The Great Deformation

by David Stockman

  By the turn of the century the United States was living far beyond its means, as measured by the cumulative trade deficit of nearly $2 trillion that had been incurred just since the 1991 recession. Under traditional fixed exchange rate discipline, the job of the central bank in these circumstances had always been to tighten money, raise interest rates, and curtail domestic demand sufficiently to eliminate the trade deficit and the associated loss of monetary reserves.

  The Greenspan Fed did the just opposite, however, and thereby contradicted every gold standard speech that Alan Greenspan had ever delivered in his earlier incarnation. The result was an artificial domestic borrowing boom unprecedented in peacetime history. Between 1993 and 2001, credit market debt outstanding soared from $16 trillion to $29 trillion, representing an 8 percent annual growth rate.

  Even a stable economy cannot sustain debt growth rates of that magnitude. In the 1990s, however, the US economy could not stand even a fraction of that debt growth rate because it was being battered by the greatest deflationary event in history; that is, the pegged currencies that enabled a tsunami of cheap labor and cheap manufactures out of the rice paddies of Asia.

  The Fed’s failure to respond appropriately to the great Asian deflation is evident in the fact that money GDP growth of $3.6 trillion during this eight-year period paled compared to the $13 trillion growth of credit market debt. In other words, there was $3.60 of debt growth for each dollar of added GDP. And it was getting worse, with credit market debt growth in 2001 alone of $2.2 trillion—6.5 times faster than money GDP.

  The great prosperity celebrated in the late 1990s was thus nothing of the kind, and in fact reflected an artificial domestic demand that was bloated by the massive Greenspan debt bubble. Moreover, this artificial domestic demand generated even greater imports and trade deficits, thereby further unbalancing the national economy.

  The cure for excess demand and borrowing, of course, is higher interest rates. Yet after the 1991 recession ended, the Greenspan Fed never even returned interest rates to their prerecession levels. It thereby abdicated the historic job of sound central banking—namely, to lean hard against a current account deficit by curtailing domestic demand.

  By late 1998, the US economy worked up a massive head of borrowed steam, and the nearly maniacal stock market finally faltered due to the Russian default and the LTCM crisis. Yet rather than letting the bubble wash out, the Fed charged ahead in the wrong direction, pegging short-term interest rates at 4 percent, a level far lower than at the start of the cycle and an inducement for the domestic debt binge to continue. In short, the nation was already living massively beyond its means, but the Greenspan Fed kept hitting the monetary accelerator, not the brakes.

  This was really nothing more than Keynesian-style monetary activism—that is, operation of the Fed’s printing presses based on whatever whims struck the fancy of its twelve-person open market committee, especially its chairman.

  Their fancy, of course, was to purge the business cycle of its natural oscillations and deftly manage the American economy to ever greater heights of performance and prosperity. As the nation’s self-appointed central planner, the Fed saw fit to translate its vague legislative mandates to pursue full employment and price stability into an open-ended license to meddle and micromanage.

  Any perceived faltering in the growth of employment and output was to be countered by toggling its monetary joystick; that is, the interest rate on federal funds. The central banking branch of the state thereby took custody of the nation’s economy.

  Ronald Reagan came to Washington to liberate free enterprise. The greatest irony of his presidency, therefore, is the appointment of a Fed chairman who repudiated his essential purpose by institutionalizing a statist régime through the back door of activist monetary policy.

  GREENSPAN’S JUNK ECONOMICS: THE CHINA PRICE AND THE FALLACY OF THE TAYLOR RULE

  The particular fancy that preoccupied the Fed chairman was that the consumer price index (CPI) trend rate of inflation dropped from around 4 percent before the 1990 recession to about 2.5 percent by the second half of the 1990s. Greenspan concluded that this was the result of a miracle of productivity and the Fed’s skill at inflation fighting.

  He therefore encouraged the open market committee to embrace a gussied up reincarnation of the Phillips curve trade-off between unemployment and inflation. The new monetarist variation was known as the Taylor rule, but it amounted to the same old demand-side error. It called for lower interest rates and a frothier party on Wall Street on the pretext that reduced inflation and available slack in potential output justified easier money. But this reasoning was upside down. The Taylor rule was mathematical junk posing as monetary science.

  The consumer price index was rising at a slower rate not because of a miracle of domestic productivity or because the Fed had scored a roaring success in subduing domestic inflation. And most certainly it was not because the US economy was wallowing in unrealized “potential” output as fantasized by Professor Taylor, who had seen fit to name the rule in his own honor.

  The downward pressure on the CPI was actually of exogenous origin. The epochal wage deflation generated by the Chinese export factories was rapidly destroying existing capacity in the American economy. This caused “potential” output to fall, not rise, as the Taylor rule enthusiasts erroneously claimed.

  Indeed, the “China price” deflated the cost of both imported goods and import-competitive domestic manufactures so sharply that the average US price level should have actually been declining, not just rising less rapidly. Yet that did not happen. From December 1990 to December 2000 the average annual CPI increase was 2.7 percent, and exceeded 3 percent during the final two years.

  Domestic price gains of nearly 3 percent annually were perverse because they thwarted the needed downward adjustment of domestic wages and production costs, an adjustment essential to preserving competitiveness and jobs. Moreover, monetary pass-through of the Asian deflation would have stretched the domestic buying power of nominal wages and bolstered real living standards.

  Instead, the Fed showered the American economy with cheap debt, which amounted to a policy of fostering more consumption and less production. It also meant that the CPI index vaulted higher by 30 percent during the decade while employee compensation per hour rose by 35 percent. American workers thus barely kept up with the cost of living, even as they priced themselves out of the world market.

  So the Fed’s claim of taming inflation during the 1990s was valid arithmetically but was not benign economically. It drastically widened the nominal wage gap with Mr. Deng’s new export factories, paving the way for an even higher tide of imported manufactures and even more extensive destruction of the US production and employment base.

  In short, Mr. Deng’s “glorious to be rich” proclamation signaled the onset of a vast and powerful tide of global deflation in wages and prices. But the Greenspan Fed blew it. Rather than allowing the US economy to harvest the living standard gains of deflation and to adjust to the pains of falling nominal wages and profits, it declared a debt party.

  THE FED’S $13 TRILLION DEBT PARTY

  The 1990s American economy could ill afford to take on more debt and raise the leverage burden on national income. In fact, its capacity to generate income was declining on a permanent basis in the face of the Asian deluge, meaning that the Fed’s policy of fostering massive growth of domestic debt was profoundly mistaken. Indeed, the Fed effectively took itself hostage. It required more and more credit-fueled consumption spending to make up for production and income which was being lost to the Asian export machine. Bubble finance became a substitute for real income and productivity.

  The Fed’s $13 trillion credit bubble during 1993–2001 also caused a phony boom on Wall Street. The soaring stock averages at the end of the decade in part reflected a near tripling of the valuation multiple (price-to-earnings [PE] ratio) on corporate earnings per share (EPS). This virtually unprecedented expansion of PE ratios im
plied that the growth potential of the US economy was accelerating.

  In fact, it was being badly eroded by soaring debt at home and the explosive growth of manufacturing capacity among the currency-pegging export mercantilists of East Asia. These fundamental forces of economic decay were obscured by the celebration of the tech revolution and the stock market bubble which supposedly reflected it.

  What was actually happening, however, was far less benign. Corporate earnings were rising moderately, but mainly on account of consumer spending gains fueled by easy credit and the gathering mortgage debt–driven boom in both commercial and residential real estate.

  Likewise, the ready availability of debt financing for corporate takeovers, leveraged buyouts, and share buybacks jigged-up earnings per share as documented more fully in chapters 21 and 22. And as the Fed pushed interest rates ever lower, the so-called cap rate on real estate and other financial assets fell, generating even higher asset prices and feeding speculative appetites still further.

  Indeed, the Fed’s low interest rate policy caused the price of American labor to become richer relative to Asia while the price of debt became cheaper relative to income. Accordingly, spurred on by Wall Street demands for higher EPS, corporate America soon undertook vast strip-mining operations designed to extract labor costs from the profit and loss accounts during the current quarter, while funding the resulting severance and restructuring costs over many future years out of cheap borrowed funds.

  Not surprisingly, business debt soared as companies borrowed money to buy back shares, take over competitors, and buy out workers. Between 1993 and 2001 nonfinancial business debt outstanding increased by nearly 100 percent, rising from $3.5 trillion to $6.8 trillion. Pretax business income only grew by 50 percent, however, meaning that business leverage ratios were steadily rising.

  The Fed ignored this evidence of weakening economic fundamentals, too. Instead, it claimed credit for a stock market boom that was in very large part fueled by the giant debt bubble and trade deficits that its own misguided policies had triggered.

  At the end of the day, the Fed’s Wall Street–coddling monetary policies of the 1990s masked the grave threat to the American economy that was incubating in East Asia. It is ironic in the extreme, therefore, that the credit-based boom in consumption and financial speculation that was engineered by the Greenspan Fed has been touted as evidence of the success of the Reagan Revolution’s supply-side policies.

  In fact, the Keynesian boom of the 1980s and the money-printing bubble of the 1990s were anti–supply side. Two decades of exporting US treasury debt and fiat dollars was generating damaging economic blowback aimed at the very heart of the economy’s actual capacity to produce output and jobs.

  On the evidence, it was clear at the dawn of the twenty-first century that the great Asian export machine far outranked every other cost-reducing invention in recorded history. It bested the Internet, Wal-Mart, numerically controlled machine tools, Henry Ford’s assembly line, central station electric power, the railroads, steam engine, spinning jenny, and possibly even the wheel.

  And the main implication was that American production, jobs, and incomes were at risk. Under the established régime of free trade, domestic jobs and incomes could be maintained only if cost and wage levels were adjusted downward to meet the powerful deflationary challenge of the Asian exporters.

  Under these conditions, the very last thing the American economy needed was lower interest rates and rapid household credit expansion. This invited domestic households to load up with far more debt relative to income than ever before imagined. The household debt-to-GDP ratio, in fact, climbed steadily for three decades, rising from a historic norm of about 45 percent in 1975 to upward of 100 percent after the turn of the century.

  At the same time, artificially bloated consumption spending was only partially captured by domestic suppliers of goods and services. On the margin, a rising share of the demand for consumer goods went straight to low-priced foreign suppliers, especially to Mr. Deng’s “China price” factories.

  The implication was straightforward. In the face of the great Asian export machine, the wage prospects of Main Street households were being impaired and their debt-carrying capacity was being rapidly eroded.

  Under these conditions, the Fed should have pushed interest rates far higher to encourage savings and a reduction of household debt, not enabled a spectacular accumulation of even more borrowings. But the Fed was lost in its growth triumphalism and pseudoscientific policy rules.

  So at the very worst time possible in the cycle of modern economic history, the nation’s central bank enabled households to bury themselves in mortgage and credit card debt. It thereby pushed the production versus consumption imbalance of the national economy to even more perilous extremes.

  The 1990s boom, therefore, was not the productivity and technology driven breakout of growth and prosperity that is was cracked up to be. Instead, it was rooted in a massive credit bubble, which masked deep structural challenges to the production, jobs, and income base of the US economy.

  THE ANTI-SUPPLY-SIDE PROSPERITY OF 2002–2007

  When the dot-com bubble burst and the mild recession of 2001 ensued, the Fed elected to juice the American economy with still another round of rock-bottom interest rates. Washington reciprocated with even more adventures in fiscal profligacy. But this time there was no way to hide the fact that the resulting cyclical rebound, as measured by the modest uptick in the GDP accounts and nonfarm payrolls during 2002–2007, was an unsustainable facade of prosperity.

  More than four years after the meltdown on Wall Street, the hard economic data shows that the US economy has actually been stalled out for a decade. During the twelve years ending in December 2012, real investment in business fixed capital grew at only a microscopic 0.8 percent annual rate.

  That is not supply-side prosperity by any stretch of the imagination, since failure to invest in productive capacity quashes future growth in GDP and living standards. In fact, real GDP growth has averaged only 1.7 percent during the same twelve-year period, and even that meager growth number would have been zero, or even negative, if inflation were calculated honestly.

  Similarly, the September 2012 nonfarm payroll count was 133.5 million jobs, virtually the same number of nationwide jobs reported in late 2000. Of greater concern, the count of full-time breadwinner jobs stands at about 66 million, or nearly 10 percent below its level at the turn of the century. Manufacturing output is not much higher than it was in February 2000.

  So the Reagan Revolution did not engender a supply-side miracle, nor cause any improvement in the trend of macroeconomic performance. Its legacy has been obscured by serial policy-induced growth bubbles: the Keynesian deficit boom of 1983–1992, the Greenspan domestic credit and stock market bubble of 1993–2000, and the giant housing and consumption boom spurred by the Fed’s absurdly low interest-rate policies after the minor 2001 recession.

  All of this came to a thundering collapse in autumn 2008 when the nation’s multi-decade debt binge hit its natural limits and the massive imbalances between production and consumption and between exports and imports reached unsustainable extremes. Yet the Reagan Revolution’s apologists have never even attempted to explain this dire turn of events, save for blaming the Obama administration for making even worse the economic debacle it found on its doorstep.

  Nevertheless, when the false narrative of macroeconomic prosperity is stripped away, what remains is the real story of the Reagan era: how the nation’s conservative party fostered the great fiscal breakdown now upon the land, and got away with it by pretending that the money printers it appointed to the Fed were fostering honest prosperity.

  The whole narrative was wrong. Reaching back to the time of Reagan, it can be shown that fiscal discipline was destroyed first by the “neocons” who coddled the warfare state in pursuit of national security illusions; and then by the “tax-cons” who dismantled Uncle Sam’s revenue base in the name of supply-side
doctrine; and finally by the “just-cons,” the rank-and-file Republicans who fulminated against Big Government but cowered continuously before the assembled lobbies of the welfare state.

  WHY THE RISING TIDE LIFTED VERY FEW BOATS

  Nor was fiscal discipline the only casualty of the Reagan Revolution’s failures and deformations. The supply-side vision had also foreseen a rising tide lifting all boats, but the last three decades have brought the opposite: economic stagnation to the middle class and a veritable cornucopia of wealth gains and opulence to the top of the economic ladder.

  In fact, the current $50,000 median household income has grown by only 0.3 percent annually after adjustment for inflation during the last thirty years, while real hourly wage rates are actually lower. Indeed, the average real wage rate of workers entering the labor force with a high school education has declined 25 percent since 1979, and has remained stagnant even for college-educated entrants.

  So the answer after three decades to the fabled question of the 1980 Reagan campaign—Are you better off?—would be quite clear for the broad middle class: not so much.

  Indeed, it is in the nature of financial bubbles based on leverage and speculation to deposit a large share of the winnings at the top of the economic ladder. Not surprisingly, the share of net worth held by the top 1 percent of households has risen from 20 percent to 35 percent since 1979 while their share of income has doubled to 25 percent.

  When measured by the net worth aggregates reported by the Federal Reserve, the skew toward the top comes into even more dramatic focus. The top 5 percent of households currently hold about $40 trillion in net worth—a $32 trillion gain over the $8 trillion they held in 1985.

  By contrast, the net worth of the bottom 95 percent of households at year-end 2011 was just $8 trillion higher than a quarter century back. The top 5 percent have thus gained four times more than the bottom 95 percent.