 I'm Lydia Mashburn. I'm the policy director for Chairman Paul's Subcommittee on Domestic Monetary Policy. And on behalf of the congressman and his office, I'd like to welcome you all to today's afternoon tea talk on the Federal Reserve System, where we're asking the question, what does the Fed do? If you will bear with me a few moments, I would like to sort of share with you a little bit where we've come in our tea talks, as we like to call them, over, I guess we've had four of them so far. So our first series started out talking about the basic principles of money. Very simple questions. What is money? What is constitutional money? Followed by what about money causes economic crises? It's really important to understand these simple things about money to understand our economy better. But so what we learned essentially was that money is a commodity. It is derived from the marketplace. And it is whatever commodity the marketplace chooses to use as a medium of exchange. Many things have been money throughout history, including beads and shells, salt, tobacco, and of course silver and gold. Silver and gold, the market has chosen them to be money more often than not because they satisfy certain properties of money, which are that they are divisible, recognizable, portable, and they retain their value. Our founding fathers, we then talked about what money is constitutionally. And our founding fathers had set up in our constitution that silver and gold should be our money, because it did retain its value so well. And they had personally experienced some pretty terrible experiments with paper money, which cause inflation and economic booms and busts, which is what our third lecture in that series was about. It was about what about money causes economic crises, which is when you have this no longer have a market-derived money system, it can be it doesn't give the market what it needs and isn't regulated by the market anymore. You can end up with too much of it, or not enough of it at times, because you're managing the money supply. So when you do that, we end up with, again, inflation, booms and busts, and economic hardship. So that was essentially our money talk. And so now we've moved into this second series, which is the Federal Reserve System, where we're continuing to talk about money, actually, because the Federal Reserve as our central bank is integral to our money. So we had Professor Seligin last time talk to us about how the marketplace for money, money in the banking system prior to the creation of the Federal Reserve, was regulated in such a way that we were not given a stable money system. And things went poorly. And then what we do so often do in a crisis, instead of responding to real problems, which were these bad regulations, we instead just added more regulations and created the central bank, our Federal Reserve System. If you missed any of those lectures, I encourage you to go to the congressman's YouTube channel. They are all posted there. We had some great lecturers. But then this brings us to today's question, which is, what does the Fed do? How does it actually operate? How do we conduct monetary policy? Which is why I'm delighted to say that we have with us today Mr. James Grant. James Grant is the founder and editor of Grant's Interstate Observer, one of the most highly respected newsletters and widely circulated newsletters on Wall Street. He's a great scholar as well. He's written a number of books. His most recent one is Mr. Speaker. So he has some little bit of understanding about how Congress works itself in the House at least. The other interesting thing about Mr. Grant, and this is just recently, he was invited by the New York Federal Reserve to come and talk to people at the New York Fed about some of the elements that people are more critical of about the Federal Reserve. So I'm delighted that he's now here to talk to you all about what the Fed does, and hopefully to give us all a much better understanding about how it's involved in our money and in our lives and in our economy. So please join me in welcoming Jim Grant. Well, thank you. What a pleasure it is to be here. Yes, I did go to the New York Fed. They invited me to come in and tell them it was wrong. I said, when Dr. Paul and I enter the government officially, he had the presidency in myself as the Fed chairman, I guess next year, there'll be some changes. And they're most gracious in accepting this information. My plan today is to describe how the Fed operates in contrast to how it was meant to operate by its founders and to propose a few modest points of improvement in the way it does operate. If you read the Federal Reserve Act, you are struck. You must be struck by how little the 21st century model resembles the projected central bank. Actually, it was not to be a central bank. The founders were quite certain about that. It was to be a decentralized system of reserve banking. The act projected an institution, quote, in my challenge to you is to identify in these not very many words the pregnant phrase that gives you a sense that could have given more sense of where this was going. OK, so here it is. The act projected an institution, quote, to provide for the establishment of the Federal Reserve Banks to furnish an elastic currency to afford means of rediscounting commercial paper and to establish a more effective supervision of banking in the United States and for other purposes. Yeah, right. For other purposes, it was the meat. And we do indeed have these purposes. So if you go on the Fed's website and read their publications, they admit to for big purposes. And a fifth, an unacknowledged purpose, I will identify presently. So here's what they do own up to doing every day. You wonder what they do for a living. Here it is. Number one, they conduct the nation's monetary policy. Well, that's new because in 1913 there was none, no monetary policy. Number two, to supervise and regulate banks and to, quote, protect the credit rights of consumers. Well, there were no such rights under Woodrow Wilson. Number three, to maintain the stability of the financial system. Well, this at least would have rung a bell with the founders because in the 30 years before the law's enactment, there were more than a few banking panics. Number four, to clear checks to administer Fedwire, which is an automated clearing system for currency and securities. And to serve as a kind of sales window for the Treasury and operate a custody business on behalf of the Treasury for foreign central banks and other such institutions. Now, in 1913 clearing was done privately. The public debt was insignificant. And the prompt settlement of international payments deficits was a scenic one-on of the gold standard. Then in force, an ergo, no mountain of Treasury securities rising up on the balance sheets of foreign central banks as we see today. So that's what they acknowledged. Number five, what I have identified in my 30 years or so of hurling brick bats their way. Number five is to serve as a kind of a national economic oracle. Of all the changes, this one from the vantage point of the first Wilson administration would seem least explicable. In a free market, after all, of what use is a government seer. The deviations of present function from original intent are almost too numerous to count. And some may hope they will stay uncounted if the point of adding them up is to charge the Fed with the heinous crime of evolution, of adoption. Institutions either adapt or they fall by the wayside. It will be correctly observed. The United States Navy, to pick a bureaucracy out of the hat, has adapted by deploying aircraft and guided missiles even though John Paul Jones knew nothing about them. Open market operations and econometric modeling would similarly have drawn a blank from the central banks legislative fathers, including Senator Carter Glass of Virginia. So the argument goes that the Fed, like the Navy, has only kept up with modern improvements, or maybe not. For here, we encounter the difference between physics and economics. Both use quantitative methods to build predictive models, but physics deals with matter. Economics confronts human beings. And because matter doesn't talk back or change its mind in the middle of a controlled experiment or buy high with a hope of selling even higher, economists can never match the predictive success of the scientists who wear lab coats. If you believe that human action is unpredictable, you will not be overly impressed by econometric forecasts of next year's GDP, still less will you share the confidence of some Federal Reserve officials in the ability of interest rate manipulation to herd human beings in a desired direction. Now, the incumbent chairman of the Fed, Ben Bernanke, is one of the true believers. He is a believer in the physics-like capability of economics to predict the future, and even to improve it before it can arrive. Hear him give a lecture many years, not so many years ago, at the London School of Economics. Quote, he said, if all goes according to plan, now that's getting off in the wrong foot, is it? If all goes according to plan, the changes in financial asset prices and returns induced by the actions of monetary policy makers lead to changes in economic behavior that the policy was trying to achieve. Close quote. Now, ladies and gentlemen, if all went according to plan, the London School of Economics is not sponsoring case studies in the triumphs of the Soviet economy, although for all I know it is. So the question before the House is, what the heck does the Fed do all day long? There's a lot of time on its hands. Thousands of employees, 250 plus PhDs in Washington alone. Can you imagine it? You know what they do? I'm going to read to you some of the titles, the research projects of the recent Federal Reserve Economic Research Staff. Bayesian analysis of stochastic volatility models with Levy-Jump's application to risk analysis. Are spectral estimators useful for implementing long-run restrictions in SVARs? And an empirical investigation of consumption-based asset pricing models with stochastic habit formation. Now, habit formation, we can get our arms around. The rest of it, I don't know. I proposed to you, rather by way of preface for what's going to follow, that we must distinguish between progress in money and finance, on the one hand, and progress in science on the other. In science, progress is cumulative. We stand on the shoulders of giants. In money and finance, progress is cyclical. We keep stepping on the same rakes. It is the signal error, to me, of the Federal Reserve not to acknowledge this humble truth. Now, I have, as the editor of Grant's Interest Rate Observer, I have had one success only in changing the behavior of the Federal Reserve Board. Even that, I'm not sure of. Years ago, the announcements, the press releases from the Federal Open Market Commission would invariably contain the somewhat presumptuous phrase, the foreseeable future. Oh, I wrote them about that. Tell me, Chairman Greenspan, how much of the future to you is foreseeable? One fiscal quarter, five minutes? Tell me, is it going to rain next Wednesday? Please, we want to know. He never answered, but the phrase vanished from the FOMC a few minutes, and wasn't I pleased? I was. I'm working on another project with the Fed. I proposed this to them on Monday. Actually, I couched it in terms of my agenda as the imminent chairman of the Fed. I said that during my incumbency, the first step I would take is to institute an office of unintended consequences. Do I have any volunteers? It would please me greatly and would not harm your career as if you put your hands up right now. I saw a couple hands. So how does the Fed do what it does? And what does it do? Well, I enumerated these kind of planned functions. And I will go into a little bit more detail that I'll circle back and describe how what they do today is at variance with what they were meant to do and propose, perhaps, new ways forward. The most important, well, the Fed has subsidiary functions as well as its major one. As I mentioned, it's the fiscal agent for the treasury. It handles the distribution of treasure securities. It does this through the agent of so-called primary government dealers. These are 21 financial institutions. Some of them very mighty indeed. Have you heard of Goldman Sachs recently? It's the one that used to have culture. By the way, what was that culture when they had it? I've forgotten now. But the Goldman Sachs is one. Namira Securities is one of these primary dealers. So is Paribas Bank in France is one. They have many domestic, some few foreign, primary dealers. Primary dealer is in the business of buying and selling treasuries and mortgages and dealing some of them in foreign exchange. What you get to do if you're a primary dealer is to interact with the open market desk of the Federal Reserve Bank in New York, the flagship bank. And this is a pretty sweet thing to do because you get to hear from the traders at the open market desk what the Fed is thinking about. You are obligated as a primary dealer to respond to the Fed's request to bid on securities. The Fed says we want to sell $100 million worth of 2% notes maturing in 10 years. You have to come forth with a bid for that lot of bonds. You have to stand ready to kind of commune with the Fed and tell them your views of the market. In short, you have to be a participant in this vast enterprise called the public debt. That is the job of the primary dealers. So what does the Fed do besides that? Well, it regulates banks. Does it ever regulate banks? Have you heard of Dodd-Frank? The Fed is a most extraordinary institution in that as a consequence of its signal failures of prediction and analysis going into our sorrows of 2007, 8, and 9, and counting. In consequence of that lapse, the Fed has emerged with much enlarged power. Wouldn't you once in your life like to own a stock that does better after the company does worse? That's the Fed. It has come away from this crisis with immense powers of regulatory oversight. It is the sidewalk superintendent of world finance. The Fed is also in the business of consumer protection. Now, frankly, this is a little rich. There is something called the Protection of Savings Act of 1991, Protection of Savings. Do you know what rate of interest you earn the savings these days? I'm sorry, it's the truth in savings, right? Anybody what rate of interest you earn? OK, answer this question. Nothing. And that's before tax, after tax is horrible. So the Fed is in charge of protecting the consumer while at the same time stripping the consumer of interest income that he or she was accustomed to getting for the first 200 odd years of American history. And by the way, I'm speaking a little bit in unacknowledged and unadmitted interest in this. My publication is called Grant's Interest Rate Observer. And there are currently no interest rates to observe. And nobody's getting any younger. I can hardly see these things in the page. They're tiny. So it's not good for business. Financial news is ever so interesting. Not good for people, but it's great for the press. The Fed, as Chairman Bernanke protested on 60 Minutes, does not actually print money. The literal printing of money falls to the Treasury's own Bureau of Engraving and Printing, which does, by the way, a pretty, pretty economical job at this. What would you reckon to be the cost of producing a unit of American currency? It doesn't matter if it's $100 bill or a humble $1 bill. Well, you guess the cost is? Well, I'm glad you asked. It's $0.04, which happens also to be the cost of producing a nickel. But paper is cheap, and the Bureau of Engraving and Printing is efficient. So that happens a little bit offstage. But the Fed, nonetheless, through its monetary operations, produces the impulses through which these units of currency are brought into the world. And it's the monetary policy function of the Fed that ought to occupy us, because that is the function that truly moves the face of the earth from Hither and Jan. How does the Fed influence the value of money? How does it affect interest rates? How does it affect asset values? How does it affect the economic lives we lead? It has a mighty lever in what is known in the trade as the federal funds rate. This is the basic wholesale money market interest rate. And the Fed influences the level and the rate of change of this rate through either creating dollar balances or erasing them. And it does this through what is called open market operations with this great round table of primary government dealers I mentioned before. So the Fed, through the buying and selling of securities, can either create dollar balances as it has done hand over fist in the past several years, or it can make those dollar balances vanish through operations of the opposite kind. It can, by buying securities and paying for them with money that didn't exist before, the Fed conjures money, it materializes that at the end there. It buys securities, it buys treasury bills, treasury notes, it bonds, mortgages with money that didn't exist until it, the Fed, hit the keystroke on a computer. And that is how they make money. It is quite an astonishing piece of work. The Fed isn't alone. The European Central Bank, in two actions, the first one being in December, the second one just a few weeks ago, the European Central Bank conjured more than 700 billion euros into existence to materialize them. They didn't exist until the European Central Bank tapped the computer key. Don't you wonder what these things are worth? I do. The Fed has become the, well, I tell you, that is by way of preface. That is by way of preface to the Fed's principal functions. And I would like to proceed by explaining how it came to do this. I think with some historical background, you will have a greater appreciation of how radical and indeed, from the point of view of the founders, how unimagined are the current techniques of operation of the Fed. The Fed virtually has overridden the price mechanism for interest rates. It has interposed itself between the buyers of money and the sellers of money. It, the Fed, has, as it were, nationalized the nation's money and bond market, hardly anyone made a peep. So the institution envisioned by the founders was intended to function passively. It was designed to forestall panics by centralizing the nation's gold reserve and serving as a lender of last resort. It would develop a market in bankers' acceptances, bills of exchange, and other commercial paper. It would lend against acceptance as an other acceptable collateral. Improving the future before it happened was not one of its legacy lines of work. The Fed would not, in fact, be a central bank. It would be a kind of a hybrid. It was partially public, partially private. The founders were conventional thinkers. Of course, they would have to be. If visionaries were to write legislation, it would never get enacted. These founders believed that the gold standard was a superior form of monetary organization. They believed that the quality of credit, much more than the quantity, was a controlling factor in central banking policy. And if the Fed lent only against the volume of commercial paper brought to it to be lent against, it would create neither too much credit nor too little. That was the idea. There was one behavior modifying intention embedded in these propositions. A credit channeled into commerce was credit denied, the New York broker loan market. The founders of the Fed were adamantly against the institution of speculation on Wall Street. That was one of the great motivating forces, which, of course, throws into the highest, if not the most amusing irony, are Federal Reserve's work nowadays of manipulating interest rates, of adjusting its regulatory actions so as to sustain in life some of the precarious institutions that almost failed. Some of them really would have failed, the biggest ones would have failed, had they been left for their own devices. The Fed, from having been the opponent and the institutional bulwark against speculation on Wall Street, has turned out to be, under the current regime, the salvation of Wall Street. Back in Woodrow Wilson's time, Wilson went on the stump in 1912, and he railed against the 12 bankers who control American economic life, the 12 bankers. Remember the book that came out a couple of years ago called 10 bankers? It was an indictment of the 10 bankers who control American. So we've gotten too worse over the past 99 years. I don't call that much progress and decentralization. But the Fed was meant to be the money market for producers, for farmers, for merchants, for manufacturers. It has instead turned out to be the great fast friend of the failed speculations on Wall Street. Anyway, almost immediately after the founding, after the bill was signed into law, if you please, with gold pens in 1913, events thwarted the founders' intentions. The international gold standard perished in World War I, which began just eight months after the Fed was signed into existence. With America's entry into the war in April 1917, the Federal Reserve began to facilitate deficit finance with credit creation, a preview of the modern age. Modernization marched double time during the war and afterward, open market operations got their start in the early 1920s. Open market operations, as I mentioned, I think just a moment ago, open market operations are kind of a monetary technique implemented by the Fed. The Fed has an idea. It has an idea about where interest rates should be. To enforce these ideas in the marketplace, it goes to its primary dealers, and it buys or sells treasury bills, notes, or bonds. What was intended was the Fed would sit there and wait for business. A bank would come knocking at the door. And the Fed would say, yes, please come in. And the bank would say, we have had rather a rush and demand for credit. We haven't got capacity, but we do have. We do have some collateral, which, if you were to lend us money against this collateral, we would be able to accommodate our borrowers. And the Fed would say, very well, let's see the collateral. If it was any good, the Fed would lend. The Fed would respond to the demand to the marketplace. It would be a part of the marketplace. It would not seek to override it. That was the founding ideal. So as I say, open market operations got their start in the early 1920s, and the stabilization of finance began in the mid-20s. Stabilization is a very tricky piece of business. How often do you hear the chairman of the Fed extolling the virtues of price stability? That is indeed one of the legislative remits of the Fed is meant to stabilize prices and promote full employment. And if the price level rises significantly or falls a little bit, the Fed has taken upon itself to intervene to drag it back into dead center of level of stability. This, to me, is one of the signal errors of the present day, but I will get to that in a moment. Let me go on and tell you how this thing evolved. So the Fed, during the 20s, invoked many of the same arguments brought forward today on behalf of inflation targeting. And the Fed resisted those pleas with many of the same objections produced today on behalf of central bank discretion. Benjamin Strong, who was the head of the Federal Reserve Bank of New York and was kind of a miracle working Alan Greenspan of his day, would feel these requests or demands by the economist of his time that the price level must be stabilized. There must be no sag in prices as they're turned out to be at moments in the 20s. Later, more perceptive economists asked this. They said, tell us in a time of the most transforming and dramatic advances in technology at a time of great, great strides in productive method and declines in the cost of production. Why shouldn't prices fall? Why should they not be everyday low and lower prices? We Americans spend most of our weekends looking for them. And the Fed spends much of its work, money through Friday, trying to resist them. What's wrong with more things for the same amount of money? Walmart has made not a bad business of this ideal. What's wrong with it? Well, the Fed resisted it. So this pre-war gold standard, the great international classical gold standard of the 100 years ending in 1914, never was put back together again. And in the 1920s, the New York Fed used monetary statistics more than monetary gold movements as a guide to policy, so much for one of the pillars of the original Federal Reserve ideal. And the Depression knocked down the others. One particular important development in the Depression era was the end of something called double liability in bank shareholdings. Today, the Fed is one of the most aggressive and hovering of the bank supervisors in America. We have several. We have the FDIC and the Office of the Control of the Currency. These regulators signally failed to detect the weaknesses in the financial structure before 1907, and they are extra dutiful today, perhaps imagining things that aren't there, rather than seeing things that are. Before 1935, if a bank failed, the shareholders in that bank got a capital call. The courts insisted that they, the stockholders, put up funds with which to pay off the creditors, including the depositors. It was their bank. It wasn't the taxpayers' bank, it wasn't the government's bank. It was their bank. If the bank failed, the stockholders should put the money up. That was capitalism. Gradually, and by degree, since the early 1930s, it seems to me, we have evolved a system of socialized finance, socialized in one direction chiefly to the capitalists to go the suites of the upside, and to we the people come the costs of downside increasingly in this country, those who take risks don't bear risks. And it will certainly be a part of the Ron Paul agenda next year that those who take risks will also bear them. I have a good friend named Paul Isaac on Wall Street, who speaks to the Fed's role in regulation. And Paul has devised what I think is a very sensible way forward in regulation. And I want to share it with you, because I think that it ought to have a serious legislative study. It is an idea that the basic notion behind the idea, the proposal, is that, yes, our bankers do love money. That is true. Perhaps they love it too much. But why not harness that very love in the public interest? Now, in regulation, we have drafted rules as thick as the old encyclopedia Britannica, when it was still printed. They have got us to that state of affairs in which some of the biggest banks in New York City would have been failures, certainly our wards of the state in a financial crisis characterized by a decline in GDP of no more than, say, 3%. It's one of the truly shocking failures of professional finance in the entire history of this country. How do we come to this pass? Our financiers can't be much dumber than their forebears who didn't fail. For example, in the 1921 Depression, there was not a single major bank failure, despite nominal GDP being down by more than 20% that peaked atroff in 18 months. Nominal GDP down more than 20% points, not one single major bank failure. This time, nominal GDP down a couple or a few percentage points, Citicorp awarded the state. How did it happen? Well, perhaps it happened because of the socialization of risk, because of the detachment of taking risk from bearing risk. So here is the legislative proposal to amend our approach to bank regulation put forth by my good and very, very smart friend, Paul Isaac. Paul's idea is that instead of hovering, instead of micromanagement, instead of sidewalk superintending, what we do is we say this. We pass a law that says that the government will have the right to claw back that portion of the compensation paid out by a failed bank in excess of 10 times the average wage in manufacturing for the seven full county years before that bank hit the wall. Any salary paid out to any officer of any failed institution over 10 times the average manufacturing wage that would make about $400,000, anything over called $400,000, that gets clawed back for seven full years before the bank failed. Now that means that no one can take a lot of risks, get paid a bonus, and leave the firm and consider himself free and clear. This reinstitutes the notion of capitalism and harnesses the financial motivation of our capitalists and would-be capitalists and aspirational billionaires. It harnesses what makes them tick in the public interest. It is a more or less free market approach and a just approach, it seems to me, to the naughty problem which we are not solving through voluminous regulation of how we restore something like market discipline to our wholly unmanageable, it seems, banks. You realize that there's a bank in Tuscany in Italy, Montedei, I can't think of its full name now. It was founded more than 500 years ago and it has recently had to do something it has not had to do in the first 500 years of its existence which the foundation that controls its affairs has to sell some stock because it got into debt. So the failure of professional finance, the failure of institutional big finance is universal. And it seems to me it falls to a capitalist country to introduce a capitalist solution. So that's my perhaps, that's Paul Isaac's good idea. So I submit to you that in the first 20 years of the Fed's existence, it changes operating methods in ways that if the founders could be brought back to life today, its founders could be invited to inspect the handy work of 1913. They would die all over again of shock. But these changes were put in place in the first 20 years of the Fed's existence. So let us fast forward 75 or so years to the present day and review the Fed's actions and the theory behind the actions and I welcome a question or two. The Fed's principal approach to its job seems to me to be one of overriding markets and suppressing prices. The most visible and to me worrying expression of the Fed's approach to the world was the December announcement by a chairman by the FOMC, the Federal Open Market Committee, that the Fed would most likely hold its federal funds rate, this rate that controls your influences. It would hold at zero through late 2014. Chairman Bernanke, is it going to rain on Tuesday? How can I know that? How can they possibly know what conditions might be in 2014? Yesterday in the credit markets, there was a huge sell-off in treasuries. I don't know what's happening today. But there are little signs of revolt in the money markets and in the credit markets against these dicta, especially the quite extraordinary evident conviction of the Fed that it knows what is good for us for the next two years. Those who have been on Wall Street for a long time and who have made some money being on Wall Street for a long time have basically taken away one lesson, which can be reduced to one phrase, that phrase being, don't be so sure. And yet the Fed, in its innocence or its arrogance, has taken upon itself A to, as they call it, to repress financial activity, impose its will on the marketplace, and to virtually, if not literally, to guarantee that things will remain as they are for two more years. It's quite unprecedented. So the sound doctrine of 21st century central banking, what passes for sound drop doctrine includes such that this so-called financial repression, this fancy phrase for control and manipulation, manipulation of interest rates, the levitation of stock prices through various techniques the Fed employs, and this frosted glass term quantitative easing, all these things fall under a single heading, which is the single heading of overriding the price mechanism. Finally, it will be said, the Fed does say, its defenders and apologists say, that those who would seek to reinstate the price mechanism, for example, under the classical gold standard, which was activated in the marketplace, and by market forces, these apologists contend that that is an anachronism, that we must look forward, we can't look back. I propose to you that the Fed's methods and techniques to control are themselves anachronistic, that command and control of the interest rate lever that influences, if not directly, control so much of our financial activity, that that is anachronistic, that the gold standard, and that the price mechanism is of a piece with these collaborative social networks, some of them known as Facebook, others known simply as markets. We are in a day and age of wiki everything, and yet the Fed persists in meeting six or eight times a year, I guess eight times a year, and issuing a press release, which through the modification of a single phrase, the interjection of a single adjective can result in hundreds of billions of dollars worth of gains and losses for those who are so exposed or those who knew that nuance was coming. It strikes me that the system in place is a relic of the kind of Italy 1953, whereas the system that was lost in 1914, oddly enough, was one that anticipated wiki finance as it's practiced in many other departments of our economic lives. So that's my, that's my two cents, literally on the Fed. I wound up when I was speaking to them. I said, as to little grants and big Fed, I'm gonna leave, I'm gonna leave it at this. I'm gonna quote in closing. I said, I'm gonna quote the opening lines of the editorial in a provincial Irish newspaper in the faithful year 1914. And these lines were, we give this solemn warning to Kaiser Wilhelm, the skibbering eagle has its eye on you. I let him know that grants, interest rate observer will be watching him. But anyway, we have a few minutes of questions, I think, and I would be delighted to take a crack if you have anything to ask on how they do what they do or why the heck they do it that way. Please do try me. Sir. I think the question concerns the Fed's ability to manipulate the interest rate. It now pays on idle balances that are lying fallow at the various Federal Reserve banks, especially that of New York. It's like a trillion dollars plus now is sitting there earning one quarter of 1%, which these days passes for a mighty fancy rate of interest. And could the Fed not raise that rate and thereby extinguish idle balances before they can do mischief in the economy? Okay. I think the question is not so much whether the Fed has the tools as they use this word tools. They do have the wherewithal to erase, extinguish what have you, these credit balance, they do. But do they have the flexibility or the judgment? The most successful investors and speculators on Wall Street are aghast at the Fed's pledge to keep rates at zero through 2014. I mean, the financial markets seemingly were created to make monkeys out of human beings who would try to anticipate them and second get. I mean, it is so hard and so interesting, but what the successful investor does is always to say, what if I'm wrong? That's the first thing you learn. And the Fed has given itself no way out. So I have no doubt the Fed could, if it's so chose, take timely action to do what it ought to do. It will not be clear until much later what it ought to have done. And the Fed don't forget. I mean, the Fed saw nothing coming in 2006. I mean nothing. The Fed had no intimation that the biggest failure in the history of professional American finance was at its doorstep. They wouldn't simply not listen. Why would they listen now? Are they any better now? They're the same people of doing the same econometric forecasting. I just don't think that human affairs are susceptible to the kind of techniques that the Fed employs in money and banking to make things work. I think that the very approach is simply, is failed. The military, cheese or whatever, there would be mass distortions of chaos in the markets, but with the interest rate, they give you free reign to do that. So my question is, in regards to the next step, once the Federal Reserve is out of the picture and you have free banking, would it be, would you support 100% reserve free banking or fraction of reserve free banking? I would support institutions that meet a need in the marketplace and that are accountable to their stockholders. It seems to me that the best approach to this, to the question of the structure of banking is variety and is the individual decisions of owners. There were examples, there's a wonderful book called Bray Hammond, Bray Hammond's the author and he wrote a book on money and politics in America from the Revolution to the Civil War. It's a terrific history of banking in the day and age before federal regulation. And he describes some of the systems that evolved spontaneously. So it was one in New Orleans, the bankers evolved. It was a model of conservatism and imagination and not least solvency. It was one in Massachusetts earlier called the Suffolk system in which it was kind of a spontaneously evolved central banking arrangement. I would be in favor of choice and variety. I don't think 100% reserves are necessary I think that there no doubt is a market for that for people who are risk averse to the point of wanting that but I think that a good banker can do with less than 100% and good bankers ought to be allowed to succeed and they ought to be allowed to fail if they prove not to be good bankers. I think the business cycle is a feature of the human animal as much as it is of the fiduciary media. People will buy at the top, they will sell at the bottom. We can't help ourselves. We get excited collectively. I have no doubt some of this has been germinated by monetary activity. I have no doubt also that in the late 1990s that the last several hundred or thousand points on the run up in the great Nasdaq bull market was the consequence of cheerleading from the Federal Reserve. But there's more than that. There was a great technological revolution and people just carry away by it. So I think that I'm not such a believer in the mechanistic properties of central banking to actually finally and definitively be the cause of these cycles. I dare say that in a banking arrangement suitable for the Garden of Eden we still have booms and maybe bust too. In third world countries, you mentioned that they fed a nationalized bond market and when I hear that I think third world countries were shabazz nationalized, that nationalized some of their GM gets bailed out by the government. The stockholders in those two instances, except that they go to the world court and get the money back, but the stockholders lose their back when this nationalization of the bond market and the federal government bailed out the banks in 2008 at the Tartan everything. Did any of the bank stockholders lose their capital or the same people still own the banks? No, I mean, let me clarify this word nationalization. I use it a little figuratively in the sense that the government by dictating the level of rates and by managing the expectations on the future course of rates has taken a lot of the volatility in a lot of the market or the market's own initiative from the discovery of interest rates. So, and I call this a kind of a nationalization. The Fed has fixed interest rates. It has manipulated the term structure or the race we call it the yield curve. Therefore, figuratively speaking, it has nationalized that. Now indeed, bank stockholders were roughed up terrifically during the liquidations of 2008, early 2009. A lot of people lost everything. I mean, these city cork became a virtually a penny stock down from like $40, I forgot where the levels were. It's called city bank of $40 stock. It was a 40 cent stock. It was that kind of washout. So yeah, plenty of people got hurt. But there still was a big disconnect between ownership and responsibility. In New York City, there are two institutions that were founded in the second decade of the 19th century. One was city cork, was today city cork. The other was Brown Brothers Harrowman. Brown Brothers Harrowman is a general partnership in which the general partners are liable for their share of the debts of the firm up and to their entire net worth. So if Brown Brothers fails, the creditors of that firm can go after you, the general partner, not just your stock holdings in Brown Brothers, your options in Brown Brothers. They can go after your house, your car, your matisse, your laboratory, or everything. So guess which one didn't fail in 2008? Well, Brown Brothers didn't fail. It was very carefully stewarded by these general partners who had so much to lose and nothing much to gain by being reckless. So the whole, this Isaac idea, my friend Paul Isaac's idea on this clawback, it is meant to inculcate the ideals or the culture of a general partnership into these limited liability corporations. And as I say, until 1935, there was this very salutary rule that if the company failed, you, the stockholder, and not us, the taxpayers, I got the capital call. So again, I reiterate that what my program is, what the program's little grants interest rate observer is for American finance is capitalism and it is the market mechanism. It's the market, it's price mechanism and capitalism. And therefore, it is a forward looking and 21st century program rather than a backward looking and an anachronistic one. I didn't mean to give a campaign speech but I heard myself giving one. It would seem that it would be more transparent to close the gap between the public expectations when it actually happens, but I think that the Fed is resisting being more transparent, or it's pretty... I think the Fed can't stop talking. I don't know how much more transparent can be. It comes out and it gives you a press release as soon as the meeting's over and then it gives you the minutes some years later as painful as they are for the incumbents to read. I mean, did you read the minutes in 2006 as the housing bubble peak? They were joking about how house prices never go down. I think the Fed is, the Fed up until about 1994, I think, did not put out a press release. You had to guess, there's a whole industry of guessing what the Fed was going to do based upon perturbations in the federal funds rate. Then they issued press releases and then they got more loquacious. Now they won't shut up. So I think, I think, is that you driving at her? I'm sorry? They don't actually list the numbers for what they do on the open moment. Right, right, right, right. Do you think that would help at all? No, no, it's just more light on the same bad process, in my opinion. You know, there was an interesting book written by a guy named Charles Goodhart, C.A.E. Goodhart, who was a very senior guy at the Bank of England before that he was a scholar and he wrote this book during his professorial days. And it was a history this book was of the New York money market from 1900, 1913. It was 14 years inclusive before the Fed was founded. And Goodhart found two interesting conclusions. He found one that never before or since has the banking system in the United States been sounder than it was in those 13 years, notwithstanding the Panic of 1907. That was one conclusion. The second conclusion was that because the Fed funds rate of that day, they call it the call money rate, because it dove and it sunk and it flew and it was all over the place, highly volatile rate. The very volatility of this rate made some, made the financiers honest. They couldn't borrow too much because they couldn't predict the cost of their debt. And if the chairman were here, if Chairman Bernanke was a famous baseball fan, I would say chairman, if you were pitching and if you told the batter that you were gonna throw cheese at baseball, high fastball, nothing but fastballs for the next, oh, two years. And by the way, right down the middle, just dig in. How would that be, as opposed to moving around the plate? So what the Fed has done in the baseball game of finance, it has totally, okay, everybody, dig in. 0% for as far as the eye can see, have a blast. And this naturally creates, paradoxically, I guess it creates the very waves of speculative lending and borrowing that seem to have gotten us in the soup before. And that's building again now. No, I don't, no. I'd say that let the market set rates and let the Fed not say a damn thing. I guess I have two questions that are very short. One is that you spoke very benevolently about the intentions of the founders of the Fed. They could see what has become of it. They could roll over in their graves. But there are a great many people that think that the founders were not so benevolent and that is witnessed by the secretaries, Jack O'Leil and all of that. Would you concede there could be a gap between the stated intentions of the people that conceived the system that we currently have and what their actual intentions were? Could be, I don't, yes, there could be. Compared to what we have now, the program set in place, legislative, let's get away from the intentions, because I don't know what they were. I do know that many people regard them as malign. But if you look at what they said in the debates, if you look at what the legislative, let's just say, if you read Carter Glasses, Adventures in Constructive Finance, what you see is the most, to me, is a kind of a benign, but they wanted the gold standard. They wanted a passive discount window approach to the money markets. They wanted the Fed to stay out of Wall Street, I guess. It seems kind of okay. To compare, let me read you, just to take a second. Let me read you a line from a guy named Parker Willis, who was the first secretary of the Federal Reserve Board. He was writing, was Willis, in 1936, or so his heart was broken by what had happened in the 20 years since the founding of the Fed. And here's what he said, central banks will do wisely to lay aside their inexpert ventures in half-baked monetary theory, merititious, statistical measurements of trade, and hasty grinding of axes of speculative interest with their suggestion that by doing so, they're achieving some sort of vague stabilization that will in the long run be for the greater good. That was Parker Willis. And he was in on it. I mean, to me, that's pretty sound stuff. Anyway, your second question. If you operate on the assumption that what is going to happen in terms of central banking and government policy from around here for the foreseeable future is we just keep doing another version of what they're doing, what would you foresee would be the inevitable consequence? Good copy, good copy for me. I think you can see the liniments or the outlines of the next financial crisis forming right now as a consequence of the intervention to force all the effects of the previous financial crisis. For example, there's a great pouring of funds into the junk bond market, to the speculative grade corporate bond market. So companies that would otherwise not be able to finance are able to finance rather easily now as a marginal drug store company called Right Aid. You've seen certainly, and it's competing against much better financed competitors such as Walgreens. Now, Right Aid has not made a profit in five years. It is spending more on interest expense than it is on refurbishing at somewhat tatty stores. And it's able to borrow at 9% for 10 or 12, I forgot the exact terms, but it had to pay 15% last fall, then the Fed comes in and says we have the funds rate at zero in two years. Now it does at 9%. New lease on life. Well, that's good for the employees of Right Aid. It's not good for the entrepreneur who had his or her site set on doing something better than Right Aid if only that ridiculous dying enterprise would gather the way. So by preserving the structure of things as they are with every good intention, our masters at the Fed are penalizing the unseen, the unimagined that could have happened with the failure of institutions that ought not to be around. So these life support operations bring us closer to Japan, but Ben Bernanke keeps on saying about the risks that we become like Japan. We have to have deflation. Well, that's how you get to be like Japan is by prolonging the established order of things through financial manipulation. What is wanted is American dynamism. We've had that. You know, I've mentioned this depression 19, 20, 21, a while ago. This is a case that Chairman Bernanke can't stop talking about the Great Depression. Every other phrase has to do with what we must not do again like the 1930s. The previous depression began in January 1920, ended in August of 21. It was ugly, violent, down 29% nominal GDP, wholesale prices down 40%, if you please. The Fed raised rates in response, 8% from 6%, the Treasury balanced the budget, the depression ended. Now that's not to say that's the way to cure a depression, but it is to say that you don't have to anesthesize the patient with continued doses of so-called stimulus. You don't have to run interest rates to zero to get us out. Why did the depression 19, 20, 21 ever end if you have to have 0% rates to end a depression? So the Fed to me, I mean all these research titles I read to you, but how about something within the Fed? How about an office or one effort in applied financial history? How about an enterprise within the Fed to say, what did work in the past? What are we doing that never has worked? Let's use experience rather than these these bowers, these perfume bowers of quadratic equations and linear algebra. This stuff is fine for the guy who didn't get into NASA after all, he didn't get a job at NASA. But the Fed to me is not working. It is one big institutional mission creep, as the Fed. Anyway, that's enough. I think one more. Just one good question. Have you observed a trend that you observed any drug skepticism from professionals in finance? Oh yeah, that's a thing. Yeah, they hate it. I had, yes, I think they don't respect it. Because of the, this Friedrich Hayek had a kind of a fancy phrase, did this great economist called the pretense of knowledge. In Brooklyn we'd say, were you kidding? How do you know that? But the Fed exhibits this insolence, this pretense of knowledge by such things as say we're going to, our econometric models indicate that for the next two years, the wholesale clearing rate should be 0%. So there's a, so people are thunderstruck on Wall Street by this rookie error. Nobody who has solved it on Wall Street has a view like that, I can guarantee you. Nobody who has solved it. Certainly nobody who's middle-aged. I mean, as I have aged, I've become rather less apocalyptic. I, if you asked me this 20 years ago, I would have been certain that there would be collapse and there might be. But to me, the United States of America is a little bit like major league baseball. Try as they might to destroy it, they just can't. So I have every, and besides that, next year, Ron Paul's going to be president. So Lydia, thank you. Our next lecture will be on what is the Fed's future? So we will be exploring that last question in a little bit more detail. That won't be until May, I believe, but we will keep you posted on details. If you would, please join me in another round of calls for Jim Great.