David Stockman: Welcome to Irrational Exuberance 2.0
Wed, Apr 3, 2013
The Gold Report: David, your new book, “The Great Deformation: The Corruption of Capitalism in America,” examines the roots of what you consider government’s fiscal irresponsibility. As President Reagan’s director of the Office of Management and Budget and a former U.S. congressman, what could have been done when you were in government that would have put a dent in the U.S. debt?
David Stockman: In the early 1980s, we did not recognize the danger of setting a precedent for running large, chronic deficits in peacetime. The Reagan program got out of control. The tax cuts became much bigger than intended. The president was unwilling to resist what became a massive defense buildup. Social Security, Medicare and other entitlements needed to be reformed but were left largely untouched. In the mid-1980s by the time the economy recovered from Volcker’s heroic inflation cure, the big deficits were there and the Republicans began to rationalize: The economy recovered because Volcker’s draconian anti-inflation medicine worked, not because deficits didn’t matter. They just got kicked down the road.
“The financial meltdown of 2008 was caused by massive speculation encouraged by the Fed’s absurdly low interest rates.”
Why was there no day of reckoning? I believe it was because, after President Nixon closed the gold window, we were on a pure fiat floating-rate system by the 1980s. Under Arthur Burns, the Federal Reserve printed money as if there was no tomorrow. Under President Carter, Paul Volcker brought inflation down, but we never restored sound money policy. Then, we got Alan Greenspan who found all kinds of ways to coddle Wall Street and make it possible to have deficits without tears: From 1987 until 2000 he bought government debt hand-over-fist—expanding the Fed’s balance sheet nearly 7% annually for 13 years. But we also offshored our tradeable goods economy in the interim, meaning the massive flow of exports from China and Asia crushed domestic prices and wages, thereby containing the CPI and diverting Greenspan’s massive liquidity injections into the financial markets and Wall Street.
During those 13 years we have the greatest stock market bubble in history—the market index rose 5x—and then it crashed in the dotcom disaster in 2000, and the Fed has just been in the serial bubble business ever since, inflating a second bubble, which crashed in 2007–2008, and now it is well on the way to its third. In fact, the market is now back exactly where it was 4,750 days ago: the Fed is an unhinged bubble machine that has destroyed the capital and money markets and turned them into mere speculative casinos.
The Nixon sin of August 1971 in defaulting on Bretton Woods and launching Milton Friedman’s floating fiat money contraption also created a three-decade monetary regime in which all the world’s central banks—especially the mercantilist central banks of the East Asian exporters like the People’s Printing Press of China—began to buy government debt as part of their currency pegging, cheap money export campaigns. That allowed U.S. politicians to run huge deficits year after year without any short-run, negative economic consequences—the foreign central banks become monetary roach motels: Treasury debt went in but it never came out. Central banks today, in fact, have sequestered in their vaults about $5 trillion of the U.S.’ $12 trillion of publicly held debt. Pretty soon, even the Republicans, led by Vice President Dick Cheney, were saying deficits do not matter.
The financial meltdown of 2008 was caused by massive speculation encouraged by the Fed’s absurdly low interest rates. In the fall of 2008, we drew exactly the wrong lesson; we did more of the same and ran additional deficits due to President Obama’s stimulus program.
It will be hard to extricate ourselves. How can the Fed stop its $85 billion ($85B) bond-buying campaign? How does it get out of a $3.2 trillion ($3.2T) balance sheet, heading to $4T or more? We have a doomsday machine operating at the Federal Reserve and in fiscal policymaking.
TGR: If this problem was decades in the making, can it be turned slowly or will the markets come to this realization in a painful, sudden way?
DS: I think we have reached the point of no return. That is why the last section of my book is called “Sundown in America: The End of Free Markets and Democracy.”
“At some point, the Fed will not be able to buy $85B of bonds each month without creating severe loss of confidence in the financial markets.”
We are in what I call a “state wreck.” The state, the central bank and the fiscal process are failing. Washington is caught in almost insuperable partisan political conflict. Democracy can no longer cope.
For 80 years, the Keynesians have assured us that the free market has its failures and imperfections, that when economic dislocations occur, the state needs to step in and smooth the business cycle, support failing industries, establish a safety net, housing everybody and so on. But when you overload the central banking branch and Washington’s fiscal arms and tax machinery with endless “stimulus” missions, you create a condition of failure. It cannot finance itself. It cannot make decisions. It cannot cope with the interest groups and lobbyists unleashed by policy activism both at the Fed and at the fiscal level.
Tax code reform is undoable because, when push comes to shove, there is too much built-in special interest and too many crony-capitalist obstacles in the way. The same is true on the spending side. The current sequester, although necessary, touches only 4% or 5% for the domestic agencies and 8% for defense, yet people are claiming great catastrophes will result from these cutbacks.
The Fed is anesthetizing everybody on Wall Street and in Washington. If you can borrow money for five years for 80 basis points, why would anyone make tough choices, impose painful cutbacks or tax increases on the American electorate? The Fed has made it so easy to be a speculator on Wall Street and to sweep the fiscal problems under the rug in Washington. The Fed is wrecking the market and our process of governance, fiscal and otherwise.
TGR: What will stop the Fed from being, as you say, easy?
DS: At some point, the Fed will not be able to buy $85B of bonds each month without creating severe loss of confidence in the financial markets. We have had essentially 0% interest rates since December 2008, and the Fed plans to keep it that way through 2015. Can we have 0%, short-term interest rates for six full years? Can the Fed smash down the yield curve and pin the 10-year bond at 2% indefinitely when inflation is 2% and the real yield is zero? If the Fed can do these things for years on end, then everything we ever believed about markets, economics and the importance of interest rates as a pricing mechanism for securities and financial assets is wrong.
“We need an honest stock market based on discounting of real economic prospects and sustainable earnings.”
The minute the Fed begins to shrink down $85B to a lower number or reverses course and begins to shrink its own balance sheet, the fixed-income markets will panic.
Most of the fast money traders do not own 10-year bonds because they like a 2% yield. They own them because they can fund it in the repo market for $0.98 of borrowed money at 10 basis points overnight; they are just taking the carry-trade profit. As soon as the treasury yield goes up, prices will fall and the carry-trade falls apart.
TGR: What is the impetus for rates to go up?
DS: Interest rates have to normalize or you will have free money forever. If free money forever is workable, why do we have capitalism? Why would anybody save or work or pay taxes? Just have the government drop money from helicopters after the Fed prints it all day and night.
Interest rates cannot stay at 10 basis points in the money market and 2% on the benchmark 10-year treasury note when the global inflation rate is 2–3%. This is totally unsustainable. The Fed destroyed the bond market in the 1970s. By the time Volcker had taken the bull by the horns, the 10-year rate hit 16% in 1981. We have been on a downward glide path for 32 years and finally reached 1.45% last fall. But now we are at the end of an era. The only direction over the next few decades is for higher yield, falling bond prices and a total dislocation in government financing and all the massive fixed income markets, which price off from the treasuries.
TGR: You blame Washington’s coddling of Wall Street for dooming Main Street to a future of debt. But there is a connection between everyday people and the stock market. If people cannot make money on their savings because of low interest rates, the market has to be healthy for them to preserve and grow wealth, right?
DS: We need an honest stock market based on discounting of real economic prospects and sustainable earnings, but that is not what we have. This is an artificial market driven by the Fed’s massive, daily liquidity injections to the government bond dealers. Those dealers sell a couple of billion dollars a day of debt that is being absorbed by the Fed, funded by freshly printed digital money deposits in their bank accounts.
There is danger everywhere: Japan is falling apart. China is the greatest credit bubble ever created. Europe cannot get out of its own way.
We are now at Irrational Exuberance 2.0, and it is entirely an artifact of a dangerous Fed policy of forcing people to take on more risk. Retirees do not want risk, but they are entitled to some yield on their hard-earned savings. To tell people that the only way they can get a return other than 40 basis points on a six-month Certificate of Deposit (CD) is to speculate in junk bonds or in a casino called the stock market is unsafe for anybody, including the boys and girls and trading robots on Wall Street. It shows how far off the deep end we are, with a central bank-dominated, warped financial market.
TGR: Talking about savers brings Cyprus to mind. Could Cyprus be a catalyst for similar actions elsewhere?
DS: Cyprus is symptomatic of the global problem of financial bubbles and debt created by central banks over several decades. The haircut being given to uninsured savers is just a symptom. The problem is Cyprus itself.
Cyprus is a tiny island with a small economy—$20B/year—mostly generated by the banking system and travel activity related to banking. Cyprus had $120B of deposits in a $20B economy. In the U.S., we have $7T of bank deposits in a $15T economy.
Cyprus was an accident waiting to happen. Gullible people put their savings in banks, believing in a guarantee the government could not possibly honor. These freakishly enlarged banks would never have happened but for the fact that Cyprus is in the European Union and became a money-laundering center for Russian and other flight capital where investors thought the banking system was backed-up by the European Central Bank (ECB). That is a case of rampant moral hazard—the disease which afflicts much of the world banking system, and especially Europe where England, France and many others have banking systems with balance sheet footing equal to 4–5x GDP. That’s nuts.
So Cyprus is not atypical. The entire banking system is bloated by money creation, by the private and public debt that goes far beyond the income-earning capacity of the underlying economies. About 18 months ago the Cypriot banks passed their EU stress tests with flying colors. Now, its biggest bank, 80% owned by the state, is being liquidated, thousands of jobs will disappear and people will take huge losses on their bank accounts. None of this was on the radar screen a few months ago.
TGR: Was the trigger in Cyprus the bad call on the Greek bonds?
DS: No, the trigger was the imbalance. Cyprus has $50B of deposits below the $100,000 ceiling guaranteed by the government. The Cyprus gross domestic product (GDP) is $20B; the government’s share of that is a few billion. The Cypriot government could never have made good on those deposit guarantees. It was a scam from day one, and it built up a house of cards.
Whether those banks invested wisely or not—and they did not—they were paying yields way above anything sensible. If Cyprus were not in the EU, if Cyprus had not been perceived as having the backing of the ECB, it could never have built up $120B worth of deposits.
TGR: How can investors protect themselves from bubbles like this bursting?
DS: Fundamentally, investors should not believe the mainstream propaganda. Do not believe that Fed Chairman Ben Bernanke and the rest of the Fed know what they are doing. They are making it up as they go along. And they keep getting it wrong.
People are frustrated and may be even getting angry because they know better than to jump back into the frying pan. We are just north of 1560 on the S&P 500 for the third time since early 2000. Yet this third bubble will burst too because the Main Street economy is failing. We lost 6 million full-time breadwinner jobs in the Great Recession and have only recovered 15%—the headline jobs numbers being reported are mostly part-time work at bars and restaurants. Yet the stock market has recovered 110% of its losses during the same period.
The Fed’s money printing does nothing except crush Main Street savers on a cross of ZIRP (zero interest) while fueling the Wall Street carry traders and speculators with the cheapest money ever invented by a central bank. Therefore, the markets are a dangerous place because the speculation will reach a crescendo and then crash just as it did the last two times. All real people can do right now is stay liquid and not fall for the propaganda of convenience from the Wall Street houses that want to sell you anything they can and scalp a margin off of you whenever possible, as well as from the politicians and the Keynesians in Washington.
TGR: What do you call this most recent bubble?
DS: We ought to call it the Bernanke Bubble. In 2012, more junk bonds and high-yield bonds and loans were issued than ever before. This is the fourth time the high-yield bond market has been inflated since 1991. People jump into bond funds because they are earning nothing on their CDs and they see that bond funds have been doing well. This cycle of crashes and recoveries is sapping the economy. Very little new capital is being raised; in fact, all the financial engineering through stock buybacks and buyouts is just shrinking the equity base and cycling cash to the fast money traders at the top of the hedge fund heap. Very little debt is being used to fund long-term capital projects.
TGR: The end of your book proposes the end of free markets and democracy. Has the free market already ended?
DS: The financial markets no longer resemble a market. Having the short-term interest rate administered by the Fed does not represent supply-and-demand of short-term funds in the money markets, commercial paper market or in the short-term deposit market. The Fed manipulates the yield curve by buying 5- and 7-year bonds, trying to force the belly of the curve down.
If you do not have an honest price for money—which is what the interest rate is for middle- and long-term money—you cannot have a market in the financial system. How can you have capitalism if the financial markets have been destroyed? Interest rates mean nothing. Everything trades on expectations and anticipations about what the Fed will do next. That is not relevant to an honest market that is pricing risk, cash flows and the legal structure of securities accurately. The free market is dead, demolished by the bloated financial system that has been created over decades by a rogue central bank.
TGR: Spoiler alert: In the last chapter of your book, you outline some dramatic steps that would make a free market function again: abolishing deposit insurance, minimum wage, Medicare, Federal Reserve regional banks, the departments of Energy, Education, Homeland Security and Transportation. You propose a 30% wealth tax and paying down the national debt to 30% of GDP. How would Contrarian Investors protect themselves in such a transition?
DS: They could not. I lay out these radical schemes because they are defensible and they provide a measure of how far away we are today from sustainable policies.
As long as policies allow the Fed to micromanage the to-and-fro of the economy, to engage in open-market operations and bond buying, we will never get out of this trap. I would abolish the Federal Open Market Committee and return to the original scheme of the Fed, which was to function as a standby agent to liquefy the commercial banking system based on good collateral on inventory and receivables and to make these loans at a penalty spread above the floating free market rate—that is, let supply and demand for savings and borrowings drive the financial market. That is 180 degrees from the central planning and total domination of the economy by the Federal Open Market Committee today.
We need a constitutional amendment requiring a balanced budget. Plenty of “green eyeshades,” who specialize in the fiscal business as I did, say that is unrealistic and too rigid. But Washington will never break its deficit habit without the imposition of a constitutional fiscal chastity belt.
TGR: Change seems unlikely given partisan political conflicts, so how will this unravel?
DS: We are in uncharted waters. If you look at the momentum built into the federal deficit and use realistic numbers, we will have more than $20T in national debt in a year or two. The GDP is growing at 3–4% in nominal terms, which means sometime in the early 2020s we will be at a 150% debt-to-GDP ratio. That is catastrophic.
The timing is very difficult to specify, but the whole system will unwind. There will be an explosion, dislocation and panic in the world’s financial markets that will make 2008 look like a Sunday-school picnic. The central banks will not be able to control it.
Look at the pathetic efforts of the ECB and the International Monetary Fund trying to deal with Cyprus and its $20B economy. If they cannot deal with Cyprus, what will they do when the banking systems of Spain, Italy and even France, come under pressure? All of these banking systems are stuck with massive amounts of government debt and lack a stable depositor base. They are oversized compared to the sustainable GDP and income of these countries.
TGR: As the baby boomers retire, should they have faith in Social Security and Medicare being there or should they resolve themselves to their disappearance?
DS: They should realize there will be a struggle year in and year out to keep Medicare and Social Security solvent. In 2000, 81 million (81M) Americans over the age of 16 were retired, unemployed, on disability or otherwise not working. Today, there are 101M; 25% growth in 12 years. I calculate that by 2020, there will be 113–114M adults not working.
Yes, some of them will be old and retired, but there will be nearly as many people in the adult population not working as holding jobs. We have only 133M nonfarm payroll jobs in the U.S. economy today. We may be able to increase that to 140M.
It is an impossible equation. Taxes will have to be pushed up. The working-age population will resist and revolt. There will be enormous political conflict and dysfunction. And every year, some of the retired population will find their benefits cut back, in jeopardy or under debate.
I blame the baby boomers who were lured into not saving by low interest rates set by the Fed after 1980. The great middle class stopped saving because they thought they could do it the easy way by huge, bubble-era gains in the value of their homes and in the stock market. Of course, both of those are pipe dreams.
TGR: How are you protecting yourself?
DS: The same thing I have said before: by investing in anything Bernanke cannot destroy, Bernanke standing for the Federal Reserve, for a state that wants to undermine the financial system.
Gold Is A Good Investment over time because sooner or later people will lose confidence in the money-printing central banks of the world. In the long run, the fiat monies will lose their value. In the short run, the only thing you can do is stay liquid, stay out of risky asset markets and try to preserve your wealth. It will be impossible to increase your wealth in the next decade; everything is going to come down.
TGR: Do you see the U.S. or the world returning to gold-backed printing?
DS: That is what we all might devoutly hope for. That is where we were in 1914, when Europe blew it up in the First World War. In the 1920s, there was a futile effort to recreate an open, free trading system with a single gold-backed money that was convertible into all the national currencies at a fixed rate. But England botched the effort by trying to go back on the cheap in the form of the sterling-based gold exchange system, which was just a back-door way for the busted British economy to borrow money from its neighbors and kick the can of financial discipline down the road. That ended in disaster when England defaulted on its obligation to redeem sterling into gold—almost exactly as Nixon did 40 years later with gold and the dollar.
The British perfidy led to the Great Depression and the rise of Keynesian economics. That led to Nixon closing the gold window and then to the appointment of Greenspan as Fed chairman. That led to the idea that everybody can get wealthier by goosing the stock market. When the stock market and people’s paper net worth are going up, the idea is that they should spend to make the economy better. All of that is false economics. It defies the wisdom of the ages.
Can we ever get back to honest money, a gold dollar? I am not sure how to do it, but maybe when the big crash comes, people will see that we need to go back to where we were a long time ago.
TGR: David, thank you for your time and your insights, and good luck with the book.
David Stockman is a former U.S. politician and businessman, serving as a Republican U.S. Representative from the state of Michigan 1977–1981 and as the director of the Office of Management and Budget under President Ronald Reagan 1981–1985. He is the author of “The Triumph of Politics: Why Reagan’s Revolution Failed” and “The Great Deformation: The Corruption of Capitalism in America.”
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