The Truman Show of Bubble Finance, 1987-2014, RIP

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The above caption was Chapter 27 of my year-ago book entitled The Great Deformation: The Corruption of Capitalism In America”. So I was glad to see this illuminating metaphor given some traction last week by Seth Klarman. The latter is proprietor of the $27 billion Baupost Fund and can fairly be described as one of the greatest hedge fund managers ever. He is also so eminently sensible that he recently returned several billions to his investors—owing to a dearth of reasonable investment opportunities.

Seth pulled no punches explaining why he is not drinking the Kool-Aid:

All the Trumans – the economists, fund managers, traders, market pundits –know at some level that the environment in which they operate is not what it seems on the surface…. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end.

Klarman is here referring to the waning days of this third and greatest financial bubble of this century. But my take is that the crack-up boom now nearing its dénouement marks not merely the season finale of still another Fed-induced cycle of financial asset inflation, but, in fact, portends the demise of an entire era of bubble finance.

The latter has had a long gestation—arguably reaching back 100 years. The Great War of 1914-1918 did supplant the stern financial discipline of the market-driven international gold standard with the backstops, bailouts and moral hazards of central bank managed money; the 1930s did install activist state management of national economies almost everywhere, with its systemic bias toward ever higher public and private debt ratios against current income; the “guns and butter” fiscal excesses of Lyndon Johnson did unhorse the William McChesney Martin style of sound money rectitude at the Fed and planted a torpedo in the side of the imperfect but serviceable Bretton Woods system of global monetary order; and Richard Nixon did finish it off with his perfidious doings at Camp David in August 1971.

Indeed, the days of honest capital markets were numbered by Tricky Dick’s proclamation that the richest nation on the planet would default on its obligation to pay its international debts in gold. On the surface, this body blow to global financial stability and discipline was done simply for the sake of avoiding a recession before November 1972—even if a decade-long boom of war spending and external borrowing had made a day of economic reckoning unavoidable.

But the real significance was that Nixon’s Camp David perfidy officially installed Milton Friedman’s Folly at the heart of the financial system. The presumption now was that a 12-member monetary politburo in the Eccles building could perfectly manage the money supply and thereby eliminate the business cycle, optimize the growth of GDP, jobs and living standards and enable market capitalism to prosper all the better.

Arthur Burns soon demonstrated that even flinty conservatives could not resist the temptation to “improve” short-run macroeconomic performance by gunning the Fed’s now unshackled printing presses–especially under the duress of ruthless bullies like Richard Nixon. To be sure, the resulting Great Inflation of the 1970s sharply reduced real economic growth, destroyed savings and habits of thrift and unleashed a global tide of inflationary speculation in oil and commodities.

So these untoward developments should have been a flashing red warning sign. Contrary to professor Friedman’s fathomless political naiveté, Washington was not about to populate the Fed’s open market committee with monetary eunuchs who would spend their days playing scrabble and reading book reviews— breaking only occasionally to adjust the monetary dials and thereby keep M1 on the professor’s stipulated eternal path of 3% growth.

Ironically, however, rather than discrediting statist economic management, the opening failures of fiat central banking spurred even more misbegotten projects and interventions. The 1970s bipartisan folly of wage and price controls, the massive Nixon-Ford-Carter boondoggles and regulatory interventions designed to achieve “energy independence” and endless tax and spending schemes to revive economic growth and spur jobs creation were its legacy.

Even Paul Volcker’s resolute and decisive actions to crush double-digit CPI inflation were soon badly misinterpreted by both Washington and Wall Street. Volcker’s heroic stand had been a desperate necessity occasioned by the wholly unnecessary  post-Camp David Fed, but it eventually became a totem to the cult of central banking.

In fact, the outbreak of runaway inflation, which saw the CPI rise by 200 percent between 1967 and 1981, had been a shocking departure from all prior peacetime experience. Under the sound money regime of William McChesney Martin prior to that, annual inflation had been corseted in a 1-2 percent annual range, and couldn’t have broken out beyond that under a disciplined monetary regime like Bretton Woods.

So after Volcker, central bankers could take fulsome credit for “taming” CPI inflation when, in fact, they barely returned it to the pre-Camp David status quo ante.  Alan Greenspan was the great pretender on this score.  Under what became celebrated as his Maestro Act, he claimed to be deftly managing a booming stock market, robust economic growth and disinflation all at the same time.

In fact, CPI inflation during Greenspan’s 19-year reign averaged 2.7% annually—a rate of gain that was the worst peacetime record of any Fed Chairman before Camp David and which, in any event, would have destroyed nearly 60% of laboring man’s savings over a 30-year working lifetime.

In truth, even the modest CPI disinflation that did occur on the Greenspan watch was a bastard step-child of relentless, unprecedented monetary inflation. During the 19-years after 1987 the Fed’s balance sheet rose more than three-fold—from $275 billion to nearly $900 billion. Yet after it had been unhinged by Burns and the hapless William Miller and had saturated the domestic banking system with massively excessive reserves, the Fed’s balance sheet needed to barely grow at all in order to preserve Volcker’s victories.

By the 1990s, however, the global economy had become populated by exactly the kind of currency-pegging mercantilist exporters that Friedman’s floating money inexorably spawned. The good libertarian professor actually dreamed that the “free market” would determine exchange rates when self-evidently his unanchored money gave rise to ”dirty floats” everywhere and increasingly aggressive statist management and manipulation of national monies—especially among the export economies of East Asia and the hydrocarbon economies of the Persian Gulf.

In short, the Maestro’s profligate outpouring of dollar liabilities did not cause CPI inflation domestically because the American economy is not a closed-system, nor does it conform to the implicit Keynesian model of the GDP as a giant economic bathtub. Instead, the outpouring of Greenspan’s printing press dollars streamed into the global economy where a convoy of currency-pegging EM central banks–led by the Peoples Printing Press of China—bought them up hand-over-fist and sequestered them in their official reserve stashes, thereby flooding their own economies with even more prodigious outpourings of RMB, won, ringgit, rupiah, Taiwan dollars and riyal.

The resulting vast and sustained, albeit artificial, stimulus to domestic demand did cause the rice paddies to be drained of cheap labor; did generate a massive expansion of export factories in east Asia; did fuel stupendous booms in alumina, copper, nickel, iron and coal mining in North China, Australia, Brazil, Russia, much of Africa and even Appalachia; and did ignite a ship-building frenzy—especially in giant dry-bulk carriers—- in the great yards of China and Korea. In all, it was a powerful but unsustainable disinflationary force.

During the quarter century after Greenspan’s panicked bailout of Wall Street in the October 1987 stock market crash, the global monetary and investment boom triggered by the mad money printers in the Eccles Building kept labor inflation flat on its back and price gains for manufactured goods in world trade at virtually zero year-in and year-out. But that did not reflect central banking virtuosity; it was an unprecedented one-time monetary boom that sucked all available under-utilized labor into the world economy and facilitated monumental investment booms from Shanghai to Dubai, Istanbul and Belo Horizonte.

Meanwhile, the inflation of financial assets has proceeded at a staggering pace—-partially reflecting the growth of hothouse economies worldwide and partially the expansion of valuation multiples to historic extremes.  Overall, the Fed’s balance sheet has grown from $300 billion in 1987 to $4.3 trillion at present—a gain of 14X. Likewise, the NASDAQ index is up 11X since the Greenspan era of bubble finance incepted and the S&P is up 8X.

By contrast, Greenspan inherited a nominal GDP of $5 trillion. Despite a 120 percent increase in consumer prices since then, it is only $17 trillion today—a gain of just 3.4X.  More pertinently, real GDP is up just 0.97X despite a substantial increase in the working age population. And today’s real median household income of $51,000 is essentially unchanged since Greenspan’s swearing-in ceremony—-an occasion when, unlike his first oath-taking as CEA chairman, he was visibly not accompanied by Ayn Rand.

In short, the Fed has become a serial bubble machine leading a convoy of global central banks engaged in the same untoward craft. Self-evidently, 25 years of this have fully corrupted money markets and capital markets; there is no longer anything that passes for honest price discovery–only an endless high velocity churning of financial assets in response to the word clouds and liquidity injections emanating from the central bank.

And the chart pattern is now also abundantly clear: with each new bubble cycle, the Wall Street gamblers buy the dips relentlessly, indefatigably  and insouciantly until the inflation becomes so extreme that a random event or black swan finally unnerves the last bid in the casino. Then the house of cards comes crashing down. Yet the gamblers on the Truman Show never seem to see it coming because as Seth Klarman observes life in the bubble is too resplendent and the mood too euphoric.

But there is also a larger factor at work. There is no policy debate or challenge to the bubble machine in the Eccles Building because both parties have embraced the doctrines of bubble finance. For the GOP this is especially convenient because it enables Republican politicians to bloviate endlessly against an abstraction called Big Government, while embracing the rank statism of massive monetary inflation and endless bailouts and puts for the Wall Street gamblers who fund their continuing grasp on political power in the beltway.

In the case of progressive Democrats, the betrayal is even more insidious. Hooked on the non-sensical Keynesian doctrine that borrowing is good and saving is bad, the so-called progressives have been a sucker for the Fed’s regime of lower interest rates, forever longer. That this regime leads to financial repression and preposterously low  “cap rates” throughout financial markets seems to escape their grasp entirely; and that rock-bottom cap rates cause drastic over-valuation of financial assets and massive windfalls to the capital owning speculative classes—does not even remotely register.

By the 2012 election this bipartisan farce had reached an extreme. Obama ran against the 1% even though the Fed, now packed with money printers he had appointed, showered the upper strata with the greatest unearned windfall in recorded history. Worse still, his opponent was a certified member of the 1%—yet didn’t have a clue as to how he got there.

While Klarman is correct that there are many Trumans in the great show of bubble finance now nearing its apotheosis, Mitt Romney was surely Jim Carrey himself. He claimed that a lifetime of LBO gambling had taught him the secrets of economic growth and endowed him the wherewithal to be a “job creator”.

Worse still, his leading economic advisor had claimed that the Fed’s disastrous housing bubble had been a splendid exercise in prosperity management and that Bernanke had done a virtuoso job bailing out the Wall Street gamblers after their toxic waste factories collapsed in the dying days of the housing disaster.

In my chapter on the Truman Show, I had further developed the notion that Romney’s candidacy marked the final defeat for any traditional notions of sound money and financial rectitude. Below are some excerpts from the Great Deformation that demonstrate that it is not only Klarman’s economists, fund managers, traders and market pundits who are in the Truman Show of bubble finance, but the entirety of the political system, too.

Had the Gipper been asked in 2012 about stopping the reign of the mad money printers, he might have replied:  if not us, whom? If not now, when?  As shown below, Romney did not even understand the question.

Excerpts from chapter 27 of the Great Deformation: The Corruption of Capitalism in America:

Candidate Mitt Romney’s whiff on the looming fiscal crisis, however, was just a warm up. Even more consequential was his complete failure to grasp that free market capitalism was failing in America because it had been fatally corrupted by two decades of Wall Street coddling by the Fed and nearly four decades of worldwide floating money and central bank monetary inflation. To be sure, he had called for Bernanke’s replacement during the primary campaign in order, apparently, to parry Governor Rick Perry’s fusillade in the direction of the Eccles Building.

But Romney’s choice of his top economic advisor was proof that he was dream-walking in the great financial bubble that had been fostered by the nation’s central bankers. According to the headline of a New York Times profile, the candidate’s “Go-To-Economist” and author of the campaign’s official economic platform was one R. Glenn Hubbard, dean of the Columbia Business School, and George W. Bush’s chief economic advisor and architect of the 2001–2003 “Bush tax cuts.” Not surprisingly, Hubbard was of the opinion that the Wall Street–coddling policies of the Greenspan- Bernanke era had been a roaring success. He suggested that Romney should consider keeping Bernanke on board because he had been a “model technocrat” who was owed a “pat on the back.”

As indicated earlier, the single most noxious deformation of bubble finance had been the $5 trillion MEW spree of the nation’s household sector. It had been the proximate source of the consumption binge that left American families buried in mortgage debt and the residential housing industry in smoldering ruins.

Yet Hubbard had been an unabashed proponent of MEW. Near the very top of the housing bubble and after gross mortgage financings had hit the freakish level of $5.3 trillion, or 40 percent of GDP, in the spring of 2003, Hubbard opined that the “revolution in housing finance” which had led to “large increases in mortgage equity withdrawal” had been a salutary development; it was “one reason why consumer spending held up well” during his tenure as chairman of the White House Council of Economic Advisers (CEA).

This is pure Keynesian blather, but Hubbard was not yet done. In an article co-authored in late 2004 with William Dudley, who was then chief economist at Goldman and is now Bernanke’s right-hand money printer as president of the New York Fed, he averred that due to the Fed’s unleashing of the Wall Street casino there had been a “dramatic decline in the cyclical volatility of housing.”

Say again! It is not surprising that Hubbard did not see the most violent collapse of housing in American history looming just around the corner: he was a full-fledged proponent of bubble finance. Accordingly, Hubbard and Dudley had found “100 percent financing to purchase a home” to be a key contributor to the great prosperity purportedly under way at the time. An exasperated blogger rightly tagged this as “the mortgage bankers’ equivalent of ‘The Anarchist Cookbook’—a recipe for disaster.”

Cookbook in hand, however, Hubbard kept candidate Romney firmly planted in the Wall Street–Fed consensus. Consequently, voters did not hear a word about the true menace stalking the land; namely, that their livelihoods, future prospects, and efficacy as citizens of American democracy were under relentless assault from the monetary politburo which inhabits the Eccles Building.

Here was a chance, in the first election after the dust had settled from the Bernanke-Paulson-instigated BlackBerry Panic, to call out the real source of what Romney appropriately called the “failing” American economy. Romney could have blasted financial repression as a gift to Wall Street speculators that undermined honest capital markets, crushed Main Street savers, battered low-and middle-income families with soaring food and energy costs, and enabled the nation to live far beyond it means while putting it in hock to the rest of the world by $8 trillion.

Instead, Romney-Ryan blamed it all on Obama, notwithstanding the inescapable facts—obvious to the overwhelming share of voters—that the terrifying meltdown on Wall Street and the associated sharp plunge of the American economy had occurred on the Republican watch of George W. Bush. So by their silence on the Fed and their defense of failed free lunch fiscal policies, the Romney-Ryan ticket failed to give the electorate a creditable reason to abandon an incumbent who drank his Keynesian Kool-Aid straight up.

Historians may someday wonder how the conservative party failed so badly when the very future of free market capitalism and fiscal solvency were at stake. The short answer would be that after three decades the entire party had become lost in the false world of bubble finance. In that regard, a considerable share of blame could be assigned to the GOP’s final rash of crypto-Keynesian economic advisors like Hubbard and his successor, Greg Mankiw of Harvard, or Ed Lazear of Stanford. As Bush’s last CEA chairman, Lazear had insisted in May 2008 that “the data are pretty clear that we are not in a recession.”

Needless to say, when the Wall Street meltdown struck with cyclonic force a few months later Lazear did not have the foggiest notion of why it happened. He just rolled over and watched Bernanke and Paulson stampede Washington into the BlackBerry Panic. But ultimately the GOP is the party of businessmen and financiers, and it was they who in Jim Carrey–like fashion had spent decades in a great and artificial financial bubble, the economic equivalent of The Truman Show.

Accordingly, they did not know why Wall Street collapsed in September 2008 and didn’t recognize that the American economy was dangerously leveraged at 3.6X national income. And most especially they did not perceive  that the violent booms and busts on Wall Street had been the handiwork of a destructive régime of monetary central planning.

So failing to comprehend the crumbling world outside the bubble, they embraced a content-free revival of Reaganite rhetoric that was a veritable caricature of what Republican governments have actually done. They decried excessive regulation when economic regulation had peaked in the 1970s and had been rolled back ever since. In fact, the only thing of material import which had happened on the regulatory front since the Gipper’s time had been the disastrous “deregulation” of banks—- licensed wards of the state which had never been free enterprises in the first place.

Republican governments of the Bush era had also brought federal spending to the highest share of GDP since WWII and turned the small surpluses of the Clinton period into a raging torrent of red ink. Self-evidently, after the mad-cap tax cutting of the Bush period the federal tax burden had been reduced to the lowest level in fifty years.

In short, the Republican mantra that the nation was overtaxed and overregulated was utterly disconnected from the economic facts, as were its tirades against the deficit. Willard M. Romney did not see this, and for a compelling reason: he was the Jim Carrey of bubble finance. He had made a fortune during a twenty-year career in the studio, riding the wave machines of debt and leveraged speculation enabled and powered up by the Fed. Not surprisingly, Romney mistook the windfall riches garnered in the great hall of bubble finance for the fruits of honest enterprise on the free market, and was therefore blind to the profound monetary and financial disorders of the American economy.

Accordingly, his presidential campaign readily adopted the content-free Reaganite rhetoric against taxes, Big Government, regulation, and deficits. As Romney saw it, there was nothing wrong with the nation’s economy which couldn’t be fixed by a can-do businessman in the Oval Office who knew what it takes to rejuvenate the “job creators,” impose fiscal discipline, and unleash the capitalist energies.

In truth, this was pure political pettifoggery that would fix nothing, but it did underscore why Romney’s successful sojourn in the financial bubble had made him uniquely unfit to be the GOP standard-bearer. He had been a big winner because the state and its central banking branch had failed miserably.

What was needed was not the unleashing of the battered and impaired remnants of free market capitalism, but a drastic throttling of the state’s engines of false prosperity; that is, an end to the madness of the Fed’s financial repression and rampage of bond buying coupled with the imposition of taxes on the electorate for every dollar of federal spending that the legislature was unwilling to cut.

A return to sound money policies, of course, would bring ruin to the 1 percent, and years of painful austerity to Main Street. Needless to say, the masses would not have cottoned to such a program, especially if championed by one of the baby boom’s biggest lottery winners. More importantly, Wall Street would have gagged and muffled their candidate before he could make a single utterance about cleaning house in the Eccles Building or taxing capital gains at the same rate as wage earners.

In fact, keeping the candidate safely enveloped in a fog of Reaganite rhetoric was exactly what Wall Street–oriented advisors like H. Glenn Hubbard excelled at. After all, the enterprising Professor Hubbard had been paid to investigate the operations of Countrywide Financial, for example, and found them laudatory. So it was plain that he could be counted on to keep the campaign looking with favor on gutting the Volcker Rule, keeping the giant Wall Street banks free from the threat of dismantlement, and em- powering the monetary central planners to keep the juices flowing from the Eccles Building.

headshotAs seen in earlier chapters, bubble finance created a vast arena of financial engineering in which debt-fueled buyouts, buybacks, and M&A takeovers systematically channeled wealth and income to the very top of the economic ladder. But these windfalls did not foster capitalist growth and wealth creation on the free market; they simply extracted unearned rents from the Wall Street casino, and it was in the leveraged buyout business —where Romney made his fortune—that the most spectacular cases of this capture occurred.

So when all was said and done, Willard “Mitt” Romney was a creature of the great deformation of finance that had been unleashed by the administration in which his father had served as secretary of HUD. History has left few clues about what George Romney thought about Nixon’s final destruction of the gold dollar, but his son’s business history documents in spades how Nixon’s actions eventually destroyed the free market in finance and fostered an unsustainable era of debt-fueled GDP growth and speculation- driven accumulation of wealth by the 1 percent.

That Mitt Romney turned out to be the conservative party’s candidate for president in 2012 is ironic in the extreme. As detailed below, Romney’s winnings from bubble finance during his years at Bain Capital were so preposterously impossible in an honest free market that it is no wonder that his 2012 campaign amounted to one giant platitude. He honestly thought his experience doing leveraged buyouts could show the way forward to ameliorate the nation’s economic ills. In fact, Romney had been an energetic agent of the very financialization process that had generated the economic failures against which he campaigned.

Reprinted with permission from David Stockman.

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