Interview Of David Stockman By Henry Bonner at Sprott Global
Ronald Reagan and David Stockman
David Stockman was elected to Congress at age 29 back in 1976; he was an avid student of Austrian economics and supported a gold-backed money system and a balanced budget. He later joined the Reagan administration as Budget Chief, where he watched in awe as the Reagan administration quickly became the most profligate spenders in the history of the United States.
After leaving the Reagan Cabinet, he worked at the well-known investment house Salomon Brothers, and later co-founded the Blackstone Group alongside legendary hedge-fund manager Steve Schwarzmann.
In his most recent book, The Great Deformation: The Corruption of Capitalism in America, Stockman systematically repudiates and dismantles the myths surrounding the Fed’s supposed past successes at helping the US economy avoid major breakdowns, going all the way back to the crash of ‘29. Instead, as he explains, “Programs born out of desperation or idealism 75 years ago have ended up as fiscal time bombs like Social Security or as captive fiefdoms of one crony capitalist syndicate or another… Policies undertaken in the name of public good inexorably become captured by special interests and crony capitalists.”
The most important lesson I took from the book and the interview? Remember that there has never been a time of such profound debt saturation, coupled with intense crony capitalism, as today. No one has ever been here to tell how it turns out. We truly are in an unprecedented era…
David, can you explain how the ‘Fed put’ works on the stock markets and bond markets? How exactly does it translate into artificially higher stock prices and lower interest rates?
The Fed injects massive amounts of liquidity into Wall Street through the dealer system – that is, the 21 authorized treasury-bond dealers. The liquidity comes in the form of new credits to their bank accounts supplied by the Fed in return for the governments bonds, notes and bills, and even the GSE (Government-sponsored entity) obligations that it buys from them. The credit that the Fed supplies to the dealers is manufactured out of thin air; therefore it expands total credits and liquidity in the system. The dealers use it to buy other types of securities – stocks, bonds, derivatives positions and so forth.
Historically, the purpose of the Fed’s open-market intervention in this form was to encourage the banking system to extend credit to the business and household sectors, thereby stimulating economic growth, as predicated by the Keynesian model. That was always a one-time parlor trick, however, because with each cycle of easing leverage ratios in the business and household sectors were ratcheted steadily higher. Household debt ratios, for example, went from 80 percent of wage and salary income prior to 1975 to 220 percent by 2007.
The problem today is that we have reached ‘peak debt.’ The household sector has $13.3 trillion of debts1, even after the modest post- crisis deleveraging; the ratio is still sky-high at 180 percent of wage and salary income.
Consequently, the household sector has been unable to borrow more money, no matter how much credit the Fed has injected through the dealers. That’s very different from where this whole Keynesian financial bubble started 40 years ago when we had, more or less, clean household balance sheets.
Underlying this domestic debt spree is the crucial fact that Nixon fundamentally changed the monetary régime in 1971; he closed the gold window, letting the Fed operate in an unfettered way. Household credit began to rise inexorably with each of the Fed’s easing cycles, until it reached the 2007 peak.
Today, money printing is not working in the traditional sense. It is not stimulating additional credit, spending, or ratcheting up the borrowing of the household sector because we have reached a condition of “peak debt”. In essence, the credit channel is now clogged and broken. Accordingly, the Fed’s injections of liquidity never leave the ‘canyons of Wall Street,’ to use a metaphor. Instead, it has essentially fuelled more carry trades and speculative buying of financial assets – stocks, bonds, derivatives, commodity futures, and so forth.
That creates overvaluations and financial bubbles that eventually break and smash the entire mainstream economy in the process. We have seen it two times now during this century alone; we are on the verge of seeing it a third.
The most dangerous element in our economy is the Fed, which I call a rogue central bank. It’s following a Keynesian model that was never valid but that now is not effective at all. It simply fuels enormous financial bubbles that are ultimately destructive in the long run when they burst. In the short-run, they lead to massive windfall gains for speculators and the ‘1 percent,’ undermining public perception of what capitalism is all about.
In your book The Great Deformation, it seems clear that politicians’ intentions or even the platform they use to get elected has little effect on outcomes. Nixon, a supposed fiscal conservative, took us off gold standard. Under Reagan, military and social spending went way up, setting the foundations for crony capitalism to thrive. Is there a natural tendency to drift towards these economic ‘deformations,’ regardless of stated intentions?
I think that in modern democracies there is a natural tendency, or impulse, towards expansion of the State -- taking on more functions, increasing the size and burden of the government. In 1971 we crossed the Rubicon when we jettisoned the external restraints of the gold standard that existed under Bretton Woods. It was far from perfect, but it did establish an external discipline on the ability of central banks, especially the Federal Reserve System in the United States, to expand credit within the private economy, and monetize the public debt.
I say that’s crucial because, prior to 1971, when governments got too zealous with spending or deficits, it had an immediate negative impact on the financial system, in the sense that interest rates tended to rise due to the ‘crowding out’ effect. That caused harm to small business and to the corporate sector generally. It created a countervailing impulse from the business sector saying to Washington, ‘wait a minute, we need to pay our bills; we can’t simply keep piling on more spending and public debt.’ The result was that there was some sense of fiscal checks and balances in the political system.
The Republicans did a decent job during the Eisenhower era, for example, in reigning in the impulse towards borrowing and higher spending that had arisen from the New Deal. They did in fact balance the budget half the time during Ike’s presidency, keep deficits at a very small fraction – 1 percent of GDP or less – and actually shrink in real terms the size of government.
After Nixon made the colossal error of closing the gold window and repudiating our obligations under Bretton Woods, putting the world on an entirely fiat money system, the world changed for the worse. Once the Fed discovered that it could expand its balance sheet at will by buying government debt, a whole new dynamic unfolded within the Washington beltway. We saw that play out over the subsequent decades.
That is, at least in the short run, Washington could run much higher deficits than had historically been considered prudent or appropriate without huge adverse effects on the financial system. Interest rates did not surge, as they would have historically. You did not have an outflow of gold or other reserve assets, as you had historically under a fixed-exchange system backed by a gold standard. In a kind of incremental or progressive manner over time, politicians realized that they had been given a ‘get out of jail’ card.
Politicians came to realize that they could run deficits with impunity as long as the central bank was willing to pin interest rates at levels that were below market outcomes and, on the margin, to clear the market of excess notes or bills being issued by the Treasury by monetizing them.
This came to a head in the 1990s under Greenspan, and went entirely out of control after the turn of the century. To give you numbers that I think put this in perspective, when Greenspan took over the Fed in 1987, the balance sheet was only $200 billion. By the turn of the century it was $500 billion2. By the time of the crisis of 2008 it was $900 billion3, and today its $4.5 trillion4.
So, there has been over the last 25 years a massive 23-fold expansion of the Fed’s balance sheet. That has essentially resulted in the monetization of a significant share of the Federal debt created during that period. It has created a dynamic in the legislative system which essentially amounts to a fiscal free lunch process.
Republicans now think ‘deficits don’t matter,’ even though they might make speeches against them from time to time. In practice, they would rather cut taxes than discipline the financial process, by cutting spending or balancing the budgets. Democrats have never believed in fiscal responsibility in modern times because they’ve adopted the Keynesian gospel. They continue to push for more stimulus, more spending, and more ‘fiscal support’ for the economy.
So one party is reducing the revenue base, and other party is expanding the spending level. What falls out is massive cumulative growth in public debt, which in turn is monetized by an out-of-control rogue central bank that justifies all this in the name of stimulating the economy. To get back to our starting point, it’s not stimulating anything except bubbles in the financial system and reckless gambling in the financial markets.
In your book, it becomes clear that nothing that the government does to ‘improve’ the economy actually works. There are countless examples of disasters caused by supposedly well-intentioned programs in US, and around the world. Yet, there’s a huge demand for the ideas of Paul Krugman, Thomas Picketty, or Janet Yellen who believe in these programs. Why is that?
Well, I think you could describe it as the triumph of the Keynesian error. Now, after decades of practice, and these bouts of government activism by both parties, we have created a mindset which is very attractive to politicians in the beltway. It essentially holds that the economy of market capitalism is like a ‘frail flower’ that is constantly in danger of faltering, lapsing into recession or depression, or as they describe it ‘continuously underperforming its potential growth rate.’ So given the inherent tendency to fail, as the model has it, you need continuous and almost unlimited intervention and stimulus from both the central banking branch of government as well as the fiscal processes including spending, credit subsidies, tax loopholes, regulatory tools, bailouts and so forth. That’s a consensus in both parties.
If you look back at 1914, the end of the golden era of growth before World War I – which it truly was for the 50 years leading to 1914 --, there was no sense in Washington of a duty of the government to achieve a certain level of GDP or job growth, or unemployment, housing starts, or retail sales, or the rest of it. That was not considered to be the job of government, nor was it believed that government had the capacity to do this anyway. That view was, and I think it is still the correct one, that private capitalism and the free market will take care of itself.
So if the consumers, investors, and entrepreneurs of a free economy produce a 3.5 percent growth rate, so be it. If it’s only 1 percent, well, those are the choices that have been made. If it’s 5 percent, that’s good too, but it’s not the duty of the State, and it is not within the competence of the State, to cause the outcome to be 2 percent, 3 percent, or 5 percent. That’s what millions of participants in free market capitalism produce as a consequence of individual actions, not as a collective goal established ahead of time.
Today, in 2014, we’re at the very opposite end of that spectrum. Politicians in Washington obsess about whether the GDP grew in a given quarter (before it is revised and the noise from inventory fluctuation and so forth is stripped out) at 2.7 or 2.4 percent, for example, as if they could or should do anything about it.
All the other economic metrics generate the same kind of obsessive focus and the same impulse towards meddling, intervention, and manipulation. As long as that mindset exists, neither party is likely to change its approach to politics. If you believe it’s the job of the State to micromanage the GDP growth rate by the quarter, then there will be endless ideas that politicians come up with, and special interest groups will then gladly embrace, to stimulate housing, or encourage people to scrap ‘clunkers’ via tax credits, and a myriad of other kinds of intervention – to support agriculture or encourage green energy for instance; there’s an endless list.
The problem that we have today is that we have the wrong core idea about the role of the State and the capacities of free-market capitalism. And as long as that core idea, the ‘Keynesian idea,’ is in place and embraced in different variations by the two parties, I think we’ll be locked in the dynamic that you started with, which is the inexorable suffocation of private capitalism by the State as it continues to grow.
According to your book, it seems like we are in an era of unprecedented crony capitalism in almost every major industry, and that every time a crisis comes around, it becomes more entrenched. Are we past the point of no return for rooting out crony capitalism?
I think it’s going to be very difficult to uproot crony capitalism, which is thoroughly embedded in Washington’s governance process. It’s worth understanding and noting that crony capitalism is really the stepchild of the Keynesian idea. If you go back to the idea that free-market capitalism is inherently weak and prone to breakdowns and recession, then the government is always looking for ways to ‘help,’ to stimulate, to prop it up.
Special interest groups are always happy to accommodate the desire of politicians to find ways to help the economy. That’s why you get one boondoggle after another; it’s why the tax code is riddled with loopholes; it’s why we have ridiculous things like the $800 billion Obama stimulus program, the green energy boondoggles that exist today, the farm price supports that have existed for 80 years since the New Deal itself, or the massive intervention in housing through every tool they have -- subsidized credit, tax benefits and direct subsidies.
Yet all of this crony capitalism results in a waste of resources, inefficiency, and grotesque unfairness depending on whether you benefit from the windfall or pay the cost as a consumer or a taxpayer. As long as job one of Washington continues to be to help the economy overcome its alleged ‘inherent tendency towards failure,’ crony capitalism will predominate and the free market will become an ever more remote figment of the past. That’s the inevitable result of the system that exists today.
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1 Federal Reserve Statistical Release. Second Quarter 2014. September 18, 2014.
2 Federal Reserve Statistical Release. January 4, 2001
3 Federal Reserve Statistical Release. January 3, 2008
4 Federal Reserve Statistical Release. November 20, 2014.