 Good afternoon ladies and gentlemen, and welcome to my last class this year at the Muses University. Unfortunately I can't remain all week with you. I wish I could but tomorrow I'll be leaving after lunch and so this is it for me and I want to make this something really rousing and exciting so I think I'll have you up in arms. Not against me, I don't know, but I want to talk this afternoon about what I call regime uncertainty and this is an idea that I didn't exactly invent. In fact I believe the substance of this idea has been around for centuries. People have understood basically what I want this term to represent but it was never called by this name. People did speak sometimes in economics of regime uncertainty but it was usually a term used by financial economists or macroeconomists in a very specific way and the way I use it is quite different from the way finance people and macroeconomists use the term. When I use it it has reference to security of private property rights and that's why the regime here is literally the ruling regime, the political regime that exercises governmental powers over whatever territory and group of people we are considering. So regime uncertainty is something that has a relation to government actions or inactions sometimes that'll cause uncertainty too and regime uncertainty is a condition that is a kind of pervasive high degree of uncertainty and particularly among investors, entrepreneurs, and business people about the future security of their private property rights. It is something that appears especially during certain times. It could appear at any time but in practice we see it most markedly appearing in the wake of business contractions since 1929. We didn't really see a regime uncertainty very much before then because before then governments did not react to business contractions by undertaking a variety of measures to fix the situation. There was an episode in the early 1890s in the United States that one might want to call regime uncertainty but it was much more specific had to do with people's confidence in the durability of the gold standard and of course that had to do with government because the gold standard was a monetary regime operated by the government which basically fixed the price of gold and maintained it at the fixed rate against the dollar but that was a much narrower episode even though it was important. We don't really see the kind of government activism we've grown used to following a major business contraction until the one that began in 1929. Previously the dominant ideology had held that there wasn't anything government could or should do about bad business developing. That was something that had happened from time to time for a century or more. When we look at the say the year 1900 we could look all the way back to the depression of 1819 for example that Murray Rothbard wrote about in his dissertation so there's nothing odd about business collapses they've been around for a long time but from 1819 all the way up to 1929 we have more than a century in which the dominant ideology the one that constrained the actions of governments in power was that there was nothing for them to do this was just something that would sort itself out and in fact if they tried to do anything about it they would make it worse and cause its recovery to be retarded and an outstanding example of acting according to that ideology was the actions of the Cleveland administration in 1890s. The business collapse of 1893 lasted quite a long time there never been a collapse that bad before or that long before nonetheless the Cleveland administration against great political pressures to intervene in various ways to fix that situation did not do so and if you look at what Cleveland administration officials said they clearly understood that it just wasn't proper right or effective for them to get involved in that and they didn't they did maintain the gold standard even though that cost them dearly politically but nonetheless they were acting in that way too completely in accordance with the long-established ideology of limited government and respect for markets and private property well those conditions began to change as a result of the progressive movement that changed many people's thinking in the first couple of decades of the 20th century especially first among opinion leaders and later among more and more members of the public but from 1929 on the ideology had changed enough that we could always see governments in power reacting very vigorously in all sorts of ways when a major business contraction took place and it's that that frenzy of activism that brings about uncertainties with regard to the future of private property rights I want to talk about this concept with specific application to two periods when it has been very prominent easy to identify I think and and consider the kinds of evidence that we can bring to bear to to establish that it was in play and that did have the kinds of effects that we would expect it to have a priori and these are the periods of the great depression in the 1930s and the crisis that began and at least most visibly began in the fall of 2008 certainly had in some ways begun earlier but by the financial debacle of September 2008 it was quite obvious that something something awful was happening and the government began to react with all sorts of wild policy actions to to remedy the financial disturbances that took place especially in September and October of 2008 and then thereafter for for many years right up to the president in some ways the government was continuing to follow up on these actions in some fashion now we don't have talk to to conduct a complete course in the great depression and the recent recession this afternoon in this session but we can just in an introductory fashion take note of some of the the high points of these episodes as Austrians would expect both of them were preceded by by periods of policy induced easy money credit became cheap that is cheaper than completely free markets would have made it in both cases and austrian economists said I've had a lot to say especially Rothbard a lot to say about the the easy money of the 1920s and the role it played in leading up to the the downturn in the middle of 1929 likewise lots of taking over the easy money policies the fed imposed from 2002 especially through 2005 and to some extent even afterwards until 2007 or so but especially during those those four years I've indicated there the fed was holding interest rates substantially below free market levels and and as a result producing effects that that wouldn't have occurred otherwise when we have that kind of easy money regime we always have malinvestments and one characteristic form of those malinvestments because artificially low interest rates have a bigger effect on longer term investments than on shorter term and that's just arithmetic that's not an austrian idea but because of that construction is always a prime culprit in these business cycles produced by by bad monetary policy because construction involves creating a very long-lived asset and so construction of new housing new office buildings new infrastructure is very sensitive to the interest rate so when you reduce the interest rate you change the composition of investment and you shift it toward longer-term investments relative to medium and short-term investments and you're getting malinvestment because you're creating a structure of capital that is not sustainable in the long term in austrian economics besides the capital's heterogeneous that it has a definite structure it must be interrelated in certain ways in order to to be viable in the long run or sustainable otherwise we've got things that don't fit together and some of those investment projects will turn out to be failures they will have to be abandoned and when they're abandoned there'll be bankruptcies and unemployment and so forth and then that will have cumulative effects and we may have a full-fledged business contraction as a result when we have these kinds of malinvestment booms we always have people who want to get rich off of them so they always act as magnets for financial wheeler dealers who invent new kinds of securities or new kinds of but financial market gimmicks and the 20s real estate bonds and holding companies were created in great numbers and higher order holding companies were created so they were companies that didn't hold any stock in a producing company and they didn't hold any stock in a holding company they held stock in a holding company that held stock in a holding company that held stock in a holding company and and when you when you create companies like that you you create the potential for enormous gains on your investment because you're essentially leveraging any profits at the lowest level the level where goods and services are being produced up through the higher levels by the fact that you don't have to own all the stock in a company to control it so your own investment ends up yielding a very very large return but it works the same way in reverse because if the fortunes of the foundation companies turn south and they they start sustaining losses or lower profits than people expected then then the effect on holding companies up the line is magnified at each stage and so in 1929 1930 nearly all these holding companies been created in the previous decade actually went bankrupt they they went from being incredibly valuable to having no value whatsoever so they just basically disappeared from the face of the financial earth so we had that in the 20s more recently we had a lot of derivative securities created with the foundation being mortgage securities you know people's promises to repay mortgage loans that they had taken out that was the source of the income flow the cash flow but then of course people created securities which amounted to packages of different kinds of mortgage loans of different risk classes for example they figured out a way to get them classified as lower risk than they really were when they contained some higher risk elements in the package so that eventually got leveraged up by by derivatives that were derivatives of derivatives you see what i'm driving it here it's the same principle as the holding companies if you had a higher order derivative security you could get huge payoffs if things went your way and you could sustain enormous losses if they didn't and to and to sort of protect themselves against the potential for large losses this new thing called a credit default swap was created and it was a way of avoiding insurance regulations it was in effect a form of insurance that was not called insurance there had been different kinds of financial swaps around for a long time but these are basically new in the form they took after 2000 they were the main financial problem in the fall of 2008 they were the reason why the the Fed and the Treasury felt it necessary to to come to the rescue of AIG and in effect thereby to come to the rescue of of investment banks such as Goldman Sachs and others now when we did have the for austrians inevitable bust that followed these episodes of easy money what we see is from mid-1929 on the the real economy against the track the stock market crashes in october and output falls eventually by the early part of 1933 by about 30 real output real gdp 30 and that in the course of about four years or less whereas in the recent crisis we have output falling from a peak early in 2008 to a a bottom in the middle of 2009 so this contraction was about the six quarters long and amounted to about a five percent reduction in real gdp there was a lot of talk around that as people were comparing the current events and the events of the great depression and much of this was hyperbole you know if you if you think they were comparable in any important sense you're wrong the five percent is not 30 percent not even close now something I'd like to show you here is an important part of the business cycle that is not emphasized it's not even noticed usually by mainstream economists and what I've done here is shown both what economists usually look at which is gdp that's that solid line right here and if you wanted to you could put a growth trend in there and I've done it by connecting the the 1929 peak with the 1948 peak and that's one way if you're plotting the data and logarithms that's one way of of showing the rate of growth that would have been manifested by the economy if they've grown steadily between those two times rather than growing sometimes it's a slower and sometimes faster so we know it can it could have followed that path because because it did it ended up going from a to b but it didn't get there along that line at any given year if it had been on its steady growth path it would have been somewhere on that line as you can see in 1932 34 it's it's actually far below that growth trend so there's a big gap between potential output and actual output at the depths of the depression and then later on there there is what looks like a period when actual output greatly exceeds potential output and you might be shaking your head and saying how can that be how can you produce more than you're capable of producing and and there are some reasons why you might be able to do that for a while by capital consumption but the real reason for this big wartime bulge is mismanagement of gdp it's just a statistical artifact for the most part and now on the bars down here in the lower part of the chart i've separated out the private part of gdp and it it behaves very differently during the war and that was one reason i drew drew this chart in the first place but in the 1930s also you can see that that that private national product falls enormously does recover some uh by 1937 and many kensians particularly like to emphasize that recovery between 33 and 37 they say ah look all was well after rosevelt took office and put his policies into effect because the economy began to grow rapidly well yes it did and even even private output was growing fairly rapidly between 33 and 37 but look in 37 the private economy is far below its growth trend okay that's that dash line that even in 37 it wasn't close to its potential output there was still a big output gap there and then of course the new deal engineered this recession into depression in 1938 and set recovery back another two years until finally in in 1940 the private economy made another gain and in 41 it it was in some ways looking as if it had got back to where it was in 1929 but look getting back to where you were in 1929 is not a recovery because you're still far below the potential you had to produce in 1941 so you know everything depends on the question you ask and it's important when you think about macroeconomics or read about it which you can do any given day in the newspapers you have to think about the implicit question that's being answered there when they tell you what's going on because very often they won't even be asking the right question and if not they'll be misleading you and everybody else so this was a situation I wanted to emphasize about what was going on in the 1930s now another important thing that was part of this great depression was was the fact that it wasn't just output shown in bars here that collapsed but especially the private investment private investment collapsed between 19 let's go back between 1929 and 1932-33 private investment fell by about 85 percent that's a gross private investment now a large part of private investment takes place in any year is made just to compensate for obsolescence and wear and tear of equipment so you have to make a lot of investment just to keep your productive capacity where it is when you begin the year and so much of gross investment amounts to capital consumption allowances the amount of money that's estimated that must be spent in order to maintain productive capacity where you start if you invest more than that you're making net investment and it's net investment that drives economic growth because if you only make enough investment to keep your capital stock fixed over time you're never enlarging your capital you're never creating the capital you need to make labor more productive both because they have more capital to work with and because when you make new investment it gives you an opportunity to implement technological changes that require complementary capital in order to become useful other two things that net investment do they're very important okay so what was happening in net investment here the answer is it had become negative in fact it failed greatly in 1930 and then it failed further and further and further for the years 1931 2345 every one of those years net private investment was negative that is to say there was not enough gross investment being made to compensate for the capital consumption it was going on because of normal wear and tear and obsolescence so if you have an economy with the a diminishing capital stock even if nothing else were happening to go wrong you would certainly expect to have a more poorly performing economy in terms of the real output it produced yeah in 1935 and 36 net private investment became positive again but not positive in large amounts and excuse me should have said 36 and 37 was positive again and in fact at that time and this relates to a story I'm going to tell in a few minutes about the Roosevelt administration that Roosevelt and his lieutenants became quite confident that recovery was virtually complete they said oh we got it made now we're even getting private investors to come back and make make outlays that help us help us get going forward okay but they were doing other actions at the same time that discouraged private investors and frightened them and as a result we had a collapse of private investment in 1938 one of the largest in all American history private investment fell in 1938 by about 35 percent look at that one year so that was a huge deal and in that year a real output fell by four or five percent too so just the one year 1938 was comparable to the recession we had more recently in the magnitude of real output declines another way to see what was happening in the investment is to look at the proportions investment constituted in in GDP and I've shown that proportion here if we start out in 1929 it's about 16 percent of GDP it's gross private investment and that's the white and then you say private investors falls falls falls and then it's a tiny bit more in 1933 and then increases in 34 35 36 37 and then there's that falling dimension in 38 and it takes you another three years to get back to where you were in 1937 so there's a lot of running in place and running back and forth in the 1930s among private investors every time they think they see some reason to go forward before long they see some reason to go backwards so when we look at the entire decade in fact in fact the 11 years 1930 through 1940 inclusive and say how much investment was made by private investors in that entire period of 11 years the answer is it adds up to a negative amount negative in other words we went 11 years we did not increase the US capital stock at all there was never a decade in US history anything like that normally that economy had been growing since the early 19th century and in a normal decade the private capital stock would grow 30 to 40 percent so here instead of having our normal 30 to 40 percent growth of capital in a decade we we have none or a little less than that that's how bad the situation was and that is the principal reason why full recovery never took place the depression was not over in 1940 there was still an extraordinarily high rate of unemployment for example there were still several million people on the dole doing make work jobs created by the Roosevelt administration now in both of these cases as i've already suggested the government's reacted with a frenetic collection of counter cyclical actions or at least actions that purported to be counter cyclical there's a big difference even if they sincerely believe that these things would help the economy recover or prevent it from falling any further almost everything they did exacerbated the decline or retarded the recovery and it wasn't just Roosevelt Hoover got got the country off to a terrible start by his reactions to the onset of the depression particularly by the the actions he took to get employers to not reduce wages wages had always been reduced at the onset of a recession in us history that was the one way that employers kept their losses in check and also because reducing wages kept their the losses from being too large they were they were not creating so many unemployed workers they were not laying off so many people they were keeping it on the payroll just paying less and if you're a worker surely better to be still working for 80 percent of what you're making than not working and earning nothing at all so this had characteristically been what happened but Hoover delves about the business cycle and how it should be dealt with that led him to think wage reductions were a bad idea and so he used his influence to get a lot of big employers together in 1929 and more or less twisted their arms to agree that they wouldn't reduce wage rates unfortunately a lot of them gave into this pressure and did not reduce wage rates and as a result the rate of unemployment in the United States climbed much more quickly than it would otherwise have climbed and that of course had secondary effects workers who weren't earning anything couldn't pay their own bills and so they might cause merchants to go bankrupt so forth down the line there were cumulative effects later on Hoover revived a world war one agency the war finance corporation and gave it a new name the reconstruction finance corporation it was exactly the same old organization they even used the same firm form so when they started out they crossed off on the form the word war and wrote in reconstruction that's how clearly we can see that where this thing came from and it was even run by the same people good old Eugene Meyer who had run the war finance corporation came back to be one of the directors of the reconstruction finance corporation in fact if you study the economic history of the 20s and 30s you know Eugene Myers he's everywhere you know he's like he's like a multi-presence he's there he was one of Bernard Baruch's cronies and Baruch is a similar guy he's everywhere you look around he either Baruch himself or one of his his kept senators will be making a lot of economic decisions so we've got these important things taking place under Hoover and then when Roosevelt takes office the new deal creates right away a large number of highly significant economic intrusions in the economy then basically all hell breaks loose at that point because it's the same kinds of mistakes that Hoover and company were making but on a much bigger scale much more highly organized much farther reaching the worst of these things probably being the the creation of the National Industrial Recovery Act a scheme to cartelize every industry in America by coercion if you didn't write a an agreement with your fellow producers in an industry these these are called codes of fair competition of course because their real purpose was to suppress competition and you should remember Higgs first law of statutory naming which states that whatever statute is called represents the exact opposite of what it actually does so a code of fair competition was actually a code to suppress competition and if you didn't write one for yourself with your fellow co-conspirators with government approval then the government would simply write one for you and impose it on you they had something called the blanket code that they would insist people have and so of course more than 700 groups of businessmen got together and wrote these these things up and it was an absolute disaster okay the whole idea being to reduce output so you know industry X can get a higher price but think it through if every industry in America reduces output isn't that what we mean by a recession I think so yeah so this was supposed to be an anti-recession measure which just on the face of it was absurd and the remarkable thing you see Adam Smith said there's a lot of ruin in the nation the remarkable thing is in spite of being IRA there was a little bit of recovery in 1934 and 35 not much and in fact some of it was spurious because some of it was just industry's attempt in the summer and fall of 1933 to produce inventories before they had to pay higher labor costs as part of the NIRA agreement so that misled a lot of economists to this day Keynesians think oh look there's an immediate spur of output and they don't bother seeing what output because they never ask what output GDP is all they ever look at aggregate output that's all they care about if you're doing economics to that level you're not really doing economics well there was a little recovery in spite of NIRA but not very much similarly agriculture was cartilized and controlled and subsidized and taxed and pulled this way and that way at the behest of agricultural interest groups agricultural equipment manufacturers and so forth now similarly after the financial debacle of 2008 we had all kinds of attempts to bail out firms big firms especially of course they always have the political clout we had the Fed decide it was going to provide liquidity for one and all basically well that's not true not one and all there were some who didn't have the influence in the clout so they didn't get any special help but a lot of people did on an extremely large scale people people like those in the in the commercial paper financial industry commercial paper short-term loans that businesses make to carry inventories until they're sold and pay the next payroll things like that well you know that's just part of the kind of day-to-day operation of business to borrow with commercial paper securities well that that market displayed rising rates of interest in late 2008 to which I said so what okay there are reasons why interest rates should be rising on commercial paper in the conditions of late 2008 that says it ought to be okay but that seemed to scare the devil out of the Fed and they rushed in to pour billions and billions of dollars into the commercial paper market to see that these dealers didn't go broke well they weren't going to go broke anyhow prices don't just cause people to go broke because they go up especially if you're just a dealer you're a middle man for Christ's sake but that was one of the things that Fed did and it did a whole host of other things to to bail out big firms big banks and the TARP program which was created to to relieve firms that found themselves loaded down with with toxic derivatives you know these mortgage-based securities that turned out to be worth a lot less than people had thought they were because their risks that have been understated and misunderstood when they were created the situation was not that these things have become worthless most of them still had considerable value but in the circumstances late in 2008 it was hard to say how much they were worth so the market sort of dried up for these things and in a sense they were worthless because it was hard to sell a lot of them quickly and people worried that if they kept holding on to these they would end up with essentially worthless securities they didn't like that especially if they were big boys so they got their pals and the Fed and the Treasury come writing in and rescue them with the TARP program but that didn't work see because the guys at the Treasury weren't any smarter what do you know they weren't any smarter than the guys in the private financial markets at figuring out what these what these toxic securities really were worth so they went out to pay the holders for these securities take them off their hands but they couldn't figure out how much to pay them and so after a few weeks they just threw up their hands and they said we give up what what say we just give you the money instead so that's what they did they they bought preferred shares in about 700 banks that is today they became investors they became part owners of all these private banking companies now interesting to an economic the story is that exactly this same thing is what was done after the national national uh after the Reconstruction Finance Corporation was created in 1932 what did they do mostly they bought preferred shares in banks insurance companies railroads farm co-ops and so forth to give money to these guys who were who were in economic difficulty okay so we got all this hell breaking loose a lot of crap about thinking that I don't have time to wade through here but the the upshot of all this bad action and bad thinking is that people don't really know what's to expect anymore they don't know what to expect anymore and especially after 1935 because then Roosevelt decided it was not politically expedient for him to be pals anymore with business interests in the beginning when they created an IRA in 1933 he was trying to trying to respond like a normal politician to all the powerful interest groups and certainly business interest groups were powerful uh the national association manufacturers the chamber of commerce those big interest lobbies and they were all they were all hot for nira of course they'd been trying to get something like that for years which by the way also goes back to world war one when the war industries board had run a prototype of this kind of scheme but in 1934 35 Roosevelt had kind of decided that well recovery's coming along I don't need these business lobbies on my side anymore and besides all these crackpots like Huey Long and and Dr. Townsend are are real political threats to me in the election of 1936 so I need to cut them off at the knees and the way I'll do it is I'll get as radical as they are I'll mount class warfare I'll start blaming everything on businessman investors bankers and of course that's easy because 99 percent of us don't belong to those classes right so that looks like a good deal politically we'll get the massive voters saying yeah hang those guys from the nearest oak tree so that was basically Roosevelt's rhetoric in 1935 36 37 and what do you know this had never happened before the whole history of the United States no president ever got on the warpath against businessman this supposed to be a country run by businessman and in large part it was up until 1935 but now the president himself and his chief aides have turned on business particularly big rich investors so they start going after with regulation with new taxes which just threats to take over their property and it scares the devil out of these guys it scares them let me tell you just as an example so you won't think I'm making everything up and by the way I'm reading from a paper I wrote called regime uncertainty you can you can google this and get a copy of it in one or two clicks in uh in 1937 Lamont Dupont who was one of the rich private investors in the country who wrote in a letter a private letter this was not a piece of propaganda he wrote uncertainty rules the tax situation the labor situation the monetary situation and practically every legal condition under which industry must operate our taxes to go higher lower or stay where they are we don't know is labor to be union or non-union are we to have inflation or deflation more government spending or less our new restrictions to be placed on capital new limits on profits it is impossible to even guess at the answers this is the difference between risk and uncertainty when it is impossible to even guess the answers that's uncertainty they didn't know what was coming up they kept trying to clarify the situation but they did not succeed until long afterwards when it clarified itself more or less now we're running out of time but I just want to emphasize that because this has begun to be discussed quite a lot finally first by by people in the press and by laypeople people like those of us in this room and even in recent years by professional economists they've finally got a clue about this this I've done people people look at what guys like like Bob Higgs right and they think oh he's just a crackpot okay but there's some evidence behind this and there are different kinds of evidence one is that we know what was going on if we're any good at history we can tell you about a lot of things happening in the 1930s or since 2008 that describe turmoil that describe irregularities that describe instabilities that make life hard to forecast okay so there's some history we can we can tell here second there's a lot of direct testimony by investors and business people themselves like Lamont Dupont who tell us you know we don't know what's going on what's next there's a lot of poll data that are relevant economists usually laugh this out of court but there's no reason why they should it's certainly as good as his national income and product accounts that they regard as gospel okay and then I think perhaps the most decisive evidence of all comes from the yield curves on corporate securities that's hard that's put your money where your mouth is stuffed you can't laugh that away and if if you're seeing an increase in regime uncertainty what you ought to expect is an extraordinary steepening of the yield curve that is you should see and disproportionate rise in the effective yields on longer term securities because you know it's not that tough to form expectations about next year but two years five years 10 20 in a situation of regime uncertainty that becomes very difficult and therefore if you're going to buy a security promising paid in 20 years from now you're probably going to discount the price you pay pretty pretty heavily and therefore raise the effective yield on that security and that's exactly what happened it happened both after 1934 and diminished in 1942 what exactly fits the second new deal what do you know and it happened after 2008 as well I ran through the same kinds of evidence for the post financial debacle they the events that more recent years are not as drastic as the ones of the 1930s and that's as I would expect because we don't have the same situation now that we had then there's also been the creation of some policy uncertainty index since the most discussed being the one by Baker blooming Davis and what you can see here is if you follow this thing the events since the financial debacle here push that index up to extraordinarily high levels compared to where it was in the previous 20 years or more so that's consistent also I have many problems with these indexes by the way I don't have time to go into that right here but but they are they are problematic and in the 1930s the system itself was up for grabs as DuPont said are we going to have capitalism or socialism or what well that question was answered long ago we're going to have fascism okay so that's not an issue anymore so now when we have regime uncertainty it's not about the nature of the system it's not the system is locked in now but but we have major policy details up for grabs things like who's going to be bailed out what's the TARP program going to do how's the Fed going to allocate credit because it's going to just use open market policy where it allocates credit to specific sectors and specific forms of investment okay and then we have these giant ones like Obamacare and the Dodd-Frank Act which open the door to hundreds of new kinds of regulation and we don't know how they're going to be fixed they've got to get the regulators working out there which means we've got hundreds of new political processes tied to every one of those proceedings as people try to get their pound of flesh out of whatever the great regulations say and that has created so much uncertainty that just these things not to mention a bunch of others that I might mention are enough to help us understand why private investment is a very slow to recover since 2009 and still is not on a net basis back to where it was before the recession okay thank you very much