[The 2011 Henry Hazlitt Memorial Lecture, given on March 12 at the Austrian Scholar’s Conference. An MP3 audio file of that lecture is available for download.]
David Stockman
The triumph of crony capitalism occurred on October 3rd, 2008. The event was the enactment of TARP — the single greatest economic-policy abomination since the 1930s, or perhaps ever.
Like most other quantum leaps in statist intervention, the Wall Street bailout was justified as a last-resort exercise in breaking the rules to save the system. In the immortal words of George W. Bush, our most economically befuddled President since FDR, “I’ve abandoned free market principles in order to save the free market system.”
Based on the panicked advice of Paulson and Bernanke, of course, the president had the misapprehension that without a bailout “this sucker is going down.” Yet 30 months after the fact, evidence that the American economy had been on the edge of a nuclear-style meltdown is nowhere to be found.
In fact, the only real difference with Iraq is that in the campaign against Saddam we found no weapons of mass destruction; by contrast, in the campaign to save the economy we actually used them — or at least their economic equivalent.
Still, the urban legend persists that in September 2008 the payments system was on the cusp of crashing, and that absent the bailouts, companies would have missed payrolls, ATMs would have gone dark and general financial disintegration would have ensued.
But the only thing that even faintly hints of this fiction is the commercial-paper market dislocation. Upon examination, however, it is evident that what actually evaporated in this sector was not the cash needed for payrolls, but billions in phony book profits, which banks had previously obtained through yield-curve arbitrages that were now violently unwinding.
At that time, the commercial-paper market was about $2 trillion and was heavily owned by institutional money-market funds — including First Reserve, which was the granddaddy with about $60 billion in footings. Most of this was rock solid, but its portfolio also included a moderate batch of Lehman commercial paper — a performance enhancer designed to garner a few extra “bips” of yield.
As it happened, this foolish exposure to a de facto hedge fund, which had been leveraged 30-to-1, resulted in the humiliating disclosure that First Reserve “broke the buck,” and that the somnolent institutional fund managers who were its clients would suffer a loss — — all of 3 percent!
This should have been a “so what” moment — except then all of the other lemming institutions who were actually paying fees to money-market funds for the privilege of getting return-free risk decided to panic and demand redemption of their deposits. This further step in the chain reaction basically meant that some maturing commercial paper could not be rolled over due to these money-market redemptions.
But this outcome, too, was a “so what”: nowhere was it written that GE Capital or the Bank One credit-card conduit, to pick two heavy users of the space, had a Federal entitlement to cheap commercial paper — so that they could earn fat spreads on their loan books.
Regardless, the nation’s number one crony capitalist — Jeff Immelt of GE — jumped on the phone to Secretary Paulsen and yelled “fire”! Soon the Fed and FDIC stopped the commercial-paper unwind dead in its tracks by essentially nationalizing the entire market. Even a cursory look at the data, however, shows that Immelt’s SOS call was a self-serving crock.
First, about $1 trillion of the $2 trillion in outstanding commercial paper was of the so-called ABCP type — paper backed by packages of consumer loans such as credit cards, auto loans, and student loans. The ABCP issuers were off-balance sheet conduits of commercial banks and finance companies; the latter originated the primary loans, and then scalped profits up front by selling these loan packages into their own conduits.
In short, had every single ABCP conduit been liquidated for want of commercial-paper funding — and over the past three years most have been — not a single consumer would have been denied a credit-card authorization or car loan. His or her bank would have merely booked the loan as an on-balance sheet asset — rather than off-balance sheet asset.
The only noticeable difference on the entire financial planet would have been that a few banks wouldn’t have been able to scalp profits from unseasoned loans. In this instance, it appears that President George W. Bush did, in fact, bomb the village to save it!
Another $400 billion of the sector was industrial-company commercial paper — the kind of facility that some blue-chip companies used to fund their payroll. But there was not a single industrial company in America then issuing commercial paper that did not also have a standby bank line behind its CP program. Moreover, since these companies had been paying a 15 or 20 basis-point standby fee for years, their banks had a contractual obligation to fund these backup lines, and none refused. There was never a chance that payrolls would not be met.
The last $600 billion of CP is where the real crony capitalist stench lies. There were three huge users in the finance-company sector — CIT, GMAC, and GE Capital. At the time of the crisis, the latter had asset footings of $600 billion — most of it long-term, highly illiquid, and sometimes sketchy corporate and commercial real-estate loans.
In violation of every rule of sound banking, more than $80 billion of these positions were funded in the super-cheap commercial-paper market. This maneuver fattened spreads on GE’s loan book and produced big management bonuses, too. But it also raised to a whole new level the ancient banking folly of mismatching short and hot liabilities with long and slow assets.
Under free-market rules, an inability to roll its $80 billion in commercial paper would have forced GE Capital into a fire sale of illiquid loan assets at deep discounts, thereby incurring heavy losses and a reversal of its prior phony profits; or in the alternative, it could have held on to its loan book, and issued massively dilutive amounts of common stock or subordinated debt to close its sudden funding gap.
Either way, GE’s shareholders would have taken the beating they deserved for over-valuing the company’s true earnings and for putting reckless managers in charge of the store.
So the financial meltdown during those eventful weeks was not triggered by the financial equivalent of a comet from deep space — but resulted from leveraged speculation that should have been punishable by ordinary market rules.
Viewed more broadly, the carnage on Wall Street in September 2008 was the inevitable crash of a 40-year financial bubble spawned by the Fed after Nixon closed the gold window in August 1971. As time passed, the Fed’s market-rigging and money-printing actions had become increasingly destructive — leaving the banking system ever more unstable and populated with a growing bevy of Too Big to Fail institutions.
The 1984 rescue of Continental Illinois; the 1994 Mexican peso crisis bailouts; the Fed’s 1998 life-support operation for LTCM — were all just steps along the way to the fall of 2008.
Then, faced with the collapse of their own handiwork, Washington panicked and joined the Fed in unleashing an indiscriminate bailout capitalism that has now thoroughly corrupted the halls of government, even as it has become a debilitating blight on the free market.
In this context, the linkage between printing-press money and fiscal profligacy merits special attention. In the post-TARP world, there remain no fiscal rules at all, and already we have had cash for clunkers, cash for caulkers, and under the homebuyer’s credit, cash for convicts.
Indeed, my belief is that the subprime meltdown was only a warm-up. The real financial widow-maker of the present era is likely to be US government debt itself.
The sheer budgetary facts are bracing enough. It needs be recalled that fiscal year 2011, now underway, will encompass not a recession bottom but the sixth-through-ninth quarter of recovery. During this interval of purported rebound, however, the White House now projects red ink of $1.645 trillion. This means that 43 cents on every dollar spent will be borrowed, thereby generating a financing requirement just shy of 11 percent of national income.
These elephantine figures mark a big lurch southward — since deficits only half this size were expected for the current year as recently as last spring. Notwithstanding a full year of green shoots and booming stocks, however, Washington embraced a monumental round of new fiscal stimulus in December.
The result was a trillion-dollar Christmas tree festooned with fiscal largesse for every citizen — inclusive of the quick as well as the dead. Moreover, this bounty was extended without prejudice to each and every social class — with workers, the unemployed, the middle class, the merely rich, and billionaires, too, getting a share.
It would be foolish in the extreme to dismiss this budgetary eruption as a fit of transient exuberance — even if by the president’s own admission the White House was in a shellacked state of mind, and in no position to restrain December’s bipartisan stampede. In fact, the United States is clocking a 10-percent-of-GDP deficit for the third year running because this latest budgetary fling is just another episode in the epochal collapse of US financial discipline that began 40 years ago at Camp David.
That the demise of the gold standard should have been as destructive of fiscal discipline as it was of monetary probity can hardly be gainsaid. Under the ancient regime of fixed exchange rates and currency convertibility, fiscal deficits without tears were simply not sustainable — no matter what errant economic doctrines lawmakers got into their heads.
Back then, the machinery of honest money could be relied upon to trump bad policy. Thus, if budget deficits were monetized by the central bank, this weakened the currency and caused a damaging external drain on monetary reserves; and if deficits were financed out of savings, interest rates were pushed up — thereby crowding out private domestic investment.
Politicians did not have to be deeply schooled in Bastiat’s parable of the seen and the unseen. The bitter fruits of chronic deficit finance were all too visible and immediate.
During the four decades since the gold window was closed — the rules of the fiscal game have been profoundly altered. Specifically, under Professor Friedman’s contraption of floating paper money, foreigners may accumulate dollar claims or exchange them for other paper monies.
But there can never be a drain on US monetary reserves because dollar claims are not convertible. This infernal engine of fiat dollars, therefore, has had numerous lamentable consequences but among the worst is that it has facilitated open-ended monetization of US government debt.
Monetization can be done in two ways. First, there is outright monetization, as is now being conducted by the Fed through its POMO program; that is, its daily purchase of $4–$8 billion of Treasury debt. Indeed, the Fed’s QE2 bond purchases have been so massive that it is literally buying Treasury paper in the secondary market almost as fast as new bonds are being issued. During January, for example, fully 40 percent of the Fed’s $100 billion bond buy was from CUSIP numbers less than 90 days old.
Needless to say, putting brand new Treasury bonds in the Fed’s vault before they have paid even a single coupon is functionally equivalent to printing greenbacks. After all, under this type of high-speed round trip, virtually all the coupons from newly issued bonds will end up as incremental profit at the Fed and be remitted back to the Treasury at year-end.
Stated differently, in the present era of massive quantitative easing, newly issued Treasury securities amount to non-interest-bearing currency without the circulation privilege.
But over the last several decades, the preferred course has been indirect monetization; that is, the world’s legion of willing mercantilist exporters from China to the Persian Gulf have printed their own money in vast quantities — ostensibly to peg their exchange rates, but with the effect of absorbing trillions of US treasury paper.
To be sure, the peoples’ money warehouse in China and those in other mercantilist lands are pleased to label these accumulations as sovereign wealth portfolios. But the fact is, these hoards of sequestered dollars are not classic monetary reserves derived from a true, sustainable surplus on current account. Instead, they are simply the book-entry offset to the inflated local money supplies that have been emitted by the global convoy of peggers — that is, mercantilist nation central banks tethered to the Fed.
That this convoy is a potent mechanism for monetizing US debt is readily evident by way of contrast with classic monetary systems anchored on a true reserve asset. At the peak of its glory before the Guns of August 1914 laid it low, the sterling-based gold standard operated smoothly with a London gold reserve amounting to 1–2 percent of British GDP.
Likewise, in 1959 at the peak of the Breton Woods, the United States held $20 billion of gold reserves against a GDP of $500 billion. Again, at about 4 percent of GDP, the hard monetary reserves needed to operate the system were extremely modest.
The reason for parsimonious reserve quantities under the gold standard was the fact of continuous settlement of trade accounts via the flow of monetary assets. In the case of a balance-of-payments deficit, the outflow of reserve assets directly and immediately contracted domestic money markets and banking systems — setting in motion an automatic downward adjustment of domestic wages, prices, and demand and encouraging an upward move in exports and domestic production.
In the cases of surpluses, the adjustments were in the opposite direction. Most importantly, with real economies constantly in adjustment, central-bank balance sheets stayed lean and mean.
By contrast, under the contraption that Professor Friedman inspired, trade account imbalances are never settled. They just grow and grow and grow — until one day they become the object of fruitless jabbering at a photo-op society called G-20.
In all fairness, Professor Friedman did not envision a world of rampant, dirty floating. Indeed, it would have taken a powerful imagination to foresee four decades ago that China would accumulate $3 trillion of foreign-currency claims, or more than 50 percent of GDP, and then insist over a period of years and decades that it did not manipulate its exchange rate!
Still, there can be little doubt that China and the other mercantilist exporters operate massive monetary warehouses where they deposit Treasury bonds acquired during their endless dollar-buying campaigns. Moreover, the apparatchiks at the US Treasury Department can now stop splitting hairs about whether China is a “currency manipulator” or not. It seems China just admitted to it.
Recently, the vice chairman of the People’s Bank of China, Yi Gang, asked, “Why do we have so much base money?” Said Mr. Yi while answering his own question, “the central bank buys up foreign exchange inflows. If it didn’t, the Yuan wouldn’t be so stable.” Now there’s one for the Guinness Book of Understatements!
So at the end of the day, American lawmakers have been freed of the classic monetary constraints. There is no monetary squeeze and there is no reserve-asset drain. The Fed always supplies enough reserves to the banking system to fund any and all private credit demand at policy rates that are invariably low. The notion of fiscal “crowding out” thus belongs in the museum of monetary history.
At the same time, the seemingly limitless emission of dollar claims by the US central bank results not in a contractionary drain of monetary reserves from the domestic banking system, but in an expansionary accumulation of these claims in the vaults of foreign central banks. In less polite language, a growing portion of the Federal debt has ended up in what amounts to a global chain of monetary roach motels: places where Treasury bonds go in but they never come out.
In fact, foreign central banks hold $2.6 trillion of US Treasuries at the New York Fed — while the Fed’s own holdings total $1.2 trillion. Add in a least a half-trillion more in Treasury debt that is officially held elsewhere, and you have the startling fact that about $4.5 trillion or 50 percent of all the publicly held Federal debt ever issued has been sequestered by central bankers.
With such a mighty bid from the world’s central bankers, we have thus experienced what our classically trained forebears held to be impossible — a prolonged era of fiscal deficits without tears.
To be sure, it took American politicians a decade or so to realize that the old rules were no longer operative. Helped immeasurably by the collapse of the Soviet war machine, orthodox Senate Republicans and bourbon Democrats achieved for a fleeting moment the appearance of fiscal balance at the turn of the century. But it was not long before the cat was out of the bag. In making the case for the Bush tax cuts of 2001 — then–Vice President Cheney summed up the new reality, postulating that “Reagan proved deficits don’t matter.”
Reagan proved no such thing, of course, but Republican politicians of the George W. Bush era had most assuredly discovered they could borrow with relative impunity. Soon, the GOP transformed the Reagan policy idea of lower marginal income tax rates into a faith-based religion of tax cutting — anywhere, anytime, for any reason.
So intense was the reawakening that the floor of the US House became thronged with fiscal holy rollers — throbbing, shaking, jerking, and gesticulating as they exorcized section after section of the revenue code. By the time Bush and the congressional Republicans were through in FY 2009, the revenue had been reduced to 14.9 percent of GDP — the lowest level since 1950 and far below the 18.4 percent level extant when Ronald Reagan left office.
To be sure, lowering the burden of taxation on the American economy is a compelling idea from both a philosophical and economic policy viewpoint. But deficit-financed tax cuts are a politician’s snare and delusion. Such fiscal actions do not actually reduce the tax burden — they just defer its collection.
Moreover, the evidence of the last 30 years shows that preemptive tax cuts don’t actually “starve the beast” — notwithstanding the popularity of this nostrum among certain K-Street philosophers whose day jobs involve panhandling outside the Ways and Means Committee hearing room.
Indeed, even as the tax-cutting branch of the GOP busied itself giving every organized constituency in America some kind of special break — including incentives to Iowa pig farmers to distill motor moonshine that they were pleased to call ethanol — the dual fiscal burden of the American welfare and warfare states was getting heavier, not lighter.
Here the GOP’s neocon war department and its domestic porker divisions were busy, too — pushing the ratio of Federal spending to GDP to record levels. In this respect, the neocons deserve their own special chapter in the annals of fiscal infamy.
Having pushed the American empire to take its stand on real estate of historically dubious merit — that is, the bloody plains of the Tigress-Euphrates and the desolate expanse of the Hindu Kush — they persisted for the better part of the decade in refusing to finance with honest taxation wars that they could not win and would not end.
The cumulative tab for Iraq and Afghanistan now totals $1.26 trillion. And therein lays a stark tribute to the efficacy with which Professor Friedman’s contraption absorbs the Federal debt. The fact is, America’s conservative party did not even break a sweat as it deficit-financed what were surely two of the most elective foreign-policy adventures ever undertaken.
Again, the contrast with the canons of classical finance helps crystallize the picture. Writing in 1924, Hartley Withers, eminent editor of the Economist and keeper of Bagehot’s wisdom on matters of money and central banking, lamented that British finances were in shambles because the government had broken all the rules of war finance during its battle with the Hun.
Rather than obtaining at least 50 percent of its revenue from current taxation and the balance from the peoples’ savings at an honest wage for capital, it had resorted to massive inflation of bank credit and issuance of paper money — “shinplasters” as they were known — to pay His Majesty’s bills.
Withers took special aim at England’s first war chancellor, Lloyd George, thundering as follows, “It is difficult to exaggerate the evil effects of the economic crime that he committed when in the spring of 1915 he imposed no taxation whatever to meet the (massive) deficit which faced him.”
So at the zenith of the monetary golden age, sound opinion held that it was an economic crime to run the printing presses — even with a million enemy soldiers bivouacked across the channel. Now, 100 years later, monetizing the expense of pursuing a tall man and 100 followers lost in the high Himalayas apparently does not even rank as a misdemeanor.
It was in the domestic spending arena, however, where the newly liberated Bush Republicans put the pedal to the medal. During the Reagan era there had been a modicum of progress in throttling the domestic welfare state — with domestic spending dropping to 13.4 percent of GDP after having averaged 15.2 percent of GDP during the Carter years. Moreover, after the next decade of divided government, the size of the domestic welfare state had drifted upward by only a touch — clocking in at 13.5 percent of GDP by fiscal year 2000.
The frightening thing about the American fiscal future lays in what happened next — with Republican control of both houses of Congress and the White House for six full years. Apologists such as Newt Gingrich had excused Reagan’s megadeficits on the grounds that conservatives were not obligated to serve as tax collectors for the welfare state.
And fair enough. With divided government during Reagan’s entire eight years, the political horsepower simply didn’t exist to take on the three core entitlement programs: Social Security, Medicare, and Medicaid.
By fiscal year 2000, however, these Big Three entitlements alone cost $740 billion or about 7.5 percent of GDP. The time for fundamental reform was long overdue. But a Republican policy offensive against the fiscal heartland of the American welfare state never came.
Instead, Medicaid was actually expanded moderately at the behest of Republican governors, Medicare spending was swollen by a huge new entitlement benefit for prescription drugs courtesy of Big Pharma, and Social Security rolled along without even a sideways glance from the antispenders. Consequently, outlays for the Big Three entitlements doubled to $1.425 trillion or 10.1 percent of GDP in Bush’s final budget — thus upping the fiscal burden by one-third in only eight years.
But wait, as the late night commercials admonish, there’s more! In that modest 15 percent corner of the Federal budget known as domestic discretionary spending, Bush-era Republican government went on a veritable rampage. Homeland Security spending, for example, soared nearly five-fold — from $13 billion in FY 2000 to $59 billion by FY 2009. Likewise, outlays for veterans programs rose from $47 billion in 2000 to nearly $100 billion by 2009.
Next there is the one President Reagan tried to abolish — the Department of Education. Charging in the opposite direction, the Bush Republicans doubled it from $33 billion to $66 billion. While they touted this education spending explosion as evidence of “compassionate conservatism,” the more apt characterization is that, once Republicans embraced yet another function for the American welfare state, they saw to it that no education lobby group would ever be left behind.
During the same eight years, housing and community development spending also doubled to $60 billion — along with a 75 percent rise in spending on transportation, a swelling of farm support programs, and the enactment of a $60 billion energy bill providing subsidies for solar, wind, fuel cells, clean coal, fusion, and ethanol — the exact menu that Republicans once held could be best sorted out by the free market.
In all, domestic spending during FY 2008 came in at a record high of $2.3 trillion. After 30 years of a rolling referendum on the American welfare state, then, the verdict was clear.
Eight years of Republican government had brought the burden of domestic spending to just under 16 percent of national income — a figure materially higher than the 15.2 percent average during the last period of unified Democratic government under Carter. Thus, while the impact of the Reagan Revolution on the size of the US government had always been immeasurably modest, it was now totally erased.
The sorry Republican record on fiscal matters is not merely a morality tale. When the conservative party in a democracy embraces “starve the beast” on taxing and “feed the beast” on spending, then fiscal governance breaks down badly. You end up with two free-lunch parties competing for the affections of the electorate — alternately depleting the revenue base and then pumping up the spending.
Needless to say, this outcome bespeaks irony. Milton Friedman was an unrelenting foe of big government and the American welfare state, yet the global monetary contraption he inspired ensured its perpetuation. Consider, for example, how the two-party free-lunch competition has perverted the budgeting process.
Here, the basic tool of long-term fiscal policy — the ten-year budget projection — has been utterly corrupted by the need of both political parties to disguise the full measure of their profligacy. The most recent CBO baseline, for example, shows the Federal deficit declining from 11 percent of GDP this year to 3 percent by 2015 — a trend that looks like progress.
Unfortunately, this baseline budget outlook is now useless, as it is riddled with fiscal booby traps in the form of major, costly entitlement and tax law provisions that expire in arbitrary, cliff-wise fashion one, two, or three years down the road.
It is widely known, of course, that the Bush income-tax-rate cuts expire promptly at midnight on December 31, 2012 — causing a $200 billion per year pickup in the revenue baseline thereafter. But what also happens on January 1, 2012 is that the $100 billion abatement of payroll taxes abruptly expires and so does the so-called AMT patch. The latter means that the number of taxpayers facing the alternative minimum tax jumps from 4 million to 33 million, causing the projected annual revenue take to rise from $34 billion under the patch to $129 billion. Likewise, the 15 percent tax rate on corporate dividends will jump to 39.6 percent in 2013.
Similarly, the estate tax rises from 35 percent on $5 million to 55 percent on $1 million. During the 2012–2014 period most of the business tax credits for R&D, ethanol, and the like also expire, as do credits for childcare, higher education, and much more. Taken altogether, the December Christmas tree contained temporary tax relief provisions worth 3.8 percent of GDP — the equivalent of $650 billion annually — that will have completely expired by 2014.
The resulting big uptick in revenue seems antiseptic enough when viewed on the computer screen. However, were these provisions to expire in real life — upwards of a hundred million different taxpayers would take a hit. Consequently, most of these tax breaks won’t expire — their due date will just be kicked down the road a couple of years as part of the annual “rinse and repeat” exercise that now passes for budget-making.
The picture is not much different on the spending side. Something called the “doc fix” has been enacted repeatedly — a measure that temporarily waives the 20 percent drop in Medicare fees built into current law. Upon passage, the politicians collect their election-year medications from the grateful physicians lobby — while taking credit for a reduction of $30 billion in future spending when the waiver expires.
Likewise, under extended unemployment benefits, 10 million workers get various “extended” tiers of the unemployment-insurance program at an annual cost of about $150 billion. Under current law, however, nearly two-thirds of this cost is temporary — meaning that out-year budgets project only $50 billion of annual expense. The reality, however, is that to avoid a cold turkey shock, Congress has repeatedly voted extensions at the 11th hour, and will again in 2012.
Going forward, there can be little doubt that the GOP is determined to forestall nearly all of the tax-law expirations currently scheduled — including the rate cuts, capital gains, the dividend and estate-tax provisions, and the business-tax credits. This means that baseline revenue is only about 16–17 percent of GDP according to current Republican policy doctrine.
At the same time, when you remove the spending expiration booby traps, it appears that current policy for outlays as advocated by the Democrats — and most of the Republicans, too — is about 24 percent of GDP. So if you go by the math of it, the current bipartisan policy path results in a permanent fiscal deficit of 7–8 percent of GDP.
That would amount to about $7 trillion in new bond issuance over the next five years, and take total public debt in the United States to over 100 percent of GDP.
There is no telling, of course, how much more of Uncle Sam’s debt the monetary roach motels of the world can ultimately absorb. But since American politicians no longer fear deficits — because they have been successfully monetized for decades now — we will surely put the matter to the test.
There is one powerful factor, however, suggesting that the man with his “the end is near” sign may show up any day now. Specifically, the aforementioned $1.5 trillion per year of current policy deficits as far as the eye can see assumes that we are having a Keynesian moment, not an Austrian one.
The new White House budget, for example, postulates that the Keynesian medication worked like a charm. Thus, there will be no recession for the next 10 years, although we have averaged one every 4.3 years since 1947. It also assumes that real GDP growth will average 3.2 percent over the next decade — or double the 1.7 percent average during the past decade. Finally, it projects that the US economy will generate 20 million new jobs during the coming decade, compared to only 1.7 million during the last 10 years. As the man with the sign also said, good luck with that!
In any event, the already baleful deficit projections would grow by trillions under more plausible economic assumptions. But the more crucial point is that the dead hand of Richard Nixon keeps showing up on the fiscal playing field. Echoing Tricky Dick, today’s GOP has once again embraced the Keynesian faith — even if it has been robed in the ideological vestments of the prosperous classes; that is, in a preference to ameliorate cyclical weakness with tax-cut stimulants rather than spending sprees.
But notwithstanding choice of stimulants, Republicans too believe that the US economy is in a conventional business cycle, and that the rebound remains much too fragile to tolerate any jarring fiscal actions. Thus, the renascent Keynesian consensus will result in kicking the fiscal can down the road again and again.
It is here that the true nightmare scenario arises — owing to the possibility that this mainstream outlook is completely erroneous, and that the nation’s deep economic ills are rooted in the massive excess debt burden accumulated on the US balance sheet after 1971. In that event, we would be in the midst of an Austrian debt deflation, not a Keynesian cyclical rebound.
From a fiscal perspective, a prolonged debt deflation would be the coup de grace. That’s because debt deflations crush nominal GDP growth, owing to the evaporation of credit-fueled additions to spending. In turn, low nominal GDP growth is bad news for revenues because what we tax, obviously, is money incomes.
Moreover, the actual GDP data suggests that debt deflation is already resident in the numbers. Total US credit-market debt essentially stopped growing in late 2007 at a level slightly above $50 trillion compared to a $14.3 trillion level of GDP. During the three years since, total debt growth has been at a tepid 1.5 percent annual rate — with public debt growing much faster than this and financial and household sector liabilities actually shrinking.
Not surprisingly, nominal or money GDP has gained only $530 billion during those 36 months, meaning that the annualized growth rate has been only 1.2 percent. There is no three-year streak that anemic anywhere in the data since the 1930s. Moreover, even if you allow for the alleged rebound since Q2 2009, the rate of money GDP growth has only been 3.8 percent, and was actually just 3.2 percent in the most recent quarter.
By contrast, the new White House budget projects money GDP growth of 5.6 percent per annum over the next five years — meaning that nominal GDP would reach $20 trillion by then. At a 3.5 percent growth rate, however, which is triple the growth rate of the last three years and in line with the post-June 2009 rate of advance — money GDP would come in at only $18 trillion by 2016.
This $2 trillion variance might be written off to wild-blue speculation. Then again, at the current marginal Federal tax yield, the implied revenue shortfall is another $400 billion annually. Stated differently, the current policy deficit may actually be in the $2 trillion annual range after factoring in realistic incomes and revenues.
The infernal engine of the dollar may thus have been doubly diabolical on the fiscal front. First, it hooked the American political system on the “deficits don’t matter” theorem by eliminating the economically painful squeezes and drains on the monetary system that traditionally accompanied fiscal deficits.
Secondly, to the extent that it fueled the debt supercycle that swelled from 1980 until 2008, it generated a false prosperity and bubble-derived fiscal windfalls that have now evaporated.
Shortly after Nixon closed the gold window in August 1971, Secretary Connally famously told an assemblage of foreign central bankers that “the dollar is our currency, but it’s your problem.” The esteemed secretary had studied at the Wright Patman School of Texas Finance, of course, not the University of Chicago.
But he nevertheless shared Professor Friedman’s assurance that floating the dollar would eliminate the nettlesome problem of the US current-account deficit; that is, such trade adjustment as might be needed would be done by the nondollar speakers in the global economy.
History now says otherwise — and resoundingly so. Indeed, once relieved of the immediate pain of self-correcting, contractionary drains on our domestic money markets and banking systems, the United States was free to embark upon on a monumental borrowing spree denominated in the world’s reserve currency.
At the same time, there emerged — up and down the East Asian main — rulers enamored with a development model amounting to export mercantilism. This scheme produced a plentitude of factory jobs and social quietude internally, while generating massive external surpluses that could be recycled into vendor financing for ever-expanding export volumes.
The resulting mutant symbiosis between the American economy and the East Asian mercantilist exporters spawned a long-term outcome that Milton Friedman held to be impossible under floating exchange rates: namely, 33 years of continuous, deep current-account deficits at 3–5 percent of GDP — external deficits that have now accumulated to more than $7 trillion since the late 1970s.
The fly in the Friedmanite theoretical ointment, of course, is that by pegging their currencies, the East Asian exporters and Persian Gulf oilies have permanently forestalled balancing their external accounts by accepting cheaper and cheaper dollars as prescribed by Texas-style monetarism. In thereby retaining their outgoing export surpluses, the mercantilist exporters have accumulated Treasury bonds from the backhaul.
Accordingly, the $9 trillion of current global forex reserves — mostly held by the aforementioned peggers — are not monetary reserves in any meaningful sense; they are effectively vendor-financed export loans, and they are what make the present economic world go round.
They are also what made the US balance sheet go parabolic. For a century after resumption of convertibility in 1879, the ratio of total US debt — both private and public — to national income was remarkably stable. Despite cycles of war and peace, boom and bust, this national leverage ratio oscillated closely around 1.6 times.
Call this remarkably stable ratio of total debt to national income the “golden constant.” Note further that after the events of August 1971, this heretofore stable national leverage ratio broke out to the upside and never looked back. By the middle 1990s it had reached 2.6 times, and then it soared to 3.6 times national income by 2007 — where it remains. Stated differently, we have added two full turns of debt on the national income since 1980 — an outcome that amounts to a nationwide LBO.
The volume of incremental debt now being lugged about by the national economy owing to this debt spree is startling. In round-dollar terms, total credit market debt would currently be about $22 trillion under the “golden constant” (i.e., at 1.6 times GDP of $14.5 trillion) compared to today’s actual debt level of $52 trillion (at 3.6 times GDP).
Wall Street bulls and Keynesian economists — to indulge in a redundancy — insist that this extra $30 trillion of debt is no sweat. Presumably, they would otherwise not be forecasting ten years of standard growth rates with no recession, and would not be capitalizing corporate earnings at the conventional 15 times EPS.
Put another way, by the lights of mainstream opinion, our recent parabolic departure from the golden constant of leverage apparently represents nothing more than a late-blooming enlightenment — the shedding of ancient superstitions about the perils of too much debt in households, businesses, and governments alike.
If this were true, it would be a pity. Had our benighted financial forebears only known better, they would have levered up the United States long ago — producing unimagined surges of growth and wealth.
Indeed, economic miracles like the Internet might have been generated at a far-earlier time — say, in 1950, not 1990; and it might have been invented by Senator Albert Gore Sr. of Tennessee rather than his son Albert Gore Jr. of Hollywood.
The alternative possibility, however, is that our forebears actually knew a thing or two about finance. Perhaps they understood that, in not settling our accounts with the world, we were merely borrowing GDP, not growing it.
The numbers, in fact, suggest exactly that. During the era of the golden constant, about $1.50 of debt growth accompanied each dollar of GDP growth. By 1989, each dollar of GDP growth took $2.50 of debt increase, and by 1999 the ratio rose to $3.30.
After that is was off the races. When the debt supercycle apogee came in 2007, it took $4 trillion of debt growth to produce a gain of just $700 billion of GDP. At that point, the debt-to-income growth ratio had climbed to 6 times, and shortly thereafter the man from Citigroup finally stopped dancing.
The evaporation of artificially inflated income growth and the bursting of the asset bubbles that inexorably followed this kind of debt supercycle have arrived at their appointed time. And the financial condition of the household sector suggest that the postulated Austrian moment may have a hang-time measured in years or even a decade, not months or quarters.
First, the adjustment in household balance sheets to date has been in the marking down of housing assets, not any material shrinkage of debt outstanding. Specifically, household net worth has dropped by $9 trillion or about 14 percent since the final quarter of 2007. However, only $380 billion or 4 percent of this decline is attributable to reduced debt. The rest is owing to shrinking asset values.
So by the lights of the golden constant, we still have a long ways to go. Indeed, back in 1975, when America’s baby boomers were still young, total household debt, including mortgages, car loans, credit cards, and bingo wagers was $730 billion or about 45 percent of GDP. Today, these households bear the enfeeblements of advancing age but have not shed many pounds of debt since the crisis of 2008: total household sector debt outstanding is still $13.4 trillion, or 91 percent of GDP — double where we started.
It is always possible, of course, that the 78 million baby boomers now marching straight away into retirement will hit the credit juice one more time. But the only household debt still growing is on the other end of the demographic curve. Total student loans outstanding — subprime credits by definition — now total $1 trillion and exceed all of the nation’s outstanding credit-card debt. But we’ve seen this movie before and it doesn’t end happily.
If in the future households have to earn — not borrow — what they spend, that 3.5 percent assumption about money GDP growth would look more than plausible. The fact is, organic income is not growing at even 3 percent.
A shocking point buried in the statistics of our government medicated-recovery is that since the Q3 2008 meltdown, personal consumption spending is up by $400 billion, or nearly 4 percent. But private wages and salaries are still $100 billion, or 2 percent, below where they were before that plunge.
Again, these figures are in nominal, not deflated, dollars. Looking at the data since 1950, you can’t find a period in which private money wages was down for even three months, let alone nearly 2.5 years.
Consequently, we have been able to keep up the appearances of consumption spending growth — even if tepid — only by resorting to Uncle Sam’s credit card. Specifically, the gap between shrunken wages and rising consumption has been filled by a $500 billion increase in government transfer payments — all of which were funded on the margin with new borrowings. Thus, in absorbing this incremental debt, it has been the Fed and its global convoy of monetary roach motels that have been the source of the entire intervening gain in US personal consumption expenditures, and then some.
When all else fails, of course, the possibility remains that a rebound of job growth could revive wage and salary incomes and get the GDP juices flowing again at rates more compatible with Keynesian recovery rather than an Austrian deflation. Well, as the man also said, good luck with that one, too.
The January nonfarm payroll number was 130.5 million — a figure first reached in November 1999. And that is the encouraging part of the story! Way back then, there were 72 million “breadwinner” jobs in the US economy — that is, jobs in manufacturing, construction, distribution, FIRE, information technology, the professions, and white-collar services. Average pay levels were about $50,000 per year in today’s dollars.
A decade later in February 2011, there were only 65 million breadwinner jobs — 10 percent fewer. Too be sure, this large drain was nearly offset by a 6 million job gain over the decade in the HES complex (health, education, and social services). But the 30 million total jobs in the HES complex have much lower average pay, at about $35,000 per year, so we are trading down — and their funding is almost entirely derived from the public purse, which is broke.
Consequently, the era of robust job growth in the HES complex is nearly over. After experiencing job gains averaging 50,000 per month during 2000–2007, the rate has now dropped to about 20,000 as the fiscal noose has tightened.
That leaves what might be termed the “part-time economy” — 35 million jobs in retail, bars, restaurants, hotels, personnel services, and temp agencies. The average wage in this segment is just $19,000 per year. Thus, from the point of view of economic throw weight: not so much. Other than providing intermittent spells of gainful employment for bell boys and barhops, this segment supports no families and funds no savings — even if it does give Wall Street economists something to count.
None of this bodes well for a spirited Keynesian recovery — or even a toothless one. Accordingly, the US economy is likely stuck in an extended Austrian moment and the US government deficit is likely beached in the $1.5 to $2.0 trillion annual range as far as the eye can see.
When it soon becomes evident that most of the $60 billion of appropriations so noisily cut by the House Republicans is mainly smoke and mirrors and a fiscal rounding error to boot — the test of Professor Freidman’s floating-rate, fiat-money contraption may finally come.
Maybe there is room for trillions more of government bonds to be absorbed by the Mighty Bid of the Fed and its chain of monetary roach motels. But looking back to 1971, it seems possible that even the ever-visionary Richard Nixon did not then realize the ultimate consequence of closing the gold window and opening the door to China in such close couple.
At that moment, the Chinese rural economy — the only one it ever really had — was prostrate under the weight of 45 million dead from starvation, and far more debilitated and destitute. By underwriting a 40-year debt supercycle, however, the newly unshackled Fed fueled unstinting American demand for the output of East China’s rapidly expanding export factories — Mr. Deng’s solution to the Great Helmsman’s follies.
In so doing, it also drained China’s stricken rice paddies of their nimble young fingers and strong young backs by the tens of millions. Willing to work Dickensian hours for quasi-slave pay rates, this army of refugees from Mao’s mayhem put the world’s wage and cost structure through a three-decade long deflationary wringer.
In this context, a clue to the next phase of this saga may lie in the conterfactual. Had Nixon kept the gold window open, China would have accumulated bullion, not bonds. America would have experienced deflationary austerity, not inflationary bubbles. And fiscal deficits would have mattered. Thus, today’s terminally imbalanced world has evolved at complete variance with the outcome that could have been expected under a regime of sound money.
The risk is that the doomsday system for global money and trade that has metastasized since 1971 may be approaching its endgame. By all appearances, Mao’s great rural swamp has now pretty much been drained.
Global wages will therefore start rising, because even Walmart has not been able to discover another country inhabited by millions of one-dollar-per-day workers. In that environment, the people’s printing press in China will have to drastically slow its creation of RMB, and therefore its capacity to absorb Treasury bonds. Its fellow traveling central banks throughout its feeder system of mercantilist exporters will likely follow its lead.
At that point, the Fed will be the last bid standing. But if it keeps buying bonds, Mr. Market may be inclined to sell dollars with prejudice — even violence. If it stops buying the bond, at what price can trillions more find a place in real, risk-based private portfolios? Either way, it will be a grand experiment. But as they say on television, it’s definitely not something that should be tried at home.
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This article is a transcript of the Henry Hazlitt Memorial Lecture given at the Austrian Scholar’s Conference on March 12, 2011. An MP3 audio file of that lecture is available for download.
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