The Great Deformation

by David Stockman

  What was heralded as a brilliant exercise in business-cycle management by the Greenspan Fed was actually a whirl of monetary delusion. The American economy was not experiencing a linear business cycle expansion, as the charts of Wall Street stock touts proclaimed; it was actually gestating twin $5 trillion housing and equity bubbles which were warping and deforming the very foundation of the Main Street economy.

  THE GREENSPAN PUT AND THE UNHINGING OF CREDIT GROWTH

  The combination of the Greenspan Put and 1 percent interest rates unleashed frightful forces of speculation—economic impulses that in a healthy monetary system are held in check by market-clearing interest rates and the fear of loss posed by the inherent risk in pyramids of financial leverage. Indeed, in the now lost world of sound money, debt financing was mainly available for long-lived capital projects with high enough risk-adjusted returns to attract the community’s savings.

  By contrast, with virtually no cost of carry and the perception that the Fed had put a one-way escalator under asset prices, the free market became a veritable devil’s workshop—credit for speculative endeavors came pouring out of both conventional fractional reserve banks, as well as from every nook and cranny of the vast shadow banking system. Soon this explosion of speculative credit would prove that the monetarists’ preoccupation with the key historic ingredient of money supply—bank reserves—had been made obsolete by Camp David, too.

  Under the T-bill standard the only real limit on credit creation was financial capital, not the cash reserves of chartered banks. Moreover, the amount of capital needed per dollar of new credit was a function of what speculative markets would tolerate.

  Banks and Wall Street broker-dealers were under regulatory capital minimums, of course, but these were so loophole ridden as to be meaningless. So, if capital was not a limiting factor in the vast unregulated shadow banking world, then new extensions of collateralized debt could soar as the value of collateral, ranging from residential real estate to copper futures contracts, raced upward.

  The reason lenders funded rising asset prices at commensurately higher loan advance levels (i.e., did not set aside more capital to cover potential credit losses) was that they believed the central bank had their back. In effect, the market monetized the Greenspan Put, thereby erasing the need for genuine lender capital. Obviously, the more heated the various financial bubbles became, the more the financial markets monetized the Greenspan Put. In effect, the market substituted the central bank’s promises to prop up asset prices for real balance sheet capital.

  The daisy chains of rehypothecation—that is, pledging an asset that was already pledged—gathered momentum. Homeowners, for example, pledged their houses to mortgage lenders; the mortgages held by lenders were pledged to securitized trusts; the bonds issued by securitized trusts were pledged to CDO conduits; the CDO obligations were pledged to CDO-squared conduits; and so on.

  The pyramids of credit grew rapidly. In effect, the Greenspan Put supplanted the scarcity of capital that would otherwise have put a brake on speculative lending in the free market. Accordingly, the liabilities (debt) of the shadow banking system, including repo, asset-backed securities, money market funds, commercial paper, and GSE mortgage pools exploded during the Greenspan bubble era, rising from $2 trillion in 1987 to a peak of $21 trillion by September 2008. In short, the unregulated, unreserved shadow banking system generated credit growth at an astounding 12 percent compound annual rate for 21 years running.

  This was the real evil of the Greenspan/Bernanke Put because it permitted the multiplication of debt without growth of savings and the dramatic bidding-up of asset prices without growth of income. When asset prices finally broke during the BlackBerry panic, however, confidence in the Greenspan/Bernanke Put quickly evaporated in the face of the ensuing selling panic. And with vastly insufficient capital under the nation’s pyramid of debt, collateral was called in and bubble-era credit was violently liquidated.

  Yet, while speculator confidence in the Greenspan Put lasted, there had been virtually no constraints on the growth of credit market debt throughout the Main Street economy. Thus, in the second year of the Fed’s post-dot-com money-printing panic, credit market debt outstanding grew by $2.5 trillion. This was an 8.6 percent increase and more than six times the growth of national income in the year ending December 2002. From there, the nation’s balance sheet entry for total debt outstanding just kept expanding by larger amounts and by a greater percentage each and every year through the final peak in 2007.

  During 2004, for example, as the housing bubble heated up and the stock averages continued to climb, annual debt growth reached $3.2 trillion, thereby clocking in at a 9.2 percent annual rate. Indeed, by the end of the cycle, the debt bubble literally turned parabolic: credit market debt outstanding surged by $4.7 trillion in 2007, or at a 10.3 percent annual rate.

  Evidence that an explosive financial deformation had now reached a breaking point lies in the fact that nominal income grew by only $670 billion in the year ending December 2007. Debt was now expanding at seven times the rate of income growth in the American economy. Still, in the minutes of its last meeting of the year on December 7, the Fed mustered only the absurdly anodyne observation that “debt in the domestic nonfinancial sector was estimated to be increasing somewhat more slowly in the fourth quarter than in the third quarter.”

  THE POSSE OF DEBT-BUBBLE DENIERS WHO INHABITED THE ECCLES BUILDING

  By that point in time, the nation’s leverage ratio had reached a “Defcon 1” status. At 3.6 times national income, the leverage ratio was so far above its historical chart lines that it threatened to vault off the top of the page. Yet the Fed did not take the slightest notice because it had no fear of debt. Indeed, the inhabitants of the Eccles Building espied prosperity across the land when they were only seeing the feedback loop from their own ceaseless money printing.

  As will be seen in chapter 29, Bernanke was an outright Keynesian who believed that debt is the eternal elixir of economic life. At the same time, Greenspan had held the profoundly mistaken view that rapidly rising debt was evidence of an outpouring of financial innovation, not the rank speculation that it had signaled throughout financial history.

  Likewise, most of the business economists who served on the Fed during the Greenspan bubble years followed the maestro’s lead and simply toted up what the nation’s billowing debt had bought during the most recent reporting period; that is, so many housing starts, coal shipments, retail sales, job gains, and the like. They never asked whether the underlying trend was sustainable, clinging instead to an illusion of prosperity derived from the positive numbers being chucked out of the government’s statistical mills.

  These reports were heralded as evidence that the Fed had engineered a perfectly balanced “Goldilocks economy” of low inflation and steady real growth. In fact, the government data mills measured only economic gossamer floating on the profoundly unstable and destructive debt bubble which was building down below.

  The preposterous Fred Mishkin headed the posse of debt-bubble deniers who dominated the Fed’s supporting cast. Prior to joining the Fed in 2006, he had conducted a major study for the government of Iceland which concluded that its banking system was sound and that the only bubbles in Iceland were those welling up from its famous hot geysers.

  Yes, the balance sheet footings of Iceland’s banking system were ten times larger than its GDP. Somehow Mishkin found this to be a source of competitive advantage, not a freakish economic accident waiting to happen.

  So Mishkin had already demonstrated perfect 20/20 bubble blindness before he was appointed to the Fed and, as vice chairman, did not allow his talents to lie fallow. From that perch of authority he could be seen continuously on the financial news networks assuring viewers that the American economy was stronger than ever before. Indeed, when the housing bubble was already showing large cracks, he assured his FOMC colleagues during its December 2006 meeting that there would be “no big spillovers” from a downturn
in housing.

  Moreover, just twelve months before the onset of the worst recession since the 1930s, Mishkin revealed himself (December 2006) to be as blind to the fundamentals of the American economy as he had been to those of Iceland. “There is a slight concern about a little weakness,” he averred, “but the right word is I guess a ‘smidgeon,’ not a whole lot.”

  This stunning misperception was not about the difficulties of forecasting the foggy future. Instead, it reflected the fact that the monetary central planners on the Fed were mesmerized by their own doctrine. For obvious reasons, they could not even begin to acknowledge that their chosen instruments of prosperity management—low interest rates, stuffing the primary bond dealers with fresh cash via constant Treasury bond purchases, and the Greenspan Put—would inherently unleash a Wall Street–driven tidal wave of credit expansion and leveraged speculation.

  Accordingly, as the debt-bloated and speculation-driven American economy approached its inexorable crash landing, most of the FOMC supporting cast echoed Mishkin’s insensible denial that trouble was at hand. Thus, in July 2007 and a few weeks before Wall Street’s first mini-crash in August, Governor Kevin Warsh uncorked an observation that ranks among the most foolish blather ever uttered by a high financial official: “We don’t see any immediate systemic risk issues…. The most important providers of market discipline are the large, global commercial and investment banks.” [Emphasis mine]

  Even before the September 2008 Wall Street meltdown, it took a confirmed Kool-Aid drinker to believe that the “investment banks” were a source of “market discipline,” and Warsh had deeply imbibed. Before joining the monetary politburo at age thirty-five, he had spent seven years as a junior Morgan Stanley associate, presumably helping to fuel the financial bubbles. Thereupon, he soldiered four years in the Bush White House writing memos that celebrated the resulting simulacrum of prosperity.

  The conspiracy minded could thus find support for their theories in the case of Governor Kevin Warsh. The evidence was unassailable that he had been sent to Washington straight from the Wall Street boot camp.

  Yet three months later, Warsh’s investment banker talking points were given scholarly sanction by Governor Randall Kroszner, erstwhile professor of economics at the University of Chicago Business School. During his ten years in that bastion of free market theory, he might have learned something about sound money, and perhaps have spread the word during his tenure at the Council of Economic Advisors between 2001 and 2003.

  But it didn’t happen that way. Instead, after fully embracing the economic triumphalism of the “deficits don’t matter” Bush White House, Kroszner was rewarded with an appointment to the Fed, perhaps to help ensure that the Bush deficits would be financed with central bank bond buying, as needed. To this end, Kroszner left no doubt that the Fed’s six-year-long money-printing spree had not put even a scratch on the purportedly solid foundation of the nation’s banking system.

  Thus, in September 2007—after Countrywide Financial had cratered, 125 mortgage companies had already imploded, and a crucial money market indicator called the Libor-OIS spread had soared during the August mini-panic—Professor Kroszner opined that all was well: “Effective banking supervision has helped foster a banking system … that today is safe, sound and well-capitalized … US commercial banks are strongly capitalized, reflecting years of robust profits.” [Emphasis mine]

  During the year which followed this unaccountable utterance, the US banking system recorded more than $100 billion in losses. Kroszner’s “years of robust profits” were effectively wiped out, owing to the fact that Wall Street had been booking phantom gains from underwriting and from trading loans, securities, and derivatives which were the progeny of the Fed’s bubble finance. So, if the monetary planners in the Eccles Building did not have a clue that the financial system was built on a house of cards even at the eleventh hour in the fall of 2007, it is not surprising that they had no clue as the bubbles evolved each step along the way.

  THE GREAT MODERATION: A DELUSION FOR THE AGES

  The monetary politburo was blind to the vast deformations it was unleashing on the American economy. In the aftermath of the dot-com crash the Fed was just plain petrified of another stock market hissy fit. As indicated, it therefore launched an orgy of interest rate reductions that had no parallel in monetary history, and was profoundly irrational in light of the massive bubbles it was bound to produce.

  Thus, in November 2000 the Federal fund rate had stood at 6.5 percent. That was not unreasonable—given the prevailing 2–3 percent inflation and the desperate need to revive the faltering domestic savings rate. As has been seen, however, the FOMC frantically hacked away with non-stop interest rate cuts of 25 and 50 basis points over the next 30 months until after 17 separate cuts the funds rate reached a rock bottom 1.0 percent in June 2003.

  In a flight of desperate interest rate cutting, the Fed had thus gone all-in with its “wealth effects” theory of prosperity management. In due course the stock market did have a rebound back into the bubble zone but the route to this dubious, short-lived success wreaked mayhem upon Main Street all along the way.

  It caused a fixed asset investment boom, but only for domestic real estate—since the grim reaper of the “China price” warded investors away from anything related to the production of tradable goods. It caused a Main Street consumption boom, but mainly from mortgage equity withdrawal, or MEW—not income honestly earned.

  It also spurred a huge increase in retail sales of durable goods, but on the margin the source of increased supply was almost entirely East Asia. It generated a surging demand for consumer services ranging from real estate brokerage to yoga classes and personal shoppers, but the demand for these services was mainly financed from transient sources like home ATM borrowings and stock market gains, rather than a permanent increase in real incomes and capacity to spend.

  Needless to say, as the effects of the Fed’s poisonously low interest rates twisted and turned through the Main Street economy, they did cause the standard measures of economic activity to tick upward, thereby perpetuating the illusion of economic recovery and growth. Meeting after meeting, year upon year, the FOMC minutes noted the improved indicators while congratulating itself for the policy astuteness that had purportedly fostered these pleasing macroeconomic results.

  The extent of its blind hubris was starkly evident when the leader of these prosperity howlers famously delivered a speech in February 2004 modestly titled “The Great Moderation.” In this statement the future Fed chairman, who would preside over the most brutal drop in employment and output since the 1930s, noted the “remarkable decline in the variability of both output and inflation” over the prior two decades. Not surprisingly, Bernanke insisted that “improved performance of macroeconomic policies, particularly monetary policy,” should be given the credit for this purported golden age of steady, unending growth.

  In fact, goods inflation had been pinned down to the global economy’s floorboard by the currency-pegging central banks of East Asia and the tens of millions of rural serfs who flooded out of the rice paddies and into the export factories of East China after 1990. By contrast, asset-price inflation had gotten more cyclically violent than at any time since 1929. That seminal fact of life would have been obvious to Bernanke, had he bothered to think about the implications of the two bruising stock market crashes (1987 and 2000) which had occurred precisely during the period of the Great Moderation.

  Keynesian models recognize debt only when it shows up as current-period spending rather than as a permanent entry on the balance sheet, perhaps owing to the fact that Keynesian models do not even have a balance sheet. Peering through these Keynesian blinders, therefore, Bernanke blotted out a huge chunk of worrisome macroeconomic reality in divining his Great Moderation.

  Even more importantly, the “moderation” in the business cycle alleged by Bernanke was an utter illusion. It resulted from the arithmetic of GDP computation under conditions of massive c
redit growth. Specifically, the $25 trillion credit bubble that the Fed was busy inflating flowed right into GDP. It showed up as incremental aggregate demand, mainly in the form of personal consumption expenditures, but also in the investment accounts for residential and commercial real estate.

  But this was credit-money growth, not honest organic expansion. Had the GDP reports been constructed by double-entry bookkeepers, they would have offset some or all of these debt-fueled spending gains with a debit for future credit losses and busted investments. At the end of the day, the Great Moderation, like the Roman Empire, depended upon the spending power of exogenously obtained loot. In this case, it came from the freshly minted credit arising from the Wall Street machinery of leverage and speculation that the Fed so assiduously attended and enabled.

  CHAPTER 18

  THE GREAT DEFORMATION

  OF CAPITAL MARKETS

  How Wall Street Got Huge

  THE COLLAPSE OF THREE SEPARATE $5 TRILLION FINANCIAL BUBBLES in less than a decade attested to the deeply impaired condition of the nation’s capital markets. Yet the spectacular round-trips of the S&P 500 and Case–Shiller housing price index were not the only progeny of the Fed’s bubble finance. There was actually an even greater deformation lurking beneath these wild rides; namely, the aberrant journey of the giant government bond market which forms the foundation of Wall Street and drives the financial rhythms by which it operates.

  During the 1970s the financial system, in the aftermath of Camp David, endured the near-destruction of the government bond market. But then for the following thirty years it was favored with continuously rising bond prices constituting not only the greatest uninterrupted market rally in financial history, but also the greatest deformation.