Yet buried in these quotidian aggregates was the fact that bank loans to business and industry, that is, to the real economy, had declined sharply during this four-year period. Consequently the entire reported gain, and then some, was due to the explosion of Wall Street brokers’ loans.
The decline of business loans in the real economy was partially the result of improved internal corporate cash flows as the 1920s boom reached its apex. However, the primary driver of this reduced appetite for bank credit was far more perverse, as had been repeatedly pointed out by Benjamin Anderson, the era’s most prescient working economist.
According to Anderson, who was chief economist of the Chase National Bank, the boom on Wall Street had permitted corporations to raise far more cash from new stock and bond issues than they needed to meet actual investment needs. Consequently, they not only used this “excess cash” to pay down bank loans, but also recycled much of it straight back to the Wall Street call money market; that is, industrial companies became part-time bankers.
Nearly 60 percent of the total $9 billion of brokers’ loans outstanding on the eve of the crash had been advanced not by the banks, but by wealthy investors and corporations recycling cash from earlier stock market winnings. In this manner, the excess liquidity from the Fed’s money-printing experiments in the mid-1920s had drained into Wall Street and fueled a self-perpetuating cycle of financial speculation.
Ironically, this same gambit reappeared about sixty years later when the Japanese invented a whole theory called “zaitech” to explain how companies could prosper by moonlighting as financial engineers. In the Japanese version, companies sold stock and convertible debt at the vastly inflated market prices which had been fueled by the Bank of Japan’s post-1985 money-printing spree. Japanese corporations then recycled the resulting cash proceeds into stock market speculation, which resulted in even more reported profits and still higher share prices.
Not surprisingly, when the Bank of Japan was forced to puncture the resulting runaway financial bubble in 1989, as the Fed had been required to do in 1928–1929, the zaitech-based house of cards collapsed almost instantly. Japan thus experienced a replay of the very same Wall Street movie which had played six decades before.
In contrast to his present-day Japanese and American counterparts, William McChesney Martin was schooled in the classic doctrines on money and banking, and did not need a rerun of the 1929 crash to know that leveraged speculation in the stock market needed to be avoided at all costs. Consequently, the hallmark of his tenure was his famous quip that the job of the Fed “is to take away the punch bowl just as the party gets going.”
WHEN MARTIN TOOK THE PUNCH BOWL AWAY FROM A FOUR-MONTH-OLD (RECOVERY)
At no time was Martin’s resolve to lean hard against a recurrence of speculative excess more evident than in August 1958, when the Fed moved to tighten policy just four months after the start of recovery from the recession of 1957–1958. Not surprisingly, his tool of choice was to raise the margin requirement on stock trading accounts from 50 percent to 70 percent, along with an increase in the Fed’s discount rate for emergency borrowings by member banks.
Moreover, three months later the Fed raised its discount rate again. And then to make sure that its message was not misunderstood, it boosted the margin requirement still higher, requiring stock traders to pony up 90 percent cash on each new trade.
By the standards of the day, the Fed had every reason to take this aggressive action. Between 1954 and 1957, bank loans outstanding had soared at a 12 percent annual rate, and CPI inflation had ticked up to 3.6 percent in the year ending March 1958. The Martin Fed found both of these trends deeply troubling and believed that, if left unchecked, they posed dire threats to the Fed’s fundamental mission of maintaining the purchasing power of the dollar and financial stability.
Furthermore, today’s central bank sophistries, such as levitating the stock market to generate economic growth through the “wealth effect” and discounting reported inflation by excluding items such as food and energy, had not yet been invented. Accordingly, the Fed continued to tighten monetary policy throughout the course of 1959.
Moreover, these moves were decisive. Unlike the ineffectual baby-step hikes of 25 basis points that Alan Greenspan later favored, Martin raised the discount rate by a full percentage point on each of several occasions, and also further tightened stock market margin lending.
In one of its post-meeting statements the Fed zeroed in directly on excessive bank lending. Unlike today’s debt-besotted central bankers, the Martin-era Fed worried about too much credit growth, not too little, saying that it was “restraining inflationary credit growth in order to foster sustainable economic growth.”
As the year drew to a close, then, Chairman Martin had well and truly demonstrated what “taking away the punch bowl” actually meant. Open market interest rates rose from 1 percent in June 1958 before the tightening started to 5 percent by December 1959, and the Treasury bond yield rose from under 3 percent to nearly 5 percent during the same period.
At the same time, the curative effect of monetary restraint was soon evident in the rapid return of price stability. During 1959, consumer price increases fell back to the 1 percent level, where they remained through 1963.
In a further marker that the inflationary threat had been quelled, the substantial outflow of gold from the United States which had occurred during 1958 owing to inflation fears was staunched by the Fed’s resolute stance. US gold stocks remained stable for several years thereafter.
Nor was sound money purchased at the price of a weak economy. Real GDP rebounded at a 6.4 percent annual rate in 1959 and averaged 4.3 percent annually during the five years after the Fed removed the punch bowl.
Indeed, under Martin’s leadership the Fed did achieve something of a golden age once the macroeconomic disruptions of the Korean War had passed. Thus, between 1954 and 1963, real GDP growth averaged 3.4 percent while annual CPI inflation remained subdued at 1.4 percent.
There was no subsequent nine-year period that had a better combined performance of these core variables. And none which left the overall economic and financial system so healthy and stable.
CHAPTER 11
EISENHOWER’S DEFENSE
MINIMUM AND THE LAST AGE
OF FISCAL RECTITUDE
CHAIRMAN WILLIAM MCCHESNEY MARTIN’S QUEST TO RESTORE sound money was aided immeasurably during the 1950s by a fiscal policy backdrop that would never again recur. Beginning with Truman’s tax financing of the Korean conflict, monetary policy was supported by two successive presidents who were firmly committed to budgetary discipline and who were willing to expend political capital to achieve it.
As it happened, it was Eisenhower who really brought the old-time religion back to the center of peacetime fiscal policy. Ike was a military war hero who hated war. He was also the former supreme commander of the costliest military campaign in history and revered balanced budgets. Accordingly, Eisenhower did not hesitate to wield the budgetary knife, and when he did the blade came down squarely on the Pentagon.
THE FOLLY OF WAR DEFICITS
The essence of Eisenhower’s immense fiscal achievement, an actual shrinkage of the federal budget in real terms during his eight-year term, is that he tamed the warfare state. In so doing, he paved the way for Uncle Sam to pay his bills out of current taxation for the better part of a decade.
The enormity of this achievement can only be fully appreciated by contrast with its opposite—that is, three devastating fiscal setbacks during the next half century under Lyndon Johnson, Ronald Reagan, and George W. Bush. In each case, the plunge of the nation’s fiscal accounts deep into the red was triggered by a resurgence of the kind of massive warfare state budgets that Ike so resolutely resisted.
In bringing down the fiscal roof, all three post-Eisenhower defense surges were enabled by a vital accomplice: Keynesian theories of prosperity management that manifested themselves in both a leftist “new economics” version and
rightist “supply side” variant. The pretension of both ideologies was that the correct policy action by Washington could spur permanent economic growth at extraordinary rates, such as 5 percent annually or even better. Consequently, by embracing this high GDP growth illusion, the White House occupants during these three episodes were led to believe that they could have war budgets without war taxes.
War deficits, of course, are what they actually got. Yet this was a good thing, according to the Keynesian professors, because such deficits inject demand into the economy, thereby lifting output closer to its full-employment potential. The supply-side apostles of Art Laffer’s tax-cutting scheme agreed. The incremental GDP growth from incentives to save, invest, and take risk would pay for all the war spending the nation might ever need.
In fact, war deficits are the worst fiscal policy imaginable. They add to civilian demand but generate no marketable output of consumer products or capital goods. Accordingly, war deficits tip the economy toward excess demand, inflationary bottlenecks, rising interest rates, and financial instability. They destroy wealth and lower living standards.
Since time immemorial, therefore, politicians have attempted to alleviate these pressures by financing war bonds with printing-press money. Lyndon Johnson did it and broke the resolve of Chairman Martin and the anti-inflation policy of the Fed.
Likewise, after global money went on the T-bill standard, Reagan and Bush did it, too, by exporting their war bonds to the central banks of Japan and China, and thereby postponing but not eliminating the day of reckoning. Eisenhower’s achievement in throttling the warfare state was thus of singular significance, even if it proved to be transient.
IKE’S DISPATCH OF THE BLOATED TRUMAN DEFENSE BUDGET
Eisenhower’s campaign for fiscal discipline started with the bloated war budget he inherited from Truman. In a notable episode of hitting the ground running, Ike traveled to Korea immediately after the election in November 1952 and set in motion a negotiations process that made an armistice on the Korean peninsula a foregone conclusion.
Given the expected cutback of war expense, the White House team led by treasury secretary and deficit hawk George Humphrey was shocked by Truman’s defense budget for the upcoming fiscal year. It was still 6 percent higher than the current year’s. With Eisenhower’s blessing, therefore, the inherited Truman budget request was slashed by nearly 30 percent, with more cuts targeted for future years.
Although defense spending never did shrink all the way to Ike’s target, the wind-down of Truman’s war budget was swift and drastic. When measured in constant 2005 dollars of purchasing power, the defense budget was reduced from a peak of $515 billion in fiscal 1953 to $370 billion by fiscal 1956. It remained at that level through the end of Eisenhower’s second term.
Moreover, even though Democrats charged that Eisenhower and Humphrey were “allowing their Neanderthal fiscal views to endanger the national security,” the actual record proves the administration’s drastic rollback of Pentagon spending was not based merely on penny-pinching. Instead, it flowed from a reasoned retrenchment of the nation’s national security strategy called the “New Look.”
The new policy doctrine of the Eisenhower administration called for a sharp reduction in land and naval forces, coupled with a significantly increased reliance for nuclear deterrence on the air force bomber fleet and the rapid development of intercontinental ballistic missiles. In addition, the European allies were called upon to play an expanded role in containing Soviet conventional forces on their own borders.
The New Look contrasted sharply with the inherited doctrine known as NSC-68. Written by Truman’s coterie of confirmed cold warriors, such as Dean Acheson and Paul Nitze, it stressed maintenance of extensive conventional forces and a US capacity to fight multiple land wars simultaneously.
At the end of the day, the general who had led the greatest land invasion ever undertaken could not be convinced that those scholastic theories of limited war were plausible in the nuclear age. But he did acutely fear that the massive permanent military budgets required by the limited war doctrines of NSC-68 would erode the economic foundation on which true national security finally depended.
The nearly one-third reduction in real defense spending during the Eisenhower period was thus achieved by sharp changes in priorities and force structure. These included shrinking the army by nearly 40 percent, large cuts in naval forces, and an overall reduction in military personnel from about 3.5 million in early 1953 to 2.5 million by December 1960.
Equally important, the military logrolling under which each armed service had been given exactly one-third of the defense budget was decisively abandoned. Instead, under the New Look doctrine of “massive retaliation,” the air force was allocated 47 percent of the DOD budget while the army got only 22 percent for its sharply circumscribed missions.
WHY THE LAND-WAR GENERALS QUIT
Needless to say, Ike’s drastic change in national security doctrine and downsizing of the conventional force structure sharply curtailed the nation’s ability to wage land wars of intervention and occupation. And it also caused an explosion of outrage in the army.
In fact, its two representatives on the joint chiefs of staff, Generals Matthew Ridgeway and Maxwell Taylor, resigned in protest against General Eisenhower’s new strategy, the implication being that the army would not be getting another Korea-type assignment anytime soon.
The irony is that Ridgeway and Taylor were later rehabilitated by Robert McNamara, the whiz-kid Ford Motor executive who became defense secretary knowing as little about military and defense matters as Ike did about selling swept-wing sedans. Nevertheless, soon after his appointment by President Kennedy, McNamara rehabilitated NSC-68, along with the extensive conventional forces needed “to prevent the steady erosion of the Free World through limited wars.”
Not surprisingly, with Ridgeway and Taylor back in charge “limited war” is exactly what the nation got: to wit, still another misguided land war in Asia which turned out to be even more strategically senseless and fiscally corrosive than the one in Korea.
It also got proof positive that imperial wars too unpopular to be financed with higher taxation were destined to end in bloody failure. On the latter score, the constant-dollar defense budget by fiscal 1968 had rebounded from Ike’s $370 billion peacetime minimum all the way back to the $515 billion war budget that Truman left on Eisenhower’s doorstep in 1953.
Likewise, the armed forces were expanded by 40 percent from Ike’s 1960 level. By the Vietnam peak they had reached the very same 3.5 million that had been attained during the Korean War.
In a few short years, therefore, the national security academics which came to the Kennedy-Johnson administration from the Ivy Leagues took policy on a complete round trip. In essence, they reestablished the dangerous and costly capacity for imperial adventures that the proven warrior from West Point had insisted should not stand.
IKE’S SINGULAR ACHIEVEMENT: CONTAINMENT OF THE WARFARE STATE WHERE HIS SUCCESSORS FAILED
Johnson was not alone in coddling the warfare state. None of Eisenhower’s successors replicated his passion for fiscal discipline at the Pentagon. Nor did they share his fear of the enormous logrolling coalitions nurtured on Capitol Hill by the military-industrial complex, and the propensity of its congressional champions to trade guns for butter in an unending rebuke to fiscal discipline.
Indeed, in a few short years after Ike left office, the profound danger of a symbiotic nexus among the warfare state and welfare state became starkly apparent. Reflecting the imprint of the Hubert Humphrey “guns and butter” liberals, both sides of the budget hit simultaneous peaks in fiscal 1968. With constant-dollar defense spending back to the $515 billion Korean War peak, domestic outlays followed suit, reaching an all-time peak of $455 billion (2005$). The latter was 75 percent higher than Ike’s outgoing 1961 budget, meaning that there was no room to finance it within the existing tax envelope. The Federal deficit thus ballooned to nearly 3 percen
t of GDP, another modern peacetime record.
The next phase was even worse. The post-Vietnam demobilization of the fighting forces and the dismantlement of their massive logistics base resulted in no restoration of the Eisenhower era fiscal discipline at all—notwithstanding eight years of Republican rule. Indeed, the Washington logrolling coalition wasted no time recycling every penny of the $200 billion “peace dividend” (2005$) back into domestic spending.
Since the federal budget actually gained 20 percent, or $200 billion, in constant dollars between fiscal 1968 and 1977, domestic spending thus rose by a stunning $400 billion. The Republican (Nixon-Ford) White House during this period was presumably equipped with a veto pen, but it rarely came out of the drawer. In fact, the approximate 80 percent gain in inflation-adjusted domestic outlays during these eight Republican years exceeded even the Kennedy-Johnson record spree.
Owing to further modest expansion during the Carter interregnum, the domestic welfare state stood at $1 trillion (2005$) when Reagan took office, double its 1968 level. This left no available fiscal space for the second post-Eisenhower surge in warfare state spending, causing the massive Reagan build-up to be financed with treasury bonds. As described in chapter 5, the Reagan defense spending spree also infused the military-industrial complex with unstoppable momentum, fostering a virulent crony capitalism that eventually drove DOD spending to levels which Eisenhower could never have imagined.
As indicated, constant-dollar spending in Reagan’s fiscal 1989 budget was 30 percent, more than Eisenhower’s last budget, but even the subsequent official end of the Cold War resulted in only a modest rollback. Clinton’s final budget was a tad smaller in inflation-adjusted dollars than Eisenhower’s, even though by the year 2000 the United States had no industrial state enemy left on the planet.
The Great Deformation Page 30