Explaining Macroeconomics, The Fed, Interest Rates and Valuations (with Matt McBrady)
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Well, hello, Acquired LPs. Welcome to an episode that is very, very near and dear to my heart. We have a special guest, Matt McBrady. Welcome to the LP show. So great to have you here on Acquired. Great to be here, Ben. It's always great to see you, even if it is virtual in this, you know, new world of ours that we may be stuck in for a little while longer, courtesy of Delta, although we all hope not. Hybrid. Hybrid is great.

Hybrid, yes. Well, by way of background, so I know Matt because we've worked together for a good part of last year on a PSL project.

LPs, like you are in for a treat today. Matt is my go-to person to try and understand all things macroeconomics, Federal Reserve, monetary policy, anything in that category. He's been working on this stuff for over 25 years. He actually worked in President Bill Clinton's Council of Economic Advisors in 1998 directly for Janet Yellen.

You worked, Matt, in the US Department of the Treasury in 99 and 2000 under Tim Geithner, who was then the Deputy Treasury Secretary. Is that right? Yep. I think it was deputy. And then BlackRock, you ran the multi-strategy head fund. You've played in sort of the operating world where you currently sit on the board of... Is the company named Taser or Axon these days? It's Axon these days. Taser is still the brand name of...

the most well-known kind of flagship product, the conducted energy weapon. Yeah.

Got it. And also, you helped get Aquantive off the ground in like 98, 99 running analytics there. Is that right? Yeah. Our mutual friend Mike Galgan and I actually came up with the business model when we were running along the Charles River. And as an ex-football player, I swore I would never run for pleasure, but I really liked Mike's company and he really liked to run. So I essentially had no choice. And we kept running farther and farther because we were having great conversations. And before you knew it, what had come out was

The fundamental idea behind Avenue A and then also the realization that, hey, we might as well run the marathon because we're running like 15 or 16 miles. So two things I never thought I would do before meeting Mike. One, found a tech company, especially back then, and two, run a marathon. And I got a chance to do both.

It's awesome. It's awesome. Well, you talking about the Charles River brings me to my last bullet point in your bio. You have a PhD in business economics from Harvard, and you currently teach at the Darden Graduate School of Business at the University of Virginia. So I think you pretty much have seen every angle of everything we're going to talk about today.

Yeah, I guess I don't stay put very long intellectually or career wise. So I kept sort of trying different things. And if there is a value to having a perspective as a policymaker, as an academic, as a private equity guy, as a hedge fund guy, and as an entrepreneur and armchair angel investor and board member, then I think I'm the one who actually really summarizes that value. If there's no value, and that's just a sign of the fact that ADD people can be really successful in lots of

different capacities, then maybe I'm proof positive of that claim too. I love it. I got to ask, have you seen the meme on Twitter of the deep fake video of Janet Yellen and Jerome Powell and Ben Bernanke singing the Rick Roll song, Never Gonna Give You Up? No.

Oh, we got to send it to you after this. We'll put it in the show notes. This is the best thing on the internet in 2021. Oh, very nice. I can't wait to see it. Well, I wanted to start this with, we're going to do sort of a Q&A with Matt here. And the idea for this spawned from the fact that Matt is in a text group with a bunch of his friends where people will throw in a thorny question about something going on in the macroeconomic world and

policymaking, and Matt is very good at distilling these plain English answers. So Matt, I want to start with a very general question for you, kind of in definitions. So what is the money supply? And when people have heard things like M1 and M2, what are those? I'd say M1 and M2 are great examples of why you rarely ever see a trained economist as either a chief marketing officer or a chief communications officer.

because as a species, we tend to have a knack for making really complex things seem really simple. On the other hand, we're pretty good at making really simple things seem really complex. So, you know, everybody knows what money is. I mean, even my nine-year-old niece knows what money is. It's what she gets when she gets her allowance and she can't wait to go spend it. It's usually kind of on candy and sometimes...

little toys that she figures out how to play games with and beat me every time that she goes me into playing with her. And so that money, the cash in the hand that she uses to spend stuff is M1. And on the other hand, she also, when she's occasionally good enough to qualify for points for good behavior, understands that points translate every two weeks into cash that she then gets to spend. So when she behaves well and she gets those points, that's M2.

It's not more complicated than that because ultimately that's what the feds have been tracking since well over 100 years, although interestingly the St. Louis feds stopped tracking some measures of it. And so M1 is just a representation of currency, coins, notes, and as we all know things are changing. When's the last time you spent any money with those? It also includes things like our savings deposits, our checking deposits, anything that can be readily turned to cash.

And the really important kind of reason that that's distinguished is everything purchased or sold in the economy, which ultimately becomes the GDP, is done with cash at the end of the day. And so then M2 is the stuff that can most quickly become cash but isn't quite cash because you couldn't use it right now today to buy something. And then there's an M3. And there used to be an MZM that the St. Louis Fed recently retired sort of the attempt to kind of track over time.

And so this is literally just a way of kind of tracking things that can be used to purchase stuff or things that will readily be used to turn into things that can be used to purchase stuff. So just to test my understanding, like a dollar bill that I'm holding in my hand right now, I'll just pull one off my wallet here. I'm amazed you have a dollar bill in your wallet. That's so old school. Yeah.

This 50 right here is M1. Yes, that is M1. That is M1. I don't have a stock certificate here in front of me, but I just recently bought some Spotify. What is that? Spotify is not going to be in the money supply, which is interesting because you can actually readily turn it to cash, we know, by selling. It's very, very liquid. But given the fact that it is a security that's outside of the use for immediate transactions, that's not included. Would like a T-bill be like a...

M2? Great question. A T-bill held by someone, you know, as owning the bill themselves in your brokerage account would not. However, money market funds do count. They count and a lot of them actually anyway count in M2 because money market funds actually have got immediate settlement. So you can actually turn in a claim and you're guaranteed to get your $1 back. That's, you know, one of the things that terrified the world in 2008 is when money markets started breaking the buck.

But that would be a whole different podcast episode. So for the layman, is it useful to really think about the difference between M1 and M2? Or is it more useful to just sum them and say, I just want to think about M1 and M2 together total as the money supply? Yep, you are asking exactly the right question. And if you didn't, I was going to take us there next, which is like, why on earth do economists and did the Fed and the St. Louis Fed take a huge role historically in tracking this stuff?

And it's because different measures, usually the aggregate measure, consistent with your intuition of money supply, which is summing up all of these things, tended to correspond really closely with inflation or more directly with the aggregate GDP, gross GDP. Makes sense, right? Because as I started off by saying, even my nine-year-old niece knows that what money is, it's the thing you buy stuff with.

And so if you kind of track good enough data on the total amount of things to buy stuff, that should correspond to the total value of stuff bought. And so that's why it was all tracked. But interestingly, and I think we're going to come back to this when we start really getting more into the meat of does any of this stuff work anymore or matter anymore, is the relationships that were historically very strong really started breaking down around 2000. I'm

And that's perhaps one of the reasons why St. Louis Fed's no longer tracking some of this stuff, because why bother? The relationships really aren't there that used to be there. So is there like a percentage of our total economy that it's healthy to have in the money supply? Or should the money supply sort of match one to one the entire value of, I don't know if it's like America's assets or America's GDP, what the right comparison would be. But is there any sort of ratio we try and maintain? Yeah.

Yeah, this is another fantastic question and it'll sort of get us probably to what we want to talk about next, which is kind of how and why monetary policy works. And we'll eventually get to why it's profoundly different today and has been ever since the advent of large scale QE, you know, over 10 years ago in the US and around 10 years ago in the US and almost 20 years ago in Japan.

So for kind of ever, leading up to 2008, if you look at the Fed's balance sheet, which is a good measure of the sum total of at least the direct stuff in the economy that the Fed is kind of managing as money supply, then you saw it was about $800 billion. And as we now know, the Fed is currently adding an additional $120 billion every month to

to its balance sheet by buying securities. So that gives you a scope of how much things have changed. And so for a long time, it was firmly held belief among economists that you really didn't want to monkey around with the overall size of the Fed's balance sheet. And instead, monetary policy was conducted through an entirely different channel called open market operations that I'm sure we'll get into when we get into some of the nuts and bolts of how all this stuff works.

So, you know, it is very intuitive to think there should be a relationship between money and the overall size of the economy. And there was, in fact, for a very, very long time, we talked about because it corresponded very nicely to the size of GDP, you know, the aggregate measures of money. And, you know, now, however, with the standard relationships breaking down, because I think the economy has just changed in a profound way, it's less clear whether it really makes any difference at all.

This is great. We got to ask, like, what's changed? This requires a little bit of a sort of walk down memory lane and a bit of the sort of simple explanations that really underpin most of everything that can be understood. And, you know, and really to kind of understand what's changed, we have to go back to sort of why monetary policy works so well for so long. And when we go back to that, the simple starting point is,

in a world that really described the early part of the 20th century, and actually, frankly, most of the 20th century, all the way up through, you know, at least through the 1990s in the U.S. when, you know, the end of the 1990s when we repealed Glass-Steagall, most of the purchasing power in the economy really was people who were holding currency or

or people who had their money in a bank, or people who could borrow money from a bank. So as long as banks were kind of the center of the financial universe,

then it makes a whole lot of sense that by controlling the sum total of this stuff called money that banks had access to, you could do a really good job of controlling the aggregate amount of purchasing power. And that was the story of the beginning of the Fed and the beginning, frankly, of modern sort of fractional reserve banking. But that story began in a really inglorious way in the turn of the century and even before with just series of bank panics after bank panics after bank panics

because banks were allowed to be state chartered. Some of them were independent. They could really just create these pieces of paper saying, I owe you. And this was an I owe you. And if you're a reputable bank, other banks would take it. And so that was money just like it is today. But it was kind of a free for all. And when, just like in It's a Wonderful Life, someone got nervous--

It's like that tells you all you need to know about central banking history and monetary policy theory was, you know, it's really kind of orchestrated around this notion of these fragile banks that can fail. Back then, what you needed was some type of an entity, which is kind of where the Fed came from, that could extend credit to banks when it's like, oh, boy, I was really nervous that bad bank A is going to fail.

Maybe we can choose to let that sucker go, but we can't allow that to trigger a panic around all the other banks. And so somebody's got to step in and say... And we've got to protect the customers of that bank. Yep. And so the customer protection came in 1933 with the creation of the FDIC. And that was all part of the Glass-Steagall Act, which was the one repealed at the end of the 90s when, hmm, coincidentally...

A couple of years later, those relationships broke down between money and the aggregate purchasing power of the GDP that's observed in a subsequent period of time. I don't think about it much in these terms. As always, this is not financial investment advice on the show. But like, I don't know about you guys, but I'm trying to keep as much of my wealth like not in banks as possible. Not because I hate banks, but I'm just like, you know, it's better elsewhere, right? Like, why bother?

Yeah, yeah. No, in fact, this is basically a bit scattershot and it'll make more sense if we kind of get through how the systems evolve. But since banks right now really don't make loans anymore, which is one of the reasons why they are not the sort of central feature and kind of controlling the extension of purchasing power into the economy, because banks right now are really just giant securitization machines, which means, you know, they don't actually make loans for very long at all. They warehouse stuff, they put it into a

big bundle and they sell it off to the securitization markets. I mean, that's stuff I used to play in in my hedge fund days. So you're saying banks, they basically don't carry a big debt load on their balance sheet in the way that they sort of classically always have because they don't actually own the debt that they're lending out. They repackage that and quickly sell it off.

Yeah, rather than the debt load, the asset load. So in the old days, it was just loan and hold or originate and hold banking. That was like, you know, I had loan officers. They went around and they decided you, Ben, are worthy. You know, Ben Incorporated are worthy of a loan. And I'm going to give you one and I'm going to keep it on my balance sheet. And I'm going to check up on you every, you know, every month, every quarter, every year. And as long as you don't violate my covenants, you're going to keep it and I'll give you more loans. And if you want to expand, I'll give you an even

bigger loan. That was the world in which monetary policy makes a lot of sense the way that we've always done it. Because if you control the amount of money banks had to lend, then more Ben Inks would get bigger loans and build more factories to make more, you know, I guess, widget insights, more podcast episodes, more podcast episodes.

And now on the other hand, the securitization market, it's literally, let's find a thousand Ben Inks. Let's make short-term loans to them, sort of extend the money to them. But I'm expecting to then get that right back because I'm going to take a package of that and I'm going to send it, sell it to the markets, get the money back. And it's rinse, lather, repeat, reload, just keep going, keep going, keep going. So you need enough capital to sort of keep that machine going. And we can't afford to have that machine stop. That was what happened when

when Lehman went under in 2008. But the extension of more cash into the banks who are doing this is not a first order driver of having them make more loans and get more securitizations done.

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Before we get to that point in history, I want to hear a little bit more about the history of the Fed. So you talked about the turn of the century, some runs on the bank, a lot of instability. The Fed is older than 1900, right? Or is it a fairly recent innovation? It's not. No, it's really interesting. Probably, in fairness, I would say the motivation for a Fed actually first probably took hold or started to roost in

in 1893, which was a really nasty depression. It was actually what we thought would be the worst depression we could ever have until we had the Great Depression. And it was finally enough to get the largely rural, when they called themselves progressives at the time, to get over their sort of fear and hatred of the centralized, money-powered interests of the eastern cities. I mean, this is just like American history stuff.

like at its core. And finally it was like, man, we can't afford to keep having these bank panics that trigger large scale recessions and now a depression for God's sake, we got to do something. But then as soon as the economy started booming again, it's short memory syndrome, you know, the different political powers would come in and go, nope, not a priority. And you

In 1907, there was another big bank panic. Once again, J.P. Morgan had to come in and literally lend money to the banks to save the American economy. Like J.P. Morgan the guy. The guy, back when he was a financier. He had a bank, of course, and it's still the same bank that still bears his name today. So a proud history for that institution.

So, you know, that was kind of the last straw where it was like finally everyone got together and then there was just a bunch of political wrangling over what it was going to look like and how it was going to be shaped.

And then finally, years later, the Federal Reserve Act finally came out five or six years after that. And the Federal Reserve Act was what gave us what we still see as the backbone of the Fed today, which is a decentralized central bank. We don't have a single building like the Bank of England with a big sort of monolithic building. We've got the 12 regional banks that are all kind of coordinated by the Fed Board of Governors, which is here in D.C., not far from my home.

And, you know, its job originally was literally to have these banks scattered throughout the country to make the loans to, you know, Jimmy Stewart's It's a Wonderful Life banks whenever those banks actually ran into panics. It was really pretty neat. And back then the aha was, ah, all right, if the banking system collapses, purchasing power collapses for exactly the same reason you see in the movie.

Purchasing power being like Americans can't buy stuff because they don't have any money because the bank that- The bank just went away. Like, wait a second. The bank where they were keeping their money lost their money. Lost the money, exactly. And it's this wonderful reflexive thing, which is why you can't allow banking systems to collapse because the bank panic,

can actually make good assets be bad assets because all of a sudden if they're illiquid, but there's nothing wrong with them, then there's a bank panic. Everyone basically says, shoot, I got to sell these assets. There's no way to buy the assets too. The values go down. People lose their jobs because there's no purchasing power. And then all of a sudden firms that were going to pay their loans back can't pay their loans back. So that was the beginning of the Fed. And then the evolution of the Fed is what's been really pretty neat as well. It was a

Literally, as globalization happened, ironically through World War I originally, when the banks started first extending or accepting bankers' acceptances to support international trade, it's gradually figured out better ways to do it, saying, "Huh, my job is to make sure credit flows in the economy

whether it's wartime, bank panic time, anything else. And that means I, the 12 regional Federal Reserve banks have got to be willing to actually bite my lip a little bit and sort of jump into the abyss and say, I'm going to lend when things get scary and then keep the system going.

And then eventually out of that, you know, sort of a few years later, through the actions of a really insightful central banker from the Central Bank or from the Federal Reserve Bank of New York, open market operations were created when he said, huh?

Rather than just actually giving credit to banks, maybe another way I can extend more purchasing power in the economy is to buy government bonds. Hmm. Let's give that a shot. So this was the beginning of the linking of monetary policy with fiscal policy. Yeah.

Yes, yes. Although not yet fiscal policy because those were government bonds that already existed. But you're kind of getting us right in the direction of kind of what modern monetary theory is all about. And we'll get there toward the end of the episode. I know. How did the Fed in its original incarnation, how did it have money to lend to banks if it wasn't originating from the federal government? Where'd the money come from?

Yeah, it came from, it had the ability to create money. Because remember we went back and said money is cash and currency. That's the easy stuff. That's the stuff that my niece really understands. But it's also bank deposits. And where do you think all the banks put their money? In the Federal Reserve. And so whenever the Federal Reserve wants to actually give credit to a bank, all it does is make a book entry transaction.

It's like literally, hey, guess what? Ben Bank, you know, you now have an additional hundred million dollars to spend. I've just given it to you. It's on deposit in your account. And then poof, money comes out of nowhere. And by the way, it still works that way.

Okay, so there's an innovation that suddenly now the Fed, instead of just doing deals with all the banks who have these bank charters, there's now another participant in the system, the federal government. How's that work?

No, the federal government's actually sort of not in the Federal Reserve System. The federal government's on the other side. That's fiscal policy. And the central bank, that's monetary policy. And so never the two shall mix until we get to modern monetary theory and the actual actions of the last couple of years, even though it hasn't been explicitly done with explicit acknowledgement that it's being motivated by those principles.

So historically, the government's just a totally different actor. It's out on the side basically saying, "I'm raising taxes, I'm spending money. Sometimes I run a deficit when I spend more than I'm raising in taxes. Other times I have a surplus when I raise more in taxes than I spend. I try to keep books about balance." That's going to have impacts on the economy that are maybe analogous in some cases to monetary policy. But think of monetary policy, especially back in the early days where it was being created,

It was not a fine-tune the economy kind of exercise. It was keep banks from going bust.

And then it really expanded from keep banks from going bust into more creative stuff with World War I, when it was like, we need to finance the war effort in Europe. We're not yet in it. And we can do that because, you know, our productive resources are still fully functioning. And in Europe, they're getting bombed and sort of shut down. So, but the way we can do that is we got to somehow enable the companies that are making stuff in the U.S.,

to get cash to make stuff when it's gonna be a while to get it from Europe. And in fact, the way things used to work back there, what I referenced earlier, these bankers acceptances. So a European bank would say on behalf of a buyer of American bullets or guns or whatever we were selling back then, or provisions and supplies,

would say, you know, "Hey, here's a good IOU. Trust me, I will pay you as soon as the goods get there, but it's gonna take a while to ship them." So they would get this thing called an IOU, the bankers acceptance, and companies would be like, "What the hell am I gonna do with this? I can't pay my employees with this." So they would go to their bank and their bank would likewise gonna go, "Well, what am I gonna do with this? I'm not gonna get paid for five or six months. Okay, I guess I'll give you some money, but it's gonna be at a really high rate." And then the Federal Reserve back then, banks started saying, "You know what? I'll take those.

I'll take those and then I will give the bank credit and I'll give the bank credit on better terms right now. And so that lowered the price of financing and increased the ability to export to support the war effort. So, you know, pretty neat. I mean, it's like it's amazing how much of the Fed, the evolution of the Fed has really been driven by just creativity.

adapting to the demands of the day to keep the flow of credit flowing. The Fed is like a, they're like cap chaser pipe for software companies today. They're like, Oh, you've got these forward, you know, SAS revenue contracts. Like I know you're going to get that money. Uh,

I'll take those contracts and I'll give you the money. Or Stripe is literally watching all of your payment flows and can dynamically send you an email that's like, by the way, we just approved you for this line of credit. Let us know if you want it because we have underwritten in real time based on your source of truth data. It's crazy this stuff that's happening. You know, what's so cool about that, guys, too, is that's arguably why this

monetary policy doesn't work anymore. I mean, I'll tip my hand and I guess I probably shouldn't say this on an episode. I may request you guys pull this down because I may go to work for the Fed at some stage. I mean, I do know a lot of folks there and I'm not sort of disparaging any of their efforts. I'm just saying, you know, in a world where if you kind of go back to first principles from the beginning, again, keep it simple.

the simple story of, you know, when the Fed worked really well, it was when banks were the first order driver of the purchasing capacity for every agent in an economy, a firm, a person, you know, like ultimately that's just not the case because now there's so many different ways to get money that have nothing to do with the conventional banking system, or at least they need to be supported by a healthy one because that's where we store our money and we make our payments back and forth. But in terms of actually a source of borrowing, it's just

I just don't see that being important anymore. To try and pare it back, my understanding, because the banks aren't the one who hold the risk. There's lots of participants in the ecosystem now who are willing to bear risk. Yeah, if you and your listeners have heard the term shadow banks, yes, I mean, that's kind of a murky sort of

you know, rather more exotic probably than it deserves to be sounding, sounding term. But it was originally coined to, you know, to refer to a lot of the securitization markets that were actually creating short term loans to companies through, you know, securitizations and, you know, commercial paper and things like that that were held by other entities other than banks. Like, huh? Interesting. These are shadow banks. So that's what cap chase pipe stripe like, you know, square all these companies are doing. Yep.

Yep. And it's interesting because ultimately when you can get cash or something you can finance out of those, again, that's just another source of generating purchasing power, which is not really responding to conventional monetary policy. All right. So, Ty, everything you just walked us through to your statement at the top of the episode that there's an extra $120 billion of debt every month. How does that mechanically happen? So, the mechanics since the Fed...

provided exceptional stimulus in COVID. And that's the big debate on when's taper going to start. And is it going to start in September? As soon as September? Is it going to be November? Is it going to be next year? And we've seen a few different episodes of when the Fed started tapering, trying to taper its support, not ending in pretty terms for markets. It's always seemed to increase volatility and cause some really pretty sharp, nasty mini corrections before the Fed goes, ah, just kidding. I guess I'll stick with it. But

But the extra 120 is literally the Fed's commitment to buy additional securities from the market that it went into. And, you know, and it's through its series of programs last year, every single month. And so every month, just like we said before, just like in the old, it's a wonderful life world where it's like,

Ben Bank Inc. needed actually credit, the $100 million of credit to stave off nervous customers and reassure them in a bank panic. And it just said, you know what, Ben, hey, guess what? I've just increased your account here. They effectively do the same thing now. They go to the dealer banks for the securities that they're buying and they say, you know, guess what? I'd like some securities. So they take the securities.

pull them out of the market and they credit the dealer bank with just newly created dollars and that, and that dealer banks account. So the dealer bank gets paid for it and it

In the markets writ large, every month now, there's 120 billion of extra buying pressure from the Fed. Yeah, from the Fed. You know, and boy, if any of your, you know, your listeners are wondering kind of why is it the valuations keep running every single month for companies at lower and lower levels of development and, you know, two guys, a dog who's

cute enough and is friendly and a good pitch book is getting a $20 million pre-money valuation, then I have a pretty simple answer to that. There's just a heck of a lot of new purchasing power being created, and it's not purchasing new goods and services. It's going right into capital markets. Okay, so the Fed is now holding all this stuff. I don't actually know the right words for this $120 billion of stuff. Yeah, what did they do with that?

Why isn't it a bad thing? Give me the bull case and the bear case. Let's try and do both sides of this argument. Is it a bad thing that the Fed is now the owner of all this stuff? And what is the stuff? Let me give you the high level answer and then say it's going to make a lot more sense if we back up a little bit. We've talked a lot about how monetary policy used to work. We haven't talked much about how or why it maybe doesn't work.

anymore. You know, we also, I'm not sure how interested your listeners are in inflation, but we also didn't really kind of give us so far, like monetary policy has just been a, you know, has been kind of the hero. Like they're the Marvel comic. The next thing it's like, you know, captain monetary policy, he swings in and sort of prevents banks from collapsing and it

It's really cool. But most of, at least my adult life as an economist, you thought more about monetary policy being the sneaky villain who lurks behind the dark corner and then unleashes the wrath of inflation, which will be like burning through a city and sort of tearing down other buildings, just not banks.

And so we should probably touch on that at some stage, too. So the high-level answer, though, about is it a good thing or is it a bad thing? You hear a lot of this reference to this in the press. It's a good thing if you really do believe that, hey, in exceptional times like during COVID, with a Congress that was not ever going to pass any fiscal support. Remember what the other side of this equation is? Governments can basically spend money to support the economy. That wasn't going to happen.

or it wasn't going to happen particularly as strongly as the Fed was going to worry about. And the Fed can frankly just act a lot faster because they don't need acts of Congress. So when this all first started happening, they were like,

I got to act really aggressively. And the only tool I got because interest rates are already pretty damn near zero, or actually they already were zero or close enough, take interest rates to zero. But that's not making much of a difference because they weren't very high to begin with. And so now I'm just going to buy a bunch of stuff because I'm trying to flood the markets with this cash.

Good thing in that, you know, maybe you got to do something. The only person who could really act was the Fed. You know, bad thing if you stick with it for too long, and this is what more and more folks are calling for, is just distortions in asset prices. Create asset pricing bubbles, you know, possibly be a world where you're keeping companies that don't deserve to refinance their debt alive and they're just consuming resources from the economy that ought to be more productively deployed elsewhere.

And so when you're referring to that, this is all happening before the stimulus checks, because you're saying this was before any fiscal policy to get the government's dollars out into the people's hands. Correct, because the Fed acted much faster because it could. And then ultimately, we did see that the stimulus was much bigger than I expected. In fact, you know, in conversations back and forth with my former colleague from the Clinton administration and good friend, Dr.

Dr. Doom himself and Oriol Rubini, we were kind of chatting back and forth saying, all right, how big do you think we need and how big do you think we're going to get? And as always, he was pretty much spot on. He was like, I think we need more than $2 billion. And I was like, boy, we're never going to get that, man. And he was like, no, I don't think we will either. But we ended up getting it. And I remember then sending him a note going, whoa.

Man, they actually did it. Interesting. So we ended up getting a big fiscal stimulus. And one of the reasons why modern monetary theory is on everybody's mind right now is because ironically, COVID had us first do the big time monetary policy and commit to it. We're not going to change it. And then big time fiscal policy came.

Fiscal policy has been on the sidelines since the wake of 2008, 2009. In fact, when Ben Bernanke created QE in the United States in 2011, quantitative easing, which we'll get into that in more detail, it was because he was essentially pleading the way that central bankers can in a very polite and signal-oriented way for fiscal policy and nothing was happening.

And so it's like, hmm, no choice but to actually create this tool, which then was used in the big bazooka way and to fight COVID in 2020.

So because we got the monetary policy and the fiscal policy, that's kind of what MMTers or modern monetary theory folks are asking for. They're just asking for it to be integrated with fiscal policy always and everywhere being extended, spend more money by the government whenever you want to stimulate the economy and have the Fed essentially just be a passive supporting actor to just mop it all up and create more money when it needs to, just to finance whatever spending is needed to keep the economy where it is.

All right, I want to tie up some loose ends, and then I want to get on to quantitative easing, modern monetary policy, and inflation. But to tie up some loose ends, what's the argument that it's a bad thing that the Fed now has all these assets on the balance sheet? And what are the assets? Are they buying company stock?

First, give some definitions because that's the important part. We haven't yet talked about in the modern days, we did actually get, we got into the 20s or 30s and started talking, jumping right to the 2020s. I warn everybody up front that maybe my career trajectory sort of gives you some sense of the ADD tendencies or preferences of my brain, but I do like to jump around. So I apologize for folks who are more linear. We could do that too. We just have to record another episode. So

We are kind of in the 20s or 30s when I kind of said the Federal Reserve Bank of New York governor kind of invented open market operations or what we now call open market operations by saying, huh, I can really increase the supply of credit or purchasing power into banks by buying government securities.

Turns out that then sort of matured and grew into the current framework that the Fed's been using really for as long as I can remember, probably really since the 40s or 50s, by controlling interest rates. Government securities being like treasury bills? Yep.

Back in the early, early days when it was done by the Fed in the 20s, it was government securities. So it was treasury bills. Absolutely. And more recently, it's been conducted. And by recently, I mean literally as long as I can remember. And we didn't really talk about the history of this stuff in grad school. So I don't know, maybe it goes all the way back to the 20s or 30s and it evolved from there. But this is done by the Federal Reserve Bank of New York still and something by a group called their Open Market Operations Desk. And

Everybody always wants to know how on earth does the Fed control interest rates? After all, if you've taken a single economics class, you know, there's a supply curve, you know, there's a demand curve and the price is the, where the two of them intersect. So to say you control a price is like scratching your head going, huh? You can't control a price. Not if there's a supply and demand curve, that's the result of the intersection of the supply and demand curve. And so the way that actually this works is,

is the open markets operations folks are deeply embedded in the dealer banks that create the money markets in New York, which are all these really short-term borrowing and lending back and forth between banks. And they have a really good sense of how much banks need to actually have on hand because banks have to hold a certain percentage of their deposits in the Fed.

And if you don't have enough deposits in the Fed, you get sort of a slap on the wrist and a penalty, and everybody's got to basically do that. And so the way that interest rates are controlled is the open markets operation desk basically puts more money into the system if it needs to actually increase the money supply to target a certain level of interest rates by not buying outright government securities all the way up until Ben Bernanke responded to the financial crisis

with the first QE, they would instead buy and sell things called repos.

which are weird to everybody who's never been on Wall Street. I even wrote a paper on them, published a paper on them because they're weird to me after finishing a PhD in financial economics. I still was like, how does this work again? And why does this security exist? And what a repo is, is literally it's agreement to buy or sell something and then turn around sometimes the next day and sometimes a week later, sometimes a month later, sometimes three months later and reverse the transaction at a preset price.

And so, you know, for all the way up until quantitative easing was actually introduced, the way monetary policy worked was these short-term reversible increases or decreases in money supply because the open markets desk would go in and say, "Aha!

the federal funds rate is getting a little bit higher than our target, shoot, we need to increase money supply to bring it back down. Because I don't control the rate. I actually can only control supply. That's what I do. And so I'm going to now increase supply by buying a bunch of repos. And I probably have that backwards. It may be reverse repos because I always forget whose perspective the terminology works from, the Fed's or the dealer's.

And what that really means is it agrees to buy a bunch of securities. So I'm taking now securities out of circulation. I'm giving money into circulation by crediting the dealer bank's account at the Fed. But I'm also at the same time saying, I'm taking it right back. So they're fine tuning to get the interest rate they want by changing the amount of cash effectively in circulation with these short-term transactions of pulling securities in or out of the markets. And it's all going on in the money markets.

which are controlling short-term interest rates. It's the federal funds rate. That's specifically what's targeted, but that's historically been very tightly related with LIBOR and all these other sort of indexes of short-term interest rates. So that's how monetary policy always worked. And it worked essentially that way as the ultimate evolution from what we talked about back in extending credit to banks to avoid bank panics. And then you get into quantitative easing. The insight there was that

We seem to have actually sort of given banks as much money as we can possibly give them and it's not doing anything. They're not actually, no more loans are happening. Like nothing's really going on and as a result,

This was after 2008. So 2008, the aftermath of the financial crisis is where we got zero interest rates for the first time. And the zero interest rates was a classic, I trust we aren't sort of too regulated to say, oh shit moment for the part of all policymakers. Because the key sort of models underneath macroeconomic policy and monetary policy are

really based on this notion that, you know, the way that you stimulate the economy is by lowering the interest rate. And when the interest rate gets to zero, it was like,

Man, I guess I remember in grad school, we all said that what mattered was the real interest rate, not the nominal interest rate. So I know, I guess we got to start some inflation. So let's see if we can kick inflation up just for the purpose of getting the real interest rate down and maybe something will happen. And the desire to create inflation, which is kind of a bizarre thing, but you hear central bankers talking about it all the time, the desire to create inflation. Inflation is too low. Ask most American households, like,

"Does inflation too low bother you?" They're like, "No, inflation too high really bothers me, but because this is the way central bankers think is it's about getting the real interest rate lower, we got to do something." This was back as I alluded to Bernanke was pleading with Congress and through the way that a central banker can do so through code and messaging and answering questions when he's hauled in front of Congress to testify about

why on earth the monetary policy wasn't working that he had done, as aggressive as it was. And he was like, let's just be clear. Monetary policy is not a panacea, and it's not the right tool to fight this. What he was saying is, give me some fiscal policy, please. But when Congress turned a deaf ear, he was like, I got to do something. So I'm going to not actually tell the open markets operations desk to buy a bunch more repos, which are these short-term repos,

ways of getting money into the short-term interest rate market because short-term interest rates were essentially already zero. It's like, I can't do anything there. Aha, I'm going to buy long-term bonds.

I'm not going to buy them on repos, I'm just going to buy them outright." That was the birth of quantitative easing in the United States. We went and bought first only treasury securities. Ben, you started me off on this path by asking what to buy. It was really thought to be pretty aggressive even by American economists at the time to even buy treasuries because those of us who really understand how the bowels of the machine work were like, "Whoa, this isn't a repo. This is now increasing the balance sheet."

Because all of these sort of short-term transactions are what kind of kept the Fed's balance sheet, the total amount of stuff it had bought and held at around that $800 billion level for a long, long time because they're reversible. So now all of a sudden it's like it's buying stuff and that's creating extra money, which is going to flood into the markets and...

heaven forbid, and then according to the old paradigms that Milton Friedman sort of coined as monetarism and lots of other folks had similar ideas, you know, a massive increase of the money supply always and everywhere was supposed to create inflation. So everyone was like, this is going to be a little ugly. Also, is there an element of fear here too, that like you're kind of connecting your exhaust up to your intake in that like you're buying, like one part of the government is buying the debt of the other part of the government, right? Yeah.

It is a little strange, isn't it? You know, this sort of gets back to the, you know, the fear of inflation, which is what a lot of folks were worried about. They're saying, hey, we've got these big, even though, you know, Bernanke and everyone else who's an economist was saying we need bigger fiscal policy. We need more aggressive support for households. You know, we need income support. We need, you know, infrastructure. We need lots of other stuff we're talking about now back then.

And it just wasn't happening. So most of us who are economists said it needs to be more. But the very traditional rooted in the history of monetary policy and economic thinking folks were very much like, oh, my gosh, my central bank is supposed to be independent on purpose from the government so we can keep inflation at bay. And now we've got all the biggest deficits we've seen in years and years and years at the same time as we've got this aggressive deficit.

who's buying government bonds and exactly like you said, isn't that just basically printing money and giving it to the government to spend? And the answer was, yes, it was actually. And so it certainly made a lot of folks nervous either for inflation or a lot of economists at the time were really writing a lot. And this is amazing to me that it just stopped being a topic of conversation about what's the exit strategy gonna look like. When Bernanke explained why he was doing this,

it was his description or his logic was as follows. It was, boy, right now everyone's afraid to take risk. Nobody wants to own stocks. Everybody wants to own safe stuff. So I'm going to go and buy up lots of the safe stuff, which are the government bonds. And by definition, if I'm taking literally hundreds of billions of dollars of government bonds out of circulation,

then investors by definition are going to have to substitute into risky assets. Right. Cause there's nothing else to buy. There's nothing else to buy. Right. So it was like, I'm going to force you into doing the thing that you don't want to do. And then by doing so, I'm going to boost asset prices.

I'm going to get them up from the depths they'd fallen down to after 2008. And it worked. All of a sudden, there wasn't anything else. All the safe stuff's getting purchased by the Fed. We got to put our liquids, investable resources into stocks and riskier stuff. They started rallying. And then we've got our markets up 400% since then.

Oh, it's fascinating. I mean, people 13 years later definitely bought a lot of stocks and prices of stocks definitely went up a lot, as you suggest. Did the other thing that they were trying to accomplish, which was to reduce the real interest rate, did that happen? Yes. I mean, thank you for bringing me back there. Not because it happened, but because that is one of the most pivotal parts of the story to tell. And I kind of glossed over it at first.

Remember, underneath all of this stuff was macroeconomic models that are the type that I learned in graduate school and that we were so proud of as economists. We're secretly envious of mathematicians and physicists and everything we did and anything you published had to be turned into a mathematical model that had a formal closed form solution. And we had these elegant models.

And every one of the models basically said the key to getting the economy to grow is getting the interest rate

down, the real interest rate down beneath what every model had a concept of, which was something which is most typically known as the neutral rate of interest. So there's a neutral rate of interest, which keeps the economy humming at just the right level to keep its resources fully occupied. When a big shock happens, all of a sudden you have a bunch of

idle resources, people unemployed, factories that are closed, but bigger frictions in the economy. And so, you know, now we got to get the interest rate down so we can overcome those frictions in the economy so that we can get growing again. And so Bernanke would have absolutely loved to have a world where he could have cut the nominal interest rate. And if he was able to do that,

How would he have done it if he could have reduced the nominal interest rate if it wasn't already zero? Who would he have been telling to do something differently? Oh, the Fed, the open markets desk. The open markets desk, exactly. But since they'd already done their job and kept rates pinned straight at zero –

They were offline. Nothing more they could do. And so he's like, I got to do the other thing I can do, which is go buy these securities. Maybe it will drop the long-term interest rate, which would reduce cost of capital. And I guess that's probably going to make people invest more stuff because that's what my models all say.

And hopefully by investing more stuff and maybe lowering the price for consumers of buying things like cars and other things you've got to basically finance, then we'll get more demand. And then hopefully that'll generate some inflation. Restart the economy.

As soon as we restart the economy, that's going to be great. And it's going to be even better if we can generate inflation out of it in addition to restarting the economy. Because then that zero interest rate is going to turn into a minus one or a minus two as long as I can get inflation up to about 2% again. And so then we'll be gangbusters. We'll start growing right back. Everybody will go back to work. And whew.

Then I can sneakily start pulling away some of the punch bowl, which in this case means that all of these securities I bought and created brand new money for, and then I've got on my balance sheet, I'm going to try to give back to the market at some stage when the market's not paying attention.

And so that actually is what Bernanke more or less tried to do by very casually referencing the fact that at some stage it would be appropriate to taper the purchase of bonds after the first sort of giant sort of open-ended QE was launched in 2011. And if you guys remember, I don't know if tech folks were paying attention. I was paying attention because I was running a hedge fund at the time. But there was this thing called the taper tantrum, which I thought was very cleverly termed.

And it was a big deal for anybody trading liquid securities, especially government treasuries. It created a huge crash of the bond markets in a short period of time. And all of a sudden, everyone who was paying attention, which was mostly folks who had a background in economics like me who were sitting on Wall Street, were like, oh, gosh, it's not going to be that easy to get out of this QE thing, is it? This is not even the Fed trying to sell bonds.

No, this was just slowing its purchases. Wow. Which I'm sure Bernanke at the time was thinking, I mean, he's a very precise man, incredibly smart. Also, as any central banker is keenly aware that every one of his words is scrutinized even in Q&A, which is when he mentioned this. So I have no doubt he was very deliberate about thinking, you know, this is a concept that's going to be safe. I'm just going to be talking about slowing my purchase. I'm not talking about

in a stopping, I'm slowing them. And I'm sure not talking about selling the stuff that I actually own. And that was enough to make markets get really scared really quickly. Interesting. So this was like a little preview of, you know, the sort of episodes we've had in the past, you know, 12 months here where when Jerome Powell, you know, makes some sort of offhanded comment somewhere and then the markets crash because they're like, oh, well, good times are coming to an end. Yeah.

You are 100% right. And in fact, there have been a couple of other episodes since the original taper tantrum where in Jerome Powell early in his tenure, I remember thinking, okay, new sheriff in town. This guy's not a trained economist. Maybe he's going to be more focused on asset price stability and avoiding bubbles and all the downside. Ben, you asked a lot earlier about what's the downside of this, the downside of the Fed owning a bunch of stuff and now having more than 60

times the amount of stuff on its balance sheet that it ever held before 2008. The downside of that is asset price bubbles and financial instability. So I thought, here's Powell, not an economist. He's going to have real world market sensitivities. He's going to talk tough. And he did talk tough. And I was like, yes.

I was helping build an internal investment office for a large nonprofit at the time. And I chose to do a hedge fund thing while I was managing money for them, which isn't probably a good idea in retrospect, which is like, I went really short duration. That means like, you know, well underneath the targeted amount of bonds we held in our portfolio, because I was like, yes, he's going to

actual taper and he's going to cut off the QE supply and it's going to be beautiful. And so I don't want to be holding a bunch of bonds when interest rates go up and their value goes down. And I was very well compensated for that decision for a short period of time until he then said, "Ew,

Things are getting a little too scary. And markets actually had taken the nosedive that they did. And all of a sudden he decided to, no, no, we're backing off. We're okay. And then they went right back in the other direction. Good times. Keep on rolling, baby. Yep. Wow. Which is also the hilarity of the meme of the never going to give you up Rick roll. Completely. I come back to that one. I mean, boy, it's exactly what's up. What's going on. I think right now.

Well, so one question that I would have, like the rat brain question is, well, how on earth are we going to stop buying all this stuff? Is the Fed going to stop buying all this stuff and actually start selling some of it? But I think the second order question is, is this okay? Like, can we exist indefinitely with the Fed being large or getting larger and larger? It's a wonderful question. And in fact, it probably gives us a good excuse to go back and talk about why it is that

People are afraid that an increase in money supply creates inflation. And let's start actually in the simple way of the way that economists have always thought about it and frankly still do in a way that I think is probably wrong, which is just about good market inflation, goods and services. So like the inflation of the stuff we buy, let's hold aside the asset price inflation for a second.

from the point of view of old time monetary policy. And remember, let's just go back to that sort of bank centered world where in the world was really simple. And you know, there's people, the things that people use to buy stuff, either was money they held in banks or in their pockets or money they could borrow from banks.

In that world, it was pretty darn dangerous that if you basically sort of doubled the money supply, in this case, we've quadrupled it or quintupled it. If you doubled it back then, that would have been pretty scary. It would have been pretty scary for pretty straightforward reasons. I mean, just the high level intuition of at any given time, there's only so much stuff an economy can make.

right so like imagine a a sort of simple world you know sort of to play this out in kind of a toy example imagine a simple world in which there's a thousand dollars worth of goods and services that are provided by a basic economy every you know every year and in turn there are a thousand dollars worth of you know either dollars in circulations or people who've got deposits in banks

and kind of that world, then we've got a situation where even if the Fed were to introduce an additional $100 into the system by say going, "Hey, Ben's Bank, Ben Banking Incorporated, I'm going to give you an additional $100 to lend out." And you're like, "Well, that's great. I'm going to lend it then." And so you lend it to David and then David basically says, "Cool, I got a hundred bucks.

And he deposits it in another bank. And the other bank's, cool, I got $100 in new deposits. I'm going to put $10 in the Fed and I'm going to take $90 and I'm going to lend it to Matt. And Matt goes, cool, I got $90. I take it to a bank, says, cool, keeps $9 with the Fed and it just keeps going again and again and again. And this is the classic sort of money multiplier idea that everyone probably heard of if you had a first course in finance.

and that underpins the velocity of money. And in that sort of world, even a $100 increase in the money supply would translate into an additional thousand because of this sort of this circular logic of everybody's loan becomes somebody else's deposit, which is more loans. And in that world, suddenly our economy that started off only having $1,000 of purchasing power has $2,000 of purchasing power.

And the price of everything as a result would double. Right. Because there's still the same amount of goods that are being created. There's still the same amount of stuff. But.

Before it cost $1,000 for everything. Now there's $2,000. So it's going to cost $2,000 for everything. In a way that the analog I always think of, and this is imperfect, but it's like dilution. Lots of our listeners are very familiar with owning shares of a company. Imagine if they just said, now there's twice as many shares. Like, you're like, shoot, my share of this company is actually worth half of what it used to be now. Exactly. Exactly. I mean, it's diluting the currency. And it's diluting the currency by raising the price of goods

And what a currency is good for is actually buying goods. So it's like, shoot, now any unit of currency is only going to give me half as many goods as it used to. And so that's the sort of dominant fear of when we increase money supply is that's going to happen. But an interesting thought experiment is, well, when would that not happen? Any thoughts there? Play.

Play the old Professor McBrady gig? I mean, if we were producing goods at a much more rapid pace than ever before, if the economic growth in terms of production of goods actually outpaced the amount of new money that we're introducing in? Ben was definitely the student who sat in the front row and always had the right answer, wasn't

Was that right or wrong? Because I could also see it being a very confident wrong answer. No, no, no. That was actually, that's a very good one. And in fact, you explained it in a way that's one of the most key economic concepts to introduce into the whole conversation, which is productivity. So if you've got the same number of folks, and even if everybody already had a job to begin with, if

suddenly we could have this wonderful shock that they made everybody twice as productive and they could make twice as many goods, then you would actually need that money supply to accommodate the increased production because it's really hard for prices to go down. That's one of the key ideas beneath all these models they taught me in grad school. It's really hard for prices to go down for a whole bunch of reasons that have been modeled a lot of different ways. At the very least, it seems like supply chain. Like you can't start charging less for your stuff until your whole supply chain is charging less to you.

Great, great example. Great real world example. All of them, you know, the ones in grad school are always much more stylized about people's behavior and real prices and a lot of other stuff that makes, you know, I told you all this whole thing about complex stuff, simple, simple stuff, complex. So, so yeah, productivity growth is one great example. And can you think there's only one other big canonical one is what's the other reason that, that, you know, could have been true in the economy? Well, the only thing I could think of is if there's other places to put your money.

And it's like, like you go invest in emerging economies or other kind of or whatever. Yeah. So you can invest it. So we're going to go back into the asset markets. But if we wanted to literally just come up with a world where you could buy just goods, how could you do that without necessarily kind of increasing prices? Number of participants in the system, like population. Yes. Yes. And the participants in the system who wouldn't be making anything the first time around would be considered the opposite of the folks who have a job.

Oh, you're talking about essentially creating a welfare state. Creating jobs. Like ultimately, if there's a bunch of unemployed people and factories closed and you did that same judo. Right. I guess, yeah, one way would be to just like create a welfare state. The other would be like, well, we're just going to create jobs. Yeah, yeah, ultimately. And the purchasing power itself created by this additional money. I remember this example started off with...

with $1,000 and $1,000 worth of goods and services bought, it's very natural for all of us to kind of go back and think, well, that probably just means everybody was working in the economy to produce those $1,000. But what if you have this chronically unemployed or underemployed set of folks who could go back to work and make stuff and factories that aren't at full capacity if only someone had the darn purchasing power to purchase what it is they would make?

then voila, this is not going to create inflation. This is going to create additional jobs and this is going to create additional factory utilization. And maybe it'll even spur some folks like Ben Inc's widget company or it's the podcast producing, you know, like we're doing so well on this, we're going to hire a couple of us.

their radio voices. Maybe we'll get McBrady to do a side podcast on random economic stuff and whatever else is on his mind in a day. And, you know, all of a sudden that increases productivity. So the same people, you guys can suddenly have a bigger empire of podcasts that you're doing. I see. So it's increasing the productivity per person and also increasing the number of people who can be productive.

Yes, yes. So now we've actually kind of gotten like fully up to speed in terms of the current state of the art thinking. So one of the reasons why fiscal policy has been so much on the sidelines for the last 20, 30, 40 years, really. And fiscal policy for layman's like me being that Congress is not passing acts saying we're going to go give money to people. Yes, Congress is not saying...

"Boy, the unemployment rate's too high. I think we should either cut taxes or we should start a welfare program, a jobs program, or we should just spend more money, like build more roads, build more bridges. That'll put people to work who are unemployed." The reason we're not doing that is because there has been this dominant belief

which is supported by all these models they taught me in grad school, that monetary policy works really well because it's all about purchasing power. If we can just create the purchasing power, which by definition in this old world where it was banks who were responsible for it, goes by just getting more money into banks,

then you don't have to really mess with fiscal policy. And fiscal policy can really just be kind of scary. And we had that scare when Lyndon Johnson's Great Society in the 70s led to the huge inflation that we got toward the end of the 70s and end of the early 80s when Paul Volcker became a hero of economic conservatives by going, nope, I'm going to raise the heck out of interest rates, pulling all this money out of the system, pulling purchasing power out and stopping inflation dead in its tracks.

And that was kind of when Milton Friedman as well was at the height of his influence with his monetary, his theory of monetarism, which is basically kind of said, if you double the money supply, you're going to double price level, period. Back to that original world where, you know, got everybody in full employment and you're making $1,000 worth of stuff. If you suddenly tinker with monetary policy and you get $2,000 worth of purchasing power, you're going to get the same stuff for $2,000 instead of $1,000.

That was exactly the way the world sort of thought of things until we got to 2008. And 2008, the gigantic kaboom that brought interest rates down to zero and brought honest policymakers and academics to their knees in their oh shit moment of going, what else are we going to do? Then is where Ben Bernanke, given his studies as an early academic of the Great Depression, was like, we got to do something.

So he did a whole bunch of somethings. That would be another great podcast episode to support the banking system to keep it from collapsing because it wasn't really the old school banks. It wasn't Jimmy Stewart and It's a Wonderful Life. It was these newfangled securitization driven banks that nobody really understood. But Ben had the right folks around him, particularly Tim Geithner, by the way, who was playing a key role in all of that as the head of the New York Fed.

So figured out how to keep the banking system stable, but still it was like, man, I can't get interest rates lower because they're at zero. I got no inflation and inflation is going down and I'm afraid of deflation, which means even with zero interest rates, we're going to get a positive real rate. And that's going to stink just given the way that the old models make everybody think about it. So what am I going to do? I'm going to print up billions and billions and billions of dollars. I'm going to buy government bonds with them.

So this takes us back to the question, is it a bad thing that the Fed owns a whole bunch of assets? Yes, this is so many wonderful, rich ways to kind of answer this question. And I'll start off with the Fed's description of why it's a good thing, because they're doing it. So that's probably a fair place to start. And the sensitivities of the Fed are

are still very much calibrated to these models. And like the Fed literally has a model. It has a model of the neutral rate of interest that's required to keep the economy humming at full employment. So it actually has that physically. And folks talk about they don't trust it as much as they used to, but they still look at it because it's the intellectual superstructure that underpins all of what they do. And do you know like literally how this model manifests? Is it like an Excel spreadsheet? Yeah.

That's a great question. I got to find somebody like a number of my buddies have been in the Fed. I need to ask them. It's like, do you at least have it like some kind of cool technology, like underlying technology? Or is it literally in the spreadsheet? We use an abacus. Yeah, exactly. So, but the thinking is so driven by, you know, okay, we've got to get the interest rates down and right in a world where the interest rate is at stuck at zero and inflation is really low. Right.

then we've got real interest rates as low as we can get them in the US. And real interest rates are really, really low. I mean, they're minus one, between minus one and minus two, even at the cash level. And it's sort of around there, even as you go further out the maturity structure. In that world, when the Fed is saying there is still these chronically underemployed or unemployed or underemployed people,

my mandate from Congress when I was created, that means the Fed, I got to act according to what my mandate is, is to pursue the twin goals of full employment and inflation at a target of 2%.

give or take. And remember, this targeting of inflation is just fascinating because, again, most of us think of it as a bad thing. And for the Fed, it's a good thing. And it's a good thing because the right level of inflation means you get real interest rates where you want them. And you certainly don't want inflation of zero or deflation because that creates a whole bunch of bad stuff if it's deflation. Even if it's zero, then you don't have extra room to play with in terms of nominal rates if you can only get nominal rates down to zero. So given that mandate, the Fed basically feels like it has no choice

other than to continue its QE. It's just like Bernanke's original logic of saying, boy, in the wake of 2008 and I'm not getting the fiscal policy that I want, I got to do this QE because what the heck else am I going to do? And I can't do nothing. Now the Fed's basically still, Jerome Powell's Fed, still kind of using the same logic of going, I've got unprecedented aggressive fiscal policy and government spending, and yet we still don't have

full employment, or yet I'm still believing there's enough reason to be afraid we are not getting to full employment that we can't take the foot off the accelerator. And my personal view is that they'd probably feel differently if there wasn't such unfortunately well-precedented challenges that await markets when you start to taper.

QE purchases. So I think there's a good deal of just realistic fear on the part of the Fed that they don't want to be seen to trigger a market correction, right, as we're not quite where they want to be. And so they're sort of walking a bit of a tightrope of saying, all right, our public statement is we will start to pull back our support.

as soon as we have sustained progress toward full employment. And with today's jobs release, it's kind of hard for me to believe they're not thinking of it as that's sustained progress. But so far, there's no public statements. Using employment as...

the right measure i don't know what the right measure is but i just think about like you know we all live in the tech industry and like in a world where you know instagram gets bought for a billion dollars and probably was worth many many billions more at acquisition and had 13 employees like that's like different than jimmy stewart like

At some point, the models have to change because you can't make the assumption that all labor is approximately equal because it's becoming more and more unequal with the lever of technology where some labor is able to produce an outcome of real value for consumers that is like 100 million X someone else's labor.

And Ben, that's actually an incredibly astute observation. Again, like the kid in the front row getting all the right answers. Thanks to David for the layup. To a level of depth you might not even realize, one of the real challenges going on right now is...

Well, with today's action, we did manage to get to a reasonable 5.3 formal unemployment rate. But one of the things that's guiding the Fed, which has always guided Janet Yellen's thinking back since way back in the late 90s when I had the privilege of working for her, is the recognition that there are these category of chronically unemployed folks who don't get counted in the traditional unemployment statistics because they're not actively seeking, searching for work.

They're either discouraged because they've been trying and trying and trying and they can't get the right job, or maybe they have the wrong skills, or maybe basically they just sort of are sick of it. But these are the folks who are not showing up because you see our labor force participation is relatively low. So what the Fed's looking to do is to pull these people back into the economy. And what we see is unprecedented levels of job openings right now.

And still a lot of unemployed, chronically unemployed people. So that sort of tells us exactly, you know, that your intuition is exactly right. I think we're struggling right now with a challenge of the chronically unemployed or underemployed just don't have the skill set to fill the jobs that are available.

I actually don't know how I would show up in the Fed statistics right now. But I assume that, you know, not like a lot of people, but they feel like I'm being like objectively like very productive. Like I know like acquired is my full time thing. You don't get this fund on this. Like objectively, my productivity is higher than it's ever been.

and yet I am not employed in any traditional sense. Yeah, I mean, there's a lot of poor... I mean, this is one of the things that David did a great call there too. So you're sitting next to Ben in the front row. That's one of the things that a lot of folks are talking about as well, and I think with good cause, which is I probably would be counted as unemployed as well at this stage. And it's like, well...

No, most of us actually have got the skills that are being prized the most now and get the privilege of doing stuff we enjoy, which means we don't have a formal employer and a W-2. And I think that's one of the challenges. And that actually brings us back, David, to your observation that was a great one, which is like,

boy, that's all well and good sort of thinking about inflation and goods and services and other stuff. But how about this crazy world in tech where 13 people can be bought for a billion and probably in today's prices would be worth 20 or 30 times that. That key observation is also the sort of key to

answering Ben's question about the downside of QE. So what's the downside of QE? Remember going all the way back to 2011 when Bernanke created open-ended QE for the first time in American history and started buying bonds outright and increasing the Fed balance sheet and putting money into the system as a result for the first time. The whole logic was not to boost QE

asset prices, it was the logic was I need to basically do something and I'm hoping to create inflation in goods prices. So that way the macro models that, you know, that run the Fed are going to tell me the economy is going to grow faster and create more jobs.

It just hasn't happened. So it hasn't happened that lower interest rates have actually generated robust growth. But what has happened was, remember going back to when I said how Bernanke described what he was doing quantitative easing for in the first place, he's going, I'm going to do this forced substitution of risk assets, risky assets for safe assets. I'm going to buy up all the treasuries. And then by definition, you know, in the aggregate, investors are going to have to hold more risky stuff.

So it wasn't just Bernanke doing this in 2011. We've been doing this for 10 years now to the tune. Remember, go back to there was $800 billion of stuff the Fed owned forever and ever and ever. And actually less than that if you went further back, no higher than $800 billion in 2008. And right now, the balance sheet is, you guys got any guesses at all? I'm reading it right from the Federal Reserve's website.

$2.5 trillion. $2.5 trillion. Boy, that sounds like a lot. David, what do you think? I'm going to guess $6 trillion. You're getting warmer. $8.22 trillion. Okay, so this is as of- What's the US GDP?

Ah, good question. Let me actually first answer this one, which is before 2008, the $8.22 trillion versus, let's go to the very beginning of January 7th of 2008.

$880 billion. So we are just under 10 times the size of the balance sheet. And remember, this happened by creating money that never before existed and using it to buy financial assets.

Don't you think it stands to reason that that would correspond with a world where financial assets writ large went up in value a lot? Supply and demand, right? Just like if we were buying goods and we could only do $1,000 worth of goods and you suddenly had $2,000 worth of purchasing power. How about...

financial securities and 10 times the purchasing power. And by analogy to what we talked about before, that was also a world where you could create more jobs, maybe you could create more productivity. So certainly there's been a proliferation of securities, especially private securities. Ben and David, when you guys met at Madrona, what was a large size venture fund back then? Yeah.

250 million? Yeah, the standard large venture fund was 250 million. What's a large venture fund now?

one and a half billion one and a half billion didn't sequoia boys 2.5 trillion something like that no the their global growth fund is 12 billion i thought i read somebody had raised like a two billion two and a half billion dollar fund oh there's plenty of them plenty of them and andreessen horowitz i think just raised 2.2 billion across a couple of funds they just raised a 2.2 billion dollar crypto fund just for crypto

So let's actually tie this back to, so Big Fun used to be 250 million. Now Big Fun is 2.5 billion. Boy, that's 10 times, isn't it? Yep. Yep. Huh. $880 billion in the Fed's balance sheet, 8.8 trillion. Hmm. What was the most valuable company in the world worth in January of 2008? That's a fantastic question. Probably Exxon. I'm guessing it was Exxon.

Or JP Morgan? Yeah, that's actually probably worth trying to take a quick gander because it'd be fun to have on the show and see where it is now compared to the trillion dollar. You know, Apple's the biggest now, right? Yeah. It was. Depends on the day. End of 2007, ExxonMobil, $472 billion market cap. Apple today is $2.4 trillion. Wow.

So we've seen a 5X in what a large company is worth or the largest company is worth. Yep. Yep. So a 5X in the largest company. And probably if you kind of go, all right, we go back to the simple logic of if you got 10 times the amount of stuff that's been purchasing assets, where are the rest? Where's the rest gone? Well, some of it goes overseas to David's observation before. Can you invest in emerging markets and others? Some has gone to actually creating more markets.

more businesses, no doubt, certainly a lot more startups. And a lot of that's getting soaked up into valuations that are incredibly big for two guys, a cute dog and a good pitch book. Fascinating. And of course the, the Apple thing, the Apple versus Exxon thing is a little farcical because I think the,

both the margin profile and the growth rate of the big $2 trillion companies today is far superior to what the exons of the world would have been in 2007, 2008. So it makes sense that it's not all multiple expansion, I guess is what I'm saying. Yeah, it's not all multiple expansion. Yeah, and the thing that just drives me a little bit crazy, but I guess it's not fair. I mean, people who have my kind of unique and crazy background, some of the stuff just seems pretty obvious to me. But

we see that multiples are as high as they've ever been. And a lot of folks are like, boy, are they going to have to go down? Are they overvalued? It's just really hard for me to not look at the basics of the underlying system and go, when you got 10 times the amount of money that you've ever had before, and it's had no choice but to be created specifically to purchase assets, that's got to be a world in which

asset prices are going to be higher than they otherwise would be. In a way, the analogy is that if you think about the market sometimes acting as a weighing machine and sometimes acting as a voting machine, it's in hardcore voting machine mode because the prices of assets are determined by the supply-demand equation of the amount of money available to purchase the assets, not at all, in quotes, let's try and weigh some of the future cash flows of this company. Right.

Yeah, I mean, and this morning was a great example of that. As soon as the employment report was released, we saw futures take a dive. And you kind of go, wait a second, if this was an adding machine, it'd be like, great, more people are employed.

That means more purchasing power. That means more cash flows. That means higher value for a business because it's the present discounted value of cash flows. And instead, it's like, nope, this is voting machine. And the voting machine in this case is going, oh, boy, that means a quicker pulling away of the punch bowl and less and less, you know, an end of beginning of tapering, maybe eventually an end where we pull money out of the system and then valuations are going to go down.

And so we're in this weird looking glass world where bad is good and good is bad for, you know, for markets where it's like anything suggesting the economy is growing really well is, is, is being perceived as short-term bad for, you know, don't take my opioids away. I'm healing. Okay. So I got, this has been awesome by the way. Like this is like, Oh, such a good primer. I'm so much more educated than I was before. Um,

I have two areas I'm curious your thoughts on that are both sort of in a like, where do we go from here? Different approaches to like, where do we go from here? Are there analogs? One is you mentioned Japan earlier and that Japan has had similar policies for longer. I'm curious what's happened there and if it's any sort of indication of where we might be going.

And then the other part I really want your opinion on is crypto land to the extent you have opinions. Yeah, I'll give you only sort of partially informed opinions on crypto. But in Japan, we can definitely take on Japan. One thing that folks don't realize is Ben Bernanke is rightfully given credit for doing something very bold. And in the scope of the alternatives that could happen after 2008, I think history will look back on him very kindly for

being willing to do something nobody else could, stretching the rules of the Fed to be able to do the stuff that he did. And there really was no other choice. I'm not so sure about subsequent Fed shares, to be honest. And I think we get a lot of evidence for that just for the fact that Japan in 1980s

Japan was gangbusters. It's when I was killing the US automobile industry and lots of knock-on consequences even for my hometown where they shut down a GM plant that employed most of my friends' dads and probably why I became an economist going, "Huh, why is that big building with all the cool people used to go to work now empty?" But Japan basically after its big booming, booming 80s created an asset price surge for all the right reasons. It wasn't monetary policy driven, but it was just

speculative sort of fervor around real estate prices and everything else. And they got a big crash at the end of it. And then the 90s have been looked at as their the lost decade because, you know, the topics only recently got back to where it was at the end of the 80s. And the economy has just been sclerotic since. So Japan spent most of the

you know, most of the 1990s getting interest rates down to zero. And then in 2000 was the first place to basically do QE going, okay, I'm going to print a bunch of money. I'm going to buy a whole bunch of bonds. And then in 2006, they gave up on it. They're like, it hasn't really changed.

There's a lot of debate about whether it worked or whether there were other things that didn't work. My general sense of my peers in the economics profession is they're so reluctant to give up their models of how the economy works that says interest rates are what matter and

Lots of these other kinds of things that the economy should really grow absent some other reason that they invented in the case of Japan, a more convenient excuse for why it didn't work. It wasn't just that QE ultimately is just not that effective at creating growth.

Instead, they're like, "Oh, this is about the Japanese, the inflexible Japanese labor markets. There's lifetime employment and still at least the vestiges of it and it's hard to fire workers." Banks will extend credit to bad companies still even though they're not supposed to because

Nobody's supposed to kind of lose any jobs and it's this big sort of rigid inflexible economy. So you hear that a lot among economists. It's like they're calling for and you hear it from the IMF and the World Bank a lot talking to developing countries too. You need a more flexible labor market. You've got structural rigidities in your economy. And to me, those are kind of like boogeymen under the bed usually. It's like, well, what do you really mean?

And do we have some good case examples of someone who's not growing, who then says, you know what, I'm going to make it easier to fire people. And suddenly that creates gangbusters growth in the economy. So, I mean, I haven't been an academic for a long time. Maybe somebody's written that paper, but if so, I haven't seen it. So, you know, when I take a look at Japan, I sort of look at the example of Japan as saying, don't rely on this too long because ultimately it doesn't work. It may have bad consequences, including sort of creating 10 times bigger problems.

venture funds and five times bigger, largest companies in the markets. I'm not sure that's a bad thing yet, but it's not a good thing from the point of view of income and wealth distribution for sure. And instead, you better come up with something else. And to some degree, this is what Larry Summers is really using as a way of championing and recreating an old idea called secular stagnation that he's attributing to somebody else, but he's really the one getting folks to pay attention to it, which is to say there just seems to be something about

advanced economies now where we just are able to produce a lot more stuff than there's demand to buy. And that creates a world where there isn't much inflation and which if there is this neutral rate of interest, it's really, really low. And so in that world, monetary policy itself probably isn't going to work the old school way. And

QE probably is doing nothing. And if it's doing anything, it's literally just raising asset prices, which is kind of exacerbating the problem. It's creating a bunch more wealth for wealthy people who are not spending it because they already got more money than they can spend. And the folks who are unemployed or underemployed, it's really never getting to them. So he's been calling for fiscal policy and sort of gets into the really wonkiness of

You know, all the models I've referred to and kind of lampooned a bit along the way about sort of saying these kind of these rigidities and frictions that mean, you know, this is natural rate of interest. And if you get the interest rate lower than natural rate, the economy grows. That's all stuff that's thought of as in the tradition and as the legacy of the tradition of Keynes. That's all called New Keynesian economics or used to be called New Keynesian economics.

And Larry is now calling for an old Keynesian economics by way of saying, if you go back and read Keynes, it wasn't about sort of models that the Fed uses of money supply and demand and these ISLM curves and lots of other stuff. He was just talking about animal spirits, like the economy grows when there's animal spirits where investors are just confident they're going to make money and there's demand out there. And so he's kind of saying, we need to actually start taking seriously the basic idea that if

that if the economy is not growing fast enough, you just spur demand. You spur demand with government spending. That's fiscal policy, not monetary policy. And ironically, I'm probably the only person who would say this, and I'm not sure I would actually-- I don't think Larry would admit it to me. I mean, we haven't been in close contact for years. So he'd probably say, you look familiar, but do I still know you? But I don't think he'd admit it to me or anybody else. But frankly, I think he's taking a lot of the modern monetary theory ideas

or at least insights, and he's dressing them up in much more palatable old language because the secular stagnation was an idea created by another Harvard economist, which is something that Larry is pretty fond of pointing out. But the basic idea is, huh, we're probably in a new world where this old paradigm of

monetary policy is the cure to all lack of demand by creating more purchasing power through the banking system. And well, maybe now we're fudging a little bit, say not through the banking system because interest rates are already zero. So we're going to create it through QE, but it's the same general intellectual architecture of saying monetary policy is your solution. And he's going, no, it's probably increasing demand. If there's not enough people with jobs and there's not enough economic growth,

get the government to spend money. And that's obviously kind of, you know, where the MMT folks come in and where the Congress is currently pursuing policies too.

It is totally fascinating that I feel like I've been personally on this journey of trying to understand how the Fed works and how our economy works. And it's slightly discomforting, Matt, to have you on the show and have you tell me, even if you understood this as well as the best economists in the world, that may actually not be the right thing for our world as it exists today. Like we may need a new system. Yeah.

I mean, Ben, I think you're crystallizing things exactly the way that I would. And one of the reasons why I think we really are sticking to the same old tools is because it's kind of terrifying. Imagine sitting in Jerome Powell's seat. I mean, he's not a trained economist, so it may be easier for him than others, but

he's a heck of an economist because he picked it up, but you know, or Janet Yellen's seat where it's like, boy, or, you know, even Paul Krugman who likes to pick fights with the MMT or is because he, you know, he got a Nobel prize for being like one of the pillars of this modern of this new Keynesian type thinking where it's like building the models that kind of explain how everything works. And it's,

it's hard to let go of them. And it's impossible to really imagine the stress of making, you know, multi-billion dollar decisions that have a huge impact on global markets and people's lives without some, some intellectual framework. But, but it is pretty intriguing. You know, and I,

I kind of take it back to one of my favorite experiences from grad school. You know, I loved the early macro classes before I kind of got skeptical that they mapped into the real world at all. And what I really loved was Greg Mankiw, who became the chairman of Council of Economic Advisors for George Bush, started our macro class by saying, my goal is to profoundly confuse you

And then everybody giggled and he said, now let's unpack that a little bit. I said specifically profoundly confused. I don't want you to be confused because you're asleep or you drank too much or because I'm doing a bad job explaining something. That would not be profound confusion. My goal is to inform you of what the key insights were at such a fundamental level that

that you will come away from the class profoundly grappling with the questions that we really can't answer. And this was back in 94, where the folks who really knew even back then were aware of the limitations of the models. And I would say we've all lost a lot of confidence in them since. And actually, I took a lot of solace in the fact that I've been saying this for years, but I've been saying it for years as a guy who's almost an armchair economist now, because I haven't been a proper economist for so long. And I've been

tainted by the markets the way everybody else has. And the market talking heads, the folks who call themselves economists usually don't have PhDs and they're just basically selling research reports. It's cool. It's a good job. They enjoy it. But to see Larry Summers himself starting to challenge the Fed a bit and saying, it's maybe time for us to acknowledge that our fundamental models are not really going to be instructive in the future. They're not working the way they used to and neither is policy.

So, yeah, I mean, I guess my goal in coming on and talking to you guys could have been said to do the same thing that Greg Mankiw did to me, which is to profoundly confuse all of your listeners. If you could leave listeners with one or two things that sort of keep an eye on this, what would those things be? Like tangible things folks can take away and potentially use in their own lives? You know, one of the most, just in terms of the things to keep an eye on is

especially if you're thinking about moving meaningful amounts of your financial wealth into out of stock markets. I mean, it's really tough to time markets. So first of all, I would tell everybody don't do it. I've tried and it's been a disaster and I used to do this for a living. I unfortunately didn't do it and I wouldn't have lasted very long as a hedge fund manager if I tried to do any kind of market timing strategies because of my own personal efforts to do so have been terrible.

But if you've got some like liquidity event or something like that, I would caution folks to put available cash that isn't yet deployed and large way into markets before we get some type of resolution on, you know, on what's going to happen with tapering, because we now are in a world where with today's employment report, unless, unless Delta really shuts things down again, we're going to be in a world where the feds are going to have to stop its exceptional support because, you know, for one of the things I'm surprised nobody's talking about more is,

We started QE in this country when Bernanke made a plea to Congress effectively in one of his testimonies for fiscal policy and they turned a deaf ear. I was like, I gotta do this. I've gotta do this 'cause it's never been done before. Not clear what the consequences are gonna be. There isn't research to back this up because it's not the way we've used to do it, but we're gonna do it. We're now in a world where we've got the biggest fiscal policy response anybody's seen since the New Deal.

You can't say there is now time to justify ongoing exceptional monetary support. You just can't. And so, you know, and so ultimately, even if we aren't in a world where the Fed ever tries to shrink its balance sheet back down, and I don't think it really ever will, we're in a world where they're at least going to have to stop

turn off this current spigot. And we haven't seen-- every time that's been tried so far, it's been bad for markets to the tune of 10% to 15%, and in one case, 20% market correction inside of a month. So I just wouldn't want anybody to be in a world where knowing that's likely to come, given everything we know, by November and possibly as early as September, that's one to keep in mind.

You know, that's, you know, so that's certainly one, you know, one kind of key takeaway. And the second actually would be anybody who's politically motivated, much more important, politically motivated. If you still sort of are clinging to the belief somehow that government deficits are bad and they're going to crowd out in a private investment or they're going to raise interest rates.

that the economists who wrote those models with one of the best ones in history, actually, frankly, being Larry Summers are now saying, hmm, maybe not. And these folks who, you know, the modern monetary theory folks who, you know, kind of sound like they're

making the claim that you can have your cake and eat it too, there's some reasonable reasons to believe that they're right across a number of dimensions. And not for everyone, but for the United States, we're in a pretty unique position. So I would sort of encourage you to sort of be, from a political point of view, much more open-minded to the idea that large-scale government spending is

if we're lucky enough to be the United States right now at this point in time is probably not a bad thing. And you have to, in a sense, sort of check at the door some of the sensitivities you'd be running if you were thinking about the economy the way you'd think about running a small family business.

Well, Matt, this has been just awesome. David and I will put a link in the show notes to the best way to reach out to Matt if you want to work with him in some capacity or there's a reason to follow up. Matt, the pleasure is all ours and we really appreciate it. Oh,

Oh, guys, thanks for having me on. I mean, I don't tire of talking about this stuff. In fact, I tired a lot of having a hedge fund job that didn't give me an opportunity to talk about this stuff. So it's been a blast. And if you guys would like to have me back to talk about anything else, please just let me know. Will do. All right, listeners, we will see you next time. We'll see you next time.