Inflation Is a Choice: Kevin Warsh on Fixing the Federal Reserve

>> Peter Robinson: The Federal Reserve System charged for more than a century and now with maintaining price stability, with fighting inflation. How's the Fed doing? Our guest today is here to say, not as well as it should be. Kevin Warsh on Uncommon Knowledge now. Welcome to Uncommon Knowledge, I'm Peter Robinson.

 

A native of upstate New York, Kevin Warsh earned his undergraduate degree at Stanford and his law degree at Harvard. Mr. Warsh spent the early years of his career on Wall Street and in Washington. In 2006, President George W Bush appointed him to the Board of Governors of the Federal Reserve, where he served until 2011.

 

Note that Mr. Warsh was on the Fed during the financial crisis of 2008, the worst financial crisis in more than half a century. Mr. Warsh now divides his time between New York, where he works in an investment firm, and Stanford, where he is a fellow here at the Hoover Institution.

 

Kevin, welcome back to Uncommon Knowledge.

>> Kevin Warsh: It's great to be back. You hid the most important thing, which is the investment firm. I happen to work for the greatest investor in the history of the world, a guy named Stan Druckenmiller.

>> Peter Robinson: Yeah.

>> Kevin Warsh: But you were trying to keep that discreet, I appreciate that.

 

I just wanted to boast about my friend and partner.

>> Peter Robinson: You keep going because I want him to appear on the show sooner or later.

>> Peter Robinson: We'll start buttering him up right now. All right, Kevin, here's the first question. Created a century and a decade ago, the Federal Reserve is the one institution in the nation charged with maintaining the value of our currency, the dollar.

 

Two quotations, the late legendary investor Charlie Munger. Quote, destroy the currency and God knows what will happen. Here's the second quotation. This comes from your remarks this past April to an organization of bankers called the Group of 30. And I have plucked from it a few of your descriptions of the Fed today.

 

Institutional drift, failure to satisfy its statutory remit, contributed to an explosion of federal spending, outsized role, and under performance. Kevin Warsh, you are attacking a sacred institution, the institution on which every one of us depends every single day for the integrity of the money we make and the money we spend.

 

What do you think you're doing?

>> Kevin Warsh: In central banking, we are taught to keep our criticisms quite closeted. So I didn't do a very good job of that in those same remarks, Peter. I described this as a love letter, more than a cold critique. You might not have taken it as the love letter, I'm not sure the current incumbent did.

 

 

>> Peter Robinson: I let the lovey-dovey stuff drop.

>> Kevin Warsh: It's a love letter because the institution's as important as your setup would suggest. It's a love letter because if the institution can reform itself, then there can be great things for the institution and the country. But it does mean that it's time to get things back on track.

 

I should say one other thing. This is our third experiment at a central bank in the United States. And it's our third experiment, not because the first two went so well, they went poorly.

>> Peter Robinson: Right.

>> Kevin Warsh: This isn't like winning a third Super Bowl, Peter, where the more you get, the better.

 

And the first two failed because they lost the consent of the governed. They lost their ability to deliver on what they promised. And this isn't a history lesson, but you can think about the Jacksonians of prior times say that central bank seems like they're trying to focus and they're all preoccupied with those special interests on the east coast and they've lost track of what's happening to us in the center of the country.

 

It's a version of what worries me today. And so the central bank's going on more than 100 years and if they reform themselves, they're gonna have another great hundred. Absent that I worry.

>> Peter Robinson: All right, so I wanna return to your remarks in a moment, but first take me through.

 

I'm a layman in these matters, you're a skilled central banker and investor. You know this world, I don't. So take me through, I've got a couple of very elementary questions. Give me a moment to set up this question. The Federal Reserve System is established in 1913, possesses the power.

 

This may be something of a Noble's oversimplification, but it possesses the power to set interest rates and regulate the money supply in the interest of achieving price stability. Those are big powers. How has it been doing? These are remarks by Milton Friedman, Nobel Prize winning economist Milton Friedman in 1994.

 

Quote, there is no institution in the United States that has such a high public standing and such a poor record of performance. The Federal Reserve began operations in 1914 and presided over a doubling of prices during World War I. It produced a major collapse in 1921. The major villain in the Great Depression was unquestionably the Federal Reserve System.

 

Since that time, it has presided over a doubling of prices since World War II. It financed the inflation of the 1970s. The Federal Reserve System has done far more harm than good, and I have long been in favor of abolishing it, close quote. Kevin, why do we need the Federal Reserve System?

 

None of this is new to you. Milton Friedman was here at Stanford when you were an undergraduate.

>> Kevin Warsh: So, Milton, I was blessed to be a student of his, and when he came here, he had a huge effect on not just me, but generations of students that followed.

 

I've spent some considerable time in the archives of the Hoover Institution looking at what Milton would say, for example, the Federal Reserve chairman. There's a beautiful book by our own Jennifer Burns that includes some of that correspondence. But I had them search and give me all the letters that went back and forth between Paul Volcker and Milton Friedman, and Alan Greenspan.

 

 

>> Peter Robinson: Okay, so give us the dates, Volcker is appointed Fed Chairman by Jimmy Carter in 78, 77.

>> Kevin Warsh: In the middle of the Carter administration, I don't have the precise date.

>> Peter Robinson: And then Ronald Reagan reappoints him and he serves until nearly the end of the Reagan administration, correct?

 

 

>> Kevin Warsh: Correct.

>> Peter Robinson: And then Alan Greenspan succeeds him and serves until?

>> Kevin Warsh: He serves 17 years until Ben Bernanke shows up.

>> Peter Robinson: In the middle of the crisis.

>> Kevin Warsh: In 2006.

>> Peter Robinson: 2006 preceding the crisis.

>> Kevin Warsh: The only reason why I know that is I recall being a junior White House staffer when I found out that not only had Chairman Bernanke, who had come to the White House from the Federal Reserve and was going back to serve the big shoes of Alan Greenspan, but he wanted me to come with him and take his old job as Fed governor.

 

So I remember that.

>> Peter Robinson: You remember that.

>> Kevin Warsh: I remember that date.

>> Peter Robinson: All right, okay, Milton.

>> Kevin Warsh: And in that correspondence of Milton, the thing that's amazing about him is he was constantly revisiting his priors. He was constantly asking whether the data and conclusions he came to one year were still relevant the next, whether his judgments on the institution were still relevant the next.

 

And in much of the correspondence during the Volcker years, and the Greenspan years, he was quite comforted by changes in approach, by new ways of thinking about the economy, by success that would come to be known as the Great Moderation. So I wouldn't say that Milton thought that the Federal Reserve was a terrible institution, he thought they had bad periods and good.

 

I can only speculate what he would say about the great inflation of the last half a dozen years and how he would have foreseen it. He would have warned of it, and in all likelihood the Fed wouldn't have listened.

>> Peter Robinson: All right, so one more of these elementary questions, and again, Milton Friedman.

 

Milton Friedman was famous for saying, quote, inflation is always and everywhere a monetary phenomenon. Now, if inflation is a monetary phenomenon and the Fed is in charge of the money supply. Inflation is always the fault ultimately of the Fed. Why don't you describe what Paul Volcker did when Carter appointed Volcker you'll know this.

 

I'm just grasping at memories here. When Carter pointed Volcker, I believe we were suffering the highest inflation since the Civil War. And by the time Paul Volcker left office, inflation was right down to 2% or thereabouts.

>> Kevin Warsh: Almost.

>> Peter Robinson: Almost 2%. So, okay, so Milton Friedman and the Fed is always responsible.

 

 

>> Kevin Warsh: Yeah, so I believe what Milton and you just channeled, which is inflation is a choice. As you said at the beginning of this setup, inflation and ensuring price stability was granted to the Federal Reserve by the Congress most recently in a review of its statutes in the 1970s.

 

So that there would be one agency that would be responsible for prices. No more blaming the other guy. We're giving the baton to you, the Central Bank. Go after it and get it. Now you wouldn't know from recent commentary of the last several years that inflation were a choice.

 

In fact, during the run up to the great inflation last five or six years, what did we hear about the causes of inflation? It was because of Putin in Ukraine.

>> Peter Robinson: Yes.

>> Kevin Warsh: It was because of the pandemic and supply chains. Well, Milton would be outraged to hear that.

 

And in my own subtle way, I was troubled to hear it as well. Those things lead to a change in prices. After all, in market economy, the prices change in Walmart every day.

>> Peter Robinson: Right.

>> Kevin Warsh: That's how the market economy works. It's not the Central Bank's role to police those prices.

 

But that's not what inflation is, that's a one time change in the price level of a widget. Inflation is what happens if that one time change in the price level becomes self fulfilling. That is higher prices beget higher prices. That means inflation ends up finding its way into every kitchen table and every boardroom.

 

Because you don't know as a decision maker what the price level is going to be. That's not about Putin and the pandemic, that's about the Federal Reserve. That's about the Central Bank. And I'm afraid in recent years this is probably because central banks are part of our culture as we do a little bit of, well, it's not my fault, it's someone else's fault.

 

And I think that's what Milton would be most outraged by in recent times. The Central Bank can hit any price level that it wants, any inflation level that it wants. We might not like how they do it, but the idea that is they should be blaming someone else strikes me as quite antithetical to good economic history.

 

 

>> Peter Robinson: And for the remainder of our conversation, it's probably important, just to repeat, not only is inflation a choice, but a sound dollar is also a choice, and Volcker did it. Within living memory, it has been done. We suffered inflation and then the Fed got it back under control.

 

All right, one more of these baby questions.

>> Kevin Warsh: If I might, so they got it back under control and then I suspect this is a little psycho babble from an economist. Then they got complacent about inflation being under control. Somehow after the period of what we call the Great Moderation, where prices were more or less stable for a period of more than a generation.

 

I think some in my profession thought this was easy and in fact that it was under control because we had all gotten so very good at this. We'd all gotten perhaps a little complacent with this business. But economics isn't that easy. And it's really because of the most recent crises of 08 and 2020 that I suspect we took our eye off the ball.

 

 

>> Peter Robinson: You've used this phrase a couple times now. Let's just define it. The Great Moderation is, I'm asking. It begins by the mid 80s when Volcker and the Fed backed, let it be said by Ronald Reagan, when they actually get inflation down into low, low single digits and inflation stays right there and the economy expands with only a couple of quarters of recession for the next quarter of a century until crisis of 2008.

 

Am I right about that, and is that what you're referring to as the Great Moderation?

>> Kevin Warsh: That's exactly right. And we don't wanna sound as though, boy, every year was perfect and central bankers didn't make any mistakes, but the mistakes were relatively small and manageable. And for viewers, I think, inflation still this very abstract concept.

 

We want the change in prices to be such that in the economy, such that no one's talking about it. That's how we know we've done our job. And what do we know about the last five or six years? It's almost everything anyone will talk about.

>> Peter Robinson: Right, last of my elementary questions here, gold.

 

President Nixon takes us off the gold standard in 1971. Until then, the dollar was always convertible into a fixed weight of precious metal, for the most part, gold, and that constrained the money supply. The journalist and investor James Grant, writing just last year, the opposite of the gold standard.

 

What we have in place now, the opposite of the gold standards is really the system in place today in the United States, one might call it the PhD standard. It's the system of discretionary manipulation of interest rates by doctors of economics, close quote. So James Grant suggests if not gold some fixed basket of commodities.

 

Milton Friedman said about the same time that of the quotation I gave you where he said he long stood for abolishing the Fed that the Fed should be replaced with a pre-announced increase in the money supply by a fixed sum that would take place each and every year.

 

So it was totally transparent markets you could plan a decade in advance. And both of those are a way of saying let's find some objective standards here, let's find some way of constraining the money supply that the markets can know about in advance and not leave it all to the subjective impulses.

 

And the group think and the who really understands that econometric latest piece of research that takes place in the Federal Reserve System now to which Kevin Warsh replies.

>> Kevin Warsh: There is no status quo ante to return to. I have many of our friends on the right who believe well let's just bring the gold standard back the world has moved on.

 

Might it have been better or worse had we made different choices along the way but you have to deal with what's right in front of you, I think that's what Orwell said. And there has to be a third choice between let the machine do it and let's have full discretion of a central banker's latest whims.

 

I think you and I might have learned from Edmund Burke of conservatism, it's a resistance to whimsical we central bankers past and present need to resist whims. There's a way to have clarity about the reaction function of Central Banks to incoming information. And if Milton were with us today I hesitate to put words in the great man's mouth but I think he would say that there had been too much scientism, scholasticism trying to make precise that which we have still imperfect understandings of.

 

Most of us in economics that are it's a better than average we try to focus to the left of the decimal point, not to the right of the decimal point. Now if we were better at our craft, if we were smarter we'd be physicists and mathematicians and most of us that are in this business we started in one of those fields and then we came to economics because frankly it was easier.

 

And so we don't have a perfected understanding of how the economy works. If we did, we could create the machine. We could create the formula. But the economy's changing every day, it's incredibly dynamic. And so I hesitate to say we have a perfected rule.

>> Peter Robinson: All right, now we'll move on to recent history, your recent history and the Fed's recent history.

 

What the financial crisis wrought. You were on the Federal Reserve Board of Governors during the financial crisis of 2008, which led to the worst economic contraction since the Great Depression and unemployment in this country of 10%.

>> Kevin Warsh: Are you drawing a causal relationship there, Peter?

>> Kevin Warsh: I'm scared where the rest is going.

 

 

>> Peter Robinson: You're just plain bad luck, Kevin. The Fed responded with a number of actions, but perhaps the most dramatic was to flood the system with liquidity. Let me give you some sense of the magnitude of the Fed's action between the first and second quarter of 2008. The Fed's balance sheet, measure of the supply of reserves in the banking system.

 

The balance sheet doubled in the space of a quarter from a trillion to 2 trillion. Now, you've written that you strongly supported that decision. So before we get to the QE2, 3, 4 and so forth. Well, you'll explain yourself in a moment, but first tell me why you supported that dramatic infusion of money into the markets in 2008.

 

 

>> Kevin Warsh: Yeah, so first of all, we keep bringing up this word money. I should say a word about that.

>> Peter Robinson: Please.

>> Kevin Warsh: Milton believed, as you suggest, that monetary policy and inflation is about money. That is heretical in the modern academy. That is not taught in introductory economics.

 

At most of these elite universities, most came from a different school. Not this monetary school, but more of a Keynesian school. And in that Keynesian school, money barely comes up. In fact, if you look at the transcripts of the Federal Reserve, they tape most of the words that we utter inside the Federal Open Market Committee.

 

You're gonna have to look a long time until you see that word money. I think money, strangely enough, has something to do with monetary policy. It has been absent from the discussion. I think is part of the reason why this great inflation came back. Because while Milton himself, I don't believe, would have held exactly to the model he had in his mind 30 years ago, he would have said money has something to do with it.

 

And in the run up of the great inflation around the time of the COVID crisis, we saw a surge of money, both money as best we measure it and velocity as best we see it.

>> Peter Robinson: So PB equals MQ? I'm trying to remember back now to classes a long time ago.

 

I would have thought that was basic in discussions at the Fed.

>> Kevin Warsh: It is non-existent in most discussions among modern economists. Now, Milton used to say, this is the last ode to Milton. Then we'll the current events.

>> Peter Robinson: All right, yes.

>> Kevin Warsh: Milton, I was a 19 or 20 year old and there was a small group of us around the table, a little larger than this.

 

And I asked him some question, probably trying to show off that I knew something about something of which I didn't. And he said, Kevin, the only thing we understand in economics is Econ 1. Everything else is made up. And I remember thinking, Peter, maybe the old man's losing it.

 

Maybe he sort of passed his day. The Nobel Prize was given some period before that. I didn't know until the financial crisis of which you now speak that the old man was exactly right. No one predicted it, no one saw it. Because all we really know about economics, we teach in Econ 1.

 

And at least in the Econ 1, before the schools of economic thinking took over at these elite departments, we said that money has something to do with monetary policy. And I still believe that to be true.

>> Peter Robinson: By the way, it occurs to me that as we sit here today, it's getting up toward 20 years ago that the financial crisis hit.

 

So why don't you take just a moment to just explain what that felt like. You're on the phone to friends in New York, you're in Washington at the time on the board of the Fed. How bad was it? What do we need to understand about that crisis?

>> Kevin Warsh: So I teach on occasion in this business school not far from where we're taping.

 

And for years I would talk about the global financial crisis and they'd look at me and these students would have some recollection. Now, they weren't exactly in business, but they remember how their parents would have come home, or they remembered watching it on TV. Now, when I talk of the global financial crisis, they had heard of it, and I could have easily been talking about the Great Depression.

 

So it was some time ago. How it felt to me is, I was 35 years old and I had finally found myself to this august position because of President Bush and Ben Bernanke. And I was in this beautiful office, and for about six or eight months, life was grand.

 

 

>> Kevin Warsh: Someone would come in and put wood in the fire. Someone else would restock this little pitcher of ice water and I thought things were good. Little did I know that was the calm before the storm. I would say it in retrospect, it was scarier than it felt at the time because we were in some ways in the bunker together.

 

While I don't know if Ben Bernanke would at all be comfortable with what I said at the IMF G30 meeting a few weeks ago, he was a heck of a strong, good battle commander. We were all in the bunker together and he was very open to a small group of people who could get around a table like this and fight about what's happening and why.

 

And he was quite open to heretical ideas. I wonder whether there's such permitted heresy in the profession or at the central bank these days. But in the darkest days of that crisis, which maybe we get a gentleman's B for how we handled it, we could have done more sooner.

 

We made plenty of mistakes. We had some successes too. The real economy was deteriorating faster than we had any historical reference of. Financial markets were down 60, 70% in equity prices. And maybe most alarming, the treasury market auctions. The auction for the most important security in the world, which is synonymous with the dollar.

 

People weren't showing up in the auctions, at least at the beginning. Bid ask spreads were wide and we were worried that the American economic was at the very cliff.

>> Peter Robinson: So flooding the system with liquidity, pushing money out into the system, was an emergency measure intended to keep the exchanges, to keep the markets functioning.

 

 

>> Kevin Warsh: Yes.

>> Peter Robinson: On the theory that keeping the markets at work, keeping the markets open and functioning, giving people enough currency to be able to buy and sell, was the best and most immediate thing that anybody could do. The markets themselves would gradually work this through, I suppose.

 

Is that the justification?

>> Kevin Warsh: So I'd say it goes back to first principles.

>> Peter Robinson: Right.

>> Kevin Warsh: This third experiment of Central Bank, the one you referenced, the one that we're still living in, created in 1913, was created in 1913 in response to a panic that had preceded it less than a decade before Central Banks were first created.

 

Or this generation of central banks to respond to just this sort of situation. A panic in the old days, what we now call a deep recession of financial crisis, is when markets aren't working, when there are spreads between what buyers are willing to pay and sellers are willing to sell.

 

And the job of the Central Bank is to show up with all sorts of money. There's that dirty word again. And get those markets to function, not to set prices, but to make sure that buyers and sellers could clear. And the central bank was there to provide liquidity when no one else would.

 

We were the backstop and are the backstop to the banking system, not just in the US but in the rest of the world. Because if we blew it, it would have been even worse for the rest of the world. So that's what we did in crises. And some of your and my friends on the right, including at institutions, we care deeply about their views, then were you should let the system burn down, a phoenix will rise from the ashes.

 

You really have no business in doing this, that's not my view. My view is the Central Bank was created to respond to panics. We had one, we recognized it belatedly, but then we showed overwhelming force. And the word you used, I think is the right word. It was an emergency.

 

 

>> Peter Robinson: Right.

>> Kevin Warsh: So you're prepared to cross more lines than you would in benign times. You're prepared in some sense, as Paul Volcker famously said, then go to the very edge of your authority. But there was an implicit promise we made to each other around the table that we made to the Treasury Department, the Congress, and I would broadly say, to the rest of the US Government.

 

When the crisis ends, we'll get out of this. We will go back to being a rather boring Central Bank. That's on page B12 of the newspaper. Six little paragraphs. The Fed met today and they raised or cut interest rates a quarter of a point. But from that moment until this moment, the Central Bank became front page news and I will argue, played a bigger role than our founders would have been comfortable with, and the founders of a Central Bank should be comfortable with.

 

 

>> Peter Robinson: All right, let's go through then, from 2008 to the present. I'm sure I'll get this wrong, so correct me. Let me go through it quickly. QE1, QE stands for quantitative easing, which is a fancy way of saying pushing money into the system. QE1 takes place in 2008.

 

We've just discussed that. The Fed's balance sheet goes from just under a trillion to just over 2 trillion. Kevin's in favor of that one. QE2 takes place in 2010. The Fed's balance sheet rises to just under 3 trillion. QE3 takes place in 2012. The Fed takes its balance sheet up to 4 trillion.

 

QE4 takes place in 2020 during the COVID lockdown, which will require a moment or two of discussion because that was an emergency toward the end of COVID by 2022, its balance sheet is up to 9 trillion. Since then, the Fed has brought it back down to 7 trillion.

 

But as you have noted, the Fed's balance sheet today is almost an order of magnitude larger than it was when you joined the Fed within living memory in 2006. Okay, we've discussed QE1, QE2, QE3, the pre COVID expansions of the money supply.

>> Kevin Warsh: You keep printing a trillion here and a trillion there.

 

It's gonna catch up to you, Peter. I mean, back in your day in Washington and in my day, various parts of the economic institutions would spend millions on this project or billions on that. We are a big and strong economy. We can tolerate these sorts of things, even if these projects aren't perfect.

 

But when the Federal Reserve prints trillions, especially in benign times, it changes everything. And it almost is a signal to the rest of Congress we're doing it and so can you. So let's just go back to the essence of quantitative easing for a moment. QE1, which by the way, at the time we tried to market it, this worked for about a week as credit easing.

 

That was our preferred nomenclature. QE sort of took off without us. And what did we say then? We debated internally whether to do this. And the story goes something like this, Peter. Secretary Paulson, he's issuing bonds on Monday and Tuesday. What do you say we buy them on Thursday and Friday?

 

And I don't believe in betraying the confidences of those that were sitting around tables. But I recall one person saying, well, that sounds like a Ponzi scheme. What else do you have to save us from the global financial crisis? Explanations were given. Small versions of this were done by the bank of Japan about a decade prior, but nothing quite like this.

 

And we weren't quite sure how it would work. But it turns out it worked and it was radical at the time. Now, if you turned economic textbooks, even introductory economics, they talk about this as like standard operating procedure. It seemed like a roll of the dice then, but we were in roll of the dice time, so we took it.

 

But that was QE1. I supported it, and I supported it with many colleagues under the view of we're gonna put this very dangerous, risky stuff back behind the covered glass until there's another crisis. We really never did that. So the story you are going to tell about the subsequent QEs during a period that I would say was reasonably strong growth, reasonably stable financial markets, reasonable periods of stable prices, we start doing it for all seasons and all reasons, and in so doing we raise the bar for when another crisis hits.

 

Because whatever you were doing couldn't possibly be enough. I should only note one other thing. You're cleansing my biography and I should be grateful I resigned.

>> Peter Robinson: You did?

>> Kevin Warsh: Yeah, when QE2 was launched.

>> Peter Robinson: In 2010.

>> Kevin Warsh: All right, I left in early 2011. My colleagues, including Chairman Bernanke, who I mentioned, for whom I had great respect as a war fighter, he and my colleagues at the Fed decided that we should keep on doing it.

 

 

>> Peter Robinson: On what grounds? If you could make the best argument for their case that you could, what would the argument be?

>> Kevin Warsh: So we don't see any costs. We have found a free lunch. Look around, asset prices are higher, markets are filled with more liquidity, the economy is good, and, gosh, if we take it away, we don't know what would happen.

 

And in some sense, they broke, in my view, the bargain that was struck. Did any of us know what would happen under various scenarios? No, because again, in economics, unlike in physics, there are no control groups, at least no very good ones. And I should say the other thing that's different between economics and physics and math is the atoms that we're tracking in economics, they change their minds.

 

So we don't know how individuals are going to react to a whole range of things. But the argument was the costs are small, the benefits are large. Let's keep doing more of the same.

>> Peter Robinson: All right, QE4 takes place during COVID, Economist Paul. I'm sure I'm gonna mispronounce this name.

 

Paul Sheard in 2021, quote, with government suppressing economic activity to quell the pandemic, fiscal policy needs, he's writing during the pandemic, needs to play a significant social insurance role by providing income support to households and small businesses. And the more that monetary policymakers show their determination to achieve their inflation target by implementing aggressive QE policies, flooding the system with still more liquidity, the more credibility they will have when it comes to fighting inflation, close quote.

 

Kevin.

>> Kevin Warsh: Much to unpack in that quote.

>> Peter Robinson: Unpack away.

>> Kevin Warsh: So when you're in a crisis, like the 2008 crisis and like the pandemic crisis, I used to be known for saying, when you've seen one financial crisis, you've seen one financial crisis. So none of them are terribly similar.

 

But again, if you had imported my mind into the 2020 pandemic, I was here in the cheap seats at Stanford and in New York, I would have said, well, this is a time where we have to be radical. But the problem is between-

>> Peter Robinson: Another emergency.

>> Kevin Warsh: Another emergency.

 

 

>> Peter Robinson: Right.

>> Kevin Warsh: But we didn't have an emergency for most of the decade between 2010 and 2020. This was the time for the Central Bank to retreat, instead, the Central Bank stayed on the front pages. And I should also note, during that period of a relatively benign period of relative peace and prosperity, Congress said, well, if the central bank are buying all the bonds, then we can spend trillions.

 

Hence the fiscal authorities, Congress and the President decided there are very few costs to all of this spending, because the Federal Reserve is subsidizing it, because we were the most important purchaser of these bonds. Then when you find your way into crisis, yes, I have sympathy for my colleagues in crisis due to crisis like things.

 

But if you treat every day for more than a decade like it's a crisis, then when the actual crisis hits, you have to cross more lines. You have to get more involved in the private sector. And in so doing, to go back to where you began, you have an economic institution that isn't the first among equals, it's the first and most important institution in the world.

 

And you see administrations, Republican and Democrats.

>> Peter Robinson: Unelected bankers.

>> Kevin Warsh: And you see members of Congress and importantly, you see businesses, they now hire lobbyists to go to the Central Bank seeking relief. This is a historical, this is, in my view, dangerous, it takes the responsibility and accountability of fiscal policy and brings it to the Central Bank.

 

And while my colleagues are well-intentioned folks and they might even make some good judgments, many of these things aren't their job.

>> Peter Robinson: Kevin, let me respond on behalf of the Federal Reserve.

>> Peter Robinson: Yes, yes, yes, yes, everything you said, but here's where we are today. Inflation is now below 2.5%, and the economy is growing in spite of it all.

 

And so instead of chiding the Federal Reserve, you should be saying, ladies and gentlemen, well done.

>> Kevin Warsh: Mission accomplished is a very dangerous thing for policymakers in Washington, and that was your attempt at mission accomplished. Let me say this, after most crises, Peter, after the 911 Crisis, after the Global Financial Crisis, there were a series of after action reports, Congressional scrutiny, Blue Ribbon Commissions.

 

How did that happen? Well, after the Great Inflation, I'm still waiting for this. Instead, we've cleaned up matters somewhat, but the institution is still, in my view, in over its skis quite a bit, and inflation is still above target. The Fed has said are doing a bit of an after action report.

 

They're looking at their objectives, they're going to come out with this report this coming August. I wonder whether their report will be up to the task of this great error. The prices of goods and services over the last five or six years are up more than 30%. Since the day before COVID, the Federal government spending is up 63%.

 

And five years ago, I don't remember thinking this is an august, efficient, well-run government, so there are consequences that we shouldn't just sweep under the rug. So I appreciate the snapshot, things are much better, but there have been costs to this error, and the costs are being felt by those that are the least well-off among us.

 

 

>> Peter Robinson: You've already mentioned some of this, but I'd like to go to the the damage the Fed has done explicitly. The Wall Street Journal, this is a remarkable thing on which I congratulate you. I've never seen it before that the Wall Street Journal reprinted over here under your name while you did it, excerpted and rewrote your remarks for a column for the Wall Street Journal, and then printed over here the lead Op-ed in the day's paper commenting on your speech.

 

A Nobel Prize is as nothing by comparison with appearing on both sides of the Wall Street Journal editorial page. So here's what the Journal said, Federal debt as a proportion of GDP in 2006 when you joined the Fed was about 34%. Federal debt as a proportion of GDP today is about 100, headed toward about 124%.

 

And the Journal quotes your speech, irresponsible spending surged, especially in the aftermath of the pandemic, I struggled to absolve the Fed of the nation's profligacy. Fed leaders encouraged government spending when times were tough, but didn't call for fiscal discipline at the time of sustained growth and full employment, close quote.

 

And now I'm going to turn on you, Kevin, because up until now I've been offering one little defense after another of the Fed's policy. Now I'm going to turn on you and say, the growth in Federal indebtedness, as Niall Ferguson pointed out in a recent very arresting column, there is just no history of any government that finds itself paying more on debt service than it does on defense, and remaining a great nation.

 

Far my friend from sounding the alarm, you've been much too tepid in attacking the Fed, this is an outrage.

>> Kevin Warsh: So now you have me defending the Federal Reserve.

>> Peter Robinson: Yes.

>> Kevin Warsh: We've reversed rules.

>> Peter Robinson: I'd like to see how you handle this one.

>> Kevin Warsh: So I believe the Federal Reserve plays this critically important role.

 

I believe the Federal Reserve is up to reform, heal thyself is an important thing for all institutions, it is not too late. But they need to ask and answer big, hard, strategic questions, instead of just sort of pushing these things under the rug. Congress deserves its own criticism for reckless, irresponsible spending made more, I would say, made acceptable because the Federal Reserve were buying those bonds in large part.

 

And signaling to the world, when the Fed buys the bonds, what are we telling the world's investors? The water's warm, come on in, you should do it, too. But plenty of blame should be given to Presidents and to Congress for pushing big spending in periods of peace and prosperity.

 

But it's incredibly dangerous, I'll make one final point. Irresponsibility runs in both directions. The connection between fiscal spending, that is what Congress does, and monetary printing, that's what the Central Bank does. When one of them is irresponsible, the other one tends to be irresponsible too. We tend not to see the harms that are done immediately, there are, as Milton famously said, long and variable lags, but there's no free lunches here.

 

And I'll make one broader point. When the rest of the world, Peter, sees the most important economic institution in the world treating normal times like they're an emergency, they do the same. No one gives us a run for our irresponsibility. The rest of the world believed about the US for a long time.

 

Well, we don't really like how they show up at these meetings of the G7, or G10, or G20, and sort of lecture us. But before the 08 crisis, you know what they thought? Well, those Americans, they might be a bit abrasive, but they sure know how to run a banking system, until we didn't.

 

Then going into the COVID crisis, what did they think? Well, those Americans, they're different than we are, but they do seem to believe in Federalism, and liberty, and human agency, until we didn't. And then, well, that Central Bank, maybe we're being too tough on them, but they prevailed on and preside over a period of stable prices for 40 years, that's pretty good, until we didn't.

 

When these institutions keep losing on important things, the rest of the world is watching, and the rest of the world's watching the Central Bank as we sit here today. And if the Central Bank can put its own house in order, hide itself from the front pages, encourage thereby the Congress to be more responsible on spending, well, then this can be the shining city on the Hill again, can it?

 

 

>> Peter Robinson: Okay, so Herbert Stein used to say that if something can't go, the late Herbert Stein, economist, and I think he was chairman of Nixon's Council of Economic Advisors. Is that correct?

>> Kevin Warsh: Yes.

>> Peter Robinson: All right, I don't think he was ever on the Fed though, was he?

 

 

>> Kevin Warsh: Not to my knowledge.

>> Peter Robinson: All right, so the late economist Herbert Stein used to say, if something can't go on forever, it won't. Here's the question, we've been running essentially a Ponzi scheme. The treasury puts bonds up for sale, the Fed buys them. This is as close to actually running a printing machine and printing money as you could possibly get.

 

And yet the world still buys T bills. In other words, why haven't world markets disciplined the United States of America?

>> Kevin Warsh: So I want to be clear.

>> Peter Robinson: Because it looks as though Ben Bernanke was right. It looks as though there is no price.

>> Kevin Warsh: So that was Peter Robinson, our host, saying that this is a Ponzi scheme.

 

That is not his guest. His guest was referring to a debate we had in a private setting about how would this appear. I actually do believe the US is, I'd rather have our cards than anyone else's in the world.

>> Peter Robinson: Right.

>> Kevin Warsh: I believe we are on the front end of a productivity boom.

 

I believe that economic growth in the US is the most important thing and could do a better job at defeating these liabilities than anything else. Just to give one simple statistic, the Congressional Budget Office in their latest report, full disclosure. I'm on a panel of economic advisers to that office.

 

They pay no heed to what I say necessarily. They say that growth over the next ten years will be 1.7 or 1.8% per year in the US, I think.

>> Peter Robinson: Over the next what?

>> Kevin Warsh: Ten years.

>> Peter Robinson: They have no idea. Excuse me, I'm not on your panel.

 

But they don't know what growth is gonna be over the next ten years.

>> Kevin Warsh: We don't know what it'll be in the next ten minutes.

>> Peter Robinson: Correct.

>> Kevin Warsh: So I agree, but I'm willing to take the over no matter what our government does. It turns out that while not a birthright of the American citizenry.

 

We're an incredibly productive society. Our government might be trying to fix prices because of QE over the last 15 years or so, but the American people will show a dynamism and adaptability and an agency that's impressive. If we could grow 1 percentage point more per year than the Congressional Budget Office forecast, which is like most, that would yield another four and a half trillion dollars of revenue into the Federal Reserve.

 

Excuse me, into the federal government's coffers.

>> Peter Robinson: Right.

>> Kevin Warsh: Well, that's a great way to defeat these liabilities. So it isn't too late, but to your question about if it can't go on forever, it won't.

>> Peter Robinson: Where are the alarm signals in world markets?

>> Kevin Warsh: So I would say.

 

 

>> Peter Robinson: Or in our own market.

>> Kevin Warsh: We don't want to get to that tipping point where we see flashing yellow lights and flashing red lights again, because this economy is even now, I'd say the best of the lot with the most promising moments. We can see things that are worrisome out there, but I wouldn't wanna say that this isn't eminently fixable.

 

But the longer we kick the can down the road, the closer we get to the tipping point. And the best way to avoid the tipping point isn't to get so close that we see it tip.

>> Peter Robinson: All right, so from a document published in March by the House Budget Committee, quote, in an attempt to eradicate inflationary pressures caused by Biden's deficit spending spree, the Federal Reserve hiked interest rates 11 times between March 2022 and July 2023.

 

Consequently, the average effective interest rate paid on the national debt doubled from 1.7% to 3.4%. And net interest costs rose from 352 billion to 881 billion. It's that 881 billion, which now means that we're paying more on debt service than we spend on the Pentagon, which is about 800 billion and change.

 

So, Kevin, the Fed still has a balance sheet of 7 trillion. How does it shrink that balance sheet? How does it claw money back in without raising it? In other words, we have to maneuver between Scylla and Charybdis here. This is a terrible pickle. And the current members of the Fed may say, Kevin, Kevin, yes, yes, yes.

 

Don't you understand, we're doing the best we can? In other words, what's your agenda for reform? That won't make matters worse.

>> Kevin Warsh: Yes, well, this might upset part of your audience, Peter. So this is a trigger warning, this is what one people like you and I do on campus.

 

I believe this administration inherited a mess, a fiscal and monetary mess, and it is incumbent on the administration to get out of it. No one said it would be easy. We didn't get into this mess overnight. We're not gonna get out of it overnight. To make the numbers you said somewhat easier, I think to understand, we were paying about a billion dollars in interest expense every day.

 

The day before COVID we're now paying more than $3 billion per day in interest expense. None of that's going to strengthen the military or help the least well off among us. That is being squandered away. So what do I suggest? As you pointed out and as you and I have discussed, but I'm not sure the economics profession believes this, there are two monetary policy instruments.

 

One is setting of interest rates.

>> Peter Robinson: Right.

>> Kevin Warsh: And the other, this money we keep talking about, we call it QE, we call it the Central Bank's balance sheet. If we would run the printing press a little quieter, we could then have lower interest rates because what we're doing right now is we have all this money that's being flooded into the system which causes inflation to be above target.

 

That's the $7 trillion balance sheet you're talking about. An order of magnitude large than when I joined the Fed. And at the same time you have another monetary policy instrument and that's interest rates. They don't work perfectly together. They're not perfect substitutes for each. But they're both monetary policy and too many that are in the central banking business say no, no, no, that balance sheet has nothing to do with monetary policy.

 

Well, if it did when you were growing it, it should have something to do with the conduct of monetary policy when it's going the other direction. I think we have to be honest about these two instruments and because I believe that growing the real economy is the more important piece for revenue, for fairness, for efficiency and growth.

 

Because you have higher inflation caused by the bigger balance sheet, we wanna shrink that. We can't do it overnight. We want the Treasury Department and the Federal Reserve to come to some accord, much like the treasury and the Federal Reserve came to in 1951. Who responsible for what?

 

Who's going to be managing interest rates? The Federal Reserve. Who's going to be handling fiscal accounts? The Treasury Department. We have blurred these lines about who's responsible. And when a President comes to power, his Treasury Secretary should be responsible for as the fiscal authority instead of blurring that over to the Federal Reserve, which only brings politics to the Federal Reserve.

 

And I would say interrupts their normal ordinary course. In my judgment, we should be shrinking the Central Bank balance sheet, taking the Fed out of these markets unless and until there's a crisis. And in so doing, you'd have less inflation that way. You and I might call that a practical monetarism.

 

I think that's what our intellectual heirs might be thinking about, intellectual teachers might be thinking about. And in so doing, you might actually be able to pull off lower interest rates which matter more to the real economy than the balance sheet.

>> Peter Robinson: All right, Kevin, let me ask you, in closing here, about two visions of the country.

 

And let me set this up with, again, a couple of quotations. Here's you, Kevin Warsh. This is beginning with the great moderation, so beginning in the mid 80s. For about 40 years, Americans scarcely thought about changes in the price level. Things were working the way they should. We could take it for granted because intelligent, hardworking people permitted the rest of the country to get on with its business, correct?

 

All right, here is former fed Chairman Alan Greenspan testifying on the financial crisis of 2008 before Congressman Henry Waxman. Greenspan, I made a mistake in presuming that the self-interests of organizations, specifically banks, were such that they were best capable of protecting their own shareholders and equity. Coming from Alan Greenspan, who began his career as an Ayn Rand fan and was as deep a believer in free markets as you could ever encounter anywhere in America in the 20th or 21st centuries, that's a statement.

 

Waxman says, in other words, you found that your free market ideology was not working. Greenspan, that's precisely the reason I was shocked because I have been going on for 40 years with very considerable evidence that it was working. Okay, so here's one vision. Beginning with Fed Chairman Paul Volcker and President Reagan back in the 1980s, we achieved low inflation, sound dollar, overall federal spending is low enough to permit the economy to grow.

 

Indeed, it grows faster than the Federal spending. We've got, as George W Bush comes into office, and before new wars take place, as he comes into office, we're actually running projected to run for a couple of years. We ran or projected to run a surplus, but it's over.

 

The financial crisis changed the world, the COVID lockdown. We have over a decade now of fiscal irresponsibility and market distorting easy money. And now you have market professionals such as James Grant and Ray Dalio casting doubt on the whole monetary system and young entrepreneurs buying Bitcoin because they no longer trust the dollar.

 

Kevin, something basic is over and it's irreparable. What do you make of that vision?

>> Kevin Warsh: That's outrageous.

>> Peter Robinson: Really?

>> Kevin Warsh: I am not a quitter. The country is not a quitter. The country is on the verge of a productivity boom, in my view, that makes that productivity boom that you knew when you were sitting in the Oval Office, helping as a scribe to the President, that's gonna make the 1980s look like we can do it all over again.

 

 

>> Peter Robinson: More than AI, so give me your vision. Give me your vision of what can happen if we don't continue screwing it up.

>> Kevin Warsh: Our government has done its level best now for more than 15 years trying to screw around and do harm to this economy and we have failed miserably, in spite of our best efforts, to undermine the United States and its role in the world.

 

The 21st century can be America's century. We have real rivals, a G2 rivalry, much like you once knew, with the Soviets on the other side of the world. We have to take it very seriously. But, boy, I'd much rather have our cards than theirs. The broad conduct of public policy doesn't have to be perfect.

 

You and I could envision, with colleagues around here, what would make for perfect trade policy, or regulatory policy, or tax policy. But of course, perfection's not the necessary ingredient. We just need to make policy a little better than it is, move it directionally back towards something that makes good sense in monetary and fiscal policy, and the US economy will boom.

 

Now, there's a tendency among some of our peers to say, well, we should just do what Reagan did, but those days are behind us. Hayek, I think famously said, the job of people like you and me is to take the ideas from the past and to restate them and rethink them in the minds of a new generation, and so it's not going back to Reaganism.

 

It's a new set of economic policies in a new world that can drive the American spirit, that can drive individual liberty and freedom. And importantly, they need institutions like the Federal Reserve to be restored to what they once were, which is important institutions that are on the sidelines most of the time and can come in in exigent circumstances.

 

And in so doing, we'll have more fiscal responsibility, we'll have higher economic growth, and this new generation of technologies, I believe started here, and the US Will be a huge beneficiary. It's not preordained, it's not a birthright, but I believe it's not only possible, but likely.

>> Peter Robinson: Two last questions, summary questions.

 

The Fed does not need to be ripped up. It doesn't need to be smashed and rebuilt. It just needs to correct its present course a few degrees. The aircraft carrier takes a while to adjust, but a few degrees will do the trick, have I got that right?

>> Kevin Warsh: Right, I think you do.

 

The Fed doesn't need a revolution. It's had a revolution in the last decade. What it needs is some degree of restoration. I know you're not a golfer, but I learned this from a famous golf course architect named Gil Hanse. When he looks at these golf courses and he tries to think about how do I make them great again, he says that he is inspired by their past but not bound by it.

 

Faithful to what the architects of that golf course, in this case the Central Bank, had in mind. Faithful to it, but don't have to literally recreate it. Again, this is just like we can't go back to Reagan regulatory policies, or Reagan fiscal or tax policies. We can't go back to Reagan monetary policies.

 

We can look back to an institution and try to restore its best elements and keep in mind how the world is changing. You made reference to Bitcoin, and I thought I heard a little bit of condescension that people are buying bitcoin in these things.

>> Peter Robinson: But doesn't it?

 

Charlie Munger, this is two or three years before he died, Charlie Munger attacked Bitcoin. He called it evil, in part because it would begin to undermine the Fed's ability to manage the economy.

>> Kevin Warsh: Or it could provide market discipline, or it could tell the world that things need to be fixed.

 

 

>> Peter Robinson: Bitcoin does not make you nervous?

>> Kevin Warsh: Bitcoin does not make me nervous. I can hearken back to a dinner I had here in 2011 with someone who is another guest on your show, I won't say his name. Okay, I just did, Mark Andreessen, who showed me the white paper.

 

That was the original white paper. I wish I had understood as clearly as he did how transformative Bitcoin and this new technology would be. Bitcoin doesn't trouble me. I think of it as an important asset that can help inform policymakers when they're doing things right and wrong. It is not a substitute to the dollar.

 

I think it can often be a very good policeman for policy. And if I were to speak more broadly to what did Charlie Munger and others perhaps have in mind. There is a proliferation of securities that go under all sorts of names. Many, if not most of them are not worth what they're might be being traded for.

 

So what did Charlie say, and maybe his pal Warren say, there's the innovators, the imitators and the incompetence. They're real innovators that are happening in and around that new technology. And what I would try to impart towards businesses and bankers is that the underlying technology that Mark showed me in that white paper, or tried to show me in that white paper, it's just software.

 

It's just the newest, coolest software that will provide us an ability to do things that we could never have done before. Can the software be used for good and evil? Yes, both like all software. So I don't cast aspersions like that. If there's a final point, it's these technologies are being built here.

 

I don't just mean on Stanford campus. I believe in the United States and the world's most talented engineers from China and Europe and everywhere they come to the United States even now to try to build this stuff. And my view is by building it here, that gives us an opportunity to be more productive and create something very special over the next decade.

 

 

>> Peter Robinson: Last question, Kevin, last question. You back in Manhattan, you work with one of the great investors of the last half century, Stanley Druckenmiller, and you're known as a macro house. You're looking at large global trends. So you see, and I know you see in detail because I know that you've been to China over and over again to investigate matters on the ground in China.

 

There we have China, which since roughly the very late 70s has lifted hundreds of millions of people out of poverty, built a modern economy. We now see growth in India, more openness to markets in India. It's lagging China, but it's coming on. We even see, I say even because for many decade, decade after decade, these were viewed as trouble spots.

 

But in sub Saharan Africa, there are signs of real economic growth in Nigeria and Kenya, among other places. Looking at all of that, aware of all of that, Kevin Warsh is still long the United States of America.

>> Kevin Warsh: Absolutely, I'll say a couple things if I can-

>> Peter Robinson: Of course, you know that.

 

 

>> Kevin Warsh: The US is the innovator of almost all of these technologies. Now might they be used in other places, absolutely. The most talented people in the world still wanna come here. The most talented people that are in the United States wanna build here. Economic policy, I believe, is trending in a better direction over the last half year than it has been.

 

Economic policy isn't perfect and it never will be. But the American people are ready to be liberated from the shackles they've been under. For all the policies that have been discussed around this table and others. We haven't mentioned the regulatory tax that has really done great harm to the US economic growth over the course of the last decade.

 

That tax is coming off, I believe, in part we've talked about this productivity revolution. We talked in some sense about technology. But I think that humans are underrated, American humans in particular, and their ability to adapt to new technologies and thrive, I think, is very real. This might sound Pollyannish to some of your listeners, but what we used to call the micro foundations of macroeconomics, which I will broadly translate in another trigger word, the culture of what's happening in the society.

 

The willingness to take risks, fail, and take risks again they are still happening in the United States more than anywhere else. They're not happening in France and Germany at this rate. They're not happening in China at this rate because of their own governance issues. And it's an incredibly exciting time as we take that regulatory tax away, as we restore some economic policies that could, that have worked better before, as we're reforming institutions right now.

 

I'm willing to take the upside of economic growth here, and I'm willing to bet that the Central Bank fixes matters that are broken, achieves price stability yet again. And the rest of the world might not love us, but once again, they're gonna look at the US and say, in spite of some of the things we don't like, their economy is growing faster, and that's where we wanna send our capital.

 

 

>> Peter Robinson: Kevin Warsh, thank you.

>> Kevin Warsh: Thank you, Peter. Honored to be back on the show.

>> Peter Robinson: For Uncommon Knowledge, the Hoover Institution and Fox Nation, I'm Peter Robinson.