The Mises Institute responded to my criticism of their video regarding the Fed. Let’s review the rebuttal.
Playing With Fire
On October 13, I wrote Playing With Fire – a Very Disappointing and Factually Incorrect Mises Article on Money
Note: When I say Mises for the rest of this post I do not mean Ludwig von Mises or the Mises Institute, but rather one particular video and the response to my article.
I have high respect for Ludwig von Mises, the person, the Mises institute, and Austrian economics.
I made the claim, and still do, the Mises video, shown below, has clips that are wrong.
The Business Cycle
Jonathan Newman responded to my post with Who Starts Business Cycles? Banks or the Fed?
Newman claims I pulled statements out of context.
I didn’t. You can check for yourself.
At the 2:30 mark Jonathan Newman, a Mises economist discusses Fractional Reserve Banking.
“How do banks make a profit? With fractional reserve banking. It involves creating new money out of thin air.”
“Fractional reserve banking is the idea that banks keep a fraction of deposits in reserve so that somebody walks in and makes a deposit. What they [the banks] actually do is take that money and they use it to finance loans that they make to other people, business loans, mortgages.”
Continuing at the 2:58 mark, Joseph Salerno, Professor Emeritus at Pace University responds to Newman with “Let’s say they lend out 90 percent. They are comfortable keeping one dollar for every ten dollars that people will deposit. So you can write checks up to $1,000 on that checking deposit. At the same time there is 900 more dollars in circulation than there was before you made that deposit.”
Fresh Video Rebuttal
I played the video again. I invite readers to do so as well, from the start to at least the 3:40 mark.
There was no mention by Mises that banking used to work the way the video describes but now doesn’t.
The video perpetuates the myth of deposits being lent out over and over and over again.
Historically Speaking
Q: How long ago did banks lend deposits?
A: When we had a full gold standard and paper dollars were convertible to physical gold on demand. Some might argue 1971 when Nixon removed all convertibility to gold, ushering in unlimited credit on demand.
And Now
As I pointed out “Banks do not lend deposits. Rather, deposits are the result of loans.”
Note: I accidentally stated that backward and Newman graciously corrected my sentence because he knew from context what I meant.
Thanks! I corrected my original post.
Fictional Reserve Lending Is the New Official Policy
With little fanfare or media coverage, the Fed made this Announcement on Reserves.
As announced on March 15, 2020, the Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirements for all depository institutions.
However, that announcement did not really change anything because reserves already did not figure into loan decisions.
When Do Banks Make Loans?
- They meet capital requirements
- They believe they have a creditworthy borrower
- Creditworthy borrowers want to borrow
From the BIS
The underlying premise of the first proposition is that bank reserves are needed for banks to make loans. An extreme version of this view is the text-book notion of a stable money multiplier.
In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.
The main exogenous constraint on the expansion of credit is minimum capital requirements.
See BIS Working Papers No 292 Unconventional Monetary November 2009.
Ending reserve requirements in 2020 was little more than admission that reserves are essentially meaningless from a lending standpoint and capital requirements are paramount.
What About the Business Cycle?
From Newman:
In October of 2008, the Fed began paying interest on reserves (IOR) to regain tight control over the Federal Funds Rate amid heightened uncertainty and massive increases in the demand for reserves. IOR provides the added benefit to the Fed by providing a gate between bank reserves and bank credit such that a large increase in bank reserves would not necessarily result in banks expanding credit. Banks obviously took advantage of this opportunity, to the point that minimum reserve requirements, which had become nonbinding, were eliminated in 2020.
In short, the Fed has immobilized bank reserves to a large extent by paying (bribing?) banks to sit on the money.
So, Shedlock was correct when he said that US banks no longer have reserve requirements, but that is because the Fed has replaced the stick with a carrot. The Fed has “reserve incentives” now, instead of reserve requirements.
We may have a bit of violent agreement here, at least in terms of what the Fed might have been trying to do.
But perhaps the Fed was just pain stupid, because this eventually blew up in their faces in a way that I believe should have been obvious.
In 2008, then Fed Chair Ben Bernanke lobbied Congress for the right to pay interest on reserves. He got his wish.
But rather than sit on money at overnight rates, banks speculated in long-dated US treasuries.
The banks were not content with the “free” money the Fed was giving banks at taxpayer expense. It was pure greed.
Interest rate speculation works fine in a falling interest rate environment.
However, Silicon Valley Bank (SVB), Silvergate Bank, and Signature Bank, all went bust in March 2023 by parking investor deposits in long-duration treasuries. When the Fed hiked rates, the long-dated treasuries had huge capital losses and a classic run on the bank ensued.
On March 10, 2023, SVB failed, marking the third-largest bank failure in United States history.
So banks didn’t just sit on QE deposits, they speculated on long-dated treasuries and blew up.
But yeah, this was a problem totally of the Fed’s making, and it’s safe to say Mises would agree.
Austrian Economics
“Finally, I want to show that Austrian economists do not have their heads in the sand, as Shedlock suggests,” said Newman.
I never suggested or implied that at all. I have high regard for Austrian economics and the Mises institute. I believe in sound money.
Rather, I was more than a bit disappointed in a video that hugely missed the mark in many ways. I expected better from the Mises Institute.
Apologies if that was not clear.
Five Business Cycle Factors
- Monetary Policy – Fed
- Fiscal Policy – Congress
- Secular Factors – e.g. Demographics
- External Factors – e.g. Oil Embargo, War
- idiosyncratic Factors – e.g. Covid
Newman blames the Fed for the business cycle. I agree with Newman that the Fed has a huge weight in the business cycle. But one cannot blame the Fed for external factors, idiosyncratic factors, or demographics.
I am open to suggestions from Mises on how to weight those factors provided the Fed has no more than 65 percent of the total.
The Fed does not control fiscal policy but the Fed certainly enables fiscal policy by monetizing the debt. Massive QE operations create economic bubbles.
The Fed was not responsible for the unprecedented fiscal stimulus in Covid, but it was responsible to understand the impact.
The Fed’s monetary response on top of a massive and unwarranted fiscal response was one of the worst errors in Fed history.
End the Fed
Like Mises, I would like to End the Fed.
My readers ask, “With what?” And my answer would be the same as Mises: “With nothing”. The Free market can set interest rates better than the Fed.
However, short of a constitutional amendment on letting the market set interest rates, End the Fed might be an unsatisfying answer.
My fear is Congress would replace the Fed by putting itself in control of interest rates and money supply.
That fear is strongly justified. The Progressive wing of the Democrat Party, led by Elizabeth Warren and AOC want to add a third mandate, climate change, to the Fed’s responsibilities.
I suspect Mises would agree that putting politicians in control of money supply and interest rates would be much worse than the Fed.
Please recall Biden’s Bank Regulatory Nominee Espouses Helicopter Money and Praises the Old USSR
Joe Biden’s nominee for the Comptroller of the Currency, Saule Omarova, commented on oil, coal and gas industries: “We want them to go bankrupt if we want to tackle climate change.”
Omarova’s paper is The People’s Ledger: How to Democratize Money and Finance the Economy
In basic terms, the Fed will credit all eligible Fed Accounts when it determines that it is necessary to expand the money supply in order to stimulate economic activity and ensure better utilization of the national economy’s productive capacity. In the economic literature, this form of unconventional (by present standards) monetary policy is commonly known as “helicopter drop” or “QE for the people.”
“QE for the People” is a doozie, straight out of the Marxist handbook.
So, what’s the way forward?
My Six Recommendations
- Separate lending banks from deposit banks
- Eliminate the Fed’s ability to do QE
- Eliminate the Fed’s ability to monetize the debt
- Eliminate Fed’s ability to pay interest on reserves
- Audit the Fed
- Balanced Budget Constitutional Amendment requiring 2/3 vote in both houses to temporarily override
Separate Lending Banks from Deposit Banks
If we separated lending banks from deposit banks and mandated 100 percent reserves on deposits, there would be no Silicon Valley style blowups.
Note that 100 percent reserves on deposits would not stop lending because deposits play no role in lending up to the point there is a run on a bank causing capital impairment.
The reason to split banks into two pieces is to remove all risk from one of the banks. Lending banks can go under by making bad loans.
FDIC is unneeded (or unlimited) at deposit banks because there is always 100 percent reserves.
Deposit banks would have a small fee for safekeeping, handling checking accounts, wire transfers, etc. The more services offered by the bank, the higher the fee.
The 100 percent reserve proposal is not new. Economist Irving Fisher Proposed 100% Reserves in 1935.
The essence of the 100% plan is to make money independent of loans; that is, to divorce the process of creating and destroying money from the business of banking. A purely incidental result would be to make banking safer and more profitable; but by far the most important result would be the prevention of great booms and depressions by ending the chronic inflations and deflations which have ever been the curse of mankind and which have sprung largely from banking.
Caitlin Long, CEO and founder of Custodia Bank, wants to create a deposit only bank and the Fed said on some spurious crypto-related charge.
I speculate the Fed does not want competition from a safekeeping bank because it wants to force you at some later date into using its own allegedly safe Central Bank Digital currency.
QE and Monetization
Reining in QE and monetization would not prevent fiscal deficits, but it would stop the Fed from being a huge enabler of deficits and economic bubbles.
The bigger the deficit, the stronger the upward pressure on interest rates.
Diversity and Groupthink
The Fed preaches diversity but where is it? Every Fed president believes in disproved models like inflation expectations, the Phillips Curve, and the need for two percent inflation.
The Fed’s own studies debunk inflation expectations and the Phillips Curve. Yet every post-FOMC meeting, Powell, like Yellen, and Bernanke, harps about inflation expectations.
The absurd theory is that people act on expectations and those expectations become self reinforcing.
Please consider the Fed report Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)
The Fed study was not only accurate, it was funny, and replete with humorous quotes.
I can make it simple. Inflation expectations don’t matter because at least 80 percent of the CPI is inelastic.
People will not double up on rent in advance if they think rent will go up. Similarly they will not double up on gasoline, medical operations, etc.
And among the elastic items, people won’t take two vacations this year an none the next if they think hotel costs will rise, etc. Factor it all in, and there is very little people can actually do that will matter, no which way they think prices are headed.
Diversity is not about race or sex. It’s about opinions and they all believe the same nonsense.
Attack From Within?
It would be a slow process, but there was some chance of that happening.
On January 17, 2020, The Mises Institute asked Could Trump’s Next Fed Chair Be A “Goldbug?”
Shelton has been a vocal Fed critic who has praised the gold standard in the past. While she has recently advocated for lower interest rates, she has also been a critic of the Fed’s policy of paying interest on excess reserves, which has become a key policy tool since 2008. Shelton’s nomination is also interesting due to the stark contrast between her background and most of her colleagues’.
The good news is that Ms. Shelton is not a technically trained academic economist, indoctrinated in the prevailing orthodoxy. She holds a doctorate in business administration from the University of Utah and has spent most of her career in the world of free-market policy think tanks, including stints at the Hoover Institute and the Atlas Network. She also writes refreshingly and articulately in favor of the gold standard, or some version of it.
The bad news is that she leans heavily toward supply-side economics, which is deeply flawed on monetary policy. Like most supply-siders, the position she advocates may be summed up in the motto, “I favor sound money—and plenty of it.”
Still, though by no means an Austrian, Shelton’s voice on the Fed would create some much-needed ideological diversity in the central bank.
Unfortunately, Shelton fell one vote short in the Senate when a Republican senator got sick from Covid and did not vote.
And the problem with attack from within idea is the next person might be another Saule Omarova or Elizabeth Warren clone.
Balanced Budget Amendment
On January 26, 1995 the House approved a balanced budget amendment. Unfortunately, the bill died in the Senate.
Profile in stupidity: In 1995, Mark Hatfield, Senator from Oregon, cast the decisive vote against the Balanced Budget Amendment to the United States Constitution.
Hatfield was the only Republican to vote against.
Conclusion
In general, I do not have strong disagreements with the Mises Institute and certainly not with Austrian economics.
I panned a specific video for two reasons that upon replay are still valid: The video perpetuates a fractional reserve lending myth and it offers no discussion of a reasonable way forward.
I would prefer to End the Fed, with a constitutional amendment, and kill deficit spending at the same time. A balanced budget amendment came within one Senate vote of passing.
My more pragmatic recommendations are along the lines of what might realistically be done.
Even if a balanced budget amendment is water over the dam, points 1-5 offer a practical approach to “End the Fed” because they would hugely restrain what the Fed can and cannot do.
Mises is free to post this, rebut it, or add to it.