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We're good So There really is supposed to be kind of an introductory session You know, we're going to talk about some what I think are some pretty complex financial ideas or economic Principles, but I'm really going to try to keep it at a level that might be Below some of you here who have a lot of knowledge of economics So be patient with me and I'd be I'll be happy to answer questions As they come up But we're gonna I'm gonna try to pitch this at a level that is for the layman for somebody who hasn't read much economics Doesn't know much about economics and we'll build it up We'll build it up from there I'm also not going to this this course is not meant to be a discussion of Why a capitalism didn't fail? Okay, so I'm not here to say Capitalism didn't fail free markets didn't fail because to me and I think to this audience That should be pretty obvious I actually think that that should be an obvious point for anybody who's got eyes and And can look out there into the world if we believe capitalism is True free markets It's it's a system in which the government does one thing and one thing only protect individual rights in which The government has very has really no role in economic behavior other than protecting property rights Then we didn't have capitalism so certainly capitalism couldn't have failed and even if you take a more moderate view of free markets, you know The government for the most part leaves markets alone and only intervenes selectively and We don't even have that we don't even have this moderate form of free markets Particularly in the industries that we're gonna talk about we're gonna get into more of the details, but just think about housing mortgage business and Banking we're talking about the most regulated businesses in the country. We're talking about businesses that are heavily heavily regulated from zoning land use requirements and so on on the housing side to you know Entities that exist by government fiat to help set interest rates on mortgages and so on to the very existence of the Federal Reserve to You know to the fact that banks Every aspect of a bank is regulated from the day it started And you say try starting a bank something. I know a little bit about you start a bank The number of agencies you need a permission your your it's the only industry in which when you start the business You have to have the regulators approve your Projections your business plan every number in the business plan is reviewed by the FDAC and typically by state Regulator if you're gonna be state started or by a federal regulator by the Fed Federal Reserve if you're gonna be federally chartered Every type of loan, you know as a type almost every aspect of the banking business is heavily regulated. So You know, this isn't a defense of capitalism of free market This is really a class or we're gonna try to understand and I think a pretty deep fundamental level What actually happened? What are the main causes of this crisis? There are other sources out there that are really good about about this I strongly recommend John Allison's talk That's on the web on the financial crisis. I also recommend a book By called meltdown By his name is that I'm Thomas Woods. I don't recommend anything else Thomas Woods has written But I do that and then I also recommend the housing boom and bust by Thomas soul Which I think deals with the with one one very one aspect of the crisis really really well It doesn't really have it doesn't really tell the whole story. It tells the story of one portion of the crisis so the other the other person I would I would strongly recommend in terms of reading is is Lawrence white WH ITE Who who you can you can find his stuff on on Kato Kato's website and he's he's just been hired by George Mason He's a I used to read him his grad school. He's a he's a banking expert So he's a particularly on on free banking. He is one of the probably the best guy in the world today On those issues, so I strongly recommend Larry Lawrence Wright's work on this Okay The crisis, you know, I don't have to I don't think I have to say much about What we're facing it in many respects it touches every one of us every one of you Whether you've got a 401k whether you've got money in the market in some other form Whether you've been laid off as millions and millions and millions of Americans have been in recent months and years You know whether whether you're watching your home price The hope the value of the home that you live in plummet This is a crisis that really has hit Americans hard it's hits. It's it's wiped out Trillions of dollars of wealth we thought we had We'll talk a little bit about whether we should have thought we had that wealth to begin with But wealth we certainly thought we had both on the real estate market and the stock market And really in almost every financial markets. This is us a crisis that is not Just in the US. I remember in the early part of the crisis. There were many commentators that were saying The rest of the world would somehow be immune to this they will be free of this But indeed if you look at emerging markets, if you look at China suddenly if you look at Europe even more if you look at the UK This is a crisis that is kind of sped across the globe is impacting almost every country out there and in having devastating impacts on many of those Countries that I think it's safe to say this is the worst financial crisis We've seen in the United States since the Great Depression and it and it ain't over yet So but but even even if it starts to cut even if we start seeing some kind of a recovery Soon this will probably still go down as a longer. So we'll talk about what I think is going to happen And why I think we're far. There's still a long road. It's still a long very very hard road In front of us that this is this crisis is not going to go away Quickly and it's not going to go away easily And we're going to see we're going to see a lot more pain as we move forward like most financial economic events There's a lot going on Crisis of this magnitude doesn't happen because one thing goes wrong Because one thing gets distorted in the economy. This is not Freddy or Fanny, you know, and that's it It just takes, you know, you just nail those two agencies and you know, you can explain the whole thing There are a lot of moving parts. I We will spend today focused really on what I think is the most important of those moving parts Which is the Federal Reserve bit and monetary policy, but there are a lot of moving parts here There were a lot of causes there a lot of reasons all the integrating car that bring about this particular crisis And we'll try to move through them I will focus on three areas during during the next three days Not a day on each because we'll spend more than a day on on on the Federal Reserve and on interest rates and what what happens? We will spend we'll spend time on the Federal Reserve and interest rates trying to understand The business cycle in particular, you know, I've come to believe strongly Believe in the that the Austrians have it right the Austrian business cycle theory developed originally by Ludwig von Mises and by Frederick Hayek Hayek did probably most of the work in it and and I think that was the source of the Nobel Prize he won in 19 I think was 74 and And further developed by Austrians today by Austrian economists today Working at George Mason and other places, so we'll talk a lot about the Austrian business cycle theory and how that works here This particular crisis is manifested itself most powerfully in in the housing market So we will talk about housing that's number two We will talk about housing policy government government housing policy We'll talk about the world Freddie and Fannie plate community of investment and a whole slew of other, you know Incentives tax incentives taxes play a huge role here in terms of housing And we'll look at what kind of incentives tax is playing taxes taxing tax policy has changed over time with regard to housing and Very few people have noted that really this last the beginning of this last spike of housing You know was affected by tax change in 1997 where houses capital gains on houses basically went away for up to half a million dollars you could you could Make money tax-free, which was the only asset you could do that in You can do that in stocks, which you know if you provide people with an asset that they can invest in tax-free What happens people invest in it and they'd rather not invest where they're gonna pay taxes and Then the third part the third part of this crisis trying to understand this crisis We're gonna look at the financial markets. We're gonna look at What it means to securitize Mortgages we're gonna look at what mortgage-backed securities really are We're gonna look at collateralized debt obligations and what those are and we'll even look at You know one of the what the media is often claimed as one of the real culpits to this crisis, which are the CDS's Credit default swaps it's that I have to keep the CDs on the CDOs and the CDS as they stand for completely different things and it The credit default swaps and I think that after the after our third class you will know what a credit default swap is what it does and What role if any it played in what was going on and we'll talk about Why is it that financial markets got so messed up and they did there's no question? Huge mistakes were made the question is why did those mistakes get made and and we'll kind of I'll review those and You know some of that is in is you can see in your hand out We'll talk about the the too big to fail doctrine We'll talk about the rating agencies and we'll even talk about without actually talking about them We'll talk about in general about kind of mathematical models as they are used in In finance, okay, we'll try to tie it all together towards the end and I'll also give you my With the with the caveat that Mac macroeconomic projection is a fool's game I will make my macroeconomic projections in spite of that With all those caveats that basically I have no clue But all I can really say is things ain't getting better anytime soon. Oh, well, they'll get better, but they're not You know nothing. We're in fall win for a messy time. We're in for, you know Five years ten years of a lot of volatility and a lot of bad stuff periods of good You know just a lot of ups and downs that that's my and how it exactly manifests itself Who knows? Who knows? Okay, so that's kind of the the plan for the next three days for the next four some hours Feel free to jump in with questions now I'm gonna have to repeat the questions because we're taping, but feel free to just raise your hand and I won't I'll I'll sometimes ignore it if I'm coming on a roll on a particular thought But I promise to get to you if you're persistent with your hand up I want to make sure that everybody is on the same page if I ask if everybody understands something and nobody raises the hand I'll assume you really understand it Last class a few days ago I asked if everybody knew if everybody understood something and everybody pretended that they did and afterwards the rumor was that nobody really did so I Had to repeat it, but that's only because somebody told me what the rumor was so Please you know, let me know because you know I'm the financial jogging is often easy for me if the financial jogging is not clear to you guys Let me know. I don't want to you know the whole point again is An introductory course the financial crisis for dummies. So, you know just act that way for that purpose Okay, any questions before we go on? Where we're heading what we're doing? Okay, good I Want to start us off with a discussion of interest rates. I think this is interest rates At the heart at the key of what's going on today and what has gone on today And I want to make sure we all understand what interest rates mean. So what? What are interest rates? What is an interest rate? Many of my questions are not hypothetical. Yes It's money that you pay for the privilege of borrowing money. Okay, so it's a price, right? It's a price for the credit. It's a price you pay to be able to borrow money How does that price or what does that price reflect what determines in your mind? How much you're willing to pay to borrow money? What is going to determine what are gonna be the factors that say? What what the interest you're willing to pay on a loan somebody is gonna give you? Okay, so so you know the determining inflation is one What else is going to determine? Yeah The terminal on the length of the loan the term What else yeah Okay, so what other opportunities you have and we'll talk about the fact that those opportunities are really gonna be determined by the other things as well Yeah, so the lender's gonna be on his side he wants to make a profit on the loan, okay So he wants to try to make a profit Yeah Yeah, so that's so that's in our opportunity. What else? Yeah Okay risk of default It's interesting because you still haven't hit the number one Determinant of interest rates particularly in a in a free market where there's no inflation Security that's the risk of default so that's that's that's risk. Yeah time preference Think of a hundred bucks that you have in your pocket the two things you could do with that hundred bucks basically You could spend it you go buy lots of ice cream, right and eat ice cream and get the satisfaction from the ice cream right now Or you could save it Invest it put it away for a certain period of time Now there's enormous value in consuming it right now You get pleasure you get satisfaction out of that consumption so if you're gonna give it up that consumption if you're gonna put the money into a saving account or If you're gonna put the money into an investment, what has to be the case? You got to get something for it in order to be willing to delay that comp You know the fact that you could consume it right now So, you know, I could consume a hundred dollars worth of ice cream today I'm willing which is a lot of ice cream I need to come up with better examples of ice cream ice cream obviously is Too too much too much gluttony Well, how about this week I could buy an iPhone now, right iPhone the cheap iPhone now is $99 I could buy an iPhone now I'm a young College kid I could buy an iPhone now How much would you be willing to give me for me to delay buying the iPhone? You know, I could delay it for a year But I want something for that delay because there's huge value in me being able to buy it right now Now if you're a young college kid you have the hundred bucks and you really want that iPhone The interest rate might be really really high that the compensation for you to delay it, right? If it's ice cream a hundred bucks of ice cream, oh, I'm willing to do that for very little I'm willing to delay the hundred the eating an ice cream with iPhone You know, you know where my preferences are you can see I've got my iPhone right here So we really have a choice when we have money in our hands or whether to consume it or to save it and what determines What determines, you know, whether we choose the consumer to save are the alternatives that we face How much we need a particular good right now? What our future prospects in the context of our entire lives? What is the best allocation and part of that an important part of that is The extent to which we think long term to which we are willing to postpone consumption So imagine a three-year-old You gave or five year old you gave the hundred bucks to five year old they could go into a toy shop and buy whatever they wanted What do you think it would take you to convince that five-year-old to put the money into the bank and save it? There's no way you're ever gonna do it right because a five-year-old can think about now Maybe tomorrow and maybe a week from now maybe But they certainly can't think in terms of years They don't have the capacity to think in terms of years They all they're about if they have money is consumed now now now now now that's all they can mentally, you know physiologically probably think about Indeed in cultures in which we are now now now Saving rates are very very low. We'll talk about the saving the negative saving rate in the United States over the last few years cultures in which and I would argue are more rational to think along a term that Pursue long-term values where individuals are thinking long-term and think and pursuing long-term values are cultures that save more Because they don't just value the fact that they have the hundred dollars now They value the fact that they can get a hundred and five dollars a year from now and that hundred and five dollars And then if you if it keeps going if it stays in the saving cuts It could grow and they're thinking about retirement and they're thinking about that bigger house They would like to have and they're thinking like the nice automobile that they were nice to have all the kids going to college or whatever it is That they have a preference for saving. They have this preference to Delay their consumption and I think as we grow, you know as we go from five to twenty something We develop that time preference. We can now think in terms of long term We can think in terms of what our plans for consuming the money is later and we can resist the temptation the emotion of wanting to buy it right now at least some adults can and Hold that off in order to save in the future. And if you aggregate that over an economy If you aggregate those saving decisions over economy, that's really where you get Economic growth from it's really where you get innovation technology because think about a Society in which we all got our paychecks and went out and spent everything on consumer goods that we then ate or Dressed up in and we're gone. Where would the venture capital come from to invest in new technologies? Where would any kind of long-term project infrastructure project any kind of long-term project? Where would the funds for that come from all the money? We would spend on the ice cream will go to ice cream manufacturer who would then build maybe more ice cream facilities and Then he would himself consume right because everybody in the culture's got the shim term mentality It would go no way you would have no economic growth indeed Ultimately would have economic shrinkage Saving is where economic growth comes from that long-term perspective is where economic growth come from the ability to Invest to save and therefore invest for the long term comes from our willingness to think about the long term Okay, make sense It's a time and our time preference here is crucial and this is an individual crucial as an individual But in a sense, it's crucial as culture as a culture because as an economy because we're aggregating those individuals So if I have a strong preference for the future If I have a strong inclination to save Everything else held constant. How would that change? Interest rates Would they go up or would they go down? They would go down the strong of my preference for the future the less I'm willing to be compensated in order to wait for the future So in a in a place where we're saving a lot and thinking about the long term interest rates are lower than otherwise Okay Again, this is a in a free market. This is where we all are making these decisions free of any intervention now We're gonna assume when we talk about interest rates for now. We can add these complexities later Let's assume that inflation doesn't exist that we're not we're not projecting inflation and for simplicity Let's assume. There's no default risk just to make things easy. So we're really talking about primarily How the trade-off between consumption and between saving okay So that's kind of our Supply right? That's our willingness to save You know the price there were but what what do we know about prices that said by what? Supply and demand so actually this is this is a demand. This is the supply This reflects a supply of loanable funds. This is the amount of money that's out there But what's gonna determine the interest rate? Yeah, so there has to be a demand now and there is a demand out there for loanable funds for loans people are borrowing money They might be borrowing money for consumption and Again in a society which is focused primarily in consumption. That's where a lot of the borrowing happens. It happens in consumption But they might be borrowing money for long-term projects to invest in plants and manufacturing they might be borrowing money to pay payroll I mean, there's a lot of borrowing going on and the demand for that Depends on the entrepreneurs on the opportunities the opportunity that the entrepreneurs sees on the profit opportunities on the type of investments That out there so we've got a supply and demand that is basically in a set and Interest rate in a free market and that interest rate reflects inaggregate our preferences about time about consumption about savings and That interest rate is incredibly important. Now. Why is it so important? Why is it so important? Why are interest rates in an economy so important? What is it about interest rates? Yeah, Evan They enter into the calculation of the present value of any investment any security so they are a way of translated future expected cash flows into present value for any project that Materializes over time which means virtually every product. Yeah, so this interest rate this in a sense It's called the risk-free interest rate the Austrians called it the natural interest rate You can also call it there in finance. We call it the real interest rate this interest rate That is determined by the supply and demand for loanable funds independent of any intervention in a truly free market That interest rate then when I want when I'm investing in a risky venture I add a risk premium to it right, and then I figure out is this Venture worth the investment and we do something called. This is this is actually the I Asked people if they knew what discounting to present value meant and this is what everybody said yes They knew and turned out that they were lying So we call this in finance present value. What we do is Is I tell you you're gonna get a hundred and five? Dollars from me a year from now. How much are you willing to give me for that? What's it worth to you today? What's a hundred and five a year from now worth to you today? so the present value is What it's worth to you today present is going to equal to the future value a hundred and five divided by one plus I And I'm not gonna go to into how we get to that pretty that's pretty straightforward If you think about putting a hundred dollars into the bank at five percent interest a hundred dollars times One point zero five gives you a hundred and five. So if you want the hundred and five brought back You know, it's just it's just the same formula massaged I I is the interest rate Interesting what's that if if we're talking about more than one year, then they'll be up to the end Assuming it's just one. It's just one product idea here is that any future promise Any future cash flow that I receive? I want to know what's it worth today and This a formula like this it gets more complicated if there are various cash flows Formula like this is what it's worth to me today. That's what the present value of that is and you can see that That that is incredibly sensitive to I So if I'm talking about a 30-year mortgage payments over 30 years What is it worth today? Well, this I plays a huge factor in it If I'm talking about Investing in a in a power plant that's gonna take five years to build so I'm putting money into it to five years And then I'm gonna get money out of it. How do I figure out if that's a worthwhile investment? I have to look at all the money I put in in today's terms all the money I'll get in today's terms if that number is positive. I do it. It's a profitable if it's negative I don't do it. That's called net present value analysis net NPV net present value The present value of what I get my said minus the present value of what I invest Pretty straightforward Okay, all in today's dollars because you can't compare today's dollars with tomorrow's dollars not because of inflation But because I could it goes back to the opportunities issue. I could have invested in the bank So I want to compare it against other opportunities that I have and therefore I use I use an interest rate What this basically tells us is that every long-term decision is Affected by interest rates every financial long-term decision whether to get married or not is not influenced by interest rates. I think Wasn't in my case. I don't know about some of you Okay, but every financial decision every economic decision you could even argue that ultimately every single Thing that we have around us that is produced is affected by interest rates Because somebody had to invest in manufacturing equipment to build these tables They had to take a loan they had to raise capital for that to do that They had a pay of return on that investment that return relates to this interest rate Because a stock when you buy a stock you require certain return on that stock that return is Ultimately a function of this interest rate so the interest rates in our economy a Crucial to every economic decision. This is a price that affects almost every other price in Many ways and this is why the financial industry is so important in any ways. This is at the heart of what Of the economy so How interest rates are set Where they're set how they're determined is crucial why what it is that they reflect about us is Really really crucial because so many people make evaluations if I look out there and I see interest rates being low What does that tell me about People's preferences as a businessman. I'm a businessman I'm trying to figure out, you know where I want to make investments what I want to do I look out I see interest rates really really low that tells me People a long term people are not concerned about consumption right now They're concerned about the long term and therefore where am I going to make my investments? I'm gonna make them a long term. That's where the money is right They're gonna consume in five years. They're not they're relatively not interested in consumption right now interest rates are reflecting that about The people out there in the marketplace when interest rates are very high I'm gonna make investments in consumption goods. I'm gonna put investments into Processes and to places that are close to the consumer because high interest rates suggest that people are going to consume now That they're less interested about the future. They're more interested in the right now as an invent as a saver if I see low interest rates No independent of everything else. Is that an inducement for me to save or not? No, it's low interest rates All right high interest rates are inducement and note that that the interest rate that we get in a few markets is an equilibrium where everybody Sees these inducements wait to invest how to invest and the interest rate gets set as an equilibrium between all these different incentives Okay, so we have supply and demand That's our This is our interest rate This is the quantity of money supplied to the supply of loanable funds You know as the interest rates goes up. I'm willing to supply more funds And this is the demand for loanable funds. Okay, so this is what would happen in a in a free market Kind of naturally right just because we're buying buying saving Bowing lending investing all of that economic activity gets aggregated through an interest rate now imagine a world in Which we could arbitrarily set the interest rates any way we want it independent of supply and demand Imagine a world in which I said, you know, I don't like this entry. Let's say this interest rate is 4% I don't like this interest rate at 4% too high for whatever reason And I am gonna put the interest rate right here. I'm gonna make the interest rate 1% What happens? So at 1% Yeah Too many people Want too few loanable funds now one of the ways I can do this One of the ways I get to this point. Yes, that would happen and they'd be a shortage right of loanable funds But I have a secret way of doing this in which I can just print up loanable funds, right? Has nothing to do with production and has nothing to do with wealth creation And has nothing to do with actual work out there I can just create the extra loanable funds for people to have so we'll never get into a situation Where people actually want to borrow money and they can't Because they'll always be enough supply. I will provide that supply What's that? You're borrowing money, right? Now why? Because it's cheap Right Now what are you gonna do with that money? You've you borrowed the money What are you gonna do with it? Well, you're gonna consume right because It's so cheap Yeah, so why what kind of investments are going to look like they're profitable? Because the money's so cheap, but don't really reflect the reality of what people really want Right because the reality of what people really want is up here. It's at four percent But I'm not officially brought it down to one percent Now what happens when interest rates are really really low what kind of investments put aside the consumption side Just in terms of investment what kind of investments suddenly look appealing Long-term investments because the longer term go back to this equation The longer the end the bigger the end The more impact I has on the present value the longer the end the bigger this number is the Shop of that declines So if I have an interest rate that's really really low it impacts long-term Investments much more than does short-term think about the hundred and five right if it's a hundred and five a year from now I Discounted over one year. It's a hundred 105 over ten years. I discounted to today. I don't know exactly what it is But it's eighty something well less than a hundred right if I increase the interest rate if I decrease the interest rate I make the interest rate lower than five percent, which is what we were using It's gonna have less impact on the one year because I only discounted it one year It only gets to apply once if I do it over five years it gets to apply five and therefore it has much bigger impact So it makes long-term investments much more appealing What other type investments is it effect? It's a long term. It biases us towards long term And what's the second thing it biases us towards? Yeah, risky investments because if you remember the risky investments are this I that we originally had plus a risk premium Right I'm investing in at the real rates at this naturally plus something that reflects that risk And let's say the I is we said it's 1% right now and the risk preference Let's say that's 4% So I need 4% to be compensated the more risk you take on the more you want to be Compensated for the risk right because there's a risk you might not get anything in return. That's how risk works by the way Right sometimes bad things happen. That's what risk kind of means Some people forgot that in the last few years So my required rate of return the rate of return I would require in order to make this investment would be 5% but when interest rates are 4% Which is the real real rate of return my required rate of return would have been 8% So an investment That let's say an investment generates 6% this investment generate 6% Then in this scenario do I make the investment or not? No, I require 8. It's only making 6. I say no, that's not a profitable investment. I'm not gonna make it Do I make it here? Yes now in a sense if you will if you translate into cost of capital my cost of capital is 4% and I can get 6 I've made money So some risky not all some risky investment They wouldn't make sense under a the real natural rate of interest now seem appealing under this artificial rate of interest Okay, yeah Magically your arbitrarily set the 1% interest rate, but the 4% risk premium is still this is a market rate Yeah, yeah the market is well. We'll talk about what freely means but relatively freely decided out there And and that's not gonna change because of the 1% although there is a relationship between the two It's very complicated and and it you know most people are gonna change it. It's gonna stay that so suddenly risky investments become profitable So when we lower the interest rates We get long-term risky investments That's where the money tends to flow if you had this artificially low interest rates That's on the one side On the other side, I'm a consumer. I'm just one of us and I was quite willing to save some money at 4% Right. I mean that's where the equilibrium was at 4% Interest rates now one percent What are you gonna save? How much are you gonna save? Less hugely less, right? I mean at 1% who wants to save any money? So what do you do with it since the alternative is save or consume? What do you do with it? You consume you buy stuff So when interest rates are artificially low and we'll talk about what that means in a minute But when interest rates how that happens in the real world when interest rates are artificially low two things happen we consume a lot and The investors who can get them hands on the money invest long-term and in risky investments Those are the two behaviors Now what happens if interest rates are too high if artificially I raise it to 6% well the opposite, right? Do I want to save? Yeah I want to save more because at 4% I was willing to save quite a bit right To get this equilibrium now. We'll need to save a lot more at 6% The investors want to invest long-term Now they want to invest short-term Right because it's 6% it drives away the long-term investments because those are worth less because interest rates have gone up And they want to invest short-term so they're investing in consumption goods, which is short-term type investments But I don't want to consume when interest rates are too low. I want to consume and they're investing in long-term goods You see how both scenarios create mal-investment Misallocations of capital going in opposite directions in equilibrium. I want to consume and they want to invest Appropriately I want to consume some I want to save some they invest some in consumption they invest some in long-term The incentives are aligned. That's the whole idea of an equilibrium of of a real Interest rate of supply and demand meeting But when it's a misalignment The interest rates don't reflect what we really want They reflect something artificial and we adjust our wants to that So when it states are really low we consume and we invest long-term Complete misalignment when it states are too high we save But the investors investors investing as if we're consuming You can see how When interest rates are misaligned you get massive mal investment bad investment Investment in the wrong things misallocation of capital Okay Questions that's a lot Yes Some Yeah, no, I'm assuming all every time I say saving I'm assuming that that translates into investment Right, but the people making the decision on how to invest are different than the people making the decision about saving So I decide to save but then what the person who? Takes that saving and invests it does with it I'm assuming you're putting in the bank think of it now I'm assuming you're giving it to the bank and they're giving you a certain return on that and then the bank is then lending it out So they're investing the money. Okay, so I'm yes, some of us do both We save and we directly invest but which makes it the same really it doesn't really matter because it's still we save in a way That reflects the in the investment incentives that are created here. Okay, the wheel. Yeah Sean I mean the only way to make up for that it seems to me is by Inflating the money supply because otherwise it would we'll get to that. Yes. Exactly. We print money, right, but No, let me get to that remind me I have to talk about inflation and what inflation means and then and then why why inflating the money supply doesn't necessarily mean price inflation it means primarily Disillocation of resources that sometimes can be price inflation. We'll get to that in a second. Yeah There was a lot of criticism Americans being consumer-oriented spending not saving. I mean, it's like a personality defect or cultural defect of immediate gratification Yeah, yeah Yeah, so this idea that they've been commentary really for a decade over a decade You know probably since the 1980s that we are consumer culture all we care about is consumption was short-term We want to consume consume consume consume. We don't think about the long term and I'd say that's absolutely right Given the incentives provided to us by the interest rates that have been as so I'm gonna make the case which I which I Think is I'm gonna make the case which I think it's true But which is a little tricky to make That we've had two bubbles that are basically the same and that are fed off of each other and That are continuation, so we're not really just talking about a housing bubble right now We never really overcame the dot-com bubble. We haven't really recovered yet from the dot-com bubble There's this one sequence of of mistakes that the Federal Reserve has made and that's who sets those arbitrary interest rates That has led to two bubbles and I you know and I'll just put up this graph because I think it's cool Well depressing and cool, but just you know it gives just gives a illustration of that because of how dramatic these things are you know, this is the S&P 500 You know, I think I think our problems started somewhere here. Oh really our problems started 1914, but in modern times That's where our problems so So Yes, I think we've been a consumer-oriented culture at least since the the late 80s because Interest rates have been held out officially low Relative to where our time preference would be in a free market and therefore we have consumed because savings didn't make sense for us and I think that's I Talked about long-term investments. What's more long-term than internet then the venture capital then all the capital that went in there Okay, now. I'm not saying the entire internet phenomenon is a bubble, but that Again as we'll talk about bubbles tend to piggy bank off of trends that are already happening bubbles tend to piggyback tend to Explode tend to build on a existing trend There's clearly real value being created here somewhere and the bubble takes it completely out of proportion There certainly was a real there were reasons why real estate prices home real estate prices were increasing They had nothing to do with interest rates as I'll talk about we'll talk about that in housing policy and so on That the bubble latches on to and blows up But yes, I think Americans have consumed too much and I've got a slide here at some point We'll talk about where you'll see that in the in the period where interest rates were the lowest Americans had negative saving rates So they were clearly borrowing more than they could more than they were putting away as a as an economy in total and indeed Asians in Asia in Southeast Asia have really positive saving rates because I think they are at a point in their their cultural cycle and in terms of where they are where they've come from and where they're heading that they are very Long-term they think long term they're focused on long term and while they're consuming more than they ever used to Because they've created wealth. They are thinking about the long-term in a more substantial way than we are But again, this isn't necessarily a cultural reflection of who we are It's about the incentives that we be provided with it's about what People in at the Federal Reserve in government have wanted us to do. This is the kind of incentive that they provided us So let's let's talk about how we get these artificially low and high interest rates. We'll talk about why they're set and And And what the implications are for for markets because the implications are these are to implicate the implications I gave about the Missile locations is just one of many many implications here So how do we get this lower interest rate? Well The Federal Reserve basically dictates Interest rates at the at the low end Fed funds rates are dictated by the Federal Reserve This is the loan. This is the rate in which banks lend and borrow money from each other Now, how do they manifest that? How do they because this is just guidance, right? They just tell the banks This is the rate we want you to lend and borrow, but there's no penalty if you lend and borrow at a different rate the way they Manipulate that price to be where it needs to be is by Increasing or decreasing the money supply. It is by buying or selling securities in the open market That's one way another way they can change the bank reserves which they really do but We'll talk about bank reserves in a while But but they can do that but the primary way is by buying or selling Securities and therefore increasing the amount of money in the economy or decreasing the amount of money in the economy now So when they increase the amount of money in the economy in a sense They've told banks they've told the world interest rates should be 1% and we're providing the supply of loanable funds for all those people who want to buy it by Buying securities in the open markets taking these bonds out of the market. I saw it and And therefore, you know, there's liquidity in the market. There's more cash in the market. Yes question What is security so securities are bonds Basically loans, so let's say I'm a bank and I hold in my in my I need to hold some a safe assets So what I do is I buy government bonds these are bonds that the government issues to raise money in order to fund their operations Okay, so these are loans to government what the Fed does is it buys those bonds from me the bank and by doing that increases the money that I now have on deposits Right, I have now cash instead of pieces of paper and that cash can then get circulated out into the into the economy Okay, and if you think about how money money circulates into an economy You know, we have in the United States something called fractional was a banking actually every banking system in the world has fraction was Oh banking and everybody every bank has had fractional was a banking since almost the beginning of banking So it's this is not something new There are aspects of it that I knew but and this is let's say. This is the assets and the liabilities of a bank When you go and deposit money at bank, let's say you deposit a hundred dollars in the bank The bank has a hundred dollar liability. It owes you a hundred dollars, right? It's a liability to the bank Now what the bank does is It takes that hundred dollars and it lends some of that money out Now in the United States Regulators say that you can lend out of every hundred dollars in a pure checking account pure pure checking out You can lend out ninety dollars. So ninety dollars a lent Ten dollars are held in cash It's just an example, right and and that's in a pure checking out It's ninety ten if it's a month if it's other types of accounts where you have checking It could go down to three and at some accounts like saving counts at zero You don't need any reserve. Okay, so the ten is the reserve the 90s lent out now. What happens this 90? I lent out. I'm a bank. I've lent you ninety dollars. What do you do with the ninety dollars? You put it in your bank, right? So somebody else Some other bank. I need to be a whiteboard. There's a ninety dollar deposit and this bank now can lend out 81 and it keeps nine right and This goes on and on and on and on theoretically right so Every time you increase by a hundred dollars the supply of money you actually if it's in the banking system like this You create Potentially up to nine hundred dollars Okay, it's kind of you know magic, but it's simple math Okay Now in a free banking era with no Federal Reserve and no reserve requirements no regulations so pre pre FDR pre 1930s banks in the United States this part of the banking wasn't regulated. There are the things that were regulated They were primarily regulated by the states. There was no Federal Regulation of banking. There was no Federal Reserve pre 1914 So pre 1914 what did banks do? Well, there were all kinds of banks Some banks if you gave them a hundred dollars into a checking account kept the entire hundred dollars in cash And the way they made money was that money you put in in a saving account Let's say a five-year saving account they'd lend out to somebody for five years. So they would match So if all their customers came to the bank on the same day and demanded their money The bank could give it all back to them. There were some banks like that very few Though some banks and this again is a minority lent out 40 percent 60 percent and kept 40 so there was a requirement of 40 percent Most banks was somewhere in between between 40 and 100 It turns to reserve a quiet no bank no bank in America under free banking with no Federal Reserve lent 90 percent Because doesn't take many people to come and demand their money And the bank is gone because it can't pay them back. It's lent all the money out Now why isn't it a concern for us since the Great Depression? We don't care that we're never gonna run to the bank and demand our money Why is that we have deposit insurance the government has basically said don't worry be happy No matter which bank you give your money to no matter how risky the bank is no matter How irresponsible they are with your money? We will always pay you back what you deposited into your account During the SNL crisis in the 80s the Wall Street Journal used to publicize a little a little box Where they used to have the highest paying CD rates in the country and in those days it was 15 16% and you could send your money to a little bank in Louisiana and get 16% return on the money and People do that. They sent lots of money to these banks That little table was a predictor almost perfect predictor of which banks are gonna go bankrupt Seriously people have done studies on this Why is that as you approach bankruptcy? You're more desperate for money. You will need to pay more for it And what do you do with the money? If I if I'm raising money from you at 15% what do I need to get as a return on my investment? Much more than 15% so how do you get more than 15%? Really really risky investment. So basically what they were doing is buying lottery tickets You know real estate lottery and oil exploration lottery and things like that But they were buying the equivalent of lottery tickets and But why in a real market in a rational free market? What would happen? I Would say I'm not gonna give those money those losers my fifth money even at 15% because the risk is enormous 15% reflects the risk that I'm not I'm not willing to do that So they would have got very little money and they would have faded into the background The SNL crisis still would have happened would have been very small But at 15% guaranteed by the US federal government. I'm willing to give them all my money And I get my 15% back because it's guaranteed by the US federal government. That's how the pot That's the SNL crisis. That's what was so big It could have been a small crisis It became a big crisis because of deposit insurance because we kept funneling money into the worst banks And of course the SNL's that won the lottery Were the ones that survived and the SNL's that lost on the lottery are the ones that lost And of course, what kind of bank what kind of people does an industry playing that game attract? Gamblers shady people right and that's why you got so many crooks all at once in the SNL's They want long-term bankers these were people who entered the industry relatively new Charles What's was named? Keating and the rest of them they were relatively new players and why were they attracted because they was free money government guaranteed which they could play the lottery with and You don't get real businessmen doing that. That's not fun You get you get the shadier Type of people going into that industry and that's why there's so many crooks all at once in the SNL industry versus any other industry Very similar to mortgage banking as we'll see Why you got shadier characters moving into mortgage banking welcome to the total wireless store We're total confidence awaits. I need a smartphone with an awesome camera got anything to fit a new dad's budget Don't worry. You got this with total wireless and now you can get $50 off on select phones $99 and up my relatives won't miss a thing now You can focus on the important stuff like diaper duty discover the total wireless stores and get total confidence the latest phones the best network All in great prices now open an LA limited time offer in 6 30 18th available while supplies last quarter required for a non-track phone brand offer only available a total wireless stores visit store for details Yeah There was an interesting graph of the economists several months ago going back to the 19th century The capital ratio of banks in the United States and in the 19th century. It was almost something like 50% you know capital Tier one equivalent of tier one capital whereas now, you know and by the 20 by them Into the 20th century was like five percent. Yeah, so big banks in the 19th century at 50% capital in the free market with no regulation No capital requirements. Nothing in our world today with tons and tons of regulations and capital requirements and everything You know the better banks had 10 to 12 percent that particularly the money center banks in New York had closer to 5% And the European banks had less than 5% one of the reasons the European banks got hit is not so much because they had a Real estate bubble or anything like that, but their capital requirements were so low in Europe That they didn't have to get hit badly on the asset side to get killed on Kind of as a net worth on the net worth side Again, we'll talk about how leverage works and why that is but the more leverage you have The riskier your position is right the more you finance a project think of your home If you finance your home a hundred percent equity hundred percent cash, right? So let's say it's a million dollar home. You pay a million bucks I'm from California so a million bucks is like buys you a little home See a million bucks you buy a home and let's say the value the home drops by 20% how much have you lost? 200,000 is a percentage of your investment. How much have you lost 20% right? Let's say instead of that you bought the house with 80% equity and 20% debt. I Mean I'm sorry 80% debt 20% equity so you put down 200,000 and you borrowed 800,000 and now the house drops 20% You've lost 200,000. What kind of a turn on your investment did you get? 100% negative return right you lost everything Now let's say you put a hundred percent down a hundred percent debt Notice the first two scenario. There was no cash outlay. You lost your 200,000. It's gone But you don't have to actually pay anything now You bought the million-dollar house with a million-dollar mortgage and the price went down 200,000 now you owe more Right than what the house is worth so now you literally if you want to pay off the debt You literally have to take another 200,000 from your wallet and pay it off or walk away from the home Which is what bankruptcy laws allows us to do which is part of a big part of the foreclosure So leverage the more debt you take on the smaller the loss can be that'll wipe you out So leverage magnifies risk. So when capital ratio is a 50% which means very low leverage Banks can survive a lot of bad things When leverage is 3% 5% it doesn't take much To wipe you out as a bank and that's what happened to American banks and European banks They got wiped on now because the losses were huge but because they had no capital to back those losses up because They weren't required to you know This is now why is it that all the banks gravitate towards what the federal government wants them to do So the federal government says that you can keep a 10% reserve Why don't some banks keep a 50% reserve because if they don't they competitors will and there's no reward for being safer Think about what happens in a free market Let's say I'm a bank. Let's have a bank that keeps a hundred percent reserve Every dollar you put into a checking account. I keep in cash Ready for you to withdraw. How much interest am I going to pay you as the banker? Probably zero I might even charge you a fee To hold on to your money and and to let you write checks, right? Let's say I'm a bank again in a free market. I've got that's one alternative as a customer I can go and I maybe have to pay a fee but I'll get zero on my checking out But let's say there's another bank in which they only keep half the money in reserve and half is gone So they are possibility that one day I'll go and ask for my money back at the bank, and it won't be there at least not on that day Is that riskier for me as a customer? Yes. So am I gonna what am I gonna demand in compensation for that a higher interest rate? So I'm not against there's some Objectivist that have come out against factional reserve banking. There's some Austrian economists that against I'm not I'm saying let them all could take care of it Some banks will be High-risk some banks will be low risk and wheels depositors We as depositors will adjust our interest rates Our interest rate the demand that we make on interest rates accordingly the high-risk banks will have to pass a lot of money To get our money the lowest banks will have we'll pay only a low interest rate with the positive insurance. That's gone What the positive insurance? I don't care if you're risky or safe. I don't care what you do with our money I don't care about anything because the government's got my back Right, and you might say well, they're wealthy people out there and theirs is not insured, right? deposit insurance is only up to 250 right now, but there's some people who have 10 million dollars companies and so on well this if they're smart What do they do? Well, somebody counts as expensive it's cumbersome put it in a big bank Nobody has ever since the Great Depression nobody's ever lost a dime if they had a deposit at a big bank We'll talk about this the last day. It's called too big to fail Too big to fail which is an actual policy was an actual policy the Federal Reserve which has proved itself true these days The first example of that was Continental Illinois in 1984 the largest failure of an American bank in history up until Washington Mutual recently Every depositor was paid off in Continental Illinois every single one including those who had tens of millions of dollars on deposit It was too big to fail Okay, so Depositors don't have to worry about their money. Therefore the banks There's no competitive advantage to being safe. So what is there? There's a race to the bottom always is and What is the bottom the bottom is whatever the government sets the bottom to be if the government set the reserve requirements as zero They'd be a race to zero so government intervention through deposit insurance makes banks riskier Not to us depositors because we don't care it makes it riskier to us as taxpayers Taxpayers because we're the ones who pay the deposit insurance once the fund is depleted, which it's on the verge of being any day No, okay, so the point is that the Fed could put in a little bit of money and it has a huge impact because of factional reserve banking money goes in and They drive it they put in enough money to drive it to the interest rate that they want and one of the reasons they lower interest rates and Increments of a quarter of a percent or half a percent usually it's pretty rare that they load in 1% is because this is pretty delicate Arts if you were buying and selling these things to do it a whole 1% would be hard Doing quarter percent they can do it slowly. They can do it much more smoothly. They do a quarter percent every few months They can increase the money supply slowly They can monitor that and not doing it too aggressively too softly that it's getting to the right place And then they do the next round and that's why you see interest rates going down down down down in steps Because the Fed is fine-tuning Their monetary policy as they go down and it's hard. Let's be clear Figuring out exactly what impact you are having by buying and selling securities on the market But when you're increasing the money supply you're buying taking the security out of the market putting in cash is Hard and indeed it's so hard that they don't even have a measure of it When you talk about money supply There are five or six different measures of the money supply the amount of money in the economy because think about it Some money is in checking accounts. Some money is cash in your pocket Some money's never going to be cash because all you're going to do is wire transfers Some money's in saving accounts some money you might have overseas some people overseas might have dollars over here The Chinese government has dollars over there There are all these different accounts summer Checking account that have 90% reserve requirements others types of saving accounts that only have three and a half percent reserve requirements Others don't have reserve requirements at all. It's complicated. So we have measures called M zero M one You might have heard of M two and three and three the US government doesn't report anymore It doesn't tell us what M three is anymore. They stopped doing that early 2006 the European Central Bank though Uses M3 as they target. That's the most important number to them. The Federal Reserve doesn't even Doesn't even report it doesn't even measure it. There's something called MZM I mean there are lots of them because every economist you speak to is using a different one because they're so complicated It's so difficult to get a handle on what's going on because there's so many moving parts when you're trying to set monetary policy When you're trying to set how much money is in the economy measure that that they can't even agree on one measure that is uniform Okay So we lower the interest rates to 1% by increasing the amount of money out there in the economy artificially now the results of anything real, okay, we just print up the money Send it into the economy. Yes I think I've got it I Think I've got him three from him That's it. So these are these are measures. That's M3 because M1 M3 accepts the government numbers and M3 is calculated himself. I Don't know I'm not I'm not this kind of economist I I don't I don't delve into these, you know, he's the only one I know calculated M3 You can see the government stopped reporting it right here right in early 2006. They just stopped giving that number out It's interesting what happens after they stopped giving it out. I mean, I'm not a conspiracy theory guy But it's just you know, it's just curious the trend afterwards You will know though this The the close to 10% increase in and you know close to 10% increase in M1 Which is the closest to actual money that is being released out there So just just in terms of definitions quickly M1 is cash. You don't have to wait this time cash travels checks checking accounts and Amount of money at the Federal Reserve the Federal Reserve's float. It's called M2 is M1 plus saving accounts Money markets with no checking Small denomination time deposits and retirement accounts M3 is M2 plus large time deposits time deposits of saving accounts you are dollars Dollars in in US banks overseas and Institutional money accounts again and then there's others there's I've seen mzm used and m0 is is even is even tighter It's even more closely to actual money actual cash So the Federal Reserve increases money supply Low as it if it wants to increase interest rates, it sucks money out it sells the security at board before and maybe some additional securities and Money sucks out money becomes in less supply and you get a higher interest rate now We've had a Federal Reserve that does this all the time every day 12 guys get together once every two months They sit around a table and they say we believe interest rates should be 1% 2% 3% 4% whatever it is They decide that particular day Why? Did they decide a particular interest rate? Well, they have a mandate They mandate is to do two things This goes back to the acts that Installed Federal Reserve and then all its amendments over the years, but they basically have two one is to minimize price inflation Doesn't say no price inflation just says, you know minimize it reduce price inflation. So prices don't go up overall second maximize employment She want to have fully employed population with no price inflation. That is what the Fed is there to do And we know how important interest rates are and the government knows that too. Everybody knows the interest rates are really really really important So they try to manipulate interest rates to achieve no inflation no price inflation and High unemployment and high low unemployment. Sorry low unemployment high employment and it's hard I try to argue it's impossible, but this is what they're trying to do. They've got very You know sophisticated formulas to calculate these things by there's something called the Taylor rule They take some inflation and some unemployment and mixes them together and results at the end is an interest rate That you should be targeting in order to offset these two so you get some optimal level The Fed generally is targeted somewhere around 2% as an acceptable inflation rate into the price inflation and Unemployment is all as fluctuated Generally over the last 10 years they try to target below 6% and actually below 5% so and if you look at how they've done They've done really well Inflation is not being very high price inflation and unemployment is being very very low until this final crisis And that's how they set monetary policy They've got a cow a formula and it pumps out an interest rate And you can actually take the Taylor rule and and plot it and you'll see that the Fed Most the time is within a certain range of that Taylor rule Sometimes it deviates out of it a little bit, but generally this they seem to be followed Taylor as a economist I think University of Chicago they tend to follow that that rule is over the last at least during the Greenspan era and The idea is this during recessions. There's a lot of unemployment. That's not good We want to minimize recessions. How do we do that? We lower interest rates significantly We lower interest rate gets people buying stuff gets people investing in stuff that The economy recovers unemployment goes up because we don't like unemployment The economy's you know heating up right you hear that term the heating up. It's growing very very fast The risk is then that prices will go up So we would you we lower? I mean we increase interest rates and they keep increasing and decreasing and increasing and increasing and increasing and decreasing All you know to get into this little groove where they smoothed out the business cycle And this is Alan Greenspan's whole shtick during his period as head of the head of the Federal Reserve was To smooth out the business cycle. So just as an example That's a same graph similar graph. This one is Dow Jones industrial When now this happened the recession after the calm hits and in 9-11 happened and we were heading towards recession Alan Greenspan Wham slashes interest rates To the lowest rate they've been in a very very long time basically 1% We will see you can see that right up here. This is the Fed funds rate You can see at you know, they were going up the bubble burst in the calm interest rates collapse That's the Fed was of lowering them. It's not interest rates in the real market collapsing It's the Fed was of lowering them. They keep him at 1% for a year which is Historically unprecedented and then they start raising them again When you say until recently they've done a good job, how far? Well, I'm sorry. I didn't say they've done a good job. They followed this path Yes, so during this period I mean since the since Alan Greenspan took over or since Volcker crushed inflation I'd say since the early to mid like the 83 84 Inflation has been relatively low unemployment's been relatively low throughout that period and indeed declining But what is in what is inflation inflation they There's a basket of goods that they measure the prices of those goods year in year out and they you know If those basket of good is increasing that's hot what they call inflation CPI consumer price inflation and Today they won't even look at all goods. There's something called Core inflation it's just a few goods they exclude what they exclude oil and they exclude food Right because we don't really consume food and oil so they're not no, but they exclude them because they're volatile Right. I mean, which is kind of funny because what if they're volatile up? Is that not inflation? I mean, but it's not included in the in it in the way the Fed looks at inflation the Fed looks at coin inflation Which excludes those things? It's only excludes the price of homes going up to two and a half times like they did in some region includes it excludes the price of Internet stocks going up a thousand times in some cases during the dot-com bubble those aren't included So, yeah, we've had stable inflation a stable unemployment, but we've had a pretty volatile time if you look at The previous chart right at least in the last decade had a pretty volatile decade You can arm economically, but you know as manifested in the stock price But the goal is eliminate those big dips at least from an unemployment and inflation perspective. That's the goal Now notice what's going on here? Since we've had a Federal Reserve Since 1914 we have no idea what this is. We don't know what the natural rate of interest is We don't know what the real rate of is There is no market, right? So we have no clue what people's true preferences in terms of consumption and saving all all we know is What the Fed would like interest rates to be and how we respond to what the Fed does So it's not that I'm arguing that ooh the Fed misbehaved here because it lowered interest rates to 1% I will see why that's that was really really a bad thing and that was a particularly dumb thing But I'm saying the very existence of the Fed Distorts the marketplace no matter what they do Because they create a barrier between the marketplace Everybody in the marketplace investors savers consumers everybody and what the interest rate really is We don't know what supply and demand for loanable funds In a real market is we know what the government would like it to be we know how the government manipulates it But we don't know what it really is So we don't know where the Americans would consume what they type true time preferences We don't know when the Americans would save more than the Chinese or less than the Chinese. We have no idea Because all Americans are doing is responding to incentives created artificially for them by the Federal Reserve and Think about the fact that this affects every decision we make every economic decision we make out there Not only whether we consume or whether we save but what kind of investments we make whether the short-term a long-time risky or not risky All of that is impacted by the Fed by the Fed setting interest rates and yes Accidentally once in a while it could set the interest rates right there But even that doesn't mean anything Even that's not a real interest rate because by their very existence they've distorted our incentives What this makes it the existence of the Federal Reserve and this is why in the fight for capitalism Federal Reserve is enemy number one Because they impact everything every decision So running a business being a consumer being a saver being an investor all done behind a fog We don't really know what's out there. We kind of have a sense But there's no reality that we're looking at because it's completely distorted by monetary policy So it shouldn't be any surprise that we have bubbles. We have crashes. We have a lot of other things That are distorting It's surprising when things go well and that's because the market in spite of the fog can somehow manage Well more short-term than we would be otherwise no question particularly when interest rates are too low But how do we know that too low? What does too low mean that would assume that we knew what the real interest rate should be and this is lower than what it Would be but we don't know what the real interest rate should be now We can tell that that's too low because that's below the rate of inflation. That's a negative real rate of a turn We'll get to that in a minute, but What is too low, you know, what are interest rates? If a defender of the Fed were to say well as long as prices are stable It must be doing the good job about inflation is the criticism of that How is how is price stability mentioned because you pointed out that the current measure actually excludes Critical components like housing prices. So I assume Greenspan would have said five or ten years ago What are you talking about? Prices have been stable. What yeah, so the question is a defender of the Fed would say something like Look we've got as long as price Prices are stable You know, everything's we're doing a good job, you know, because that's that's our main function is prices stable and look For the last 15 years Take two three years back prices have been stable. So we've done a good job. What more can you expect from monetary policy? Well a lot To begin with wise price stability the standard in in a free market. It's not clear that prices are stable They're probably rapidly declining not rapidly. They're probably somewhat declining right things become cheaper. Look at your computer Right even with price inflation it becomes cheaper all the time or higher quality all the time Why wouldn't everything look at it? Why wouldn't housing decline? Right the technology to make houses improves all the time. We should be getting better and better houses for the same price Why should possibly every go up? If there's more demand for housing because of immigration because we have lots of kids Build more homes plenty of land in this country. Just look around So it's not clear that price stability should be the standard, but secondly and this is the more important point What's important is not the level of prices and Oh, let's say that is important, but that's not the only thing that's important. What's also important are the relative prices Because what is what are the relative prices of tomatoes versus automobiles versus real estate versus something else? What are those reflect in a real free market? People's free voluntary preferences for those goods So where they are is important if everybody's you know Everybody's buying tomatoes because of some government incentive to go and buy tomatoes But the price level is the same Because on average something else has gone, but nobody really wants that many tomatoes. It's stupid So it's silly. Oh in this case everybody buying a home Everybody pricing a home way out of the stratosphere. We don't need those homes We don't need to build all those homes the fact that at the same time price levels were stable is meaningless When so much waste so much misalocation is kept so the point is and this is the difference between the Austrians and the freedmen style monitorists Milton Friedman and the monitor school that particularly comes out of the University of Chicago believe and I'm simplifying here I know if you're an economist the simplification believe that when the Fed increases the money supply Their money flows into all goods and all prices go up so if you want to percent if The Fed achieves 2% increase that means a certain increase in the money supply, but that's it It just stays 2% and that's okay. It's relatively stable But that it goes in a sense equally into the economy in some way it impacts all prices It might take a little bit of while, but not very long pretty quick the Austrians say no, there's no reason to believe that There's so many other things going on at the same time money could flow all into real estate and Prices were way up in real estate and the rest of prices might still be stable You know, maybe some prices so invent miss what the Austrians emphasize are the relative prices And what the Austrians emphasize is the misallocation of capital Misallocated we're building too many houses given real supply and demand We're putting too much money into internet stocks given their true nature We're not putting enough money into Who knows what? You know who knows what the market would be putting money into in a truly free market. I don't know nobody knows That's the beauty of our market who knows where entrepreneurs would be making new discoveries would be inventing new things would be making investments We don't know but that's the importance of the Fed's distortion And this is why and I think this as I don't I haven't figured out the full implications But this has implications mathematical For some of the mathematical models that assume, you know Because I think a lot of the neoclassical economists coming out of Chicago assume that everything's mathematically modeled because it's all simple Right money gets in prices go up. Bam. You got a new equilibrium. Everything stays normal And therefore everything everything is modeled like that. Everything is easy. So you can even regulate, right? You can regulate you can tinker with this you can tinker with that because we can model everything but reality is a thousand times messier than that and Therefore it doesn't behave in those simple kind of patterns So you can't observe them as allocations obviously or easily like you would price increases. That's measurable I can tell that pretty quickly But real estate bubble that takes a while to figure out that it's happening and then Figure me out when it's gonna boost or when it's gonna peak and all this stuff. That's hard messy Yucky stuff can't model it mathematically So we tend towards the simplification of the models So the whole I think the fact that the monoliths have dominated the Friedman style have dominated that the free market school of Economics has done free market a lot of harm Because it's made the world believe that it's simple And it's not So that the key here is this misallocation Austrian economics says and I think absolutely true and I didn't believe this for a long time I was a finance professor in finance. It's all pretty simple stuff We're very influenced by Milton Friedman and the monetarists are all finance professors believe in free market But they believe in them from an economics perspective with a huge flaw in their thinking and that's why they can't explain bubbles They can't explain misallocations. They can't explain the irrationality of the market. It's not pure irrationality as much as it is These kind of distortions and fog that is created Of most integrity doing the absolute best one could one could have been chairman of the fed and the same Disasterous result could have happened because there wouldn't have been a way of knowing how the relative Misallocation guess I think that's right So the question is you know, even if you were the best intention Fed reserve chairman You couldn't do it right and that's absolutely true You cannot run the Fed right and and Alan Greenspan knew this a long time ago in the 60s I think there is no right way to run the Fed reserve I once had this debate with a colleague and I said well, what if we do it Friedman said we only increase the money supply Two or three percent every year, but it's it's a rule and everybody knows it doesn't work Won't get it right because again that three percent is right wrong too much too little into the In terms of what the market demands in terms of the census state creates misallocations and provisions. What if we targeted gold? Well, but is gold really a market price for money or is it a gold the market price for something else What does it really mean that once you have a Federal Reserve you screwed is the bottom line There's no way to do a good job with the Federal Reserve if you believe in markets Then it's markets the Federal Reserve is not a market the Federal Reserve is a government entity with a monopoly over Interest rates a monopoly over money Yeah, Ted Would there be a business cycle in a truly free market, I think there would be a sessions in a truly free market I don't think there would be a business cycle cycle implies a certain pattern to it There would be no pattern so for example imagine that you imagine a major new technology Entered into the marketplace something that was going to revolutionize all of our lives and had major implications For every other industry, you know, maybe the automobile industry maybe technology and as a consequence Massive amounts of restructuring needed to happen plants in the Midwest had a shutdown Because they couldn't compete anymore labor had to be retrained to work in this new technology And it was so big and it's really hard to imagine because I think these things would be rare and shallow But you would have to have a period In which some companies were in bankrupt and their employees got retrained in order to do these new jobs over here So you'd have a shallow recession with some unemployment and then an increase again But it wouldn't be cyclical because those technology sharks are rare. I Guess you could also have a monetary shock if you if gold was your standard And there was suddenly a gold discovery somewhere that for a short period of time would distort places I haven't really thought that one through but I think that's another Potential reason why that would happen now. I am out of time. Thank you all This course continues with lecture to welcome to the total wireless store. We're total confidence awaits I need a smartphone with an awesome camera got anything to fit a new dad's budget Don't worry. 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