The Great Deformation

by David Stockman

  But the data make clear that the famous spurt of government activity in the first two years of the New Deal did little to revive the private economy. For instance, private nonfarm hours worked in 1934 were flat with the level of 1932. This means the modest rebound within this period was nothing more than the reversal of the post-election slump brought on by the Roosevelt banking panic.

  Likewise, nominal GNP reached just $65 billion in 1934, representing only a 6 percent annualized rate of rebound from the 1932 level. Even then, the strongest gains were in consumer durables and fixed investment, the beneficiaries of a natural rebound from their depression lows.

  During the middle 1930s, the natural rebound of the nation’s capitalist economy continued, but the real truth was that the numbers looked strong on an annual basis only because the export, investment, and durables collapse had been so severe. Still, as of 1939, after which the tides of war preparation took over the economic numbers, the recovery had been slow and halting. Nominal GDP that year totaled $90 billion, a figure that was still 12 percent below its 1929 peak.

  Likewise, fixed business investment was still 40 percent below the 1929 level, and private nonfarm hours worked told the same story. The US Bureau of Labor Statistics (BLS) recorded 75 billion man-hours in 1939—an astounding 15 percent below the 90 billion recorded for 1929. Similarly, steel production was still at 55 million tons compared to 62 million tons in 1929, and value added by all manufactures was $24.5 billion, a figure 20 percent below its $31 billion peak prior to the stock market crash.

  In short, the New Deal historiography has relied on a trick; namely, the assumption that the US economy would have remained mired in depression without the New Deal, and that the moderate recovery which did occur was entirely attributable to it. That is pure sophistry.

  What actually happened is that as the whirling dervish of experimentation that comprised the New Deal stumbled forward, it modestly increased the girth of the state. Government spending amounted to about 5 percent of GDP when FDR took office and was still under 10 percent as of 1939.

  For all the Republican arm-waving about Rooseveltian Big Government, that was really the least of the New Deal’s evils. Compared to the $33 billion recovery of total GNP between 1932 and 1939, only about $5 billion—just 16 percent—was accounted for by the government-spending component of the national accounts.

  In truth, the acronyms which caused this fiscal expansion—NRA, TVA, AAA, WPA, PWA, CCC, etc.—did not constitute a coherent countercyclical fiscal policy and did not cause the US economy to be any larger by 1939 than it would have been had the Hoover recovery continued with Mr. Hoover in the White House.

  THE WRONG LEGEND TAKEN

  In early spring of 2008, an unschooled treasury secretary and politically craven White House enacted a giant $150 billion proto-Keynesian stimulus in the form of one-time tax rebates to bolster a faltering economy. Hard on the heels of its November 2008 election victory, the Obama administration instantly pushed through a sight-unseen $800 billion stimulus measure that was a true Keynesian dispensation, or so it was certified by the great thinker’s current vicar on earth, Professor Larry Summers.

  Together these measures, along with the $700 billion TARP and sundry other measures of fiscal largesse, caused $2 trillion in fiscal stimulus to be authorized inside the span of one year to fight an alleged impending economic collapse. The historical significance of this wanton raid on the US Treasury cannot be gainsaid.

  For a flickering moment early in the Reagan administration the essential Keynesian predicate had been in headlong retreat; namely, the notion that downturns in the business cycle are avoidable and that the public purse should be aggressively used to counteract them. Now, twenty-seven years later, that predicate was again in full bloom, and with bipartisan enthusiasm.

  Ironically, the proximate cause of the economic downdraft that brought the Keynesian project roaring back to life was that the banking monster had escaped its New Deal shackles (see chapter 9) and wreaked havoc on the American economy. In response, desperate politicians began conjuring the ghost of the New Deal, believing that it had been an efficacious shock therapy for a deep economic slump. That was a double irony because the New Deal had not resuscitated anything. Among its many legacies had been a serviceable banking law (Glass-Steagall) and a feckless assault on sound money. The latter eventually morphed into Greenspan-Bernanke bubble finance. It was the catalyst that caused the unshackled banking system to go over the bend.

  Yet outside of banking and money, the New Deal amounted to little more than a politically driven spasm of Washington activism. It did not address the causes of the Great Depression, did not cure or even relieve its pall on the American economy, and amounted to little that was economically coherent or purposeful.

  Most especially, the notion that the New Deal had pioneered a road map to recovery by means of countercyclical fiscal policy is mostly a postwar academic legend. It is readily contradicted by the historical record, starting with the fact that, as shown above, the corner had been turned on a natural business cycle recovery before Roosevelt was even elected.

  CHAPTER 9

  THE NEW DEAL’S TRUE LEGACY

  Crony Capitalism and Fiscal Demise

  THE NEW DEAL DID NOT ADDRESS THE CAUSES OF THE DEPRESSION, even if its work relief and other humanitarian measures did ameliorate for millions of citizens the terrible costs of its unnecessary prolongation. Still, most of this safety net consisted of ad hoc programs, such as the WPA, which were never institutionalized and did not survive the 1930s.

  What did survive is a destructive legacy of fiscal profligacy and crony capitalist abuse of state power. Policy measures like Fannie Mae, deposit insurance, social insurance, the Wagner Act, the farm programs, and monetary activism share a common disability. They fail to recognize that the state bears an inherent flaw that dwarfs the imperfections purported to afflict the free market; namely, that policies undertaken in the name of the public good inexorably become captured by special interests and crony capitalists who appropriate resources from society’s commons for their own private ends.

  Roosevelt’s unprincipled and unbridled activism is a powerful case in point. Orthodox historians have positioned FDR as the scourge of “economic royalists” and the champion of the common man. He was neither. In fact, he was the patron saint of crony capitalism.

  As a power-driven politician he recognized no rules or standards for public policy or any particular limits on the role of the state. Indeed, FDR has been nearly defied for being a “pragmatist” who experimented until he found something that “worked.” Accordingly, it was only a matter of time before the very capitalists that FDR professed to despise captured for their own ends the programs he legitimized in the name of the public good.

  THE NEW DEAL ORIGINS OF FANNIE MAE AND THE HOUSING COMPLEX

  Fannie Mae is a classic crony capitalist progeny of the New Deal that began life in 1938, quite innocently, as still another ad hoc New Deal program to boost the depression-weakened housing market. It grew into something quite different: a monster that deeply deformed and corrupted the nation’s entire financial system seventy years later.

  The policy aim of Fannie Mae was “forcing water to flow uphill” in the residential mortgage market so that low-rate thirty-year home mortgages became available to wage-earning households of modest means. Such mortgages did not then exist for a good reason: they were not economic. No prudent local bank or thrift would take the underwriting risk.

  Fannie Mae would thus override the market’s veto by turning local banks and thrifts into government contractors or agents, rather than mortgage debt underwriters. Accordingly, they would be relieved of their aversion to the risk of default loss by means of a Washington-funded “secondary market.” The latter would purchase these commercially unappealing mortgage loans for cash, enabling local bankers to reloan this cash again and again in a government-supported rinse and repeat cycle.

  Meanwhile, the default losses
that the market refused to underwrite would be shifted to taxpayers, since Fannie Mae’s funding would implicitly depend on the public credit of the United States. The slowly recovering residential housing sector would thus receive the kind of booster shot much favored by the New Dealers.

  What Fannie Mae also did, unfortunately, was to start the home mortgage market down a slippery slope. This included separating the loan origination process from the long-term servicing and ownership of the resulting mortgage, in an alleged financing “innovation” that would give rise to predatory mortgage-broker boiler rooms a few generations down the road.

  Likewise, it opened the door to the funding of home loans in the global markets for U. S. sovereign debt, rather than out of the savings deposits of local bank customers. This became possible because Fannie Mae took on quasi-sovereign status, meaning that investors were funding the general credit of the United States, not the specific risk of local mortgage borrowers and separate residential markets.

  There were several crucial upgrades in ensuing decades to the original New Deal scheme before it reached its stunning dénouement in Washington’s panicky $6 trillion nationalization and bailout in September 2008. Among these milestones were LBJ’s maneuver to put Fannie “off-budget” in 1968 in order to hide its exploding use of Uncle Sam’s credit card.

  LBJ’s so-called privatization plan, in turn, paved the way for Fannie to morph into a hybrid entity called a GSE (government-sponsored enterprise) in which ownership was private but its debt issues were implicitly government guaranteed. Politicians and policy makers who inherited FDR’s “anything that works” mantle were pleased to describe the GSEs as creative “public/private partnerships.”

  They were no such thing. The GSEs were actually dangerous and unstable freaks of economic nature, hiding behind the deceptive good-housekeeping seal afforded by their New Deal–sanctioned mission to support middle-class housing. This was especially the case after Fannie’s initial public offering and subsequent ability to tap the public capital markets for virtually limitless funds.

  Another crucial step was Wall Street’s perfection of the mortgage securitization model. This “innovation” vastly improved Fannie’s ability to sweep up mortgages originated by local bankers on a massive wholesale basis, and then guarantee and package them for distribution into increasingly broad and liquid national and international capital markets. When this was combined with high speed computerized underwriting in the 1990s, disasters like Countrywide Financial became inevitable.

  As time passed, the evolution of the Fannie Mae monster only got more fantastical. Thus, the rise of the worldwide T-bill standard generated a nearly inexhaustible appetite among mercantilist central banks for US government or quasi-government GSE paper. These vast monetary roach motels were not exactly honest “markets” for mortgage loans from Cleveland or Fort Myers, but GSEs went into overdrive supplying the unquenchable thirst of foreign central banks for dollar liabilities, especially when heavy currency pegging began after 1994.

  Not surprisingly, when Treasury Secretary Hank Paulson’s fabled bazooka failed and Washington had to nationalize the GSEs, foreign central banks and other state institutions owned more than $2 trillion of American home mortgages, including upward of $1 trillion domiciled at the People’s Printing Press of China.

  In short, Fannie Mae’s journey started in 1938 with a Washington, DC, filing cabinet containing a few thousand mortgage notes which had been gussied up and christened as the nation’s “secondary mortgage market.” Yet the progeny of this innocent filing cabinet ended up eighty years later scattered around the globe in the trust accounts of Norwegian fishing villages and as a trillion-dollar stash in the central bank vault of Red China.

  In the interim, massive social costs and economic losses built up inside the housing marketplace and became ripe to explode. As detailed more fully in chapter 20, the whole GSE scheme functioned to underprice mortgages, undermine lending standards, over qualify home buyers, fuel greedy broker predation, and fund a speculative climate.

  In the process, the principal assets of the American middle class, family residences, were turned into an ATM machine and became the object of frenzied buying, selling, and serial refinancing. Unfortunately, this ruinous journey was far more inexorable than it was merely accidental.

  At each step along the way, powerful special interest groups—mortgage bankers, real estate developers, home builders, building material suppliers, Wall Street underwriters, law and title firms, appraisers, and brokers—drove policy toward their own benefit. These changes, elaborations, enlargements, and aggrandizements had a common purpose: namely, to enable the Fannie Mae (and Freddie Mac) mortgage-financing machine to harvest ever greater volumes, profits and fees.

  Indeed, the Fannie Mae saga demonstrates that once crony capitalism captures an arm of the state, its potential for cancerous growth is truly perilous. More importantly, it underscores that the resulting carnage can be vastly disproportionate to the alleged social ill that justified the original policy intervention.

  In this case, the housing market had essentially recovered before Fannie Mae opened its doors. After hitting bottom at 125,000 units per year in 1931–1933, the volume of new starts had nearly tripled by the late 1930s. By then, it was by no means evident that the nation’s remaining willing lenders and solvent borrowers were producing the wrong answer with respect to the number of housing starts. So fiddling with an arbitrary goal of higher housing starts, the New Dealers gave birth to what eventually became a crony capitalist monster, and that was all.

  SOCIAL SECURITY: THE NEW DEAL’S FISCAL PONZI

  The Social Security Act of 1935 had virtually nothing to do with ending the depression, and if anything it had a contractionary impact. Payroll taxes began in 1937 while regular benefit payments did not commence until 1940.

  Yet its fiscal legacy threatens disaster in the present era because its core principle of “social insurance” inexorably gives rise to a fiscal doomsday machine. When in the context of modern political democracy the state offers universal transfer payments to its citizens without proof of need, it offers thereby to bankrupt itself—eventually.

  By contrast, a minor portion of the 1935 legislation embodied the opposite principle—namely, the means-tested safety net offered through categorical aid for the low-income elderly, blind, disabled and dependent families. These programs were inherently self-contained because beneficiaries of means-tested transfers simply do not have the wherewithal—that is, PACs and organized lobbying machinery—to “capture” policy-making and thereby imperil the public purse.

  To the extent that means-tested social welfare is strictly cash-based, as was cogently advocated by Milton Friedman in his negative income tax plan, it is even more fiscally stable. Such purely cash based transfers do not enlist and mobilize the lobbying power of providers and vendors of in-kind assistance, such as housing and medical services.

  Social insurance, on the other hand, suffers the twin disability of being regressive as a distributional matter and explosively expansionary as a fiscal matter. The source of both ills is the principle of “income replacement” provided through mandatory socialization of huge population pools.

  On the financing side, the heavy taxation needed to fund the scheme has been made politically feasible by the mythology that participants are paying a “premium” for an “earned” annuity, not a tax. Consequently, payroll tax financing is deeply regressive because all participants pay a uniform rate regardless of income.

  At the same time, benefits are also regressive because those with the highest life-time wages get the greatest replacement. This regressive outcome is only partially ameliorated by the so-called “bend points” which provide higher replacement on the first dollar of covered wages than on the last.

  The New Deal social insurance philosophers thus struck a Faustian bargain. To get government funded pensions and unemployment benefits for the most needy, they eschewed a means test and, instead, agreed t
o generous wage replacement on a universal basis. To fund the massive cost of these universal benefits they agreed to a regressive payroll tax by disguising it as an insurance premium. Yet the long run results could not have been more perverse.

  The payroll tax has become an anti-jobs monster, but under the banner of a universal entitlement organized labor tenaciously defends what should be its nemesis. At the same time, the prosperous classes have gotten a big slice of these transfer payments, and now claim they have earned them—when affluent citizens should have no proper claim on the public purse at all.

  Accordingly, social insurance co-opts all potential sources of political opposition, making it inherently a fiscal doomsday machine. It was only a matter of time, for example, before its giant recipient populations would capture control of benefit policy in both parties, and most especially co-opt the conservative fiscal opposition.

  Within a few decades, in fact, Republican fiscal scruples had vanished entirely. This was more than evident when Richard Nixon did not veto but, instead, signed a 20 percent Social Security benefit increase on the eve of the 1972 election. Worse still, the bill also contained the infamous “double-indexing” provision which since then has generated massive hidden benefit increases by over-indexing every worker’s payroll history.

  The fiscal cost of relentless universal benefit expansion has driven an epic increase in the payroll tax. The initial 1937 payroll tax rate was about 2 percent of wages, but after numerous legislated benefit increases, the addition of Medicare in 1965, the Nixon benefit explosion and the Carter and Reagan era payroll tax increases, the combined employer/employee rate is now pushing 16 percent (including the unemployment tax).

  Accordingly, Federal and state payroll taxes for social insurance generate $1.2 trillion per year in revenue—four times more than the corporate income tax. So with the highest labor costs in the world, the U.S now imposes punishing levies on payrolls. It thus remains hostage to a political happenstance—that is, the destructive bargain struck eight decades ago when high tariff walls, not containerships loaded with cheap goods made from cheap foreign labor, surrounded it harbors.