 This is Jeff Deist, and you're listening to the Human Action Podcast. All right, ladies and gentlemen, welcome and happy New Year to all of you. This is the first Human Action podcast of 2020. It is, in fact, January 1st, New Year's Day. And our guest is none other than Bob Murphy, Dr. Robert Murphy. So Bob, great to talk to you. Happy New Year to you. Happy New Year to you, Jeff. I made a resolution. I want to talk to Jeff Deist more, and I'm getting off to a good start. Well, I want to just give a little background about what we're talking about today. And our subject is actually money mechanics. Now, what do we mean by that? You know, a few years ago, I happened to come across an old article. It's out of print now, but it was produced by the Fed Reserve Bank of Chicago up until about the 1990s, and it was called Modern Money Mechanics, a workbook on bank reserves and deposit expansion. So if you look at this article, which there are still old PDFs of this out there on the internet, we'll actually link to one of those. But if you go to the introduction of it, it says the purpose of this booklet is to describe the basic process of money creation in a fractional reserve banking system. And so when I worked through this a little bit, it's actually kind of tough sledding this particular article. I wouldn't say it's aimed at an academic audience, but it's certainly aimed at an audience that has some understanding of central bank operations. So I set it around a few different professors and academics in our circles, and some of them actually began using it in their classrooms, et cetera. So it got me thinking that those of us who have some sympathy towards the Austrian School of Economics tend to be very critical of central banks, and particularly the Fed, for those of us who are Americans. But yet a criticism that's often weighed against us with, I think, some validity is that we don't necessarily understand the commercial or mechanical side of banking as well as we do the theoretical. So I shouldn't say we, I'm not an economist, but I'm the conduit between economists and the audience. In other words, we understand a lot about theory when it comes to money and credit creation. Austrian business cycle theory is obviously a big part of the Austrian worldview, but we don't understand as much how central banks and commercial banks and retail banks actually operate, how money comes into being, how interest rates are set, how it all flows throughout the economy, how this has an interplay with treasury debt. It's all very complex mechanically, and I thought, well, what if we had our own version of an article or a book that helped explain this and give it some visuals, give it some graphics, make it very understandable for a layperson? I thought that that would have a lot of value. And so I reached out to Bob Murphy and said, hey, let's discuss this idea of creating an article or a series of articles on money mechanics. And so as Bob and I fleshed this out, it became clear, hey, why don't we have a bunch of short chapters, have them come out in a serial manner, and then when this is all done, we'll have a book or an e-book or something where we want to keep it pretty short, maybe 100 to 150 pages, and that this will really help people understand Fed money mechanics. So we worked out if Bob produced an outline of chapters, and so we think that this book is going to be a bunch of really short digestible chapters. And so the series of articles which Bob is in the process of writing are going to begin coming out on Mises.org here now in January 2020. They will continue for every other week, bi-weekly, for a period of months until we've gotten through all about 13 to 15 chapters, and then at the end, we'll put them together into a book. So all that said, I hope the audience understands where we're going with this and sees this as a worthy venture. I think it's going to be, Bob, a book that really simplifies and demystifies this process, and in that sense, I think it's going to be very valuable. So just give us your sort of overarching thoughts. Well, sure. So I was real excited, Jeff, when you pitched the idea to me, and I thought, yes, there is a need for this. And I had independently come across that Chicago Fed primer on money mechanics or whatever, you know, however they described it. And I thought that was great at the time. Like it actually sort of encouraged me that, because it was compatible with the stuff Rothbard did in his work that, you know, that I was more familiar with. And so just kind of reassured me that, yeah, this isn't some weird little Austrian thing. This is what the standard canonical view is of these topics. And so, yeah, I think also too, because central banks are now doing so much more than they were before the financial crisis of 08, that more and more sort of regular people want to know, yeah, what's going on with this? And so it is, especially in the age of the Internet, short attention spans, you know, people aren't going to read 300-page treatise on banking. And so I think, yeah, that this is going to, what I would like this to do, number one, is just to be a reference so that any college professor would be comfortable, you know, giving it to the kids in this class. I would say, okay, now in Chapter 8, they get into the Austrian theory of the business cycle. I don't particularly agree with that, but those first seven chapters, that's just all standard. That's great stuff. Let you know the organization of the Federal Reserve. Like what's the open market committee? What's the difference between, you know, the presidents and the board of governors? There's little things like that that we all hear referenced in the news, but we probably don't actually know exactly how it all fits together. That's one of the things that I want this series to answer. Yeah. And I don't think, for the most part, it's going to have an Austrian flavor. It's going to be descriptive just how this stuff works. I mean, that's obviously the idea behind the book. Right. Exactly. That I want it to be very, you know, non-controversial. Just these are just factual statements that it's all in one nice spot, like you say, with good graphics. So it's not just a bunch of dense text, just so people can very quickly get up to speed on this is how the Federal Reserve works and central banking more generally. How is money created? Because that's something too that I mean, it's, it really is a, you know, I think that's why, you know, it was called the mystery of banking. When you really understand like the, how there's a sense in which a commercial bank by granting a loan to give an example, Jeff, the kind of thing. I've seen a lot of libertarian hard money types. Sometimes they act as if it's only fiat money, central banks that can quote, create money out of thin air. But actually there's a sense even when regular old commercial banks when they advanced loans do the same. And so just things like that, that there's a lot of sort of nuts and bolts that I think it would help people if they just had a sort of, you know, one spot where they could go and just see it all spelled out clearly and it will click for them. Yeah, of course, some people with perhaps very superficial knowledge will just say things like, oh, the Fed just prints up the money to cover the deficit or that sort of thing, which is obviously grossly factually untrue. Right. In terms of, I mean, there's two things concerning about that. I don't know which one you meant, like the fact that they are literally running printing presses now for a lot of when the Fed creates money, but also too. And this, this is some of the stuff that we're going to get into, you know, perhaps later in the series, but issues about, you know, modern monetary theory and is it correct that like when the federal government runs a budget deficit, do they just instruct the private, you know, the, there's a treasury just say create more money. Well, lots of things like that where we will just sort of get in and just lay out the material just to try to help people make sense of current policy debates and things like that. Because with a lot of these things, I think part of the problem is there's a lot of talking past each other and the layperson doesn't really know what the underlying reality is. And so it's hard to understand when certain people, you know, push a political recommendation under the guise of, oh, this is just standard. You know, this is just the way the world works. Well, actually you're smuggling some stuff in there. Well, I hope our listeners will seize on this opportunity because I would argue not only do many, maybe most economists not understand money and credit creation in a fractured reserve system or how the Fed or the ECB or whatever actually operate on a mechanical or technical basis. I would even argue a lot of monetary economists, people who specialize in this stuff don't really understand. So there's, there's an opportunity here. And I also think that, you know, sometimes our critics will say, oh, you know, the Austrians don't really understand this stuff. You just, you just look at it theoretical. So, you know, all that said, I guess first and foremost, you and I had discussed having some sort of article or chapter discussing money creation, money and credit creation in the U.S. before the Fed, which is obviously a big part of our history. So you intend to address this. Right, exactly. So the period to the, which would be the gold standard and just, you know, how does that relate? And also to, this is another misconception. A lot of times Austrian school economists or I should rather say lay people who are fans of the Austrian school will say things like, oh, yeah, the business cycle is caused by central banks. And then that leads you open to the criticism. Oh, well, wait a minute. So before the Federal Reserve, there were no recessions in the United States. You know, that kind of stuff. Yes, definitely want to get, bring in some historical material there, partly to explain how did the gold standard actually work or what was the relationship between the gold standard and these other things we're talking about. But yeah, just to know how did this stuff happen before the Fed even existed? And also too, Jeff, I might add, I don't want to forget to say this. You mentioned, to me, one of the things that we definitely want to tackle in this series is there's a recurring critique when you see the Austrians or just any, you know, mainstream economist even giving the orthodox explanation of, oh, well, the Federal Reserve buys assets and that creates reserves and then banks go out and they lend in a lot of people. So no, no, you guys got it backwards in the real world. If you knew anything, if you left your textbooks, you'd know that banks make loans first. That creates deposit. So we're going to definitely tackle that particular objection. I'm sure many listeners have heard that and maybe are sympathetic to it just to just try to reconcile that because it does seem like there's two camps out there. And I think there is a way to reconcile those two views, but in practice it often comes off that, oh, no, you guys are just looking at your textbooks and you don't know how banking actually works. Right. And so a series like this I think needs a little bit of history and background on money and banking. And so even listeners who maybe even haven't read Rothbard's What Has Government Done to Our Money or haven't read much in the world of monetary policy or monetary economics, they'll get a little bit of history and background here, but in a nice, succinct fashion. Right. Yeah. So there's not going to be any... Everything that's in here will be there because it needs to be in there. Put it that way. We don't want to waste your time. We know we're going to give you as much as we think is necessary to get the point across so that, yeah, when you read the chapter on a certain issue, it's digestible, it's quick, but it's comprehensive. Some treatment of money early in the U.S., some treatment of the classical gold standard, some treatment of history like Bretton Woods and that sort of thing will be included. Oh, yeah, definitely. Okay. Let's sort of put that aside for the moment and move into the Fed and its creation in the 1910s. First and foremost, let's just talk a little bit about the basic structure. So you have the Federal Reserve Bank itself, which is headquartered in Washington, D.C. That's where the chairman of the Fed sits and works. That's where a lot of economists sit and work. So what about the 12 Fed member banks? What are they? Where are they? Why are they? Well, I mean, they're spread around the country and, of course, we may get into some of the history that originally it was based. So there could be banks right now that are in areas that you might not have picked and that's because back then that was more commercially relevant. And also, one of the things we're going to cover in terms of the history is to show that originally it was more decentralized, right? That they were the governors. They were called governors and then they got changed to being just bank presidents. So in other words, the regional heads used to have more authority and then it was in the 1930s under the Roosevelt administration that power was more migrated towards the board of governors in D.C. and that the other members now were called president because among bankers, governors are more prestigious title than president. And so that's part of what happened. So yeah, there's a lot of history even just in there. It's not that the Federal Reserve was in its modern structure and form at the outset. And of course, too, there's a whole, you know, and here we got to be sure because I'm sure many of our listeners know the genre of, you know, the creature from Jekyll Island and it's, you know, it is, you know, that is true. Like it really was a secret meeting with people and they really, you know, why are they called the Federal Reserve? You know, even though there's the joke going, it's neither federal nor reserve discussed. And so that was the issue that, you know, the Americans would have been very skeptical of a central bank and so they were trying to make it look like, no, it's this decentralized thing. So all that stuff is the fascinating history that of course, you know, is a lot of people have seized on and, you know, taken in strange places. But, you know, that's stuff that people aren't making that up. There really is this background history here that's pretty scandalous. Well, and listeners need to come out and meet people like me and Bob. We're going to have an event at Jekyll Island this coming October 2020. So go to Mesa.org, check your calendar, come see us, come meet us. It's going to be fascinating to be, you know, right there and talk about all of this stuff. So the 12 Fed member banks as you indicated, that's where the economic power was early in the history of the United States. I don't think you'd have one in Cleveland today. You'd probably have one in Phoenix or something, some big population center, right? I mean, they sort of show an East Coast bias as to where the 12 are located. Right. And so, yeah, I think that's a combination of, again, you know, the economic power structure back then but also, yes, it's just there were politics involved even back then. And you can see it's like even so to this day, like, you know, it's still the case obviously that the head of the New York Federal Reserve Bank, you know, it has a lot more power whether, you know, in terms of both officially in terms of the structure but also in practice. So you see all those elements too. And that was certainly true back then as well. And some of the structure, you know, might be a legacy of the political power dynamics back then and sort of carry towards it today. So I just want to stress the idea of the podcast today is to get people interested in this series of articles and reading it so that we're not here, you know, in today's podcast to understand, to explain everything about the mechanics of money to you because we would be here for the next, you know, 10 weeks or something like that. But so you're going to have some information about the structure of the Fed, how it's made up, the Board of Governors and all that. So I'm very much looking forward to that because I think people are murky about that. I certainly am. And, you know, another term I've always been murky about is this concept of primary dealers. So these aren't actual Fed banks. These are commercial banks like Goldman Sachs, for example, but they trade directly with the Fed. And so I think we have this idea that primary dealers are somehow closer to new money and credit creations. You know, just give us, you know, a quick take on what a primary dealer is. Well, sure. So I think, you know, in practice, the issue is when the, when the Treasury runs a deficit, you know, so the government, and this is something too though, again, these are real simple things. And we have got experts and the listeners who know the stuff with the back of their hand, but other people might be murky for them. And this is also too, why I want to be clear, you know, to try to sort out the MMT claims, the modern monetary theory people, because I think sometimes they blend this together and act like it's all the same thing when in practice, you know, it is technically different. But yeah, when the federal government runs a budget deficit, so the US Treasury spends more than they take in a tax revenue, they have to borrow money to cover the gap. That's a budget deficit. They issue bonds. And we know that simultaneously, the Federal Reserve often is in a sense creating money out of thin air with which to go into the market and buy bonds that are issued by the federal government. But they can't just do it all in the same operation. And because both in appearance, you know, both in the letter and spirit, that would look like, oh, wow, they're just monetizing the debt. Look at that. And so, yeah, the primary dealers, one way to think of it, you know, they're the ones that are buying the bonds at auction and then, you know, in turn, then can sell them to the Federal Reserve. So the Federal Reserve can't literally just cover the Treasury's deficit. They have to go through intermediaries in the private sector. So to the extent that, you know, those players can, you know, perhaps it acts early on a Fed and out, you know, do things before it's actually announced or just sort of get ahead of the market. There's a lot of allegations that they have a special, you know, relationship and they benefit from that cozy relationship, that it's not just a frictionless, pure market the way it's often depicted in a standard textbook. Right. In the market perspective, they're, you know, they benefit, of course, but also there's a task assigned to them, which is to make a market, to be there available to purchase Treasury debt at a reasonable bid price. So, you know, that's not a free market if there is an implicit or de facto backstop for Federal debt, right? I mean, for Treasury debt, if that's always there, that would seem to me to be an artifice of sorts that props up, you know, Treasury debt, the value of it. Oh, right, exactly. Yeah, I hope I wasn't coming off like I was disagreeing with that sentiment. I'm just saying in practice, yeah, that's partly what's going on there that they want to give the appearance. And that's why too, that during, so especially it was from like 2009 through 2011 or so, that you had the Federal government was running, you know, trillion-dollar-plus deficits while the Fed was engaged in its various rounds of quantitative easing. And so I always thought, huh, that's kind of a coincidence, isn't it that the Federal Reserve has decided its monetary policy objectives for unemployment and inflation happened to coincide with massive bond buying right at the period when the government is also issuing huge amounts of new debt. So, yeah, I think in practice, obviously, there are independent decisions. But again, just strictly speaking to understand the mechanics that, yeah, it's supposed to, the Treasury has to auction it to the private sector first, and then those in turn get sold. And as you say, it's not just, you know, Joe Schmoe who gets to go and get it, and then the Fed buys it off of him. So the whole thing, yes, the Federal government benefits from that backstop. And also, there is a benefit to being, you know, a privileged few that get to handle those contracts. So in your articles, are we going to, you know, start to understand the relationship between the central bank and then primary dealers and then regular commercial banks and then maybe your local hometown retail bank? I mean, how this money or credit creation sort of flows out to a credit union, let's say, in Auburn, Alabama? Right, exactly. Yeah, that's one of the goals that for sure we want to accomplish with this is to try to, you know, using graphics and perhaps a numerical example. But yeah, just to, but also as you say, to keep it real, you know what I mean? Maybe document an actual string of transactions that really happened in history just to kind of show this process so that people can see enough of the theory so that the reader has a framework. You know, it's not just a bunch of statements about them. This happened and this happened and this happened. So you have to interpret it and file it away, but also to keep it realistic enough so they can, you know, hang that theory or that framework onto real world events so they understand what's going on because you're right that there is that gap that right now you can read stuff in the Wall Street Journal about Goldman Sachs or whatever. But and then you look at a standard money and banking textbook and it's too abstract. And so that's what I think this is trying to do among other objectives is so that the reader can understand how is it that Fed policy is impacting, you know, when I go to get a car loan or something, you know, what the interest rate is? Well, there's so much opacity there. I think it's just because there's so many steps involved. I mean, if you go into the credit union in Auburn and borrow 30 grand or whatever it costs to buy a Honda Accord, where does that money come from? Where did it originate? Where does it reside on a balance sheet? Is it an asset? Is it a deficit? It's really pretty fascinating to think about what ought to be a very simple operation has been made so complex. I think that's the reason we have the title, The Mystery of Banking. Yeah, I agree, Jeff, and I would just say too that yeah, it's for people who know how balance sheets work and stuff like for a regular business like, you know, regular accounting, when I show them, I can very quickly if they already have that knowledge and how assets and liabilities work for a regular business. When I show them what goes on with commercial banking the way it's practiced, you know, in modern times, it's, for some people, it's mind blowing because it looks like it's magic or like, wow, they shouldn't be allowed to do that kind of thing. And that's where, of course, you know, the wing of the Austrian school that is against fractionaries or banking, you know, that's partly where that's coming from is just to say, look at this, there's something weird going on here. So in this series, you know, we're not, it's the goal is to make sure everyone understands how it works, you know, we're not going to try to beat some people over that with our preferences or, you know, our views on what's desirable or not. But yeah, that is part of what goes on and the people haven't really understood it. And that's kind of what I meant earlier when I said I think some libertarians even have this idea that, oh, the only kind of weird stuff going on is with the federal, with the central bank creating money out of thin air. And I'm going to say, no, even at the local level, there's something going on that a lot of people, when they see it and don't understand it, think that's just unusual. It's mysterious, put it that way, as you say. So we will have, in one of the chapters of treatment, not only of fractional reserve banking versus full reserve banking, but we'll also have some explanation of the money supply. In other words, what is the money supply? What are the various different aggregates? Most people are probably familiar with things like M1, M2. So we're going to have that kind of nitty-gritty detail. Yeah, exactly. Because again, one of those knowledge professors who's teaching undergrads on money and banking that if somebody says, hey, you know, is there some good primer somewhere? Oh yeah, that thing's fine. Even if someone who's not an Austrian would just say, oh yeah, the factual statements they make about the organization and the monetary aggregates and the way to think about it, yeah, go read that. That'll get you up to speed real fast. But what we won't have in this series of articles is any argumentation about fractional reserve banking versus those two things without getting into it because that's a whole other topic. You know, I want to touch on interest rates. Sometimes we say colloquially, oh, the Fed sets the interest rate. Well, it doesn't really. It targets what's called a federal funds rate. So can you talk about that for us? What's the federal funds rate and how and why does the Fed target it? Okay, sure, yeah. So the definition of the federal funds rate or sometimes it's called the Fed funds rate or short, is it's, so commercial banks have reserves and that consists of money that's either deposited, that the commercial banks have on deposit with the federal reserve system itself or with actual currency like in the vault. So that's very high powered money as it were and commercial banks can make loans of those reserves to each other and so the federal funds rate is the interest rate that's charged on non-collateralized overnight loans of those reserves. So it's an interest rate that banks, regular commercial banks charge each other when they lend reserves and there's various reasons like why would one bank want to, you know, get more reserves and things like that but at various times banks for various reasons some want more reserves than they have and other ones have excess reserves and so they borrow and lend those amongst each other and the interest rate that they charge is what's called the federal funds rate. So that's what it is and then like you say Jeff the, for various reasons it wasn't always this way but for a while now that's one of the primary things when the press says oh yeah the Fed set interest rates at such and such or you know they held Pat, that's what they're referring to and as you say it's not a price control it's not like raising or lowering what landlords in New York City can charge and run control departments where in a sense you say the government set the price so here it's not a price control the way the Federal Reserve ultimately tries to affect those interest rates is by buying and selling assets primarily and now since the financial crisis they're using new tools as well which we're going to cover at some point in the series as well but that's what goes on and one last thing I'll say is this is another area of criticism that the conventional not just Austrian approach but even just standard textbook money and banking approach gets hit with is people to say oh yeah in the grand scheme central banks don't have any power to control interest rates anymore it's all international global commerce and Chinese savings and stuff like that so there's a lot of claims but before you get into trying to refer to any of that stuff you need to know exactly what the terminology is and what do you mean by these terms and what can the Fed do right and readers may or listeners may be familiar with John Tammany who writes at Real Clear Markets and he's kind of in that camp although he's sympathetic to us and to Austrians he's in that camp that the Fed doesn't really matter yeah if I might just because I realize I might love to see people hanging there so to finish that train of thoughts so because what the commercial banks are doing is lending and borrowing reserves from each other the Fed has the direct power to create or destroy reserves through its buying or selling off of assets so if the Fed wants to create more reserves it just buys more assets so that's the lever through which the Fed can affect the federal funds rate is because they can affect the supply reserve so to go back to the rental price controls and the rental market if somehow the government could magically create or destroy apartment units then that would be a way they could affect the rental price of a unit in Brooklyn without you know putting an actual price control in place so that's kind of what goes on and that's the weird thing with money and banking is there's a you can quote create reserves out of thin air and that functions just like regular money in a way that you know just snapping your fingers and saying oh here's claims to more apartments doesn't create more apartments right and they're not flipping the switch overnight that affects the interest rate you pay at the car dealership let's say I mean it's it's a little more of a hoost than that but ultimately the Fed funds rate the rate at which banks borrow can borrow overnight from one another for to meet reserve requirements that does filter out to us right I mean that affects the so-called prime rate which is the rate given to really good high quality borrowers and that ultimately the Fed funds rate which was very high during Paul Volcker's tenure and you know 79 1980 when Jimmy Carter was president Reagan was coming in but ultimately it does affect retail interest rates that you and I pay on our mortgage let's say right exactly so I mean obviously a commercial bank if it can if some other commercial bank on an overnight loan of reserves is willing to offer certain interest rate the commercial bank would never loan those funds out to a regular person from the public at a lower rate right in other words lending to another commercial bank for an overnight loan is a much safer risk so clearly the federal funds rate is going to be a floor on most types of other and as you say Jeff that if the federal funds rate goes up then that means clearly all the other rates have to go up and usually there's going to be some some spread in there because there's more risk involved if somebody takes out a mortgage or whatever that's a riskier loan than just lending reserves overnight to somebody else to another commercial bank so that is the sense but there is slippage it's not that a mortgage rate is always x percentage points above what the federal funds rate is and people saw this too during the in the immediate wake of the financial crisis even though the federal funds rate came down to basically zero or a little bit above and was held there for seven years it's not that regular consumers who were drowning in credit card debt all of a sudden you know saw their APRs go down to two percent or something you know I mean so there is that element too and that's partly why so many people are hostile towards you know the banking system or the big banks is that they know something was kind of fishy with all that and the ostensible goals of those rounds of QE to sort of keep credit flowing the main street that yeah I think there is some justification for the people that thought that that wasn't really what was going on there well Bob I hate this disconnect though I mean even today with interest rates at historical lows even negative on European corporate and sovereign debt you still have you know here in America you have poor people subprime borrowers going to these shady car lots going to these rena centers they're paying you know 20% plus so I mean there is a populist argument here that this doesn't benefit average people so much as it does the banking class yeah and I mean I think that's true more generally with government intervention so for example I've done some a lot of work on you know the energy sector and there's like in the 1970s there were price controls that were put in place on crude oil and there were a lot of arguments that accounts were making showing that that wasn't actually the ostensible goal was oh we don't want the Arab oil embargo to be making you know Americans have to pay more at the pump and so you know we don't want the owners of oil deposits to be pocketing that windfall gain so let's limit and that wasn't suppressing prices at the pump it was more that the refiners and the intermediate stages they were just pocketing the gains rather than the owner of the oil deposit it wasn't trickling down if you will to the consumer so I think there's a similar thing here that that yes if somebody is a poor credit risk you know that no matter what happens in terms of the Fed buying mortgage backed securities or treasuries and showering trillions of dollars you know into the financial sector ultimately if somebody is a poor credit risk nobody is going to lend them money at a low interest rate that's just not going to happen and so that people need to realize that when political figures and others try to justify those bailouts saying oh we got a bailout Wall Street to keep credit flowing to Main Street people need to realize there often is that disjoint well and of course we're talking about the federal funds rate we have to point out that something very important happened in 2008 around the time of the crisis the then Treasury Secretary Hank Paulson really helped push a bill through Congress which we call it the bank bailout bill but it was called the Economic Stabilization Act of 2008 and as a result of that it sped up earlier legislation by Congress this wasn't the Fed just deciding to do this this was congressionally authorized that the Fed would start paying interest on excess reserves held with the Fed this is the first time in history so a lot of people have argued from different spectrums of the econ sphere that you know when the Fed started paying interest on excess reserves this was a big game changer so is that true what should we think about this okay so it's definitely true that they started doing that right in October I think it was October 2008 and certainly that it drastically altered Federal Reserve policy in terms of what they were allowed to do and so in particular and this you know I'm not speculating here like if you go and read what the Federal Reserve was saying in its statements at the time and what you know what economists were commenting on it the idea was they wanted to continue to buy Treasuries and mortgage backed securities to try to stabilize the housing sector you know that was the thought they remember they're calling them toxic assets that those bundled securities that had mortgages that were building on them and so once the housing market crashed those things all of a sudden nobody wanted to touch them and so to prevent a sort of cascade effect where one investment bank goes down and then because they go down it started dragging everybody down the Fed comes in starts buying up all these mortgage backed securities to try to stabilize that sector but normally in terms of textbook open market operations and monetary policy that would flood the market with a bunch of reserves and normally that would push down interest rates and since they were still worried about price inflation because remember oil prices had been really high the previous summer the Fed was saying okay we want to be able to divorce those two aspects of what we're doing we want to on the one hand buy and sell assets because of our objectives in terms of stabilizing the housing sector for example but on the other hand we also want to set the federal funds rate at a certain level that we think will quell inflationary pressures and so again normally it's you do one or the other and the lock sit and so that's what they were trying to separate and again the mechanism they used was they for the first time in October of 08 started directly paying commercial banks saying if you have reserves we will start paying you interest on them and so that was a way so they could effect that and so they could sort of keep it bottled up at the bank the bank would not go out and lend reserves to a regular borrower unless the person was paying a higher interest rate than what they could get for sure from the Fed so it's like the Fed started paying you know on a checking account balance to the commercial banks keeping their money part of the Fed that's a way of thinking about it whereas before the Fed was paying 0% and so by doing that again that allowed the Fed then to flood the market with new reserves and the QE program when they wanted to buy assets for other reasons but it didn't allow them to independently set the interest rates so in practice for a long time afterward it didn't matter because the Fed funds rate was basically 0% but then once they started raising rates that's really where you saw Jeff the distinction and the importance of that new tool was originally when the Fed started quote tightening and raising interest rates they didn't sell off assets because they were afraid if we start selling off mortgage securities we're going to crash the housing market so they were able to raise rates without selling assets which normally you wouldn't think would be possible and that's because they just raised the interest rate they were paying to the commercial banks and currently the interest on excess reserve rate it stands at 1.8% and so Bob as you say this is a de facto floor no banks going to lend overnight and they'll get at zero risk from the Fed right exactly so that's the way if the Fed wants to lift all the spectrum of interest rates they can just raise that floor with the rate they're paying because you say the Fed's not going to default the Fed can just create money electronically without legal constraints so a commercial bank the safest thing they can do is keep their money the reserves parked at the Fed according to that guaranteed rate right and according to my google search this morning there's about 2.4 trillion of so called excess reserve parked at the Fed and you can understand a guaranteed 1.8 in today's environment maybe isn't the worst thing in the world from a bankers perspective I mean you can't just snap your fingers and find all kinds of credit worthy projects out there to lend to reserves aren't lent but the point is is that you have to have a certain amount of reserves on hold with the Fed in order to lend and so it's interesting to me though as an aside when you talk about this panic around housing prices at the time what's so infuriating Bob is that there's a lot of young people out there a lot of less affluent people who might very well like to see housing prices crash you know nobody cries big crocodile tears when oil prices crash and the oil companies make less money or when grocery prices go you know it's just what makes housing this magic form of humor durable that we should all be so sad I mean yeah it's tough if you're a homeowner I get that but you know what about it's that's just half the equation what about all the would-be buyers yeah it is very interesting how that has occurred and I mean I guess it's understandable because a certainly in the United States Americans in practice that's like your one of your major assets that you always oh your house and so you wouldn't just like you wouldn't you wouldn't normally people wouldn't say oh well you know the my asset portfolio had all these different stocks and they all went down 10% but that's good because now stocks are more affordable like people don't normally think of the way if electricity becomes cheaper gasoline becomes cheaper like that's considered a boon to the average person that so it is interesting that that dynamic and I think again this stuff all plays together I think that's one of the insidious consequences of leaving the gold standard and well you know other related measures is that there's such instability that people can't you know just go buy bonds or something and that's a real say they get you gotta go oh you gotta get in the real estate otherwise you're gonna get killed by inflation and then of course when that volatile asset crashes that's that's considered unmitigated disaster when like you say Jeff if interesting people simultaneously complain about how everyone's living at home and young people today you know they can't afford a new house and that there's overcrowding and on the other hand they also complain if housing prices go down and like the Federal Reserve's explicit policy wisdom to quote you know rescue the housing market which in practice means making a house more expensive yeah it is infuriating but I want to touch a little bit more on QE Quante B's and you've mentioned a couple times this was the process begun after 2008 under in an era of what VAT officials themselves called extraordinary monetary policy whereby they create bank reserves out of thin air and purchase those grant those to commercial banks and buy either their treasury debt in the best case scenario but oftentimes much worse in other words mortgage back securities that they were holding mortgages which hadn't been marked to market I mean imagine if when B of A was forced to buy countrywide during the crisis period imagine if B of A had been made to mark to market at the moment all of the real value of those mortgages that now held under its subsidiary countrywide that would have been quite ugly and of course that didn't happen but so what I struggle to understand is with QE you give banks reserves in exchange for taking their mortgage back securities or their treasury securities off their hands isn't that in effect a sort of de facto recapitalization of the banks in other words they get bank reserves in exchange for assets that might have been dodgy yes that's a great question so one thing let me just clarify too is where that you see different explanations for it like why do they call it quantitative easing like what's the quantitative mean in that I mean easing is pretty obvious and what I've seen enough places I think is the generally accepted explanation is what they were trying to do is focus on the scale of asset purchases because remember up to that point whenever the Federal Reserve did something the press would just report oh this is what they did with interest rates and so the problem was that by the end of 08 the target interest rate that we talked about before was basically at 0 to 25 basis points or 0.25% so they had already pushed that down as low as it would go which was unprecedented by the way obviously the economy was still on the ropes and so in terms of standard Keynesian monetary theory like oh gee well once you push into zero what else can you do and so that's why they said oh okay instead of now telling the public this is what we're going to do with interest rates let's start telling them this is how much money we're going to inject into the system and so that's why they were calling it quantitative easing so that I think that's important because up till then I think they actually like the fact that a bit mysterious and probably the average person didn't understand that oh yeah when the Fed announced today they were going to cut interest rates that meant they were going to buy more assets and quote create more money out of thin air whereas you know by 2009 that had become a virtue like the public is like oh please tell us how much money are you going to create out of nothing throw at us so yeah there's that element and then you're right Jeff it is interesting there were different justifications given so I think you know one of the real ones that cynic would say is oh yeah because a bunch of these banks as you say we're sitting on assets that if they had just let market forces ensue they would have been marked way down and a lot of firms would have been insolvent and also too there was this whole fire sale problem that the concern was even firms that originally were fine once you know Morage Back Security started crashing they would be in trouble or they held credit default swaps issued by somebody that was also vulnerable like it was going to be this cascade effect where everyone was going to have to start selling assets and that was just going to further push the prices down so by the Fed coming in and buying them up at a floor price that kind of calmed everybody down because they knew the Fed was sitting there as a backstop so that's I think what was really going on and then as you say in the mechanics of it yeah that were taking assets yes it wasn't alone and I think that's what you're trying to get at Jeff that the the direct quantitative easing thing was different from just letting banks borrow money so you know letting banks borrow money from the Fed is a subsidy if they're getting it on better terms than they would get from the private sector but that's not recapitalizing them but whereas an asset that originally was going to fall to a million if the Fed's buying it from you at 5 million then yeah that's that's giving you more equity as it were well with respect to the mortgage backstop though let's say a bookie had a bunch of outstanding debt obligations owed him and some of them were of dubious collectability and the Fed just came along and said don't worry about it Mr. Bookie just give us your book and we'll give you the cash nominal cash value of all those bets good or bad and you'll get U.S. cash okay well you know in other words what industries get recapitalized and what don't apparently banking insurance do and and autos by the way so you know the whole period if you want to read an excellent sort of day by day week by week account of what was going on in those terrible months around the crisis pick up David Stockman's a great deformation now of course he goes farther and argues that this Wall Street crisis would not have spread to Main Street he argues that all you know QE and and all of this was unnecessary that's a matter of opinion I share it but nonetheless if you just want to know what was happening behind closed doors with people like Hank Paulson and AIG and countrywide and B of A and layman brothers and Bear Stearns I mean it's a really really good book so I recommend it yeah his Stockman's chapter dealing with the 08 crisis and in Stockman's Stockman I think makes the best case I've ever seen just armed with facts you know overflowing of why it wouldn't have been armed again right people were saying oh we don't bail the banks out in the fall of 08 you know your ATM card isn't going to work anymore stuff like that or your life insurance policies aren't going to be and Stockman just goes through and shows why or at least I would say it's the most persuasive case I've seen to show that that was largely just fear mongering so the public went along with something that was crazy and also if I could just come back yeah I like your book example that was probably I was trying to say that but yeah you just said it very succinctly that was the issue and one thing too I was trying because there were a lot of economists some libertarian-ish economists even who were trying to say like QE wasn't a big you know it wasn't a bailout it was just a asset and I was saying things like I use the analysis I said what if I was a car dealer and the Fed came in and did quantitative easing on my inventory and they were buying cars from me and taking it on their balance sheet you're saying that wouldn't help me out you think that would just be neutral in the long run because money's neutral you know I mean like it did seem like they had a bit of a naive interpretation they weren't being practical about that yeah clearly if the feds coming in and buying assets from you that's a huge increase in demand for those assets and other things equal you would expect that's going to help you out and that's that's going to help recapitalize you well since QE is such a bizarre thing really unprecedented you know the feds balance sheet went up over four times in the period of less than eight or ten years I just wonder you know I'm looking at this old article that I mentioned at the outset of the show understanding Fed monetary mechanics it was written 1991 I wonder how much of this stuff is out the window Bob and you actually have a section or you're going to have a section in this series of articles about post 2008 monetary policy and how it's different right exactly we've already touched on some of the stuff with the interest on reserves but I mean the idea just what I said a minute ago that the Fed was trying to divorce the asset purchases from setting interest rates because they needed the asset purchases to do specific things like oh let's we need to facilitate or at least salvage stabilize would probably be a nice soothing verb they would have used the housing sector I mean that's kind of unusual right like I think 30 years ago or something the idea that oh yeah should this Federal Reserve be intervening in specific markets to rescue certain asset classes I think that would have been heretical to a lot of people so what are you kidding me that that's you know first of all that they don't have the ability to do that in an expert fashion like they would be bungling but also look at the corruption that involves that they got the printing press you don't want them to be able to intervene and selectively bail out certain asset classes that's crazy and yet that's where we are there's even elements too I'll touch on this a little bit in the series Jeff where it's a dubious legality as to what they actually did because of the there were you know there was statutory language to try to prevent against this sort of thing and they were doing things like establishing a land LLC because that you know that was a street Wall Street and like that that LLC was going and buying these things and the Fed was just sort of lending money to the LLC you know I mean so there was like some weird hijinks they had to do just because the legality of it because there were you know in the original enabling legislation for the Federal Reserve that you know there were protections put in place that they wouldn't just want them giving money to their buddies well we can call that the fog of war I mean let's face Hank Paulson was a war time consigliore that's for sure so I want to just touch on something that's been newsworthy lately and it ties into later chapters or later sections of this series of articles what's repo what are the repo markets and what was this big hubbub a month or two back about banks seeming to not have enough overnight cash to fund their operations sure so the phrase is from the term purchase agreement and they just shorten it to repo and yeah in terms of the simple definition the idea is it was just a sort of quick version to have a sort of standardized loan contract that was easily that you could market it to other people instead of just having an actual loan contract signed up between two people so the idea would be that oh I have whatever a treasury or something and so some outside person they're going to buy my treasury for a certain amount of money and then I'm going to buy it right back from them tomorrow or next week or two weeks for more money so if you think about what's going on there the person's giving me cash today and then in the tomorrow or two weeks I'm going to give them back more dollars and if I don't for some reason then they keep my asset the treasury or whatever it is they bought from me and so really it's just a way of of synthetically you know creating a collateralized loan right instead of them just borrowing money and me paying back or instead of me borrowing money and paying them back at a certain interest rate and if I default they seize the treasury it's just a quicker way of doing that right so that's that's what it is and for various reasons so here now people have more speculation as to why but that market the interest rate on that started shooting way up back in September right and you know and the Federal Reserve was very alarmed and they came in and had to basically flood the market with very short term injections of credits to try to push down those interest rates they're like oh everything's fine and they just they had to kind of institutionalize that process now that this was supposed to at the time people say oh that's just a one off thing there were a bunch of corporations that had to pay their tax bill and whatever and that just puts them up with pressure but don't worry about it and yet you know now this is a recurring thing so it's I think it's just indicating that there is something going on with the global interconnected monetary system where you see these little pockets of problems jumping up in central banks and keep sort of doing whack-a-mole but I think it is indicative that there's the system right now is not you know slowly returning to normal I think that there was a lot that kind of swept under the rug by just drowning the world in artificial credit from 08 onwards and they didn't really solve the underlying problems but if we get away from the technical details doesn't it just seem crazy that we've had all this expansionary monetary policy since 2008 and here we find ourselves 11 years later and we still have these banks stressed out for cash I mean why do we have liquidity problems that seems crazy to me yeah I think you're right and it's I mean it's sort of like with every major government intervention right like if the public had known this is how much work how long we're going to be in Afghanistan how much money we're going to spend and what the accomplishments will have been 10 years later 13 years would anybody do it no of course not so yeah I think it's a similar thing that if people had been told in 2008 okay this is the things we're going to do and yet we're still going to be needing to come in years later otherwise there's going to be a global liquidity crisis I think people would realize okay well then let's not do that let's just get it over with now because it looks like you're not really solving the problem well so once again I think this is going to be a great series of articles I think it's going to help all of you tremendously to read and know and understand this stuff and at least in simplified format we're very grateful to Bob Murphy for agreeing to do this and rolling up his sleeves and applying some of his knowledge of money and banking to the really practical real world operation of how this stuff works and we very much look forward to reading it and that said ladies and gentlemen as promised you know put on your thinking caps because in the over the coming months we are going to tackle both Human Action by Ludwig Van Mises and Man Economy and State by Murray Rothbard in podcast form in a series of podcasts with a few different guests so if you haven't read those books you were thinking about reading them you were a little apprehensive about tackling them 2020 is really the year to arm yourself with some new substantive knowledge and so once again we want to wish all of you a very very happy new year and thank you for tuning in to the Human Action podcast The Human Action podcast is available on iTunes SoundCloud, Stitcher, Spotify, Google Play and on Mises.org Subscribe to get new episodes every week and find more content like this on Mises.org