 This is Mises Weekends with your host Jeff Dice. Ladies and gentlemen, welcome back once again to Mises Weekends. We are joined this weekend by our friend and colleague, Lucas Engelhardt, whom I'm sure many of you know. He is a professor of economics at Kent State University in Ohio, obtained his undergraduate degree at the Great Gross City College and his PhD at the Ohio State University, a team which will not be playing for the SEC championship this weekend, nor any weekend, but only the Big Ten championship. So that being said, Lucas, great to see you. How are you? I'm doing pretty well. How are you? Well, I'm doing great. And we wanted to speak to you because there's a lot going on with the Fed right now sort of behind the scenes because other things are in the news, sexual harassment and all these other topics. And I fear that sometimes the important news gets a bit buried. But yesterday before Congress at the Joint Economic Committee, Janet Yellen made a statement to the effect that, well, this $20 trillion in debt sort of keeps me up at night or ought to keep Americans up at night. Does this rub you the wrong way, given what we know about the Fed's complicity in all of this? Well, I mean, I wish it had been keeping her up at night longer, really. The way things are running at the moment, like a lot of this debt at the moment, I don't necessarily need to worry that much about the debt itself, just as a normal person, because the reality is the government is borrowing this money, but they're not borrowing it from me. Instead, the Fed is printing it and handing it to them. So it's having very little impact as far as that goes on me personally. Now eventually though, every debt has to be paid. So I'm going to end up paying this debt one of two ways, either they're eventually going to have to raise taxes on me. And then yes, we will actually have to pay it in an obvious way, or perhaps all this new money that has been created will actually start having impact on prices. And then it's much less obvious how we're paying it, but I'm going to pay in higher prices. So like you said, the complicity of the Fed in this whole scenario, we're going to end up paying one way or the other, either taxes or because of the Fed's actions, we're going to pay in higher prices. Well, the $20 trillion number, a lot of people in the general public are aware of it. People are less aware of the Fed's balance sheet itself, which as you know, went from something like $800 billion in the right before prior to the crash of 2008 and quintupled more than five times to about $4.5 trillion. Talk about what this means for the average guy or guy. Why should we care about the size of the Fed's balance sheet? This is something where I'm going to confess that I got some things wrong early on because I got very, very nervous immediately as this was happening. Because the Fed is increasing the size of its balance sheet. What that means is basically two things. One is that there is more physical money in circulation, so actual paper dollar bills that are being passed around, and that can naturally lead to higher prices unless people just want to hold these for some reason. Secondly, the other way that this shows up is as reserves in the banking system, which as long as the reserves in the banking system, it really doesn't affect me that much. But generally, historically, banks don't like to have lots of reserves because they don't do anything for them. Just having money sitting in the vault is not very profitable. So instead, banks will take the money they have sitting in the vault, we'll lend it out into the economy, and because of the way our banking system is structured, they can effectively lend this out multiple times. So they first make a loan, somebody goes and spends this money, that person deposits it, it's showing up in the bank vault again, so they lend it out again. To the point where we could end up with something in the neighborhood of 10 times as much money being created in the economy for each dollar that's sitting in the bank vault. When I saw that, I got really nervous because when we look at the reserves, those increased substantially to where at the moment there are about somewhere in the neighborhood of $2 trillion, $2.2 trillion in excess reserves that banks could lend out if they wanted to, and could lend it out multiple times. So you do the math interestingly, that comes to about $20 trillion that could enter the economy, that's going to have a huge impact on prices if it does. So when this first happened, I was really nervous, I was predicting significant inflation coming as a result. But it turns out we didn't see a whole lot of price inflation happening because of apparently two things, one being people did actually want to hold on to more physical money, it seems. Turns out in bad economic times, people do actually feel better holding on to physical cash. Turns out banks also were perfectly happy to keep money sitting in the bank vault, which at first I was puzzled by until I started looking at the timeline of when did banks start holding all these excess reserves and what else was going on. Right around the time the Fed was doing this quantitative easing, introducing this money into the economy, they introduced a new policy where they started paying interest on excess reserves for banks. So banks do actually earn something from holding on to this money over time. So they haven't felt any need to lend this out to anybody else, they're just holding on to it. As a result, we're not seeing the huge change in prices that I expected. Well, the fact that banks are sitting on these excess reserves and as a result of that emergency legislation from 08, they're being paid, albeit a small rate of interest. Doesn't this also demonstrate, as Janet Yellen has said, the limits of monetary policy. There's only so much you can do. You can't force banks to lend, you can't gin up credit worthy borrowers and projects out of thin air. Right, exactly. And at the same time, it turns out that I was wrong, I shouldn't have been as nervous, but these excess reserves are still there. Banks could, if they did actually see opportunities that they thought were worthwhile, this money could still come out into the economy, could still have these effects on prices. In effect, we've been lucky that the economy has been so bad that these opportunities haven't existed so that banks haven't felt a need to lend this money out. They'd rather take the guaranteed very small interest from the Fed that they've been paying. Well, while you mentioned that there hasn't been, depending on how you define it, perhaps significant price inflation, there has been consumer price inflation, I should say. There has certainly been some asset price inflation in real estate markets and in equity markets, especially the stock markets themselves. So talk about how new money hits the economy unevenly, the so-called cantalone effect. All right, so that's a big difference between the way we as Austrians kind of view the money supply and how money comes into the economy versus, say, a more mainstream notion. In the mainstream, they tend to be the inheritors of, I think they call it Gabriel's horn or more famously, more recently, Friedman's helicopter. Where we imagine that as new money is created, it's just dropped out of a helicopter evenly over the entire economy and as a result, we'd expect prices to rise basically in proportion to each other. So double the amount of money, prices all double, it really doesn't make much difference. Austrians would point out that that's not at all the way this works. Janet Yellen, maybe she owns a helicopter I don't know, but she hasn't been dropping any money out of it over my house. So this new money comes into the economy through a specific way and that is through the banking system. Now, the moment is basically been sitting in the banking system mostly, but that means the people that get it first are going to be those that interact with the banking system. Mostly that's the financial sector. So we do see lots of financial assets rising in price as they are getting some of this money. It's not all sitting there in banks and also it turns out one of the biggest borrowers in our economy, unsurprisingly, is the federal government also is first in line in getting a lot of this new money. And then we add to that other classes of borrowers as well, but certainly in terms of major groups, the financial sector gets the money first as well as the federal government. Now, since they get it first, prices haven't really adjusted yet. Because we haven't seen huge amounts of money in everybody's pockets. People that are just buying bread don't have more money. They're not paying more for bread because they don't have more money to pay for bread. So instead, we'll see the rising prices based on those things that the financial sector would buy, so these financial assets you mentioned, and also things the federal government would tend to buy. So we might see a lot of this money flowing into, as we're continuously fighting wars, say the defense sector might get a next in line, something like that. And eventually, now it does, as we have employees being paid and that kind of thing, it does eventually affect the entire economy. We do eventually see the employees of the federal government do go out and buy bread, so bread prices eventually rise. But that's not the first place we see it. So it really shouldn't be the first place we look either. Or put another way, people in the mainstream will accept that this change in the money supply affects the average level of prices with a lag. They don't really explain that lag, except in very vague terms. But as Austrians, we know that the lag happens because it takes time for money to move from its original entry point towards spread out through more of the economy. And we see prices move similarly. They move a lot at that entry point and less throughout the economy until time passes. But as you mentioned, it's not just that it's uneven. It's that it's political, right? There's a sinister element to this. There are people who benefit politically by being close to the belly of the beast, like a defense contractor, in a way that Main Street absolutely does not benefit. Absolutely. Now, as to your point about prices, is it not important to understand that there's still supply and demand for stuff that affects prices? Inflation is a monetary phenomenon, but there's still organic rising demand, let's say, in the San Francisco Bay area for housing. Right, right, exactly. And that's something that really makes our jobs as economists somewhat difficult. Because it's trying to tease out how much of a particular price increase is because of changes in what Mises would call the money relation. So money supply is changing, money demand is changing. That should affect the value of money, which is reflected then in prices. And how much of it is something specific to this particular market? So in San Francisco, we know that they're very restrictive of construction, right? So there's very restricted supply, besides just geographically, there's only so much space, right? So if we may throw into that, it might be that they have great job opportunities or something like that, or a culture that is very attractive to our current culture more broadly. So lots of people want to move there. These are not necessarily monetary things. It could be these job opportunities or the culture they've created are something that are specific to that particular good. Well, elaborate when you talk about Mises and supply and demand for money. Elaborate on that, because we don't talk a lot about that. We talk about supply and demand for goods and services, but not money. Yeah, I think this was one of Mises's great insights, was that we could take supply and demand analysis like we would apply to anything, housing in San Francisco or bread or what have you, and use the same kind of analysis to talk about money and its value. Now what makes things more complicated is that money doesn't have say one single numerical value that we can attach to it the way that the price of a particular house does. But we can still understand the general idea of the value of money in terms of its purchasing power by thinking about supply and demand, right? So on the one hand, we have a certain amount of money that is available to us or the stock or supply of money, and that changes in our economy based on what the Fed policy is and based on banks' decisions about lending. So that determines the supply side, which I think a lot of the time economists focus a lot on the supply side, ignoring the demand side as well. That is that people do actually want to hold money in its various forms, whether it be as cash or whether it be in deposit accounts or whether it be in my savings account, these various accounts that I can hold money in, I do actually want to hold money over time. It makes me feel more secure. It lets me spend money when I want to spend money. So I have to hold money to be able to do that. So understanding both of these influences allows us then to understand the value of money. So like I mentioned before, I really expected a lot of price inflation because I thought the value of money was going to fall very quickly as we were creating additional money that Federal Reserve was. At the same time, it turns out that people feeling insecure about their lives wanting to have a lot more money as a buffer against the bad times they were experiencing, the demand for money increased. Well, that would hold up the value of money. And this is something where, at first I was kind of baffled by it, but it shouldn't have been. Mises actually talks about this as something you will often see in the first stages before you get significant price inflation. You get a huge increase in the money supply, but people decide to hold some more of it, and that props up its value for a while. Eventually, people feel more secure or start realizing that money doesn't hold its value as well as they thought it would. And the demand for money falls, well, just like with any other good. If the demand for something falls, its value falls. If the demand for money falls, the value of money will fall. So that can lead then to significant price inflation that we may not see being able to be justified by an increase in the supply of money alone because people have changed their attitudes toward money. So one thing I love about Mises is that he's very aware that both sides can't have an influence, and that's something that I think too often I know myself, I don't always keep in mind and probably should keep in mind more. Well, on this subject, you talk about the value of money is hard to assign, but interest rates, in effect, are a price for money, a price for borrowing money. They ought to represent that, at least from a time preference and an Austrian viewpoint. Can you give us sort of the quick and dirty version of what happens when governments or central banks artificially keep interest rates low? How does malinvestment happen in layman's terms? OK, I guess the way that I would explain it, so it all starts right with central banks in the economies we have, deciding that they want to stimulate the economy. And the way they do this is by creating additional money and putting it into credit markets. As we have this additional supply of credit available, I really like to think of interest rates as kind of the price on credit that we have to pay. So for me to borrow, I have to pay the interest. And so if this additional supply of credit, which is really just new money, that drives down interest rates. And now this all feels very good, because now that I have this new money available, I can go and buy a house or buy a car or build a factory. What have you? And that's where we'd see the boom that we would every one from the mainstream through. Austrians agree that we get this boom kind of a fact. Now where Austrians would step in and is pointing out, this is unsustainable. Ultimately, we're going to see significant changes in prices as this is all depending upon this increase in the money supply happening over time. And if we stop doing that, say like in our economy, we've been fairly fortunate in the Federal Reserve has generally been become worried about inflation before it's gotten horribly out of hand. So they start slowing down the increase in the money supply. Well, once you do that, you're cutting off that additional supply of credit that was keeping interest rates low. Well, once you cut off that additional supply of credit, interest rates are going to rise, reflecting that there's a lesser supply of credit available. Once interest rates rise, then all these things that look like great decisions before look no longer look like great decisions. I don't necessarily want to buy a new house now. Interest rates have gotten too high. I don't want to buy a new car. I may not want to build a new factory and so on. So all of this activity we saw before gets cut off. Now, some of it may be sustained. So, for example, if I got a nice low interest rate in 2003, when interest rates were very, very low and I got a 30 year mortgage and bought my house, I won't necessarily leave that house when interest rates rise. At the same time, we know that there are some types of loans, for example, where they're very sensitive to what interest rates are at that moment. So, for example, we saw this a lot in the housing market with the adjustable rate mortgages. So people going out and buying a house in 2003 come to 2008. Interest rates are significantly higher because you have an adjustable rate mortgage. You find out you have to pay a lot more for the house. And it very well may be that you can't afford it anymore. It turns out because of, if you get a long mortgage, like 30 years is fairly typical in the United States, so much of that is interest that if I increase your interest rate from 3% to 6%, which in percentage point terms is not very much, we can talk about almost doubling your house payment. I know if I doubled my house payment, I would have to move. That house has to go on the market. But we all experience interest rates at the same time, which means looking at the housing market again, going back then to 2008, all of us with adjustable rate mortgages find we can't afford that house at the same time. We all try to sell at the same time. Come back to supply and demand in that particular market. Huge supply of housing going on to the market as people are trying to move out of these homes. The price plummets, eliminating people's equity. People find out that now they actually owe more on the home than the home is worth as the prices fallen so rapidly. So we end up with the bust where people end up where they're in effect bankrupt. They don't have the assets to pay off their debt. And this happens not only at the personal level, as we see more obviously in things like the housing market, but also the business level. As businesses have done the same thing and taking out these loans that looked pretty good at the time, making investments that looked good at the time. As times change and interest rates adjust back up, they still have the debt, the debt won't vanish. But the assets lose a lot of value. And they may find that they're also having serious problems, perhaps even in bankruptcy. Well, the final question for you, you have a lot of young students. I assume you teach micro and macro at various points. Mostly micro actually. How do we get young people especially interested in this? It's not as sound bite friendly to understand inflation and interest rates and business cycles as it is to get people worried about Trump or tax reform or the Supreme Court issues that are a little more friendly to political persuasion. How do we get people to worry about this and stay up at night? And how do we get people energized about money in the Fed? Right. One thing I like to do, especially when I teach money in banking, is point out just how unusual the times we're living in are. One of the most startling graphs that I show my students on at least a few times during the semester is looking, anybody who wants to can go, right? Google Fred, look for excess reserves of depository institutions. That's the money that's sitting in the bank vault. The banks could easily lend out if they want to. If you look before about 2009, it's sitting right at zero. Banks typically just did not hold excess reserves. It wasn't something they did. The only exception, you can see this tiny little blip around, I think it's about mid-September of 2001. So right around 9-11, OK, people might be nervous about the banking system. So in this case, was the Fed provided extra reserves, but they left right away. But then you come to what we're looking at today, where it's nearly vertical when you look at excess reserves. They just shoot up and now they're kind of gradually coming down. I think the peak was somewhere around 2.6 trillion, 2.5 trillion dollars. Now we're down to 2.2 trillion dollars. We're living in unusual times. And then once we get from the fact that things are weird right now, then we can start explaining, OK, what's the significance of this? Is there a danger involved? And then, yeah, but certainly not sound quite friendly, but we have to explain the process of relending of deposits and that kind of thing. How money actually gets into the economy and is going to have an impact could potentially have a very big impact. Then we realize this can be a real problem. And so I think you start with that excess reserves. That's a weird thing. Everybody can see it's a weird thing. And that raises the question of, OK, what's the significance? Well, I certainly hope that your students will spend the weekend on the St. Louis Fed website as opposed to Snapchat or some other time suck. But with that, Dr. Lucas Engelhardt, thank you so much for your time. And if any of you are interested in Mises University, Lucas is one of our summer professors. So you can come to Auburn and take a class or two of his. Ladies and gentlemen, have a great weekend. Subscribe to Mises Weekends via iTunes U, Stitcher and SoundCloud or listen on Mises.org and YouTube.