The Great Deformation

by David Stockman

  To be sure, this staggering explosion of credit money in the banking system had not been a deliberate objective of policy. It happened by default because by the mid-1990s the Fed had become totally preoccupied with fomenting prosperity by fiddling the funds rate. It had ceased to really care about the growth rate of money and credit.

  Indeed, Greenspan had by then put a Nixonian kibosh on Friedman’s fixed-rate rule of money supply growth; that is, he had declared it “non-operative,” and for good reason. As indicated, once the Fed permitted overnight “sweep” accounts, whereby demand deposits are turned into savings accounts while we are sleeping, the Fed could no longer measure “money supply” accurately.

  Thus, as the now published minutes of its deliberations show, the Fed staff assiduously tracked hundreds of economic variables, including obscure indicators like rail car loadings of crushed stone and gravel. But as the records of its proceedings also show, the FOMC gave short shrift to tracking and assessing the actual mother of all economic variables, which, of course, was credit in all its traditional and shadow banking permutations.

  So as the Greenspan era settled in at the Fed, all the historic rule-based approaches to central bank policy, including even Milton Friedman’s fixed M1 growth rate, were abandoned. The fusty notions of sound money and financial discipline embodied in the Greenspan 1.0 doctrine had no resonance whatsoever.

  Instead, the Fed had declared itself to be in the immodest business of macroeconomic growth and prosperity management. This was the Greenspan 2.0 agenda, and it was to be pursued purely from the ad hoc wisdom and judgment of the twelve members of the FOMC as they parsed and cogitated on the “incoming data.”

  Needless to say, there was no small irony in the fact that Ayn Rand’s disciple had turned the Fed into a monetary politburo. With a self-assigned mandate to rule the US economy in a manner which was at once plenary and ultimately based on a capricious stab at the unknowable future, the Greenspan Fed insouciantly ambled forward, permitting a huge, boisterous party to rage on Wall Street when every signal light was flashing red with the same warnings that had accompanied the final years of the Japanese bubble.

  HOW THE FED TOOK ITSELF HOSTAGE TO WALL STREET

  This stance, heedless of history, was rooted in a fatal illusion, widely shared in the Eccles Building, about the Fed’s powers to control the American economy. The nation’s monetary politburo had come to believe it could deftly maneuver the course of a then-$10 trillion economy through a combination of open market and open mouth operations. Main Street could then be steered, stimulated, boosted, and braked along whatever glide path of growth, jobs, and inflation the Fed deemed appropriate.

  All of this grandiose central planning assumed, of course, that the FOMC had a reliable and efficacious transmission mechanism through which it could implement its intentions. But that is something it did not possess, not by any stretch of the imagination. All of its commands and signals had to be processed by Wall Street, which is to say, the money and capital markets. However, in reacting to the Fed’s buying and selling of securities and its targets for the federal funds rate or verbal cues and smoke signals with respect to future policy moves, Wall Street was not positioned as an honest broker.

  In fact, it functioned as an aggressive counterparty engaged in trading, arbing, and front running everything the Fed did or said. Moreover, as the Fed pumped more and more reserves into the banking system and displayed an increasing disinclination to lean hard against the resulting bubble in credit and equity prices, its policy target drifted. Stabilization of its Wall Street transmission mechanism, rather than management of the macroeconomy, progressively took control of monetary policy.

  As Greenspan candidly admitted in his memoirs, the Fed eventually took itself hostage because it could not rein in its agents on Wall Street. He thus noted that when the Fed’s first tightening episode came to an end in February 1995, stock prices had swiftly reverted to their upward path and that “when we tightened again in 1997 … prices again resume[d] their rise after the rate move.”

  As the maestro saw it, the Fed was caught in a “puzzle palace” where tightening would have the same effect as easing: “We seemed in effect to be ratcheting up the price move…. If Fed tightening could not knock down stock prices … owning stocks became an ever less risky activity.”

  The giant defect in this ratchet theory, however, is that it was based on the Fed’s tepid quarter-point federal funds rate moves and its well-telegraphed warnings ahead of time. By contrast, a Volcker-style surprise in which money market rates were dropkicked skyward would not have been so impotent. Greenspan acknowledged as much: “A giant rate hike would be a different story … [With that] we could explode any bubble overnight.”

  Not surprisingly, Greenspan rejected that option out of hand because it was in direct conflict with the Fed’s prosperity management agenda. Any stringent moves to discipline the financial system and curtail the rampant asset inflation then under way would have been “devastating [to] the economy, wiping out the very growth we sought to protect. We’d be killing the patient to cure the disease.”

  Disease was an excellent, if inadvertent, choice of metaphor. By 1998 the US financial system had, in fact, become disease ridden, exhibiting a metastasizing growth of leverage and speculation which the Fed’s own printing-press policies had caused. But in Richard Nixon’s memorable phrase, the Fed now found itself to be a “pitiful helpless giant,” fearful of confronting the very bubble it had spawned.

  THE HOUSING BUBBLE WAS WAITING IN THE FED’S DRAWER

  As conceded by the maestro in slightly more delicate terms, “The idea of addressing the stock market boom directly and preemptively seemed out of reach…. Instead, the Fed would position itself to protect the economy in the event of a crash.”

  As will be seen below, the Fed’s election to wait it out ignored all of the collateral damage that was being engendered by the 1990s stock market bubble while it was still inflating. Worse still, there had already developed a “consensus within the FOMC” to implement an aggressive money-printing campaign on a post-crash basis.

  Greenspan later recalled that having put such a plan in the drawer, the Fed essentially stood around waiting for the stock market to crash; then after the bubble broke “our policy would be to move aggressively, lowering interest rates and flooding the system with liquidity to mitigate the economic fallout.”

  Needless to say, what the Fed actually had in the drawer was the next bubble—the housing and real estate mania that would spread the speculative fevers across the length and breadth of Main Street America. Self-evidently, the Fed learned nothing about the danger of keeping interest rates too low and policy too friendly to Wall Street during the stock market boom.

  The Fed’s panicked reaction to the dot-com crash and the subsequent collapse of telecoms and other high-flying sectors in its aftermath make this abundantly clear. The federal funds rate stood at 6.5 percent on Christmas Eve of December 2000. During the following year rates came tumbling down the monetary chimney, as it were, with a clatter.

  THE GREENSPAN RATE-CUTTING CAMPAIGN OF 2001:

  CENTRAL BANK PANIC WITHOUT REASON

  The Fed cut its policy target rate on eleven separate occasions, so that by Christmas Eve 2001 it had plunged to 1.75 percent. If Wall Street ever had any doubt about the Fed’s capacity for panic, this inglorious retreat removed it.

  Never in the history of the Federal Reserve had there been anything close to a 75 percent reduction in the policy rate in such a brief time. Yet there was absolutely no emergency on Main Street. Real personal consumption expenditures during the fourth quarter of 2001 were actually 2.8 percent higher than a year earlier when the rate-cutting panic was initiated. Likewise, real GDP was still at its highest level in history, notwithstanding a heavy liquidation of business inventories during the final four months of 2001 in response to the 9/11 shock.

  Thus, the Fed’s furious money printing was about braking the fall of the
stock averages, not keeping the national economy afloat. And this unnecessary money-printing campaign was indeed furious. By the time the S&P finally hit bottom in February 2003, the Fed’s hand-over-fist buying of Treasury debt totaled $120 billion. This represented a 24 percent expansion of its holdings in just twenty-four months.

  To be sure, in the new vocabulary of prosperity management, as dispensed in the Fed’s post-meeting communiqués, all this bond buying was explained in highly antiseptic terms. Conjuring vast amounts of new cash out of thin air in order to pay Wall Street for its bond purchases, the nation’s central bank maintained it was merely effectuating an “accommodative policy stance” and “easing financial conditions.”

  Yet these words had no inherent economic meaning; they were just a smoke screen obscuring the plain fact that during the 2001–2002 stock market slump, the Fed pumped $120 billion into primary dealer accounts for no good reason. The purpose all along was to salve Wall Street’s self-inflicted financial wounds resulting from the speculative excesses of the equity bubble.

  Moreover, the floor under the stock averages resulting from the Fed’s flood of cash could not be justified as a desperate last-ditch bulwark to forestall calamity. In fact, the February 2003 market bottom at 840 on the S&P 500 represented nearly a 9 percent compound annual rate of gain for the period stretching all the way back to Black Monday in October 1987.

  Was that not enough? In fact, this 9 percent annual rise was the highest consecutive sixteen-year rate of stock price gain in recorded history! Accordingly, there was no reason at all for the Fed to worry about the stock averages or to flood Wall Street with so much cash that a new bubble was inevitable. Indeed, there are fewer things more striking about the deformation of the nation’s financial system after August 1971 than this episode.

  There was no valid economic emergency. Notwithstanding the 2000–2002 equity market bust, Main Street had only been modestly set back and could have recovered in a healthy, sustainable manner, even if halting, on its own steam. By contrast, there was every reason to purge the borrow, spend, gamble, and get-rich-quick regimen that the Fed had implanted in the American economy. The painful losses from the stock market bust could have served as a powerful catalyst, had gamblers and speculators been left to lick their wounds without hope of more juice from the central bank.

  In short, the dot-com bust was the last chance for the Fed to pivot and liberate the American economy from the corrosive financialization it had fostered. A determined policy of higher interest rates and renunciation of the Greenspan Put would have paved the way for a return to current account balance, sharply increased domestic savings, the elevation of investment over consumption, and a restoration of financial discipline in both public and private life.

  Needless to say, the Fed never even considered this historic opportunity. Instead, it chose to double-down on the colossal failure it had already produced, driving interest rates into the sub-basement of historic experience. This inexorably triggered the next and most destructive bubble ever.

  CHAPTER 16

  BULL MARKET CULTURE

  AND THE DELUSION

  OF QUICK RICHES

  WHEN THE FED FINISHED ITS EASING CYCLE IN JUNE 2003, short-term money rates were at 1 percent and had been slashed by more than 85 percent in just thirty months’ time. Needless to say, this kind of unprecedented, madcap policy action cries out for an explanation.

  The short answer is that by the turn of the century the nation’s central bank had come in complete thrall to Wall Street. In part this was due to the Fed’s embrace of a faulty monetary theory; that is, the notion that it could micromanage the vast US economy to prosperity by rigging interest rates and periodically flooding the primary dealers with freshly minted cash. Unfortunately, this had almost nothing to do with the real challenges then confronting the American economy.

  These growing structural headwinds included massive trade deficits, rapid offshoring of jobs and output from the tradable goods sector, swiftly rising levels of household debt, a collapsing domestic savings rate, and a buildup of vast overcapacity in some of the bubble sectors like telecoms. None of these genuine challenges, however, could be ameliorated by 1 percent interest rates; they all required less consumption and higher savings, not a cheap money–fueled buildup of even more debt.

  Yet the Fed’s insensible slashing of interest rates in the wake of the dotcom bust to levels not seen since the Great Depression cannot be entirely explained by the ideological conceits of the nation’s new monetary politburo. By 2001–2003, a more insidious force had captured control of monetary policy.

  During the thirty years after Camp David, a powerful bull market culture had arisen on Wall Street and spread across the land, based on the proposition that stock prices grow to the sky and that vast riches are obtainable through parabolic gains in the value of financial assets and real estate. Now, as the twenty-first century dawned, the Fed literally was afraid to unsettle the raging bull.

  So, as prosperity management through ultralow interest rates became settled Fed policy, not only was it exactly the wrong cure for the real problems of overconsumption and too much borrowing, but it also rewarded what had become an addiction in the markets. Indeed, the Fed’s aggressive money-printing campaigns over the prior three decades had finally contaminated the very warp and woof of the financial system. It had spawned a speculative bull-market culture like the world had never before seen.

  FABULOUS RICHES AND EFFORTLESS GAINS:

  HOW SAVING BECAME OBSOLETE

  The idea took root, first in the trading precincts of Wall Street and then across the land, that quick riches were there for the taking. The spectacular gains being routinely garnered in the stock market seemed to imply that the traditional rules of capitalist wealth creation—inspiration, perspiration, and patience—had been superseded. Now there was a shortcut to fabulous riches based on effortless gains from leveraged financial speculation.

  Get-rich-quick schemes always abound along the margins of capitalist economies, even financially healthy ones. But the Fed’s new prosperity management model resulted in an aberrational period of massive and unsustainable financial asset appreciation, owing largely to a drastic rise in valuation multiples. Not surprisingly, there is not even a hint that the self-assured mandarins who ran the FOMC ever once stopped to consider whether the scorching stock price gains its policies were fueling could be damaging to the nation’s financial culture.

  This phenomenon of multiple expansion—the proposition that an asset which had been worth five times its cash flow yesterday was now worth fifteen times that very same cash flow—was hardly a novel development. It had been at the heart of the late 1920s stock market boom, and had been repeatedly warned about by sound money commentators of the era such as the venerable Benjamin Anderson, chief economist of Chase Bank.

  There is no evidence, however, that Greenspan 2.0 ever revisited any aspect of the 1920s stock market bubble, let alone the drastic inflation of valuation multiples which had eventually brought it to ruin. Indeed, among all the ruminations about stock market bubbles contained in nearly a decade’s worth of published FOMC minutes there is not even a grade-school discussion of the 1929 crash, by Greenspan or anyone else.

  It was as if the 1966 insights of Greenspan 1.0 had been flushed down the memory hole in the basement of the Eccles Building. Consequently, when the Fed succumbed to its easing panic after the LTCM crisis, it did not even remotely recognize that the subsequent run-up in PE multiples followed the identical parabolic rise which had occurred during the final months before October 1929.

  In fact, a cursory review of pre-Keynesian commentary from the 1920s would have put the Greenspan Fed into a cold sweat, even if these voices did belong to long defunct economists of an earlier era. Keynes had once used this expression to ridicule any and all wisdom predating his own, but in this instance Benjamin Anderson, Professor Willis, and many of their sound money contemporaries had quite plainly seen the disaster of 192
9 coming.

  In their view, the 1920s Federal Reserve System fostered way too much private credit. As previously documented, much of this excess had flowed into the call loan market on Wall Street. It grew fourfold after 1922 and had nearly doubled in size, from 4 percent to 9 percent of GDP, in the final fifteen months before the crash. Even Herbert Hoover had fretted about the stock mania fueled by call money speculators.

  In his scintillating but long-ignored history of the boom and bust of that era, Benjamin Anderson noted that once the Fed triggered the speculative credit bubble and the broker loan boom went unchecked, the stock market collapse was only a matter of time: “With the renewal of the Federal Reserve cheap money policy late in the summer of 1927, a sharp acceleration of the upward movement of stock prices began … a great collapse was certain the moment that doubt and reflection broke the spell of mob contagion …”

  The 1998–2000 replay was not much different, except this time hot money had taken more sophisticated forms. Speculators did not need to pile up margin loans, because now they could obtain more extensive and even cheaper leverage in the form of stock options and futures and an inexhaustible supply of OTC-based wagers crafted by their Wall Street prime brokers.

  Needless to say, by the time the stock market bubble reached its fevered top, the Fed and its staff were so pleased with their own prowess in managing the nation’s economy that they had scant use for musty historical narratives. So when the initial Greenspan bull market finally reached its traumatic end, the Fed became focused on reviving Wall Street as rapidly as possible. It never even considered the possibility that the dot-com crash had been a blessing, and that the more urgent need in its aftermath was to thoroughly purge this bull market culture and its now engrained tendency toward speculative excess.

  So the way was paved for an even more virulent new round of bubble finance. An equity market boom which lasted almost continuously for the better part of two decades had inculcated vast popular delusions about financial returns. Indeed, the final NASDAQ blow-off generated such immense, almost freakish, capital gains that even the thundering stock market collapse of 2000–2002 could not extinguish the gambling impulses these windfalls had fostered on Wall Street and Main Street alike.