 This is Mises Weekends with your host Jeff Deist, the only podcast dedicated to Austrian economics. Well, ladies and gentlemen, welcome back once again to Mises Weekends. I'm joined by a guest that doesn't need much of an introduction to most of you, no doubt, Dr. Jeffrey Herbner. Obviously a longtime friend and senior fellow at the Mises Institute, also a professor of economics and actually chair of the Department of Economics at Grove City College in Grove City, Pennsylvania. And Jeff, it's been a while, but thanks for joining us. Great to talk to you. Well, thanks for having me on. It's always a pleasure. Well, we are talking this weekend about the Fed and trying to demystify it a bit and talk about the mechanics. And Dr. Herbner, as you know, it's no great crime for anyone to not understand how the Fed operates mechanically or even conceptually. I would venture that really even the majority of economists don't have a real good sense of how the Fed operates. It's become almost a niche in economics, in monetary economics. But I wanted to just give our audience a little bit of an Austrian basic course in the Fed this weekend. So maybe we could start, if you could, just give us a brief overview of how the Austrian school views money and the creation of money versus other you know, nominally free market schools, Chicagoites, monetarists, etc. What makes the Austrian perspective on money and banking different? Well, as usual, the Austrians take a causal realist view that we want to serve the actual process gone in money, inflation and credit creation. This would be opposed to, say, a monetarist economist who doesn't link these things together, but treats economy in a kind of overly aggregated way. So our position is simply to look at what the Fed does in practice and how they conduct, say, an open market operation. And the way in which this and their regulatory apparatus over the banks then allows the banks to spend their loan portfolios through the issue of checking account balances. So the basic process is that the Fed will buy securities from banks and pay them with their balances. And they regulate banks to hold a certain fraction of those reserves against their checking accounts. So if a bank sells a million dollars of securities to the Fed, the bank can then use that million dollars as a reserve. And Carly, on top of that one million dollar reserve, ten million dollars, let's say, do loans, and they extend these loans to customers by just crediting their checking accounts. But this, I mean, this most recent round of quantitative easing since the 2008 crash, I mean, this is really an unprecedented in terms of volume. In other words, the Fed is creating bank reserves at a pace it never has before. Is that correct? Yeah, that's right. Before the QE programs began in the fall of 2008, the Fed's balance sheet was about $850 billion, and today it's about $4.4 trillion. And this represents the acquisition of about $2.5 trillion worth of treasury securities by the Fed, and about $1.7 trillion in mortgage-backed securities. It's really incredible to think about, but I'm sure a lot of our audience is familiar with these terms, but can you talk a little bit about what the monetary base is, i.e., the Fed's balance sheet, versus the broader money supply itself? Sure. So the monetary base is the items that the Fed directly controls that are monetary. So it includes the currency that they print, and then it includes bank reserves. So the currency right now is about $1.4 trillion, and the bank reserves are about $2.6 trillion, so the monetary base is about $4 trillion. And then, as we mentioned earlier, the banks, with those reserves, the banks can create checking account balances by extending loans to customers, and of course they create checking account balances just as a regular part of their business. And then the money supply would be adding in those claims to money or checking account balances along with the currency to get, say, a money aggregate of M1. Well, a lot of people say that increasing commercial bank reserves does not create inflationary pressure because, as you mentioned, those reserves stay within the commercial banks themselves, they're not let out, they're used as reserve against checking demands. Would you disagree that, I guess we've more than quadrupled the monetary base, would you disagree that this $2.5 trillion of new bank reserves is going to have an inflationary effect, ultimately? Right, it certainly will. If banks go back to their normal lending practices and reduce their reserve holding to, say, a fraction of just maybe, say, 10%, then this would involve a quite enormous expansion of their checking account balances through credit creation. Right now, they're holding pretty close to 200% reserve. And historically, that's higher than usual. The only time it's ever been at this level, anything near this level was during the Great Depression. But isn't this interesting, though, that this attempt to stimulate the economy by creating bank reserves, it doesn't force banks to lend if there's not credit-worthy borrowers or projects out there, then in effect you're risking inflation without necessarily stimulating the economy here and now? That's exactly right. It's back in the 1930s, the opponents of this kind of policy that the Fed had adopted back then likened it to pushing on a string. So the Fed, of course, can create all these bank reserves at once. But as you say, this doesn't necessarily create demand for credit, worthy projects for banks to lend into or for entrepreneurs to undertake. And so we have a repetition, just like we did in the Great Depression, of a suppression of business investment because of the tremendous uncertainty that exists in this particular economy. So we're talking about the supply of money and the shorter version of that, the monetary base. So that's sort of one side of the coin here. But the other side of the coin is the cost of money. Can you explain for us, first and foremost, the concept and the idea behind the federal funds rate? Sure. The federal funds rate is the interest rate that banks charge to other banks when they engage in interbank overnight lending. Basically, this is the lending that one bank would do to another bank of the reserves that that bank holds. And the main reason for lending reserves in this manner is, again, to meet regulations. So that's the Fed funds market. And this market, of course, by lending, moving reserves around to banks that could use them to parlay loans, would maximize really the, in normal times, the extent to which checking account money substitutes could be created on the basis of these reserves. But the irony is that the banks aren't lending overnight to each other because there's not a robust lending market. They'd like to be out there making money by lending it. But in other words, part of the reason behind the statutory creation of a small interest rate payment from the Fed to commercial banks themselves on their holdings currently, half of a basis point or half of a percentage point, was because, if not, the overnight rate might drop even negative because the bank simply there was no demand between the banks. So it doesn't seem to be working. Yeah, you're absolutely correct. Again, it's very similar to the situation of the Great Depression, where the banks simply don't have a large number of viable customers to lend to. The demand side for loans has collapsed. And the banks also, just like businesses, want to move to liquidity in times of uncertainty. And so it is a reasonable strategy for them to just hold the reserves and get paid half a percent of interest as opposed to starting this process of normal commercial lending. Well, the other point is that half point is also risk-free. It's a sure bet, courtesy of Congress, as opposed to lending risk. Now, when it comes to the federal funds rate, obviously that is an interest rate that affects other interest rates throughout the economy that we all pay for a mortgage or a car loan, whatever it might be. David Stockman calls the federal funds rate the most important price in the economy. Can you talk about how Austrians view interest rates that they ought to be seen as prices? And can you give us maybe a short exposition of the time preference theory of interest? Sure. So this is the idea that our saving that we're willing to engage in to provide the funds for lending come from our desire to balance intertemporally the satisfaction that we can have from making purchases sooner as opposed to later. So person is inclined to delay the satisfaction of, let's say, buying something for a thousand dollars. They'd be willing to save and lend out on interest that thousand dollars to someone else who has a more urgent present need. And it's that sort of interplay between people with, as we say, lower time preference, the people higher time preference come into the market, into the loanable funds market and contract with each other to lend and borrow. And so just like in any other market, the interest rate is the price that clears this market. And it would be set in without government interference, just like any other price to reflect the preferences that people have in this market. But isn't it astonishing if you just step back and think about it conceptually, that mainstream economists by and large view interest rates as some sort of policy tool. They don't view it as a price or a meeting in the marketplace between lenders and borrowers. Yeah, it's astonishing. And it might harken back to the point we made earlier about how mainstream economists see the economy overall in the aggregate. So they think that every production activity in the economy stimulated by aggregate demand. And so lower interest rates in their view would always elicit more spending and therefore have a positive stimulus effect on the economy. Well, so we talk about how the Federal Reserve distorts the supply of money through creating bank reserves and increasing monetary base. We can talk about how the Federal Reserve, in effect, distorts interest rates, the price of money by manipulating the Fed funds rate or targeting the Fed funds rate. So we take what Austrians would call two types of distortions. And can you talk about how these distortions affect the production process? There's obviously Austrian business cycle theory says that this is a harmful thing. Could you give us sort of a quick version of Austrian business cycle theory? Again, this harkens back to the way that the Austrians view the economy realistically. So we see the economy as a structure of capital production. So to take the housing bubble as an example of this, in order to build more houses, we first have to cut more trees down in the forest and then mill more lumber. And you have to mine more materials, say iron out of the ground to produce more nails and so on and so forth. So once there's an expansion of credit that creates this artificial demand for some particular product in the economy, it sets in motion a reallocation of investment towards the these earlier stages of production, as we would say, towards the extraction of raw materials and the building up of the capital capacity to produce the intermediate goods like the nails and two by fours and so on and so forth to eventually produce the greater demanded result in more houses and more cars and so on and so forth. The problem with all of this reallocation of resources in the economy is that it isn't called forth by a change in people's time preferences. It isn't that people are willing to save more now so that they can have more products in the future to release resources into the expansion of these capital production processes throughout the economy. Quite the contrary, people's time preferences haven't changed. In fact, if anything, they've intensified during the boom their demand for consumer goods right now. And so the resources in the economy get pulled in two directions that aren't consistent with one another. They get pulled toward the production of consumer goods and they get pulled simultaneously toward the production of mining and building up capital capacity and so on and so forth. So there's really a resource constraint that doesn't allow both these things to be built up simultaneously that eventually brings the boom to an end and requires then a period of a reallocation of the resources into their best use that's consistent with people's preferences. But the reallocation is not always so easy, is it? I mean, if a factory tooled up to make Cadillac escalates because in an artificial credit and money market, there was a demand for these really fancy $80,000 SUVs. And then it turns out that that demand is short-lived even in an artificially propped-up economy. It's not always a simple matter to shift to building little electric cars because there's a lot of sunk costs in a certain kind of assembly line. So there's a timeline. I mean, there's real harm here. Do you sense that we don't always understand this? Right, especially conventional economists, they think of the capital stock in the economy as Play-Doh that can just be remolded at will into any configuration that we need. We could take an auto factory that we over-invested in during the boom and just refashion it immediately into a washing machine factory or something else. But as you point out, there's a degree of specificity that's created in the boom in producing these capital goods. You have a lumber mill that you produce and you can't just, without cost, tear it down and reallocate the resources into other uses that are now being demanded in relatively more highly. Well, talk about how cheap credit or when we say cheap, we mean cheaper than it otherwise would be. It affects business decisions. In other words, it makes certain projects work on paper that wouldn't work with what we would call a more natural rate of interest. What does it mean to lengthen or shorten the structure of production? That's right. When the Fed engages in this monetary expansion through the increased supply credit in the banking system, then interest rates are suppressed and the lowering of interest rates then creates a greater present value for heavier, more heavily invested capital projects than otherwise. We see asset price inflation, as we like to call it, along the lines of particularly capital intensive production processes. These tend to be the ones that where demand is shifting relatively towards those things. Again, to take automobiles is another example. It's one thing to increase the demand for automobiles and this translates then to increase demand for iron out of an iron mine. During the boom, not only do you get that increase in demand, but you get an increase in demand for iron from all the other sources that iron is used for, iron rot fences for fancier houses and so on and so forth. There's a certain concentration of increased demand and therefore higher prices for the assets in production of assets held, capital stock held in the higher stages. That is the process of lengthening out the capital structure. When resources move from more direct production processes like labor and materials going into producing a car to more indirect production processes like labor and materials going into mining iron, which then produces steel, which then produces eventually a car. Well, Jeff, despite these distortions, there are people who benefit. Can you talk a little bit about how, unlike helicopter money, which is the joke that Ben Bernanke famously said we could dump money out of helicopters? Well, that would be distributed somewhat evenly across people and across the economy, but that's not how things happen with the Fed. Can you talk about the importance of primary dealers and how they help us understand the concept of earlier recipients of new money? Sure. So we'll start with the latter point because it's, I think, more basic. So when the Fed inflates the money supply and they use it to buy something, then of course the first recipients, the ones who receive this new money first in the social process, benefit the most. They get wealth transferred to them because they're able to buy the goods that they want to buy with this new money before prices are bid up generally. But people will eventually receive this new money after a long time of the social process of spending and earning income and re-spending and so on. And they'll get the new money when prices are already bid up and so they have their wealth reduced. Now, the primary dealers are first in line in this process of money creation. So they are the ones that the Fed buys securities from or sells securities to. As they start this process of monetary inflation and credit expansion. So for folks who aren't familiar, I mean, primary dealers are actual banks or security brokers that are authorized to deal directly with the Fed itself. So in a sense, the names of these primary dealers are available. So if it's cronyism, it's not hidden per se. Yeah, that's right. So they're the big banking houses, security houses, city group, Goldman Sachs, JP Morgan, Wells Fargo. There are several foreign held companies that are on the list. I think it right now is at 15 or 20, something like that. So UBS is on the list, Deutsche Bank, Credit Suisse and so on. Well, ladies and gentlemen, I'm actually sitting in a hotel in Las Vegas as we record this. This area is called Lake Las Vegas in Henderson. It is really an unbelievable stark example of what we're talking about, Dr. Herbner, because this rivals any Chinese ghost city. I mean, there are huge unfinished buildings out here. There's a casino that had begun to operate before the 08 crash, which now sits empty with weeds growing up around it. There are empty condominiums, empty storefronts, empty restaurants. The western resort I'm sitting in is half empty. And of course, we're very, very far from the Las Vegas strip here, which has kind of been an analogy for people who are far from the DC money machine. And it really is a stark example of what this Lake Las Vegas community seemed feasible at one point in one credit environment when the economy was such as it was in the first half of the 2000s. And now we're sitting on these empty buildings. And it's really quite a sad spectacle to see this beautiful resort so empty. There's an eeriness to it. And Jeff, if you would just to close this out here. Can you talk about this? This is always a problem for Austrians because of Bastia's idea of the scene and the unseen. In other words, it's easy to see the skyscraper that goes up in an artificial interest rate environment. Say, gee whiz, look at that. That's a tangible economic benefit to what the Fed is doing or what Congress is doing. But what's not so easy to see is the opportunity cost or the lost opportunity to use money elsewhere. That's always a perennial problem for us as economists is to wake people up to this fact. It's a little bit easier with the business cycle, though, since we do see the liquidation process. Even though people have sometimes a hard time connecting the two, at least that is something tangible that they can look at as you are surveying Vegas at the moment, that something has gone terribly wrong. And it is possible through good economic analysis to wake people up to the connection between the boom and then the following liquidation process. It also strikes me as an excellent example of the malinvestment in Vegas. It's an excellent example of why the Fed's policy of reflation doesn't work because now we see that when they have reinflated the economy and the housing boom has started over, it hasn't reinvigorated Vegas. It's just created malinvestment in San Francisco. Yeah, no, it's a real tragedy out here. Dr. Herbner, we thank you so much for your time this weekend. Ladies and gentlemen, we're going to post a link to a really interesting out-of-date publication from the Federal Reserve Bank of Chicago itself that explains Fed money mechanics. And I've sent this around and really even quite a few economists haven't seen it. So I really recommend if you want to be adequate critics of central banking to Fed, we really have to understand what it's doing and how it operates. I'm going to recommend that to you. And of course, Jeff, there's a million books that people could read on this. If you go to Mises.org, I'm going to throw out Rothbard's Mystery of Banking, of course, Rothbard's, what has government done to our money. And if you want a treatment that reads just as well today as when it was written more than 100 years ago, you can read Ludwig von Mises' Theory of Money and Credit. I was skimming that the other day and there are paragraphs in that that sound like a Fed meeting today. I mean, they're so on point. And people may not be familiar with it, but Dr. Herbner edited a book called The Pure Time Theory of Interest, which features Israel Kerser and Roger Garrison, Frank Federer. So that's also a book I would recommend to people who are interested in really understanding what interest rates ought to be. Dr. Herbner, as we leave you, are there any particular books or articles that stand out to you that we might recommend to people? Also a little more advanced is Joe Salerno's book on money sound and unsound. Also excellent work. Well, Jeff, we really appreciate your time. Ladies and gentlemen, check out Mises.org and have a great weekend. Thanks so much.