The Great Deformation

by David Stockman

  For example, the household savings rate averaged about 2.5 percent of GDP during 1938–1939, but then soared to nearly 17 percent during 1942–1945. This was a savings rate not even remotely approached either before or since.

  In turn, this explosion of thrift led to a dramatic deleveraging of household and business balance sheets. This clearing of debt accounts was reinforced by the fact that there was virtually no new business or personal borrowing during the war.

  As a result of these trends, household debt dropped from about 60 percent of GDP in 1938 to just over 20 percent by 1945, meaning that consumers ended the war virtually debt free. Likewise, corporate business debt also fell sharply during the same seven-year period, dropping from about 90 percent of GDP to 40 percent.

  Owing to the forced savings of wartime dirigisme, therefore, private sector leverage (corporations plus households) was rolled back from its prewar ratio of 150 percent of national income to just 60 percent, a level far lower than any recorded since the nineteenth century. Stated differently, the US economy emerged from the war in solid financial shape mainly because the private debt burden had been virtually erased, thereby creating vast “headroom” on the nation’s balance sheet for federal debt to be readily absorbed by available national savings.

  Furthermore, even this high-water mark was exceedingly temporary. During the immediate postwar period, Washington’s vestigial fiscal conservatism played out in one final chapter, resulting in a sharp, speedy reduction in the government’s debt ratio. A war-weary nation demanded rapid demobilization of the military machine, so annual federal outlays plummeted from $95 billion in 1945 to only $37 billion in fiscal 1947. At the same time, the heavy régime of wartime taxes was only modestly reduced, permitting the federal budget to swing into surplus during fiscal 1947. It then remained in the black for several more years, until the next war.

  The federal government’s debt ratio thus completed a sweeping round trip. After having surged from 50 percent of GDP in 1938 to 125 percent at the 1945 peak, the federal debt ratio retraced three-fifths of this wartime gain, falling to under 80 percent of national income by 1950.

  Moreover, even with a modest rebound in private borrowing, total credit market debt by 1950 had fallen back to 170 percent of national income, nearly spot-on its historical norm spanning all the way back to the Civil War. In short, what the warfare state of 1941–1945 proved was that wars should be funded with taxes and savings, not that federal deficits are harmless or that they were a cure for the Great Depression.

  HARRY TRUMAN’S HONEST WAR

  The initial postwar fiscal equilibrium was not destined to be sustainable. It depended upon high wartime tax rates and on a monetary policy régime vested with latent inflationary propensities.

  Eventually, the Federal Reserve would capitulate to the bullying of Lyndon Johnson and Richard Nixon by throwing open the switches on its printing press. This unleashed a virulent inflation that would cause consumer prices to nearly triple between 1967 and 1980.

  At multiple steps along the way, however, an honor roll of statesmen attempted to resist the tide of fiscal profligacy and monetary debasement which had been set in motion by the New Deal and the warfare state. It began with Harry Truman’s resolute stand for fiscal responsibility on the matter of war finance during the Korean action.

  From a contemporary vantage point, of course, it is not clear what purpose US intervention on the Korean peninsula ultimately served. Today’s prosperous Republic of Korea would have otherwise ended up an equally booming province of China’s Red Capitalism, the last great hope according to bullish speculators.

  Once the war decision had been made, however, Truman insisted that it be financed the old-fashioned way—with taxes. Accordingly, he promptly pushed through the Congress a hefty tax increase in September 1950, and another one in January 1951 after the war widened at the time Chinese forces poured across the Yalu River.

  In the final reckoning, federal spending surged nearly 80 percent during the war period. Yet, amazingly, at least by current standards, the Korean War budgets were financed on a pay-as-you-go basis. Stated in constant dollars (2005), outlays totaled $1.76 trillion during fiscal years 1951–1953, while revenues came in at a nearly identical $1.75 trillion. No elective war has ever been financed with such purposeful discipline.

  As it turned out, this episode marked the end of sound war finance, and also the beginning of extended wars of occupation—in Vietnam, Iraq, Afghanistan—that were financed with Treasury bonds. This contrast was not coincidental. Owing to Truman’s unwavering insistence on stiff war taxes, GOP conservatives had no stomach for open-ended war in the barren hills of Korea if it meant permanently high taxes, and therefore blessed Eisenhower’s decisive move for peace within weeks of his election.

  After that, America’s imperialistic misadventures in other strategically barren redoubts of the planet faced no such political constraints. Lyndon Johnson set the new tone with his “guns and butter” adventure in Southeast Asia, even when the historical record shows that the Chinese people were now starving in their villages, not fixing to pour across the border of another purported domino.

  Yet LBJ couldn’t bring himself to ask for war taxes until the very end, a drastic failing that opened the way for equally irresponsible war finance by future GOP administrations. Indeed, four decades later George W. Bush’s equally bootless imperial missions were carried out entirely tax free. Indeed, what poured out of China this time was the money to fund them.

  THE FED’S 1951 STAND AGAINST THE TREASURY PEG AND THE REPRIEVE OF SOUND MONEY

  The next constructive but ultimately unavailing effort to restore sound money occurred in the spring of 1951. At that time, a dramatic Washington political confrontation ended the Fed’s wartime servitude to the Treasury Department and eliminated the inflationary “peg” on Treasury interest rates.

  The precipitating force was a surge of anticipatory price increases resulting from the threat that Washington would reimpose price controls when the Korean conflict escalated. In short order, the CPI was increasing at double-digit rates well ahead of open market interest rates, which were rising with a lag.

  Real interest rates had thus become deeply negative, fueling a “cheap money” burst of bank credit expansion. The growth of new lending, in fact, reached a 20 percent annual rate during the winter of 1950–1951. This was a credit expansion rate that had not been recorded since the Roaring Twenties.

  Notwithstanding this frothy surge of inflation and credit, the Fed was still being forced to buy Treasury debt hand over fist in order to keep the long bond at par and prevent yields from rising above the 2.5 percent wartime peg. Not surprisingly, its purchases of government debt shot up by 10 percent during 1950 and were rising at a 20 percent rate in early 1951.

  All of this monetization of government debt, of course, was being funded by newly minted reserves which the Fed injected into the banking system. This threatened even more inflationary credit expansion.

  The leadership of the Fed, including Chairman Thomas McCabe and the legendary Marriner Eccles, recognized that the Depression-era days of monetary quiescence were over. So as Eccles and McCabe saw it, the Fed had to be consistently disciplined in its provision of reserves to the banking system. In what was now essentially a fiat money régime, the only real barrier to runaway inflation was to keep the banking system firmly in harness. The violent inflationary flare-up in early 1951 was a cogent reminder.

  To be sure, the Fed leadership and staff in 1951 were not comprised of scholastic monetarists. Milton Friedman had not yet even revived the quantity theory of money. But Eccles and his fellow board members didn’t need academic theories and math models to conduct their business. Having witnessed the runaway credit expansion of the 1920s, especially the explosion in stock market margin lending and the resulting trauma of debt deflation which followed the bubble’s collapse, this first postwar generation of Fed leaders possessed an innate, healthy fear of bank credit.
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  Nor did that generation of Fed leaders harbor the later illusion that cheap debt was the key to economic growth. Consequently, it was evident to the Fed that the Treasury peg had to be ended forthwith, so that it could prudently manage the provision of reserves to the banking system, and thereby permit only a measured expansion of credit to businesses and households.

  Testifying before a congressional committee at the time, Marriner Eccles cogently expressed this bank reserve–focused monetary doctrine and the reason for the Fed’s insistence on jettisoning the wartime peg: “As long as the Federal Reserve is required to buy government securities at the will of the market for the purpose of defending a fixed pattern of interest rates established by the Treasury, it must stand ready to create new bank reserves in an unlimited amount. This policy makes the entire banking system, through the action of the Federal Reserve System, an engine of inflation.”

  During the fall and winter of 1950–1951, the Fed leadership repeatedly advised the Truman administration of the rising inflationary danger posed by adherence to the peg. Unfortunately, President Truman was as obtuse on monetary policy as he was courageous on fiscal matters. Worse still, he had appointed a Missouri political crony and small-time banker, John W. Snyder, as secretary of the treasury.

  Like many sons of the middle border, Snyder was an adherent of FDR’s hayseed coalition when it came to interest rates and monetary matters. Accordingly, he stubbornly demanded that the Fed keep buying bonds at the pegged rates, and eventually lured President Truman into a public showdown with the nation’s central bank in February 1951.

  Truman had demanded a face-to-face meeting with the Federal Reserve Board. With Snyder’s complicity he had afterward made public a letter to the board expressing appreciation for an alleged “renewal” of its commitment to maintain the peg. The Truman letter was a flat-out lie, and it soon triggered one of the great acts of political courage in modern times.

  Marriner Eccles probably earned the right to have the Fed’s headquarters named after him when he leaked the minutes of the board’s White House meeting with Truman to the New York Times. The leaked minutes proved beyond a shadow of a doubt that the board had made no such commitment.

  The White House soon sought a compromise, and while Secretary Snyder was in the hospital, a clever assistant secretary of the treasury invented a formula that allowed both sides to save face. The Treasury Department was forced to issue nonmarketable long-term bonds with a 2.75 percent coupon, thereby breaking the long-standing 2.5 percent peg. At the same time, the Fed swapped them into another previously issued five-year note at par for a limited number of weeks in order to put a fig leaf on the White House pledge that bondholders would not lose money. In short order, however, the Fed’s support operation ended, the five-year Treasury notes slipped to a discount in the secondary market, and the Fed’s first era of rigging the government bond market came to a close.

  THE RISE OF WILLIAM MCCHESNEY MARTIN: TRIBUNE OF SOUND MONEY

  As it happened, the assistant secretary who arranged the White House retreat was William McChesney Martin, who was soon appointed chairman of the Federal Reserve. It did not take long for Martin to establish that he had been on the Fed’s side all along, declaring in his speech accepting the appointment that inflation was “an even more serious threat to the vitality of our country” than the aggression in Korea.

  Martin then concluded his remarks and began his nineteen-year tenure as Fed chairman, with an expression of support for sound money that, apart from the Volcker interlude of 1979–1987, would rarely be heard again in the halls of the Eccles Building. The statement was plain vanilla financial orthodoxy.

  In those sensible times, financial leaders knew that inflation was destructive and unfair, so Martin’s words were not rhetorical. He literally meant that inflation should be held close to zero: “I pledge myself to support all reasonable measures to preserve the purchasing power of the dollar.”

  Martin’s stern doctrine of financial discipline and anti-inflation vigilance embodies a stunning contrast to the spurious 2 percent inflation target of today’s Fed. The latter is the very antithesis of sound money because it gives the Fed an excuse to fuel credit growth and Wall Street speculation, while silently cutting the purchasing power of the dollar by 50 percent during the working lifetime of every citizen.

  By contrast, Martin’s sound money views had been formed by his experiences at the epicenter of the financial markets in the 1920s and 1930s. His father had assisted Carter Glass in drafting the 1913 act, and had gone on to play an influential role in the new monetary arrangement as president of the Federal Reserve Bank of St. Louis.

  Consequently, Martin had been exposed at an early age to dinnertime monetary discourses by his father’s notable colleagues including Benjamin Strong, the powerful chief of the New York Fed, and H. Parker Willis, the era’s leading authority on money and banking and the technician who had actually drafted much of the 1913 act.

  Professor Willis was also a learned proponent of the classical English banking model, which held that commercial banks should lend only against liquid trade receivables, not real estate, corporate securities, or other illiquid collateral. Indeed, the modern device of an unsecured “cash flow” loan would have struck him as pure heresy.

  Willis advocated this stringent approach to permissible bank assets not because he was an anti-market regulator, but because he recognized the inherent danger of fractional reserve deposit banking. The only way to have a stable banking system when the vast majority of deposits are callable on demand, he maintained, was to keep assets equally short term and self-liquidating.

  For this reason, the Federal Reserve banks in the framework designed by Willis and his colleagues had a very narrow mandate. The sole function of the “reserve banks” was to help keep the commercial banking system liquid by advancing cash to member banks against their own liquid trade credits whenever they presented them at the discount loan window as collateral.

  The central banking system established in 1913 was therefore not in the economic management business and did not need to know whether GDP was rising or falling, or whether housing starts were robust or punk. Most especially, it would not have discounted even a scrap of the illiquid toxic securities that the Bernanke Fed accepted as collateral in September 2008. The $100 billion of advances it provided Morgan Stanley, for example, to cover up the firm’s bald-face lie that it was still solvent would have been unthinkable.

  The reason that the Willis-designed Fed had been indifferent to Wall Street troubles was that its congressional sponsors, especially Carter Glass, had a profound fear of credit-based speculation. That’s why there was no provision in the original act for the Fed to purchase or lend against government debt or to carry out the open market purchase and sale of investment securities.

  All of these latter adaptations were designed to inject central bank credit into the financial system for the purpose of stimulating borrowing, spending, and GDP. But Willis believed that central bank credit would be invariably diverted into speculative lending and stock market gambling.

  When the New York Fed opened the credit spigots in the summer of 1927, for the laudable purpose of helping the British adhere to their gold standard obligations, he was soon proven correct. The outcome was a giant margin loan bubble which fueled an unprecedented speculative mania on Wall Street during the next two years.

  By the time of Martin’s reign at the Fed, of course, Professor Willis’s doctrines had been steadily diluted and compromised, especially after the Fed became the fiscal agent for the wartime needs of the Treasury. Yet his fundamental admonition about the dangers of unchecked credit inflation and bank-enabled commodity and stock speculation remained central to Martin’s monetary philosophy.

  In fact, Martin had gotten his Wall Street education firsthand and at an early age. When he was just thirty-one years old he was chosen to become president of the New York Stock Exchange. His job assignment was to sweep clean the Augean s
tables in the wake of a scandal which in 1938 finally brought down Richard Whitney, the longtime head of the exchange, and his old-guard associates.

  Martin accomplished this mission with aplomb, taking away from his six-year tenure a widely praised record of reform in exchange practices and accommodation to the new SEC regulatory régime. But far more important, he also gained a deep appreciation for the degree to which rampant margin lending had turned the stock market into a veritable gambling casino in the run-up to the 1929 crash.

  MARGIN LOANS AND THE LESSONS OF 1929

  These so called brokers’ loans were a volatile form of hot money and were callable on a moment’s notice. At the time of the market peak, they had amounted to about 9 percent of GDP, which would amount to the not inconsiderable sum of $1.4 trillion in today’s economy.

  Moreover, as the speculative wave reached its final peak, broker loans outstanding had ballooned wildly. Outstanding margin credit to stock speculators had increased by 50 percent in the final twelve months of the stock mania.

  When viewed through the lens of the carnage which followed the crash, Martin had little trouble seeing that it was this volcanic mountain of margin debt which had lifted the stock averages to insane levels. He thus deeply believed that keeping speculative credit out of Wall Street was essential to the revival of an honest stock market and healthy national economy.

  Martin also had little doubt that the Fed’s easy-money policies during the later 1920s, particularly the aggressive easing in 1927, had fueled the massive flow of speculative credit into Wall Street. That cardinal fact was lost on postwar historians and monetarists, however, because the margin credit bubble had been hidden between the lines of the commercial banking system loan data. Between 1925 and 1929, for example, bank loans outstanding had increased by a seemingly modest $7.5 billion, or 5 percent, annual rate.