 Trevor Burrus Welcome to Free Thoughts. I'm Trevor Burrus. Tom Clucketsy And I'm Tom Clucketsy. Trevor Burrus Joining us today is George Selgen, a senior fellow and director of the Center for Monetary and Financial Alternatives at the Cato Institute and professor emeritus of economics at the University of Georgia. Welcome back to Free Thoughts, George. George Selgen Thanks, Trevor. It's nice to be here. Trevor Burrus What is the Federal Reserve? George Selgen The Federal Reserve is the United States central bank. What that means is that it's the bank responsible for determining what other banks do and the resources they have available for their activities. The Fed creates the ultimate dollars in the U.S. monetary system. Those dollars consist of the Federal Reserve notes everybody sees and they also consist of credits that banks can keep at the Fed, can have at the Fed, which is for that reason called the bankers bank. And those reserve credits, so-called, can be converted by the banks into paper dollars anytime the banks request it. So using these Federal Reserve dollars as an essential input as it were, the banks go about their business of creating their own claims to dollars, making loans in dollars and creating deposits that are denominated in dollars that people can also spend. Trevor Burrus So does the Fed do this? I mean, does it have the authority over printing money and stuff and does it decide how much money is printed or does it do it through some other mechanism? George Selgen Essentially the Federal Reserve decides the overall amount of Federal Reserve dollars, including paper currency and those credits I mentioned that banks hold at the Fed. The Fed determines that some of those two values and by doing that determines the scale indirectly of all dollar creation of the creation of private dollars like bank deposit dollars because the amount of those ultimately depends to some extent on the availability of the dollars that the Fed creates. I should mention because it's a common source of confusion that the Fed doesn't actually print Federal Reserve notes that's done by the Bureau of Engraving and Printing, but the Bureau of Engraving and Printing just acts as a service or supplier for the Fed. But it's the Fed's policies ultimately that determine how many of these notes get put into circulation. Trevor Burrus Now George, you haven't mentioned interest rates yet. I think if you ask most people what does the Fed do? What is monetary policy? Well, they'd say the central bank sets interest rates. I don't think that's quite right, but if it's not, where the interest rates come into this story? George Greenberg That's the one thing people know. Trevor Burrus The one thing people know. George Greenberg The one thing people know. Trevor Burrus Yes. Well, it's the one thing people know, but it is really starting as it were kind of in the middle instead of the basics. The basics really do have to do with the Fed's creation of dollars and the reason interest rates come into the story is because the way the Fed regulates the extent to which it creates basic dollars or the available supply of basic dollars or regulates the purchasing power of those dollars, one or the other depending on the regime, is through interest rates that it manipulates or controls. So for example, the Federal Reserve before the crisis would set a policy rate and that would be the rate at which banks could borrow Federal Reserve credits from one another overnight. So as I mentioned before, some of the basic Fed dollars that are created consist of credits that banks have, deposits that banks keep at the Fed, dollar denominated of course. And in the old system, things have changed in a way I hope we'll get around to talking about. In the old system, if banks were short of these deposit credits for their reserve requirements or other reasons, they could borrow, one of their choices was to borrow from other banks that had more than they needed. And that rate of interest at which that overnight interbank borrowing of Federal Reserve credits took place, Federal Reserve dollars is called the federal funds rate. So that rate for years was the policy target rate. And so the Fed would say, well, we think a good place for the federal funds rate to be is let's say 3%. And if it crept up above that level, that would indicate that reserves were a little bit in short supply and it would create some more dollars, put some more dollars into the economy, make reserves, Fed dollars more abundant to bring it the rate back down to the target of 3%. So superficially, monetary policy was about setting the federal funds rate target. So it was about it not just interest rates, but specifically this one interest rate. But underlying this process or goal of keeping this interest rate on target was the basics of supply and demand for Federal Reserve dollars for the dollars that the Federal Reserve alone was capable of actually creating or removing from the system, if necessary. You mentioned it's the bank of the United States. Now, if you study American history and you learn about the battles over the first bank of the United States and the second bank of the United States, is the Fed like the third bank of the United States? Is it kind of in the same vein as that? Or I guess I'm also asking, when did it come about? Where did it come from in that kind of line of progression? Well, yes, according to most authorities, the Federal Reserve is in effect the third bank of the United States in that the first two federally chartered banks, the first bank of the United States and its successor, the second bank, they were at least proto-central banks. They had some things in common with a modern central bank like the Fed. They weren't quite full-fledged central banks in many respects, but they certainly had some features of modern central banks. That's why there was a great to-do about the establishment of the Fed because the previous federal banks had been quite controversial and the second federal banks charter had been famously not renewed by Andrew Jackson, who employed his veto power to veto the bill to recharter the second bank. It looked like at that point, the United States was done with this idea of a federally chartered bank or proto-central bank or whatever you want to call it. It took some pretty clever, political maneuvering and several financial crises to get us back to having a central bank, to having the Fed, which was established in 1914. There's a long story about the politics and the instability that informed our taking up again this idea of having a central bank. It took a lot of people by surprise to find back in 1914 that we had not, after all, settled the question of whether we should have a central bank or not once and for all. We thought we had. Everybody thought so, particularly the Democrats, who were the party who got rid of the second bank in the United States, but lo and behold, they were also the party that decided to pass the Federal Reserve Act. So that period of time, roughly 80 years of no central bank, was there some huge gap or was there some institution that did the job or was that job not really needed to be done? Well, first of all, in principle, the job doesn't need to be done, particularly if you have a specie or a gold or silver standard, which was the case back in the 19th century and early 20th century. When you have such a standard, first of all, you have a sort of basic money that doesn't inherently have to be supplied by public authority today, where our standard is paper money itself. Of course, it's not something that's naturally scarce. So only a public utility as it were could be relied upon to supply this stuff and with luck supply so little of it that it doesn't become worthless. But when you have a specie standard, in principle, you have a monetary standard that doesn't absolutely require a central bank. Now, the question is, can you have also a stable, safe, monetary and banking system without a central bank? And the answer there is yes, you can. Canada here offers a particularly good illustration because until 1935, Canada didn't have a central bank, but it had the same basic gold unit, gold dollar that the United States had. It had a decentralized system. Multiple banks, commercial banks, issued the paper money of Canada that was convertible into a fixed amounts of gold, and it was a very stable, well-working system. So Canada's case certainly suggests that you didn't need to have a central bank. Of course, the United States didn't have that same system. When we got rid of the second bank in the United States, what emerged from that step was not a Canadian-type system, but a system that was a real motley arrangement with numerous states, first of all, that had their own banking and currency systems, all of which were quite different and involving different degrees of government intervention and regulation. And that was the situation until the outbreak of the Civil War. In those systems, some of them performed relatively well, particularly the ones in the Northeast and some of the Southern systems, but others performed quite poorly. One of the things though that was common generally, with the exception of a few Southern states, was that banks could have no branch offices. That meant that there was no paper money that was nationally recognized or uniform in value. Banks' notes could be well received and accepted at their face value locally and maybe for some distance from their source. But if they traveled far away enough to other states, then at some point they would not be trusted or known enough to command their full value. So we didn't have a uniform paper currency. The only thing that was uniform was gold coin itself. If you took it or silver, if you took it to other parts of the country, it was still worth what it said it was worth. So Canada's system was quite different in that regard. They allowed their note issuing banks to branch nationwide, and most of them took advantage of that. And so by the 1880s, 90s, you had a system of bank notes with different brands of notes, but you could take a note from Halifax to Vancouver still would be worth its face value. So the Canadian system achieved a uniform paper currency, uniform in a sense of uniform value by allowing banks to be more free. Whereas in the U.S., our motley system of state bank regulations prevented any such result from happening. That's before the Civil War. So do you need a... Am I hearing correctly that it's better argument that you would need one of these if you have fiat currency of some sort. But when we started it, we were still on the gold standard from what I understand. Yes, my point is that if you have a fiat currency, since the fiat money only doesn't have a natural scarcity, so it's going to command value, its quantity has to be artificially restricted and that has to be a matter of policy. And it isn't obviously something that you can rely on profit maximizing issuers to do, because they might just want to issue a whole bunch at once and get what they can. So in practice, if you have an irredeemable money, you need some kind of public authority that you hope you entrust with the responsibility of limiting the quantity of the stuff, supplying it, but supplying it only to a sufficiently limited extent. And that's why fiat money systems require some kind of central authority, usually a central bank. It doesn't follow, that central banks have only been created for the purpose of controlling fiat money. Central banking predates fiat money. As you noted, it was a case of the Fed and of course, the earliest central banks go much further back. The motivations for creating central banks in fiat, sorry, in metallics money systems are quite different. The further back you go, the more obvious it is that the motivations were fiscal. Basically, these public authorities could, had a flexibility that allowed them to contribute to the financing of their sponsoring governments and make life easy for them, especially during wars through generous accommodation in return for the monopoly privileges that they enjoy. This was a story with the Bank of England, Bank of France. Then later on, you had the development of the view that central banks could contribute to the stability of gold standards by serving as lenders of last resorts to the commercial banks and by being a source of emergency loans to them. And this view particularly solidified after the publication of Walter Badget's famous book Lombard Street, which is the Bible of last resort lending. However, that was 1873. However, it should be said and many people don't realize this, that when Badget wrote Lombard Street, he was referring, of course, to the Bank of England and the role it should play in averting or limiting crises, he was very explicit in that book. He said that the ultimate source of instability in the English banking system was the Bank of England's monopoly privileges and the way that they resulted in a concentration of reserves in that bank, such that it became the only agency capable, it was both the instrument by which instability was generated and the one institution that could act to contain the damage from that instability if it would only act in a public spirited way by lending generously once a crisis broke out. But Badget was quite emphatic that if you hadn't had this heaping up of monopoly privileges in the Bank of England, if you'd had what he called a natural banking system with reserves and privileges spread out among competing banks and an example, example would have been the Scottish system, then you won't need a lender of last resort because you won't have the underlying cause of instability in the first place. So unfortunately, most people have read, most economists have read Badget as making a positive case for central banks as lenders of last resort in a gold standard context. And of course, in the fiat money context, therefore, you have two rationales for having a central bank. One is to control the ultimate quantity of money, which otherwise is not self-controlling. And the other is to have a source of emergency funds when things go awry in the banking system. And that's the conventional wisdom today. Yes, I mean, we've had the Fed now for 100 years or more, and it's clearly changed an awful lot over that period of time. What monetary policy means in practice has really developed beyond all recognition. And so I think we should probably bring this conversation a little bit more up to the present day. In particular, the financial crisis of 2008, I know for me, and I think for a lot of people, that was when we really got interested in monetary policy, when people thought maybe there's something weird going on here and we should learn more about it. So maybe before we just jump into that though, let's talk about what was the status quo before the financial crisis in terms of monetary policy. Now, you've already said the Fed would manipulate the federal funds rate. They'd affect the cost of banks lending or borrowing from one another. Why were they doing that? If they raised interest, that interest rate or lowered it, what were they trying to do and what was its knock-on effect in the economy? So as you said, Tom, the Fed's responsibilities and power changed dramatically since 1914, and by the period before the crisis for some decades, of course, the gold standard was no longer part of the story. So the Fed had absolute responsibility for the overall amount of money created in the economy and therefore for controlling the rate of inflation and deflation. And the Fed's mandate required it both to avoid dramatic instability of the value of money, substantial changes in that value, and also to limit unemployment. So the Fed had, as it were, a kind of secular mandate, a longer-run mandate to make sure the dollar didn't depreciate too rapidly relative to goods, and then a more cyclical mandate to make sure we didn't have cycles of unemployment, which could partly be a reflection of a short-run shortage of money. Okay, that seems like something that's not related to monetary policy. No, it is. It is. Too much money, you get inflation, too little money, you get deflation, too little money in the short run, you can get a business downturn with unemployment until either the central bank makes up for the monetary shortage or prices adjust downward and we end up with the new equilibrium, but that's a process fraught with difficulties. So actually, George, when we say there isn't enough money and in the short run that can cause a downturn, what does that practically mean not enough money in the system? It's not like people can't find the banknotes. What it means is that people, in practice, what it means is that there may be plenty of money out there, but the money isn't being spent. So people hold on to money balances to a certain degree, but ultimately the main reason people hold on to money, which consists of Federal Reserve cash or certain kinds of bank deposits, is to have a ready access to purchasing power for spending. Things go sour, monetarily speaking, either when the rate of spending is excessive, so there's too much money chasing after too few goods in the famous formulation of Milton Friedman, or when the opposite happens when spending declines rapidly. The reason these are both problems is because businesses have to recoup their expenses on average. Some businesses may not, and others may profit, but on average we don't want them all losing money, because that just means that that doesn't prove that the businesses are bad or that we should be putting resources elsewhere. It just proves that spending is not keeping up with underlying costs, it's spending is shrinking. So avoiding a shrinkage in the flow of spending is important as a way of limiting business cycles and unemployment and deflation. On the other hand, if everybody is, if people are spending more than ever, profits are swollen, that doesn't give you a useful signal about which businesses to support. You can't have more of everything, you can have more investment and everything. So what ends up happening, of course, is costs start rising, the profits disappear, costs keep up with prices. In equilibrium, there's an equilibrium that's the same as where you started, but the process of adjustment can involve some waste. And so this is where we get this idea that a good central bank will manage things so that prices neither rise rapidly nor fall rapidly and cycles are avoided. But at bottom, it's really about stabilizing, not prices per se, but spending, keeping spending on a nice, even schedule. This is what, this is like before, so because from what I understand- This is still true. This is still true, but what I understand with the, so this is what they were doing before the Great Depression, in the 50s, I mean it was, they were all, they were still just mostly focusing on what you said, the inflation rate and the unemployment. What I've just described is what they ought to do, and it's still what they ought to do. It has never been exactly what they have done because they screw up all the time. You've had episodes of severe deflation like the 30s, you've had long periods of mounting inflation like the 70s and early 80s, late 60s, and of course you've had the recent crisis. What I was describing was an ideal, what they ought to try to do rather than what the Fed or any other central bank has actually been doing, and the ideal hasn't changed. The ideal was the ideal before 2008, it's still the ideal today. The question then is how did they try to do the right thing, whether they did it or not, and before 2008 to go back to that discussion of interest rates and all that, they used, what they would do was they would set a policy rate target. Now basically what this means is that they would say to themselves, well we believe that if banks are borrowing from each other at a 3% rate, that's going to be consistent with an overall level of money creation, lending, et cetera, that will achieve our spending, stable spending target, implicitly, or that won't cause too much inflation or deflation, it won't cause too much unemployment. The target rate is what they believe is the rate that's consistent with achieving their overarching objectives. They might be wrong in their choice of this target rate, but let's assume that they actually are correct, that they know where that rate should be to keep things going smoothly. Then of course their objective, their media challenge is to see to it that the actual rate at which banks are borrowing from each other doesn't deviate from that target. The way they would do that in the old pre-2008 days was if the actual federal funds rate tended to be rising above the target, let's say above the percent, they would go out and purchase assets in the marketplace, usually government securities, and they would pay for them with newly created deposit credits, federal reserve credits. That would mean that bank reserves become more plentiful, and that would mean that the supply of federal funds, which reserves available for overnight lending, would go up, and that should lower the actual equilibrium funds rate and help get the target. That would lower the interest rate on borrowing, but theoretically encourage more buying of houses and car loans. The idea is that if the federal funds rate is getting too high, that also will tend to mean tightness in other lending markets, so in keeping it from rising, you're also keeping those other rates from rising. Conversely, if the Fed funds rate is sagging, that suggests that there's not much demand for federal funds, you want to keep it at target, you're going to withdraw some reserves because evidently there's more out there than banks need to sustain the target interbank rate. That's how the system works. It was a combination of setting a target interest rate that you hoped was the right target, and then engaging in what are called open market operations, which is either buying government securities in the open market, having the Fed buy these securities, or selling them depending on whether they wanted to make reserves more available or less to achieve the target. If doing all this, they then found that the inflation rate is higher than we thought it would be, or lower, or unemployment is not where we think it should be, that would of course be cause for rethinking the target they've been setting, adjusting it upward or downward, and then undertaking corresponding open market operations to achieve the new and hopefully correct rate target. So hopefully correct. But did this process go completely haywire in the run-up to the financial crisis? I mean, if so, what kind of role did it play? I wouldn't say that the process went haywire in the run-up to the financial crisis. Financial crisis, of course, is a situation where you can have, and often typically do have, an extraordinary demand for reserves because of panic, because of uncertainty, because of perceived risks of lending, and so suddenly other things equal. The tendency is for banks to clamp down on lending, including interbank lending, and for the demand to hold reserves to become extraordinarily high under those circumstances. For a given federal funds rate target, the challenge of monetary policy becomes to supply that many more reserves to keep the rate at that target, because otherwise it's certainly going to tend to rise above. So in a way, there's nothing different from a crisis situation. It's business as usual, except that it's a situation where in order to keep its target, the central bank has to create a lot more reserves than it normally would ever have to do, that is, than it would have to do in a non-crisis time. Until 2008, sometime in the middle of 2008, the Fed was, I think, more or less doing that. For example, the first big shock of the crisis, a big financial shock that mattered from a monetary policy point of view was when the bank pair of us in France looked like it was about to go under. In response to this big liquidity shock, sure enough, you've had... But that term, liquidity shock, they just can't get enough money right at that moment. There's an exceptional demand to pile up bank reserves by different financial institutions, banks, and other financial institutions want to stock up on cash. That is precisely the circumstance. It means that they're less willing to lend cash, which means that the interbank rates are going to go up unless somebody else makes more cash available, which is where the central banks went in. That's just what the Fed did in that episode. You can look at the statistics and you see the amount of Federal Reserve dollars spikes, because they're pouring more in to make up for the reality that there's an exceptional demand, and that is still ultimately aimed at keeping the target rate where it's supposed to be. Now, of course, in the background, you have the ongoing consideration of whether the target rate itself needs to be adjusted in light of these developments, because it may also turn out that you need to set that rate lower in order to accommodate the changing reality that involves a greater, once again, a much greater demand for reserves in liquidity. The two things are happening. One, it takes more reserves in a crisis to keep the target where it is. Also, a crisis is a time when your target rate might need to be lowered in recognition of the exceptional persistent demand for liquidity. As I said, until 2008 at least, I think the Fed's conduct was about right in light of these basic principles. But then in 2008, things started to go quite haywire and did so, I think because of not just because the crisis became that much more severe, which it did, but because I think that the Fed made some very serious miscalculations that actually in turn contributed to the severity of the crisis. Well, some of those, I've heard some people argue that some of those included low interest rates after 9-11, like too low of interest rates helped move us toward the crisis because people were borrowing too much. Well, now you're stepping back a little bit. There is a question whether the Fed set its targets too low, not so much after 9-11, but after the dot-com crash, whether it kept rates too low for too long, said its target too low, and then of course acted to achieve that target. No, I think there's a lot of truth to that. That is setting too low a target in turn contributed to excess creation of reserves, excess credit, excess lending, which contributed to the subprime, what we know in retrospect, was a kind of subprime bubble, and I think that's all true. The mistakes I'm talking about are ones the Fed committed after the bubble breaks, which I believe it started to make some real mistakes in that case sometime in mid-2008. So what are those? Are they related to just bad interest rate setting? Or is it anything entirely? Ultimately, they are. Ultimately, they are to put it as tersely as possible. Starting around mid-2008, the Fed became determined to stick to what in retrospect was too tight a monetary policy stands to maintain a target interest rate that was too high relative to what was really required to help the economy stay on its feet or avoid a collapse. For some time, they set the target rate of 2%, which sounds very low and was low by historical standards and more typical norm would be 4% twice that. However, again, in a crisis situation, it can take a much lower target interest rate to avoid a downward spiral. And I think in retrospect, it's pretty clear that the 2% rate that the Fed was striving to maintain was too high. It only very reluctantly lowered that rate first to 1.5% after the Lehman disaster and then eventually as low as 0.25% or range from 0 to 0.25. By that time, it was too late. And indeed, even 0.25 was too high. But it's interesting to look back at why the Fed was obstinate. And again, this is all hindsight, right? So we mustn't be too ungenerous when all this is going on. It's very hard to tell exactly what the situation is. But what seems to have been the case was at the time the inflation numbers did not seem to suggest that the monetary policy was too tight. And then there were genuine fears that it might, in fact, be too loose. So you had people pressing for the maintenance of 2% arguing against lowering it. The so-called inflation hawks were doing their thing. And it was to satisfy those concerns that the consensus ended up favoring, trying to maintain first 2% and then 1.5%. Even though if you look at what was happening at the time, regardless of the inflation numbers, actual spending was collapsing. And inflation numbers can be very misleading because they indicate a number of things. Most obviously, they don't just depend on how much people are spending. They depend on the state of availability of various goods and services and commodities. And so spending is really what you wanted to look at. And if you looked at spending, it was going down very rapidly. But it's how the Fed strove to maintain 2% despite what was going on that I think was particularly tragic because, in fact, the Fed was creating reserves or would have been creating reserves during this period. These are the months leading up to Lehman Brothers and including the time of its collapse. The Fed was engaged in substantial emergency lending to various banks through various lending programs, banks and some other financial institutions and markets. If the Fed had simply done that and not tried to compensate by other means, we would have had a substantial increase in reserves, analogous to the increase when the bank-paribus crisis hit, that should have helped to maintain liquidity, keep lending and spending from collapsing. However, because it was determined to maintain a 2% rate target, the Fed feared that these lending programs would create too many reserves and it offset them until Lehman's failure or after offset them 100% with open market sales, which of course are normally a tightening measure. So it took back with one hand what it put in with the other. Total liquidity didn't increase at all, therefore, for these crucial months when spending was actually collapsing, you can see that the Fed's balance sheet doesn't grow at all. It's flat because there's more lending, but there's open market operations. That's the Fed's selling treasuries from its portfolio to offset the loans that are otherwise increasing the total assets. So there's no net liquidity creation in this crisis. It's much worse than bank-paribus. You would think, let's put a lot of liquidity out there because things are really getting scary and that's not what the Fed's doing. It is actually depriving the more solvent financial institutions in the marketplace of funds in order to move a greater supply of funds to troubled institutions that are taking part in its emergency lending programs. So that's interesting because it makes me wonder about why it makes these choices. Is it politically influenced? Is there something going on? It's supposed to not be. Even though the president chooses the Fed chairman, does it seem like that they're playing politics to some degree? Well, there's no question that there's a lot of pressure on the Fed to aid particular financial institutions, especially the large ones, the too big to fail ones, that it's going to give them credit no matter what because it fears that if they fail, the dominoes will start falling. The problem is that, be that as it may, whether those decisions are sound or not, it doesn't make any sense if you're concerned about other dominoes falling. So you want to prop up the one domino in front of the line that you're most concerned about you can't do that by taking credit away from all the other dominoes in order to prop up the first domino because then you're causing them to suffer liquidity shortage. So they may not be in trouble because the big domino falls on them. They're in trouble because you're taking liquidity away from them to prop up. All the back dominoes are falling, even though the front ones are standing up. And if we go back to Badget, of course, if we go back to Badget, this is entirely contrary to the spirit of Badget. For Badget, the reason you need a lender of last resort is not to prop up the trouble institutions. It's to see to it that the sound institutions stay sound, that they don't suffer collateral damage from other failures. And it's perfectly possible in principle for the Federal Reserve to lend generously in a crisis to sound institutions instead of lending to the unsound by depriving the sound of liquidity. A second best solution would be create a lot of net liquidity, bail out some big firms, but make sure you keep the other firms that are sound from suffering as a result of your policies. The Fed chose to do the worst possible thing. It propped up the insolvent or presumably insolvent institutions by lending generously to them, but it was also a sucking back liquidity from the rest of the marketplace which causes the crisis to spread that way. And if your goal is to keep the crisis from spreading, you're not going to do it by punishing the solvent firms to prop up the insolvent ones. And so the Fed started to go wrong in the middle of 2008. They weren't increasing general liquidity. They were sort of bailing out some organizations. They were offsetting that by clamping down elsewhere. And so spending in the wider economy kept tumbling. Did the Fed eventually catch up with events? Did they realize they'd gone wrong and try to fix it? Unfortunately, they really didn't. They did in the sense that they relented ultimately in trying to maintain what was first 2% and then 1.5%. They stopped trying to do that. But they stopped only when they were failing utterly. The actual federal funds rate was just falling below their target. And the target became meaningless. So finally they said, okay, we're going to move our target to get it closer to where the rates actually are. And in that sense, they relented and they loosened. But in fact though, they never actually provided the liquidity that by then the economy desperately needed. And this is when things really get weird because after the failure of layman's and also the bailout of AIG, they took another step. You see, by then the amount of emergency credits that the Fed was creating were such that it could no longer offset the credits with open market sales. The Fed needed to keep a certain amount of Treasury securities on its books for income purposes. It needs to be generating income, which you don't do by buying doubtful assets. You have to have assets that are paying some interest. So at a certain point the Fed, as it were, ran out of Treasuries, which is to sterilize or offset the emergency lending. This happened after the layman disaster. But now at that point, of course, it might have just said, okay, well, we're going to have to let our balance sheet grow and let that contribute to liquidity. But they were still determined to not let that happen, to not let emergency policies translate into easier monetary policy. And so they had to come up with a scheme other than sterilization to achieve that result. And that's what interest payments on reserves originally served, the purpose that it originally served. The right for the Fed to pay interest on reserves was already on the statute books as a result of a 2006 law. But it wouldn't have taken effect until 2011, if I remember correctly. So they passed an emergency measure that essentially allowed them to begin paying interest on reserves two years earlier than the original law would have. And that meant they could begin paying in October 2008. Now, what was the point of this? The point was, now that the balance sheet's going to grow, how can we keep that from actually contributing to general liquidity in the marketplace and to an overall easing of policy? If we pay interest on reserves and make it adequately remunerative for banks to pile up reserves, then the emergency, the lure reserves we're creating through our emergency programs will, they'll go into the banks, they will add to net total reserves, but the demand to hold reserves will go up as well. And so the banks will just sit on them, just sit on them. And that will mean that it doesn't spill over into the Fed funds market and of course, by implication, what's spill over into other markets, other bank lending markets, because the banks are going to hoard the reserves. This was deliberate. This was a deliberate move, once again, aimed at maintaining what in retrospect was an overly tight monetary policy stance, whether it was 1.5% or whatever the number was, because we still have spending collapsing. And interest on reserves, that became the new way of not easing monetary policy at a time when it desperately needed to be eased. And the irony of this, if I may, I'm going on for long, but this was October 2008. Remember, at this time, the concern is that policy is, must not get any looser. It's where we need it to be, because there is some potential for inflation, a very wrong perspective, again, in retrospect. By November, by mid-November, late November, it's now abundantly clear to everybody that policy is not too tight and that what the economy could desperately use is some monetary stimulus. So now, you would think at that point that the Fed officials would say, okay, fine, now we want monetary stimulus. We had better stop paying banks to pile up reserves, because that's something we've been doing to prevent monetary stimulus from happening, even as we create more reserves. So logically, let's get rid of the interest on reserves. That's what you might think they would have done, but they didn't. Instead, they decided that they were going to keep this interest on reserves in place, and the only new policy they'd pursue is that they would now more aggressively create reserves, not just create them incidentally to emergency lending, but to create them on purpose and in vast amounts, quantitative easing, large-scale asset purchases. But wait a minute, hold on. If interest on reserves served before then, to make sure that however many reserves the Fed created, they didn't serve to stimulate bank lending and spending, why should it be any different now that you're deliberately creating reserves? Won't that just mean that banks have that many more reserves that they sit on? And we know that in fact that is exactly what it meant. As I put it in testifying to Congress in July, I said, if insanity is thinking that doing the same thing over again will result in a different outcome than before, then the people at the Fed seem to have been a little bit off their rockers, because you have the same policy of credit expansion or reserve expansion that they have set things up so that it won't matter that they do this, it won't ease things. Now you're just going to say, well, if we're going to leave that setup in place and we're going to create that many more reserves, but this time it will ease things. And of course, something did change. Something did change, right? No, they weren't completely insane. So something had to change in their minds between October 2008 and late November 2008 that allows them coherently to, somewhat coherently to believe that a balance sheet expansion, that the system that prevented balance sheet expansion from providing stimulus until November 2008 is starting in December 2008 is going to allow balance sheet expansion to be stimulating. Did I lose you on that? No, no, no. I'm just, because there's also an election in there. No, I don't think that had anything to do with it. I honestly don't. It was in October of November 2008. Yeah, I don't think that had anything to do with it, but the point is, certainly what's true is now they want to stimulate. They've got the same system in place that makes reserves pile up no matter how many you create or why, but now they're going to say that creating the reserves, even though they still pile up, is going to stimulate. How do they convince themselves that things have changed? What's changed is between October 2008 and December 2008 is they've got a new theory. They have a new theory. The new theory is the theory of portfolio adjustment, etc. That's a theory of how large-scale asset purchases can stimulate the economy, even if the purchases, the reserves that the purchases create sit in banks, vaults, as it were, without moving. A theory has changed, and because the theory has changed, reality should change with it. This is a little less than completely insane, but it is not completely sane either. We've shifted from a system where, if the Fed wants to stimulate the economy somehow, they'll create bank reserves. The banks will be flushed with cash, so they'll lend more. That will encourage spending. It's a fairly straightforward transmission. That's right. Now we're in a situation where we're going to give the banks lots of reserves, but we explicitly don't want the banks to lend them out. That's right. We want a portfolio balance effect to take place. What does that really mean? It means that as the Fed buys assets in large quantities, of course the prices of the assets it's purchasing are going to be bid up, and the yields of those assets will come down. The idea is that if any interest rates change on any assets, that should have trickle-down effects through arbitrage that's going to affect other interest rates, including short-term rates, so that you are, after all, putting downward pressure on short-term rates, but you're not doing it by actually increasing the scale of lending and money creation that goes on. You're just, as it were, achieving a new equilibrium set of interest rates without any change in the nominal scale of activity, the total dollars moving around in the economy. Well, this is where thinking of monetary policy solely in terms of interest rates becomes dangerous, because the right way to think about it is, yes, interest rates are instruments, their means. We can think of policy setting as setting interest rates, but what we're really doing is changing the amount of money creation that's going on, that the banking system is engaged in, and that means more or less lending and so on. But if you start to think that monetary policy is only about moving interest rates where that's the ultimate objective, now you can embrace a portfolio balance theory where anything that gets interest rates, say short-term rates, to go down is great, even if it doesn't translate into an increase in bank lending, money creation, deposit growth, and so on. This is a big mistake. It's true that these portfolio effects are not irrelevant when interest rates change, prices are changing, those are relative prices, so some economic activity is going to be changing. But gosh, if what you want is to get people to spend again, this is a much more loose connection. There's a much more doubtful connection between portfolio effect changes in short-term interest rates and just how much spending and lending are going on versus the old-fashioned adjustment in short-term rates that is caused by creating more Federal Reserve dollars, getting them into the loan markets, getting more bank deposits created. That is a much more certain connection. Interest rates can fall in different ways and in some ways that declines don't have much to do with overall spending activity in other ways. In other cases, they do. We've moved from a transmission mechanism where the connection between lowering interest rates and increasing spending is pretty certain to one where the connection between lowering interest rates and increasing spending is quite uncertain. The defenders of QE or large-scale asset purchases at the Fed and elsewhere, what they'll do is say, we know this policy worked. Oh, how do you know that? Look, the interest rates changed. That's what their studies show. But if you ask them and I have asked them, I said, okay, but does that come along with more spending? Did it reduce unemployment? Did it actually ultimately achieve the macroeconomic changes that we really care about because we don't care about the interest rate per se? They would say, well, the studies on that are a little less clear. In other words, no. We have no evidence that that happened, and I don't think it happened very much. It's no secret that the recovery was sluggish, but it is perhaps a somewhat well-kept secret that quantitative easing just didn't work very well when it comes to the things that really matter. So, it's the whole thing kind of quixotic and the endeavor of the Fed. It doesn't seem to be... It's made a lot of mistakes. It's arguably the Great Depression in 2008. It's trying to figure out the right number in a very complex economy so you can criticize it on sort of Hayekian or Austrian grounds that no one can really figure out what the right rate is or things like this. And it makes a lot of mistakes, and sometimes those mistakes are cataclysmic. So, is this the kind of thing that is sort of too error prone to continue to exist in the way at least it does or they're sort of in the Fed people that it's just... It's not an undertaking worth doing or doing well. Well, it's easy enough to point to the mistakes the Fed has made and to argue, as you say along Hayekian lines, that it's unlikely that we can have a Federal Reserve that doesn't make mistakes like this, because both the information required and the necessary incentives are lacking to be expected to always do the right thing. But to get from there to saying, therefore, we shouldn't have a Fed, you can't just jump to that conclusion from those observations. You have to have an idea in mind of some alternative arrangement that is going to be capable of addressing these problems, that is going to do a better job of stabilizing the economy. Now, I did say earlier that in the past we had systems like the Canadian system, the Scottish system that worked pretty darn well, but they also depended on the existence of a reasonably stable external monetary standard, precious metal standard that was the foundation for the whole thing. I also explained that if you don't have precious metal, if you don't have a commodity standard of some kind, you've got to have a public authority that's ultimately controlling the supply of your fiat monetary standard. So, we either have to go to some commodity, it doesn't have to be gold or silver, it could be Bitcoin, which is a kind of... I've called it a synthetic commodity, but let's not get into a Bitcoin discussion for once. But if you're not going to do that, and there are all kinds of reasons why trying to get back to a metallic standard is a very difficult proposition. See our last episode with you. We'll link it in the show notes. That's right. Then, of course, you have to have at least a skeletal central bank that's responsible for the total quantity of fiat money. Then, the question is, can we organize things so that it arranges that quantity or manages that quantity in a way that's more satisfactory than what we've seen over the course of the Fed's existence? And I think the answer is yes, we could. We could do a lot better. I joined forces with the so-called market monitorists and believing that, first of all, our monetary policy should be oriented towards stabilizing total spending or statistically its counterpart of nominal GDP or something like that, that that alone would be a vast improvement because at least we're trying to do what we should be trying to do. Then, it becomes a question of what are the right mechanisms for seeing to it that nominal GNP is stable and favor there a more automatic approach so that we don't have to worry about Fed officials being distracted by other concerns, goals, interest pressures. These are some of my thoughts. It would help to have a financial system that is itself less vulnerable to crises and there's a lot that can be done in that direction, but it doesn't consist of heaping more regulations on to what we already have. That's how we've gotten to the place we're at and it has not worked. It rather consists of appreciating what kinds of deregulation can help to lead us to a self-regulating arrangement and that certainly includes getting rid of the promise of bailouts that is such a source of a corrupting factor in our system. There's a lot to be said about how we could do better than the present Federal Reserve arrangement, but saying why don't we just get rid of the Fed is not saying very much because it really just leaves you with begging all kinds of questions about what sort of arrangement is supposed to fill that vacuum. I think we have to think hard about how we can get from where we are to a better system and not just think about what we'd like to get rid of because that's only half the story.