The Great Deformation

by David Stockman

  Yet there is more and it is worse. The current punishing payroll tax is actually way too low—that is, it drastically underfunds future benefits owing to positively fictional rates of economic growth assumed in the 75-year actuarial projections. As a result, the benefit structure grinds forward on automatic pilot facing no political opposition whatsoever. In the meanwhile, the fast approaching day or reckoning is thinly disguised by trust fund accounting fictions.

  In truth the trust funds are both meaningless and broke. Annual benefit payouts already exceed tax receipts by upward of $50 billion annually, while the so-called trust funds reserves—$3 trillion of fictional treasury bonds accumulated in earlier decades—are mere promises to use the general taxing powers of the US government to make good on the rising tide of benefits.

  The New Deal social insurance mythology of “earned” annuities on “paid-in” premiums that have been accumulated as trust fund “reserves” is thus an unadulterated fiscal scam. In reality, Social Security is really just an intergenerational transfer payment system.

  Moreover, the latter is predicated on the erroneous belief that new workers and wages can be forever drafted into the system faster than the growth of benefits. During the heady days of 1967, for example, Paul Samuelson and his Keynesian acolytes in the Johnson Administration still believed that the American economy was capable of sustained growth at a 5 percent annual rate. The Nobel Prize winner thus assured his Newsweek column readers that paying unearned windfalls to current social security beneficiaries was no sweat: “The beauty of social insurance is that it is actuarially unsound. Everyone … is given benefit privileges that far exceed anything he has paid in …”

  Samuelson rhetorically inquired as to how was this possible and succinctly answered his own question: “National product is growing at a compound interest rate and can be expected to do so as far as the eye can see … Social security is squarely based on compound interest…. the greatest Ponzi game ever invented.”

  When 5 percent real growth turned out to be a Keynesian illusion and output growth decayed to 1–2 percent annual rate after the turn of the century, the actuarial foundation of Samuelson’s Ponzi game came crashing down. It is now evident that Washington cannot shrink, or even brake, the fiscal doomsday machine that lies underneath.

  The fiscal catastrophe embedded in the New Deal social insurance scheme was not inevitable. A means-tested retirement program funded with general revenues was explicitly recommended by the analytically proficient experts commissioned by the Roosevelt White House in 1935. But FDR’s cabal of social work reformers led by Labor Secretary Frances Perkins thought a means-test was demeaning, having no clue that a means-test is the only real defense available to the public purse in a welfare state democracy.

  When the American economy was riding high in 1960, Paul Samuelson’s Ponzi was extracting payroll tax revenue amounting to about 2.8 percent of GDP. A half century later, after a devastating flight of jobs to East Asia and other emerging economies, the payroll tax extracts two-and-one half times more, taking in nearly 6.5 percent of GDP. So the remarkable thing is not that wooly-eyed idealists who drafted the 1935 act succumbed to social insurance’s Faustian bargain at the time. The puzzling thing is that 75 years later—with all the terrible facts fully known—the doctrinaire conviction abides on the Left that social insurance is the New Deal’s crowning achievement. In fact, it is its costliest mistake.

  GLASS-STEAGALL:

  ANOTHER FAUSTIAN BARGAIN WHICH FAILED

  Another untoward legacy of the New Deal is the 1933 enactment of the great banking abomination known as “deposit insurance.” The keenest financial minds of the time vehemently opposed deposit insurance because they well understood the inherent dangers of fractional reserve banking, or what really amounts to borrowing short and lending long.

  Financial conservatives of that era believed that effective discipline on bankers had to come from the liability side of their balance sheets. Bankers could be prevented from taking reckless credit risk, or foolishly mismatching short-term liquid deposits with too many illiquid long-term loans and investments, it was believed, only if they faced continuous depositor scrutiny and the threat of deposit withdrawals, even a “run” on the bank when all else failed.

  Certainly that was the view in 1933 of the intrepid leader of the Senate banking committee, Carter Glass. It was also the position taken by the American Bankers Association, as well as by such distinctively less banker-friendly experts as the original draftsman of the Federal Reserve Act, Professor H. Parker Willis of Columbia University. And not to be overlooked, either, is the fact that deposit insurance was also strongly opposed by Franklin D. Roosevelt himself.

  It was only after months of legislative haggling that the Faustian bargain finally materialized. Hailing from the hardscrabble state of Alabama, which had been especially devastated by bank failures, Congressman Henry B. Steagall represented the populist demand for deposit insurance to protect the “little guy.” At the same time, the final bill incorporated a regulatory régime for the asset side of the banking system designed by Carter Glass and Professor Willis.

  These latter restrictions famously centered on the separation of investment and commercial banking. But they also included restrictions on bank holdings of illiquid real estate and corporate securities, the prohibition of interest on checking accounts, and the remainder of what came to be known as the Glass-Steagall regulatory régime.

  The implicit theory of this two-headed compromise, therefore, was that the heavy inducement to risk taking and moral hazard, owing to taxpayer insurance of deposit liabilities, would be offset by strict safety and soundness regulation of banking operations and balance sheet holdings. In effect, traditional marketplace discipline on the deposit and liability side of bank balance sheets would be supplanted by strict regulation of their asset side.

  At the time, the “Steagall” and the “Glass” components of the 1933 banking legislation seemed firmly harnessed. The US House of Representatives was a hotbed of anti-banker sentiment during the 1930s, while Senator Carter Glass was a deeply knowledgeable and stern taskmaster.

  Even Wall Street grudgingly deferred to him. So the Glass-Steagall legislative fusion seemed immune to banker-sponsored dilution or repeal, and it was on that understanding that Carter Glass, the foremost banking expert of his time, reluctantly embraced deposit insurance.

  In the fullness of time, however, it turned out to be just another Faustian bargain which came a cropper. Once the world went on the T-bill standard and inflation soared in the 1970s, Senator Glass’s carefully designed harness on the asset and operating side of commercial banking came under relentless pressure for liberalization.

  The Great Inflation of the 1970s which followed Nixon’s demolition of Bretton Woods, in fact, destroyed the political foundation of Glass-Steagall; that is, a régime of bad money very quickly spawned a parallel régime of bad banking. The reason is that high inflation flushed the liquid deposits out of banks while crushing the fixed-rate assets that were stranded in them.

  A key feature of Glass-Steagall had been interest rate ceilings on bank deposits (Regulation Q). These were designed to discourage banks from aggressively expanding their loan books and then funding them with deposits obtained from their competitors by chasing interest rates higher. This ceiling arrangement was deeply offensive to free marketers, but Senator Glass had well understood that competitive efficiency had to be sacrificed to banking safety, given the moral hazard of deposit insurance and fractional reserve banking.

  When Arthur Burns ignited the fires of inflation for Nixon’s reelection party, however, Regulation Q caused a perverse outcome that the gold standard Senator from Virginia probably never imagined; namely, a flight of deposits out of the banking system into unregulated money market funds that could offer higher rates. The latter, in turn, were able to invest their inflows in the choicest assets of the banking system, such as high-grade commercial paper and Treasury bills.

>   At the same time, soaring inflation caused massive mark-to-market losses on the core fixed-rate assets that the commercial banking system did retain, such as long-term Treasury bonds and mortgages. This brutal squeeze not only endangered the solvency and viability of the banking system, but it also generated a more sympathetic reception in Washington for the banking industry than at any time since the 1920s.

  It would be no exaggeration to say that Richard Nixon and Arthur Burns were the real executioners of Glass-Steagall—and fully two decades before the Gramm-Leach-Bliley repeal act was even drafted. Ostentatiously displaying their wounds from the Great Inflation, in fact, the banks relentlessly pleaded for flexibility to pursue riskier business while also getting Regulation Q lifted.

  The desire on Capitol Hill to help alleviate the squeeze on hometown banks and thrifts is what really fueled the deregulation drive during the Reagan era. For instance, the landmark Garn–St. Germain bill of 1982 conferred vastly expanded asset powers, such as real estate development lending and junk bond investments, on the massively insolvent savings and loan industry.

  While the Senate side of this legislative duo had an affinity for free market doctrine, the decisive voice was that of Congressman Freddie St. Germain of Rhode Island. The latter was a practical politician who rarely met a lobbyist he could not accommodate.

  St. Germain’s case for deregulation was not about the glories of the free market, but simply that it was an unavoidable emergency expedient designed to help thrifts to earn their way out of their current balance sheet disasters. The Great Inflation thus spawned a cure which was worse than the disease. As the thrift industry piled into reckless speculation far afield from home mortgages, it was only a matter of time before virtually the entire industry collapsed into insolvency.

  The relentless drive of the commercial banks into new product lines such as securitized mortgages, interest rate swaps and other derivatives, stock and bond underwriting, and eventually market making and proprietary trading had similar roots. All of these ultimately destructive banking charter expansions gained their initial impetus and legislative cover from the unassailable fact that high inflation and double-digit interest rates had busted the balance sheets and business model of traditional deposit banking.

  To be sure, the ideology of free markets was inappropriately applied to the banking industry during the Reagan era and ever since. Under modern institutional arrangements, including deposit insurance and the Fed’s bailout window, banks are inherently wards of the state and cannot be safely deregulated.

  Yet as the Fed fostered a growing speculative climate and financialization of the American economy after 1987 there ensued a step-by-step dismantlement of Glass’s regulatory harness, and then its outright repeal in 1999. What was left in the aftermath of repeal was nothing other than the naked moral hazard of Congressman Steagall’s deposit insurance scheme.

  Once the Fed flooded the banking system with virtually free money after December 2000, the bargain of 1933 became a colossal financial accident waiting to happen. The populist Congressman Steagall would doubtless roll in his grave upon learning that his gift to the “little guy” had enabled the depredations of Citigroup eight decades later. His coauthor and legendary student of banking, Senator Glass, undoubtedly would have retorted, “I told you so.”

  In all, Glass-Steagall’s desultory ending was not atypical of the long-term fate which befell most of what emerged from the devil’s workshop that was the New Deal. More often than not, programs born out of desperation or idealism seventy-five years ago have ended up as fiscal time bombs like Social Security, or as captive fiefdoms of one crony capitalist syndicate or another.

  THE CRONY CAPITALISM OF FDR’S HAYSEED COALITION

  The Agricultural Adjustment Act (AAA) of 1933 was the quintessential product of the New Deal devil’s workshop, boasting a record of contemporary economic mayhem and destructive future legacy with few parallels. The giant flaw was that the AAA was an anti-market scheme utterly incapable of alleviating the deep farm depression that sprung from the aberrations of the Great War.

  American farms had then functioned as the “granary” to the world after world war broke out in 1914. During that glorious and unrepeatable episode in American agricultural history, farm exports soared from about $1 billion annually to nearly $4 billion at the war-induced peak.

  The Great War temporarily transformed the American agricultural heartland into a Persian Gulf equivalent for wheat, wool, cotton, and pork. Wheat prices, for example, climbed from $0.70 per bushel to $2.20. Accordingly, the windfall rents accruing to the suddenly “scarce” supply of American farmlands were enormous. Farm income soared from $3.5 billion in 1913 to $9 billion by 1919.

  But even that stunning gain does not capture the full impact: rural economies were transformed into redoubts of never before imagined prosperity, even opulence, almost overnight. This ebullient war prosperity also caused land values to double, spurred robust investment in farm improvements and machinery, and encouraged aggressive credit expansion by country banks.

  But in the spring of 1919, the US government abruptly shut down the massive stream of war loans that had been going to the European allies. Within months, the demand for exports from the American granary began to rapidly dwindle, and by the next year (1920) the farmlands of Europe came back into production.

  The economic tide in the agricultural hinterlands rapidly reversed during 1920–1921 when farm commodities experienced a violent deflation. Sky-high farm prices were hammered down relentlessly—with wheat, for example, falling from $2.20 per bushel in 1919 to $0.95 per bushel two years later.

  The 1920s return to the pre-war equilibrium, however, was exacerbated by an additive factor—the agricultural mechanization revolution—which came cheek-by-jowl with the loss of bloated wartime export markets. In 1914 there were only about 15,000 tractors and 17,000 work trucks on American farms, but by 1930 it was a totally different world. These figures had increased fifty-fold to nearly one million tractors and a like number of farm trucks.

  The arrival of this vast armada of farm tractors and trucks tremendously increased farmer productivity at the same that US farm exports were cut in half to $2 billion by 1922 and remained at this level for most of the 1920s. When the foreign bond market crashed after 1928, this last vestige of artificial demand vanished, causing US farm exports to experience another violent down-leg to a mere $750 million by 1932.

  During the course of twelve years, therefore, the value of American farm exports plunged by 80 percent. The windfall rents and surging rural prosperity that was the result of the Great War became its nightmarish opposite by the early 1930s.

  Not surprisingly, the wartime peak farm income of $9 billion was cut to $5 billion by 1925 and eventually to $2 billion by 1932. Accordingly, farm land prices followed the path of income downward, dropping by 50 percent. By the early 1930s farm land was back to a per-acre value not seen since around 1900.

  In the natural economic scheme of things, however, one metric of the farm economy remained elevated to the very day of FDR’s inauguration; namely, farm mortgages and other debts. After more than doubling to $12 billion in 1921, farm debts remained grudgingly high at $10 billion through 1933.

  Once again, therefore, an old economic truth rudely asserted itself. Debts are contractual and fixed, even as boom-time incomes and asset values plummet back to earth. Indeed, farm income had plummeted by 80 percent whereas farm debt had been reduced by only 15 percent.

  Accordingly, the debt service burden on American farmers climbed from 5 percent of income in 1919 to nearly 35 percent by 1933. Not surprisingly, foreclosures reached such epic proportions that nearly all of the rural states enacted moratoriums.

  And so, in the fullness of time, the massive farm borrowing spree which had been induced by the windfall rents of the Great War ended in tears. After weighing heavily on the rural countryside in the midst of the nation’s temporary urban prosperity of the 1920s, it finished up by crus
hing the shrunken remnants of the US farm economy when worldwide depression finally materialized in the early 1930s.

  THE RISE OF FDR’S HAYSEED COALITION:

  THE REAL POLITICAL BASE OF THE NEW DEAL

  The agricultural corridors of America became the epicenter of the Great Depression. Drained of cash flow by the collapsing prices of its crops and denied credit by its widely insolvent banks, the rural economy by March 1933 had plunged from the pinnacle of wartime prosperity to a deeper depression than ever before experienced in American history.

  The inner truth of the New Deal is that FDR’s nomination at the 1932 Democratic convention and the electoral votes that put him in the White House were overwhelmingly secured in these same burned-out agricultural districts—the South, the middle border, the Great Plains, and the farm and mining areas of the Southwest and West. Consequently, the essence of Roosevelt’s anti-depression policy arose out of the hayseed coalition from these districts, and consisted of the witch’s brew of home-made remedies, schemes, reforms, crusades, and monetary quackery that emanated from the stricken farm economy.

  The depression theory of the hayseed coalition, a notion which FDR embraced thoroughly, was that the prolonged agricultural depression in the countryside had infected the whole national economy by reducing rural demand for manufactured goods. In turn, this fueled a downward spiral of factory shutdowns and unemployment, resulting in reduced urban incomes and spending.

  The whole key to national recovery, therefore, was to levitate farm prices sharply upward. This would cause rural incomes to rebound smartly. Soon, orders for manufactured goods would revive, factories would reopen, workers would have money to spend again, and the great engine of the national economy would gain steam.