlay the macroeconomic model that Richard Ebling had just mentioned. The topic for this afternoon is the central bank, the case against the central bank. As I was making notes for this talk, I realized that what we now more affectionately call the Federal Reserve System is a name that was introduced as something of a euphemism when the idea of a central bank had bad press, better not to call it that, call it something that sounds more innocuous. How about Federal Reserve? Nowadays, Federal Reserve sounds pretty ominous, doesn't it? And central bank seems like more of a generic term, more neutral. So that twist in and of itself suggests something about the history of this particular institution. It was created just about 80 years ago this year and certainly has had an ominous history, not one that's a great source of pride. I think most of you, if you've read a lot about the Federal Reserve in the context of 20th century history, would have read some of the work of Milton Friedman possibly or Murray Rothbard. And you think of the Federal Reserve as a big player in critical episodes, especially of the Great Depression. And so let me review for you that particular episode and then bring the discussion of the Federal Reserve more up to date. The key players in that time, as far as academics was concerned, of course, are the Keynesians, the monetarists, Milton Friedman, and the Austrians, Murray Rothbard, Ludwig von Mises. If you look at the academic community nowadays, what you see is that the Keynesian view is pretty much discredited, at least in academics. If you walk down the halls of my home institution, Auburn University, walk down the halls of the economics department looking for a card carrying Keynesian, you won't find one. Or at least not in the raw form. People nowadays who write under the Keynesian label always have an adjective. It's post-Keynesian or neo-Keynesian or new Keynesian or whatever, trying to trade on the Keynesian label without actually being a Keynesian. Actually being a Keynesian is now something that you just don't see in academics. In fact, as I speak, there was a paper being delivered at Auburn University. I'm sorry to have to miss it. By visiting scholar who titled his talk, The Blob, Colin, can we ever get rid of Keynesian economics? And if you remember, The Blob was a 1958 movie starring Steve McQueen in which this blob fell out of the skies and consumed people as it grew, an apt metaphor I think for Keynesian economics. Well, the good news, though, is that we've gotten rid of the blob in academics. The bad news is, of course, the Keynesians went to Washington. There's much more demand for their advice there than there is for instruction at the universities. Well, if Keynesianism has gone, what does that leave? Well, it certainly leaves the monetarists, let's say, in the Austrians. And here is a pair that we can live with because if you think about it, again in the context of the Great Depression, Friedman writing about the Great Depression argues that the Federal Reserve blundered mightily in 1929 allowing the money supply to collapse, driving the economy into deep depression, keeping it there for virtually 10 years. He's got the statistics to back it up. Mises and the Austrians argue that the Fed blundered mightily during the 20s, creating an artificial boom that was inherently unsustainable and eventually came to an end in 1929. In 29 there was nothing much the Fed could do but allow the economy to go through something of a depression by allowing the money supply to collapse that made the depression even worse than it otherwise would have been. So you see here, academic debate centers on just how it was that the Fed blundered. Was it during the 20s or was it during the 29 to 33 period when the economy had already collapsed into depression? Well, opponents of the central bank can live with that debate, okay? We can live with that. Now, if the history of central banking is a particularly notorious one, the history of the alternative, free banking, is largely unknown. Not much about it in economic curriculums, not much about it in the history books. And yet, if you know where to look, if you dig in the right places, you'll find that it has quite a history and quite an admirable one. History books rarely mention the free banking era that dated just before the Civil War. And yet it was a particularly prosperous period and a period in which the banking institutions functioned quite well. If history books mention it all, though, they mention it for its perceived excesses and for its perceived failures and never for its success stories. They mention, for instance, the so-called Wildcat banking, a practice that was pursued in a handful of states and that was made possible actually by perverse state regulations of free banking. The states on occasion would allow the banks to suspend specie payment and they could legally not redeem dollars in specie and gold or whatever. This is what gave rise to free banking, not anything inherent in the nature of free banking. One estimate by Richard Timberlake, who wrote a book called History of Central Banking in the United States, argues that all of the losses suffered during the period of free banking due to Wildcat banking or other problems were actually less than the losses that would be suffered today during a 2% inflation. So in some, the problems of free banking didn't amount too much. The history books almost always omit, though, talking about the success stories of central banking. So let me try to fill that void in the next few minutes. Before the Civil War, there were banks all over the country that issued their own banknotes and they were banknotes that people readily accepted. They were as good as gold because they were redeemable in gold. One of the most successful ones was a bank in New Orleans and the distinctive quality of the banknotes that that bank issued derived from the French influence. French had an influence on almost all economic activity in New Orleans at the period and still does for that matter. But the denomination of the banknotes were written out in French rather than English. The 10 spot, for instance, would say D-I-X on the back. Well, the French called that D's. Southerners, of course, called it Dicks. And there were banknotes that circulated across a wide area of the southeast. In other words, that bank was so successful in issuing banknotes and having those notes accepted because they were good banknotes. They didn't depreciate. You didn't have inflation in terms of those banknotes. And so they circulated over a wide area of the southeast. They were affectionately called Dixies, of course, and the area over which they circulated, of course, was called Dixieland. So if you were living in the northeast and you headed south during that period, and, well, I started to say you stopped for gas, I guess you'd stopped for oats or whatever, made transactions of one sort or another, you'd begin to get your change in banknotes issued by that bank. That's what arrived in Dixieland. I tell this to my students down at Auburn and some of them are crushed by this particular tale of the origin of that name. They think somehow that that takes the romanticism out of Dixieland. But it certainly doesn't for me. I mean, money has a special place in my heart. And knowing that as the origin, I think, is something special. You might mention, though, that it's hard to get this out of a history book. It's hard to get it out of a history book. They simply don't mention it. And one place you can get it is a good dictionary. Look up Dixie in a good dictionary and it will explain to you what the origins of the term is. To include that in a history book would require them to give an account of the success of that particular instance of free banking. Well, why wasn't the success continued? Well, of course, it turns out during the Civil War, both in the north and south, there were all sorts of actions to put those banknotes to rest. After all, if competitors were out there issuing banknotes whose value didn't depreciate, then the government either on the north or the south would be hard pressed to issue its own money and pay for the war effort and get people to accept those banknotes. So in the north, for instance, there was a 10% tax in the 1860s levied against the issue of all private banknotes. And the free banking was effectively taxed out of existence. So it wasn't done in by itself, but rather by the government, who was trying to make room for its own greenbacks as a way of financing the Civil War. Now, in today's talk, I'm going to come down pretty strong in favor of free banking. In fact, I see that as the alternative to central banking. I understand that tomorrow there will be a talk given by Mark Scousen entitled Restoring Sound Money. If I know Mark, he might have something to say about gold. He has some good things to say about gold. The talk I'm giving is not at all at odds with that, in fact, quite to the contrary. That if you have competitive banking, if you have individual banks each free to issue their own banknotes, then if they want those banknotes to be accepted by the public, they'd better anchor them in something real. Historically, of course, that thing has been gold, and that was the experience largely of the free banking era. Now, I want to turn now to the comparison of central banking and free banking, first on a fairly general basis, and then I want to relate it specifically to some of the things that have been going on lately. And I think I can link it up in ways that dovetail fairly nicely with Doug Casey's talk over lunch. One of the basic problems with central banking is it has about a half a dozen different goals. It's trying to do about a half a dozen different things, only one of which is to maintain sound money, supposedly. All of the other goals tend to get in its way and cause it to do a worse job of maintaining sound money than it otherwise would do. Let me list some of these things that it has to do. It has a half a dozen different things to do, but it only has one policy tool to do them with. It controls one and only one thing, and that's the supply of money. It can increase it, decrease it, or hold the line. That's it. That's all it's got to do. While trying to achieve a half a dozen different goals with that one policy tool, it's no wonder that it gets itself and the rest of us in trouble. I'll even list as the first policy goal, which at least I think should be paramount among them, probably the only policy goal, is to maintain some sort of monetary stability. And for a central bank, about the best it could do, if it actually tried to do this and this alone, would be to maintain stable prices. Just hold the line on prices. If prices are rising, then it's creating too much money. If prices are falling, it probably thinks it's not creating enough money. Well, that's the way central banks operate. Still, if it created just the amount of money that would give the stable prices, that's probably the best that the central bank could do. Now, to explain just how the bank does this, actually if I were in a classroom, this is the point where I'd turn around and write an equation on the board, the familiar equation of exchange, mv equals pq, which just shows that the price level and the economy depends first and foremost on the amount of money that the bank creates. During one of the morning sessions, I had complained that there was no blackboard behind me, but instead only a mirror. And I had threatened just half-jokingly to borrow someone's lipstick so I could write mv equal pq on the mirror. Well, I think Bumper-Hornberger must have overheard me and had this screen installed back here. I can't even do that. But I think I can milk the essence out of that equation, even if I'm not allowed to write it. Freedman recommends that the central bank adopt a monetary rule, a strict rule, to increase the money supply year in and year out by a certain percent. Well, okay, what percent? Well, it's based on a long-run estimate of how fast the economy grows. So take the real growth rate of the economy if it grows at 3% a year, then the money supply needs to be increased at at least 3% a year to keep prices from falling, to keep the price level stable. But, well, there's one more consideration. That as time goes by and people are wealthier, they tend to want to hold more money than before. The demand for money itself over and above the goods it'll buy increases, and this adds another 2% to that rule. So if the Federal Reserve were to increase the money supply at 5%, 3% for real growth, 2% for increase in the demand for money, then the price level would be about stable, wouldn't change over the long run. So that's the 5% rule. Now, even this can be modified and some monitors would suggest that it need be because deflation is typically viewed as more onerous than inflation. There's ingrained beliefs about prices being sticky downwards and beliefs that the resulting unemployment is worse for a society than the inflation that would happen with an increasing money supply. It causes some monitors to suggest that the rule should be something in excess of 5%. In other words, a mild inflation is protection against any actual deflation that would be disruptive in the economy. So what we're seeing here is that a central bank operating even at its best, even at its most ideal state would increase the money supply, possibly 5%, possibly a little more inflation would be mild, and that's the best it could do. Now, it turns out it doesn't do that well, never has, and in my guess it never will. For it to adopt a monetary rule would essentially be for it to forsake all the power that it actually has, isn't that right? I mean, after all, Time Magazine, Newsweek, and a number of others have featured the chairman of the Board of Governors of the Federal Reserve Bank on their cover, and I remember one particular issue had the caption, the second most powerful man in the United States, and it was the chairman of the Board of Governors of the Federal Reserve System. Well, of course, if he was bound by a strict monetary rule, he wouldn't be the number two man. He'd be down there below where you and I are. So the very fact that the Federal Reserve Bank is perceived as having the power that it undoubtedly has is evidence enough that it's not about to adopt such a rule. However helpful that would be for us if it did. Now, maintaining monetary stability or price level stability is only one of the goals of the Central Bank. It has a number of others, and each of those others get in the way of its maintaining stability. In fact, as we'll see later, some of those other rules get in the way of one another and create a tremendous amount of instability in the economy that could easily eventually do the economy in. So what are these other goals that it has? Well, one goal that's increasingly important as time goes by is to accommodate the Treasury, accommodate the Treasury. That simply means that the Federal Reserve is one of the buyers of Treasury bills. It tends to buy them indirectly, not directly from the Treasury, but rather from large New York banks, but at the discretion of the Treasury. So if the Treasury is issuing excessive amounts of Treasury bills which would put upward pressure on interest rates if it weren't for the Federal Reserve, the Federal Reserve is in the market buying those Treasury bills to keep the pressure off the interest rates. They're accommodating the Treasury. And of course, to the extent they do that, then they're not free to, at the same time, maintain a stable price level in the economy. Another goal of the Central Bank is to stimulate the economy, or in modern terms, I guess, we'd say to grow the economy. Grow has now become a transitive verb. We grow the economy. This is something that's been done over and over since about World War II, and it tends to be done, for the most part, in the year and a half preceding a presidential election and has given rise to what's called political business cycle theory that administrations tend to increase the rate of monetary expansion going into the election, growing the economy, or I like to use a more colorful term, goosing up the economy to ride through the election and then deal with the inflation and aftermath of the monetary stimulant following the election. This has been prevalent with just a few telling exceptions, and I think it's instructive even to look at the exceptions. I'll tell you three exceptions, and then you tell me what they have in common. The first exception is the administration of Gerald Ford, who is, for the most part, a good person. And when it was explained to him by his economic advisors that it's time to begin increasing the money supply as an election ahead, he didn't quite understand. It doesn't seem like a very respectable thing to do. If that's what it takes to get elected, I don't know that we need to do that. And the statistics reveal that he simply didn't do it. Arthur Burns was chairman of the Federal Reserve at the time. He had cooperated fully with Nixon in 72 to help him win that election by stimulating the economy. He was still in place going into the 76 election, but there was no monetary stimulant. There was no goosing up the economy before the election. Gerald Ford didn't play the game. Now, following the election of Jimmy Carter, we got something quite different. In fact, if any of you remember when Carter was in Plains, Georgia, after the election and before the inauguration, he announced at the press a number of times that his administration was going to hit the ground running. And in monetary terms, this translates into hit-the-ground printing. As indeed he did. So what happened during the Carter administration, in effect, is that he played the game, but he started way too early. If you start increasing the money supply at the beginning of your administration, then you get all of the negative effects well before the next election. Oh, you get the stimulant, but it's only in the first two years. After that, you get inflation, stagflation, the misery index, which was of Carter's own making, but of course Carter was beat over the head with it by Reagan in 1980. So all of the negative results of that monetary stimulus were being felt in 1980, and Reagan won that election. Now, the third exception is George Bush. George Bush played the game, but he started too late. You see, Bush had achieved victory in the Persian Gulf in January of 1991. And imagine at the time that this would be enough to see him through the next election. Tried desperately to keep the Persian Gulf war, the victory, fresh in the minds of the voters through November of 1992. Well, that was just too long a period from early 1991 to late 1992. And he began to see, but only too late, that he needed something more. By August or so of 1992, he realized that he needed a kicker. And of course the standard kicker is monetary stimulation. And this is then when the Federal Reserve began to cooperate and increase the money supply in a last minute, and then all turns out too late effort to help Bush out. We got the monetary stimulant, but it came in February and March of 1993 after the Carter or the Clinton inauguration. So he was able to point to that and suggest that you should be happy you voted for him if you did. Okay, well, those are the three exceptions. Ford, Carter and Bush, what is it they all had in common? They lost, okay. So administrations that tend to win elections tend to do it with the help of some monetary stimulation. And you can imagine monetary stimulation from the central bank on this kind of a basis, it's sort of a push on the accelerator to get you through the next election, push on the brakes to deal with the inflation that follows. It's not a formula for macroeconomic stability. It's not a formula for price level stability. It has a very strong built-in inflationary bias that we've all seen over the last number of years. The Federal Reserve has still other goals. Anytime major industries such as, say, the housing industry is in a slump and interest rates need to be lowered in order to get it out of a slump. The Federal Reserve is supposed to be there at the ready, increasing the money supply, flooding credit markets with new money, getting the housing market back on its feet. It's supposed to be there to manipulate exchange rate when export industries are in trouble and need a boost. And if there's instabilities in Wall Street, well, it needs to be there, too, providing liquidity, which means new money for Wall Streeters to hold while they become more certain about just how to invest their funds. So all of these other goals get in the way of monetary stability. Now, I can compare that very briefly with free banking. I'm brief in part because we don't have any modern experience with free banking, so I can't tell histories of modern practices here, but also brief in part because free banking is simply characterized by the lack of these perversities that in a competitive environment banks can issue bank notes only to the extent that people are willing to hold them. And people are willing to hold them only to the extent that they don't lose value, which means if the bank over issues, it will do itself in rather than do the economy in. That's the whole business of competition. Competitive banking means no one bank is in a position to have major effects on the economy and that any ill-conceived expansion is something that does that bank in and not the economy as a whole. Also, under free banking, there's no notion here that somehow the bank can issue money just because there's real economic growth. Just because there's real economic growth doesn't mean that people are more willing to hold the bank notes of any competitive bank. And so, again, I need the blackboard, but real economic growth simply puts downward pressure on prices. But those pressures are felt in the very points where the growth occurs and that in itself doesn't provide any hardships to the economy, quite to the contrary. The falling prices where growth occurs makes it more possible for working people and all people for that matter to buy that real output more cheaply. So under free banking you would actually get a gradual deflation, a gradual downward trend in prices. There's no inflationary bias at all, quite to the contrary, a mild deflation but one that is not at all harmful to the economy. Now, I want to apply these remarks about central banking to the current situation. And by current, I mean the economy as it's functioning under deficit finance. I think deficit finance is sort of the big story of the last several years. When the macroeconomic history comes to be written of this period, deficit finance will loom large on every page. And just to focus your attention, let me pick up on a practice that we see on one of the modern news magazine shows. They have something called Timeline. You watch that. And I'll name a few events and you tell me what year these events occurred. There's some people in the audience of sufficient age to remember them well. Chevrolet introduced a new personal luxury car called the Monte Carlo. Dwight Eisenhower was laid to rest. It was the first year of men walking on the moon and it was the last year the federal government was in balance. Last year the budget was balanced. You're right, 1969, 25 years ago was the last time that we had a balanced budget in this economy. The imbalances and dramatic and chronic imbalances of recent years is taking its toll now and will take more later, as Doug Casey suggested during the luncheon talk. During the last quarter of a century when the government has been in deficit year after year after year, it's given rise to a lot of apologetics. Listen to the Sunday morning quiz shows or write-ups in the news magazines. All sorts of apologies for the deficit, how it's not really so bad. It's even in the textbooks and it's in the economic professional journals. You'd be amazed, maybe some of you have looked at this, but if you look at the major journals in the economic profession, the American economic review, economic inquiry, the Southern economic review, whichever journal you want to pick up and look through all those articles for even a hint that the deficit may be a problem, you're not going to find it. In fact, quite to the contrary, you find article after article that show either how the deficit doesn't matter or how we need larger deficits in order to stimulate the economy, for instance. So it's amazing. One part of the story when the macroeconomic history of this period comes to be written is how the economics profession missed the boat. Why didn't they pick up on this? One of the key phrases that you'll see in treatments of the deficit, usually in an early section in a paper or early chapter in a book, and it's let's put the government deficit in perspective. When you read that, watch out. Because that line ranks right up there along with one size fits all and of course I'll respect you in the morning. And typically these apologetics simply describe the deficit as a percentage of something. And of course the bigger thing you put in the denominator, the smaller the deficit looks. Deficit as compared to gross national product. What was a gross national product? If you remember your EC101, it's essentially everything. So almost anything including the government deficit looks fairly small compared with everything. One of my favorite politicians ever at Dirksen, long since deceased now from Illinois, used to say that the major function of the GNP statistic was to make anything else look small by comparison because everybody's spending program was stated as a percentage of GNP. Sometimes the deficit is expressed as a percentage of the total outstanding debt. If you stop to think about that, it does make you worry. Well this huge deficit we're running up this year is a large in comparison with the total accumulation of all the debt. Yeah that number is getting smaller but that's the cause for concern right there. Or sometimes they say well the U.S. deficit isn't all that large compared to the deficits of other western countries or compared to private borrowing. Well actually that makes you feel more uneasy too because if there are all these demands for lendable funds by our government, other governments and the rest of us puts a lot of pressure on the supply doesn't it? In fact if there's one ratio that's the one to use you don't see it used in all the apologetics but how about the government deficit as a percentage of saving because that's what's borrowed isn't it? The government is borrowing our savings and savings is small and getting smaller while the deficit is large and getting bigger. So that suggests that the deficit is getting out of hand. If you look at recent figures you see that the U.S. government is borrowing the equivalent of about 75% of total personal savings. Now it doesn't literally borrow all of your savings because it goes abroad and borrows them from Japan and Germany and others but that puts the deficit in perspective. Now once we see this huge deficit looming large over the economy then all of a sudden this puts the central bank in a new role and one that is lost I think even on most macroeconomists they haven't yet caught on to this but I think it's important to think about because the central bank is a key player in the treasury borrowing all that money and not just because of the particular amount that the Fed itself buys the Fed still accommodates the treasury the Fed still borrows some of those treasury issues but if you look at the statistics that's not the number that jumps off the chart you think well it's always done that what it does and I think this is much more important is it functions in a standby capacity ask yourself this why is it that there's no default risk premium on treasury bills? why is it treasury bills are considered safe? and you all know this if you're thinking about your personal investment decisions you think well do I want to risk my wealth and buy puts and calls and options or stocks and bonds or whatever or am I too scared to do that and instead we'll put my money in treasury bills or money market funds that buy large quantities of treasury bills so you see treasury bills as being risk-free are they? are they really risk-free? well they are to the person that bought them but at the same time they create tremendous amounts of risks for the rest of the economy the reason they're risk-free to the people that buy them is because the Fed is there standing by to monetize if it needs to in its capacity as potential debt monetizer it's giving the treasury a much longer leash than it would otherwise have it's allowing the treasury to borrow much more excessively than it otherwise could you know that corporations that get overextended face penalty rates and have to get their house in order even municipalities, Cleveland or New York and others who have pushed physical excesses beyond belief have had to get their house in order because there's a default risk premium on those securities but that's the premium that will never attach itself to treasury bills and precisely because the Fed is there standing by its very existence keeps those treasury bills default risk-free actually there's an imminent scholar at Auburn who argues that the government ought to run higher deficits and the reason he gives is because treasury securities are riskless and this economy needs more riskless securities with all the other risks there are out there in the economy and that's why he's an imminent scholar and I'm not I guess I don't know but if any of you know the economic jargon I like to say that the function of the Fed in this capacity is to externalize the risk in other words the risk that otherwise would attach itself to the treasury bills because of the treasury's being so overextended instead shows up in the financial sector it gets cut off from the treasury bills and it makes investing in other securities even more risky well let me show you just how we're certain that the treasury somehow or other needs to get that deficit accommodated year in year out it has to find ready lenders somehow somewhere most of this debt of course is very short term debt so it's out there looking all the time we're certain that it has to get it accommodated somehow but we're not at all sure about just how and trying to figure out just how is actually the main basis of speculation in security markets these days stocks and bonds and derivative securities all will give you profits or losses depending on whether you guess right about just how that treasury debt is going to get accommodated think about it for a minute that if the Fed actually borrows money from you from domestic savers then that means you're going to have high interest rates and all that that entails for corporations and industry generally trying to borrow if the treasury leans on the Federal Reserve more heavily for more actual deficit accommodation then you're going to have high inflation rates with all that entails if the treasury is able to continue borrowing abroad from Germany and from Japan then you're going to have weak export markets as our trading partners lend funds to the government rather than buy our exports so the treasury action has an enormous effect a first order effect on the profitability of different securities that you could buy on Wall Street so here comes the Federal Reserve in still a different capacity that I haven't even mentioned yet and that is that the Federal Reserve is called upon to supply liquidity to Wall Street whenever there is a significant downturn I think in recent times they've come to be called the mini crashes like in 87 or 89 and some even cents and here the Fed is pretty much pitted against itself and has a tremendous credibility problem let's see if we can sort it out by a typical episode suppose for instance that the White House and the Treasury leans on the Fed a little more heavily saying we need more deficit accommodation our foreign trading partners are more reluctant to extend further credit we don't want to borrow domestically for fear of driving up interest rates we need more deficit accommodation we need the Fed to print more money and buy government securities now the Fed which is concerned to some extent with inflation may be reluctant to do that now I don't think we can increase the accommodation at this time so we have the White House and Treasury pitted against the Fed now in Wall Street there's going to be a lot of heavy trading one way or the other is going to be high trading volumes there's going to be lots of price movements as people speculate about the final outcome of this will the White House and Treasury become even more insistent of the accommodation will the reluctance fade on the part of the central bank and what's the timing will it start monetizing right away or will it take a while will it monetize dramatically or only a little bit this is the basis for speculation now in Wall Street that kind of speculation can turn fairly quickly into a liquidity crisis in other words people who ordinarily speculate on the basis of the fundamentals profitability of different corporations might decide I don't want to try to out guess what Alan Greenspan is going to do next I don't want to try to out guess who has the stronger will Clinton or Alan Greenspan I'll get out of the market and they get out of the market and other people follow and soon enough it can be a route that people are getting out of the market and they're trying to get liquid they're trying to hold money well now here comes the Federal Reserve in its capacity of dealing with a liquidity crisis what's the Fed supposed to do in a liquidity crisis it's supposed to increase the money supply to supply the liquidity for people to hold while they become more certain about where they want to invest and the Fed right here is pitted against itself it's saying no we're not going to increase the money supply to accommodate the Treasury but we are going to increase the money supply to accommodate the people who demand liquidity because of their refusal to speculate about whether we will accommodate the Treasury you see that if it sounds confusing it is and the people in Wall Street are going to need some tea leaves to figure out just what the Fed is doing and what the Fed isn't doing they are increasing the money supply but not to accommodate the Treasury to avert the liquidity crisis now it gets more complicated because if they don't increase the money supply it has to be increased at the right time and by the right amount this is very touchy this is very iffy you have to increase it by the right time and by the right amount to quell these fears on Wall Street if you don't increase it enough then the liquidity crisis will affect the whole economy because people will be hoarding money they will be piling up liquid assets it puts downward pressure on prices generally and sends the economy into depression so the role of the Fed here is to build a firewall so to speak between the financial sector and the real sector to keep that from happening and to do that they have to provide enough liquidity now if they provide too much well willy-nilly that accommodates the Treasury doesn't it so they end up doing exactly what they said that they wouldn't do even on their own terms and even this is only half the story because once the Fed has supplied that liquidity then it becomes necessary to withdraw that liquidity from the markets as the liquidity crisis subsides in other words those people decide well this is only a mini crash it didn't affect the real economy we can go back into stocks and bonds so they begin getting out of liquidity and when they do the Fed has to withdraw it has to pull the money back out of the markets because if the Fed fails in that capacity then there's too much money out there and you start getting inflation the dollar starts weakening on international markets and that can cause a crisis of another kind in fact Larry Summers who wrote an article on financial crisis and macroeconomic stability it's in a volume entitled the risk of economic collapse edited by Martin Feldstein he argues that it's quite possible that the Fed's attempt to deal with the liquidity crisis will in fact precipitate a currency crisis in just the way I'm suggesting in other words if the Fed injects money markets with too much liquidity or doesn't pull it out in a timely fashion that weakens the dollar causes foreign holders of dollars and dollar denominated assets to begin dumping those assets which in fact are the international crisis possibly worse than the liquidity crisis that the Fed was trying to avoid now are these fears real do they really have a basis and if so why haven't we seen a major collapse to date well one of the arguments and it's one that makes me particularly uneasy but things have gone better than you might have thought simply because our leader and by that they didn't mean Bill Clinton they meant Alan Greenspan and before him Paul Voker the chairman of the Federal Reserve System are geniuses these people are geniuses okay well genius might overstate the case maybe more inclined to say sleuth-footed or nimble I guess savvy is this an argument that you're comfortable with I would hope not on several bases one is well first let me concede to a certain extent as critical of my remarks are about the central bank in general the Federal Reserve in particular I would be hard-pressed to name two other people who I would rather have seen calling the shots and running the fed than Paul Voker and Alan Greenspan they did well they're doing well Greenspan is given what he's got to work with and at the same time I would turn that argument against having a central bank that depends critically on the genius of the person in charge is not a formula for lasting stability you need a set of institutions that work independent of that kind of leadership free banking would do the trick even geniuses can fail and besides that as Summers points out it may well be that in a crisis in our future there won't be any room for genius to be exercised in other words it's quite possible that the liquidity required to stave off a liquidity crisis is more than enough to trigger a currency crisis in which case genius or not the firewall comes down and the mini crash burns into the real sector further while it's true that Volcker and then Greenspan have managed to deal with liquidity crisis seemingly one after the other it's awfully hard to maintain a flawless winning streak it's not enough that they're a genius in this episode or the next or the one after that they have to be a genius all the time and winning streaks are not easy to maintain I say that coming from Auburn University where the Auburn Tigers by the way are 18 and 0 but even they will lose eventually and even Greenspan or his successor will lose eventually in fact you could almost argue that success will breed failure in the sense that the belief that Greenspan is a genius or the belief that the Federal Reserve is there at the ready to maintain the firewall and to keep mini crash from turning into a route in the economy has caused investors to maintain lower levels of liquidity generally if you listen to your financial news on TV or in local papers it's now almost a presumption that there's no relationship between the financial sector and the real sector they're two different things and over those mini crashes that's just something that happens on Wall Street it doesn't affect the real economy it doesn't well it doesn't if Alan Greenspan is there to do just the right thing at just the right time or at least it will stave off dealing with the problems until sometime in the future but the more successes he has the more unlikely it is to continue eventually the firewall burns down and the the economy goes down with the financial sector there's a term in financial circles it's called the triple witching hour I'll let Mark Scousen explain what that actually means but I could conjure up a triple witching hour of my own by saying that watch out because next year is the end of Greenspan's term of office the credibility of the Fed may change dramatically when that organization is taken over by a Clinton appointee who will it be and how much of a genius is he or she at about the same time it may become obvious to one and all that deficit reduction in spite all of the rhetoric is not happening and the debt continues to be a persistent problem and about that same time you may see the White House and the Treasury leaning still more heavily on the central bank so you got an increasing problem of debt a White House leaning on the central bank and a new leader at the helm about which there's no basis to form expectations any crisis liquidity crisis falling on the heels of that is very likely to spill over into real prices thank you