ABC’s of Business Cycle Theory

Part 1 — A Libertarian Visits the Fed

A Primer on Central Banking & the Business Cycle

It’s said that money makes the world go ‘round. But it can also bring it grinding to a halt. Leading up to the the Great Depression, the economy was more globalized than ever before. The stock market crash of 1929 — known as Black Tuesday for the shadow it cast across the whole world — set the stage for World War II, and the breakdown of peaceful trade among nations. Economists are still debating the lessons of the Great Depression, but they all agree that one industry — banking — and one commodity — money — bear the brunt of the responsibility.

In 1910, six men held a secret meeting at Jekyll Island — “the richest, the most exclusive, the most inaccessible” club in the world — to craft a plan to rebuild the American banking system. They aimed to create an institution “scientific in its method, and democratic in its control.” Three years later, the Federal Reserve Bank of the United States — aka “the Fed” was born. There have been nearly a dozen recessions since then, suggesting the “science” of the business cycle is still poorly understood. The President of the United States appoints the Board of Governors to Fed, but beyond this, the United States’ central bank is autonomous and has failed to live up to its democratic promise.

In order to correct these imbalances, we need to understand how central banking works and what it aims to accomplish.

The so-called Great Recession of 2007–2008 revived of one of the greatest intellectual debates of the 20th century. This series explains what the leading schools of thought believe to be the proper role of a central bank — if there is to be one at all. The so-called “Austrian School,” for example, has re-emerged with a strong critique of the Fed, arguing that central banks — despite their allegedly scientific methods — tend to amplify whatever natural tendency to extremes the economy might have.

Ignoring the jargon — the talk of partial equilibrium, interest rate targets, yield curves, and quantitative easing—the first thing you need to know is that all a central bank really controls is the money supply. They have a printing press and they’re not afraid to use it. But even that control is tenuous. The Federal Reserve has modified its strategy over the years, but their track record at stabilizing the economy is still shaky at best. During the first decade of the 21st century, after a roughly 30-year period known as the “Great Moderation,” the economy once more came crashing down. Had the Fed learned anything from the 1930s?

Zen Mind Beginner’s Mind

In the beginner’s mind there are many possibilities, but in the expert’s, there are few.
Shunryu Suzuki *Zen Mind Beginner’s Mind*

The stereotypical economist is someone so obsessed with his own mental models that he forgets to make them understandable to the public — and, more importantly, to policymakers. Each guest was chosen based on two factors: 1) their expertise on a particular school of thought, and 2) their effectiveness at communicating ideas to the general public. It’s no coincidence that they each write popular blogs.

Macroeconomics: The Dynamics of Disequilibrium

Economics as a science uses simplified models of the real world to try to make predictions. These models rely on the concept of equilibrium. Variables like the price and the quantity produced will stabilize around an equilibrium that puts them in harmony with people’s preferences and the relative scarcity of the inputs.

In microeconomics, the forces of supply and demand reliably interact to bring markets into balance. The equilibrium price provides a sufficient reward to actors to make the “right” amount of something —i.e., the quantity that leaves enough resources to produce all of the other things people value. No economist worth his salt can promise to predict a change in a specific stock price, or how well the stock market as a whole will perform. However, because of certain dependable laws of human nature, economists can talk meaningfully about how prices of different goods and services will change relative to one another.

Macroeconomics is not concerned with the changes in a specific industry or single business, but rather large-scale economic activity — the unpredictable cycles in overall employment, output, and prices. While individual entrepreneurs frequently miscalculate and go bankrupt, a recession is something different. It manifests as a cluster of errors — or as Lord Keynes speculated, a sudden outbreak of irrational “animal spirits,” leading to widespread business failure and a decline in economic output. Usually, it comes in the form of a reversal of a previous period of faster growth.

Each theory of what drives these changes involves a story about the peculiar market for money. Money is a unique good because it is a medium of exchange (we pay for things with it), a unit of account (we denote prices in it), and a store of value (we save it for later purchases).

Furthermore, all other goods and services are priced or valued in terms of money. Thus, a disturbance to either money supply or money demand can result in a mismatch between the “nominal” or numerical prices of goods, and their real value relative to other things, such as the amount of money people tend to have in their bank accounts at a given time. If microeconomics is primarily a story about equilibrium, macroeconomics is primarily about disequilibrium — a situation in which the economy fails to reach the mathematically pure end-state at which supply of money perfectly equals the supply of money demanded. This will all be explained in greater detail later, but the short version is that an increase in the demand for money — with no concomitant increase in the supply of money — will result in a disequilibrium in which prices need to fall in order to restore a healthy economy.

Unlike other goods, the money supply need not be fixed by fundamental scarcity (as it was in the days of the Gold Standard). We can make it out thin air. But should we? If so, how much should we make, and where should it go first?

These are the questions we seek to answer, standing on the shoulders of giants.

The Monetary Mavens

Let’s meet our cast of characters:

Lord Keynes: British statesman and economist John Maynard Keynes believed the key to a stable economy was to provide expert managers (like himself) with precise data about the economy — i.e., measurable statistics about broad categories of spending like consumption, investment, and government spending.

Followers of Keynes, aka Keynesians, think the first two categories are unstable on account of human whims, which ride on mysterious forces of group psychology. When people get scared, they demand more cash because of its a safe form of savings relative to other investments. Unfortunately, when everyone simultaneously tries to hoard cash, less money gets spent overall by definition. When less money gets spent, less money gets earned, and so savings and investment fall too. This so-called “paradox of thrift” makes it impossible for everyone to simultaneously save more. According to Keynesians, however, a wise government armed with the right information could adjust its own spending to balance the ups and downs in the public’s whims — forcing greater overall spending when psychologically people are inclined to save.

Keynesians think consumption and investment are unstable on account of human whims, which ride on mysterious forces of group psychology.

Public works and “make work” projects are examples of Keynesian stimulus spending, which are supposed to be paid for in the future, once the economy has recovered. What’s important for this story is that the confidence and spending comes from outside the system of frightened private actors. Government comes to the rescue, as an exogenous force (i.e., “outside the system”).

Uncle Milton: Milton Friedman — a monetarist — famously favored a less active role for government spending, but still advocated some intervention by a governmental authority in order to keep the economy stabilized. He wanted a central bank to operate according to a firm rule: when people suddenly demand more cash from the vaults, the central bank would provide more liquidity to banks to increase the supply of money. This offsetting action is intended to prevent deflation and keep prices stable.

Monetarism depends on a simple enough observation that in the long run, money and prices are directly related. If the government suddenly printed twice the amount of existing cash and started dropping it out of helicopters, people would temporarily rush out and increase their spending, but soon prices would be bid up to twice their old amount, and “real” spending would stabilize even though the dollar amount of spending would double. The fact that an injection of liquidity leads to a temporary spike in spending theoretically means that a central bank can smooth the public’s whims without engaging in direct spending. In the monetarist paradigm, a central bank can simply buy some government IOUs (Treasury bonds) from the banking system with newly minted cash.

Buying bonds tends to boost spending just like a helicopter drops. Why? Because when the Federal Reserve buys up bonds with new money, it changes the composition of the economy’s balance sheet. Banks and their customers now hold more wealth in the form of easy-to-spend cash, and they want to go out and spend or invest it until they reach their old ratio of cash to other investments. If money were perfectly neutral, then prices would have to adjust immediately by the same proportion as the increase to the money supply. In reality, only some prices respond to the new information about an injection of liquidity. Others, like wages and the price of anything that is difficult to change on a dime, remain “sticky.”

While Keynesianism was the dominant paradigm for most of the 20th century, monetarism has attracted many libertarians and conservatives, despite the role it grants government to regulate the supply of money. Friedman’s libertarianism made him allergic to command-and-control style interventions, which he believed only slowed down the economy’s natural tendency to self-correct. He thus emphasized rules as the key to a successful central bank policy, since government left to its own devices will always take an excuse to finance its growth through the printing of money.

Von Hayek: Austrians, including thinkers like Friedrich Hayek, Ludwig Mises and Eugen Böhm-Bawerk have enjoyed less popularity — especially in academia — but are finding an outlet in the internet-era.

Whereas Keynesians start with aggregates and statistics compiled by government bureaus, Austrians start with the fundamental principles of human action — the motivations behind all economic activity. Ludwig Von Mises’ magnum opus, Human Action, begins with a seemingly obvious statement that he then takes over 800 pages to unpack in all of its implications: Human action is purposeful action.

Knowing how much aggregate demand, consumption, savings, or investment changed over the past 18 months might tell an economist something of value, but Austrians understand market corrections to be ushered in by economic actors with specific, “local knowledge” of the best allocation of resources in their industry. These are the entrepreneurs: purposeful actors who build their plans around expectations — forecasts of input prices and consumer demands. Sometimes they make errors, incurring losses, and sometimes they get it right, and profit as a result. As a group, they are believed by Austrians to do the best job of bringing markets back into equilibrium.

Human action is purposeful action.

Austrians put less emphasis on data, because they believe the business cycle can be diagnosed and cured without micromanagement. The problem is that governments distort important price signals. Fiddling with the money supply to “smooth out” the business cycle only incentivizes bad investments that wouldn’t be made by private actors. In other words, it gives fuel for the imaginations of an already error-prone public. The solution is getting rid of these distortions.

These are just contours of the theories, which will be explored in the three parts of this series.

We begin with the Austrian School.

Part 1 — A Libertarian Visits the Fed

Arch-libertarian Robert Wenzel tells the story of his speech at the Federal Reserve, how Austrian economics plays into his work as a financial advisor, and why negative interest rates are an unprecedented danger.

Listen to Part 1 — Bob Wenzel: A Libertarian Visits the Fed:

Part 2 — A Synthesis of Hayek, Minsky, Friedman and Keynes, with Brad DeLong

Part 3 — What Would Milton Say? Scott Sumner on Market Monetarism

Or, read the transcript of his interview with Charlie Deist:

Wenzel’s Warning

In 2005, Wenzel wrote an essay using Austrian Business Cycle Theory (ABCT) to question the Federal Reserve’s efforts to prop up the economy following the recession of 2000–2001. Alan Greenspan was tooting his own horn, but Wenzel was sounding the alarm: persistently low interest rates were inflating a bubble in long-term assets like housing, just as the Austrians predicted they would.

Three years later, when the bubble burst, Wenzel wrote to a researcher at the Fed seeking validation of his predictions. Through an unlikely series of events, Wenzel — a radical libertarian and arch-critic of the Fed — was invited to give a talk at New York Federal Reserve Bank. He later recounted the story of the speech in a short book, The Fed Flunks: My Speech at the New York Federal Reserve Bank.

If blog statistics are to be trusted, many thousands of people have since read the speech, in which Wenzel pleaded with a scant crowd of attendees — all dedicated employees at the Fed — to leave their posts and never come back. Although his advice was ignored, Wenzel had already planted the seed. It would seem that the Austrian approach had enabled him to predict not only the housing bubble four years before it burst, but also the timing of the actual recession, based on a rapid decline in the money supply.

On July 11, 2008, Wenzel wrote:

“After growing at near double digit rates for months, money growth has slowed dramatically. Annualized money growth over the last 3 months is only 5.2%. Over the last two months, there has been zero growth in the M2NSA money measure.
This is something that must be watched carefully. If such a dramatic slowdown continues, a severe recession is inevitable. [SUPER ALERT: Dramatic Slowdown In Money Supply Growth].”

Just weeks later, the Great Recession began.

Charlie Deist: I’m joined here in studio by Robert Wenzel. Robert writes the popular economics blog and provides financial consulting, which he backs up with an Austrian perspective.

I have to warn our listeners that Austrian theory is not taught in mainstream economic departments. It is a heterodox school — you could call it the“Red Pill” of economic theory.

A is for Actual Growth

To understand the fluctuations that make up a business cycle, one first needs a model of what drives the generally upward trend of growth in free economies. Until relatively recently, growth and prosperity were not the norm. They are rather the result of delicate institutions that enable people to invest their savings in productive capital.

Entrepreneurs and lending institutions are the primary channels for transforming savings into investment. They borrow on the expectation of being able to repay the initial loan plus interest out of their future earnings, and the banks charge an interest rate based on the supply and demand of savings, or loanable funds. When people save more of what they produce, there are more resources available for future production. When they consume more, there are fewer resources available for future production.

In a free market, prices determine how resources are allocated. I might want to pave my driveway with gold, but the economics dictate in favor of using cement instead. The interest rate is a special price which determines the allocation of resources across time. This “time value of money” then determines how the different stages of production are structured. Austrian theory notes that businesses can choose longer or shorter ways to complete a project. All else equal, it takes more savings to support longer structures of production, with more intermediate stages. Adding stages enables more complex and sophisticated ways of making things [See “H is for Hayekian Triangles”], but it also requires more patience. Savers effectively trade their patience — the decision not to consume in the present — for interest payments from a risk-taking borrower who invests in the hope of making a bigger return on a lengthier structure of production.

When people save more of what they produce, there are more resources available for future production. When they consume more, there are fewer resources available for future production.

Austrian economist Robert Murphy explains it like this:

Loosely speaking, a high interest rate means that consumers are relatively impatient, and penalize entrepreneurs heavily when they tie up resources in long-term projects. In contrast, a low interest rate is the market’s green light to entrepreneurs that consumers are willing to wait longer for the finished product, and so it is acceptable to tie up resources in projects that will produce valuable goods and services at a much later date.

Shorter structures of production position capital closer to consumers, like a basket for collecting apples that are taken to a nearby market. Longer structures of production remove capital further away from the consumer, like a factory mold for tractor tires used on an industrial farms, harvesting a single ingredient for a processed food product. In the Austrian story, the important point is that more savings are required for an economy to build up the higher orders of capital. The greater the patience of the society (i.e., the more it saves relative to what it consumes) the lower the interest rate, and the more likely entrepreneurs are to take risky investments in productive capital.

Ghost towns were the result of a boom in certain kinds of capital, which proved useless when the wells or mines dried up. There is no way to repurpose some kinds of investments — they’re just plain bad.

Austrians also point out that capital does not come from a homogeneous pool known as “investment.” It is conceived of and built for specific purposes, even though these purposes may have multiple applications. A truck, for example, can be used on a construction site, or by a landscape architect, and a concrete mixer can be used for many different kinds of construction, from the building’s foundation to the final sidewalk paving. However, a crane cannot easily be re-purposed for landscaping. If too much capital of a certain order is produced, it will be harder for entrepreneurs to put that capital to productive use, and it will have to be liquidated at a much lower price, or abandoned altogether. This model helps explain why the economy had trouble re-organizing after the housing boom of 2007 — so much higher-order capital could not be repurposed for uses outside of housing, once demand for new homes had crashed.

Actual growth, in short, depends not only on aggregated chunks of savings being moved around by a central planer, but on the patterns of production which entrepreneurs estimate will produce sustainable profits. People chose their occupations based on what industries and capital formations they think can best complement their skills, and so-called “patterns of sustainable specialization and trade” are born. Unless people systematically choose the wrong kinds of investments, free markets

B is for Boom

Austrians see things going awry when government tampers with the interest rate. The true, or natural interest rate, is based on savings and ultimately on people’s time preferences, or patience. It is not the same as the artificial “rate of interest”, which is manipulated by central banks through changes in the supply of government-issued “fiat” currency.

The Austrian Business Cycle Theory holds that unsustainable booms and busts are driven by artificial credit expansion — loans created through a banking system distorted by government intervention. An expansion of credit increases the total supply of money and lowers the interest rate. Cheap credit sends the signal that there are enough savings to support higher-order capital investment — projects that take longer to complete, and require more intermediate stages.

There’s a boom and bust cycle, and good reason to fear it.

The new projects are considered malinvestment, because there has not been a change in the society’s underlying patience to sustain the productive use and maintenance of these investments. During the boom, there is an increase in prices — especially in the asset categories that are stimulated most by the lending of new credit. During the housing boom of 2004–2007, for example, subsidized mortgages fueled skyrocketing home prices, and led to malinvestment in construction in houses that people couldn’t afford. Now back to the interview.

The Speech Heard Throughout the Fed

Charlie Deist: Bob, I wanted to start off with your story that became a book, The Fed Flunks: My Speech at the New York Federal Reserve Bank.

First, would I be correct to say that you’re something of a radical libertarian?

Robert Wenzel: Yeah, I think so. Even some of the radical libertarians would think I’m radical beyond them.

Charlie Deist: And that makes you an arch-critic of the Federal Reserve.

Robert Wenzel: Absolutely. I’m with Ron Paul on that— end the Fed.

Charlie Deist: How was it that a radical libertarian and arch-critic of the Fed came to give a speech at, not just any branch of the Federal Reserve, but the central branch, The New York Federal Reserve Bank?

Robert Wenzel: In 2005, two New York Bank Federal Reserve Bank economists wrote a paper saying there was no housing bubble. I replied to that, discussing why they were wrong, and pointing out errors in their thinking and analysis. Then I wrote that they were making the greatest error since Irving Fisher said, in 1929 — just before the stock market crash — that stocks were at a new permanently high plateau. Then they went around the country presenting their idea that there was no housing bubble, and put up my quote about Fisher and the crash (saying that they were making the same error) as, “an alternative perspective.”

Of course, we all know what happened after that. There was a stock market real estate crash and it just killed the real estate market.

It was clearly a bubble.

Simon Potter, one of the top Federal Reserve officials at that time, wrote a piece admitting that the Fed got it wrong, that there was a real estate bubble, and that many people didn’t see or understand it. And he mentioned a couple of names [of people who did see it], and I wrote him and said, “Hey, what about me? Not only did I recognize that it was a bubble but I specifically identified the paper that your two economists wrote and said they were making mistake at the time.”

So he forwarded it to two economists there and I got in an email conversation with one of them, Richard Peach. Richard is a great guy—at some point he says, “Why don’t you come over and tell us, you know, how you saw this.”

So I said, “Sure, absolutely.”

Buy the book on Amazon

Now I’m completely anti-Federal-Reserve. Anybody familiar with my writings (there may have been a couple at the Federal Reserve) would have known that I’m going to go in there and blast the place up. So I was amazed that he invited me, and I took him up on the offer. He put a notice out, and then they quickly changed and killed the notice and said, “Well, we’re going to do it this way instead of that way,” and all that kind of stuff. But he kept to his word, and set the whole thing up.

He had a place for about 20 or 30 economists, and it was just a couple of them that showed up. He said that they were busy — tied up at some of the meeting — which did not surprise me.

Once I was in New York Federal Reserve Bank, I was going to give the speech, even if I had to give it in the in the men’s room.

But I didn’t have to do that. McCarthy and Peach were just absolutely great. We had a discussion after I gave the speech that is now in my book The Fed Flunks.

Charlie Deist: You’re the arch-critic of the Federal Reserve, coming in and presenting the Austrian theory, which which is not necessarily well-known, even among the Federal Reserve Bank’s professional economists. These ideas are not so complicated that you need to spend years studying them to understand them. You can plant a seed in the course of a single speech, which is what you did here in the book.

Mugger’s Money

Charlie Deist: Let’s talk about the philosophy of the Austrian school.

My understanding of Austrian Business Cycle Theory is that it’s not just a theory of over-investment or overstimulating the general economy, but it’s about how cheap credit distorts the economy in specific ways. Why is it that the housing market was particularly affected by the actions of the Federal Reserve? What do Austrians say the role of the Fed is in creating something like a housing bubble?

Robert Wenzel: The reason it’s called the Austrian Business Cycle Theory is not because it’s something that only applies to the country of Austria. The original thinkers on this theory came out of Austria. The key people were Ludwig von Mises and Friedrich von Hayek, who won the Nobel Prize in Economics for his business cycle theory.

It’s really a simple theory and I don’t understand why mainstream economists don’t adopt it (well, I do — it’s for political reasons) but it very clearly explains why:

To describe it in a short manner, the Austrian business cycle, says the Federal Reserve — or a central bank, whatever the country is — prints money; where that money flows is where you will get a boom in the economy, because you get more money going in, bidding up prices. Generally it’s in the capital goods sector, which means the stock market, real estate, etc.

The consumer end is a little more technical. It’s just sort of revolving stuff around (increasing the “velocity”). But when it goes to the capital goods sector, you have the boom. Then at some point the central banks always stop. They have to stop or they’ll start a hyperinflation, such as we’ve seen in Zimbabwe and Venezuela.

I carry what I call “mugger’s money” around with me, which is money from former Yugoslavia. It’s too bad we don’t have a video here, because I’ll show you, Charlie.

Charlie Deist: Bob is pulling out… what is it, 500 billion or 500 million?

Robert Wenzel: Yeah, a 500 million dollar note out of Yugoslavia.

Charlie Deist: You’re a rich man.

Robert Wenzel: I actually had to use a couple of these when I was walking in Boston Common fairly late at night. These two guys came up to me and they said, you know, “Can you spare some change?” And they were clearly going to take it from me if I wasn’t going to give them something, so I pulled out a couple 500 billion dollar notes, and they were jumping around and all happy. Of course, the problem for them was they didn’t understand hyperinflation. If they got ten cents for each one of those pieces of paper when they got to the bank that would have been a lot.

So, the Federal Reserve and central banks always have to stop printing at some point. They can pump, and pump, and pump in one direction, but in a modern society (outside of Germany, where they had two major hyperinflations), most of the time they stop well short of a hyperinflation. When we had William Miller as Fed chairman in the 1970s, it went its highest, to 15 percent, but usually when inflation gets over 5-10 percent they slam it on. And when they slam it on, there’s no more money flowing into the capital goods sector, the stock market, and real estate, so they crash.

It’s that simple: You pump the money in. It’s going to go up. You stop pumping it and it’s going to crash.

There have been 18 recessions in the United States since the Federal Reserve started operating in essentially 1913.

C is for Correction

When entrepreneurs and investors begin to realize their errors, it triggers a sudden sell-off of the most obviously over-priced assets. Then, everyone scrambles to turn their overvalued assets back into cash at the same time. This increases the demand for money (or “cash balances”) sends interest rates back up to what Austrians consider their natural levels, and ushers in the painful correction to the lop-sided structure of production.

D is for Deflation (and Money Demand)

Warning: this is one of the more technical sections — take a sip of coffee and proceed one sentence at a time.

In the Keynesian story, a recession is a sudden and unnecessary reversal in the earlier period prosperity. Spending — especially spending on wages — must be kept its earlier level, or else we end up with the dreaded deflationary spiral, whereby falling wages further reduce consuming spending, depress prices even further, cause more borrowers to default on their loans, and so on.

In the Austrian story, the fall in spending is part of a necessary restoration of people’s true saving preferences. As people spend less and hold onto more cash, there is a temporary painful disequilibrium, in which demand for money exceeds the available supply, putting deflationary pressure on the economy.

If money were a normal good, we could tell a nice, neat story of how markets grope their way to a new equilibrium. But, again, money is special. Keynesians have a point about the paradox of thrift — i.e., that not everyone can hoard more cash at the same. Keynesians say this painful correction can be avoided if government supplies the money to make up the difference, but Austrians say this just postpones the inevitable more difficult process of reaching a true equilibrium. The demand for money is a function of people’s desire to hold some of their wealth in the form of immediate purchasing power, as a buffer against financial insecurity. Purchasing power grows as prices fall. Eventually, if people decrease their spending, prices will fall until the amount of cash people are holding gives them a sufficient buffer relative to the deflated prices.

Employees have to take wage cuts, since wages are one of the most important prices in need of adjustment before malinvested savings can be channeled into sustainable new paths. Unfortunately, wages don’t easily downward for psychological reasons (no one likes cutting wages). Economists therefore call them sticky. Sticky wages and prices are a kind of friction that prevents the nice, neat, new equilibrium.

There is a related problem of “who goes first?” The first person or company to accept lower wages or prices has to eat their losses. Later wage cuts are easier to swallow since things are starting to cost less, but Keynesian remedies like price floors, minimum wages, and direct hiring by government at the old prevailing wage are appealing because of the inability of a free market to coordinate a sudden and uniform fall in prices.

So why not prop up prices like the Keynesians suggest? Austrians prescribe the bitter bill of deflation as the cure for recession for two related reasons.

  1. It discourages additional malinvestment, since borrowing becomes more expensive in nominal terms — i.e., during a period of deflation, money must be paid back in dollars that are worth more. Now, entrepreneurs have to focus on investment opportunities with higher rates of return, paying higher interest based on people’s true time preferences and the real scarcity of savings.
  2. Falling wages are the key to making these new investments profitable at higher interest rates. Once wages fall, you get a hiring boom. Higher interest rates are a happy signal that investors expect higher nominal returns on their investments, due to low production costs (such as wages) relative to the cost of final goods. Although nominal wages may fall, Austrians believe that the total percentage of spending on labor relative to other portions of the economy (such as land rents and capital) should actually increase during this period.

Now back to the interview…

Follow the Money: Interest Rates vs. Money Supply

Charlie Deist: So from 2001 or so Alan Greenspan starts lowering interest rates to make sure that that the headwinds the economy was facing didn’t drag it down. Is that correct?

Robert Wenzel: You have to go back to around 1987, when Alan Greenspan had been in power for about seven or eight months. Paul Volcker — who was the Federal Reserve chairman before him — sort of gave him a gift in the end. I’m speaking facetiously here, because Volcker started slowing money supply when he left. He didn’t want to have a legacy of inflation getting out of control, so he slammed on the brakes knowing that it takes a few months for it to kick in — it would be for Greenspan to deal with the crash.

The crash came in October of 1987, and Greenspan really started pumping in there. He slowed a little bit in 2000–2001, when we had the Internet bubble, and then he just pumped it up again, and we had tremendous amounts of money flowing into the capital goods sector because of the way the Federal Reserve works. You had the stock market going up. You had real estate…

Generally, there’s a sector that leads all the others in terms of the capital goods boom, and in this case it was the housing market, because there are a lot of regulations that the government uses to try to push money in that direction. Consequently, it was clearly a bubble, and it burst in 2008.

Charlie Deist: I want to quote from your book. This is Ben Bernanke speaking in 2008, shortly before the recession hit — he’s providing an update on the economy — and he says:

“Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly. Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so. Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy.”

What happened next that led to such a huge downturn that we now know as the Great Recession?

Robert Wenzel: What Bernanke is doing is a perfect example of what all the Federal Reserve economists and most mainstream economists do — looking at the data coming in. There’s nothing telling them what’s causing this data or what might be changing that may change the flow of data in the trends.

They’re basically just trend-watchers — they’re doing what anybody can do by just looking out there and seeing if prices are going up or down or whatever. There’s no theory behind what they’re doing. They talk a bit about aggregate demand but they’re really just looking at whether unemployment is up or down? If it’s up, maybe they’ll continue this way — depending upon what’s going on in other sectors.

But they missed the inflection points. They have nothing that tells them that things will change dramatically. And that’s what Austrian Business Cycle Theory does, because it says, “Look, if you stop printing that money so it’s not flowing into those sectors anymore, it’s going to crash.”

It’s basic stuff, and they don’t get that.

If I can go back to the time when I gave the speech at the Federal Reserve, after I talked to McCarthy and Peach, I was discussing the Austrian Business Cycle Theory with them a little bit. One of them said (I’m not going to mention names on this part), “Well, I know what you guys are, you are the guys that have that formula, M x V = P x T”, which completely shocked me, because not only is that not the Austrian school — that’s the Chicago School formula!

So it taught me that these senior guys at the Federal Reserve don’t even understand University of Chicago school monetary theory. They are so in the tunnel of Keynesian economics. It’s remarkable.

They don’t know anything else. And that’s really not a theory other than “demand is stopping and slow.” But why is demand stopping? Why are people no longer building the houses, or demanding stocks? That’s where the Austrian school comes in and says, “Look, you’re printing the money, it’s going to go there. You stop printing the money, it’s going to stop going there.”

Charlie Deist: At the risk of getting into too technical of territory, I want to stop for a little bit on this question of Keynesian versus Monetarism versus Austrian school.

The Keynesian model of aggregate demand is pumping money into the economy increases demand in periods when consumers might otherwise lose confidence.

But in the long term, as the monetarists have pointed out, when you increase the money supply, all you end up with is an increase in prices. Maybe you get a short-term boost in spending, but if you’re not stably increasing the money supply over the long term, then you get these these erratic booms and busts.

One more quote that I found particularly interesting in your book is that as a financial planner, you say:

“I find it extremely difficult to give long-term advice when in short periods I’ve seen three month annualized M2 money growth go from near 20 percent to near zero and then in another period to see it go from 25 percent to 6 percent.”

This was during the recession. Can you explain in layman’s terms:

a) how money supply is measured;

b) why you choose money supply as the metric for monetary policy; and

c) what was going on in that period?

Robert Wenzel: First you have to get a full picture of what is actually being used as money to bid prices up. I tweak a little bit with regard to how I calculate money supply.

All economists will grant you that the physical money that you have in your wallet and in your checking account should be considered part of the money supply. Basically, most savings accounts — if it’s not a certificate of a deposit — that you can pull out any time should be considered part of the money supply. I also include money markets, because a lot of people use that as a sort of checking account and pay their monthly rent or mortgage with a money market fund in other accounts.

Charlie Deist: Where does this misconception come from that the Federal Reserve controls interest rates? We can talk about the the federal funds rate — the overnight rate at which banks lend to one another — which the Fed can influence through their actions of buying and selling Treasury bonds. But where does this idea come from that it sets the market interest rate, which everyone from banks to borrowers look at when thinking about their long-term decisions. Why might it be mistaken relative to thinking more in terms of the money supply?

Robert Wenzel: Well, the Federal Reserve has some control over the money supply, but it’s not complete. We’ve had four or five interest rate hikes in the last two years, and basically we’ve had a situation where the Federal Reserve is raising that rate — and it does cause an increase in the very very short-term rates.

The long-term rates are a little bit different, because you also have people adjusting for what they think inflation might be in the future, in different demands, at different places on the on the yield curve — the time schedule of how far out you’re going. So they don’t control all rates but they have a major influence.

Now, the key is, when an Austrian looks at the business cycle, he doesn’t necessarily look at the interest rate. He looks at the amount of money, or he should. I battled certain Austrians for the last two years — I call them Austrian Lites — they sort of get the idea that the Federal Reserve does something, but they panic at the least change.

Charlie Deist: Austrian Lite, like Coors Lite.

Robert Wenzel: Right. Right exactly.

Charlie Deist: It’s watered down.

Robert Wenzel: Maybe I should call them Austrian snowflakes, because when the Federal Reserve first started this recent hike in interest rates in December 2015, they thought the stock market was going to crash. You had guys writing that the Federal Reserve is going to have to reverse the interest rate hike. They raised it by a quarter point — 25 basis points — it’s a tiny little speck in the ocean, and they thought this was going to dramatically change things.

Well, to understand how the Fed creates money, you also have to factor in the inflation rate. So, let’s just use this as an example — it was lower than this, but let’s say inflation was 2 percent. If the Fed increases the Federal funds rate from .25 to .50, there’s still going to be a lot of willingness to borrow at that rate given that the inflation rate is at 2 percent, just to use a big example. You have to look at how much change there is, and how much money is being printed. You could have a full 1 percent increase in the interest rate but if inflation is starting to heat up by 3 or 4 percent, people are going to still borrow at very very low rates. If the Fed funds rate is at, say, 2 percent, and the inflation rate is 4 percent, they’re going to want to borrow a lot.

So, you have to look at how much the Fed is raising the interest rate, and how much the inflation rate is jumping during that same period, to get a sense for how much it’s going to increase the money supply.

The borrowing occurs through the bank sector — the banks create this money and put it in a corporate checking account, or the Federal Reserve might come in and buy Treasury securities, and that money goes in to the banks and then the loans out from that. That’s the base: power money.

Charlie Deist: The Fractional Reserve System, where it gets multiplied.

Robert Wenzel: Correct.

Charlie Deist: All these variables are enough to make my head spin sometimes, and I’m sort of an amateur economist. But for the average person listening, I think the key points to understand are that actors in the economy tend to be rational — they’re receiving price signals from all over.

This is an idea that Hayek talks about — F.A. Hayek, one of the the leading lights of the Austrian school — and in this model entrepreneurs are the planners. They’re the ones who are making the long-term economic decisions, and they need to know what resources are scarce, and how much savings there is in the economy to be channeled into long-term investments, like housing, like the stock market — these capital intensive industries.

When the Federal Reserve manipulates this important variable of the money supply, it clouds all of these signals. We’re talking on the radio — some people are maybe listening with a poor radio signal — and you can imagine that the Federal Reserve is mixing up these signals. It’s injecting, not just unpredictability, but also a general skew in the direction of cheap credit. It’s incentivizing people to pursue these long-term projects for which there are no underlying resources. Would you say that’s a fair summary?

Robert Wenzel: It is. But I want to be careful about using the term “rational actors,” because Austrians look at the individual and say, “Okay, an individual makes decisions, and he has a value scale of different things he wants to buy at different times.”

This is different from mainstream economists who say most actors are rational. We don’t assume that what they’re doing is rational. It could be entirely crazy. As a matter of fact, buying houses at the top of the bubble was an absolutely insane thing to do in 2006, especially going into 2007. They wouldn’t have bought at the prices they were buying at if they really understood anything. You can have people buying all kinds of crazy things. So it’s not as much the rationality factor.

Some Austrians say, “Well, the signal is distorted.” That’s part of it, because the interest rates are lower when corporations are planning. But the key is that there’s more money out there. It doesn’t really matter if people are rational or irrational if there’s no money for them to do nutty stuff with — to buy stocks when they’re selling at 300 or 500 times earnings — however crazy it gets. You can have irrational people doing that, but they can only do it if the money is available to continue that buying. The key remains how much money is being pumped.

E is for Entrepreneurs

In a video for Marginal Revolution University, Tyler Cowen describes the critical role entrepreneurs play in the Austrian conception as those who respond to distorted price signals:

His main critique of the theory is, “If entrepreneurs are so smart, how come they are fooled by the temporarily low interest rates to invest in long-term projects?”

In rebuttal, Roger Garrison has drawn an analogy to a radio signal getting jammed. Not every entrepreneur will fail to hear the signal through the noise, but the economy will incorporate more of the cumulative mistakes. Borrowing the video’s image of the radio tower beaming out price signals, to which entrepreneurs are tuned in, we can add more radio towers — one for each input for production. Price signals get louder (cheaper) or softer (more expensive) depending on the underlying scarcity of the resource, but also on monetary factors. The entrepreneur has no way to know whether a particular variable in their decision, such as the cost of credit, is changing for real or artificial reasons.

F is for Fractional Reserve Banking

The distinction between “real” and “artificial” credit expansion is rooted in the organizations regulating the money supply — the banks and other lending institutions that determine who is worthy to borrow, and at what interest rate.

Base money — money proper — is the “raw material” which banks and private institutions use to create money substitutes. This base money is created by the Treasury and is held in people’s wallets, ATMs, deposited in private bank vaults, and lastly, stored in the vaults of the Federal Reserve itself. The U.S. Treasury has the power to print money out of thin air, and deposit it to the account of the Federal Reserve Bank, which then injects the money into the economy by purchasing government debt from the banking system.

Under the fractional reserve system, banks are only a required to keep a portion, or fraction, of deposits in their vaults. The remainder ( 90% of the original deposit under a 10% “reserve requirement”) works its way back into the banking system, gets partially loaned again, until the original increase in the money supply has been multiplied several times over [1 + (.9) + (.9 x .9 )+ (.9 x .9 x .9) … etc.].

This is how the banking industry “manufactures” new money — also called high-powered money — with the “inputs” of base money.

Most of the time, banks are correct in assuming that not everyone will try to take out their deposits at the same time, but a bank run can occur when people lose confidence in a financial institution that has made a series of bad loans.

Ever since the Great Depression the Federal Government has insured all deposits up to $250,000, to prevent the situation in which everyone tries to withdraw their money simultaneously. It has also injected new money into the system by purchasing Treasury bonds from the public in times of waning confidence, although the results in terms of economic stability have been mixed.

G is for Gold Backing

Austrian economist Ludwig Von Mises thought the solution to this boom-and-bust cycle was to eliminate fractional reserve banking and Federal Reserve altogether. Many Austrians favor of a credit system where all loans are backed 100% — not only by government-issued cash in the vault, but by gold. Gold’s value, unlike fiat currency, is determined by the market, based on its industrial uses (i.e., crowns in dentistry) and its historical value as a precious metal. Gold also has the virtue of being transportable, divisible and storable. It doesn’t degrade over time, and has all of the attributes of an ideal medium of exchange, except for its weight relative to paper currency.

H is for Hayekian Triangles

Roger Garrison writes:

Capital goods are heterogeneous in nature and are related to one another by various degrees of substitutability and complementarity. Given the time consuming nature of the investment process, the problem of investment–from a societal point of view–is one of committing some resources to the early stages of the processes while reserving enough resources for the later stages. The capital goods associated with the early and the late stages, or alternatively: higher-order capital goods and lower-order capital goods, are intertemporal complements. Intertemporal discoordination triggered by an artificially low interest rate manifests itself initially as overinvestment in higher-order capital goods. But only the passage of time and the subsequent scarcity of (complementary) lower-order capital goods will reveal this intertemporal discoordination.

Hayek first articulated this idea in the 1930s in a series of lectures where he drew a triangle-shaped diagram to illustrate the relationship between time and the capital structure that produces a given level of output.

With more savings available, a longer structure of production can be achieved and overall production and future consumption can grow. When newly printed money first enters the credit markets, as it does under fractional reserve banking, it lowers the interest rate and gives the illusion of new savings. However, there has been no underlying change in the patience of the public, so longer structures of production are unsustainable. Resources must be drawn out of the lower-order, or “intermediate stages” of production to complete the higher-order finished goods. Mises likens this scenario to a builder who fails to take inventory of his materials before embarking on a construction project, and finds himself short of bricks at the end of the project. It can also be thought of in terms of a failure to do maintenance on the intermediate capital — i.e., the stuff you need to make the stuff consumers actually buy.

This attempt to model the trade-offs between present and future consumption, and the complexity or “round-about-ness” of production, has failed to catch on in academic departments.

Incidentally, Hayek has been criticized by contemporary Austrians for the sin of “over-aggregation,” most frequently committed by Keynesians. However, his underlying project of rigorously evaluating the effects of real and artificial changes in the interest rate on the structure of production remains a vital task for modern economists. The insights of the Austrians, although less formally developed than the Keynesians or Monetarists, may have more relevance than ever as the Federal Reserve enters uncharted territory in 2018 and beyond.

Making A Sticky Problem Stickier

“Morpheus: ”This is your last chance. After this there is no turning back. You take the blue pill and the story ends. You wake up in your bed and believe whatever you want. You take the red pill, you stay in Wonderland, and I show you how deep the rabbit hole goes. Remember, all I’m offering is the truth. Nothing more.” — Morpheus, *The Matrix*

Charlie Deist: Welcome back — I’m spending the hour with Bob Wenzel author of the economics blog and the book *The Fed Flunks: My Speech at the New York Federal Reserve Bank.* We’ve been talking about how the Federal Reserve manipulates the money supply and, in doing so, has exacerbated booms and busts in the overall economy, including the Great Recession. Perhaps we’re headed for another one.

Does Austrian economics represent the Red Pill worldview? You be the judge.

Let’s talk about one particular aspect of Austrian Business Cycle Theory that puts it at odds with the Keynesian theory, which grants a special role for sticky wages. It’s hard for wages to adjust downward. You have business owners who are reluctant to cut wages for their employees for a variety of reasons — some are psychological and some are related to other frictions in the economy. But in the Austrian story wages need to move downward in order for the markets to clear after this period of inflation.

You mention in this book that Herbert Hoover famously tried to shame businesses during the Great Depression for cutting wages. Are you saying that that this wasn’t the right thing to do? Did Hoover not have the worker’s best interests in mind when he was calling for their wages to stay the same?

Robert Wenzel: Right. Keynes himself promoted this idea that is wrong at a basic level. When you look at supply and demand, markets clear. There’s no case where markets don’t clear. So if you’re demanding regulations, and trying to prevent companies from hiring outside of unions, and doing all these things that cement above-market wages, you’re going to just log jam the employment. That’s what you saw in the 1930s and every recession after that. You’ve got governments trying to prop things up, and then you give people unemployment insurance — you actually pay them not to work. That’s going to take a bunch of people out too.

Now, when these wages drop, it doesn’t necessarily mean that people are losing buying power. During the down side of the business cycle, people are fearful. They don’t know what’s going to happen. They don’t know if they’re going to lose their job, so they don’t spend as much money. They keep it in their wallet. They husband it, and they’re careful. You have a deflation in the economy, which is not necessarily good or bad — it’s just a readjustment of wages and consumer prices. Wages drop, but prices are dropping at the same time. People have the same kind of buying power — if you’ve got the people working, they are producing things, and if things are being produced you’re going to have demand for those things, just at cheaper prices.

That’s something you don’t really see mainstream economists pointing out. They’re just saying wages are sticky. Wages aren’t sticky — prices clear; and especially wages. If a guy doesn’t have any job, and he has no money coming in, he’s going to take a lower wage. It’s not sticky. It makes no makes no sense.

Charlie Deist: There’s sort of a self-fulfilling prophecy, because the theory says that wages are sticky downward, therefore we must enforce them at the current level — so then it actually does become sticky. The only way that markets don’t clear is if you enforce it through further government intervention.

Robert Wenzel: Exactly. They’re actually doing the opposite of what they’re saying. They’re saying, “Oh my, wages are sticky so we have to go and enact laws,” but the laws are making them sticky. They’re causing the stickiness. Again, if a wage drops during a downturn, when there’s a general deflation, even if wages drop, the buying power of that wage is going to stay basically the same.

A Brief History of Booms and Busts

Charlie Deist: We have a caller on the line. Michael what’s your question for Bob?

Michael: Hi Charlie, I have two questions. One is, what was the business cycle like in the 100 years before the Federal Reserve? And the follow on is, how is the Austrian school doing in popularity among economists over the last 10 years?

Robert Wenzel: Okay. Thank you, Michael. There’s never really been a period where there’s been a free market, where the government has not attempted in some sense to control the money supply. Go back to the American Revolution and you had the term that’s still around a little bit, “Not worth a Continental,” because the Continental currency was printed so rapidly that it caused a huge hyperinflation.

There were swings up and down in the economy at that time during the Civil War. I’m pointing out things that are probably more memorable to people. You had the Greenback, which was printed in huge quantities and caused a huge inflation. These all would have caused the same kinds of fluctuations in the economy, so we’ve never really had a period of stable money, with gold and silver backing. Maybe early on in different pockets, there were, for very short periods of time, but where it wasn’t the Federal Reserve, there was some other central bank. The technical details were a different as far as how it was run and controlled, but it still caused the same kind of effect.

Now, it really has intensified with the Federal Reserve. Every 10 years you’re getting some kind of major downturn, because they’ve got this ability to print money and make a mess of the economy honed down.

As far as the Austrian school, I don’t think it’s really advancing to any great degree. There are probably more Austrians around thanks to places like the Mises Institute, and the work that economists like Murray Rothbard have done on business cycle theory. But basically, we’re still in a period where there are powerful forces within the government to keep up this phony Keynesian theory of how the economy works, because when they’re printing a lot of money, it goes to purchase Treasury bills and Treasury securities.

Recently they were buying more long-term securities. All of this props up government deficit spending, so there’s a lot of incentive. All these economists are working for the Federal Reserve or for academia, where it’s sponsored by the government. It’s very hard to break through — it’s going to have to be from outside.

Charlie Deist: This speaks to the question of whether or not the Federal Reserve is inadvertently causing business cycles, or whether there is some sort of ulterior or motive. You don’t have to be a conspiracy theorist to notice that by buying up these Treasury bonds, the Federal Reserve does assist an agenda of higher spending. It’s one way out of the bind politicians find themselves in, where they want to spend but they don’t want to tax.

Robert Wenzel: That’s exactly what’s going on. And, of course, the Federal Reserve is very close to the Wall Street banksters. There are good people on Wall Street, but there are also what I call “the banksters”— the ones we saw propped up during the most recent financial crisis in 2008. The Federal Reserve came in and bought all kinds of securities from these guys, and just propped them up because they would have failed and been wiped out. They should have been in my view.

All these economists are working for the Federal Reserve or for academia, where it’s sponsored by the government. It’s very hard [for Austrians] to break through — it’s going to have to be from outside.

Charlie Deist: There is as strong revolving door between Wall Street and the government in some cases, and while the central bank is supposed to maintain its independence, it’s hard to imagine that being the case with all of the overlapping incentives, and people just coming out of one agency into into the private sector.

Let’s hear from another caller.

Caller 2: What is the most recent activity of the Federal Reserve? My impression is that the Fed has increased the money supply in recent years. Does that relate to the run up in housing and stock prices? And next, what is the Fed doing recently, and how will that affect stock and housing prices?

Robert Wenzel: That’s a very good question — you’re absolutely right. When the financial crisis really deepened in late 2008, Ben Bernanke turned on the money spigots, and money has been flying out ever since. An enormous amount of money has been printed.

I like to say there’s a spigot right under Silicon Valley. That’s why you’re seeing the incredible boom in Silicon Valley. And housing prices here spread to other parts of the country and, of course, you’re seeing most of it in major cities. That’s where it tends to start.

Now, for the very near term I also publish a newsletter for individuals who are looking to understand the economy — small business people, or real estate builders, or stock market investors. I track the money supply weekly in the EPJ Daily Alert.

Generally there starts to be a turn upward in money supply at this time of year. The way I calculated the three-month annualized rate. There is a little bit of a turn, but it’s been fairly slow within the band of where it’s been over the last five or six years. Over the last five or six years, you’d see money supply at 6 or 7 percent, and it’s about 4.5 percent right now, and that is not weak money supply — you can see it drop some times from that level, but it’s very low.

So I don’t think we’re going into a recession just yet. I think we’re okay for at least the first half of 2018, but I am very suspicious as far as the stock market run — whether the stock market run can continue, because with that kind of money supply, again, there’s a lot going in, but there’s not a lot, so it could hurt the sector that is most liquid — where money impacts the economy quickly, and that, of course, is the stock market. So I think we could see some weakness here in the very short term.

Charlie Deist: Thanks, John, for your call.

Future Fed

Charlie Deist: Another point on more recent Federal Reserve policy: there have been some changes in the staff at the Federal Reserve. Ben Bernanke is no longer the chairman, and there are some new Trump appointees. Tell us about what’s going on, how it might affect Federal Reserve policy going forward.

Robert Wenzel: Sure. Ben Bernanke is long gone, after he (in my book) created the financial crisis and this ridiculous bailout of the Wall Street banksters. Then Janet Yellen came to serve a term, and her term ends on February 3, and President Trump has nominated Jerome Powell to be the new Fed chairman. He’ll probably pretty much follow in the footsteps of Yellen. It doesn’t seem that he’s got any particular theories that will move away from the policy she does, which basically means he’s going to look at the numbers like Bernanke did, and adjust the interest rates, and do that based upon whether the data is coming in low or high, or whatever. Kind of a boring guy there, but we’re heading into a dangerous period. I think price inflation is going to kick up significantly. It’ll be interesting to see how he deals with that.

Remember, Powell is not an economist — he’s a lawyer. Nothing against lawyers but even though the Keynesians are pretty bad economists, even bad economists seem to know in the back of their head that inflation can be really bad, and that we need to fight it. The last time we had a Federal Reserve chairman who was not an economist was G. William Miller under Jimmy Carter. Inflation went up to about 15 percent under him, and he didn’t think it was a problem. So the Rockefellers actually forced Jimmy Carter to push him out. Paul Volcker came in and turned the whole thing turn.

Negative Interest Rates?

Robert Wenzel: Now a more concerning guy — I don’t think he’s going to get a lot of votes for his theories at this point, but he’s just dangerous to have on the Federal Reserve Board — President Trump nominated Marvin Goodfriend to be a Federal Reserve Governor. He’s just going to be one governor, so he won’t have major influence, but the guy’s theories are absolutely nuts. He wants negative interest rates when the economy goes down because he’s got this Keynesian aggregate demand idea.

The problem with negative interest rates is that if you drop interest rates too low, individuals are going to pull their money out of the bank, and keep it under the mattress. If you put an interest rate to negative 10 percent, you’re just not going to keep your money in a checking account. So, he has come up with this brilliant (I guess, in his mind) method to solve that: if people have currency in their wallet, he wants it to have a floating value. In other words, if you pull your money out of the bank because you don’t want to get this negative interest rate, and you go spend it at McDonald’s or Macy’s, he’s going to charge the corporation when they deposit that money in the corporate account.

Goodfriend is going to say, “Alright, if somebody comes in, and you take in cash, we’re only going to give you 90 cents for the dollar, or whatever it will be.” He wants a floating value to the money in your wallet — absolutely nuts. He doesn’t seem to have any followers among the other governors on the Fed — which is a good thing — but this is really crazy stuff and it concerns me that a guy like that ends up on the board, because if he starts sticking that idea in other people’s minds, soon we’re going to be walking around with money that changes its value. It’s nuts.

Charlie Deist: Bob’s pointing out that there is this lower bound on where the interest rate can go — how much the Federal Reserve can incentivize spending just by pumping money into the economy. At a certain point, people will just hoard cash. That’s always been the constraint on central banks — currency can’t just be marked down. But if you were to mark it down at the point of re-entry into the banking system, that could make it technically feasible.

Bitcoin and Alt-Currencies

Charlie Deist: What are the possibilities for moving into more of a virtual currency? You blog about Bitcoin sometimes, and you also took note of a headline last week about the Federal Reserve exploring the possibility of a virtual currency — in the model of Bitcoin — to replace the U.S. dollar at some point.

Robert Wenzel: Right — I put out a YouTube video recently where I talk about Bitcoin. Generally, when you analyze an investment, you analyze it from earnings flow, and there is no earnings flow from Bitcoin. I explain where the price could go, where it could not go, and all that in the video.

But the other thing with regard to Bitcoin is that you’ve got a lot of libertarians who claim that it’s a libertarian move away from government — but Bitcoin is much more trackable than currency and it’s very dangerous. An example someone used once: if you go on the street and you buy drugs, and you’re paying cash, you’re busted for that one transaction and you’re going to suffer whatever consequences go with that. But if there is no physical currency, and you’re busted on one trade, well then the government can go back and look at all of the transactions you’ve done — bust you for a whole Major League bunch of transactions. I’m actually having a couple of debates on Bitcoin coming up.

Bitcoin enthusiasts will argue that there are ways around — that you can launder your transactions and stuff like that — but it it really ignores a number of problems with that, which would take too long to go into right now. I expect them to put very heavy regulations on Bitcoin, which is going to make it very difficult to operate.

But the other problem is that the Fed is in the early stages of designing their own coin. They’re in the early stages of coming out with some kind of Fed coin, which would be a real disaster.

Charlie Deist: We’ll be sure to watch that as it develops. People who want to follow your writing can go to You also host a podcast — The Robert Wenzel Show.

Again, Robert Wenzel is a financial consultant with an Austrian perspective. If you’re interested in the Austrian perspective on business cycles, bitcoin, or anything else, be sure to check out his work on the web and tune in next week, when we continue the topic of business cycle theory.

Thank you, Robert for spending the hour with us this morning.

Next, we will hear from a guest who embodies the neo-classical synthesis — an updated version of Keynesianism that incorporates insights from Milton Friedman’s monetarism. Stay tuned, and listen live, every Sunday, from 8–9am PACIFIC.