Editor's Note: This article was written by David Stockman, who was elected to U.S. House of Representatives for the 95th Congress and was reelected in two subsequent elections, serving from January 1977 until his resignation January 1981. He then became Director of the Office of Management and Budget under President Ronald Reagan, serving from 1981 until August 1985. He was the youngest cabinet member in the 20th century. After leaving government, Stockman joined Wall St. investment bank Salomon Bros. and later became a founding partner at New York-based private equity firm, The Blackstone Group. He left Blackstone in 1999 to start his own private equity fund, Heartland Industrial Partners, L.P., based in Greenwich, CT.
My proposition today is that we’re in a fiscal calamity caused by the further, and perhaps, final triumph of politics. Admittedly, I issued this very same forecast awhile back -- 23 years ago to be exact. But I’m not reluctant to try again. Having read Grant’s
continuously since 1988, I’ve learned there’s no shame whatsoever in being early -- even often!The Triumph of Politics
was published early, mainly in the unflattering sense that I’d not completed my homework. I was hip to statist fiscal and regulatory evils, but had only dimly grasped the Austrian masters’ wisdom on money; that is, in printing money backed by nothing, central banks inherently threaten prosperity. So today I’ll add the proposition that fiscal decay is the inevitable step-child of the very monetary rot that the Austrians -- Mises, Hayek, Rothbard -- so deplored.
My tardiness on money perhaps owes to the Reagan Revolution’s disinterest. Secretary Don Regan averred that sound money could be readily attested by the height of the Dow
while his deputy, a monetarist, gauged it by the width of M2.
Even Alan Greenspan, that is, Greenspan version 1.0, urged not to worry. Gold, he assured Ronald Reagan, was meant to anchor -- not the Fed’s actual balance sheet, but something more ethereal, like perhaps its state of mind.
My libertarian screed thus omitted money while cataloging the Reagan Revolution’s lesser shortcomings. These included gargantuan deficits, subsidies for favored Republican constituencies like farmers, homebuilders and exporters, a complete whiff on entitlements, and protectionism for dying industries like steel and textiles -- even for a motorcycle company whose ticker symbol, fittingly, was HOG
Then, too, there were tax giveaways to real estate, oil and gas, and, come to think of it, to any other worthy industry with the foresight to hire a pair of Gucci loafers domiciled on K-street. On top of this, came the big defense budgets at a peacetime record 7% of GDP. Deep Federal deficits thus stretched as far as the eye could see.
Yet, I didn't perceive that this already alarming fiscal ledger would be further aggravated by two looming tectonic shifts. Oddly enough, these financial temblors were rooted in history’s most consequential pair of train cars.
The first was the sealed car that took Lenin to Moscow in 1917 -- a 75-year trip to hell and back that finally ended in 1991 when a Moscow politician, whose normal confrontations were with a Vodka bottle, was inspired to mount a Soviet tank and command the Red Army to stand down. Promptly thereupon the US defense budget was stood down, too, dropping overnight to approximately 3% of GDP -- half its prior size. This unexpected game changer coupled with marginal tinkering on taxes and spending computed out to a balanced budget. Soon enough, the fiscal all-clear horn was sounded by no less than Wall Street’s own money man, Secretary Rubin.
In fact, the fiscal equation was just then tumbling into a fatal descent. And it is here -- let’s pinpoint the exact date at Greenspan’s “irrational exuberance” call in December 1996 -- where the Austrian men separate themselves from the Keynesian and Friedmanite boys. The latter continued to quibble about how to measure money, whether it was growing too fast or slow and if more or less financial regulation was needed.
Peering through a different frame, however, the Austrian notes that US money GDP was about $10.0 trillion at the time the Maestro let his exuberant cat out of the bag. Under an honest monetary regime this nicely rounded number might have stalled-out indefinitely -- owing to the Great East Asian Deflation just then gathering a head of steam.
The truth is, the extraordinary force of economic nature represented by the mercantilist export machine that sprung up in East Asia in the late 20th century was profoundly deflationary. Absent puffed-up domestic credit, the in-coming Asian trade would have flattened American employment, wages, incomes and prices. In so doing, it would have kept money GDP bottled-up at around $10 trillion, thereby denying the next decade’s debt-fueled rise in both output and prices which took money GDP to $14 trillion.
By Austrian lights, then, this $4 trillion difference represents counterfeit GDP, owing to the false conversion of unsupportable borrowings into current income -- debt which is now being forcibly liquidated. This bubble-driven inflation of money GDP also caused government revenues to swell unsustainably, thereby camouflaging for more than a decade the fiscal deficit’s actual, far more frightful, aspect.
There's no mystery in this contra-factual history. With money anchored to a standard, say gold, the armada of containerships steaming from the Pacific Rim into Long Beach would have brought massive trade deficits, but also would have set in motion their own correction. Taking flight in the opposite direction, gold bullion, not paper dollars, would have been on the backhaul to East Asia.
In turn, an old-fashioned drain on America’s gold would have obviated a lot of fatuous jawing about the Chinese being seven-feet-tall economically or excessively addicted to an alleged financial opium called “over-saving." Instead, without need for a single meeting of the open market committee, the loss of gold would have presently caused a sharp contraction of domestic bank reserves, a shrinkage of loans by an approximate 10 times multiple thereof and a sharp rise in the rate of interest on the dollar markets.
Admittedly, consumption, imports, money wages, jobs and cost-bloated domestic enterprises would have all been laid low by such hard money discipline. But having thus been put to the mat, a nation of aging and now over-priced workers -- and bankers, too -- wouldn't have found it expedient to live high on the hog. Instead, they would have discovered the “new normal” of higher savings, fewer credit cards, lower consumption, and slimmer paychecks -- all on their own and about a decade sooner. It goes without saying that believers in the elixir of counterfeit money and credit, which is to say Keynesians, monetarists, and Goldman Sachs
(GS) partners, will dismiss all this as flat-earth doctrine -- fossilized ideas pre-dating the discovery of government’s wondrous power to manage the macro-economy.
Still, a doctrine that holds out the state as an agent of economic betterment suffers from some deep flaws of its own. Decades of experience show, for example, that fiscal stimulus is an exercise by which one class and region steals from another. But the worse flaw is the hallowed central bank doctrine that deflation is always bad. In fact, wrong-headed deflation fighting is what generated the boom of the 1920s and the subsequent bust -- a scenario repeated almost exactly during the last decade.
The famous quote from "Bubbles Ben" about the Fed at Milton Friedman’s 90th birthday is thus replete with irony. Said Bernanke in November 2002: “You’re right. We did it. We’re very sorry...we won’t do it again.” But the Fed did it again, generating the most massive speculative bubble ever. And this time the Fed even assured that if a bubble should ever break, it would stand ready to -- well -- rinse and repeat!
Here, the Austrians note that the central bankers' allergy to deflation is rooted not in sound economics, but in weak politics; in the catering to the pressures of promoters, speculators and borrowers. In fact, the Austrians showed that deflations owing to powerful secular cost-reduction trends -- whether based on new technologies, new economic geographies, or new forms of enterprise -- are healthy. They raise real incomes and wealth, even as they cause commodity prices to fall.
Thus, the East Asian export machine far outranked every other cost-crasher in recorded history. It bested the Internet, Walmart
Ford’s moving assembly line, central station electric power, the railroads, canals, the steam engine, the spinning jenny, and, while we're at it, let’s throw in the wheel, too!
The Fed’s strategy in the face of the Great East Asian Deflation, then, was exactly upside down. It should have raised interest rates and liquidated credit in order to encourage a deflation of domestic wages, prices, and corporate cost structures which were no longer competitive or viable in the new global markets. But by keeping interest rates absurdly low on the pretext that the “core” CPI Index
was, as it was pleased to say, “well-anchored," the Fed thwarted the fundamental economic adjustments that were vital for the American economy to regain its footings.
The “panic of 2008," therefore, wasn't a random policy error, nor was it caused by the machinations of overly-bonused bankers. In fact, the massive quantities of unsupportable debt and the vast malinvestments in housing, banking, shopping malls, office buildings, and Pilates studios, too, which came crashing down last September, were rooted in history’s other star-crossed rail car. That was the gilded club car which in November 1910, had secretly whisked away Senator Nelson Aldrich and his coterie of Morgan, Rockefeller and Kuhn Loeb bankers to a duck-hunting blind on Jekyll Island, Georgia.
The truth is, the monster that was hatched there -- the Federal Reserve System -- has always been an instrument of politics; that is, the politics of the speculative classes, whether domiciled on Wall Street, Main Street, or the Agrarian plains. Let the political chatter get fevered enough about unfairly “low” prices for goods, grains, or labor and there's invariably been a new theory and willing maestro at the Fed to print-up some easy credit. My thesis today is that monetary rot underpins fiscal decay, but that’s not to gainsay the complicity of Capitol Hill and the White House in the march to budgetary ruin -- particularly the complicity of the type of Republican Whiggery which emerged after the 2000 election.
The truth is, just as the Great East Asian Deflation called for monetary hardening, not ease, it also warranted a large increase in national savings -- including public sector surpluses. But by then there had been assembled in Karl Rove’s political assault camp, a coalition of the neo-cons, the social-cons, the tax-cons and the just-cons. None of them gave two hoots about real fiscal discipline.
The neo-cons postured as big-time thinkers, articulating a lofty policy case for an American Imperium. But unlike real imperialists, the neo-cons had nothing to say about the crucial issue of war finance.
Indeed, since DOD couldn’t seem to keep a pipeline open in the planet’s second richest oil province, the neo-cons couldn't even fallback on the imperialist’s traditional gambit of looting the colonies. Obviously, the real answer was a war tax -- especially since the war at issue was an elective. But that idea was anathema in Karl Rove’s assault camp, so the neo-cons simply ignored the fiscal consequence of the multi-hundred billion annual drain on the treasury their policies entailed. War finance, it seems, was relegated to the GOP’s all-purpose folklore -- the myth that lower taxes and more growth would cover any fiscal hole.
The tax cons, for their part, did not even think about fiscal policy; they issued Papal Edicts. Consequently, a kernel of truth -- the notion that lower marginal tax rates are economically beneficial -- became ensnared in a body of debatable doctrine, even outright claptrap.
Foremost among the latter is the alleged absence of a correlation between deficits and either interest rates or real growth. Fine. If that’s the test, let’s abolish taxes completely and put the Federal government on a regimen of 100% bond finance.
Likewise, the tax-cons have shamelessly misapplied evidence that a lower capital gains rate did generate higher revenue. True, these cuts sped the realization of gains already extant, but that has nothing to do with the revenue impact from lowering or raising rates on 95% of what we actually tax; that is, accrued payrolls and earned income.
Not technical quibbles, these points highlight the folly of elevating tax-cutting to the status of religious writ. Indeed, unwilling to cut spending by so much as a single veto in eight years, the Bush Administration needed to get revenue raising on the table as a matter of pure math. But the tax-cons, having totally befuddled what passes for GOP fiscal thinking, were able to drive the herd in just the opposite direction, slashing Federal revenues twice more during the Bush fiscal debauch. The profound financial danger, therefore, is that there's no longer in the United States a conservative fiscal opposition even worthy of the name.
Moreover, this fiscally perilous condition continues to be exacerbated by the tattered remnants of Karl Rove’s political assault camp. The social-cons, relentless as ever in their bible-thumping and immigrant-bashing, help to elect real socialists, as often as not. And the just-cons continue to turn fiscal responsibility into a bad joke. Last election, 85% of the American people were against the abomination called TARP. But on that central issue, the Republican standard bearer went radio silent while chattering endlessly about appropriations earmarks. But taken together, those 8,000 earmarks add-up to just 15 hours of annual Federal spending. The needless bailout of Wall Street engineered by Bubbles and the Henry "Hammer" Paulson, by contrast, destroyed forever any residual will to control spending that remained on Capitol Hill.
So now there are no fiscal rules. None. Cash for clunkers -- and for pig farmers, homebuilders, real estate speculators, and GE’s
(GE) green machines, too -- will never stop flowing. Eventually -- perhaps soon -- there will be more Treasury bonds to sell than the world’s shrinking base of dollar holders can possibly absorb.
Then the Big Panic will come. In the event, some will look back and wonder why we destroyed our capacity for fiscal governance in order to save the likes of AIG
(C), and especially Goldman during the comparatively minor disorder of September ’08. Certainly, the so-called “systemic risk” will have been exposed for the cover story it was.
None of AIG’s alleged CDS time bomb, for example, really mattered. The European banks who were wrapping dodgy assets with AIG’s bogus AAA cover would have gotten bailed out by their own socialist governments, anyway. For Goldman, the loss would have meant six months of bonus accruals. For the big insured US depositories, losses would have meant their Sheila-gram would have come sooner, rather than later.
Then there's the specious claim that the money market funds would have come unglued. Well, they did, and investors in the largest of them, the Reserve Primary Fund, appear to be getting about 98 cents on the dollar -- the Lehman losses and all
The question thus presents itself: Did a few thousand institutional money managers who should have been watching out for their own risk -- especially the kind which accompanied black box enhanced yield -- really need to be spared even two cents of loss?
Here, it's said that it wasn’t the two cents of money fund loss but the $2 trillion of commercial paper it funded which was the real systemic risk -- even down to the specter of skipped payrolls, had the paper been unable to roll. Let’s see. About a trillion of that commercial paper was credit card, auto, and other types of ABS -- the financial equivalent of a twice-baked potato. Had it not rolled, no one would have repossessed the autos or refused a Visa
(V) authorization. Instead, the underlying bank issuers would have found new credit card loans building up on their balance sheets -- a modest bulge that they could have readily funded with virtually free consumer deposits.
Another $300 billion was industrial commercial paper. It’s a good thing no senator ever asked the Hammer to name even a single industrial issuer that couldn’t have funded expiring paper out of its back-up credit lines. He couldn’t have answered.
That leaves about $700 billion of Finance company paper -- a goodly portion of which was accounted for by the likes of GE Capital, Household Finance, GMAC and CIT
(CIT). Here the lessons taught by JP Morgan himself, ninety-nine years earlier almost to the date, are more than instructive. Wishing not to allow undercapitalized brokers, who had gone all-in speculating on margin loans, to go unpunished, Morgan allowed the call loan rate to soar to 30%, even more, on some days during the panic of 1907.
Needless to say, loan books resting on 30% overnight money, not real capital, got liquidated and fast. While the economic sky didn't fall thereafter, more than a few holders of the brokers’ junior debt and equity capital got rudely torched.
Nevertheless, ten decades later came the panic of 2008, and GE Capital, like the feckless brokers of JP Morgan’s time, found itself caught short with $100 billion of commercial paper propping up its $ 700 billion of asset footings. Yet we're now supposed to believe that capitalism’s very foundation had become so frail that GE couldn't be allowed to take the required haircut for its foolish asset/liability mismatch. Well, we shouldn’t believe the financial system would have gone tilt had taxpayers not propped up GE’s shares and debentures because the claim simply isn’t believable.
Thus, “systemic risk” was but a fig leaf for aggrandizement of the state, and especially its central banking branch. The resulting waste of resources and ballooning of moral hazard was palpable. But the real cost was in the final destruction of political discipline which resulted from the mad rush to TARP.
The Bush era had already aggravated the nation’s fiscal predicament immeasurably. Now the few remaining fiscal stalwarts still in the trenches, such as Senators Shelby and Bunning, were fragged from behind by their own officers. And now, too, the Democrats and socialists had every place to run and no need, politically, to hide even their most wanton raids on the Treasury.