Explaining Macroeconomics, The Fed, Interest Rates and Valuations (with Matt McBrady)

Ben: Hello, Acquired LPs. Welcome to an episode that is 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. 

Matt: Great to be here, Ben. It's always great to see you even if it is virtual in a new world of ours that we may be stuck in for a little while longer, courtesy of Delta, although we all hope not.

David: Hybrid is great. 

Ben: By way of background, I know Matt because we've worked together for a good part of last year on a PSL project. 

LPs, 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 Advisers in 1998, directly for Janet Yellen. 

You worked, Matt, in the US Department of the Treasury in 1999 and 2000 under Tim Geithner who was then the Deputy Treasury Secretary, is that right?

Matt: Yeah, he was a deputy.

Ben: Then at BlackRock, you ran the multi-strategy hedge fund. You've played in the operating world where you currently sit on the board of, is the company named Taser or Axon these days?

Matt: It's Axon these days. Taser is still the brand name of the most well-known flagship product that conducted energy weapons. 

Ben: Got it. Also, you helped get aQuantive off the ground in 1998–1999 running analytics there. Is that right?

Matt: Yeah. Our mutual friend, Mike Galgon, and I actually came up with a business model when we were running along the Charles River. 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. 

We kept running farther and farther because we were having great conversations, and before we knew it, what we had come out was the fundamental idea behind Avenue A, and then also the realization that we might be able to run a marathon because we're running 15 or 16 miles. 

Two things I never thought I would do before meeting Mike: (1) Found a tech company, especially back then, and (2) run a marathon. And I got a chance to do both.

Ben: It's awesome. 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. I think you pretty much have seen every angle of everything we're going to talk about today. 

Matt: Yeah. I guess I don't stay put very long intellectually or career-wise, so I kept also trying different things. If there is a value to having a perspective as a policymaker, an academic, a private equity guy, a hedge fund guy, an entrepreneur, armchair angel investor, and a 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.

David: I love it. I got to ask, have you seen the meme on Twitter of the deep fake video of Janet Yellen, Jerome Powell, and Ben Bernanke singing the Rickroll song, Never Gonna Give You Up?

Matt: No, I haven't.

David: 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.

Matt: Oh, very nice. I can't wait to see it. 

Ben: We're going to do a Q&A with Matt here. 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 in plain English answers. 

Matt, I want to start with a very general question for you in definitions. What is the money supply? When people have heard things like M1 and M2, what are those?

Matt: 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. 

Everybody knows what money is. 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 on candy and sometimes little toys that she figures out how to play games with and beats me every time that she goes me into playing with her. 

That money, the cash in the hand that she uses to spend stuff is M1. 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. 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 Fed stopped tracking some measures of it. So M1 is just a representation of currency, coins, and notes. 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, and anything that can be readily turned to cash. The really important reason that that's distinguished is that everything purchased or sold in the economy, which ultimately becomes the GDP, is done with cash at the end of the day.

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. 

Then, there's an M3. There used to be an MZM that the St. Louis Fed recently retired in the attempt to track over time. This is literally just a way 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. 

Ben: Just to test my understanding, a $1 bill that I'm holding in my hand right now; just pulling off my wallet here.

David: I'm amazed you have a $1 bill in your wallet. That's so old-school.

Ben: This $50 right here is M1.

Matt: Yes, that is M1.

Ben: I don't have a stock certificate here in front of me, but I just recently bought some Spotify. What is that?

Matt: Spotify is not going to be in the money supply, which is interesting because you could 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.

David: Would a T-bill be an M2?

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

Ben: 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?

Matt: Yup. You are asking exactly the right question. If you didn't, I was going to take us there next, which is like, why on earth do economists and the St. Louis Fed take a huge role historically in tracking this stuff? 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.

Makes sense because as I started off by saying even my nine-year-old niece knows what money is, it's the thing you buy stuff with. So if you tracked good enough data on the total amount of things to buy stuff, that should correspond to the total value of stuff bought. 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 or matter anymore—the relationships that were historically very strong really started breaking down around 2000. That's perhaps one of the reasons why I'm saying that Feds are no longer tracking some of this stuff because why bother? The relationships really aren't there that used to be there.

Ben: Is there a percentage of our total economy that is healthy to have in the money supply? Or should the money supply match one-to-one the entire value of America's assets or America's GDP, what the right comparison would be. Is there any ratio we try to maintain?

Matt: Yeah. This is another fantastic question. It'll also get us probably to what we want to talk about next, which is how and why monetary policy works. We'll eventually get to why it's profoundly different today and has been ever since the advent of large-scale QE around 10 years ago in the US and almost 20 years ago in Japan.

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 managing as money supply—then you thought it was about $800 billion. As we now know, the Fed is currently adding an additional $120 billion every month to its balance sheet by buying securities. 

That gives you a scope of how much things have changed. For a long time, it was a firmly-held belief among economists that you really didn't want to monkey around with the overall size of the Fed's balance sheet. 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 this stuff works.

It is very intuitive to think that there should be a relationship between money and the overall size of the economy, and there was (in fact) for a very long time as we talked about because it corresponded very nicely to the size of GDP and the aggregate measures of money. 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.

David: This is great. We got to ask. What's changed?

Matt: This requires a little bit of a walk down memory lane and a bit of the simple explanations that really underpin most of everything that can be understood. Really, to understand what's changed, we have to go back to why monetary policy worked so well for so long.

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 at least through the end of the 1990s in the US when we repealed Glass Steagall—most of the purchasing power in the economy really was people who were holding currency, people who had their money in a bank, or people who could borrow money from a bank.

So as long as banks were 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.

That was the story of the beginning of the Fed, and the beginning (frankly) of modern fractional reserve banking. But that story began in a really inglorious way in the turn of the century and even before with a series of bank panics after bank panics because banks were allowed to be state-chartered. Some are more independent. They could really just create these pieces of paper saying IOU. This IOU, if you're a reputable bank, other banks would take it. That was money just like it is today, but it was a free-for-all. 

Just like in It's a Wonderful Life, someone got nervous. That tells you all you need to know about central banking history and monetary policy theory. It's really orchestrated around this notion of these fragile banks that can fail. Back then, what you needed was some type of an entity—which is 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, so somebody's got to step in.

David: And we got to protect the customers of that bank.

Matt: Yup, So the Customer Protection came in 1933 with the creation of the FDIC. That was all part of the Glass Steagall Act which was the one repealed at the end of the 1990s when coincidentally, a couple of years later, those relationships broke down between money and the aggregate purchasing power, the GDP that's observed in a subsequent period of time.

David: I don't think about it much in these terms. As always, this is not financial investment advice on the show. I don't know about you guys, but I'm trying to keep as much of my wealth not in banks as possible. Not because I hate banks, but it's better elsewhere. Why bother?

Matt: Yeah. In fact, this is basically a bit scattershot. It'll make more sense if we 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 central feature and controlling the extension of purchasing power into the economy—they (right now) are really just giant securitization machines which means 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. That's stuff I used to play in my hedge fund days.

Ben: You're saying that banks basically don't carry a big debt load on their balance sheet in the way that they classically always have because they don't actually own the debt that they're lending out. They repackage that and quickly sell it off.

Matt: Yeah. Rather than the debt load, the asset load. In the old days, it was loan and hold, originating in hold banking. I had loan officers, they went around, and they decided, you, Ben Incorporated are worthy of a loan. I'm going to give you one and I'm going to keep it on my balance sheet. I'm going to check up on you every month, every quarter, every year. As long as you don't violate my covenants, you're going to keep it and I'll give you more loans. 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 banks would get bigger loans and build more factories to make more (I guess) widget insights.

David: More podcast episodes?

Matt: Yes, more podcast episodes. Now, on the other hand, the securitization market is literally like, let's find 1000 Ben Inc., let's make short term loans to them, and 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 number. I'm going to send it all to the markets, get the money back, and rinse, lather, repeat, reload. Just keep going and keep going. We need enough capital to keep that machine going and we can't afford to have that machine stop.

That was what happened 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.

Ben: Before we get to that point in history, I want to hear a little bit more about the history of the Fed. You talked about the turn of the century, some runs on the bank, and a lot of instability. The Fed is older than 1900, right? Or is it a fairly recent innovation?

Matt: It's not. It's really interesting. Probably, in fairness, I would say the motivation for a Fed actually first took hold or started to roost 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. 

It was finally enough to get the largely rural—they call themselves progressives at the time—to get over their fear and hatred of the centralized, money-empowered interests of the eastern cities. This is just like American history stuff at its core.

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. Different political powers would come in and go, no, not a priority. You'd have another one. 

In 1907, there was another big bank panic and once again, JP Morgan had to come in and literally lend the money to the banks to save the American economy.

Ben: JP Morgan, the guy?

Matt: The guy back when he was a financier. He had a bank, of course. It's still the same bank. It still bears his name today, so a proud history for that institution.

That was the last straw where 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. Then finally, years later, the Federal Reserve Act finally came out five or six years after that. 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 monolithic building. We've got the 12 regional banks that are all coordinated by the Fed Board of Governors which is here in DC and not far from my home.

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

Ben: Purchasing power being like, Americans can't buy stuff because they don't have any money because the bank where they were keeping their money lost their money.

Matt: Lost the money, exactly. 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 is purchasing power. Then, all of a sudden, firms that were going to pay their loans back can't pay their loans back. That was the beginning of the Fed.

The evolution of the Fed is what's been really pretty neat as well. Literally, as globalization happened—ironically through World War I originally when the bank started first extending or accepting bankers acceptances to support international trade—it's gradually figured out better ways to do it, saying, my job is to make sure credit flows in the economy whether it's war time, bank panic time, anything else. That means I, the 12 Regional Federal Reserve banks, have got to be willing to actually bite my lip a little bit, jump into the end of the abyss, and say, I'm going to lend when things get scary and then keep the system going.

Then eventually, out of that 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, oh, 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. Let's give that a shot.

David: So this was the beginning of the linking of monetary policy with fiscal policy.

Matt: Yes. Although not yet fiscal policy because those were government bonds that already existed, you're getting us right in the direction of what modern monetary theory is all about. We'll get there toward the end of the episode, I know.

Ben: How did the Fed in its original incarnation have money to lend to banks if it wasn't originating from the federal government? Where did the money come from?

Matt: It had the ability to create money because (remember) when 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. Where do you think all the banks put their money? In the Federal Reserve. So whenever the Federal Reserve wants to actually give credit to a bank, all it does is make a book entry transaction. 

It's literally, hey, guess what, Ben Bank? You now have an additional $100 million to spend. I've just given it to you. It's on deposit in your account. Then poof, money comes out of nowhere. By the way, it still works that way.

Ben: Okay. 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 another participant in the system, the federal government. How does that work?

Matt: The federal government's actually not in the Federal Reserve System. The federal government's on the other side. That's fiscal policy. In the central bank, that's monetary policy. 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.

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.

When I think of monetary policy, especially back in the early days when it was being created, it was not a fine-tune-the-economy exercise. It was to keep banks from going bust. Then, it really expanded from keeping 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. We can do that because our productive resources are still fully functioning and in Europe, they're getting bombed and shut down.

The way we can do that is we got to somehow enable the companies that are making stuff in the US to get cash to make stuff when it's going to be a while to get it from Europe. In fact, the way things used to work back there or what I referenced earlier these banker’s acceptances, is the European bank would say, on behalf of a buyer of American bullets, guns, or whatever we were selling back then, our provisions and supplies would say hey, here's a good IOU. Trust me. I will pay you as soon as the goods get there, but it's going to take a while to ship them. They would get this thing called an IOU, those banker’s acceptances, and companies would be like, what am I going to do with this? I can't pay my employees with this.

They would go to their bank and their bank would likewise going to go, what am I going to do with this? I'm not going to get paid for five or six months. Okay, I guess I'll give you some money, but it's going to be a really high rate. Then, the Federal Reserve bank started saying, you know what? I'll take those and then I will give the bank credit. I'll give the bank credit on better terms right now. That lowered the price of financing and increased the ability to export to support the war effort.

It's pretty neat. It's amazing how much the evolution of the Fed has really been driven by just creatively adapting to the demands of the day to keep the flow of credit flowing.

David: The Fed is like Capchase, Pipe for software companies today. They're like, oh, you've got these forward SaaS revenue contracts. I know you're going to get that money. I'll take those contracts and I'll give you the money.

Ben: 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 that stuff is happening.

Matt: What's so cool about that, too, is that’s arguably why this monetary policy doesn't work anymore. I'll tip my hand. 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 do know a lot of folks there and I'm not disparaging any of their efforts. I'm just saying in a world where if you go back to first principles from the beginning, again, keep it simple.

The simple story of when the Fed worked really well was when banks were the first-order driver of the purchasing capacity for every agent in an economy—a firm, a person. Ultimately, that's just not the case because now, there are 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, I just don't see that being important anymore.

Ben: To try and pare it back my understanding, because the banks aren't the one who hold the risk, there are lots of participants in the ecosystem now who are willing to bear risk.

Matt: Yeah. If you and your listeners have heard the term shadow banks, yes. That's a murky, rather more exotic probably than it deserves to be a sounding term. It was originally coined to refer to a lot of the securitization markets that were actually creating short-term loans to companies through securitizations, commercial paper, and things like that that were held by other entities other than banks, like huh, interesting, these are shadow banks.

David: That's what Capchase, Pipe, Stripe, Square, and all these companies are doing.

Matt: Yup. It's interesting because ultimately, when you can get cash or something you can finance out of those, again, it's just another source of generating purchasing power which is not really responding to conventional monetary policy.

Ben: All right. Tie 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?

Matt: Since the Fed provided exceptional stimulus in COVID, and that's the big debate on when's taper is going to start. Is it going to start in September? Is it going to be November? Is it going to be next year?

We've seen a few different episodes of when the Fed started trying to taper its support and that not ending in pretty terms for markets. It always seems to increase volatility and cause some really pretty sharp, nasty mini corrections before the Fed goes, just kidding. I guess I'll stick with it.

The extra $120 billion is literally the Fed's commitment to buy additional securities from the market that I went into. It's through its series of programs last year, every single month. Every month, just like we said before, just like in the It's a Wonderful Life world where Ben Bank Inc. needs to actually credit the $100 million of credit to stave off nervous customers and reassure them in a bank panic, 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, guess what, I'd like some securities. They take the securities, pull them out of the market, and they credit the dealer bank with just newly-created dollars in that dealer bank's account. The bank gets paid for it.

David: In the market's writ large, every month now, there's $120 billion of extra buying pressure from the Fed.

Matt: Yeah. Boy, if any of your listeners are wondering why is it that the valuations keep running every single month for companies at lower and lower levels of development, and 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 a lot of new purchasing power being created. It's not purchasing new goods and services. It's going right into the capital markets.

Ben: The Fed is now holding all this stuff. I don't actually know the right words for this $120 billion of stuff.

David: Yeah. What did they do with that?

Ben: Why isn't it a bad thing? Give me the bull case and the bear case. Let's try to do both sides of this argument. Is it a bad thing that the Fed is now the owner of all this stuff? What is the stuff?

Matt: Let me give you a 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 too much about how or why it maybe doesn't work anymore. We also are not sure how interested your listeners are in inflation.

So far, monetary policy has just been the hero. They're the Marvel comic, the next thing. It's like Captain Monetary Policy. He swings in, prevents banks from collapsing, and it's really cool. But most of, at least in my adult life as an economist, I know a lot more about monetary policy being the sneaky villain who lurks behind the dark corner and then unleashes the wrath of inflation which will be burning through a city and tearing down other buildings, just not banks. We should probably touch on that at some stage, too. 

The high-level answer about whether it is a good thing or is it a bad thing, you hear a lot of this reference in the press. It's a good thing if you really do believe that in exceptional times like during COVID with Congress that was not ever going to pass any fiscal support. Remember the other thing. 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. The Fed can frankly just act a lot faster because they don't need acts of Congress.

When this all first started happening, they're like, I got to act really aggressively in the only tool I got because interest rates are already pretty near zero. 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. Now, I'm just going to buy a bunch of stuff because I'm trying to flood the markets with this cash.

Good thing, maybe you got to do something. The only person who could really act was the Fed. Bad thing if you stick with it for too long. This is what more and more folks are calling for. It's distortions and asset prices. Create asset pricing bubbles. 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.

Ben: 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.

Matt: Correct. The Fed acted much faster because it could. Then ultimately, we did see that the stimulus was much bigger than I expected. In fact, in conversations back and forth with my former colleague from the Clinton administration and my good friend Dr. Doom himself, Nouriel Roubini, we were 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? 

As always, he was pretty much spot-on. He was like, I think we need more than $2 billion. I was like, boy, we're never going to get that, man. He's like, no, we will be there. We ended up getting it. I remember then sending him a note going, whoa, man, they actually did it. Interesting.

We ended up getting a big fiscal stimulus. 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 (quantitative easing) in the United States in 2011—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. He was like, no choice but to actually create this tool which then was used in the big bazooka way to fight COVID in 2020. 

Because we got the monetary policy and the fiscal policy, that's what MMT 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 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.

Ben: 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. 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? What are the assets? Are they buying company stock?

Matt: First, I'll give some definitions because that's the important part. We haven't talked about in the modern days, we did actually get [...] 20s or 30s and started talking and jumping right to the 2020s. I warned everybody upfront that maybe my career trajectory 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.

We were in the 20s or 30s when I said the Federal Reserve Bank of New York Governor invented open market operations—or what we now call open market operations—by saying, I can really increase the supply of credit or purchasing power into banks by buying government securities. Turns out, that then matured and grew into the current framework that the Feds have been using really for as long as I can remember, probably really since the 40s or 50s by controlling interest rates.

Ben: Government securities being treasury bills?

Matt: Yeah. Back in the early, early days when it was done by the Fed in the 20s, it was government security so treasury bills. Absolutely. More recently, it's been conducted. By recently, I mean literally as long as I can remember. We didn't really talk about the history of this stuff in grad school. Maybe because it goes all the way back to the 20s or 30s and it evolved from there. But this was done by the Federal Reserve Bank of New York still and something by a group called open market operations desk.

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 and there's a demand curve, and the price is where the two of them intersect. To say you control a price is like scratching your head going, you can't control the price. Not if there's a supply and demand curve that's the result of the intersection of the supply and demand curve.

The way that this actually works 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. 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 the deposits in the Fed. If you don't have enough deposits in the Fed, you get a slap on the wrist and a penalty. Everybody's got to basically do that.

The way that interest rates are controlled was 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 and published a paper on them because they're weird to me after finishing a PhD in financial economics systems. I was like, how does this work again? Why does this security exist? What a repo is is literally an agreement to buy or sell something, turn around sometimes the next day, a week later, a month later, or three months later, and reverse the transaction at a preset price.

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 the money supply to bring it back down. I not only control the rate. I actually can only control supply. That's what I do. I'm going to increase supply by buying a bunch of repos. 

I probably have that backwards and maybe reverse repos because I always forget whose perspective the terminology works, from the Feds or the dealers.

What that really means is it agrees to buy a bunch of securities. I'm taking 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.

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. 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 targeted, but that's historically been very tightly-related with labor and all these other sorts of indexes of short-term interest rates.

That's how monetary policy always worked. It worked essentially that way as the ultimate evolution for what we talked about back in extending credit to banks to avoid bank panics. Then, you get into quantitative easing. The insight there was we seem to have actually given banks as much money as we can possibly give them and it's not doing anything. No more loans are happening. Nothing's really going on.

As a result, this was after 2008, the aftermath of the financial crisis where we got zero interest rates for the first time. The zero interest rate was a classic. I trust the regulators and say, oh [...] moment, for the part of all policymakers because the key models underneath macroeconomic policy and monetary policy are really based on this notion that the way that you stimulate the economy is by lowering the interest rate. 

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. I guess we got to start some inflation. 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. 

The desire to create inflation is a bizarre thing, but you hear central bankers talking about it all the time. Inflation is too low. Ask most American households, 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—it's about getting the real interest rate lower—they're like, we got to do something.

This is back as I alluded to with Bernanke was pleading with Congress and through the way that a central banker can do so, through code, 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 aggressively as it was. He was like, let's just be clear. Monetary policy is not a panacea. It's not the right tool to fight this. He's saying, give me some fiscal policy, please.

When Congress turned a deaf ear, he was like, I got to do something. I'm going to not actually tell the open markets operations desk to buy a bunch more repos, which are these short-term ways of getting money into the short-term interest rate market, because short-term interest rates were essentially already zero. He's like, I can't do anything there. Aha, I'm going to buy long-term bonds and 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.

He went and bought first only treasury securities. Ben, you started me out 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, we're like, whoa, this isn't a repo. This is now increasing the balance sheet because all of these short-term transactions are what 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.

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, according to the old paradigms, that Milton Friedman coined as monetarism and lots of other folks had similar ideas, a massive increase of the money supply always and everywhere was supposed to create inflation. Everyone's like, this is going to be a little ugly.

David: Also, is there the element of fear here that you're connecting your exhaust up to your intake in that? One part of the government is buying the debt of the other part of the government, right?

Matt: It is a little strange, isn't it? This gets back to the fear of inflation, which is what a lot of folks were worried about. Even though Bernanke and everyone else who's an economist was saying, we need bigger fiscal policy, we need more aggressive support for households, we need income support, we need infrastructure, we need lots of other stuff we're talking about now back then, it just wasn't happening.

Most of us who are economist said what 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, we've got this aggressive Fed who's buying government bonds. Exactly like you said, isn't that just basically printing money and giving it to the government to spend? The answer was yes, it was actually.

It certainly made a lot of folks nervous, either for inflation or a lot of economists at the time were really writing a lot. It's amazing to me that it just stopped being a topic of conversation about what the exit strategy is going to look like. When Bernanke explained what he was doing and why he was doing this, his description or his logic was as follows. It was, boy, right now everyone's afraid to take risks.

Nobody wants to own stocks. Everybody wants to own safe stuff. I'm going to go and buy up lots of the safe stuff, which are the government bonds. 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.

David: Right, because there's nothing else to buy.

Matt: There's nothing else to buy. It was like, I'm going to force you into doing the thing that you don't want to do. 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. It worked. All of a sudden, there wasn't anything else. All the safe stuff getting purchased by the Fed. We got to put our liquid investable resources into stocks and riskier stuff. They started rallying and then we've got our markets up 400% since then.

Ben: It's fascinating. People, 13 years later, definitely bought a lot of stocks, and prices of stocks definitely went up a lot, as you suggest. The other thing that they were trying to accomplish, which to create inflation in order to reduce the real interest rate. Did that happen?

Matt: Yes. 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 glossed over at it 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. Everything we did and anything you published had to be turned into a mathematical model that had a formal closed-form solution.

We had these elegant models. 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. 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. Now we have to get the interest rate down so we can overcome those frictions in the economy, so that we can get growing again. 

Bernanke would have absolutely loved to have a world where he could have cut the nominal interest rate. 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 different?

Ben: The Fed. The open markets desk and the Fed.

Matt: 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. He's like, I got to do everything I can do, which is go buy these securities. Maybe it will drop the long-term interest rate, which would reduce the cost of capital. I guess that's probably going to make people invest more stuff because that's what my models all say.

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. Hopefully, that'll generate some inflation. Since 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 to a minus one or minus two, as long as I can get inflation up to about 2% again.

Then we'll be gangbusters. We'll start growing right back, everybody will go back to work. Now I can sneakily start pulling away some of the punchbowl, which in this case means all of these securities I bought and created brand new money for, and then I've got my balance sheet, I'm going to try to give back to the market at some stage when the market’s not paying attention.

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 giant open-ended QE was launched in 2011. 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. It was a big deal for anybody trading liquid securities, especially government treasuries.

It created a huge crash of the bond markets, any short period of time. 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?

Ben: This is not even the Fed trying to sell all these...

Matt: No, this was just slowing its purchases. Bernanke'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. I have no doubt, he was very deliberate about thinking 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 stopping, I'm slowing them. I'm sure I'm not talking about selling the stuff that I actually own. That was enough to make markets get really scared really quickly.

David: This was like a little preview of the episodes we've had in the past 12 months here, where when Jerome Powell makes some offhanded comment somewhere and then the markets crashed because they like, oh, well, good times are coming to an end.

Matt: You are 100% right. In fact, there have been a couple of other episodes since the original taper tantrum where 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, 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 six 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. 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. I was like, yes. I was helping build an internal investment office for a large nonprofit at the time. 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 I went for a really short duration.

That means well underneath the targeted amount of bonds we held in our portfolio because I was like, yes, he's going to actual paper, he's going to cut off the QE supply, and it's going to be beautiful. I don't want to be holding a bunch of bonds when interest rates go up and their value goes down. I was very well compensated for that decision for a short period of time until, he then said, things are getting a little too scary. The markets actually had taken the nosedive that they did. 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.

David: Good times keep on rolling baby.

Matt: Yup.

David: Wow, which is also the hilarity of the meme of the Never Gonna Give You Up Rickroll.

Matt: Completely. Come back to that one, boy, it's exactly what's going on right now.

Ben: One question that I would have, the rat brain question is, how on earth are we going to stop buying all this stuff? As the Fed is going to stop buying all this stuff and actually start selling some of it. I think the second order question is, is this okay? Can we exist indefinitely with the Fed being large or getting larger and larger?

Matt: It's a wonderful question. 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? Let's start actually in the simple way that economists have always thought about and frankly, still do in a way that I think is probably wrong, which is just about good market inflation, goods and services. The inflation of the stuff we buy, let's hold aside the asset and price inflation for a second.

Remember, just going back to that bank centered world where the world was really simple and the things that people used to buy stuff, either with 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 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.

The high level intuition at any given time, there's only so much stuff that the economy can make. Imagine a simple world. To play this out in a toy example, imagine a simple world in which there's $1000 worth of goods and services that are provided by a basic economy every year. In turn, there are $1000 worth of dollars in circulation or people who have got deposits in banks. In 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.

You lend it to David and then David basically says, cool, I got $100, and he deposits it in another bank. The other bank, cool. I got a $100 new deposit. 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. Matt goes, cool, I got $90. I take it to a bank and say, cool. Keeps $9 with the Fed and it just keeps going again, and again, and again.

This is the classic money multiplier idea that everyone probably heard of if you had a first course in finance, and that underpins the velocity of money. In that world, even a $100 increase in the money supply would translate into an additional $1000 because of this circular logic of everybody's loan becomes somebody else's deposit, which is more loans. In that world, suddenly our economy that started off only having $1000 of purchasing power has $2000 of purchasing power. The price of everything as a result, would double.

David: Because there's still the same amount of goods that are being created.

Matt: Still the same amount of stuff.

David: Before it costs $1000 for everything, now there's $2000. That's going to cost $2000 for everything.

Ben: In a way, the analog I always think of—and this is imperfect—it's like dilution. Lots of our listeners are very familiar with owning shares of a company. Imagine if they just said, now there are twice as many shares. You're like, shoot, my share of this company is actually worth half of what it used to be now.

Matt: Exactly. It means diluting the currency and it's diluting the currency by raising the price of goods. What a currency is good for is actually buying goods. It's like, shoot, now any unit of currency is only going to give me half as many goods as it used to. That's the dominant fear of when we increase money supplies, that's going to happen. An interesting thought experiment is, when would that not happen? Any thoughts there? Play the old professor McBrady gig.

Ben: 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.

Matt: Ben was definitely the student who sat in the front row and always had the right answer, wasn't he?

Ben: Was that right or wrong? Because I could also see it being a very confident wrong answer.

Matt: No, that's a very good one. The fact that you explained it in a way that that's one of the most key economic concepts introduced into the whole conversation, which is productivity. 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 it 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.

Ben: At the very least, it seems like a supply chain. You can't start charging less for your stuff until your whole supply chain is charging less to you.

Matt: Great, great example. A great real world example. The ones in grad school are always much more stylized about people's behavior, real prices, and a lot of other stuff. I told you all this whole thing about complex stuff simple, simple stuff complex. Productivity growth is one great example. You think there's only one other big canonical one. What's the other reason that could have been true for the economy?

David: The only thing that I could think of is that there are other places to put your money. It's like you go invest in emerging economies, or other economy, or whatever.

Matt: Yeah, so you can invest it. We're going to go back into the asset markets. If we wanted to literally just come up with a world where we can buy just goods, how could you do that without necessarily increasing prices?

Ben: Number of participants in the system like population?

Matt: Yes. 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.

David: You're talking about essentially creating a welfare state.

Matt: Creating jobs. There's a bunch of unemployed people, and factories closed, and you did the same… 

David: Right. One way would be to just create a welfare state. The other would be we're just going to create jobs.

Matt: Yeah, ultimately. The purchasing power itself, created by this additional money—you got to remember this example started off with $1000 and a $1000 worth the goods and services bought—it's very natural for all of us to kind of go back and think, well, it probably just means everybody was working in the economy to produce those $1000. 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'd make, then voila, this is not going to create inflation, this is going to create additional jobs. This is going to create additional factory utilization. Maybe it'll even disperse some folks like Ben Inc's widget company or in the podcast producing.

We're doing so well on this, we're going to hire a couple of other radio voices. Maybe we'll get a McBrady to do a side podcast on random economic stuff and whatever else is on his mind in a day. 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.

Ben: I see. It's increasing the productivity per person and also increasing the number of people who can be productive.

Matt: Yes. Now we've actually gotten fully up to speed in terms of the current state of the art thinking. One of the reasons why fiscal policy has been so much on the sidelines for the last 20, 30, 40 years really...

Ben: In fiscal policy, for laymen like me being that Congress is not passing acts, saying we're going to go give [...].

Matt: Yes. Congress is not saying, boy, the unemployment rate is 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 will 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 banks are responsible for it goes by just getting more money into banks, then you don't have to really mess with fiscal policy. Fiscal policy can really just be scary. 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 into the early 80s, when Paul Volcker became 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.

That was when Milton Friedman as well was, at the height of his influence with his theory of monetarism which basically said if you double the money supply, you're going to double the price level. Back to that original world where you got everybody in full employment and you're making $1000 worth of stuff, if you suddenly tinker with monetary policy and you get $2000 with the purchasing power, you're going to get the same stuff for $2000 instead of $1000.

That was exactly the way the world thought of things until we got to 2008. 2008, the gigantic kaboom that brought interest rates down to zero and brought honest policymakers and academics to their knees in their oh [...] moment of going, what else are we going to do? Then it's where Ben Bernanke had given us studies as an early academic of the Great Depression. It was like, we got to do something. He did a whole bunch of some things.

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 in It's a Wonderful Life. It was these newfangled securitization-driven banks that nobody really understood, but then had the right folks around them, particularly Tim Geithner, by the way, who was playing a key role in all of that, as the head of the New York Fed.

He 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. I'm afraid of deflation, which means even with zero interest rates, we're going to get a positive real rate. That's going to stink, just given the way that the old models make everybody think about it. 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.

Ben: This takes us back to the question, is it a bad thing that the Fed owns a whole bunch of assets?

Matt: Yes. So many wonderful rich ways to answer this question. I'll start off with the feds description of why it's a good thing because they're doing it. That's probably a fair place to start. The sensitivities of the Fed are still very much calibrated to these models. 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. 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.

Ben: Do you know literally how this model manifests? Is it like an Excel spreadsheet?

Matt: That’s a great question. I remember my buddies had been in the Fed. I need to ask them. It's like, do you at least have some cool technology, underlying technology, or is it literally in the spreadsheet? The thinking is so driven by, okay, we've got to get the interest rates down. In a world where the interest rate is stuck at zero and inflation is really low, then we've got real interest rates as low as we can get them in the US where the real interest rates are really, really low.

This means minus one and minus two, even at the cash level. It's right around there, even as you go further out the maturity structure. In that world, when the Fed is saying there is still this chronically 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.

Remember this targeting inflation is just fascinating. Again, most of us think of it as a bad thing. For the Fed, it's a good thing. 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 at 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.

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? I can't do nothing. Now the Feds basically, still Jerome Powell's Fed, still 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.

My personal view is that they probably feel differently if there weren't such unfortunately well-precedented challenges that await markets when you start to taper QE purchases. 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.

They're 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. With today's jobs release, it's hard for me to believe they're not thinking of it as, that's sustained progress, but so far, there are no public statements.

David: Using employment as the right measure, I don't know what the right measure is, but I just think about it like, we all live in the tech industry and in a world where Instagram gets bought for a billion dollars and probably was worth many, many billions more at acquisition and had 13 employees. That's different from Jimmy Stewart.

Ben: 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 level of technology where some labor is able to produce an outcome of real value for consumers that is a 100 million X someone else's labor.

Matt: Ben, that's actually an incredibly astute observation, again, like the kid in the front row, getting all the right answers.

Ben: Thanks to David for the layup.

Matt: That too. To a level of depth, you might not even realize, one of the real challenges going on right now is, 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 thinking since way back in the late 90s when I had the privilege of working for as 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 are sick of it. These are the folks who are not showing up because our labor force participation is relatively low. What the Feds are looking to do is to pull these people back into the economy.

What we see is unprecedented levels of job openings right now, and still a lot of chronically unemployed people. That tells us exactly 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.

David: I actually don't know how I would show up in the Fed statistics right now. I assume not like a lot of people, but I'm being objectively very productive. I know Acquired is my full-time thing. You don't get this funded, it's like, objectively, my productivity is higher than it's ever been, and yet I am not employed in any traditional sense.

Matt: There's a lot of poor. This only means that David has a great call there, too. 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 the stage and it's like, well, no, most of us actually who got the skills that are being prized the most now will get the privilege of doing stuff we enjoy, which means we don't have a formal employer and a W-2. I think that's one of the challenges.

That actually brings us back, David, to your observation. That was a great one, which is like, boy, that's all well and good thinking about inflation, goods, services, and other stuff. How about this crazy world in tech where 13 people can be bought for a billion and probably, in today's prices will be worth 20 or 30 times that. That key observation is also the key to answering Ben's question about the downside of QE.

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, increasing the Fed's balance sheet and putting money into the system as a result for the first time. The whole logic was not to boost asset prices. The logic was, I need to basically do something, and I'm hoping to create inflation in goods prices. That way, the macro models 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.

It hasn't happened that lower interest rates have actually generated robust growth. What has happened is remember, going back to what I said how Bernanke described what he was doing quantitative easing for in the first place is going, I'm going to do this forced substitution of risky assets for safe assets. I'm going to buy up all the treasuries. By definition, in the aggregate, investors are going to have to hold more risky stuff.

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

Ben: $2.5 trillion.

Matt: Boy, that sounds like a lot. David, what do you think?

David: I'm going to guess, $6 trillion?

Matt: You're getting warmer. $8.22 trillion.

Ben: What's the US GDP?

Matt: Good question. Let me ask you first to answer this one. Before 2008, the $8.22 trillion versus January 7th of 2008, $880 billion. We're just under 10 times the size of the balance sheet. 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?

David: Totally. Supply and demand.

Matt: Just like if we were buying goods, and then we could only do $1000 worth of goods, and you suddenly have $2000 with a purchasing power. How about financial securities and 10 times the purchasing power? 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. Certainly, there's been a proliferation of securities, especially private securities. Ben and David, when you guys met at Madrona, what was the large size venture fund back then?

Ben: $250 million?

David: Yeah. The standard large venture fund was $250 million.

Matt: What's the largest venture fund now?

Ben: $1.5 billion.

Matt: Didn't Sequoia boys, $2.5 trillion or something like that?

Ben: No.

David: Their global growth fund is $12 billion.

Matt: I thought I read somebody raised like a $2.5 billion fund.

David: There are plenty of them.

Ben: Andreessen Horowitz, I think just raised $2.2 billion across a couple of funds.

David: They just raised a $2.2 billion crypto fund just for crypto.

Matt: Big fund used to be $250 million, now big fund is $2.5 billion. Boy, that's 10 times, isn't it?

David: Yup.

Matt: $880 billion in the Fed's balance sheet, $8.8 trillion.

Ben: What was the most valuable company in the world worth in January of 2008?

Matt: That's a fantastic question.

David: Most probably Exxon.

Ben: I'm guessing it was Exxon or JP Morgan?

Matt: That's actually probably worth trying to take a quick gander. It would be fun to have on the show and see where it is now compared to the trillion dollar because Apple is the biggest now, right?

Ben: Yeah, at the end of the day.

David: End of 2007, Exxon Mobil, $472 billion market cap. Apple today is $2.4 trillion.

Ben: We've seen a 5X in what a large company is worth or the largest company is worth.

Matt: Yup. So 5X in the largest company. 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's the rest gone? Some of it goes overseas, David's observation before. Can I invest in emerging markets and others? Someone's gone to actually creating 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 pitchbook.

Ben: Fascinating. Of course, the Apple versus Exxon thing is a little farcical because I think both the margin profile and the growth rate of the big $2 trillion companies today is far superior to what the Exxons of the world would have been in 2007–2008. It makes sense that it's not all multiple expansion, I guess, is what I'm saying.

Matt: It's not all multiple expansions. The thing that just drives me a little bit crazy—I guess it's not fair, people who have my unique and crazy background and some of the stuff that seems pretty obvious to me—we see that multiples are as high as they've ever been. 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. It 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.

Ben: 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 "Let's try and weigh some of the future cash flows of this company."

Matt: This morning was a great example of that. As soon as the employment report was released, we saw futures take a dive. You 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. Instead, it's like, nope, this is a voting machine. The voting machine in this case is going, oh, boy, that means quicker pulling away from the punchbowl, and ending up beginning of tapering, maybe eventually an end, where we pull money out of the system and then valuations are going to go down.

We're in this weird looking glass world where bad is good and good is bad for markets, where it's like anything suggesting the economy's growing really well is being perceived as short-term bad for...

Ben: Don't take my opioids away, I'm healing.

David: This has been awesome, by the way. This is such a good primer. I'm so much more educated than I was before. I have two areas I'm curious to your thoughts on where do we go from here? Different approaches to, where do we go from here? Are there analogs?

One is that 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 indication of where we might be going? The other part I really want your opinion on is CryptoLand, to the extent you have opinions.

Matt: I'll give you only partially-informed opinions on crypto, but Japan, we can definitely take on. One of the things that folks don't realize is Ben Bernanke has rightfully been given credit for doing something very bold. 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 chairs, to be honest. I think we get a lot of evidence for that, just for the fact that Japan in the 1980s was gangbusters. It's when they were killing the US automobile industry and lots of knock-on consequences even from 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 people used to go to work now empty?

Japan, basically, after its big booming, booming 80s, created an asset price surge for all the right reasons. It wasn't monetary policy–driven. It was just speculative fervor around real estate prices and everything else, and they got a big crash at the end of it. The 90s have been looked at as their lost decade because the topics only recently got back to where it was at the end of the 80s. The economy's just been sclerotic since.

Japan spent most of the 1990s getting interest rates down to zero. Then in 2000, was the first place to basically do QE, going, ok, I'm going to print a bunch of money, I'm going to buy a whole bunch of bonds. 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 other kinds of things that the economy should really grow at and 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 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. So banks will extend credit, the bad companies still, even though they're not supposed to because nobody's supposed to lose any jobs. It's this big rigid, inflexible economy.

You ​hear that a lot among economists. They're calling for it 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. To me, those are like boogeymen under the bed, usually. It's like, what do you really mean?

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. I haven't been an academic for a long time. Maybe somebody's written that paper, but still I haven't seen it. 

When I take a look at Japan, I look at the example of Japan saying, don't rely on this too long because ultimately it doesn't work. It may have bad consequences, including creating ten times bigger 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. Instead, you better come up with something else.

To some degree, this is what Larry Summers is really using as a way of champing 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 saying 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. That creates a world where there isn't much inflation in which if there is this neutral rate of interest, it's really, really low.

In that world, monetary policy itself probably isn't going to work the old school way and QE probably is doing nothing. If it's doing anything, it's literally just raising asset prices, which is 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. The folks who are unemployed or underemployed, it's really never getting to them.

He's been calling for fiscal policy and it gets into the really wonkiness of all the models I referred to and lampooned a bit along the way about saying these rigidities and frictions that mean this is a natural rate of interest. If you get the interest rate lower than the 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 Keynes in economics.

Larry is now calling for an old Keynesian economics, by way of saying. If you go back and read Keynes, it wasn't about models that the Fed uses of money supply and demand, these ISLM curves, and lots of other stuff. He was just talking about animal spirits, like the economy grows when there are animal spirits, where investors are just confident they're going to make money, and there's demand out there. He's saying, we need to actually start taking seriously the basic idea 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. Ironically, I'm probably the only person who would say this and I don't think Larry would admit it to me when we haven't been in close contact for years. He'll probably say, you look familiar, but do I still know you? Again, admit it to me or anybody else, but frankly, I think he's taking a lot of the modern monetary theory ideas, and 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.

The basic idea is 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. 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. It's the same general intellectual architecture of saying monetary policy is your solution. 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. That's obviously where the MMT folks come in and where the Congress is currently pursuing policies, too.

Ben: 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. 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. We may need a new system.

Matt: Ben, I think you're crystallizing things exactly the way that I would. One of the reasons why I think we really are sticking to the same old tools is because it's terrifying. Imagine sitting in Jerome Powell's. He's not a trained economist, so maybe easier for him than others, but he's a heck of an economist because he's picked it up, or Janet Yellen's seat, or even Paul Krugman who likes to pick fights with the MMTiers because he got a Nobel Prize for being one of the pillars of this new Keynesian type of thinking where it's like building the models that explain how everything works.

It's hard to let go of them, and it's impossible to really imagine the stress of making multi-billion-dollar decisions that have a huge impact on global markets and people's lives without some intellectual framework.

It is pretty intriguing. I take it back to one of my favorite experiences in grad school. I loved the early macro classes before I got skeptical that they mapped on the real world at all. What I really loved was Greg Mankiw, who became the Chairman of the Council of Economic Advisors for George Bush, started our macro class by saying, my goal is to profoundly confuse you. Everybody giggled, and he said, now, let's unpack that a little bit. He 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 you will come away from the class profoundly grappling with the questions that we really can't answer.

This was back in 1994, where the folks who really knew even back then were aware of the limitations of the models. I would say we've all lost a lot of confidence in them since. 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 arm share economist now because I haven't been a proper economist for so long. I've been tainted by the markets the way everybody else has.

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. 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. I guess my goal in coming on 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.

Ben: If you could leave listeners with one or two things that keep an eye on this, what would those things be, like tangible things folks can take away and potentially use in their own lives?

Matt: One of the most, 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, it's really tough to time markets. First of all, I would tell everybody, don't do it. I've tried and it's been a disaster. I used to do this for a living. I unfortunately didn't do it. I wouldn't have lasted very long as a hedge fund manager if I tried to do any market timing strategies because my own personal efforts to do so have been terrible.

If you've got some liquidity event or something like that, I would caution folks to put available cash that isn't yet deployed in a large way into markets before we get some type of resolution on what's going to happen with tapering. Because we now are in a world where with today's employment report, unless Delta really shut things down again, we're going to be in a world where the Feds are going to have to stop its exceptional support because one of the things I'm surprised that nobody's talking about more, is we started QE in this country when Bernanke made a plea of Congress effectively in one of his testimonies for fiscal policy, and they turned to deaf ear. 

I got to do this. I've got to do this because it's never been done before, not clear what the consequences are going to be. There isn't research to back this up because it's not the way we've used to do it, but we're going to do it.

We're now in a world where we've got the biggest fiscal policy response anybody's seen since the new deal. It can't say there is now time to justify ongoing exceptional monetary support. You just can't. 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.

Every time that's been tried so far, it's been bad for markets to the 10%–15% and in one case, 20% market correction inside of a month. I just wouldn't want anybody to be in a world where knowing that's likely to come, giving everything we know by November and possibly as early as September, that's one thing to keep in mind. That's certainly one key takeaway.

The second, actually would be anybody who's politically motivated. Much more important, politically motivated, if you still cling to the belief somehow that government deficits are bad, and they're going to crowd out private investment, or they're going to raise interest rates. Recognize that the economists who wrote those models with one of the best ones in history, actually, frankly, being Larry Summers, are now saying, maybe not.

The modern monetary theory folks who 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, not forever everyone, but for the United States to run a pretty unique position. 

I would encourage you to be, from a political point of view, much more open minded to the idea that large-scale government spending, if we're lucky enough to be the United States right now at this point in time, is probably not a bad thing. You have to, in a sense, check at the door some of the sensitivities you'd be running into if you were thinking about the economy the way you'd think about running a small family business.

Ben: 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.

Matt: Guys, thanks for having me on. I don't tire of talking about this stuff. In fact, I tire a lot of having a hedge fund job. It didn't give me an opportunity to talk about this stuff. It's been a blast. If you guys would like to have me back to talk about anything else, please just let me know.

Ben: Will do. All right, listeners, we will see you next time.

David: We'll see you next time.