The Great Deformation

by David Stockman

  It has also crushed the interest rate mechanism as an honest price signal in the financial markets; turned the treasury yield curve into a frontrunner’s paradise; and fueled massively leveraged carry trades which feed the 1 percent with windfalls while these trades work and generate petulant demands for bailouts when they crash. Turning Wall Street into a reckless, dangerous, and greed-riven casino, the Fed has at the same time crucified the nation’s savers on a rack of ZIRP (zero interest) and fueled a global commodity bubble that erodes Main Street living standards via soaring food and energy prices—inflation that the Fed then fecklessly deletes from the CPI.

  Needless to say, it took a long time to get to this lamentable state; nearly one hundred years, in fact. And that is what I now trace: a revisionist history of our era. It shows how the state-wreck ahead was fostered by FDR’s repudiation of the bipartisan tradition of sound money and the New Deal’s incubation of crony capitalist government. The Great Deformation was then put into brief remission during the mid-century golden era of sound money and fiscal rectitude under Dwight Eisenhower in the White House and William McChesney Martin at the Fed.

  After that, the incipient state-wreck was powerfully revived by Nixon’s perfidious weekend at Camp David in August 1971, where Tricky Dick blatantly and defiantly defaulted on the nation’s debt obligations under the Bretton Woods gold standard. Taking the United States off the gold standard was the starting point for the present era of floating money, massive debt creation, and a dangerously unstable global money-printing spree. Nixon’s malefactions were then further nourished by the final destruction of fiscal rectitude during the Reagan era, enabling both the warfare state and welfare state to balloon without the yoke of taxes weighing on the people. In the final descent into bubble finance, the Greenspan and Bernanke Fed institutionalized the financial repression, wealth effects, and Wall Street–coddling policies that have triggered the crisis at hand.

  The order of this book is not exactly chronological. It aims first to unpeel the onion of obfuscation that has emanated from Wall Street, bailout apologists, and the trio of Washington economic doctrines that assume the state can revive a failing economy when, in reality, it is a failing state that is crushing what remains of Main Street prosperity.

  Part 1 on the BlackBerry Panic, that historic moment in September 2008 when Washington flooded Wall Street with bailout money, refutes the hoary urban legends that were used by the Fed and the Treasury to panic the Congress into passing TARP and to justify the Fed’s balance sheet explosion. The so-called financial meltdown was purely in the canyons of Wall Street where it would have burned out on its own and meted out to speculators the losses they deserved. By contrast, the Main Street banking system was never in serious jeopardy, ATMs were not going dark, the money market industry was not imploding, and there was never any Great Depression 2.0 remotely in prospect.

  That’s important because it demonstrates that the September 2008 Wall Street crisis did not arrive mysteriously on a comet from deep space, thereby justifying emergency heat shields of money printing, deficits, and bailouts which broke all the rules. Instead, it grew out of decades during which Washington defied the rules, corrupting the nation’s financial condition with unfinanced wars, tax cuts, and welfare state expansion, permitting rampant special interest plunder of the public purse and conducting a financial casino out of the Fed’s headquarters in Washington.

  Part 2, “The Reagan Era Revisited: False Narratives of Our Times,” unpeels another layer of the onion that obscures a clear-eyed view of the Great Deformation’s deeper history. It debunks the GOP’s nostalgic claim that despite the mysterious ailment that caused the financial disasters of recent years, all would be well by simply going back to undiluted Reaganism. But “Morning in America” never happened and a fiscal disaster most surely did. Likewise, part 3 clears away the other short-circuit to comprehending the historical depth of the current crisis; namely, the claim of present-day high priests of Keynesianism that the New Deal already wrote the sacred texts and now they only need to be aggressively followed in order to clear the decks. In fact, the New Deal, despite its vaunted place in the history books, was largely a political gong show that didn’t cure the Great Depression, which, in any event, was caused by a global trade and commodity collapse that is totally irrelevant to America’s current traumas.

  The Great Deformation is a story that evolves decade by decade after the First World War. It is a historical sketch of what happened and a polemic about what went wrong. It features a gallery of policy villains, that is, proponents of unsound finance, including Franklin Roosevelt, Richard Nixon, Arthur Burns, Walter Heller, Milton Friedman, John Connally, George Schulz, Art Laffer, Cap Weinberger, Alan Greenspan, Newt Gingrich, Bob Rubin, George W. Bush, Hank Paulson, Tim Geithner, Jeff Immelt, John Mack, Paul Krugman, Larry Summers, Barack Obama, and most especially Ben Bernanke. Alongside is a cast of policy heroes who champion the cause of sound money and fiscal rectitude at crucial times, including, in the early periods, Carter Glass, Professor H. Parker Willis, Calvin Coolidge, Herbert Hoover, Lewis Douglas, James Warburg, and later, Harry Truman, Dwight Eisenhower, George Humphrey, William McChesney Martin, Douglas Dillon, Bill Simon, Paul Volcker, Howard Baker, Pete Domenici, Bill Clinton, Paul O’Neill, Ron Paul, Richard Shelby, and Sheila Bair.

  The battle turns out to be not equal. By the end of the story it will be apparent how crony capitalism won the struggle, why the fiscal cliff is insurmountable, and how a Keynesian state-wreck is at hand. The final chapter assays another road that could be taken: one that is compelling but, given the roots of the Great Deformation, difficult in the extreme.

  THE GREAT

  DEFORMATION

  PART I

  THE BLACKBERRY PANIC OF 2008

  CHAPTER 1

  PAULSON’S FOLLY

  The Needless Rescue of AIG and Wall Street

  IN THE SECOND DECADE OF THE TWENTY-FIRST CENTURY, AMERICA IS faltering under the weight of a dual crisis. Its public sector teeters on the ragged edge of political dysfunction and fiscal collapse. At the same time, its private enterprise foundation has morphed into a speculative casino which swindles the masses and enriches the few. These lamentable conditions are the Janus-faces of crony capitalism—a mutant régime which now threatens to cripple the nation’s bedrock institutions of political democracy and the free market economy.

  A decisive tipping point in the evolution of American capitalism and democracy—the triumph of crony capitalism—took place on October 3, 2008. That was the day of the forced march approval on Capitol Hill of the $700 billion TARP (Troubled Asset Relief Program) bill to bail out Wall Street. This spasm of financial market intervention, including multitrillion-dollar support lines provided to the big banks and financial companies by the Federal Reserve, was but the latest brick in the foundation of a fundamentally anti-capitalist régime known as “Too Big to Fail” (TBTF). It had been under construction for many decades, but now there was no turning back. The Wall Street bailouts of 2008 shattered what little remained of the old-time fiscal rules.

  There was no longer any pretense that the free market should determine winners and losers and that tapping the public treasury requires proof of compelling societal benefit. Not when AAA-rated General Electric had been given $30 billion in taxpayer loans and guarantees to avoid taking modest losses on toxic assets it had foolishly funded with overnight borrowings that suddenly couldn’t be rolled over.

  Even more improbably, Goldman Sachs had been handed $10 billion to save itself from alleged extinction. Yet it then swiveled on a dime and generated a $29 billion financial surplus—$16 billion in salary and bonuses on top of $13 billion in net income—for the year that began just three months later.

  Even if Goldman didn’t really need the money, as it later claimed, a round trip from purported rags to evident riches in fifteen months stretched the bounds of credulity. It was reminiscent of actor Gary Cooper’s immortal 1950s expression of suspicion about Commun
ism. “From what I have heard about it,” he told a congressional committee, “it isn’t on the level.”

  Nor was Washington’s panicked bailout of Wall Street on the level; it was both unnecessary and targeted at the wrong problem. The so-called financial meltdown was not the real crisis; it was only the tip of the iceberg, the leading edge of a more fundamental economic malady. In truth, the US economy was heading for the wringer because a multi-decade spree of unsustainable borrowing, speculation, and financialization of the national economy was coming to an abrupt end.

  In the years after 1980, America had undergone the equivalent of a national leveraged buyout (LBO). It was now saddled with $30 trillion more in combined public and private debt than would have been the case under the time-tested canons of financial discipline and prudence which prevailed during the nation’s long economic ascent. This massive debt burden had fueled a three-decade prosperity party by mortgaging the nation’s future. Now the bill was coming due and our national simulacrum of prosperity was over.

  This rendezvous with the limits of “peak debt,” however, did not mean that the Main Street economy was in danger of collapse into an instant depression. That was the specious claim of the bailsters. What did threaten was a deeper and more enduring adversity. The demise of this thirty-year debt super cycle actually meant that it was payback time. Instead of swiping growth from the future, the American economy would now face a long twilight of debt deflation and struggle to restore household, corporate, and public sector solvency.

  This abrupt turn in the road should not have been surprising. America’s fantastic collective binging on debt, public and private, had no historical precedent. During the century prior to 1980, for example, total public and private debt on US balance sheets rarely exceeded 1.6 times GDP. When the national borrowing spree reached its apogee in 2007, however, the $4 trillion of new debt issued by households, business, banks, and governments amounted to 6 times that year’s $700 billion gain in GDP. Plain and simple, what was being recorded as GDP growth was little more than faux prosperity borrowed from the future.

  In fact, by the time of the financial crisis total US debt outstanding was $52 trillion and represented 3.6 times national income of $14 trillion. Accordingly, there were now two full turns of extra debt weighing on the nation’s economy. And the embedded math was forbidding: at the historic leverage ratio of 1.6 times national income, which had prevailed for most of the hundred years prior to 1980, total US public and private debt would have been only $22 trillion at the end of 2008.

  So the nation’s households, businesses, and taxpayers were now lugging around the aforementioned $30 trillion in excess debt. This staggering financial burden dwarfed levels which had historically been proven to be healthy, prudent, and sustainable. TARP and all its kindred bailouts and the Fed’s ceaseless money printing could not relieve it. And Washington’s reckless use of Uncle Sam’s credit card to fund the Obama stimulus actually made it far worse by attempting to revive the false prosperity of the bubble years. The obvious question remains: Why did this plague of debt arise? Did the American people suddenly become profligate and greedy through a mysterious process of moral and social decay?

  There is no evidence for the greed disease theory but plenty of reason to suspect a more foreboding cause. The real reason for the current crisis of debt and financial disorder is that public policy had veered into the ditch, permitting an unprecedented aggrandizement of the state and its central banking branch. In the process, the vital nerve center of capitalism, its money and capital markets, had been perverted and deformed. Wall Street has become a vast casino where leveraged speculation and rent seeking have displaced its vital function of price discovery and capital allocation.

  The September 2008 financial crisis, therefore, was about the need to drastically deflate the Wall Street behemoths—that is, dangerous and unstable gambling houses—fostered by decades of money printing and market rigging by the Fed. Yet policy veered in the opposite direction, propping them up and thereby perpetuating their baleful effects, owing to a predicate that was dead wrong.

  A handful of panic-stricken top officials, led by treasury secretary Hank Paulson and Fed chairman Ben Bernanke, proclaimed that the financial system had been stricken by a deadly “contagion” that had come out of nowhere and threatened a chain reaction of financial failures that would end in cataclysm. That proposition was completely false, but it gave rise to a fateful injunction—namely, that all the normal rules of free market capitalism and fiscal prudence needed to be suspended so that unprecedented and unlimited public resources could be poured into the rescue of Wall Street’s floundering behemoths.

  AIG WAS SAFE ENOUGH TO FAIL

  As it happened, Washington drew the red line at AIG the day after the Lehman failure. Yet the relevant facts show that an AIG bankruptcy would not have started a chain reaction—that there never was a financial doomsday lurking around the corner. In fact, none of the bailouts were necessary because the meltdown was strictly a matter confined to the canyons of Wall Street. It would have burned out there on its own had Washington allowed the free market to have its way with a handful of insolvent institutions that needed to be taken out: Morgan Stanley, Goldman, and Citigroup, among others.

  In short, the financial “contagion” predicate, which triggered the bailout madness of the Bush White House and the Bernanke Fed, had no basis in fact. And the proof starts with AIG, the bailout poster child itself, and the alleged catalyst for the purported chain reaction. The plain fact of the matter is that AIG was structurally incapable of starting a contagion. Any modest hit to the balance sheets of a handful of its huge, global banking customers owing to the collapse of its bogus credit default insurance (CDS) would have caused a healthy purge of busted assets. At the same time, its millions of insurance policy holders were never in harms’ way; they were always a pretext to obfuscate the real purposes of the Washington bailsters.

  At the time of the crisis, 90 percent of AIG was solvent and no danger to the financial system or anyone else. Its $800 billion balance sheet consisted mostly of high-grade stocks and bonds that were domiciled in a manner which utterly invalidated the “contagion” theory. Indeed, this giant asset total was a statistical artifact of AIG’s consolidated financial statements: its massive horde of high-grade assets was actually parceled out into scores of insurance subsidiaries subject to legal and regulatory jurisdictions scattered all over the globe. Those lockups both protected policyholders and ensured that there would be no massive asset-dumping campaign by AIG, the presumptive catalyst for the contagion.

  So the crisis did not implicate AIG’s vast assets. It was actually all about its hemorrhaging CDS liabilities—which could have been easily ring fenced. They were domiciled exclusively in AIG’s holding company and accounted for less than 10 percent of its consolidated liabilities. These obligations could have been readily liquidated in bankruptcy without any disruption to the insurance companies, their solid assets, or their policyholders.

  Nevertheless, AIG was handed a massive and wholly unwarranted taxpayer-funded infusion that ultimately totaled $180 billion. Hank Paulson, the most destructive unguided missile ever to rain down on the free market from the third floor of the US Treasury Building, later claimed, “If AIG went down, we faced real disaster. More than almost any financial firm I could think of, AIG was entwined in every part of the global system, touching businesses and consumers alike.”

  That was balderdash and subterfuge. A “global” firm by definition has a global footprint in the same manner as a zebra has stripes. But that obvious factoid doesn’t prove that free market exchange is a transmitter of communicable economic disease, which was what Paulson and his fellow bailsters constantly implied. In fact, the unjustified largesse granted to AIG was not designed to inoculate the masses from harm, but to save the bacon of a few dozen speculators.

  The paper trail uncovered by congressional investigators shows that the $400 billion (notational value) of busted
CDS insurance issued by the AIG holding company was held by a very small number of the world’s largest financial institutions, and virtually none of it was held by the banks of Main Street America which were allegedly being shielded from AIG’s imminent collapse. Moreover, the worst-case loss faced by the dozen or so giant institutions actually exposed to an AIG bankruptcy would have amounted to no more than a few months’ bonus accrual.

  Yet there is not a shred of evidence that the panic-stricken amateurs surrounding Paulson ever investigated which institutions held the CDS contracts or their capacity for absorbing losses. Instead, in one of the most egregious derelictions of duty every recorded, Paulson and his posse of Goldmanite hotshots hastily and blindly shielded these behemoths from even a dollar of loss on their AIG insurance policies.

  As the congressional investigators later determined, AIG’s big-bank customers were actually supplied cash from a multitude of bailout spigots that aggregated to truly stunning magnitudes. This evidence also shows that each and every recipient institution had the balance sheet capacity to absorb the AIG hit, so the bailout was all about protecting short-term earnings and current-year executive and trader bonuses. That is the shocking truth of what the AIG bailout actually accomplished. Saddling innocent taxpayers with business enterprise losses generated on the free market is always an inappropriate exercise of state power, but shattering policy rules and precedent in order to vouchsafe the bonuses of a few thousand bankers is beyond the pale.

  Not surprisingly, Goldman Sachs was the largest beneficiary of taxpayer largesse and was paid out nearly $19 billion on its various claims against AIG. But many of the other financial behemoths were not far behind, with a total of $17 billion going to France’s second largest bank, Société Générale, while $15 billion was transferred to Deutsche Bank, $14 billion to Bank of America and Merrill Lynch, and nearly $10 billion to London-based Barclays, which also got the corpse of Lehman as a consolation prize.