 This is Mises Weekends with your host, Jeff Deist. Our show this weekend features a talk from Kevin Dowd. He's a professor in the UK at Durham University, and he gave an absolutely fantastic talk at our recent academic conference entitled The Failure of Monetary Stimulus. And what this talk really explains in a superb fashion is perhaps the biggest untold story of our times, which is how central banks across the world responded and continue to respond to the great crash of 2008, namely with monetary stimulus. The problem is it doesn't work, and it actually makes things far worse in the long run. So if you're interested in this topic, stay tuned for a fantastic talk from Kevin Dowd. Modern policymakers are fixated with the belief that inadequate macro performance is due to inadequate aggregate demand, and their only solution is to stimulate demand. To a Keynesian with a hammer, every problem looks like a nail. Now other diagnoses, other solutions, such as the needs to address structural problems, to address tax regulatory reform and fiscal sustainability are ignored. Fundamental problems then remain unresolved, and Keynesian policymakers are left wondering why their policies are not working as they expected. They also make a deeper intellectual error. Instead of seeing the monetary system as a spontaneous social order, whose sole purpose is to serve its participants, they see the monetary system as something to be controlled for some allegedly higher end. So the interest rate and the supply of money are not seen as the products of markets, but as control instruments to be controlled by a central authority. Analysis of the monetary system as a self-organizing social order gives way to control and optimization analysis. How best, I.E., how best to manipulate these instruments, quote, to achieve some central bank objective. So thank you very much, Paul Samuelson. From this perspective, more instruments are always to be preferred to less, and the inbuilt constraints that protect a free monetary order, like constraints against the over-issue of money, are mere hindrances that prevent central banks doing as they please. Underline this error a deeper ones. They assume that they can understand the economy and think that if they understand it, they can control it. Of course, if they did understand the economy, they would also understand that they can't control it. Yeah, to imagine otherwise is a category mistake. It's a logical error. The point is that one cannot control a spontaneous social order as if it were a predictable machine. But nonetheless, attempts to do so can certainly damage it. Okay, so before the Fed, interest rates and monetary aggregates were constrained by the gold standard. Once the Fed was established, it began to manage the system and it's so doing to undermine it. To illustrate, according to BLS data, the US dollar had lost 83% of its 1914 purchasing power by the time the last vestiges of the gold standard were abandoned in 1971. Since then, thanks to the Fed, its purchasing power has fallen by over 96% relative to 1914. Now, this is not a particularly good track record. Over time, the Fed acquired more control over interest rates and interest rates are the most important prices in the market economy. And since 71, interest rates have been determined by the whims of the FOMC and have been far more volatile than before. The Fed's control led to wild swings as the Fed lurched from monetary, let's see, there we are. Oh, sorry, that's, I must have taken that slide out. Anyway, the Fed's control over interest rates led to wild swings as the Fed lurched from monetary excess to restraint and back again, creating one boom bus cycle after another. And then fast forward to 96 and Greenspan famously warned of irrational exuberance in the stock markets before easing monetary policy to stimulate them further. The Greenspan put protected investors on the downside, encouraging them to buy more stocks and push up their prices. But market fundamentals eventually reassert themselves. The markets then boomed before crashing in 2001, only for Greenspan and later Bernanke to repeat the process to produce another stock boom and a housing boom, both of which crashed in 0708. The Fed then responded by stocking the biggest booms yet and in virtually all asset markets. And so you can see that in the chart. And for want of a better name, you can call this the everything bubble because all the asset markets are doing just fine. But repeatedly doing the same thing and expecting a different result the next time is literally insane, right? So the everything bubble is the biggest monetary experiment ever. So why wouldn't it also lead to the biggest ever collapse? Well, I suppose we'll find out soon enough. Now, one of the Fed's main responses to the crisis was to push interest rates to almost zero and they haven't changed much since. Zero interest rate or ZERP policies have a number of adverse effects. They encourage investors to take more risks to boost yields, risks spreads are compressed, so true risks are not apparent. They encourage more borrowing and higher leverage. Many companies have used low interest rates to load upon debt they don't need in order to invest in equity markets via M&A or share buybacks that push up share prices even further. Low interest rates also delay restructuring by allowing zombies that would otherwise fail to continue in operation. And of course, they encourage fiscal profligacy. So lots of zombies and lots of unicorns. They also reduce low interest rates, reduce returns to savers and big time too. The law of compound interest implies that sustained ultra low interest rates have a devastating effect on savers and pension funds. We're talking here trillions in accumulated lost returns. ZERP also reduces bank profits, especially when the yield curve becomes flat or inverted. The flatter or more inverted the curve, the less profitable is bank's traditional core business of borrowing short to lend long. ZERP then discourages bank lending. There's little profit in from lending so the supply of loans falls. And so ZERP intensified the credit crunch instead of alleviating it. Now a second pillar of unconventional policy is large scale asset purchases or QE. Now this program saw the Fed's balance sheet grow from 490 billion to 4.3 trillion when the program was ended. The stated purpose of the program was to reduce long-term yields to encourage investment and spending and so boost output and employment. You know, the usual Keynesian nonsense. QE was accompanied by the payment of interest on excess reserves intended to neutralize the flood of excess reserves that QE was creating. The combination of QE and interest on excess reserves is best understood, not as monetary policy per se, but as preferential credit allocation policy. This policy is a very bad idea. In the words of Larry White, QE is overreaching, wasteful, morally hazardous and fraught with serious governance problems. That's pretty bad. Now credit allocation policy is a kind of central planning in which the Federal Reserve substitutes its judgment for that of financial market participants. Fed directed allocation of funds to a declining industry, for example, just throws good resources after bad. An increase in political credit allocation reduces economic growth, not only by creating deadweight loss, but also by incentivizing unproductive lobbying efforts and it's probably a whole lot more damaging. It creates tremendous moral hazard and an environment ripe for cronyism. All this buying achieved little benefit except to Wall Street types who naturally loved it. QE was the greatest backdoor Wall Street bailout of all time. It killed the urgency for Washington to confront the real issue, which is the structural problems in the US economy. Of course, the same goes for Europe. Now the failure of Fed policies is apparent from a whole range of indicators. I'll just quickly chop through a few of them. A slowdown in the economic growth rate, a fall in job creation, a fall in labor force participation, a stubbornly high, I think it's U6 unemployment rate, you'll discourage labor. And stagnant or declining real income, and that's a real shocker, rising inequality, a slowdown in small business formation, a fall in savings. Most Americans haven't savings to cope with a major emergency. That's a real worry. Then we have a rise in dependency on state aid, and possibly the most damaging of all, long-term potentially, is a collapse in productivity growth. Now, unconventional policies have not only failed, but they're not sustainable either. Now part of the reason is that central banks cannot eliminate risks. Instead, they can only suppress them temporarily at the cost of making the eventual crisis worse. Central bank policies have smoothed out the smaller risks, the ones that don't really matter, at the expense of leaving the economy more exposed to the tail risks. And these are the ones to worry about. Historical experience also suggests that risks are greatest when measured spreads and volatilities are at their lowest level, and people start wondering where all the risks have gone. Remember late 2006, early 2007 maybe, the risks had all gone. But current policies cannot go in indefinitely, go on indefinitely, and the buildup of debt is unsustainable. So recent IMF data suggests that current debt levels are close to 250% of world GDP, well up on 2007, and this ignores a whole ton of off-balance sheet stuff, so the true figures are much, much greater. Higher debt creates a headwind against recovery and obviously poses a major risk to financial stability. When the next downturn occurs, many of these debts will not be repaid, and we will be looking at defaults on a large scale. Now the bad news is that if current policy is unsustainable, it's not clear how the Fed can restore monetary normality. There may be no safe exit either. An exit strategy requires that the Fed raise rates to normal levels. Now I don't know exactly what that should be, but that's not really the point. And the problem is how to raise them to any sensible levels without triggering a crisis. Arising rates would increase financing costs and impose a major strain on highly leveraged companies, many of which would be bankrupt. That's pretty obvious. Higher rates would also put pressure on governments and prompt bankruptcies, or should I say more bankruptcies at municipal level, and I think fairly certainly bankruptcies at state level. Let me look at Illinois for example. Furthermore, the potential losses are enormous. My back of the envelope, duration calculations, suggested a rise to normal rates would trigger losses of three to four trillion, and other estimates are higher. I could easily get higher numbers than that. And these are only the losses to bondholders. Now financial markets are now highly correlated, and one might even say that the only asset that now matters is the 10-year treasury. A sharp rise in rates would then have major adverse effects on other asset markets, and all the asset bubbles that the Fed has so lovingly blown would burst. Large pools of institutional capital have also become accustomed to strategies based on short-term returns and relative performance, risk parity strategies and so on. Such strategies produce steady returns and the appearance of low risk, but leave investors highly exposed and prime the markets for the next black swan. And then they'll say, we had no reason to expect this when it happens. The bottom line is that all assets are very much correlated, so there is only one big bet out there. What you might describe as the everything bet. There's a kind of collective psychology that says that the Fed is in control. But this is an illusion. Furthermore, many of these exposures are poorly hedged. Many market participants have never experienced a decent hike in interest rates, and they cannot design a hedging strategy to hedge against interest rate risk because interest rates have been so stable. In other words, they don't have the data to calibrate their hedges. Risk models are difficult to calibrate for the same reason and have a ton of other problems besides. Bottom line here is that the risk models can't be calibrated and are useless when it comes to anticipating the consequences of out-of-sample events. In fact, and this is most important, risk models would worsen market instability. Should any trigger event trigger losses, the model-based risk management strategies would respond by sell-offs to get the risk numbers back down. Now, of course, that works for an individual company but doesn't work for the market as a whole. So this creates a positive feedback loop that would greatly intensify a downturn. We saw this with some other strategies in 1987, but this would be much, much worse on a much bigger scale. Since then, risk management has become a whole lot more quote-unquote sophisticated and this just worsens the underlying problems. So the Fed is then boxed in. It needs to raise interest rates to restore monetary normality but it can't feasibly do so and the longer it delays, the worse the underlying misallocation and risk build-up problems become. In the meantime, the choice remains what it always was, a bad turn, a bad downturn now or worse later and the clock is ticking. To quote the punchline of an old Irish joke, I wouldn't start from here if I were you. Okay, so what do our Keynesian friends suggest that we do? Well, let's forget about the obvious solution that they never consider. To abandon the Keynesian experiment, roll back the state, end the Fed, return to gold. No, no, we can't do that. Thank you, thank you. Thank you. Instead, their suggestion is to double down basically a whole lot more dangerous experimentation. So were the economy some lab animal, it wouldn't be allowed to be regarded as cruel. So, okay, let's go through these. The first suggestion is to ramp up QE and we're leaving aside that it hasn't worked already. This solution has already been tried big time and failed in Japan. Look at that red line. Japan entered the financial crisis with an already bloated central bank balance sheet which was roughly as big relative to GDP as the Fed's is today. It has since tripled more or less. And as I say, note that upward trend. This enormous stimulus achieved little beneficial effect. Unemployment fell a little, but growth was negligible. Now, if QE on this scale didn't work in Japan, there's no reason to think it would work anywhere else. That's possibly where we're going. Now, this policy had a number of adverse effects. First off, the Bank of Japan's bond purchases were on such a scale that it's cornered the market and has been struggling to find further bonds to buy. These purchases distort interest rates across the yield curve and mean that Japanese financial institutions are increasingly assessing bonds have been for some time based on their likelihood of being bought by the BOJ instead of on the basis of their underlying credit worthiness. The Bank of Japan is well on the way to becoming the biggest shareholder in the country as well. It's gradually nationalizing the stock market. So the impact on bond markets and the impact on stock markets, both very worrying. Remember that stock prices are supposed to reflect the underlying value of a company and to be priced correctly, equities should reflect earnings and other fundamentals, not the whims of central bankers on a buying binge. Instead, the market is becoming detached from fundamentals and the BOJ is creating a ginormous bubble. Now, despite these failures, Japanese policymakers remain fixated on stimulus and Governor Corrado's attempts at reassurance don't particularly reassure. Now, to quote a speech from a little while back, he said, many of you are familiar with the story of Peter Pan, in which it says, the moment you doubt whether you can fly, you cease forever to be able to do it. Well, just to point out the obvious, Peter Pan is a fictional children's story. So not very reassured about that, okay? So the second wheeze is negative interest rate policy or NERP. The argument usually made is that NERP would stimulate the economy by encouraging people to spend instead of save, i.e. NERP is the extension of ZERP. But this argument fails to learn from ZERP's failure to stimulate. And that it might not be the best of ideas is suggested by the fact that NERP had no precedence in nearly 5,000 years since Hammurabi. So what has changed in the last few years to make negative interest rates suddenly a good idea after 5,000 years? Now, to me, that's a bit of a head scratcher. But it gets worse. NERP means that you get paid to borrow and you pay to lend. But if I have to pay to lend, why would I lend at all? Just makes no sense. If I'm an investor wanting a safe haven in a NERP world, where do I go? The answer presumably is cash. But cash then becomes so sought after that the NERPers, or the twerpers, or whatever you wanna call them, the NERPers want to abolish it. So that's really helpful. So another example of the weirdness of NERP was highlighted by Richard Rahn. If government can borrow at negative interest rates and endlessly roll over its debts, then it makes no sense to tax rather than borrow. That's an interesting insight. And he says, if this sounds a bit mad to you, then you haven't totally lost your grip on reality. Yeah, yeah. Now, to implement NERP is to enter a twilight zone in which nothing works as it should. If NERP were implemented, would it lead to people spending more as intended? Well, I very much doubt it. Preliminary evidence from Europe and elsewhere suggests that NERP in other countries is failing to encourage spending. But at a deeper level, it's difficult to see how a sustained policy of taxing bank reserves or deposits, which is what NERP entails, could stimulate. Since when is any tax stimulative? It makes no sense. That's what I mean about the twilight zone. Negative interest rates suggest liquidation, destroy the capital stock, and cause a shrinkage in the amount of credit. Again, where's the darn stimulus? Worse still, sustained NERP would destroy the financial system. NERP would make banks core business models unviable. Especially when the yield curve becomes inverted. However strong they might currently be, and they are not particularly, well, especially in Europe, NERP will eventually bankrupt them. Okay, so NERP would turn banks into loss making entities that must eventually fail. Defined benefit pension schemes would also become unviable as negative returns would undermine their ability to meet their long-term commitments. Asset managers, hedge funds, even insurance companies would all become unviable. At the most fundamental level, negative interest rates are a dreadful idea because they penalize thrift and reward impetuousness. They're the epitome of institutionalized short-termism in which we are encouraged to live for today when any reasonable person can see that we shouldn't. There's also a reason why historical interest rates have always been positive. It's called time preference. Negative interest rates are an offense against the law of time preference, and to mess with that is to unleash monetary pandemonium. So why on earth would any rational person wanna do that? But to NERP us, the zero-law bound is not a boundary to be respected and protected, but an obstacle to be kicked aside so omniscient central bankers can ramp up their monetary experiments in a misguided attempt to gamble their way out of their own previous mistakes. Anyway, let us suppose nonetheless that the monetary authorities determine on NERP. They then run into an obvious constraint. If the central banks push interest rates too far into negative territory, then bank depositors and bond investors would switch into cash to obtain a zero return instead. Zero return is better than a negative one. A serious effort at NERP therefore needs to be enabled by blocking this escape route, i.e. by abolishing cash. Now central bankers could then impose whatever negative interest rates they wanted and we would have to put up with it. Yet those who would ban cash ignore the substantial costs that this proposal entails. It's not in their models, you see. An example, an example that worries me very greatly is the impact on the extreme poor. In 2011, there were over 4 million people in the United States who live on less than $2 a day. These include the indigent and many who are ill-educated and mentally ill, i.e. the most vulnerable. These people are completely dependent on the cash economy. And to me, to deprive these people of the benefits of cash is simply cruel. There are also those who have chosen to hold much of their wealth in the form of cash, including many foreigners for whom US dollars are a protection against financial repression in their own countries. Banning cash would expropriate much or all of their wealth. It would also constitute a default. Once people get worse even, once people are forced to rely solely on digital currency controlled by the state, then all transactions would be monitored and only state-approved transactions would be permitted. You can see where I'm going. All financial holdings would be vulnerable to state predation and any remaining rights to financial privacy would be destroyed. There would be obviously a huge loss of civil liberties. The state would then acquire much greater control over everyone's lives, as if it didn't have enough already. With no other access to their money, anyone targeted by the state couldn't hide, couldn't resist, and couldn't escape. So basically they could be outlawed. You can throw people out of such a society where they have nothing to live on. Think of Will Smith in Enemy of the State. But we're not all Will Smiths who can fight the system and win in the end. Okay, so what credible assurances do we have that innocent people will not be targeted in this way? Well, none at all. Once those powers are conceded to the state, we must expect proposals to use those powers to achieve other supposedly worthwhile objectives that our lords and masters dictate. Indeed, one of the reasons put forward for abolishing cash is to make life difficult for bad guys, such as drug dealers. The suppression of cash then becomes a weapon in the wars against drugs, terror, tax evasion, and so on. You see, bad guys use cash. So we should ban cash to stop them. Okay, so by that logic, every single amenity that we all use should be banned because the bad guys use them too. Forcing everybody, but it gets even worse, forcing everybody to use state-controlled digital currency also makes it much easier for the state to pursue pseudo-economic policies in which it punishes anyone it doesn't like. Savers, rentiers, dissidents are obvious targets. The state then has the ultimate instrument for social control. Anyone who steps out of line gets whacked. There is also the danger that the control apparatus would be hijacked by some group with a control agenda, socialists, fascists, whatever. Now, to me, this doesn't bear thinking about, but these dangers mean nothing to the cash-hating technocrats. You see, for these people, cash is just another barbarous relic, civil liberties too. And then we can imagine a truly dystopian future in which these policies, all these barmy canes and policies, are implemented jointly. You have massive QE, and the central bank buys everything up. Cash is banned and there's no longer any financial privacy. NERP has implemented returns go negative. The major financial institutions, banks, insurance companies, pension funds, et cetera, are bankrupted. The banks are taken over then as state-run utilities and old age provision becomes a state monopoly. A deflationary spiral is avoided by large-scale money printing. All policy, fiscal and monetary, is then driven by the illusion that helicopter money is free and free helicopter money becomes the dominant policy instrument. All constraints to protect sensible finance and sound money go out of the window and the value of the currency goes to its intrinsic commodity value, i.e. nothing. So I think Keynes and his deluded followers have a lot to answer for. The good news is that it does not have to end this way but we have our work cut out to make sure it doesn't. We know the answers. Restore commodity money, end the Fed, roll back the state. And so we return to where we started, this problem of monetary governance. Now, to quote Ron Paul, we need to take away the government's monetary power. The dollar's soundness depends on its being untied from the machine that can make an infinite number of copies of dollars and reduce their value to zero. It's as simple and as difficult as that. So thank you all and good evening. Subscribe to Mises Weekends via iTunes U, Stitcher and SoundCloud or listen on Mises.org and YouTube.