I find it amazing that an Austrian economist was asked to speak at the NY Federal Reserve Bank.  This speech was given by Robert Wenzel and I am reposting it here from Mises Institue.  You can also go to Robert Wenzel’s personal website here.  In addition there is an audio file here.  Apparently this speech has been pretty big news on the internet but the mainstream media has not mentioned whatsoever.

Here is the transcript:

At the invitation of the New York Federal Reserve Bank, I spoke and had lunch in the bank’s Liberty Room. Below are my prepared remarks.


Thank you very much for inviting me to speak here at the New York Federal Reserve Bank.

Intellectual discourse is, of course, extraordinarily valuable in reaching truth. In this sense, I welcome the opportunity to discuss my views on the economy and monetary policy and how they may differ with those of you here at the Fed.

That said, I suspect my views are so different from those of you here today that my comments will be a complete failure in convincing you to do what I believe should be done, which is to close down the entire Federal Reserve System

My views, I suspect, differ from beginning to end. From the proper methodology to be used in the science of economics, to the manner in which the macro-economy functions, to the role of the Federal Reserve, and to the accomplishments of the Federal Reserve, I stand here confused as to how you see the world so differently than I do.

I simply do not understand most of the thinking that goes on here at the Fed and I do not understand how this thinking can go on when in my view it smacks up against reality.

Please allow me to begin with methodology, I hold the view developed by such great economic thinkers as Ludwig von Mises, Friedrich Hayek and Murray Rothbard that there are no constants in the science of economics similar to those in the  physical sciences.

In the science of physics, we know that water freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed..

There are no such constants in the field of economics since the science of economics deals with human action, which can change at any time. If potato prices remain the same for 10 weeks, it does not mean they will be the same the following day. I defy anyone in this room to provide me with a constant in the field of economics that has the same unchanging constancy that exists in the fields of physics or chemistry.

And yet, in paper after paper here at the Federal Reserve, I see equations built as though constants do exist. It is as if one were to assume a constant relationship existed between interest rates here and in Russia and throughout the world, and create equations based on this belief and then attempt to trade based on these equations. That was tried and the result was the blow up of the fund Long Term Capital Management, a blow up that resulted in high level meetings in this very building.

It is as if traders assumed a given default rate was constant for subprime mortgage paper and traded on that belief. Only to see it blow up in their faces, as it did,  again, with intense meetings being held in this very building.

Yet, the equations, assuming constants, continue to be published in papers throughout the Fed system. I scratch my head.

I also find curious the general belief in the Keynesian model of the economy that somehow results in the belief that demand drives the economy, rather than production. I look out at the world and see iPhones, iPads, microwave ovens, flat screen televisions, which suggest to me that it is production that boosts an economy. Without production of these things and millions of other items, where would we be? Yet, the Keynesians in this room will reply, “But you need demand to buy these products.” And I will reply, “Do you not believe in supply and demand? Do you not believe that products once made will adjust to a market clearing price?”

Further , I will argue that the price of the factors of production will adjust to prices at the consumer level and that thus the markets at all levels will clear. Again do you believe in supply and demand or not?

I scratch my head that somehow most of you on some academic level believe in the theory of supply and demand and how market setting prices result, but yet you deny them in your macro thinking about the economy.

You will argue with me that prices are sticky on the downside, especially labor prices and therefore that you must pump money to get the economy going. And,  I will look on in amazement as your fellow Keynesian brethren in the government create an environment  of sticky non-downward bending wages.

The economist  Robert Murphy reports that President  Herbert Hoover continually pressured businessmen to not lower wages.[1]

He quoted Hoover in a speech delivered to a group of businessmen:

In this country there has been a concerted and determined effort  on the part of government and business… to prevent any reduction in wages.

He then reports that FDR actually outdid Hoover by seeking to “raise wages rates rather than merely put a floor under them.”

I ask you, with presidents actively conducting policies that attempt to defy supply and demand and prop up wages, are you really surprised that wages were sticky downward during the Great Depression?

In present day America, the government focus has changed a bit. In the new focus, the government  attempts much more to prop up the unemployed by extended payments for not working. Is it really a surprise that unemployment is so high when you pay people not to work.? The 2010 Nobel Prize was awarded to economists for their studies which showed that, and I quote from the Nobel press release announcing the award:

One conclusion is that more generous unemployment benefits give rise to higher unemployment and longer search times.[2]

Don’t you think it would make more sense to stop these policies which are a direct factor in causing unemployment, than to add to the mess and devalue the currency by printing more money?

I scratch my head that somehow your conclusions about unemployment are so different than mine  and that you call for the printing of money to boost “demand”. A call, I add, that since the founding of the Federal Reserve has resulted in an increase of the money supply by 12,230%.

I also must scratch my head at the view that the Federal Reserve should maintain a stable price level. What is wrong with having falling prices across the economy, like we now have in the computer sector, the flat screen television sector and the cell phone sector? Why, I ask, do you want stable prices? And, oh by the way, how’s that stable price thing going for you here at the Fed?

Since the start of the Fed, prices have increased at the consumer level by 2,241% [3]. that’s not me misspeaking, I will repeat, since the start of the Fed, prices have increased at the consumer level by 2,241%.

So you then might tell me that stable prices are only a secondary goal of the Federal Reserve and that your real goal is to prevent serious declines in the economy but, since the start of the Fed, there have been 18 recessions including the Great Depression and the most recent Great Recession. These downturns  have resulted in stock market crashes, tens of  millions of unemployed and untold business bankruptcies.

I scratch my head and wonder how you think the Fed is any type of success when all this has occurred.

I am especially confused, since Austrian business cycle theory (ABCT), developed by Mises, Hayek and Rothbard, has warned about all these things. According to ABCT, it is central bank money printing that causes the business cycle and, again you here at the Fed have certainly done that by increasing the money supply. Can you imagine the distortions in the economy caused by the Fed by this massive money printing?

According to ABCT, if you print money those sectors where the money goes  will boom, stop printing and those sectors will crash. Fed printing tends to find its way to Wall Street and other capital goods sectors first, thus it is no surprise to Austrian school economists that the crashes are most dramatic in these sectors, such as the stock market and real estate sectors. The economist Murray Rothbard in his book America’s Great Depression [4] went into painstaking detail outlining how the changes in money supply growth resulted in the Great Depression.

On a more personal level, as the recent crisis was developing here, I warned throughout the summer of 2008 of the impending crisis. On July 11, 2008 at EconomicPolicyJournal.com, I wrote[5]:

SUPER ALERT: Dramatic Slowdown In Money Supply Growth

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.

We have never seen such a dramatic change in money supply growth from a double digit climb to 5% growth. Does Bernanke have any clue as to what the hell he is doing?

On July 20, 2008, I wrote [6]:

I have previously noted that over the last two months money supply has been collapsing. M2NSA has gone from double digit growth to nearly zero growth .

A review of the credit situation appears worse. According to recent Fed data, for the 13 weeks ended June 25, bank credit (securities and loans) contracted at an annual rate of 7.9%.

There has been a minor blip up since June 25 in both credit growth and M2NSA, but the growth rates remain extremely slow.

If a dramatic turnaround in these numbers doesn’t happen within the next few weeks, we are going to have to warn of a possible Great Depression style downturn.


Yet, just weeks before these warnings from me, Chairman Bernanke, while the money supply growth was crashing, had a decidedly much more optimistic outlook, In a speech on June 9, 2008, At the Federal Reserve Bank of Boston’s 53rd Annual Economic Conference [7], he said:


I would like to provide a brief update on the outlook for the economy and policy, beginning with the prospects for growth.  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.

I believe the Great Recession that followed is still fresh enough in our minds so it is not necessary to recount in detail as to whose forecast, mine or the chairman’s, was more accurate.  

I am also confused by many other policy making steps here at the Federal Reserve. There have been more changes in monetary policy direction during the Bernanke era then at any other time in the modern era of the Fed. Not under Arthur Burns, not under G. William Miller, not under Paul Volcker, not under Alan Greenspan  have there been so many dramatically shifting Fed monetary policy moves. Under Chairman Bernanke there have been significant changes in direction of the money supply growth FIVE different times. Thus, for me, I am not at all surprised at the current stop and go economy. The current erratic monetary policy makes it exceedingly difficult for businessmen to make any long term plans.  Indeed, in my own Daily Alert on the economy [8] I find it extremely difficult to give long term advice, when in short periods I have seen three month annualized M2 money growth go from near 20% to near zero, and then in another period see it go from 25% to 6% . [9]

I am also confused by many of the monetary programs instituted by Chairman Bernanke. For example, Operation Twist.

This is not the first time an Operation Twist was tried. an Operation Twist was tried in 1961, at the start of the Kennedy Administration [10] A paper [11] was written by three Federal Reserve economists in 2004 that, in part, examined the 1960′s Operation Twist

Their conclusion (My bold):

A second well-known historical episode involving the attempted manipulation of the term structure was so-called Operation Twist.  Launched in early 1961 by the incoming Kennedy Administration, Operation Twist was intended to raise short-term rates (thereby promoting capital inflows and supporting the dollar) while lowering, or at least not raising, long-term rates. (Modigliani and Sutch 1966)…. The two main actions of Operation Twist were the use of Federal Reserve open market operations and Treasury debt management operations..Operation Twist is widely viewed today as having been a failure, largely due to classic work by  Modigliani and Sutch….

However, Modigliani and Sutch also noted that Operation Twist was a relatively small operation, and, indeed, that over a slightly longer period the maturity of outstanding government debt rose significantly, rather than falling…Thus, Operation Twist does not seem to provide strong evidence in either direction as to the possible effects of changes in the composition of the central bank’s balance sheet….

We believe that our findings go some way to refuting the strong hypothesis that nonstandard policy actions, including quantitative easing and targeted asset purchases, cannot be successful in a modern industrial economy.  However, the effects of such policies remain quantitatively quite uncertain.  

One of the authors of this 2004 paper was Federal Reserve Chairman Bernanke. Thus, I have to ask, what the hell is Chairman Bernanke doing implementing such a program, since it is his paper that states it was a failure according to Modigliani, and his paper implies that a larger test would be required to determine true performance.

I ask, is the Chairman using the United States economy as a lab with Americans as the lab rats to test his intellectual curiosity about such things as Operation Twist?

Further, I am very confused by the response of Chairman Bernanke to questioning by Congressman Ron Paul. To a seemingly near off the cuff question by Congressman Paul on Federal Reserve money provided to the Watergate burglars, Chairman Bernanke contacted the Inspector General’s Office of the Federal Reserve and requested an investigation [12]. Yet, the congressman has regularly asked about the gold certificates held by the Federal Reserve [13] and whether the gold at Fort Knox backing up the certificates will be audited. Yet there have been no requests by the Chairman  to the Treasury for an audit of the gold.This I find very odd. The Chairman calls for a major investigation of what can only be an historical point of interest but fails to seek out any confirmation on a point that would be of vital interest to many present day Americans.

In this very building, deep in the underground vaults, sits billions of dollars of gold, held by the Federal Reserve  for foreign governments. The Federal Reserve gives regular tours of these vaults, even to school children. [14] Yet, America’s gold is off limits to seemingly everyone and has never been properly audited. Doesn’t that seem odd to you? If nothing else, does anyone at the Fed know the quality and fineness of the gold at Fort Knox?

In conclusion, it is my belief  that from start to finish  the Fed is a failure. I believe faulty methodology is used, I believe that  the justification for the Fed, to bring price and economic stability, has never been a success. I repeat, prices since the start of the Fed have climbed by 2,241% and there have been over the same period 18 recessions. No one seems to care at the Fed about the gold supposedly backing up the gold certificates on the Fed balance sheet. The emperor has no clothes.  Austrian Business cycle theorists are regularly ignored by the Fed, yet they have the best records with regard to spotting overall downturns, and further they specifically recognized the developing housing bubble. Let it not be forgotten that in 2004, two economists here at the New York Fed wrote a paper [15] denying there was a housing bubble. I responded to the paper [16] and wrote:

The faulty analysis by [these] Federal Reserve economists… may go down in financial history as the greatest forecasting error since Irving Fisher declared in 1929, just prior to the stock market crash, that stocks prices looked to be at a permanently high plateau.

Data released just yesterday, now show housing prices have crashed to  2002 levels. [17]

I will now give you more warnings about the economy.

The noose is tightening on your organization, vast amounts of money printing are now required to keep your manipulated economy afloat. It will ultimately result in huge price inflation, or,  if you stop printing, another massive economic crash will occur. There is no other way out.

Again, thank you for inviting me. You have prepared food, so I will not be rude, I will stay and eat.

Let’s have one good meal here. Let’s make it a feast. Then I ask you, I plead with you, I beg you all, walk out of here with me, never to come back. It’s the moral and ethical thing to do. Nothing good goes on in this place. Let’s lock the doors and leave the building to the spiders, moths and four-legged rats.

Footnotes

[1] http://www.amazon.com/Politically-Incorrect-Guide-Depression-Guides/dp/1596980966/ref=sr_1_1?ie=UTF8&qid=1335313972&sr=8-1

[2] http://www.nobelprize.org/nobel_prizes/economics/laureates/2010/press.html

[3] ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

[4] http://www.amazon.com/Americas-Great-Depression-Murray-Rothbard/dp/146793481X/ref=sr_1_1?ie=UTF8&qid=1335314537&sr=8-1

[5] http://www.economicpolicyjournal.com/2008/07/super-alert-dramatic-slowdown-in-money.html

[6] http://www.economicpolicyjournal.com/2008/07/alert-collapsing-credit.html

[7] http://www.federalreserve.gov/newsevents/speech/bernanke20080609a.htm

[8] http://www.economicpolicyjournal.com/2009/04/announcing-epj-quarterly-economic.html

[9]http://www.economicpolicyjournal.com/2008/07/super-alert-dramatic-slowdown-in-money.html

[10] http://www.frbsf.org/publications/economics/letter/2011/el2011-13.html

[11] http://www.federalreserve.gov/pubs/feds/2004/200448/200448pap.pdf

[12] http://www.huffingtonpost.com/2012/04/03/federal-reserve-watergate-iraqi-weapons_n_1400645.html

[13] http://www.federalreserve.gov/releases/h41/Current/

[14] http://www.newyorkfed.org/aboutthefed/visiting.html

[15] http://fednewyork.org/research/epr/04v10n3/0412mcca.pdf

[16] http://www.economicpolicyjournal.com/2012/02/checkmate-new-york-fed-as-totally.html

[17] http://www.nytimes.com/2012/04/25/business/economy/survey-shows-us-home-prices-still-weak.html

Special thanks to the following, who helped me research and collect data for this paper: Stephen Davis, Bob English, Jon Lyons, Ash Navabi, Joseph Nelson, Nick Nero,  Antony Zegers

Bob Wenzel’s Later Summery

Here are the details surrounding my speech at the New York Federal Reserve Bank. First, I am surprised it actually occurred. Someone at the NY Fed tried to kill my speaking there as soon as he heard about my invitation.

Reaction inside the New York Fed to news of the invitation for me to speak was, indeed, fast and furious, once it became public inside the bank.

I am not going to go into specifics of who invited me, I believe that economist had a true curiosity about my views, but when he put out a formal invitation via email within the NY Fed (I received a copy), it was cancelled within 15 minutes of being put out (I also have a copy of the cancellation). So much for overall curiosity at the Fed about true differing views.,

The economist who invited me assured me that he was still arranging the speech. Yet, as the day grew closer, I feared that I would get word that my speech time would be cancelled.

When I arrived at the bank, the economist who originally invited me told me that there was a “schedule conflict” with a seminar and that the group meeting would be smaller than originally planned. That really didn’t bother me, I was in the Fed and those wanting to hear my speech would.

However, I did detect tension in faces, while I gave my speech, and perhaps some anger. But the anger soon dissipated.

As soon as I finished my speech and to defuse the tension, I asked an immediate question as to whether the economists present believed that Austrian Theory had a legitimate case to make. The eventual response came down to the statement by a Fed economist that there had been worse crashes in the economy before the start of the Fed. (Side note, this is a regular argument used by those supporting the Fed, they will claim that crises were worse before the Fed. I have seen fragmented work demolishing this view, but I think there is the opportunity for some economics student to delve into the pre-Fed period in America and delve into the crashes from an Austrian business cycle viewpoint and point out clearly how government was involved in such crises, if they were–which I suspect they were. Such a study would be extremely valuable in knocking a peg out from under the Fed supporters who attempt to justify the Fed by this argument)

I then asked one economist ( a 20 year plus veteran of the Fed) if he was familiar with Austrian economics. He said that in college he had taken two history of economics courses and then said that the Austrian school is part of the classical tradition. This told me that he was not aware of the important differences between the Austrian school and classical economics (and also the neo-classical tradition).

Later on in the Q&A, one economist remarked that he understood the Austrian school and that they were the group that wanted a constant increase in the money supply and developed the equation PV=MT. This, of course, is not the Austrian view, but a view held by the Chicago school. Thus, in one swoop, this economist demonstrated not only his ignorance of Austrian views on monetary policy, but also confusion about Chicago school views.

To diffuse the tension a bit more, when one economist made a particularly Keynesian statement, I said, “It does not sound like you are going to be walking out of here with me after lunch like I recommend.” That brought laughter.

At another point, I told the story of how in a phone conversation with Lew Rockwell, Lew and I were discussing why I had received an invitation by the Fed and Lew said, “They are probably sick and tired of all those boring speeches that they have to listen to.” That really brought laughter.

A good deal of the Q&A was about my Rothbardian view that prices should be allowed to decline. They were really fascinated by this view and clearly had never heard it before. One economist raised the question of how falling prices would impact assets. The answer is, of course, that an asset is valued based on its discounted value stream and that falling prices would be taken into account in the discounted present value models. However, I do not believe this view has yet been developed fully, and it is another good project for a budding economist.

Overall, I was simply amazed at the lack of knowledge of these economists about the Austrian school. It was very close to non-existent. This points out the extremely important work being done by the Mises Institute and also Ron Paul. The number of students with an understanding of Austrian economics is increasing at an exponential rate. I can’t imagine that future economists, even those who work for the Fed, won’t have some acquaintance with Austrian economics thanks to MI and Ron Paul.

My experience at the Fed points out the importance of intellectual debate and study. Clearly, the economists that I met at the Fed were brought up in an intellectual tunnel, where they had no exposure to Austrian economic theory. They read and study within a limited range of writers. But they were very curious about my view.

One economist asked me how I knew the housing market was going to crash. I responded that because of Austrian theory, I understood that money created by the Fed enters the economy at specific points and that it was obvious the housing market was one of the those points. I told him that I also knew that this would eventually result in price inflation (as the money spread through the economy) and that at that point the Fed would slow printing and the housing market would collapse, which is just what occurred.

I suspect that at the top of the Fed, there are some very evil types who understand the game is to protect the banksters, but I don’t think that is the view held by the outer ring. They have been brought up in the system and they don’t ask questions that threaten their pay checks (It was most difficult impossible to get the economists to discuss any of the erratic moves made by Bernanke) and work developing models within the twisted Keynesian model.

If you set a firecracker under them, like with the speech I gave and then treat them with respect while discussing their opposing views and lighten things up a bit after the firecracker has gone off, perhaps some impact will be made to the tunnel thinking that they have been exposed to their entire professional life. Even more important, hopefully my speech will help budding students to understand that the Fed propaganda machine claims lots of justifications for their money printing machines that when looked at closely can not be justified,. The greater the number that understand the failures of Fed thinking and operations, the closer we will be to ending the Fed.

What is malinvestment? It seems like no one in the media really knows. Most economists probably don’t understand what malinvestment is either because of their Keynesian heritage.

First, let’s look at government investment in general. To Keynes all investment was equal.  Keynes believed that the government building a pyramid was just as economically valuable as building roads or cars or anything else for that matter.  This may seem absurd, building pyramids does not increase the wealth of society, it destroys wealth by taking valuable resources and labor and putting them to use that is not needed.  The thousands of people building the pyramids could have instead added value to society by building stuff that was actually needed like roads.  Unfortunately, roads were not easy for a government to build either.  Though the pyramid contributes no economic value to society, roads do because they provide transportation.  The problem is that government planers are not very good at building roads to meet the needs of society.  How many roads should a community build?  Should a government build five roads for a small town or twenty five?  Should it be on this side of town or that side? When government gets into building roads absurd things happen like the “Bridge to Nowhere”, a three hundred million dollar investment for a town of fifty people.  This is not wise but for a government bureaucrat there is no cost benefit analysis.  Would a one million dollar bridge be worth it?  Or would a fifty thousand dollar ferry be more cost efficient?  There is really no way for a bureaucrat to know, because there is no market pricing system that signals demand for such things.  It is only when a totally ridiculous “investment” like the Bridge to Nowhere is proposed that people take notice but most bad investments do not go noticed because there is truly no way to know if it is a bad investment until it reaches the realm of absurdity.  It should be apparent through these examples that some investments are better than others but ultimately it is still a guessing game because there is no price system.  Governments waste a huge amount of capital on bad investments because they are basically guessing at what the public needs.  It is like throwing a dart at a dart board in the dark.  You hope it hits in the right place but you don’t really know where it will go.  Government spending is the same way, its usefulness will never be known until it is built.  Even then, we still don’t know if the funds could have been used more productively in a different area. Ultimately, bridges to nowhere, pyramids, and roads built where nobody drives might be bad investments but they are not considered malinvestment.

If these are bad investments what are malinvestments?

Malinvestment, a term used by the Austrian economists, have very unique set of characteristics.  To put it simply, malinvestments are created in the private sector during an inflationary boom. They are investments that were made even though there was no or very little market demand for them.  Just like the government infrastructure that served no real purpose because there is no public demand for huge pyramids or bridges to nowhere, the private market can potentially create goods that are not demanded by the public either.  The housing boom that ended in 2008 was a perfect example of this.  The housing sector in the United States created millions of more homes than were not needed by the public.  Keynes never really understood why booms and busts happen and blamed irrational human behavior or “animal spirits” for this.  The Austrians economists were unsatisfied with this reason and wanted to look deeper into the boom/bust phenomenon in the “free-market”.  As the Austrians started studying boom and busts they started to observe unique market characteristics of booms and busts that would later lead to an explanation about their nature. While the Keynesians simply considered booms and busts a natural element of the unbridled free-market without any analysis, the Austrians actually looked at the phenomena in a penetrating way.   The Austrians noticed that booms were characterized by a large amount of investment errors in a small period of time across the economy as a whole.  This is very unusual because the market naturally sifts out entrepreneurs who make poor predictions through the profit and loss system. Poorly run firms incur economic losses and factors in a free-market naturally shift capital to economic actors who make more accurate economic forecasts about future demand.  For entrepreneurs across the economy as a whole to make a series or errors at once in a very small time frame in very odd to say the least and goes against common sense economic understanding of how national economy should function.

The other characteristic that Austrian Economists noticed about booms and busts was that errors seemed to be much larger in long term investment projects that take many years to complete like mines, power plants, and other complex industries.  Short term consumer goods were affected much less by the bust part of the cycle and did not suffer from as large of losses on their balance sheets.  These two observed phenomena that characterized booms and busts lead the Austrians to believe that there was more “going on” than the simple Keynesian explanation of “animal spirits” or today’s term “irrational market exuberance”

If markets naturally move toward equilibrium and market actors in general make good market predictions, what was going on?  Why were booms and busts happening if the free-market should naturally become more stabilized over time?  The Austrians correctly believed that there was another unseen actor on the scene.  Something had to be influencing the system that had been previously neglected by mainstream economists.

This unseen force creating the boom bust cycle was central banking.

The Austrians knew that there had to be something that was influencing how entrepreneurs were making investments. Entrepreneurs, by their nature, take risk in the hope of gaining profit down the road.  Entrepreneurs also take out loans from banks to finance their projects.  Banks charge an interest rate and this interest rate is very important key to whether a investment project will be profitable or not.  Even small change in the interest rate can mean the difference from a profitable investment or an investment that will incur losses.  One way to think about this is to think about the housing market.  When interest rates are very low, a home becomes much more affordable.   A one or two point drop in the interest rate can save a home buyer hundreds of dollars a month. A home buyer that could originally afford a $150,000 house could potentially own a $180,000 or a $200,000 house.  This drop in the interest rate literally changes human behavior because now people can afford a much more expensive house than they could before.  Human beings, being what they are, want the biggest house they can afford and will buy the bigger house.  Entrepreneurs make similar decisions as well. They make investments that are similarly more expensive than they otherwise would have if the national interest rate was higher.  Higher interest rates would have signaled that the investment would not be profitable.  If I can build a property or a factory the can produce a certain amount of income per year, I would need the cost of building the property to be less than the income generated by the developed property to make a profit.  For example, if I built a car factory for ten million dollars because of low interest rates and the cars that were finally produced by the factory produced an income of one million dollars a year then the company would be profitable in ten years. If interest rates were high, the factory could cost twenty million dollars or more to build and this would not yield a profit for twenty years or longer.  Such a long time frame to reach profitability means much more risk because there is no guarantee that the model of cars produced or any product for that matter will still be in demand twenty years down the road.  This could mean the difference from a potentially profitable business and a business that will go totally bankrupt.  A small tinkering with interest rates can potentially have wide range impact that is hard to precisely predict.

As you can see, interest rates can have a profound impact on business and the economy but what are interest rates?  Well, let’s take a closer look. When central banks lower interest rates, money is “cheap”.  When a person takes out a loan the interest rate is the “price” of money.  This can be easily understood with a little critical thinking.  Human beings naturally prefer to have their money in the present.  This should be obvious if someone asked you if you wanted a million dollars now or a million dollars fifty years from now, which would you choose?  People obviously prefer money in the present not to mention that a person could make their fortune much larger if they had fifty years to be more productive with it. People naturally want to have money in the present and want to consume goods in the moment.  Investors have to give people an incentive for people to part with their money.  This incentive is interest; people defer present consumption by giving money to an investor in hopes that he will get more money back in the future. Banks are the intermediary between investors and savers.  Both sides of this transaction gain from it.  The investor gains because he is able to start his project with the capital he received from the saver and the saver gains because he will be able to consume more goods in the future with the extra capital he receives in interest from the investor.  This transaction happens millions of times in an advance economy and is responsible for most modern economic growth.  The lower the interest rate is a signal that there is a large amount of savings in the economy.  Just like any market, the larger the supply of a good, the lower the price.  The more savings there is in the economy as a whole, the lower the cost to borrow savings.  The interest rate is a critical price signal in the economy.  Just like all prices, it creates incentives.  When interest rates are high because there is little savings in banks or because of high demand for capital investment, people are more likely to save because they will get larger returns on their savings.  When interest rates are low because of a glut in savings or little investment demand, people (entrepreneurs included) are more likely to take out loans.  When banks and interest are left unfettered, the market tends towards equilibrium and money is allocated efficiently.  The problems start when central banks artificially lower the interest rate through open market functions (the details of which are not important to this article.)

When central banks artificially lower interest rates across a whole economy it creates false price signals.  Entrepreneurs take huge loans for projects that they would have never done otherwise because money is “cheap.”  Your average person will also often take out very large loans that they use for consumption like buying a car or a large house because they can now afford it. Even worse, people are much less likely to save money because they will receive less return on their capital.   This creates a two fold problem where people are taking out very large loans even though there is very little capital in banks and capital is reduced even more than it would have otherwise because less people are saving because of low interest rates.  This creates an unsustainable boom that will eventually result in a bust.  Simply put, the money simply is not there.  People do not consciously think about how much money is in an economy but instead act upon what the given interest rate is.  It is a price, and like any good, the lower the price, the more people will want it.  When the cost of money (interest) is low, people will demand more of it but as discussed above the money is simply not there.  This is where malinvestment comes in.

The distortions created in the interest rates lead entrepreneurs to invest in unsustainable projects.  Consumer goods are produced when there is not enough demand.  These are the malinvestments.  The houses that were over built in the housing boom where the most obvious types of malinvestments during the last boom but the houses themselves were by no means the only part of the economy that was over built.   Anything associated with housing, like home improvement stores, where built in overabundance.  Also, millions of jobs went into the housing market that otherwise would not have if there was no central bank fueled bubble.  Potentially millions of people are in career fields where there was never the level of demand that they thought.  Construction workers, home loan bankers, real-estate agents and the dozens if not hundreds of other jobs associated with the housing market will have to be reduced.  As you can see, the central bank driven boom and bust cycle not only wastes a tremendous amount of physical capital but it also wastes a huge amount of human capital as well.  The time spent training workers, the energy used to build building/goods and the materials used to build the capital and goods are all lost. This is malinvestment, mostly unrecoverable investment made in the wrong areas of the economy.  Trillions were lost during the housing boom.  Not only were these trillions lost, but if they were invested in the right areas of the economy trillions more of capital could have been produced on top of it.  So not only was there an immediate loss of capital but there was future capital lost as well.  It is kind of like taking away a foundation of a house.  If the foundation was built correctly, the rest of the house could have been easily been built on top of it but if it is not built correctly than the builder also loses the future house as well.  This is what was happening millions of times over during the housing boom, the economy as a whole not only lost present wealth but future wealth as well because foundations were built in the wrong places.  Multiply this process over and over again since the creation of central banking and the losses are incalculable.  Maybe without a hundred years of the boom bust cycle the average American citizen would be able to buy a new car for $5,000 or maybe we would be colonizing the moon, we simply don’t know.  As much as central bank inflation steals money from the people, the distortions caused central banking likely steals much more.  The only solution is sound money and free banking.