Hello, and welcome to another episode of the Odd Lots podcast.
I'm Joe Wisenthal and I'm Tracy Alloway.
Tracy, you know obviously recording this September twenty twenty three. Inflation has come way down over the last year, but there is definitely anxiety about, well, could we see another wave, particularly if we don't have a recession, Like, no one is really convinced that it's over.
Right, So gas prices are starting to creep up again. House prices have been incredibly stable and also starting to rise slightly, so that could also figure into shelter costs. But I think generally there is this concern that are we going to see another leg up in inflation? And part of the reason there seems to be this concern is because, as we've discussed on this podcast before, everyone tends to reach for the nineteen seventies as the big parallel or analogy for periods of higher inflation.
Right, you know, when we were out in Jackson Hole, I guess in August that was when Larry Summers tweeted that famous chart saying, you know it was a good reminder, right that this was when you.
Were looking at the mountains and thinking of USCPI charge.
Yeah, the Grand Teetons looked like the USCPI from nineteen seventy four to nineteen eighty five. But it's true that throughout the seventies there were multiple times where people sort of breathed a sigh of relief, they said, inflation has been licked, and then it came back. And it's really you know, there's this story that there's all this respon irresponsible policy and then finally Vulgar came and smashed inflation, and it really did not exactly happen like.
That, right.
I always find that kind of weird because Arthur Burns hiked RAITs a lot before Vulker did the same thing. But you're absolutely right, and the inflation of the nineteen seventies it's important in many ways, possibly not the right ones, but one of the ways that's important is it tends to be the period that a lot of our policy makers and economists and academics kind of came of age in, and it tends to be the one that they go
back to to explain what's happening now. And so, you know, there are some shades of the nineteen seventies to our current situation. You did have supply shocks in the form of oil. There was I think some fiscal stimulus from the Vietnam War going into the nineteen seventies, things like that.
But overall, the sort of standard interpretation of the nineteen seventies is that monetarist view the old like Milton Friedman, inflation is always in everywhere a monetary phenomenon and basically blaming the FED for not reacting fast enough.
You're absolutely right, and you mentioned that the nineteen seventies looms so large. You know, policy makers the FED, in particular central bankers, they take a lot of pride in the fact that they defeated inflation, that inflation has been stable, that they sort of embedded this idea of stable and inflation expectations. They prize that stability quite a bit. You and I we joke a lot about how we both started our careers in two thousand and eight right on the eve of the crisis.
And we're always worried about defuse.
We're always worried about, you know, crisis and downturn and surging unemployment. So it had, you know, and you look at the people who now make policy today, many of them,
as you said, came of age then. But again, it feels as though if we're going to have a conversation about possible second waves, if we're going to compare and contrast now with the nineteen seventies, then actually we better get a better handle on what really happened in the nineteen seventies, because I don't think that outside of these vague things like oh, they let policy run too loose and some oil and gas lines, that actually we've really
you know, that there is a crisp, coherent story like yeah, but why was inflation so persistent and so reoccurring throughout, you know, roughly a decade.
The ghost of Paul Volker is going to be so mad at us, But I think we should do that.
Well.
I am very excited. We have the perfect guest, someone who has done original research on nineteen seventies inflation and really sort of broke down what happened. We're going to be speaking with Itamar Drexler. He is a professor of finance at the University of Pennsylvania, someone who's done a lot of research on this period and what it means. Professor Drexler, thank you so much for coming on odd Laws.
Thank you very much for having me. This is really fun and nice to talk about a topic I care a lot about and think is very interesting.
Excellent. Well, you know what, why don't we start with if you were just in a room full of random economists and you said, well, what caused the nineteen seventies inflation? Why did it keep coming back? What sort of just like you know, we mentioned in the beginning, you know, the the gas lines and the end of the Vietnam War, and maybe policymakers were not strong enough in fighting it. But what is the sort of macro consensus about what happened in that decade?
So I think the most common story narrati is that the Fed there were at the outset, say, some kind of shocks that led to the beginning of inflation, but that once inflation got going, the FED did not respond aggressively enough to increases in inflation by raising the FED funds rate as later policy would dictate, which is that, according to the tailor rule, the FED has to raise the nominal rate more than one for one with expected inflation.
What that does is raise the real interest rate. They're by lowering demand or what they call demand management, and preventing inflation. From accommodating inflation by letting it go up, and so not doing that, they overtime lost credibility, and that meant that if people expected inflation to go up, inflation would actually go up because the FED wasn't actually leaning into it. It wasn't making it wasn't slowing demand
in the face of say, increasing inflation expectations. That, to the best that I understand, is kind of the most common narrative.
Right, So the ideas the prices started to rise, the FED basically lost control of inflation expectations, and then you got this self reinforcing cycle of the wage price spiral where people start demanding more money. And then it wasn't until Paul Volker came in told everyone whose boss re established the Fed's credibility and kind of deflated those inflation expectations that things got better. Right, Yeah, So your paper
takes a very different view to that whole narrative. You kind of placed the blames squarely on an element of financial regulation that actually Joe I realized this has popped up a couple times on all thoughts, most notably in our episodes with Josh Younger and Lev Menon where we were talking about the origins of your dollars in shadow banks, but you place it on REGQ. Can you talk a little bit more about that thesis.
Yeah, sure, So reg Q does come up a lot. It's a very famous banking regulation. Historically, people, many banking people and monetary people are well aware of it. So red Q was a regulation that came out of the nineteen thirty three Banking Act that allowed the Fed to place a ceiling on what banks could pay, what kind of interest rates banks could pay on different kinds of deposits, and for example, checking deposits had to pay a zero
interest rate. Savings deposits had their own ceiling, and then CDs could have their own ceiling. For almost all of the time from nineteen thirty three until nineteen sixty five, the FED put the ceiling above the Fed Funds rate, so when it would raise the Fed Funds rate, it would raise the ceiling, and so basically it didn't bind. Maybe it would prevent you from setting some crazy rate,
but it didn't bind. But starting in sixty five, they didn't raise it, so that when they would raise the Fed Funds rate, deposits couldn't keep up with the Fed Funds rate.
So the reason they put in that restriction was because my understanding is that in the nineteen thirties there was there were a lot of bank failures, and so there was concern that if banks were competing with each other to attract depositors, so just raising deposit rates to uneconomic levels, that it would lead to more bank failure. So they thought, well, we'll put a cap on this and then we'll have healthier competition.
Is that right, that's the story that's told. I know it's impossible to say that's exactly what was in their mind, but yes, also that act established they have d IC and deposit insurance, So in some sense it makes it makes sense if you're going to give people insurance, you don't want them to attract deposits by doing crazy things.
Right because if you're if you know that you're insured. I could just go out and say, oh, here, here's ten percent.
The Bank of Joe and Tracy will offer fifty percent.
Interest cent I collect all of the deposits from everyone else, and maybe I fail because whatever I'm doing with that, but I got all the deposit I mean, let's do it.
Yeah, okay, So I stopped you right up. In the late nineteen sixties. So in the late nineteen sixties they make this change.
Yeah, they decide, they debate it, but they just to use this rule as a tool of monetary policy very consciously. So this is part of a general wave of what was called credit controls that many developed countries used and had been exploring for a while. It was a popular idea that you could influence directly the price and quantity of credit in order to do monetary policy and not just leave it to the short term rate. And so this was used in the UK famously, in France and
Italy and Belgium. In the Netherlands, there was an awareness that credit controls of various types were used, usually consisting of often together controls on the level of interest rates you could pay on deposit, ceilings on what you could charge for loans, or ceilings on the quantity of loans you could make, or loan growth.
You know, it's interesting because and I will get to the whole debunking of the popular story, or at least the reinterpretation of the popular story. Actually have two questions from a professional standpoint, how did this become an area of interest and research.
For Yeah, so it's a little bit out of left field for me and my co authors. I have two very common co authors that we've worked a ton together at NYU, Alexisavov and Philip Novel, and we work on monetary policy and banking. We're coming at it from a finance point of view and the way we got to this so we think a lot about these things. We
did not think so much about inflation. We're working on how the business of banking works and how bank's ability to raise deposits is influenced by monetary policy, how much money they make on deposits, spreads, And we're presenting some of our work and we noticed that if you just g the FED Funds rate against deposit rates, the average deposit rate that banks pay, you can see very clearly that in the nineteen sixties and seventies the average deposit
rate barely reacted at all to the Fed Funds rate. Now, that's not a discovery, because I knew about regulation Q and just had never never been in my face that way. And there's a very famous graph coming out of the literature of the standard now narrative Clarida Galley Gertler is the most famous paper with thousands of citations. That is a similar graph, but instead of deposit rates, which they
don't consider, they have the Fed funds are in inflation. And that's the famous graph that shows that before nineteen eighty two, the Fed funds rate just mostly kind of sticks to inflation, whereas afterwards, with Vulcar and green Span, it reacts more than one for one. And the idea was that sensitivity heightens the sensitivity and of policy in people's reaction to inflation. But here we saw that deposit rates are also kind of look like that. I thought the timing was sort
of better. And if you think that the people's deposits is an important part of their savings, which it is an important aspect of transmission of monetary policy across our mind, that maybe another thing that could have gone in there is that deposit rates did not react at all, and we knew that reg Q was there, so we start to thinking maybe that has something to do with the macro of the time and inflation. You start to look, there's a lot of there's a lot of smoke and fire there.
Before we get into the specific sort of discovery of your research. One thing that strikes me is interesting and Tracy mentioned this at the beginning, which is the sort of we think of vulgar as the start of this sort of monitorius turn in policy in which the entire goal or the thinking at the time was, well, we can solve the inflation problem, if we can solve the supply of money problem, if we can sort of get a handle on the supply of money problem, then inflation
will take care of itself. Judging by what you're saying about credit controls and this, like, Okay, this is how much we want to have in checking, This is how much we want to have in people's savings accounts, this is the cap on CDs. It felt it sounds like this was brewing for a while, that it was very popular already for some time for policymakers to really think about like bucketing different types of money and keeping sort of lid or handle on each of.
Them the way we hear things now. I also had the impression that there was a lot of monetarism at the time looking for it. It's after the fact not as much of my impression. Certainly, these ideas are out there, but I feel like the monitorism specifically comes somewhat later. Actually, if you read the way they talked about it, demand management often sounds not that different than we talk about
it today. What I will say is, I usually say this at the end of the talk, is I think so there was a lot of there was it by the end, a lot of looking at growth and the money supply and in trying to keep tamping down growth in this and a big part of the money supply and the most responsive are deposits. So jumping sort of to something I usually say at the end, I think that I'm not a big fan of moneitorism, and I think most of the mainstream macro and monetari is not.
Now doesn't mean it's wrong, but I think monitoris a little bit don't understand their own theory. So what I mean by this is if you want to reinterpret what happened in terms of moneitorism, so you start out with why do people hold money? This is like standard monitorism. Money is you know, pays no interest and so it's a dominated asset and must have some other use. And as you raise, as you lower the interest rate, you make it more you know, easy for people to have
money and they can spend more. So the thing is it treats each each money as just number of dollars. But in the what you see in the right Q time is when you don't let deposits pay the interest that they want, each dollar is now missing a lot of interest. So in that sense, its opportunity cost is going way up. So people take out deposits. There's less dollars, but each dollar is much more money, much more dominated
than it was before. So though you have less dollars, the cost to people holding those dollars is way bigger when the number of dollars is smaller, when this ceiling
binds tightly. And so that actually suggests that if you sort of don't make this jump of thinking about the number of dollars, but the opportunity cost of holding dollars, the amount of money that's that's that's sort of burning a hole in people's pocket, is actually much higher when were high and the ceiling was binding, then when there was more dollars but the ceiling was not binding.
The ghost of Milton Friedman is going to haunt us too on this podcast. Okay, well, take that line of thinking, or that pushback on the monetarist view and apply it to the binding REGQ ceiling and inflation in the nineteen seventies. So you know prices are going up, but banks are restricted from paying out more deposits to savers. How does that impact prices?
The idea was that by not letting them pay the interest that they want, some deposits would leave the banks. That was the in fact intention, That is what happened. It was called disintermediation, and so deposits would flow out. The idea I believe was that this would tampen down demand because credit growth was the source of excess demand, and that would help, just like raising the interest rate
should help. However, what we argue was it led to the disintermediation, but instead of having a stronger effect on demand or only an effect on demand, what it had a strong effect was on the supply by firms, by producers, because it's been well documented that each of the times that the Fed funds rate went above the ceiling rate, which happened a lot during this time periods, whenever they raised rates, then as deposits flowed out, there were credit crunches,
meaning firms wanted credit. Banks wanted to raise more deposits, they couldn't pay the rate they couldn't get enough deposits, so they started to ration firms. And so if the credit became scarce and expensive, now firms need credit to do business. I think that's kind of clear. So it's an input. Think of it like oil, but a much more important input. If you can't get it, what do
you do? You fall behind in producing things. You cut supply, and you raise prices because it's more expensive to produce. And so we show that each of these cycles where they raised rates where the ceiling was binding, you see both. Well, you see this is known. You see both inflation and a decrease in output. And then we look across firms and we show that more credit constraint, firms raised prices more and cut output, more, cut employment, more cut investment, more inventories more.
All right, let's talk about the data that you collected, because it's a good story, right that. Okay, the money leaves the banking system, supply of credit therefore becomes ration, and then you have all these supply side constraints and that contributes to inflation. It's a good story. What is the actual data that you looked at to establish your claim?
So there's there's the aggregate part of the data, which I think is important to see, but for economists usually can't by itself be convincing because you're just looking at the time series for the whole country.
Wait, you can't do economics just by like looking at two big charts.
I think you could do.
I've made my whole career on that.
I think. Actually that's a lot of times very important and the most convincing thing to people. But if you are in the business of being the you know, a skeptic, then that is not going to be enough. So we look at a lot of aggregate things, So looking at how deposits flowed out whenever the ceiling was binding, they flowed out more when it was when the gap between the fems right and the ceiling was more. We looked at unfilled orders or backlogs of orders that rose during
that time. So I don't know which of these you
find the most compelling. But then, like I said the second part of the paper, we looked at the cross section of firms to say, okay, let's look at something that just compares firms that were more exposed to this problem versus less exposed holding constant things you know that are aggregate, like the fed's credibility, like oil shocks, any of these things that you want to try to difference out in order to just focus on exposure to the particular channel that you think is at work.
So just to be clear, we're talking about disintermediation and the idea that money can flow out of banks because they can't compete on deposits, and then that could lead to less investment. But what about just savings itself, Like how does REGQ and the deposit rate cap impact people's behavior when it comes to spending versus savings?
Right, that apps actually the first line of reasoning that we went through. So we actually had two papers on this, but I'm talking to you about the supply one, but I'll tell you about the demand one. So that also makes inflation worse because so both effects go in the same direction, which I can tell you in a second how that happens. So if you want to if you're thinking about saving, and let's say that for you, the marginal saving is deposit, which for people at that time
and even today a lot of people, it is. And you see the rate and you see that you're getting a terrible real rate, right, it's way below the inflation rate. At times it was seven eight nine percent below inflation because the cap was like five to five and a half percent. Inflation was fourteen percent at one point. That's just a complete disaster. So that on the margin would push you to try to consume, not to save. So
if anything, it makes people want to consume more. At the same time, and for the same reason, there's less credit to firms, so they can't produce as much. Both effects go in the direction of higher prices. The production effect lower supply. The demand effect increases you know, would increase by itself total output. But both of them are making inflation go higher. So it's kind of a bad situation in that respect.
Right, And it kind of gets to the heart part of how transmission of monetary policy is supposed to work. Because you're supposed to propagate these interest rate changes out into the system. Rates go up, people are supposed to hold on to more of their money. But if you have a deposit rate cap, then that isn't happening.
Yeah, so usually so a sign of what microeconomists think of a sign of dysfunction is when you have wedges and here there's a giant wedge, there's a wedge between the rate that depositors get the savings rate, and the rate that borrowers pay the borrowing rate. The economy always tries to push you to make those things equal. So if people are willing to pay you a lot for loans, then you pay people higher deposit rates, and then there's more savings and the equilibrium is where they meet. But
here you couldn't. It's like a big friction sand in the gears. So what you get is two rates. You get a low rate for saver and a high rate for borrowers. And so it's like asking, was the rate to hire too low? Well, it was too high and too low, and that's because of this wedge in between. That is like a classical sign of a part problem when you have different prices for the same thing on both sides and it's not coming together.
Wait, can I ask a devil's advocate monetarist question? If Milton Friedman was in the room with us right now, maybe he would ask this. But like, there must be a monetarist interpretation of the impact of REDQ as well, which I imagine would be like, well, if you make deposits unattractive, then maybe you're inhibiting monetary growth the growth that was there.
That was the way that monitors saw that, and when you saw no evidence of that, No, I think it's the opposite when they raised interest rates because this gap grew. It's always deposits were flowing out. It's the clearest thing in the data. So in that sense, it looks like
you're reducing the rate of money growth. But I'm arguing that it made each dollar if you want to have that monitors right, like them each dollar much more money, Like do you mind having dollars if if they pay if you know your deposits pay the Fed funds right, and you earn a real rate, it's not a big deal. If they're earning minus eight percent real rate, that's all that's really money. Like, it's really bad. You have to sort of think what was the point of monetaring.
It's like the nature of the money kind of changes almost.
I think it becomes more money.
I mean, this is like they use the term hot potato, right. People didn't want to hold quick question and then a longer question. Was this an an extremely profitable period for banks?
Surprisingly, I don't think it was that profitable, And it's a good question why. But I think also the rates at which they the real rates at which they lent out, for example, for long term mortgages and stuff, which is what a lot of snls did, were also lowered by this kind of thing. So actually, at the time people thought that when you get rid of REGQ, it would make the banks very unprofitable. I tell you what it did do It led to the SNL crisis. I guess
they shouldn't be kid. It's well known that lifting the ceilings on deposit rates left snls having to pay fair market rates, which made a big hole in their balance.
Getting back to your supply side analysis, and you mentioned you sort of tried to go sector bisector. Who would be particularly in like, okay, who, all things being equal, who is exposed to this sort of severe rationing of credit from the banking system having less money? What did you find when you look at the sort of sectoral breakdowns, what kind of things pop up?
So should should be specific and say that the database we have, because we needed a database of lots of information, is the nbr CS Database on Manufacturing Industries. So already it's all manufacturers, okay, So we need the prices they charge, and we need stuff on their inputs, and so it's
all different kinds of manufacturing. And so that by the construction of our measure, are companies that need to pay a lot upfront in terms of production costs and labor costs relative to the money they would have from the last cycle of selling, relative to the operating margins that they have. So I don't remember exactly which ones were like high, if it was like textiles versus I think the tobacco was low. But so I can't say that that manufacturers that could tell you exactly which ones were
more and which ones or less. But you'd think that somebody carrying a lot of inventory a lot of upfront costs would need a lot of credit, and somebody who doesn't you know at all, and maybe the tobacco manufacturers, it's not as big of a deal.
So you had less investment because of the disintermediation dynamics that you described. Meanwhile, you also had people spending more because they're not incentivized to save their money and put it in deposits that are less than inflation. That seems like a bad dynamic.
Yeah, I think it's I think it's quite a bad dinneric.
So Okay, well, which is great. Are I really appreciate it? No, I understand the seventies.
So when you did the research, I mean, did you find one of those factors, like the supply side versus the demand side, which one was bigger.
You can see in the aggregate data that the net effect, meaning the one that overwhelms is the supply one. Because in this part, I think is not new because despite all the narrative focusing on the feds inability to control demand, the four cycles in the seventies, sixties, and seventies, which are the stagflationary cycles, were called that because each time that inflation went up, output was dropping at the same time. By the way, it's quite different than what we've seen recently.
So that's well known. And so you when we first started, we're like, why are they keep talking about demand when clearly output is going down. But the reason people say that is because they took the decrease in output as like basically exogenous like stuff happened like oil happened before there was some other crisis that happened, and so they're like, okay, well we can't do anything about that. That's just our job,
the fed's job. To deal with that. And so in light of these various supply shocks that apparently kept happening, the FED didn't do a good job controlling demand. Whereas we're saying these supply shocks, it's happened all the time, and it happened in this fashion, it's not a coincidence. Actually, it was a huge financial friction that made this happen.
Why you know, you mentioned, look, if credit is going to be rational, investment is going to go down. Investment is also a demand impulse, right, So building factories is you know, that's someone else's income, that's activity. Company is going out of business and laying off workers, we would think would be disinflationary, right, So why is it that, as you describe, you have this sort of rationing of credit,
this credit constraint that hurt a lot of manufacturers. Why, I mean, just intuitively that could you know, and it sounds like it could be a disinflationary Oh.
Absolutely, But the thing we actually are not emphasizing the investment that's that is there, but we're emphasizing the ongoing operations. So I think classically, oftentimes people think of credit as going to investment, but most of the credit the stock of credit to firms is like working cap, not just working capital, but you pay upfront for a lot of things, like just to take an extreme case, if you deal
with the contractor, you pay them usually half upfront. It's not like you tell them, yeah, go build my house and when you're done, I'll pay you. So people pay for materials in labor in large part, this is where trade credit comes in and all these things. Companies need a lot of credit up front. So we're talking about the direct operations of the firm. It is also true that you saw a decrease in investment, and like you're saying that by itself could be interpreted as lower demand.
So it's not our emphasis in this part.
So you know, again going to when Vulker came and I've been plugging this a lot lately, but I was, you know, I finally read the book Secret to the Temple, and it totally changed my perspective on like, at least the first few years of the Vulker regime, because it was not actually a simple story of like finally we're gonna get tough. It was just like all of these levers being pulled and the huge swings in the fed funds rate and it was kind of a the first
few years seemed like a total mess. What did actually then, in your view, create the real durable turn in inflation.
So yeah, we look at this in both papers. I think the timing lines up very well. I would say, bet this is heresy. Now it's better than the vulcar
rate hike. With the two stages of the deregulation of reg Q, the first one being the first major deregulation at the end of nineteen seventy eight and nineteen seventy nine, and then for this one, the total essentially getting rid of almost the rest of it at the end of nineteen eighty two, and both were associated with huge inflows of the respective deposits that were, you know, deregulated, And we look at banks that were benefited more from this versus less and sort of see the unwind of what
we're seeing before, and then connect it to firms that were located in areas that were able to borrow from those banks, as well as the ones that were more financially dependent in areas that were more affected by the deregulation, and they show the unwinding and these so that they increased production and raised prices or cut price, you know, raise prices lesser, cut prices more than the other ones. And I think if you look at the COOTE now
you know, inflation is very messy. Now that we've gone through it, you can see how hard I just to know exactly where it is. But inflation starts to come down at the end of seventy nine, beginning of eighty, several quarters before Volker's like big rate hike. So that is not going to convince any monetary person my story, but I do think that it's there if you want to be convinced.
The market was pricing it in preemptively efficient markets.
Well, I'm talking about the inflation.
Yeah, yeah, yeah, yeah.
I think I think bond markets didn't think that Vulkar had won until like the mid mid nineteen eighty four. So ten year rates were as high in mid eighty four as they had been before Volcar raised rates.
Wow, And Tracy, that's when Bill Gross slammed the accelerator. As we talk about no right, like it was like the raids stayed really high. And that's what he said, is like that's when you knew the moment.
Was like he knew go all in knew.
I want to bring us up to present day because I mean, it's very useful to have this overview of the nineteen seventies. But maybe there are some lessons here that we can apply specifically to what's happening now in twenty twenty three. And let me start with a really simple one, which we've discussed on this podcast before, notably
with Barclay's Joe abat the Money Market Strategist. We don't have that binding constraint of reg Q anymore, and yet it feels like it's been a relatively slow process to see banks in the US raise their deposit rate. And I was looking before the show. The average bank rate according to bankrate dot com on retail deposit savings accounts is still only like zero point five eight percent, which is kind of crazy. It's higher on certificates of deposit
and money market funds and things like that. But why aren't we seeing more of a pass through from higher benchmark rates?
Yeah. So, actually a lot of work we've done is on this and the effect of this in times after reg Q. That's where we started with. I mean, the simple answer is they have a lot of market power, and so people aren't leaving despite the lack of higher rates. You saw after SVB that there's a lot of discussion that now people will wake up to the fact that rates are really low, they'll demand rates.
Yeah, it still hasn't really happened.
No, it really, it really hasn't. It happens. It's some small banks. But I was quite skeptical at the time because you don't you know, you don't get everybody can't be asleep and they just wake up. Like I know, we all listen to odd lots and yeah, most people still the majority of the world is still not listening. So your market share could grow a lot.
I'm gonna I'm going to renew my call to improve the transmission of monetary policy and defeat inflation. We all need to find a savings account with a high interest rate, So go out and do it. Do the market research.
So they have they have a lot of market power. It's a very big part of the of the banking business. The difference is is that they could raise it if they wanted, if people became aware, if they left banks to go to other banks, and so that's kind of that's a response, that's their optimal response, whereas in the seventies, they wanted to raise the rates and couldn't. That's very different.
So they were kind of like a like a super monopolist, but so much of a monopolist, and they didn't want to be like even a monopolist doesn't want to set the price so high you can't sell anything.
So thinking about now versus the nineteen seventies, there are two ways that I could think of that maybe the economy is fundamentally different. But let me start with the one that's sort of most directly to this. In the late in the seventies, the banks are probably like the main game in town for credit, whereas today there's all kinds of different ways that a firm of any sort, even a manufacturer, there's a you know, the bond.
Market, bond market loaded.
Since then we talk about private credit and private lending, et cetera. Talk to us just start like, how much more important were banks for the provision of credit in the time that you focus on then versus today?
So I do think they were more important. I want to push back a little bit because I've learned myself over time. Certainly the bond market's big, and certainly there are other non bank sources of credit. However, I do think that the diminishment of bank's importance has multiple times been overstated. Just to give you some data and looked
at this. So, there are about one thousand firms in the US that are rated, meaning that they can issue bonds, out of the about three thousand, five hundred firms that are listed on the stock market. There were about half as many firms that could issue bonds by the end of the seventies out of about four thousand, five hundred firms that were listed. In any case, that's not that many firms. They are gigantic on average, so in terms
of valuate they're very important. But there are about seven hundred thousand firms with over twenty people, which means that six hundred and ninety nine thousand of them cannot issue bonds.
We're talking about today, yes, okay.
And there were about three hundred and fifty thousand firms at that time that were above twenty people and so couldn't issue bonds. And so although there's been an expansion of this, the vast majority we have a firm. People call them small firms, but that makes you think of like a laundromat. They get a lot bigger than that, so small medium firms cannot. It's just very few even out of the stock market. Like I said, two thirds don't issue bonds.
Right, So even today there is a huge pool of companies that really, if they need credit, need to go to a bank or.
Something like the bank.
Now, the other way that maybe the economy feels like it could be different than the nineteen seventies is huge drivers of you know, the US economy maybe are less credit center. I'm think you like tech for example, or software in which we don't really associate them with like borrowing. Was the economy inherently more credit sensitive? I would imagine in a manufacturing economy you have to build factories or
even just maintain inventory. Was the economy just sort of more and were more companies in perpetual need of credit than today?
I don't know the answer to that. I would have actually guessed that with financial deepening in general, were more financialized. I should just say, just to not give the wrong the press. I don't think that the inflation of the last couple of years was due to financial friction per se. I think the analogy is, and I believe this for a long time that the main driver was the supply chain shocks. It's in that respect that I think it's similar. I make the increase in demand due to transfers or
fiscal or I was thought that was secondary. I thought that once the supply chain gets solved, the effect will be largely diminishment of that. So that that's been my opinion. I think more people are there now than the world like a year ago, but that's the analogy the way I see it.
Just to press on this interest rate sensitivity point. I know I mentioned before that we've talked about reg Q in passing a few times with Josh Junger and Lev
Menon in one or two other episodes. But if it sounds familiar to our listeners, it might also be because it came up in a very famous speech made by Ben Bernanke in two thousand and seven, where he was talking about how sensitive the housing market was to change in the FED funds rate, and he basically said, because we don't have REGQ ceilings anymore on deposit rates, that means that deposits are a much diminished source of housing finance.
So everything is going to be fine, And that turned out not to be the case.
So it's true that Bernanki and if you actually you go back and read his papers from the eighties and not just him, there was a lot of understanding that REGQ made it so that housing was very credit sensitive when REGQ was there. So for the reason we said banks would lose deposits, one of the main forms of bank lending is mortgages and also loans to contractors, and so you would see house market basically dry up, and then when deposits came back in, housing would be on
a tear. And it was the impression of a lot of monetary people that once REGQ was abolished in nineteen eighty two, first, this was the reason we didn't see these kinds of wild gyrations anymore. And also they assumed, which I think was wrong, that deposits would transmit policy then, you know, one for one, which was sort of true right when reg Q was abolished and became less and less true until your question of why are deposit rates so pathetically low?
Now, well, going back, I mean, policy must makers must have seen this wadge that you were talking about in real time, and it must have sort of been obvious that they could keep hiking rates to fight inflation, but that there was it would have minimal impact on actual rates of deposit that people got. Were they what were they saying at the time. Was there an awareness that this was a tension, that this was impeding the transmission
of monetary policy? And if you said that, as you pointed out, historically they would sort of lift the cap over time along with the Fed Fund rate, why wasn't that.
Lifting so a couple things. I think they definitely saw the credit crunches. They actually didn't like those. Weirdly, even though they wanted there to be less credit, they just didn't want it to be like that hysterical. So I think they thought this was helping partly that the monitor's view would tell you, look, there are less deposits, so less money growth, and this should be helping inflation and so.
And of course, whenever they eased up, the deposits would flow back in, which would look like a lot of money creations. So this was kind of annoying them very much. But it's also tell people it's like giving a sick patient the medicine, Well, if they get sicker. There's two conclusions, and unfortunately they're diametrically opposite. One is that the medicine is not working. The other one is that you didn't
give the patient enough medicine. So if the medicine's making them sicker, the second one is not going to be that good. And they if you read, they thought that there must be lots of other avenues that banks are able to circumvent this. One view was that this is like barely holding the dam, and that these guys are finding lots of ways around it. If you look at total credit growth, they did not find many ways around it.
They did many things that you guys have mentioned, like the beginning of money market mutual funds, the Euro Many many financial innovations come from this time period. It's scuchly a really interesting time period, but they did not actually circumvent it that much.
Tracy, this is a real diversion. But I you know, after college, my first job was in a now tro food is grocery store.
Oh, I've heard your sandwich stories.
This is not a sandwich story. I just want to say, I've been around a lot of people in my life that did like very strange like self medication to like treat a sickness, and they would get worse and worse and convince themselves that they're getting healthier and healthier. So I feel like, you know, like I'm just going to like do nothing but like take golden seal or like eat pure Leona or something like that, and they get sicker and sicker and more more emaciated, and it's like
maybe it's not working anyway. I just understand that phenomenon firsthand.
Thank you Joe for that insight.
I want to, you know, just sort of wrap it up this idea that the reg Q, as you describe it, had really two effects. And there was the demand effect because the hot potato effect on money, It's like it was just terrible to hold cash and so you spend it. And then, as you mentioned, the sort of supply chain side, the supply disruption raising the cost of capital for companies and then companies have a markup, and then so went
beyond that. How do you you just sort of establish that it wasn't mostly the demand side because I think, you know, you know, you're saying, like, well, there's this consistent throughput. Maybe the story now is the story then supply side impairment. But as you say, you also found this demand effect from the failure to transmit monetary policy effectively. What gives you the confidence that it wasn't just that hot potato effect.
Well on the neck part is just that you see that as inflation's going up, output growth is going down, including negative output growth. And then we have this chart at the beginning where you see unfilled orders going up and up, which by which could by itself look like a lot of demand. But the peak of unfilled orders is when growth is negative.
What year is this?
This is actually throughout the whole time period. If you look it tracks unfilled orders leads inflation by a quarter or two. In the way. This is just beautiful, and it's just it's the quantity of unfilled orders. So we're deflating it by prices. There's not a mechanical effect. So if you just look at it goes up and inflation follows, and when it peaks and starts to go down, inflation
starts to decrease. And like I said, all all sequly might think, well, people are just ordering so much stuff, but actually output growth is falling and even negative at the peak of this thing.
Let me ask a question to sort of sum it up. But we started this conversation talking about how the memory of the nineteen seventies inflation, the traditional interpretation of it, kind of looms large in a lot of people's minds, especially policymakers and economists and academics looking at it through the lens that you described, what should be our biggest takeaway of that period and what should the lesson be for twenty twenty three.
It's odd question. I tell you. Some of the inferences I make. I think that the focus of monetary policy and the way it understands histories mostly through excess demand causing inflation and variation in demand causing business cycles. And I think I think there's a lot of evidence that many times supply was just as important, if not more, in driving both inflationary episodes and business cycles. And actually, although it didn't happen this time, credit crunches with which
many of the business cycles. If you look at people who do history in the post war business cycles, many of them involved credit crunches of one form or another. And I guess there to say is that monetary policy and that with the financial friction, can have an impact on supply, not just demand. In terms of looking forward, for example, we had supply chain issues, unfilled orders, I would look for those kinds of things. If we have more of those going forward, I would get very worried.
Like the auto industry was a perfect proxy. So long as autos weren't being produced anywhere near the level they were before, I felt like that's an indication that the problem inherently is still there. If we were to go back to that, I'd be quite worried about it.
Tomar Drexlert, thank you so much for coming on Odd Lots. You're gonna have to maybe send us some of these charts because I think that's fascinating. The idea that right now, like it is tough to disambiguit between supplies, it too
much supply is a too little demand. But if if we're if it's if the worst of the inflationary waves of that period were actually periods of not you know, declining growth or declining rates of growth, that's a pretty strong sounds like a strong indication, So we got to show that.
Thank you very much, Thank.
You so much. That was a great conversation, Tracy. I really enjoyed that conversation. I mean, there's obviously a lot there, but it also just generally seems to be the case, like we can't always talk about nineteen seventies nineteen seventies without really like digging into the actually, you know, they severed the gold huge seventy on oil shock, all these you know, spendthrift Keynesians running around, and then finally stern
tall Paul comes in and lays down the law. And it sounds like those are you know, ohen unions of course, and unions demanding that they get a pay rise, the cost of living adjustments so forth. There's a lot there, and it's all sort of this big soup of ideas. So it's sort of helpful to actually think about, like, okay, let's talk about how monetary policy work back then.
Right totally. And I also think, unfortunately, except to a select few maybe US two and a few other people, like reg Q, is just not that sexy a topic now compared to the gold standard and things like that. So I can see why it hasn't been a focus of a lot of research historically. When it comes to
the nineteen seventies period of inflation. I also have to say, you know, a lot of what's going on right now with the discussion over interest rates and inflation, it feels like there are the same people who are sort of complaining that rates are too high now are also the people who were complaining that, right, it's too.
Low for the last fifteen three years.
And so the wedge idea, like the idea that like rates were both kind of too low and too high or just like not well suited to the problem that was trying to be solved, uh, is a very attractive one to me. Like it feels a lot more nuanced.
Absolutely. Also, it's just sort of interesting to think of the cost of credit as a business input, right, And so as item mentioned, of course, you know it's not going to be conducive to a boom if you have companies literally going out of business or not building new factories. But if you have operations, ongoing operations that require credit to continue going and the cost goes up but it doesn't destroy the business, then it sort of makes sense
that you know that that comes through as a higher cost. Also, it sort of fits in these days maybe a little bit with some of our conversations about housing and real estate, right and the impairment of new development. And then now we see house prices going up, and why do we never have enough housing supply to have sustained deflation or disinflation in shelter. It still feels like that sort of rate component of supply still matters, at least in some way.
Yeah, well, now that we're done trashing Paul Volker's legacy.
Shall we leave it there?
He did, you know, he did some good. Let's leave it there.
Okay.
This has been another episode of the Audlots Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.
And I'm Joe Wisenthal. You can follow me at the Stalwart. Follow our guest Itamar Drexler. He's at idrex, Follow our producers Carmen Rodriguez at Carmen Arman and Dashel Bennett at Dashbot and special thanks to our producer Moses Ondam.
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