The median U.S. household income in 2012 was $51,000, but that’s nothing to crow about. That same figure was first reached way back in 1989— meaning that the living standard of Main Street America has gone nowhere for the last quarter century. Since there was no prior span in U.S. history when real household incomes remained dead-in-the-water for 25 years, it cannot be gainsaid that the great American prosperity machine has stalled out.

Even worse, the bottom of the socio-economic ladder has actually slipped lower and, by some measures, significantly so. The current poverty rate of 15 percent was only 12.8 percent back in 1989; there are now 48 million people on food stamps compared to 18 million then; and more than 16 million children lived in poverty households last year or one-third more than a quarter century back.

Likewise, last year the bottom quintile of households struggled to make ends meet on $11,500 annually —-a level 20 percent lower than the $14,000 of constant dollar income the bottom 20 million households had available on average twenty-five years ago. 

Then, again, not all of the vectors have pointed south. Back in 1989 the Dow-Jones index was at 3,000, and by 2012 it was up five-fold to 15,000.  Likewise, the aggregate wealth of the Forbes 400 clocked in at $300 billion back then, and now stands at more than $2 trillion—a gain of 7X.

 And the big gains were not just limited to the 400 billionaires. We have had a share the wealth movement of sorts— at least among the top rungs of the ladder. By contrast to the plight of the lower ranks, there has been nothing dead-in-the-water about the incomes of the 5 million U.S. households which comprise the top five percent. They enjoyed an average income of $320,000 last year, representing a sprightly 33 percent gain from the $240,000 inflation-adjusted level of 1989.

The same top tier of households had combined net worth of about $10 trillion back at the end of Ronald Reagan’s second term.  And by the beginning of Barack Obama’s second term that had grown to $50 trillion, meaning that just the $40 trillion gain among the very top 5 percent rung is nearly double the entire current net worth of the remaining 95 percent of American households.

So, no, Sean Hannity need not have fretted about the alleged left-wing disciple of Saul Alinsky and Bill Ayers who ascended to the oval office in early 2009. During Obama’s initial four years, in fact, 95 percent of the entire gain in household income in America was captured by the top 1 percent.

Some other things were rising smartly during the last quarter century, too. The Pentagon budget was $450 billion in today’s dollars during the year in which the Berlin Wall came tumbling down.

Now we have no industrial state enemies left on the planet: Russia has become a kleptocracy led by a thief who prefers stealing from his own people rather than his neighbors; and China, as the Sneakers and Apple factory of the world, would collapse into economic chaos almost instantly—if it were actually foolish enough to bomb its 4,000 Wal-Mart outlets in America.

Still, facing no serious military threat to the homeland, the defense budget has risen to $650 billion—-that is, it has ballooned by more than 40 percent in constant dollars since the Cold War ended 25 year ago. Washington obviously didn’t get the memo, nor did the Harvard “peace” candidate elected in 2008, who promptly re-hired the Bush national security team and then beat his mandate for plough shares into an even mightier sword than the one bequeathed him by the statesman from Yale he replaced.

Banks have been heading skyward, as well.  The top six Wall Street banks in 1989 had combined balance sheet footings of $0.6 trillion, representing 30 percent of the industry total. Today their combined asset footings are 17 times larger, amounting to $10 trillion and account for 65 percent of the industry.

The fact that the big banks led by JPMorgan and Bank of America have been assessed the incredible sum of $100 billion in fines, settlements and penalties since the 2008 financial crisis suggests that in bulking up their girth they have hardly become any more safe, sound or stable.

Then there’s the Washington DC metropolitan area where a rising tide did indeed lift a lot of boats.Whereas the nationwide real median income, as we have seen, has been stagnant for two-and-one-half decades, the DC metro area’s median income actually surged from $48,000 to $66,000 during that same interval or by nearly 40 percent in constant dollars.

Finally, we have the leading growth category among all others—-namely, debt and the cheap central bank money that enables it. Notwithstanding the eight years of giant Reagan deficits, the national debt was just $3 trillion or 35 percent of GDP in 1989. Today, of course, it is $17 trillion, where it weighs in at 105 percent of GDP and is gaining heft more rapidly than Jonah Hill prepping for a Hollywood casting call.

Likewise, total US credit market debt—including that of households, business, financial institutions and government— was $13 trillion or 2.3X national income in 1989. Even back then the national leverage ratio had already reached a new historic record, exceeding the World War II peak of 2.0X national income.

Nevertheless, since 1989 total US credit market debt has simply gone parabolic. Today it is nearly $58 trillion or 3.6X GDP and represents a leverage ratio far above the historic trend line of 1.6X national income—a level that held for most of the century prior to 1980.  In fact, owing to the madness of our rolling national LBO over the last quarter century, the American economy is now lugging a financial albatross which amounts to two extra turns of debt or about $30 trillion.

In due course we will identify the major villainous forces behind these lamentable trends, but note this in passing: The Federal Reserve was created in 1913, and during its first 73 years it grew its balance sheet in turtle-like fashion at a few billion dollars a year, reaching $250 billion by 1987—at which time Alan Greenspan, the lapsed gold bug disciple of Ayn Rand, took over the Fed and chanced to discover the printing press in the basement of the Eccles Building.

Alas, the Fed’s balance sheet is now nearly $4 trillion, meaning that it exploded by sixteen hundred percent in the last 25 years, and is currently emitting $4 billion of make-believe money each and every business day.

So we can summarize the last quarter century thus: What has been growing is the wealth of the rich, the remit of the state, the girth of Wall Street, the debt burden of the people, the prosperity of the beltway and the sway of the three great branches of government which are domiciled there—that is, the warfare state, the welfare state and the central bank.

What is flailing, by contrast, is the vast expanse of the Main Street economy where the great majority has experienced stagnant living standards, rising job insecurity, failure to accumulate any material savings, rapidly approaching old age and the certainty of a Hobbesian future where, inexorably, taxes will rise and social benefits will be cut.

 And what is positively falling is the lower ranks of society whose prospects for jobs, income and a decent living standard have been steadily darkening.

I call this condition “Sundown in America”.  It marks the arrival of a dystopic “new normal” where historic notions of perpetual progress and robust economic growth no longer pertain. Even more crucially, these baleful realities are being dangerously obfuscated by the ideological nostrums of both Left and Right.

Contrary to their respective talking points, what needs fixing is not the remnants of our private capitalist economy —which both parties propose to artificially goose, stimulate, incentivize and otherwise levitate by means of one or another beltway originated policy interventions.

Instead, what is failing is the American state itself—-a floundering leviathan which has been given one assignment after another over the past eight decades to manage the business cycle, even out the regions, roll out a giant social insurance blanket, end poverty, save the cities, house the nation, flood higher education with hundreds of billions, massively subsidize medical care, prop-up old industries like wheat and the merchant marine, foster new ones like wind turbines and electric cars, and most especially, police the world and bring the blessings of Coca-Cola, the ballot box and satellite TV to the backward peoples of the earth.

In the fullness of time, therefore, the Federal government has become corpulent and distended—a Savior State which can no longer save the economy and society because it has fallen victim to its own inherent shortcomings and inefficacies.

Taking on too many functions and missions, it has become paralyzed by political conflict and decision overload. Swamped with insatiable demand on the public purse and deepening taxpayer resistance, it has become unable to maintain even a semblance of balance between its income and outgo.

Exposed to constant raids by powerful organized lobby groups, it has lost all pretenses that the public interest is distinguishable from private looting. Indeed, the fact that Goldman Sachs got a $1.5 billion tax break to subsidize its new headquarters in the New Year’s eve fiscal cliff bill— legislation allegedly to save the middle class from tax hikes— is just the most recent striking albeit odorous case.

Now the American state—-the agency which was supposed to save capitalism from its inherent flaws and imperfections—-careens wildly into dysfunction and incoherence. One week Washington proposes to bomb a nation that can’t possibly harm us and the next week it floods Wall Street speculators, who can’t possibly help us, with continued flows of maniacal monetary stimulus.

Meanwhile, the White House pompously eschews the first responsibility of government—that is, to make an honest budget, which is the essence of what the Tea Party is demanding in return for yet another debilitating increase in the national debt.

To be sure, the mainstream press is pleased to dismiss this latest outburst of fiscal mayhem as evidence of partisan irresponsibility—that is, a dearth of “statesmanship” which presumably could be cured by stiffer backbones and greater enlightenment.  Well, to use a phrase I learned from Daniel Patrick Moynihan during my school days here, “would that it were”.

What is really happening is that Washington’s machinery of national governance is literally melting down. It is the victim of 80 years of Keynesian error—much of it nurtured in the environs of Harvard Yard—- about the nature of the business cycle and the capacity of the state—especially its central banking branch— to ameliorate the alleged imperfections of free market capitalism.

As to the proof, we need look no further than last week’s unaccountable decision by the Fed to keep Wall Street on its monetary heroin addiction by continuing to purchase $85 billion per month of government and GSE debt.

Never mind that the first $2.5 trillion of QE has done virtually nothing for jobs and the Main Street economy or that we are now in month number 51 of the current economic recovery— a milestone that approximates the average total duration of all ten business cycle expansions since 1950. So why does the Fed have the stimulus accelerator pressed to the floor board when the business cycle is already so long in the tooth—-and when it is evident that the problem is structural, not cyclical?

The answer is captured, clients, that is, it is doing the bidding of Wall Street and the vast machinery of hedge funds and speculation that have built up during decades of cheap money and financial market coddling by the Greenspan and Bernanke regimes.  The truth is that the monetary politburo of 12 men and women holed up in the Eccles Building is terrified that Wall Street will have a hissy fit if it tapers its daily injections of dope.

So we now have the spectacle of the state’s central banking branch blindly adhering to a policy that has but one principal effect: namely, the massive and continuous transfer of income and wealth from the middle and lower ranks of American society to the 1 percent.

The great hedge fund industry founder and legendary trader who broke the Bank of England in 1992, Stanley Druckenmiller, summed-up the case succinctly after Bernanke’s abject capitulation last week. “I love this stuff”, he said, “…. (Its) fantastic for every rich person. It’s the biggest redistribution of wealth from the poor and middle classes to the rich ever”.

Indeed, a zero Federal funds rate and a rigged market for short-term repo finance is the mother’s milk of the carry trade: speculators can buy anything with a yield—-such as treasurie notes, Fannie Mae MBS, Turkish debt, junk bonds and even busted commercial real estate securities— and fund them 90 cents or better on the dollar with overnight repo loans costing hardly ten basis points.

 Not only do speculators laugh all the way to the bank collecting this huge spread, but they sleep like babies at night because the central banking branch of the state has incessantly promised that it will prop up bond prices and other assets values come hell or high water, while keeping the cost of repo funding at essentially zero for years to come.

If this sounds like the next best thing to legalized bank robbery, it is. And dubious economics is only the half of it.

This reverse Robin Hood policy is also an open affront to the essence of political democracy.  After all, the other side of the virtually free money being manufactured by the Fed on behalf of speculators is massive thievery from savers. Tens of millions of the latter are earning infinitesimal returns on upwards of $8 trillion of bank deposits not because the free market in the supply and demand for saving produces bank account yields of 0.4 percent, but because price controllers at the Fed have decreed it.

For all intents and purposes, in fact, the Fed is conducting a massive fiscal transfer from the have nots to the haves without so much as a House vote or even a Senate filibuster. The scale of the transfer—upwards of $300 billion per year—-causes most other Capitol Hill pursuits to pale into insignificance, and, in any event, would be shouted down in a hail of thunderous outrage were it ever to actually be put to the people’s representatives for a vote.

To be sure, all of this madness is justified by our out-of-control monetary politburo in terms of a specious claim that Humphrey-Hawkins makes them do it—that is, print money until unemployment virtually disappears or at least hits some target rate which is arbitrary, ever-changing and impossible to consistently measure over time.

In fact, however, this ballyhooed statute is a wholly elastic and content-free expression of Congressional sentiment.  In their wisdom, our legislators essentially said that less inflation and more jobs would be a swell thing. So the act contains no quantitative targets for unemployment, inflation or anything else and was no less open-ended when Paul Volcker chose to crush the speculators of his day than it was last week when Bernanke elected (once again) to pander obsequiously to them.

In truth, the Fed’s entire macro-economic management enterprise is a stunning case of bureaucratic mission creep that has virtually no statutory mandate. Certainly the author of the Federal Reserve Act, the incomparable Carter Glass of Glass-Steagall fame, abhorred the notion that the central bank would become a tool of Wall Street.

To that end, the Fed originally had no authority to own government debt or to conduct open market operations buying and selling treasury securities on Wall Street. And Carter Glass would be rolling in his grave upon discovery that the Fed was rigging interest rates, manipulating the yield curve, providing succor to financial speculators by propping up risk asset markets, placing a Put under the S&P 500 or bragging, as Bubbles Ben did recently, that he had levitated an ultra-speculative stock index called the Russell 2000.

Summing up a wholly opposite Congressional intent in the early 1920s, Senator Glass was almost lyrical:  “We cured this financial cancer by making the regional reserve banks, not Wall Street, the custodian of the nation’s reserve funds… (And) by making them minister to commerce and industry rather than the schemes of speculative adventure. The country banks were made free. Business was unshackled. Aspiration and enterprise were loosened. Never again would there be a money panic.”

Except…except….except that the Fed eventually strayed from its original modest mandate to be a “banker’s bank”—-and in due course we got the crashes of 1929, 1974, 1987, 1998, 2000, and 2008,  to name those so far. In the original formulation, however, these cycles of bubble and bust would not have happened: the Federal Reserve’s only job was the humble matter of passively supplying cash to member banks at a penalty spread above the free market interest rate.

In this modality, the Fed was to function as a redoubt of green-eyeshades, not the committee to save the world. Central bankers would dispense cash at the Fed’s discount window only upon the presentation of good collateral. Moreover, eligible collateral was to originate in trade receivables and other short-term paper arising out of the ebb and flow of free enterprise commerce throughout the hinterlands, not the push and pull of confusion and double-talk among monetary central planners domiciled in the nation’s political capital.

Accordingly, the Federal Reserve that Carter Glass built could not have become a serial bubble machine like the rogue central banks of today. The primary reason is that under the Glassian scheme the free market set the interest rate, not price controllers in Washington.

This meant, in turn, that any sustained outbreak of speculative excess—- what Alan Greenspan once warned was “irrational exuberance” and then promptly hit the delete button when Wall Street objected—would be crushed in the bud by soaring money market interest rates. In effect, leveraged speculators would cure their own euphoria and greed by pushing carry trades—that is, buying long and borrowing short—to the point where they would turn upside down. When spreads went negative, the bubble would promptly stop inflating as overly exuberant speculators were carried off to meet their financial maker—or at least their banker.

And, yes, Carter Glass’ Fed did function under the ancient regime of the gold standard, but there was nothing especially “barbarous” about it—-J. M. Keynes to the contrary notwithstanding.  It merely insured that if the central bank was ever tempted to violate its own rules and repress interest rates in order to accommodate speculators and debtors, more prudent members of the financial community could dump dollar deposits for gold, thereby bringing bank credit expansion up short and aborting incipient financial bubbles before they swelled up.

Needless to say, a central bank which could not create credit-fueled financial bubbles could not have become today’s monetary central planning agency, either. Indeed, the remit of the Glassian banker’s bank did not include managing the business cycle, levitating the GDP, targeting the unemployment rate, goosing the housing market or fretting over the rate of monthly consumer spending.

Certainly it did not involve worrying whether the inflation rate was coming in below 2 percent—the current inexplicable target of the Fed which Paul Volcker has rightly pointed out amounts to robbing the typical laboring man of half the value of his savings over a working lifetime of 30 years.

In short, in the Glassian world the state had no dog in the GDP hunt: whether it grew at an annual rate of 4 percent, 1 percent or went backwards was up to millions of producers, consumers, savers, investors, entrepreneurs and, yes, even speculators interacting on the free market. Indeed, the so-called macroeconomic aggregates—-such as national income, total employment, credit outstanding and money supply—-were passive outcomes on the market, not active targets of state policy.

Needless to say, no Glassian central banker would have ever dreamed of levitating the macro-economic aggregates through the Fed’s current radical, anti-democratic doctrine called “wealth effects”.

Under the latter, the 10 percent of the population which owns 85 percent of the financial assets—and especially the 1 percent which owns most of the so-called “risk assets” managed by hedge funds and fast money speculators—are induced to feel richer by the deliberate and wholly artificial inflation of financial asset values.

In the case of the Russell 2000 which is Bernanke’s favorite wealth effects tool, for instance, the index gain from 350 in March 2009 to 1080 at present amounts to 200 percent and that is for un-leveraged holdings; the Fed-engineered windfall actually amounts to a 400 or 500 percent gain under typical options, leverage and timing based strategies employed by the fast money.

In any event, feeling wealthier, the rich are supposed to spend more on high-end restaurants, gardeners and Pilate’s instructors, thereby causing a “trickle-down” jolt to aggregate demand and eliciting a virtuous circle of rising output, incomes and consumption—-indeed,  always more consumption.

Having been involved in another radical experiment in “trickle down”—-the giant Reagan tax cuts of 1981—-I no longer believe in Voodoo economics. But at least the Gipper’s tax cuts were voted through by a democratic legislature. The Greenspan-Bernanke-Yellen version of “trickle-down”, by contrast, is a pure gift from a handful of central bank apparatchiks to the super-rich.

Nevertheless, the more virulent form of “trickle-down” being practiced in 2013 is rooted in the same erroneous predicate as the mistake of 1981—-namely, the Keynesian gospel that the free enterprise economy is inherently prone to business cycle instability and perennially under-performs its so-called “potential” full employment growth rate.  Accordingly, enlightened intervention—if that is not an oxymoron— by the fiscal and monetary branches of the state is claimed to be necessary to cure these existential disabilities.

The truth of the matter, however, is that Keynesian monetary and fiscal stimulus has never really been needed in the post-war world. Among the ten business cycle contractions since 1950, two of them were unavoidable, self-correcting dislocations resulting from the abrupt cooling down of hot wars in Korea and Vietnam.

The other eight downturns were actually caused by the Federal Reserve, not cured by it.  After the Fed first got carried away with too much stimulus and credit creation in 1971-1974, for example, it had to trigger a short-lived inventory correction to halt the resulting inflation and speculative excesses in financial, labor and commodity markets. But once these necessary inventory corrections ran their course, the economy rebounded on its own each and every time.

To be sure, the Reagan tax cut intervention of 1981 came in a quasi-libertarian guise. By getting the tax-man out of the way, GDP growth was supposed to be unleashed throughout the economic hinterlands, rising by something crazy like 5 percent annually— forever and ever, world without end.

But in practice, “supply-side” was just Keynesian economics for the prosperous classes—that is, it ended up being a scheme to goose the GDP aggregates by drawing down Uncle Sam’s credit card and then passing along the borrowings to so-called “job creators” through tax cuts rather than to dim-witted bureaucrats thru spending schemes.

Indeed, the circumstances of my own ex-communication from the supply-side church underscore the Reaganite embrace of the Keynesian gospel. The true-believers—led by Art Laffer, an economist with a Magic Napkin, and Jude Wanniski, an ex-Wall Street Journal agit-prop man who chanced to stuff said napkin into his pocket— were militantly opposed to spending cuts designed to offset the revenue loss from the Reagan tax reductions.

They called this “root canal” economics and insisted that the Republican Party could never compete with the Keynesian Democrats unless it abandoned its historic commitment to balanced budgets and fiscal rectitude, and instead, campaigned on tax cuts everywhere and always and a fiscal free lunch owing to a purported cornucopia of economic growth.

So supply-side became just another campaign slogan—a competitive entry in the Washington beltway enterprise of running up the national debt in order to perfect and improve upon the otherwise inferior results of the free market economy. In the fullness of time, of course, supply-side economics degenerated into Dick Cheney’s fatuous claim that Reagan proved “deficits don’t matter”.

From there came two giant unfinanced tax cuts and two pointless unfinanced wars under George W. Bush. And then there arose, finally, the GOP’s descent into fiscal know-nothingism during the Obama era— wherein it refused to cut defense, law enforcement, veterans, farm subsidies, the border patrol, middle class student loans, social security, Medicare, the SBA and export-import bank loans to Boeing and General Electric, among countless others— while insisting that no tax-payer should suffer the inconvenience of higher taxes to pay Uncle Sam’s bloated bills.

We thus ended up with the New Year’s Day Folly of 2013. Save for the top 2 percent of taxpayers who were being generously taken care of by the Fed already, all of America got a huge permanent tax cut—-amounting to $2 trillion over the coming decade alone.

Never mind that the Democrats had spent the entire prior decade denouncing the Bush tax cuts as fiscal madness. Now, the tax bidding war which had started in the Reagan White House in May 1981 became institutionalized in the Oval Office.

The so-called Progressive Left was in charge of the veto pen, of course, but the latter was found wanting for ink and in that outcome the nation’s fiscal demise was sealed. There was no progressive case whatsoever for extending the Bush tax cuts because, as Willard M. Romney had so inartfully taught the nation during the Presidential campaign, the bottom 47 percent of households don’t pay any income tax in the first place!

In short, the most left-wing President ever elected in America was showering the upper middle-class with trillions in extra spending loot for no reason of policy—-except to ensure that they would buy more Coach Bags and flat screen TVs.

The fiscal end game—policy paralysis and the eventual bankruptcy of the state—thus became visible. All of the beltway players—-Republican, Democrats and central bankers alike—-are now so hooked on the Keynesian Kool-aid that they cannot imagine the Main Street economy standing on its own two feet without continuous, massive injections of state largesse.

Indeed, the lunacy of the Fed’s trickle-down-to- the-rich was justified last week by Bernanke himself on the grounds that the minor fiscal pinprick owing to the budget sequester was keeping the GDP from growing at its appointed rate.

Based on the same logic the GOP’s most fearsome fiscal hawk, Congressman Paul Ryan, proposed a budget which actually increased the deficit by $200 billion over the next three years on the grounds that the economy was too weak to tolerate fiscal rectitude in the here and now.  In the manner of St. Augustine, the Ryan budget got to balance in the by-in-by—that is, in 2037 to be exact— pleading “Lord, make me chaste— but not just now”.

In other words, the entire fiscal and monetary apparatus of the state has become a jobs program.Progressives pleasure households earning a quarter million dollars annually with tax cuts so that they will hire another gardener; conservatives support modernization of our already lethal fleet of 10,000 M-1 tanks to keep the production line open in Lima, Ohio—-notwithstanding that no nation in the world can invade the US homeland and that the American people are tired of invading the homelands of innocent peoples abroad.

In the same vein, by all accounts the US income tax code is a disgrace— a milk-cow for the K-street lobbies, a briar patch of screaming inequities and the leakiest revenue raising system ever concocted.

But it also amounts to 70,000 pages of jobs programs. None of these can be spared, according to the beltway consensus, so long as GDP and job growth is not up to snuff—that is, as long as they fall short of the American economy’s so-called full employment potential. The latter is an ethereal number known only to the Keynesian priesthood, led by the great thinker’s current vicar on earth, professor Larry Summers, who during his tenure in the White House turned Art Laffer’s napkin upside down and wrote “$800 billion” on the back.

That was the magic number which, when multiplied by another magic number called the fiscal multiplier, would generate an amount of incremental GDP exactly equal to the gap between actual GDP in early 2009 and potential GDP, as calibrated by the vicar.

This might be called the bath-tub theory of macroeconomics because according to Summers and the White House, it didn’t matter much what  was in the $800 billion package—-the urgent matter was to get Washington’s fiscal pumping machinery operating at full-tilt.

Accordingly, once the magic number had been scribbled on the White House napkin, the nation’s check-writing pen was handed off to Speaker Nancy Pelosi and Harry Reid, who conducted the most gluttonous  feeding frenzy every witnessed along the corridors of K-Street.

In exactly twenty-two days from the inauguration, the new administration conceived, drafted, circulated, legislated and signed into law an $800 billion omnibus package of spending and tax cutting that amounted to nearly 6 percent of GDP.  I had been part of a new administration that moved way too fast on a grand plan and had seen the peril first hand. But the Reagan fiscal mishap did not even remotely compare to the reckless, unspeakable folly conducted by the Obama White House.

In fact, the stimulus bill was not a rational economic plan at all; it was a spasmodic eruption of beltway larceny that has now become our standard form of governance.

Stated differently, the stimulus bill was a Noah’s ark which had welcomed aboard every single pet project of any organization domiciled in the nation’s capital with a K-street address. Most items were boarded without any policy review or adult supervision, reflecting a rank exercise in political log-rolling that proceeded straight down the gang planks to the bulging decks below.

Indeed, the true calamity of the Obama stimulus was not merely its massive girth, but the cynical, helter-skelter process by which the public purse was raided. At the end of the day, it was a startling demonstration that the power of a bad idea—-the Keynesian predicate—-when coupled with the massive money power of the PACs and K-Street lobbies, has rendered the nation fiscally incontinent.

This unhinged modus operandi undoubtedly accounts for the plethora of sordid deals that an allegedly “progressive” White House waved through. Thus, the homebuilders were given “refunds” of $15 billion for taxes they had paid during the bubble years; manufacturers got 100 percent first year tax write-offs for equipment that should have been written off over a decade or longer; and crony capitalist investors got $90 billion for uneconomic solar, wind and electric vehicle projects under the fig leaf of “green energy”.

Likewise, insulation suppliers got a $10 billion hand-out via tax credits to homeowners to improve the thermal efficiency of their own properties; congressman on the public works committees got $10 billion earmarked for pork barrel water and reclamation projects in the home districts; and the already corpulent budget of the Pentagon was handed another $10 billion for base construction it most definitely didn’t need—to say nothing of a new headquarters for the insanely bloated  and incompetent Homeland Security Department.

Moreover, the big ticket stuff was far worse. Nearly $50 billion was allocated to highway construction—much of it for repaving highways that didn’t need it or building interchanges where the traffic didn’t warrant it; and, in any event, it should have been paid for with user gasoline taxes, not permanent debt on the general public.

Still, the real pyramid building gambit was the $30 billion or so for transit and high speed rail. Forty-five years of mucking around with the abomination known as Amtrak proves unequivocally that cross-country rail can never be viable in the US because it cannot compete with air travel among the overwhelming majority of city-pairs.

Presently, every single ticket sold on the Sunset Limited from New Orleans to Los Angeles, for example, requires a subsidy that is nearly double the cost of an airline ticket, and is indicative of why we pour $1 billion down the drain each year subsidizing the public transit myth —a boondoggle that will become all the greater owing to the distribution of billions of high speed rail “stimulus” funds which were not subject to even a single hour of hearings.

Then there was $80 billion for education but the only rhyme or reason to it was the list of K-Street lobbies that had lined-up outside Speaker Pelosi’s door: to wit, the National Education Association, the school superintendents lobby, the textbook publishers, the school construction industry, the special education complex, the pre-school providers association, and dozens more.

In a similar manner, the nursing home lobby, home health providers, the hospital association, the knee and hip replacement manufactures, the scooter chair hawkers and the Medicaid mills were all delighted to pocket an extra $80 billion of Federal funding, thereby relieving pressures for reimbursement reductions from the regular state Medicaid programs.

Finally, there was the Obama “money drop” whereby $250 billion was dispersed in helicopter fashion to 140 million tax filers and 65 million citizens who receive social security, veterans and other benefit checks. But there was virtually no relationship to need: tax filers with incomes up to $200,000 were eligible, or about 95 percent of the population.

And among the beneficiary population receiving a $250 stimulus check, less than 10 percent were actually means-tested— while millions of these checks went to affluent social security retirees happy to have Uncle Sam pay for an extra round or two of golf.

Indeed, there was no public policy purpose at all to Obama’s quarter trillion dollar money drop except filling the Keynesian bathtub with make believe income, hoping that citizens would use it to buy a new lawnmower , a goose-down comforter, dinner at the Red Lobster or a new pair of shoes.

Yet ensnared in the Keynesian delusion that society can create wealth by mortgaging its future, the stimulus-besotted denizens of the beltway blew it entirely on the one true domestic function of the state—even under the regime of crony capitalism that now prevails. That imperative is to maintain and adequately fund a sturdy safety net to support citizens who cannot work due to age or health, and to supplement the incomes of families whose marketplace earnings fall below a minimum standard of living.

Yet notwithstanding the feeding frenzy on K-Street to fill-in the Keynesian vicar’s $800 billion blank check in a record twenty-two days, only 3.8 percent of the total—-a mere $30 billion—was allocated to means-tested cash benefits which actually fund the safety net for the needy. Yet with $17 trillion of national debt on the books already, and the certainty that will double or triple in the decades immediately ahead, indiscriminately filling the Keynesian bathtub with borrowed money is not only reckless, but also a cruel insult to any reasonable standard of equitable justice.

The fiscal madness of the Obama era cannot be excused on the grounds that the nation was faced with Great Depression 2.0. We weren’t and the widespread belief that we were so threatened is almost entirely attributable to Ben Bernanke’s faulty scholarship about the Fed’s alleged mistake of not undertaking a massive government debt buying spree to counter-act the Great Depression.

The latter, in turn, was borrowed almost entirely from Milton Friedman’s primitive quantity theory of money which was wrong in 1930 and ridiculously irrelevant to the circumstances of 2008. Nevertheless, it was the basis for Bernanke’s panicked flooding of Wall Street with indiscriminate bailouts and endless free liquidity after the Lehman event.

But what was actually happening was that the giant credit and housing bubble, which had been created by the Greenspan-Bernanke Fed in the wake of the bursting dotcom bubble, which it had also created, was being liquidated. Most of the carnage was happening within the gambling halls of Wall Street because it was the wholesale money market and the shadow banking system that was experiencing a run, not the retail banks of main street America.

The so-called financial crisis, therefore, consisted first and foremost of a violent mark-down of hugely leveraged, multi-trillion Wall Street balance sheets that were loaded with toxic securities— that is, the residue of speculative trading books and undistributed underwritings of sub-prime CDOs, junk bonds, commercial real estate securitizations, hung LBO bridge loans, CDOs squared—- and which had been recklessly funded with massive dollops of overnight repo and other short-term wholesale money.

 This was just one more iteration of the speculator’s age old folly of investing long and illiquid and funding short and hot.

By the time of the frenzied bailout of AIG on September 16^th, led by Bernanke and Hank Paulson, the most dangerous unguided missile every to rain down on the free market from the third floor of the Treasury building, it was nearly all over except for the shouting.  Bear Stearns, Lehman and Merrill Lynch were already gone because they were insolvent and should have been liquidated—-including the bondholders who have foolishly invested in their junior capital for a few basis points of extra yield.

Likewise, Morgan Stanley was bankrupt, too—-propped up ultimately by $100 billion of Fed loans and guarantees that accomplished no public purpose whatsoever, except to keep a gambling house alive that the nation doesn’t need, and to rescue the value of stock held by insiders and bonds owned by money managers who had feasted for years on its reckless bets and rickety balance sheet.

Indeed, at the end of the day the only real purpose of the September 2008 bailouts was to rescue Goldman Sachs from short-sellers who would have taken it down, had not Paulson and Bernanke bailed out Morgan Stanley first, and then outlawed the right of free citizens to sell short the stock of any financial companies until the crisis had passed.

The case for bailing out AIG was even more sketchy.  It had around $800 billion of mostly solid assets in the form of blue chip stocks, bonds, governments, GSE securities and long-term, secured aircraft leases, among others.

So the great global empire of dozens of insurance and leasing companies that Hank Greenberg had built over the decades wasn’t really insolvent: the problem was that its holding company, which had written hundreds of billions of credit default swaps, was illiquid.

It couldn’t met margin calls against the CDS it had written because state insurance commissioners in their wisdom had imposed capital requirements and dividend stoppers on AIG’s far flung insurance subsidiaries—-precisely so that policy-holders couldn’t be fleeced by holding company executives and Boards needing to fund their gambling debts.

In short, virtually none of the AIG subsidiaries would have failed; millions of life insurance policies and retirement annuities would have been money good, and the fire insurance on factories in Peoria would have remained in force.

The only thing that really happened was that something like twelve gunslingers based in London, who sold massive amounts of loss insurance on sub-prime mortgage bonds to about a dozen multi-trillion global banks, would have had to hire protection on their lives in the absence of the bailout. These CDS policies issued by the AIG holding company, in fact, were almost completely bogus and would have generated about $60 billion in losses among Goldman, JPMorgan, Barclays, Deutsche Bank, SocGen, BNP-Paribas, Citi bank and a handful other giants with combined balance sheet footings of $20 trillion.

So the loss would have been less than one-half of one percent of the aggregate balance sheet of the global banks impacted—that is, a London Whale or two, and nothing more.

But by dishing out around $15 billion of bailout money to each of the above named institutions, the American taxpayer kindly protected the P&L of these banks from a modest one-time hit, and kept executive bonuses in the money, too.   It also left AIG under the care of unreconstructed princes of Wall Street whose claims to entitlement know no bounds, as exemplified by Mr. Benmosche’s recent stupefying inability to distinguish between a lynching and the loss of undeserved bonuses.

But as they say on late night TV, there’s more. We were told that ATMs would go dark, big companies would miss payrolls for want of cash and the $3.8 trillion money market fund industry would go down the tubes.

All of these legends are refuted in the section of my book called the Blackberry Panic of 2008—-the title being a metaphor for the fact that the Treasury Department of the US government was in the hands of Wall Street plenipotentiaries who could not keep their eyes off the swooning price charts for the S&P 500 and Goldman Sachs flickering red on their blackberry screens.

But just consider this. Fully $1.8 trillion or 50 percent of total money market industry was in the form of so-called “government only” funds or Treasury paper. Not a single net dime left these funds during the panic and for the good reason that treasury interest payments were never in doubt.

Likewise, the other half of the industry consisted of so-called “prime” funds which included modest amounts of commercial paper along with governments and bank obligations. About $400 billion or 20 percent of these holdings did leave these “prime” funds.

Yet, the overwhelming share of these withdrawals—upwards of 85 percent—simply migrated within money fund companies from slightly risky “prime” funds to virtually riskless “government only” funds.  In effect, the much ballyhooed flight from the money market funds consisted of professional investors hitting the “transfer” button on their account pages.

Worse still, the only significant investor loss in this $4 trillion sector, which was supposedly ground zero of the meltdown, was on about $800 million of Lehman commercial paper held by the industry’s largest operation called the Reserve Prime Fund.  The loss amounted to 0.002 percent of the money market industry’s holdings on the eve of the crisis.

In a similar vein, the $2 trillion commercial paper market was said to be melting down, but this too is an urban legend fostered by the nation’s leading crony capitalist, Jeff Immelt of GE. Unaccountably, the latter did manage to secure $30 billion of Fed guarantees for General Electric’s AAA balance sheet, thereby obviating any need to do the right free market thing—that is, to make a dilutive issue of stock or long-term debt to pay down some cheap commercial paper that could not be rolled during the crisis.

Accordingly, GE Capital’s practice of funding long-term, sticky assets with short-term hot money should have caused shareholders to take a hit, and the company’s executives to be brought up short on the bonus front.

Instead, the bailout of GE’s commercial paper gave rise to the urban legend that companies could not fund their payrolls, when the truth is that every single industrial company that had a commercial paper facility also had back up lines at their commercial bank, and not a single bank refused to fund, meaning no payroll disbursement was ever in jeopardy.

What actually shrank, and deservedly so, was the $1 trillion asset-backed commercial paper market—a place where banks go to refinance credit card and auto loan receivables so that they can book the lifetime profits on these loans upfront—literally the instant your card is swiped— under the “gain-on-sale” accounting scam.

Consequently, the subsequent sharp decline of the ABCP market has been entirely a matter of bank profit timing. It never prevented a single consumer from swiping a credit card or obtaining an auto loan.

In short, by the time of TARP and the massive liquidity injections into Wall Street by the Fed——when it doubled its 94 year-old balance sheet in seven weeks thru October 25, 2008—the meltdown in the canyons of Wall Street had pretty much burned itself out.

Had Mr. Market been allowed to have his way with the street, a healthy purge of decades’ worth of speculative excesses would have occurred. Indeed, the main effect would be that perhaps a half-dozen “sons of Goldman” would be operating today, not the vampire squid which remains—-and they would be run by chastened people who would have lost their stake during the free market’s cleansing interlude.

In a similar manner, the one-time hit to GDP and jobs which resulted from economically warranted collapse of the housing, commercial real estate and the consumer credit bubbles was actually over within nine months.

The ensuring rebound that incepted in June 2009 reflected the regenerative powers of the free market, and not the Fed’s mad-cap money printing or the Obama fiscal stimulus.  The Fed did lower interest rates to zero, and thereby it revived the speculative juices on Wall Street. But the plain fact is that household and business credit continued to contract on Main Street long after the June 2009 bottom, and for good reason:  both sectors were massively over-leveraged after three decades of continuous, pell mell credit expansion.

The household sector, for example, had $13 trillion of debt which represented 205 percent of wage and salary income—compared to the historic ratio of under 90 percent which had prevailed during healthier times prior to 1980. So the Fed’s massive balance sheet expansion did nothing to cause higher borrowing, spending, output or employment on Main Street, even as it put the hedge funds back into the carry-trade business—now with essentially zero cost of funds.

By the time the rebound began in June 2009 not even $75 billion of the stimulus bill—that is, one-half of one percent of GDP—- had hit the spending stream, meaning, again, that the recovery already  underway was self-generating.

As it happened, the initial wave of business inventory liquidation and labor-shedding triggered by the Wall Street meltdown had burned itself out quickly during the first nine months after the Lehman crisis. Thus, business inventories totaled $1.54 trillion in August 2008, and dropped by a total of $215 billion or 14 percent during the course of the recession. Yet fully $185 billion of that liquidation occurred before June 2009, and inventories started to actually rebuild a few months later.

The story was similar for non-farm payrolls. Nearly 7.6 million jobs were shed during the Great Recession but fully 6.6 million or 90 percent of the adjustment was completed by June 2009. Indeed, the idea that this short but sharp recession had anything to do with the Great Depression is essentially ludicrous, and fails completely to note the vast structural differences between the two eras.

 During the early 1930s, the US was the great creditor and exporter to the world, with 70 percent of GDP accounted for by primary production industries—-agriculture, mining and manufacturing— which have long pipelines of crude, intermediate and finished inventory.

 By the time of the 2008 Wall Street meltdown, however, the primary production sector had become a mere shadow of its former self, accounting for only 17 percent of GDP. Accordingly, when recession hit the American economy this time, the downward spiral of inventory liquidation was muted—-with the total inventory liquidation amounting to 2 percent of GDP in 2008-09 compared to 20 percent in the early 1930s.

Indeed, the inherent recession dynamics of the contemporary US service economy— with its massive built-in stabilizers in the form of transfer payment and huge government payrolls— militated against the entire scare story of a Great Depression 2.0.

 During the nine months through June 2009, for example, government transfer payments for foods stamps, unemployment insurance, Medicaid, cash assistance and social security disability soared at a $300 billion annual rate, thereby more than off-setting the $275 billion drop in total wage and salary income.

Likewise, government wages and salaries actually rose during the period, and the vast US service sector payrolls were tapered back modestly, rather than going dark in the form of traditional factory shutdowns. Aerobics class instructors, for example, experienced modestly reduced paid hours, but unlike factories and mines, fitness centers did not go dark in order to burn off excess inventories; they stuck to burning off calories at a modestly reduced rate.

In fact, by 2008 China, Australia and Brazil had become the world’s new mining and manufacturing economy—that is, the US economy of the 1930s. When upwards of 50 million Chinese migrant workers were sent home from idle Chinese export factors, the villages of China’s vast interior became the “Hoovervilles “of the present era.

 In short, Bernanke’s depression call was reckless and uninformed. The real challenge facing the American economy was to get off the massive credit binge which had bloated and inflated output, jobs and incomes for more than two decades.

Instead, Washington poured gasoline on the fire, thereby re-igniting an even greater bubble that will ultimately end in state-wreck—that is, in the thundering collapse of the financial markets. Indeed, the nation’s rogue central bank will eventually be engulfed in the Wall Street hissy fit it fears—undone by waves of relentless selling when the monetary politburo finally loses control of panicked day traders and raging robo trading machines.

Likewise, the Federal budget has become a doomsday machine because the processes of fiscal governance are paralyzed and broken. There will be recurrent debt ceiling and shutdown crises like the carnage scheduled for next week, as far as the eye can see.

Indeed, notwithstanding the assurances of debt deniers like professor Krugman, the honest structural deficit is $1-2 trillion annually for the next decade and then it will get far worse. In fact, when you set aside the Rosy Scenario used by CBO and its preposterous Keynesian assumption that we will reach full employment in 2017 and never fall short of potential GDP ever again for all eternity, the fiscal equation is irremediable.

Under these conditions what remains of our free enterprise economy will buckle under the weight of taxes and crisis.  Sundown in America is well-nigh unavoidable.

Reprinted with permission from ZeroHedge.com.

Mises Institute: In the book, you oppose Bernanke’s view of the Great Depression, which you point out relies heavily on the views of Milton Friedman.

David Stockman: Bernanke has cultivated this idea that he is a brilliant scholar of The Great Depression, but that’s not true at all. What Bernanke did was basically copy Milton Friedman’s misguided and very damaging theory that the Federal Reserve didn’t expand its balance sheet fast enough by massive open market purchases of government debt during the Great Depression. Bernanke therefore claimed that monetary stringency deepened and lengthened the depression, but in fact interest rates plummeted during the crucial 1930-1933 period: credit contracted due to genuine and widespread insolvencies in the agricultural districts and industrial boom towns, causing bank deposits to shrink as a passive consequence. So Bernanke had cause and effect upside down — a historical error that he replicated with reckless abandon in response to the bursting of the housing and credit bubble in 2008.

Friedman’s error about the great depression led him, albeit inadvertently, into the deep waters of statism. He claimed to be the tribune of free markets, but in urging Nixon to scrap the Bretton Woods gold standard he inaugurated the present era of fiat central banking. He held that the central banking branch of the state could improve upon the performance of the free market by targeting the correct level of M1 (money supply) and thereby ensure optimum performance of aggregate demand, real GDP, and inflation. That’s Keynesianism through the monetary control dials, and has led to outright monetary central planning under Greenspan, Bernanke, and most of the other central banks of the world today.

MI: You blame many of our current woes on the movement away from monetary and fiscal discipline started decades ago. Yet, why did it take so long for the U.S. economy to get into the deep trouble we’re in today? Have things gotten worse in recent years?

DS: Although central banking does cause moral hazards and lends itself to abuses, there have been periods in which monetary and fiscal discipline have been employed. Fed Chairman William McChesney Martin, for example, really did take the punch bowl away when the party got started because he took monetary discipline seriously. Fiscal discipline under Eisenhower and the gold standard behind Bretton Woods helped put off the day of reckoning for quite a long time. But fiscal discipline went out the window with Lyndon Johnson and Richard Nixon, and the elimination of the weak gold standard behind Bretton Woods certainly didn’t help. The deficit spending of the Reagan years made things even worse.

The Greenspan and Bernanke years then opened the door the massive abuse of the system we see today. Greenspan took the Federal Reserve, which for years had been run by far more cautious and conservative men, and turned it into a machine for fine-tuning every aspect of the economy. Bernanke has continued this, and taken it even further.

MI: Among many conservatives and Republicans, it is often claimed that the Reagan years were a victory for free markets and that the 1990s vindicated this strategy. Is this the case?

DS: In the early days of the Reagan years I thought, with many others, that the Reagan Revolution would in fact lead to smaller government. I turned out to be wrong, and politics overwhelmed any commitment Reagan had to making government smaller. The reality was huge growth in the deficit, more government spending, and the laying of the groundwork for the huge debt-based problems we have today.

During the Reagan years and since, the GOP has made peace with tinkering with the economy through the central bank, and joined the Democrats in wanting to gin up so-called aggregate demand and stimulate growth. Dick Cheney declared that deficits don’t matter, and the Republicans abandoned any serious commitment to taking a true hands-off approach to the economy.

In spite of this, the perception remains that the Reagan years were a period of laissez-faire, and this in turn has led to the myth that the fiscal indiscipline of the 1980s led to the boom of the nineties. In reality, the 1990s were a period of monetary profligacy, with a big expansion in the money supply under Greenspan, and a real acceleration in the Fed’s drive to manipulate economic growth and employment from the Fed. This in turn led to the dot-com bubble which burst in 2000-2001.

MI: We’ve been told that deregulation of the financial sector caused the 2008 crisis, and that a lack of regulation allows the “One Percent” to prosper while the “99 Percent” suffers.

DS: Fundamentally, the financial crisis was a product of the Fed’s repeated blowing up of bubbles, and not of deregulation. Moreover, any suffering inflicted on the 99 Percent by our system doesn’t come from the free market, it comes from the crony capitalism that is now our economic system. The Blackberry Panic of September 2008, in which Washington policy makers led by former Goldman Sachs CEO Hank Paulson, panicked as they saw Wall Street stock prices plummet on their mobile devices, had very little to do with the Main Street economy in the United States. The panic and bailouts that followed were really about protecting the bonuses and incomes of very wealthy and politically well-connected managers at banks and other heavily leveraged businesses that were eventually deemed too big to fail. What followed was a massive transfer of wealth from the taxpayers and middle-class savers, in the form of bailouts and zero interest rates on bank deposits imposed by the Fed, to the so-called One Percent.

As I show in my book, none of this was necessary to save the larger economy, since the losses that would have taken place as a result of the collapse would have been largely limited to Wall Street. What the bailouts did was preserve the wealth of wealthy and powerful Wall Street players. Meanwhile, we’ve seen no real economic recovery in the rest of the economy.

This transfer of wealth continues, by the way, in the form of relentlessly low interest rates, and an ongoing war by the Fed on safe and stable investment tools such as savings accounts and low-risk bonds. Indeed, this is a deliberate policy to get people away from these safer investments, and to get them investing in more volatile and higher yield investments. The idea is that the Fed can somehow force bigger returns on these riskier investments, and this will lead to a wealth effect. People will then think they’re richer, and we can then spend ourselves into a recovery. This is a terrible doctrine, but that’s what rules Washington right now. It actively works against middle-class people who want to work and save and invest their money responsibly and conservatively.

MI: It seems that the Fed today tries to manage everything from growth to employment to the mortgage rate. Has this always been the case?

DS: The Greenspan-Bernanke Fed has become a tool for central planning and manipulation of the economy, but it hasn’t always been that way. One way to reverse this dangerous and unstable deformation of policy would be to return to the vision of Carter Glass, and employ the Fed as a “banker’s bank.” In such a situation, the Fed takes its cues from the market. The market sets prices (i.e., interest rates on money and debt), and the Fed only provides additional liquidity, in exchange for sound collateral, at a penalty rate, when the banks needed liquidity.

The system we have now is one in which the Fed decides, through a Politburo of planners sitting in Washington, how much liquidity is necessary, what the interest rate should be, what the unemployment rate should be, and what economic growth should be.

There is no honest pricing left at all anywhere in the world because central banks everywhere manipulate and rig the price of all financial assets. We can’t even analyze the economy in the traditional sense anymore because so much of it depends not on market forces, but on the whims of people at the Fed.

MI: Is there any way to fix things before a major crisis comes?

DS: You’re not going to have legislation to change the mandate of the Fed, and I don’t see how you’ll get new people on the Fed who think differently from the current group. Even if you get rid of Bernanke, then you just get Janet Yellen. I just don’t see the political will right now to make any great reforms or cut spending significantly.

I think the political realities of the situation make the most likely scenario one in which there will be some kind of real financial collapse and disorder that will require a total reconstruction of the system. It’s impossible to say how that will be done, and this may be the chance to go back to a gold standard or to a very sharply circumscribed remit for central banks.

Indeed, the tragedy of this vast string of misbegotten interventions—from the 1953 coup against Mossedegh in Iran through the recent bombing campaign in Libya —-is that virtually none of them involved defending the homeland or any tangible, steely-eyed linkages to national security. They were all rooted in ideology—that is, anti-communism, anti-terrorism, humanitarianism, R2Pism, nation-building, American exceptionalism. These were the historic building blocks of a failed Pax Americana. Now the White House wants authorization for the last straw: Namely, to deliver from the firing tubes of U.S. naval destroyers a dose of righteous “punishment” that has no plausible military or strategic purpose. By the President’s own statements the proposed attack is merely designed to censure the Syrian regime for allegedly visiting one particularly horrific form of violence on its own citizens.

Well, really? After having rained napalm, white phosphorous, bunker-busters, drone missiles and the most violent machinery of conventional warfare ever assembled upon millions of innocent Vietnamese, Cambodians, Serbs, Somalis, Iraqis, Afghans, Pakistanis, Yemeni, Libyans and countless more, Washington now presupposes to be in the moral sanctions business?  That’s downright farcical.  Nevertheless, by declaring himself the world’s spanker-in-chief, President Obama has unwittingly precipitated the mother of all clarifying moments.

The screaming strategic truth is that America no longer has any industrial state enemies capable of delivering military harm to its shores: Russia has become a feeble kleptocracy run by a loud-mouthed thief and the communist party oligarchs in China would face a devastating economic collapse within months were it to attack its American markets for sneakers and Apples. So the real question now before Congress recurs: how is it possible that the peace-loving citizens of America, facing no industrial-scale military threat from anywhere on the planet, find themselves in a constant state of war?  The answer is that they have been betrayed by the beltway political class which is in thrall to a vast warfare state apparatus that endlessly invents specious reasons for meddling, spying, intervention and occupation.

In pursuit of nothing more ennobling than raw self-perpetuation, the propaganda machinery of the warfare state—along with its media affiliates such as the War Channel (CNN) and the War Press (Washington Post) —- have over recent decades churned out a stream of vastly exaggerated “threats”, falsely transforming tin-pot dictators and tyrants like Ho Chi Minh, Daniel Ortega, Slobodan Milosevic, the Taliban, the Ayatollah Khomeini, Saddam Hussein and now Bashar Assad into dangerous enemies. At length, triggering incidents are concocted such as the phony gulf of Tonkin episode, the Madison Avenue based fabrications about Iraqi soldiers stealing babies from incubators in Kuwait, the vastly exaggerated claims of ethnic cleaning in Kosovo, and Saddam’s reputed WMDs.  Eventually, the drumbeat for military intervention is cranked to a fever pitch, and cable TV drives it home with non-stop telestrators and talking heads. Only after the fact, when billions in taxpayer resources have been squandered and thousands of American servicemen have been killed and maimed, do we learn that it was all a mistake; that the collateral destruction vastly exceeded the ostensible threat;  and that there remains not a trace of long-term security benefit to the American people.

Setting aside the self-evident catastrophes in Vietnam, Afghanistan and Iraq, even the alleged “good” interventions are simply not what they are cracked up to be by warfare state apologists. The 1991 Persian Gulf War, for instance, only insured that Saddam Hussein would not get the oilfield revenues from what he claimed to be Iraq’s “19^th province” so that he could fund projects to placate his 30 million deprived, abused and restless citizens. Instead, the loot was retained for the benefit of the despicable Emir Al- Sabah IV and a few hundred gluttonous Kuwaiti princes.

Yet in the long-run, “saving” the Kuwaiti regime and its unspeakably decadent opulence did not lower the world price of oil by a dime (Iraq would have produced every barrel it could). And it most surely subtracted from national security because it resulted in the permanent basing of 10,000 U.S. troops on Saudi soil. This utterly stupid and unnecessary provocation was the very proof that “infidels” were occupying Islamic holy lands—the principal leitmotif used by Osama bin Laden to recruit a few hundred fanatical jihadists and pull off the flukish scheme that became 9/11.

Likewise, the “triumph” of Kosovo is pure gist from the national security propaganda mill. The true essence of the episode was a mere swap-out among the ethnic cleansers:  The brutal Serbian army was expelled from Kosovo so that the Albanian thugs of the KLA (Kosovo Liberation Army which was on the terrorist list until it was mysteriously dropped in 1998) could liquidate minority Serbs and confiscate their property—–a tragic routine that has been going on in the Balkans for centuries.

The recurrent phony narratives that generate these war drum campaigns and then rationalize their disastrous aftermath are rooted in a common structural cause: a vastly bloated war machine and national spying apparatus, the Imperial Presidency and the house-trained lap-dogs which occupy the congressional intelligence, foreign affairs and defense committees. This triangle of deception keeps the American public bamboozled with superficial propaganda and the media supplied with short bursts of reality TV when the Tomahawks periodically let fly.

But it is the backbone of the permanent warfare state bureaucracy that keeps the gambit going. Presidents come and go but it is now obvious that virtually any ideological script—left or right—can be co-opted into service of the Imperium. The Obama White House’s preposterous drive to intervene in the Syrian tinderbox with its inherent potential for fractures and blowback across the entire Middle East is being ram-roded by the dogma of “responsibility to protect”. In that context, its chief protagonists—Susan Rice and Samantha Power—-are the moral equivalent of Bush’s neo-con hit-men, Douglas Feith and Paul Wolfowitz. In both cases, ideological agendas which have absolutely nothing to do with the safety of the American people were enabled to activate the awful violence of the American war machine mainly because it was there, marching in place waiting for an assignment.

And that truth encapsulates the inflection point now upon us. There should be no $650 billion war machine with carrier battle groups and cruise missile batteries at the ready to tempt Presidents to heed the advice of ideological fanatics like Power and Wolfowitz.  The cold war ended 25 years back, and like in 1919 and 1946 the American war machine should have been drastically demobilized and dismantled long ago; it should be funded at under $300 billion, not over $600 billion. The five destroyers today menacing the coast of Syria should have been mothballed, if not consigned to the scrap yard. No President need have worried about choosing sides among ethnic cleansers in Kosovo or Islamic sectarians and tribalists in Syria because his available tool-kit would have been to call for a peace conference in Portsmouth, New Hampshire, not a Tomahawk strike from warships in the Eastern Mediterranean.

In this context, Barack Obama may yet earn his Nobel Peace prize, owing to the Syria debate he has now unleashed. It will finally show that there is no threat to America’s security lurking behind the curtain in the Middle East—only a cacophony of internal religious, ethnic, tribal and nationalist conflicts that will eventually burn themselves out. Rather than the “new caliphate” of Fox News’ demented imagination, the truth on the ground is that the Islamic world is enmeshed in a vicious conflict pitting the Shia axis of Iran, Syria, Southern Iraq and the Hezbollah-Lebanon corridor against the surrounding Sunni circle which is nominally aligned with the Syrian rebels. Yet even the Sunni world is noisily fracturing, with Turkey and Qatar lined-up with the Muslim Brotherhood and Saudi Arabia and the other Gulf State aligned with the Egyptian generals. Meanwhile, Jordan cowers in the shadows.

The cowardly hypocrisy of the Arab League should tell the Congressional rank-and-file all they need to know about why we should stay out of Syria and shut down the CIA-sponsored rebel training camp in Jordan through which Saudi arms, including chemical weapons according to some reports, are being interjected into the slaughter in Syria.  If the Assad regime is truly an existential threat to regional peace and stability, let Saudi Arabia and Turkey take it out. After all, during the last several decades they have received a combined $100 billion in advanced aircraft, missiles, electronic warfare gear and other weaponry from American arms merchants financed by the US government.

Needless to say, the spineless Arab League/Saudi potentates who are now demanding “deterrence” never intend to do the job themselves, preferring to stealthily hold the coats of American mercenary forces instead.  The truth is that at the end of the day, they find the threat of Iranian retaliation far more compelling than ending Assad’s brutality or building a pipeline through a prospective Sunni-controlled Syria to supply Qatar’s natural gas to European markets.

That leaves the need to dispatch the final and most insidious myth of the warfare state: namely, the lie that Iran is hell-bent on obtaining and using nuclear weapons. Even the CIA’s own intelligence estimates refute that hoary canard. And whatever the proper share of blame ascribable to each side for failed nuclear negotiations in the past, the Iranian people have once again freely elected a President who wishes to normalize relationships with the US and its allies—notwithstanding the cruel and mindless suffering visited upon them by the West’s misbegotten economic “sanctions”. Indeed, if Obama had the wisdom and astuteness President Eisenhower demonstrated going to Korea, he would be now headed for a peace conference table in Tehran, not the war room in the White House.

So let the sun shine in. Perhaps the unruly backbenchers on Capitol Hill will now learn that they have been sold out by their betters on the jurisdictional committees, such as knee-jerk hawks like Senators Feinstein and Melendez, who chair the key Senate committees, and Mike Rogers who chairs the House (alleged) Intelligence Committee. If they do, they will understand that the US has no dog in the Middle East hunt, and that the wise course of action would be a thorough-going retreat and disengagement from the internecine conflicts of the Levant, North Africa and the Persian Gulf, just as Ronald Reagan discovered after his nose was bloodied in Lebanon.  But however the current debate specifically unfolds, the good news is that the world greatest deliberative body is now back in charge of American foreign policy. By long standing historical demonstration, the US Congress specializes in paralysis, indecision and dysfunction. In the end, that is how the American warfare state will be finally brought to heel and why the American Imperium will come to an end—at last.

Excerpt from The Great Deformation: The Corruption of Capitalism in America by David A. Stockman. Published by PublicAffairs.

When Professor Friedman Opened Pandora’s Box: Open Market Operations

At the end of the day, Friedman jettisoned the gold standard for a remarkable statist reason. Just as Keynes had been, he was afflicted with the economist’s ambition to prescribe the route to higher national income and prosperity and the intervention tools and recipes that would deliver it. The only difference was that Keynes was originally and primarily a fiscalist, whereas Friedman had seized upon open market operations by the central bank as the route to optimum aggregate demand and national income.

There were massive and multiple ironies in that stance. It put the central bank in the proactive and morally sanctioned business of buying the government’s debt in the conduct of its open market operations. Friedman said, of course, that the FOMC should buy bonds and bills at a rate no greater than 3 percent per annum, but that limit was a thin reed.

Indeed, it cannot be gainsaid that it was Professor Friedman, the scourge of Big Government, who showed the way for Republican central bankers to foster that very thing. Under their auspices, the Fed was soon gorging on the Treasury’s debt emissions, thereby alleviating the inconvenience of funding more government with more taxes.

Friedman also said democracy would thrive better under a régime of free markets, and he was entirely correct. Yet his preferred tool of prosperity promotion, Fed management of the money supply, was far more anti-democratic than Keynes’s methods. Fiscal policy activism was at least subject to the deliberations of the legislature and, in some vague sense, electoral review by the citizenry.

By contrast, the twelve-member FOMC is about as close to an unelected politburo as is obtainable under American governance. When in the fullness of time, the FOMC lined up squarely on the side of debtors, real estate owners, and leveraged financial speculators – and against savers, wage earners, and equity financed businessmen – the latter had no recourse from its policy actions.

The greatest untoward consequence of the closet statism implicit in Friedman’s monetary theories, however, is that it put him squarely in opposition to the vision of the Fed’s founders. As has been seen, Carter Glass and Professor Willis assigned to the Federal Reserve System the humble mission of passively liquefying the good collateral of commercial banks when they presented it.

Consequently, the difference between a “banker’s bank” running a discount window service and a central bank engaged in continuous open market operations was fundamental and monumental, not merely a question of technique. By facilitating a better alignment of liquidity between the asset and liability side of the balance sheets of fractional reserve deposit banks, the original “reserve banks” of the 1913 act would, arguably, improve banking efficiency, stability, and utilization of systemwide reserves.

Yet any impact of these discount window operations on the systemwide banking aggregates of money and credit, especially if the borrowing rate were properly set at a penalty spread above the free market interest rate, would have been purely incidental and derivative, not an object of policy. Obviously, such a discount window-based system could have no pretensions at all as to managing the macroeconomic aggregates such as production, spending, and employment.

In short, under the original discount window model, national employment, production prices, and GDP were a bottoms-up outcome on the free market, not an artifact of state policy. By contrast, open market operations inherently lead to national economic planning and targeting of GDP and other macroeconomic aggregates. The truth is, there is no other reason to control M1 than to steer demand, production, and employment from Washington.

Why did the libertarian professor, who was so hostile to all of the projects and works of government, wish to empower what even he could have recognized as an incipient monetary politburo with such vast powers to plan and manage the national economy, even if by means of the remote and seemingly unobtrusive steering gear of M1? There is but one answer: Friedman thoroughly misunderstood the Great Depression and concluded erroneously that undue regard for the gold standard rules by the Fed during 1929–1933 had resulted in its failure to conduct aggressive open market purchases of government debt, and hence to prevent the deep slide of M1 during the forty-five months after the crash.

Yet the historical evidence is unambiguous; there was no liquidity shortage and no failure by the Fed to do its job as a banker’s bank. Indeed, the six thousand member banks of the Federal Reserve System did not make heavy use of the discount window during this period and none who presented good collateral were denied access to borrowed reserves. Consequently, commercial banks were not constrained at all in their ability to make loans or generate demand deposits (M1).

But from the lofty perch of his library at the University of Chicago three decades later, Professor Friedman determined that the banking system should have been flooded with new reserves, anyway. And this post facto academician’s edict went straight to the heart of the open market operations issue.

The discount window was the mechanism by which real world bankers voluntarily drew new reserves into the system in order to accommodate an expansion of loans and deposits. By contrast, open market bond purchases were the mechanism by which the incipient central planners at the Fed forced reserves into the banking system, whether sought by member banks or not.

Friedman thus sided with the central planners, contending that the market of the day was wrong and that thousands of banks that already had excess reserves should have been doused with more and still more reserves, until they started lending and creating deposits in accordance with the dictates of the monetarist gospel. Needless to say, the historic data show this proposition to be essentially farcical, and that the real-world exercise in exactly this kind of bank reserve flooding maneuver conducted by the Bernanke Fed forty years later has been a total failure – a monumental case of “pushing on a string.”

Friedman’s Erroneous Critique of the Depression-Era Fed Opened the Door to Monetary Central Planning

The historical truth is that the Fed’s core mission of that era, to rediscount bank loan paper, had been carried out consistently, effectively, and fully by the twelve Federal Reserve banks during the crucial forty-five months between the October 1929 stock market crash and FDR’s inauguration in March 1933. And the documented lack of member bank demand for discount window borrowings was not because the Fed had charged a punishingly high interest rate. In fact, the Fed’s discount rate had been progressively lowered from 6 percent before the crash to 2.5 percent by early 1933.

More crucially, the “excess reserves” in the banking system grew dramatically during this forty-five-month period, implying just the opposite of monetary stringency. Prior to the stock market crash in September 1929, excess reserves in the banking system stood at $35 million, but then rose to $100 million by January 1931 and ultimately to $525 million by January 1933.

In short, the tenfold expansion of excess (i.e., idle) reserves in the banking system was dramatic proof that the banking system had not been parched for liquidity but was actually awash in it. The only mission the Fed failed to perform is one that Professor Friedman assigned to it thirty years after the fact; that is, to maintain an arbitrary level of M1 by forcing reserves into the banking system by means of open market purchases of Uncle Sam’s debt.

As it happened, the money supply (M1) did drop by about 23 percent during the same forty-five-month period in which excess reserves soared tenfold. As a technical matter, this meant that the money multiplier had crashed. As has been seen, however, the big drop in checking account deposits (the bulk of M1) did not represent a squeeze on money. It was merely the arithmetic result of the nearly 50 percent shrinkage of the commercial loan book during that period.

As previously detailed, this extensive liquidation of bad debt was an unavoidable and healthy correction of the previous debt bubble. Bank loans outstanding, in fact, had grown at manic rates during the previous fifteen years, nearly tripling from $14 billion to $42 billion. As in most credit-fueled booms, the vast expansion of lending during the Great War and the Roaring Twenties left banks stuffed with bad loans that could no longer be rolled over when the music stopped in October 1929.

Consequently, during the aftermath of the crash upward of $20 billion of bank loans were liquidated, including billions of write-offs due to business failures and foreclosures. As previously explained, nearly half of the loan contraction was attributable to the $9 billion of stock market margin loans which were called in when the stock market bubble collapsed in 1929.

Likewise, loan balances for working capital borrowings also fell sharply in the face of falling production. Again, this was the passive consequence of the bursting industrial and export sector bubble, not something caused by the Fed’s failure to supply sufficient bank reserves. In short, the liquidation of bank loans was almost exclusively the result of bubbles being punctured in the real economy, not stinginess at the central bank.

In fact, there has never been any wide-scale evidence that bank loans outstanding declined during 1930–1933 on account of banks calling performing loans or denying credit to solvent potential borrowers. Yet unless those things happened, there is simply no case that monetary stringency caused the Great Depression.

Friedman and his followers, including Bernanke, came up with an academic canard to explain away these obvious facts. Since the wholesale price level had fallen sharply during the forty-five months after the crash, they claimed that “real” interest rates were inordinately high after adjusting for deflation.

Yet this is academic pettifoggery. Real-world businessmen confronted with plummeting order books would have eschewed new borrowing for the obvious reason that they had no need for funds, not because they deemed the “deflation-adjusted” interest rate too high.

At the end of the day, Friedman’s monetary treatise offers no evidence whatsoever and simply asserts false causation; namely, that the passive decline of the money supply was the active cause of the drop in output and spending. The true causation went the other way: the nation’s stock of money fell sharply during the post-crash period because bank loans are the mother’s milk of bank deposits. So, as bloated loan books were cut down to sustainable size, the stock of deposit money (M1) fell on a parallel basis.

Given this credit collapse and the associated crash of the money multiplier, there was only one way for the Fed to even attempt to reflate the money supply. It would have been required to purchase and monetize nearly every single dime of the $16 billion of US Treasury debt then outstanding.

Today’s incorrigible money printers undoubtedly would say, “No problem.” Yet there is no doubt whatsoever that, given the universal antipathy to monetary inflation at the time, such a move would have triggered sheer panic and bedlam in what remained of the financial markets. Needless to say, Friedman never explained how the Fed was supposed to reignite the drooping money multiplier or, failing that, explain to the financial markets why it was buying up all of the public debt.

Beyond that, Friedman could not prove at the time of his writing A Monetary History of the United States in 1965 that the creation out of thin air of a huge new quantity of bank reserves would have caused the banking system to convert such reserves into an upwelling of new loans and deposits. Indeed, Friedman did not attempt to prove that proposition, either. According to the quantity theory of money, it was an a priori truth.

In actual fact, by the bottom of the depression in 1932, interest rates proved the opposite. Rates on T-bills and commercial paper were one-half percent and 1 percent, respectively, meaning that there was virtually no unsatisfied loan demand from creditworthy borrowers. The dwindling business at the discount windows of the twelve Federal Reserve banks further proved the point. In September 1929 member banks borrowed nearly $1 billion at the discount windows, but by January 1933 this declined to only $280 million. In sum, banks were not lending because they were short of reserves; they weren’t lending because they were short of solvent borrowers and real credit demand.

In any event, Friedman’s entire theory of the Great Depression was thoroughly demolished by Ben S. Bernanke, his most famous disciple, in a real-world experiment after September 2008. The Bernanke Fed undertook massive open market operations in response to the financial crisis, purchasing and monetizing more than $2 trillion of treasury and agency debt.

As is by now transparently evident, the result was a monumental wheel-spinning exercise. The fact that there is now $1.7 trillion of “excess reserves” parked at the Fed (compared to a mere $40 billion before the crisis) meant that nearly all of the new bank reserves resulting from the Fed’s bond-buying sprees have been stillborn.

By staying on deposit at the central bank, they have fueled no growth at all of Main Street bank loans or money supply. There is no reason whatsoever, therefore, to believe that the outcome would have been any different in 1930–1932.

Milton Friedman: Freshwater Keynesian and the Libertarian Professor Who Fathered Big Government

The great irony, then, is that the nation’s most famous modern conservative economist became the father of Big Government, chronic deficits, and national fiscal bankruptcy. It was Friedman who first urged the removal of the Bretton Woods gold standard restraints on central bank money printing, and then added insult to injury by giving conservative sanction to perpetual open market purchases of government debt by the Fed. Friedman’s monetarism thereby institutionalized a régime which allowed politicians to chronically spend without taxing.

Likewise, it was the free market professor of the Chicago school who also blessed the fundamental Keynesian proposition that Washington must continuously manage and stimulate the national economy. To be sure, Friedman’s “freshwater” proposition, in Paul Krugman’s famous paradigm, was far more modest than the vast “fine-tuning” pretensions of his “saltwater” rivals. The saltwater Keynesians of the 1960s proposed to stimulate the economy until the last billion dollars of potential GDP was realized; that is, they would achieve prosperity by causing the state to do anything that was needed through a multiplicity of fiscal interventions.

By contrast, the freshwater Keynesian, Milton Friedman, thought that capitalism could take care of itself as long as it had precisely the right quantity of money at all times; that is, Friedman would attain prosperity by causing the state to do the one thing that was needed through the single spigot of M1 growth.

But the common predicate is undeniable. As has been seen, Friedman thought that member banks of the Federal Reserve System could not be trusted to keep the economy adequately stocked with money by voluntarily coming to the discount window when they needed reserves to accommodate business activity. Instead, the central bank had to target and deliver a precise quantity of M1 so that the GDP would reflect what economic wise men thought possible, not merely the natural level resulting from the interaction of consumers, producers, and investors on the free market.

For all practical purposes, then, it was Friedman who shifted the foundation of the nation’s money from gold to T-bills. Indeed, in Friedman’s scheme of things central bank purchase of Treasury bonds and bills was the monetary manufacturing process by which prosperity could be managed and delivered.

What Friedman failed to see was that one wise man’s quantity rule for M1 could be supplanted by another wise man’s quantity rule for M2 (a broader measure of money supply that included savings deposits) or still another quantity target for aggregate demand (nominal GDP targeting) or even the quantity of jobs created, such as the target of 200,000 per month recently enunciated by Fed governor Charles Evans. It could even be the quantity of change in the Russell 2000 index of stock prices, as Bernanke has advocated.

Yet it is hard to imagine a world in which any of these alternative “quantities” would not fall short of the “target” level deemed essential to the nation’s economic well-being by their proponents. In short, the committee of twelve wise men and women unshackled by Friedman’s plan for floating paper dollars would always find reasons to buy government debt, thereby laying the foundation for fiscal deficits without tears.

The Best of David Stockman

Excerpt from The Great Deformation: The Corruption of Capitalism in America by David A. Stockman. Published by PublicAffairs.

The Social Security Act of 1935 had virtually nothing to do with ending the depression, and if anything it had a contractionary impact. Payroll taxes began in 1937 while regular benefit payments did not commence until 1940.

Yet its fiscal legacy threatens disaster in the present era because its core principle of “social insurance” inexorably gives rise to a fiscal doomsday machine. When in the context of modern political democracy the state offers universal transfer payments to its citizens without proof of need, it offers thereby to bankrupt itself – eventually.

By contrast, a minor portion of the 1935 legislation embodied the opposite principle – namely, the means-tested safety net offered through categorical aid for the low-income elderly, blind, disabled and dependent families. These programs were inherently self-contained because beneficiaries of means-tested transfers simply do not have the wherewithal – that is, PACs and organized lobbying machinery – to “capture” policy-making and thereby imperil the public purse.

To the extent that means-tested social welfare is strictly cash-based, as was cogently advocated by Milton Friedman in his negative income tax plan, it is even more fiscally stable. Such purely cash based transfers do not enlist and mobilize the lobbying power of providers and vendors of in-kind assistance, such as housing and medical services.

Social insurance, on the other hand, suffers the twin disability of being regressive as a distributional matter and explosively expansionary as a fiscal matter. The source of both ills is the principle of “income replacement” provided through mandatory socialization of huge population pools.

On the financing side, the heavy taxation needed to fund the scheme has been made politically feasible by the mythology that participants are paying a “premium” for an “earned” annuity, not a tax. Consequently, payroll tax financing is deeply regressive because all participants pay a uniform rate regardless of income.

At the same time, benefits are also regressive because those with the highest life-time wages get the greatest replacement. This regressive outcome is only partially ameliorated by the so-called “bend points” which provide higher replacement on the first dollar of covered wages than on the last.

The New Deal social insurance philosophers thus struck a Faustian bargain. To get government funded pensions and unemployment benefits for the most needy, they eschewed a means test and, instead, agreed to generous wage replacement on a universal basis. To fund the massive cost of these universal benefits they agreed to a regressive payroll tax by disguising it as an insurance premium. Yet the long run results could not have been more perverse.

The payroll tax has become an anti-jobs monster, but under the banner of a universal entitlement organized labor tenaciously defends what should be its nemesis. At the same time, the prosperous classes have gotten a big slice of these transfer payments, and now claim they have earned them – when affluent citizens should have no proper claim on the public purse at all.

Accordingly, social insurance co-opts all potential sources of political opposition, making it inherently a fiscal doomsday machine. It was only a matter of time, for example, before its giant recipient populations would capture control of benefit policy in both parties, and most especially co-opt the conservative fiscal opposition.

Within a few decades, in fact, Republican fiscal scruples had vanished entirely. This was more than evident when Richard Nixon did not veto but, instead, signed a 20 percent Social Security benefit increase on the eve of the 1972 election. Worse still, the bill also contained the infamous “double-indexing” provision which since then has generated massive hidden benefit increases by over-indexing every worker’s payroll history. The fiscal cost of relentless universal benefit expansion has driven an epic increase in the payroll tax. The initial 1937 payroll tax rate was about 2 percent of wages, but after numerous legislated benefit increases, the addition of Medicare in 1965, the Nixon benefit explosion and the Carter and Reagan era payroll tax increases, the combined employer/employee rate is now pushing 16 percent (including the unemployment tax).

Accordingly, Federal and state payroll taxes for social insurance generate $1.2 trillion per year in revenue – four times more than the corporate income tax. So with the highest labor costs in the world, the U.S now imposes punishing levies on payrolls. It thus remains hostage to a political happen-stance – that is, the destructive bargain struck eight decades ago when high tariff walls, not containerships loaded with cheap goods made from cheap foreign labor, surrounded it harbors.

Yet there is more and it is worse. The current punishing payroll tax is actually way too low – that is, it drastically underfunds future benefits owing to positively fictional rates of economic growth assumed in the 75-year actuarial projections. As a result, the benefit structure grinds forward on automatic pilot facing no political opposition whatsoever. In the meanwhile, the fast approaching day or reckoning is thinly disguised by trust fund accounting fictions.

In truth the trust funds are both meaningless and broke. Annual benefit payouts already exceed tax receipts by upward of $50 billion annually, while the so-called trust funds reserves – $3 trillion of fictional treasury bonds accumulated in earlier decades – are mere promises to use the general taxing powers of the US government to make good on the rising tide of benefits.

The New Deal social insurance mythology of “earned” annuities on “paid-in” premiums that have been accumulated as trust fund “reserves” is thus an unadulterated fiscal scam. In reality, Social Security is really just an intergenerational transfer payment system.

Moreover, the latter is predicated on the erroneous belief that new workers and wages can be forever drafted into the system faster than the growth of benefits. During the heady days of 1967, for example, Paul Samuelson and his Keynesian acolytes in the Johnson administration still believed that the American economy was capable of sustained growth at a 5 percent annual rate. The Nobel Prize winner thus assured his Newsweek column readers that paying unearned windfalls to current social security beneficiaries was no sweat: “The beauty of social insurance is that it is actuarially unsound. Everyone … is given benefit privileges that far exceed anything he has paid in …”

Samuelson rhetorically inquired as to how was this possible and succinctly answered his own question: “National product is growing at a compound interest rate and can be expected to do so as far as the eye can see. … Social security is squarely based on compound interest … the greatest Ponzi game ever invented.”

When 5 percent real growth turned out to be a Keynesian illusion and output growth decayed to 1–2 percent annual rate after the turn of the century, the actuarial foundation of Samuelson’s Ponzi game came crashing down. It is now evident that Washington cannot shrink, or even brake, the fiscal doomsday machine that lies underneath.

The fiscal catastrophe embedded in the New Deal social insurance scheme was not inevitable. A means-tested retirement program funded with general revenues was explicitly recommended by the analytically proficient experts commissioned by the Roosevelt White House in 1935. But FDR’s cabal of social work reformers led by Labor Secretary Frances Perkins thought a means-test was demeaning, having no clue that a means-test is the only real defense available to the public purse in a welfare state democracy.

When the American economy was riding high in 1960, Paul Samuelson’s Ponzi was extracting payroll tax revenue amounting to about 2.8 percent of GDP. A half century later, after a devastating flight of jobs to East Asia and other emerging economies, the payroll tax extracts two-and-one half times more, taking in nearly 6.5 percent of GDP. So the remarkable thing is not that wooly-eyed idealists who drafted the 1935 act succumbed to social insurance’s Faustian bargain at the time. The puzzling thing is that 75 years later – with all the terrible facts fully known – the doctrinaire conviction abides on the Left that social insurance is the New Deal’s crowning achievement. In fact, it is its costliest mistake.

Attend the Stockman Seminar

CHAPTER 13
MILTON FRIEDMAN’S FOLLY
Rise of the T-Bill Standard
T
he stage was thus set for the final “run” on the dollar
and for a spectacular default by the designated “reserve currency”
provider under the gold exchange standard’s second outing. And
as it happened, the American people saw fit to install in the White House
in January 1969 just the man to crush what remained of gold-based money
and the financial discipline that it enabled.
Richard M. Nixon, as we know, possessed numerous and notable flaws.
Foremost was his capacity to carry a grudge against anyone whom he be-
lieved had caused him to lose an election, especially any economist, policy
maker, or bystander who could be pinned with accountability for the mild
1960 recession that he believed responsible for his loss to John F. Kennedy.
Nixon’s vendetta on the matter of the 1960 election literally knew no lim-
its. For example, he insisted that a midlevel career bureaucrat named Jack
Goldstein, who headed the Bureau of Labor Statistics (BLS), had deliber-
ately spun the monthly unemployment report issued on the eve of the 1960
election so as to damage his campaign. Eight years later, Nixon informed
the White House staff that job one was to determine if Goldstein was still
at the BLS, and to get him fired if he was.
It is not surprising, therefore, that Nixon rolled into the Oval Office ob-
sessed with replacing Chairman Martin and bringing the Fed to heel. To be
sure, his only real interest in monetary policy consisted of ensuring that
the one great threat to Republican success, a rising unemployment rate,
did not happen in the vicinity of an election.
Yet it was that very cynicism which made him prey to Milton Friedman’s
alluring doctrine of floating paper money. As has been seen, Nixon wanted
absolute freedom to cause the domestic economy to boom during his 1972
reelection campaign. Friedman’s disciples at Camp David served up ex-
actly that gift, and wrapped it in the monetary doctrine of the nation’s lead-
ing conservative intellectual.
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FRIEDMAN’S RULE OF FIXED MONEY SUPPLY GROWTH
WAS ACADEMIC POPPYCOCK
Those adhering to traditional monetary doctrine always and properly
feared the inflationary threat of state-issued fiat money. So when the CPI
reached the unheard of peacetime level of 6.3 percent by January 1969, it
was a warning that the tottering structure of Bretton Woods was reaching a
dangerous turning point and that the monetary foundation of the postwar
world was in peril.
But not according to Professor Milton Friedman. As was typical of the
Chicago school conservatives, he simply brushed off the gathering infla-
tionary crisis as the product of dimwits at the Fed. Martin’s “mistake” in
succumbing to pressure to open up the monetary spigot to fund LBJ’s
deficits, Friedman insisted, could be easily fixed. Literally, with the flick of
a switch.
According to Professor Friedman’s vast archive of historic data, inflation
would be rapidly extinguished if money supply was harnessed to a fixed
and unwavering rate of growth, such as 3 percent per annum. If that disci-
pline was adhered to consistently, nothing more was needed to unleash
capitalist prosperity—not gold convertibility, fixed exchange rates, cur-
rency swap lines, or any of the other accoutrements of central banking
which had grown up around the Bretton Woods system.
Indeed, once the central bank got the money supply growth rate into a
fixed and reliable groove, the free market would take care of everything
else, including determination of the correct exchange rate between the
dollar and every other currency on the planet. Under Friedman’s monetary
deus ex machina, for example, the unseen hand would silently and effi-
ciently mete out rewards for success and punishments for failure in the
banking and securities markets. The need for clumsy and inefficient regu-
lation of financial institutions would be eliminated.
Friedman’s “fixed rule” monetary theory was fundamentally flawed,
however, for reasons Martin had long ago discovered down in the trenches
of the financial markets. The killer was that the Federal Reserve couldn’t
control Friedman’s single variable, which is to say, the “money supply” as
measured by the sum of demand deposits and currency (M1).
During nearly two decades at the helm, Martin learned that the only
thing the Fed could roughly gauge was the level of bank reserves in the sys-
tem. Beyond that there simply weren’t any fixed arithmetic ratios, starting
with the “money multiplier.”
The latter measured the ratio between bank reserves, which are potential
money, and bank deposits, which are actual money. As previously indicated,
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however, commercial banks don’t create actual money (checking account
deposits) directly; they make loans and then credit the proceeds to cus-
tomer accounts. So the transmission process between bank reserves and
money supply wends through bank lending departments and the credit
creation process.
Needless to say, the Fed couldn’t control the animal spirits of either
lenders or borrowers; that was the job of free market interest rates. Accord-
ingly, banks would utilize their reserves aggressively during periods of ro-
bust loan demand until borrower exuberance was choked off by high
interest rates. By contrast, bank reserves would lie fallow during times of
slumping loan demand and low free market rates. The “money multiplier”
therefore varied enormously, depending upon economic and financial
conditions.
Furthermore, even if the resulting “money supply” could be accurately
measured and controlled, which was not the case, it did not have a fixed
“velocity” or relationship to economic activity or GDP, either. In fact, dur-
ing deflationary times of weak credit expansion, velocity tended to fall,
meaning less new GDP for each new dollar of M1. On the other hand, dur-
ing inflationary times of rapid bank credit expansion it would tend to rise,
resulting in higher GDP gains per dollar of M1 growth.
So the chain of causation was long and opaque. The linkages from open
market operations (adding to bank reserves) to commercial bank credit
creation (adding to the money supply) to credit-fueled additional spending
(adding to GDP) resembled nothing so much as the loose steering gear on
an old jalopy: turning the steering wheel did not necessarily mean the
ditch would be avoided.
Most certainly there was no possible reason to believe that M1 could be
managed to an unerring 3 percent growth rate, and that, in any event,
keeping M1 growth on the straight and narrow would lead to any pre-
dictable rate of economic activity or mix of real growth and inflation. In
short, Friedman’s single variable–fixed money supply growth rule was ba-
sically academic poppycock.
The monetarists, of course, had a ready answer to all of these disabili-
ties; namely, that there were “leads and lags” in the transmission of mone-
tary policy, and that given sufficient time the money multipliers and
velocity would regress to a standard rate. Yet that “sufficient time” caveat
had two insurmountable flaws: it meant that Friedman’s fixed rule could
not be implemented in the real day-to-day world of fast-moving financial
markets; and more importantly, it betrayed the deep, hopeless political
naïveté of the monetarists and Professor Friedman especially.
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THE MONETARIST CONE:
SILLY PUTTY ON THE WHITE HOUSE GRAPHS
As to practicality, I had a real-time encounter with it during the Reagan
years when the Treasury’s monetary policy post was held by a religious dis-
ciple of Friedman: Beryl Sprinkel. Week after week at White House eco-
nomic briefings he presented a graph based on the patented “monetarist
cone.” The graph consisted of two upward-sloping dotted lines from a
common starting date which showed where the money supply would be if
it had been growing at an upper boundary of, say, 4 percent and a lower
boundary of, say, 2 percent.
The implication was that if the Fed were following Professor Friedman’s
rule, the path of the actual money supply would fall snugly inside the
“cone” as it extended out over months and quarters, thereby indicating that
all was well on the monetary front, the only thing which mattered. Except
the solid line on the graph tracking the actual week-to-week growth of
money supply gyrated wildly and was almost always outside the cone,
sometimes on the high side and other times on the low.
In other words, the greatest central banker of modern times, Paul Vol-
cker, was flunking the monetarists’ test week after week, causing Sprinkel
to engage in alternating bouts of table pounding because the Fed was ei-
ther dangerously too tight or too loose. Fortunately, Sprinkel’s graphs didn’t
lead to much: President Reagan would look puzzled, Jim Baker, the chief of
staff, would yawn, and domestic policy advisor Ed Meese would suggest
moving on to the next topic.
More importantly, Volcker could easily explain the manifold complexi-
ties and anomalies in the short-term movement of the reported money
supply numbers, and that on an “adjusted” basis he was actually inside the
cone. Besides that, credit growth was slowing sharply, from a rate of 12 per-
cent in 1979 to 7 percent in 1981 and 3 percent in 1982. That caused the
economy to temporarily buckle and inflation to plunge from double digits
to under 4 percent in less than twenty-four months. Volcker was getting the
job done, in compliance with the monetarist cone or not.
In fact, the monetarist cone was just a Silly Putty numbers exercise, rep-
resenting annualized rates of change from an arbitrary starting date that
kept getting reset owing to one alleged anomaly or another. The far more
relevant imperative was to slow the perilous expansion of the Fed’s balance
sheet. It had doubled from $60 billion to $125 billion in the nine years be-
fore Volcker’s arrival at the Eccles Building, thereby saturating the banking
system with newly minted reserves and the wherewithal for inflationary
credit growth.
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Volcker accomplished this true anti-inflation objective with alacrity. By
curtailing the Fed’s balance sheet growth rate to less than 5 percent by
1982, Volcker convinced the markets that the Fed would not continue to
passively validate inflation, as Burns and Miller had done, and that specu-
lating on rising prices was no longer a one-way bet. Volcker thus cracked
the inflation spiral through a display of central bank resolve, not through a
single-variable focus on a rubbery monetary statistic called M1.
Volcker also demonstrated that the short-run growth rate of M1 was
largely irrelevant and impossible to manage, but that the Fed could nev-
ertheless contain the inflationary furies by tough-minded discipline of its
own balance sheet. Yet that very success went straight to an even more
fatal flaw in the monetarist fixed money growth rule: Friedman never ex-
plained how the Fed, once liberated from the external discipline of the
Bretton Woods gold standard, would be continuously populated with
iron-willed statesmen like Volcker, and how they would even remain in
office when push came to shove like it did during the monetary crunch
of 1982.
In fact, Volcker’s reappointment the next year was a close call because
most of the White House staff and the Senate Republican leadership
wanted to take him down, owing to the considerable political inconven-
ience of the recessionary trauma his policies had induced. Senate leader
Howard Baker, for example, angrily demanded that Volcker “get his foot off
the neck of American business now.”
Volcker survived only because of Ronald Reagan’s stubborn (and cor-
rect) belief that the Fed’s long bout of profligacy had caused inflation and
that only a period of painful monetary parsimony could cure it. The next
several decades would prove decisively, however, that the process of Amer-
ican governance produces few Reagans and even fewer Volckers.
So Friedman unleashed the demon of floating-rate money based on the
naïve view that the inhabitants of the Eccles Building could and would fol-
low his monetary rules. That was a surprising posture because Friedman’s
splendid scholarship on the free market, going all the way back to his pio-
neering critique of New York City rent controls in the late 1940s, was in-
fused with an abiding skepticism of politicians and all of their mischievous
works.
Yet by unshackling the Fed from the constraints of fixed exchange rates
and the redemption of dollar liabilities for gold, Friedman’s monetary doc-
trine actually handed politicians a stupendous new prize. It rendered triv-
ial by comparison the ills owing to garden variety insults to the free market,
such as rent control or the regulation of interstate trucking.
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IMPLICIT RULE BY MONETARY EUNUCHS
The Friedman monetary theory actually placed the nation’s stock of bank
reserves, money, and credit under the unfettered sway of what amounted
to a twelve-member monetary politburo. Once relieved of the gold stan-
dard’s external discipline, the central banking branch of the state thus had
unlimited scope to extend its mission to plenary management of the na-
tion’s entire GDP and for deep, persistent, and ultimately suffocating inter-
vention in the money and capital markets.
It goes without saying, of course, that the libertarian professor was not
peddling a statist scheme. So the implication was that the Fed would be
run by self-abnegating monetary eunuchs who would never be tempted to
deviate from the fixed money growth rule or by any other manifestation of
mission creep. Needless to say, Friedman never sought a franchise to train
and appoint such governors, nor did he propose any significant reforms
with respect to the Fed’s selection process or of the manner in which its
normal operations were conducted.
This glaring omission, however, is what made Friedman’s monetarism
all the more dangerous. His monetary opus, A Monetary History of the
United States, was published only four years before his disciples, led by
George Shultz, filled the ranks of the Nixon White House in 1969.
Possessed with the zeal of recent converts, they soon caused a real-
world experiment in Friedman’s grand theory. In so doing, they were also
implicitly betting on an improbable proposition: that monetarism would
work because the run-of-the-mill political appointees—bankers, econo-
mists, businessmen, and ex-politicians who then sat on the Federal Open
Market Committee (FOMC), along with their successors—would be forever
smitten with the logic of 3 percent annual money supply growth.
FRIEDMAN’S GREAT GIFT TO WALL STREET
The very idea that the FOMC would function as faithful monetary eunuchs,
keeping their eyes on the M1 gauge and deftly adjusting the dial in either
direction upon any deviation from the 3 percent target, was sheer fantasy.
And not only because of its political naïveté, something Nixon’s brutaliza-
tion of the hapless Arthur Burns aptly conveyed.
Friedman’s austere, rule-bound version of discretionary central banking
also completely ignored the Fed’s susceptibility to capture by the Wall Street
bond dealers and the vast network of member banks, large and small, which
maintained their cash reserves on deposit there. Yet once the Fed no longer
had to worry about protecting the dollar’s foreign exchange value and the
US gold reserve, it had a much wider scope to pursue financial repression
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policies, such as low interest rates and a steep yield curve, that inherently
fuel Wall Street prosperity.
As it happened, the Fed’s drift into these Wall Street–pleasing policies
was temporarily stalled by Volcker’s epic campaign against the Great Infla-
tion. Dousing inflation the hard way, through brutal tightening of money
market conditions, Volcker had produced the singular nightmare that Wall
Street and the banking system loathe; namely, a violent and unprece-
dented inversion of the yield curve.
With short-term interest rates at 20 percent or more and way above
long-term bond yields (12–15 percent), it meant that speculators and
banks could not make money on the carry trade and that the value of
dealer stock and bond inventories got clobbered: high and rising interest
rates mean low and falling financial asset values. Accordingly, the Volcker
Fed did not even dream of levitating the economy through the “wealth ef-
fects” or by coddling Wall Street speculators.
Yet once Volcker scored an initial success and was unceremoniously
dumped by the Baker Treasury Department (in 1987), the anti-inflation
brief passed on to a more congenial mechanism; that is, Mr. Deng’s indus-
trial army and the “China price” deflation that rolled across the US econ-
omy in the 1990s and after. With inflation-fighting stringency no longer
having such immediate urgency, it did not take long for the Greenspan Fed
to adopt a prosperity promotion agenda.
First, however, it had to rid itself of any vestigial restraints owing to the
Friedman fixed money growth rule. The latter was dispatched easily by a
regulatory change in the early 1990s which allowed banks to offer “sweep”
accounts; that is, checking accounts by day which turned into savings ac-
counts overnight. Accordingly, Professor Friedman’s M1 could no longer be
measured accurately.
Out of sight was apparently out of mind: for the last two decades, the
central bank that Friedman caused to be liberated from the alleged tyranny
of Bretton Woods so that it could swear an oath of fixed money supply
growth has not even bothered to review or mention money supply. Indeed,
the Greenspan and Bernanke Fed have been wholly preoccupied with ma-
nipulation of the price of money, that is, interest rates, and have relegated
Friedman’s entire quantity theory of money to the dustbin of history. And
Bernanke claims to have been a disciple!
Constrained neither by gold nor a fixed money growth rule, the Fed in
due course declared itself to be the open market committee for the man-
agement and planning of the nation’s entire GDP . In this Brobdingnagian
endeavor, of course, the Wall Street bond dealers were the vital transmission
belt which brought credit-fueled prosperity to Main Street and delivered the
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elixir of asset inflation to the speculative classes. Consequently, when it
came to Wall Street, the Fed became solicitous at first, and craven in the end.
Apologists might claim that Milton Friedman could not have foreseen
that the great experiment in discretionary central banking unleashed by
his disciples in the Nixon White House would result in the abject capitula-
tion to Wall Street which emerged during the Greenspan era and became a
noxious, unyielding reality under Bernanke. But financial statesmen of an
earlier era had embraced the gold standard for good reason: it was the ulti-
mate bulwark against the pretensions and follies of central bankers.
WHEN PROFESSOR FRIEDMAN OPENED PANDORA’S BOX:
OPEN MARKET OPERATIONS
At the end of the day, Friedman jettisoned the gold standard for a remark-
able statist reason. Just as Keynes had been, he was afflicted with the econ-
omist’s ambition to prescribe the route to higher national income and
prosperity and the intervention tools and recipes that would deliver it. The
only difference was that Keynes was originally and primarily a fiscalist,
whereas Friedman had seized upon open market operations by the central
bank as the route to optimum aggregate demand and national income.
There were massive and multiple ironies in that stance. It put the central
bank in the proactive and morally sanctioned business of buying the gov-
ernment’s debt in the conduct of its open market operations. Friedman
said, of course, that the FOMC should buy bonds and bills at a rate no
greater than 3 percent per annum, but that limit was a thin reed.
Indeed, it cannot be gainsaid that it was Professor Friedman, the
scourge of Big Government, who showed the way for Republican central
bankers to foster that very thing. Under their auspices, the Fed was soon
gorging on the Treasury’s debt emissions, thereby alleviating the inconven-
ience of funding more government with more taxes.
Friedman also said democracy would thrive better under a régime of
free markets, and he was entirely correct. Yet his preferred tool of prosper-
ity promotion, Fed management of the money supply, was far more anti-
democratic than Keynes’s methods. Fiscal policy activism was at least
subject to the deliberations of the legislature and, in some vague sense,
electoral review by the citizenry.
By contrast, the twelve-member FOMC is about as close to an unelected
politburo as is obtainable under American governance. When in the full-
ness of time, the FOMC lined up squarely on the side of debtors, real estate
owners, and leveraged financial speculators—and against savers, wage
earners, and equity financed businessmen—the latter had no recourse
from its policy actions.
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The greatest untoward consequence of the closet statism implicit in
Friedman’s monetary theories, however, is that it put him squarely in op-
position to the vision of the Fed’s founders. As has been seen, Carter Glass
and Professor Willis assigned to the Federal Reserve System the humble
mission of passively liquefying the good collateral of commercial banks
when they presented it.
Consequently, the difference between a “banker’s bank” running a dis-
count window service and a central bank engaged in continuous open
market operations was fundamental and monumental, not merely a ques-
tion of technique. By facilitating a better alignment of liquidity between
the asset and liability side of the balance sheets of fractional reserve de-
posit banks, the original “reserve banks” of the 1913 act would, arguably,
improve banking efficiency, stability, and utilization of systemwide
reserves.
Yet any impact of these discount window operations on the systemwide
banking aggregates of money and credit, especially if the borrowing rate
were properly set at a penalty spread above the free market interest rate,
would have been purely incidental and derivative, not an object of policy.
Obviously, such a discount window–based system could have no preten-
sions at all as to managing the macroeconomic aggregates such as produc-
tion, spending, and employment.
In short, under the original discount window model, national employ-
ment, production prices, and GDP were a bottoms-up outcome on the free
market, not an artifact of state policy. By contrast, open market operations
inherently lead to national economic planning and targeting of GDP and
other macroeconomic aggregates. The truth is, there is no other reason to
control M1 than to steer demand, production, and employment from
Washington.
Why did the libertarian professor, who was so hostile to all of the proj-
ects and works of government, wish to empower what even he could have
recognized as an incipient monetary politburo with such vast powers to
plan and manage the national economy, even if by means of the remote
and seemingly unobtrusive steering gear of M1? There is but one answer:
Friedman thoroughly misunderstood the Great Depression and concluded
erroneously that undue regard for the gold standard rules by the Fed dur-
ing 1929–1933 had resulted in its failure to conduct aggressive open market
purchases of government debt, and hence to prevent the deep slide of M1
during the forty-five months after the crash.
Yet the historical evidence is unambiguous; there was no liquidity short-
age and no failure by the Fed to do its job as a banker’s bank. Indeed, the
six thousand member banks of the Federal Reserve System did not make
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heavy use of the discount window during this period and none who pre-
sented good collateral were denied access to borrowed reserves. Conse-
quently, commercial banks were not constrained at all in their ability to
make loans or generate demand deposits (M1).
But from the lofty perch of his library at the University of Chicago three
decades later, Professor Friedman determined that the banking system
should have been flooded with new reserves, anyway. And this post facto
academician’s edict went straight to the heart of the open market opera-
tions issue.
The discount window was the mechanism by which real world bankers
voluntarily drew new reserves into the system in order to accommodate an
expansion of loans and deposits. By contrast, open market bond purchases
were the mechanism by which the incipient central planners at the Fed
forced reserves into the banking system, whether sought by member banks
or not.
Friedman thus sided with the central planners, contending that the
market of the day was wrong and that thousands of banks that already had
excess reserves should have been doused with more and still more re-
serves, until they started lending and creating deposits in accordance with
the dictates of the monetarist gospel. Needless to say, the historic data
show this proposition to be essentially farcical, and that the real-world ex-
ercise in exactly this kind of bank reserve flooding maneuver conducted by
the Bernanke Fed forty years later has been a total failure—a monumental
case of “pushing on a string.”
FRIEDMAN’S ERRONEOUS CRITIQUE OF THE
DEPRESSION-ERA FED OPENED THE DOOR
TO MONETARY CENTRAL PLANNING
The historical truth is that the Fed’s core mission of that era, to rediscount
bank loan paper, had been carried out consistently, effectively, and fully by
the twelve Federal Reserve banks during the crucial forty-five months be-
tween the October 1929 stock market crash and FDR’s inauguration in
March 1933. And the documented lack of member bank demand for dis-
count window borrowings was not because the Fed had charged a punish-
ingly high interest rate. In fact, the Fed’s discount rate had been
progressively lowered from 6 percent before the crash to 2.5 percent by
early 1933.
More crucially, the “excess reserves” in the banking system grew dramat-
ically during this forty-five-month period, implying just the opposite of
monetary stringency. Prior to the stock market crash in September 1929,
excess reserves in the banking system stood at $35 million, but then rose
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to $100 million by January 1931 and ultimately to $525 million by January
1933.
In short, the tenfold expansion of excess (i.e., idle) reserves in the bank-
ing system was dramatic proof that the banking system had not been
parched for liquidity but was actually awash in it. The only mission the Fed
failed to perform is one that Professor Friedman assigned to it thirty years
after the fact; that is, to maintain an arbitrary level of M1 by forcing re-
serves into the banking system by means of open market purchases of Un-
cle Sam’s debt.
As it happened, the money supply (M1) did drop by about 23 percent
during the same forty-five-month period in which excess reserves soared
tenfold. As a technical matter, this meant that the money multiplier had
crashed. As has been seen, however, the big drop in checking account de-
posits (the bulk of M1) did not represent a squeeze on money. It was merely
the arithmetic result of the nearly 50 percent shrinkage of the commercial
loan book during that period.
As previously detailed, this extensive liquidation of bad debt was an un-
avoidable and healthy correction of the previous debt bubble. Bank loans
outstanding, in fact, had grown at manic rates during the previous fifteen
years, nearly tripling from $14 billion to $42 billion. As in most credit-
fueled booms, the vast expansion of lending during the Great War and the
Roaring Twenties left banks stuffed with bad loans that could no longer be
rolled over when the music stopped in October 1929.
Consequently, during the aftermath of the crash upward of $20 billion of
bank loans were liquidated, including billions of write-offs due to business
failures and foreclosures. As previously explained, nearly half of the loan
contraction was attributable to the $9 billion of stock market margin loans
which were called in when the stock market bubble collapsed in 1929.
Likewise, loan balances for working capital borrowings also fell sharply
in the face of falling production. Again, this was the passive consequence
of the bursting industrial and export sector bubble, not something caused
by the Fed’s failure to supply sufficient bank reserves. In short, the liquida-
tion of bank loans was almost exclusively the result of bubbles being punc-
tured in the real economy, not stinginess at the central bank.
In fact, there has never been any wide-scale evidence that bank loans
outstanding declined during 1930–1933 on account of banks calling per-
forming loans or denying credit to solvent potential borrowers. Yet unless
those things happened, there is simply no case that monetary stringency
caused the Great Depression.
Friedman and his followers, including Bernanke, came up with an aca-
demic canard to explain away these obvious facts. Since the wholesale
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price level had fallen sharply during the forty-five months after the crash,
they claimed that “real” interest rates were inordinately high after adjusting
for deflation.
Yet this is academic pettifoggery. Real-world businessmen confronted
with plummeting order books would have eschewed new borrowing for the
obvious reason that they had no need for funds, not because they deemed
the “deflation-adjusted” interest rate too high.
At the end of the day, Friedman’s monetary treatise offers no evidence
whatsoever and simply asserts false causation; namely, that the passive de-
cline of the money supply was the active cause of the drop in output and
spending. The true causation went the other way: the nation’s stock of
money fell sharply during the post-crash period because bank loans are
the mother’s milk of bank deposits. So, as bloated loan books were cut
down to sustainable size, the stock of deposit money (M1) fell on a parallel
basis.
Given this credit collapse and the associated crash of the money multi-
plier, there was only one way for the Fed to even attempt to reflate the
money supply. It would have been required to purchase and monetize
nearly every single dime of the $16 billion of US Treasury debt then out-
standing.
Today’s incorrigible money printers undoubtedly would say, “No prob-
lem.” Yet there is no doubt whatsoever that, given the universal antipathy
to monetary inflation at the time, such a move would have triggered sheer
panic and bedlam in what remained of the financial markets. Needless to
say, Friedman never explained how the Fed was supposed to reignite the
drooping money multiplier or, failing that, explain to the financial markets
why it was buying up all of the public debt.
Beyond that, Friedman could not prove at the time of his writing A Mon-
etary History of the United States in 1965 that the creation out of thin air of
a huge new quantity of bank reserves would have caused the banking sys-
tem to convert such reserves into an upwelling of new loans and deposits.
Indeed, Friedman did not attempt to prove that proposition, either. Ac-
cording to the quantity theory of money, it was an a priori truth.
In actual fact, by the bottom of the depression in 1932, interest rates
proved the opposite. Rates on T-bills and commercial paper were one-half
percent and 1 percent, respectively, meaning that there was virtually no
unsatisfied loan demand from credit-worthy borrowers. The dwindling
business at the discount windows of the twelve Federal Reserve banks fur-
ther proved the point. In September 1929 member banks borrowed nearly
$1 billion at the discount windows, but by January 1933 this declined to
only $280 million. In sum, banks were not lending because they were short
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of reserves; they weren’t lending because they were short of solvent bor-
rowers and real credit demand.
In any event, Friedman’s entire theory of the Great Depression was thor-
oughly demolished by Ben S. Bernanke, his most famous disciple, in a real-
world experiment after September 2008. The Bernanke Fed undertook
massive open market operations in response to the financial crisis, pur-
chasing and monetizing more than $2 trillion of treasury and agency debt.
As is by now transparently evident, the result was a monumental wheel-
spinning exercise. The fact that there is now $1.7 trillion of “excess re-
serves” parked at the Fed (compared to a mere $40 billion before the crisis)
meant that nearly all of the new bank reserves resulting from the Fed’s
bond-buying sprees have been stillborn.
By staying on deposit at the central bank, they have fueled no growth at
all of Main Street bank loans or money supply. There is no reason whatso-
ever, therefore, to believe that the outcome would have been any different
in 1930–1932.
MILTON FRIEDMAN: FRESHWATER KEYNESIAN
AND THE LIBERTARIAN PROFESSOR WHO
FATHERED BIG GOVERNMENT
The great irony, then, is that the nation’s most famous modern conserva-
tive economist became the father of Big Government, chronic deficits, and
national fiscal bankruptcy. It was Friedman who first urged the removal of
the Bretton Woods gold standard restraints on central bank money print-
ing, and then added insult to injury by giving conservative sanction to per-
petual open market purchases of government debt by the Fed. Friedman’s
monetarism thereby institutionalized a régime which allowed politicians
to chronically spend without taxing.
Likewise, it was the free market professor of the Chicago school who also
blessed the fundamental Keynesian proposition that Washington must
continuously manage and stimulate the national economy. To be sure,
Friedman’s “freshwater” proposition, in Paul Krugman’s famous paradigm,
was far more modest than the vast “fine-tuning” pretensions of his “salt-
water” rivals. The saltwater Keynesians of the 1960s proposed to stimulate
the economy until the last billion dollars of potential GDP was realized;
that is, they would achieve prosperity by causing the state to do anything
that was needed through a multiplicity of fiscal interventions.
By contrast, the freshwater Keynesian, Milton Friedman, thought that
capitalism could take care of itself as long as it had precisely the right
quantity of money at all times; that is, Friedman would attain prosperity
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by causing the state to do the one thing that was needed through the single
spigot of M1 growth.
But the common predicate is undeniable. As has been seen, Friedman
thought that member banks of the Federal Reserve System could not be
trusted to keep the economy adequately stocked with money by voluntar-
ily coming to the discount window when they needed reserves to accom-
modate business activity. Instead, the central bank had to target and
deliver a precise quantity of M1 so that the GDP would reflect what eco-
nomic wise men thought possible, not merely the natural level resulting
from the interaction of consumers, producers, and investors on the free
market.
For all practical purposes, then, it was Friedman who shifted the foun-
dation of the nation’s money from gold to T-bills. Indeed, in Friedman’s
scheme of things central bank purchase of Treasury bonds and bills was
the monetary manufacturing process by which prosperity could be man-
aged and delivered.
What Friedman failed to see was that one wise man’s quantity rule for
M1 could be supplanted by another wise man’s quantity rule for M2 (a
broader measure of money supply that included savings deposits) or still
another quantity target for aggregate demand (nominal GDP targeting) or
even the quantity of jobs created, such as the target of 200,000 per month
recently enunciated by Fed governor Charles Evans. It could even be the
quantity of change in the Russell 2000 index of stock prices, as Bernanke
has advocated.
Yet it is hard to imagine a world in which any of these alternative “quan-
tities” would not fall short of the “target” level deemed essential to the na-
tion’s economic well-being by their proponents. In short, the committee of
twelve wise men and women unshackled by Friedman’s plan for floating
paper dollars would always find reasons to buy government debt, thereby
laying the foundation for fiscal deficits without tears.
THE UNSEEN HAND NEVER REPORTED FOR WORK
IN THE GLOBAL CURRENCY MARKETS
Open-ended monetization of US Treasury debt by the nation’s central bank
was only part of the sound money demise triggered by the Camp David
events. The decision to destroy Bretton Woods and float the dollar also
caused an irreparable breakdown of international financial discipline.
Never again were trade accounts between nations properly settled, and
most especially in the case of the United States. As previously indicated, the
cumulative current account deficit since 1971 exceeds $8 trillion, meaning
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that Americans have borrowed one-half “turn” of national income from the
rest of the world in order to live permanently beyond their means.
These massive US trade deficits have actually become a way of life since
Camp David, yet they were not supposed to even happen. Professor Fried-
man advised the Nixon White House at the time that market forces would
actually eliminate the incipient US trade deficit by “price discovery” of the
“correct” market clearing exchange rates.
In this manner, floating exchange rates would continuously rebalance
the flows of merchandise trade, direct investment, portfolio capital, and
short-term financial instruments according to the changing circumstances
of each nation. A global variant of Adam Smith’s “unseen hand” would sup-
plant the financial stabilization and trade settlement functions of the old-
fashioned gold standard that the discarded Bretton Woods system had
been built upon.
In short, international markets would be cleared by the continuous
repricing of exchange rates. This meant that deficit countries would suffer
currency depreciation and surplus countries the opposite, thereby main-
taining international payments equilibrium.
As previously demonstrated, this seemingly enlightened, pragmatic, and
market-driven arrangement didn’t work in practice. As it turned out, Adam
Smith’s unseen hand never even reported for work after Professor Fried-
man’s floating-rate contraption was put into global operation.
Instead of floating with market forces, exchange rates have been chron-
ically and heavily manipulated by governments. This is especially the case
with respect to the mercantilist nations of Asia in pursuit of an “export your
way to prosperity” economic growth model.
In pegging their currencies far below market-clearing levels in mono-
maniacal pursuit of export advantage, Japan, China, South Korea, and the
caravan of imitators along the East Asian rim accumulated more and more
dollars. They then parked these excess dollars in Treasury bills and bonds,
and sequestered the latter in the vaults of their central banks.
Over the years, these staggering accumulations of dollar liabilities have
been labeled as “foreign exchange reserves” in deference to the wholly ar-
chaic notion that the dollar is a “reserve currency.” But the $7 trillion of dol-
lar liabilities now held by foreign central banks are not classic monetary
reserves at all.
The classic system’s monetary reserves were designed to function as in-
ternational petty cash accounts; that is, world money in the form of gold
was available to clear temporary imbalances in trade and capital flows be-
tween national currency areas. But the current system does not need petty
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cash reserves to clear international account imbalances because the latter
can persist indefinitely so long as mercantilist nations peg their currencies.
Consequently, the more apt characterization of these vast dollar accu-
mulations is that they are vendor-supplied export loans to the American
economy. Like any other vendor loan, they are designed to enable Ameri-
can customers to collectively purchase foreign goods and services far in ex-
cess of their actual earnings on current production.
This continuous stream of vendor loans was heavily channeled into
Treasury bonds and bills, along with the implicitly guaranteed paper of
Fannie Mae and Freddie Mac. Thus, the true foundation of the post–
Bretton Woods monetary system was US government debt. The latter be-
came the medium of exchange which permitted Americans to consume far
more than they produced, while enabling the developing Asian economies
to export vastly more goods than their customers could afford.
Indeed, with the passage of time the swap of mercantilist nation exports
for US government paper became embedded as the modus operandi of the
global economy. Milton Friedman’s monetary contraption has thus be-
come a ravenous consumer of Uncle Sam’s debt emissions, an outcome
that the idealistic professor had apparently never even contemplated.
By the end of 2012, however, the facts were unassailable. After three
decades of “deficits don’t matter” fiscal policy, the nation’s publicly held
debt amounted to $11.5 trillion. Yet as indicated, a stunning $5 trillion, or
nearly 50 percent, of that total was not held by private investors either at
home or overseas. Instead, it had been sequestered in the vaults of central
banks, including the Federal Reserve and those of major exporters.
MONETARY ROACH MOTELS:
THE BONDS WENT IN BUT NEVER CAME OUT
This freakish central bank accumulation of dollar liabilities, in turn, was
the result of the greatest money-printing spree in world history. In essence,
we printed and then they printed, and the cycle never stopped repeating.
In this manner, the massive excess of dollar liabilities generated by the Fed
were absorbed by its currency-pegging counterparts, and then recycled
into swelling domestic money supplies of yuan, yen, won, ringgit, and
Hong Kong dollars.
As the US debt-based global monetary system became increasingly
more unstable in recent years, central bank absorption of incremental
Treasury debt reached stunning proportions. Thus, United States publicly
held debt rose by $6 trillion between 2004 and 2012, but upward of $4 tril-
lion, or 70 percent, of this was taken down by central banks.
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It could be truly said, therefore, that the world’s central banks have
morphed into a global chain of monetary roach motels. The bonds went
in, but they never came out. And therein lays the secret of “deficits without
tears.”
American politicians thus found themselves in the great fiscal sweet
spot of world history. For several decades to come, they would have the
unique privilege to issue bonds, notes, and bills from the US Treasury with-
out limit. Only in the foggy future, when the world finally ran out of mer-
cantilist rulers willing to swap the sweat of their people for Washington’s
profligate debt emissions, would fiscal limits reemerge.
As it happened, not all American politicians immediately recognized
that they had essentially died and gone to fiscal heaven. Hence in the first
half of the 1990s, under George H. W. Bush and then President Bill Clinton,
old-guard Republicans joined bourbon Democrats in the enactment of
comprehensive fiscal plans that did actually reduce spending and raise
new tax revenues.
But Bill Clinton’s courageously balanced budgets were the last hurrah of
the old fiscal orthodoxy. These outcomes rested on a frail reed of personal
conviction among politicians who had learned the fiscal rules of an earlier
era.
In the emerging world of American crony capitalism, however, fiscal or-
thodoxy based on mere conviction untethered to real-world economic and
financial pressures was not destined to survive. Instead, the assembled
lobbies of K Street would soon have their way with the nation’s public
purse.
In due course, the revenue base would be depleted in the name of
spurring the growth of everything from ethanol plants to private aircraft to
the gross national product itself. Meanwhile, the spending side of the
budget became swollen with new subventions to the sick-care complex,
the housing complex, the education behemoth, the farm subsidy har-
vesters’ alliance, and the alphabet soup of energy alternatives.
In the larger scheme of things, the nation’s descent into permanent fis-
cal profligacy during the late twentieth century should not have been sur-
prising. The historical record prior to the T-bill standard quite clearly
demonstrates that fiscal discipline had never really depended upon the
fortitude of principled statesmen.
GREENSPAN’S BORROWED PROSPERITY
After the Greenspan Fed abruptly abandoned its 1994 effort to impose a
mild semblance of monetary discipline, the world’s T-bill-based monetary
system was off to the races. Frenetic money pumping by the Fed was re-
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ciprocated by even more aggressive currency pegging in East Asia, most es-
pecially in China, where the exchange rate was devalued by nearly 60 per-
cent at the beginning of Mr. Deng’s export campaign in 1994.
Fueled by this reciprocating monetary engine of central bank printing
presses, the world economy was soon booming and the US current ac-
count deficits swelled to massive proportions. Thus, the current account
deficit of $114 billion in 1995 was already an alarming 1.6 percent of GDP,
but that was just a warm-up for the coming binge of borrowed prosperity.
Thereafter, the US current account deficit with the rest of the world went
parabolic, rising to $416 billion, or 4.2 percent, of GDP by the year 2000.
Indeed, for the entire 1990s decade the nation’s cumulative deficit with the
world was $2.0 trillion—a giant loan from abroad that bought a lot of de-
signer jeans, personal computers, granite-top kitchen counters, gas-
chugging SUVs, and luxury cruises that American households had not
actually earned.
Yet the borrowing binge fostered by the Greenspan Fed was just getting
warmed-up. American overspending financed by exporter nation loans at-
tained nearly riotous proportions after the turn of the century, reaching, a
peak current account deficit of $800 billion, or 6.1 percent, of GDP in 2006.
For the decade ending in 2011, cumulative borrowings from the rest of
the world tripled from $2 billion in the 1990s to $6 trillion. And so America’s
garages, pantries, media rooms, and second homes filled up with even
more stuff bought on the prodigious flow of credit generated by the world’s
T-bill-based monetary system.
In the fullness of time, floating-rate money led to fiscal profligacy on a
scale never before imagined. Spending without the inconvenience of tax-
ing opened the door to state subventions, bailouts, and endless tax breaks
throughout the length and breadth of the American economy.
But the plenary mobilization of the state and all its agencies and organs
of intervention, including the prosperity management régime of the cen-
tral banking branch, is what fueled the rise of crony capitalism. It is a long-
standing truism of political science that focused, organized special
interests will always trump the diffuse public interest. So once raiding the
Treasury and leveraging Wall Street and the banking system were deemed
to be the pathway to the greater good, K Street lobbies and political action
committees (PACs) captured the instruments of policy and extracted the
resources of the public purse like never before.
So the irony was abundant. Friedman the historian was dead wrong on
the gold standard and the Fed’s responsibility for the Great Depression. Ac-
cordingly, the libertarian economist from the University of Chicago, more
than any other single intellectual, fostered the Nixonian breakdown of
MILTON FRIEDMAN’S FOLLY
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monetary integrity and helped crush the last age of fiscal rectitude so
painstakingly restored by Dwight D. Eisenhower.
Proffering what is by the hindsight of history a spurious rule of money
supply growth, Friedman gave birth to the T-bill standard and a massively
disordered and unbalanced international system in which mercantilist
governments swap the labor of their people and natural resources of their
lands for “money” which is merely dollar-denominated American debt.
Worse still, the later process became the foundation for the age of bub-
ble finance, a great financial deformation that resulted in a Wall Street
crescendo of speculation and rent seeking that had no historical parallel.
Neither did Friedman’s folly.
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Recently by David Stockman: The Forgotten Cause of Sound Money

Then, when the Fed’s fire hoses started spraying an elephant soup of liquidity injections in every direction and its balance sheet grew by $1.3 trillion in just thirteen weeks compared to $850 billion during its first ninety-four years, I became convinced that the Fed was flying by the seat of its pants, making it up as it went along. It was evident that its aim was to stop the hissy fit on Wall Street and that the thread of a Great Depression 2.0 was just a cover story for a panicked spree of money printing that exceeded any other episode in recorded human history.

~ David Stockman, The Great Deformation

David Stockman, former director of the OMB under President Reagan, former US Representative, and veteran financier is an insider's insider. Few people understand the ways in which both Washington DC and Wall Street work and intersect better than he does.

In his upcoming book, The Great Deformation: The Corruption of Capitalism in America, Stockman lays out how we have devolved from a free market economy into a managed one that operates for the benefit of a privileged few. And when trouble arises, these few are bailed out at the expense of the public good.

By manipulating the price of money through sustained and historically low interest rates, Greenspan and Bernanke created an era of asset mis-pricing that inevitably would need to correct.  And when market forces attempted to do so in 2008, Paulson et al hoodwinked the world into believing the repercussions would be so calamitous for all that the institutions responsible for the bad actions that instigated the problem needed to be rescued — in full — at all costs. 

Of course, history shows that our markets and economy would have been better off had the system been allowed to correct. Most of the "too big to fail" institutions would have survived or been broken into smaller, more resilient, entities. For those that would have failed, smaller, more responsible banks would have stepped up to replace them – as happens as part of the natural course of a free market system:

Essentially there was a cleansing run on the wholesale funding market in the canyons of Wall Street going on. It would have worked its will, just like JP Morgan allowed it to happen in 1907 when we did not have the Fed getting in the way. Because they stopped it in its tracks after the AIG bailout and then all the alphabet soup of different lines that the Fed threw out, and then the enactment of TARP, the last two investment banks standing were rescued, Goldman and Morgan [Stanley], and they should not have been. As a result of being rescued and having the cleansing liquidation of rotten balance sheets stopped, within a few weeks and certainly months they were back to the same old games, such that Goldman Sachs got $10 billion for the fiscal year that started three months later after that check went out, which was October 2008. For the fiscal 2009 year, Goldman Sachs generated what I call a $29 billion surplus – $13 billion of net income after tax, and on top of that $16 billion of salaries and bonuses, 95% of it which was bonuses.

Therefore, the idea that they were on death’s door does not stack up. Even if they had been, it would not make any difference to the health of the financial system. These firms are supposed to come and go, and if people make really bad bets, if they have a trillion dollar balance sheet with six, seven, eight hundred billion dollars worth of hot-money short-term funding, then they ought to take their just reward, because it would create lessons, it would create discipline. So all the new firms that would have been formed out of the remnants of Goldman Sachs where everybody lost their stock values – which for most of these partners is tens of millions, hundreds of millions – when they formed a new firm, I doubt whether they would have gone back to the old game. What happened was the Fed stopped everything in its tracks, kept Goldman Sachs intact, the reckless Goldman Sachs and the reckless Morgan Stanley, everyone quickly recovered their stock value and the game continues. This is one of the evils that comes from this kind of deep intervention in the capital and money markets.

Stockman's anger at the unnecessary and unfair capital transfer from taxpayer to TBTF bank is matched only by his concern that, even with those bailouts, the banking system is still unacceptably vulnerable to a repeat of the same crime:

The banks quickly worked out their solvency issues because the Fed basically took it out of the hides of Main Street savers and depositors throughout America. When the Fed panicked, it basically destroyed the free-market interest rate – you cannot have capitalism, you cannot have healthy financial markets without an interest rate, which is the price of money, the price of capital that can freely measure and reflect risk and true economic prospects.

Well, once you basically unplug the pricing mechanism of a capital market and make it entirely an administered rate by the Fed, you are going to cause all kinds of deformations as I call them, or mal-investments as some of the Austrians used to call them, that basically pollutes and corrupts the system. Look at the deposit rate right now, it is 50 basis points, maybe 40, for six months. As a result of that, probably $400-500 billion a year is being transferred as a fiscal maneuver by the Fed from savers to the banks. They are collecting the spread, they've then booked the profits, they've rebuilt their book net worth, and they paid back the TARP basically out of what was thieved from the savers of America.

Now they go down and pound the table and whine and pout like JP Morgan and the rest of them, you have to let us do stock buy backs, you have to let us pay out dividends so we can ramp our stock and collect our stock option winnings. It is outrageous that the authorities, after the so-called “near death experience" of 2008 and this massive fiscal safety net and monetary safety net was put out there, is allowing them to pay dividends and to go into the market and buy back their stock. They should be under house arrest in a sense that every dime they are making from this artificial yield group being delivered by the Fed out of the hides of savers should be put on their balance sheet to build up retained earnings, to build up a cushion. I do not care whether it is fifteen or twenty or twenty-five percent common equity and retained earnings-to-assets or not, that is what we should be doing if we are going to protect the system from another raid by these people the next time we get a meltdown, which can happen at any time.

You can see why I talk about corruption, why crony capitalism is so bad. I mean, the Basel capital standards, they are a joke. We are just allowing the banks to go back into the same old game they were playing before. Everybody said the banks in late 2007 were the greatest thing since sliced bread. The market cap of the ten largest banks in America, including from Bear Stearns all the way to Citibank and JP Morgan and Goldman and so forth, was $1.25 trillion. That was up thirty times from where the predecessors of those institutions had been. Only in 1987, when Greenspan took over and began the era of bubble finance – slowly at first then rapidly, eventually, to have the market cap grow thirty times – and then on the eve of the great meltdown see the $1.25 trillion to market cap disappear, vanish, vaporize in panic in September 2008. Only a few months later, $1 trillion of that market cap disappeared in to the abyss and panic, and Bear Stearns is going down, and all the rest.

This tells you the system is dramatically unstable. In a healthy financial system and a free capital market, if I can put it that way, you are not going to have stuff going from nowhere to @1.2 trillion and then back to a trillion practically at the drop of a hat. That is instability; that is a case of a medicated market that is essentially very dangerous and is one of the many adverse consequences and deformations that result from the central-bank dominated, corrupt monetary system that has slowly built up ever since Nixon closed the gold window, but really as I say in my book, going back to 1933 in April when Roosevelt took all the private gold. So we are in a big dead-end trap, and they are digging deeper every time you get a new maneuver.

Click the play button below to listen to Chris' interview with David Stockman (56m:33s):

Recently by David Stockman: Mitt Romney: TheGreatDeformer

The Henry Hazlitt Memorial Lecture, Austrian Scholars Conference, March 10-12, 2011. Listen to the podcast.

ROCKWELL: Well, it’s great to have as our Henry Hazlitt Memorial lecturer this year, Mr. David Stockman. David is a graduate of Michigan State University. He did graduate work at Harvard University. He was elected to Congress three times from the state of Michigan.

And back when I first went to work for Ron Paul in the reign of Jimmy I —

(Laughter)

— outside of admiring our own boss, the Ron Paul staff always admired David Stockman, who got a chance to work with him on things like the draft, draft registration and other issues. And in fact, among the Republican staffers, he was generally considered one of the most brilliant people ever to be elected to Congress. That might seem like faint praise but it’s actually not.

(Laughter)

Actually, not. So obviously the talent spotters for the Reagan administration had the same view. They brought him on board as director of the Office of Management and Budget. He was the youngest cabinet secretary in the 20th century when he took that job.

Now, he was very unusual in that job. I would say unique in the Reagan administration and maybe unique in Republican politics at the presidential level. He actually tried to cut spending. And his opponents were people like Ed Meese, the Conservatives, who always talked a good game but, in fact, of course, were for bigger and bigger government.

When he left that job, he wrote one of the most wonderful books ever written on American politics. I think The Triumph of Politics was a best-seller. As I say, a very significant book, too. And in fact, I hope he’ll talk to us today about the book that he is writing right now about crony capitalism and the very unfortunate current American political and economic system.

When David left the Reagan administration and finished his book, he went to work for Salomon Brothers and then he became a founding partner of the Blackstone Group, thereby, proving the Republican staffers’ view of him as smart some years before. He now runs his own investment bank, the Heartland Industrial Partners.

David, we’re so glad to have you here. It’s an honor that you’ve flown down here as — and he’s donating his travel expenses, or an honorary. He’s doing this all on his own as a gift to the Mises Institute and a gift to us and to everybody who will watch this on the Internet and in the future on Mises.org.

So please help me welcome Mr. David Stockman.

(Applause)

STOCKMAN: Well, thank you, Lew.

And let me start by saying, like everyone mis-educated in the 1960s —

(Laughter)

— I’ve benefited enormously from the economic — from Economics in One Lesson, The Failure of the New Economics, and all of the other work of Henry Hazlitt.

But I have to confess that my mis-education was at Harvard Divinity School, and the subject was not economics. But I did try to get economically mis-educated anyway by auditing John Kenneth Galbraith’s course on economics, not knowing at the time that I was going right to the heartland of error.

(Laughter)

Anyway, it seems that his lectures were exceedingly popular. Something like a thousand students would fight outside the hall to get in. But I soon learned that it was for the entertainment value. The first 30 minutes or so were non-stop, canned jokes about the stupidity of Republicans, of businessmen, of Wall Street, of most economists, and generally anyone who wasn’t John Kenneth Galbraith.

(Laughter)

But, of course, I came from — I came to these lectures for the substance which followed, and that was canned, too. But only later did I learn that this part of the lecture was the real joke of the thing —

(Laughter)

— when was all was said and done.

(Laughter)

Anyway, I escaped Harvard not being mis-educated in economics. I went to work on Capital Hill. I worked for a moderate Republican. We were allowed to read Newsweek in that office.

(Laughter)

And as a result, I became educated directly for the first time by Henry Hazlitt’s columns week after week. And so it really is a great honor to try to give a lecture today that may update and incorporate and apply to the circumstances of the moment some of the enormous wisdom and fundamentally correct economics that he wrote about and stood for for so long.

So I would start today by saying the triumph of crony capitalism occurred on October 3, 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 —

(Laughter)

— since FDR, “I’ve abandoned free-market principles in order to save the free-market system.”

(Laughter)

Now I’ve checked that out several times and he did say that, just in case anyone thinks I’m exaggerating.

Based on the panicked advice of Paulson and Bernanke, of course, the president had the misapprehension that without a bailout, quote, “This sucker is going down,” unquote.

(Laughter)

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 —

(Laughter)

— or at least their economic equivalent.

(Laughter)

Still, the urban legend persists that in September 2008, this payment 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 ensured. But the only thing that even faintly hints at this fiction is the commercial paper market dislocation that occurred at the time. 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 which were now violently unwinding.

At the 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 I guess you might call it, designed to garner a few extra bips of yield. As it happened, this foolish exposure to a defacto hedge fund, which was leveraged 30 to one, resulted in the humiliating disclosure that First Reserve broke the buck and that the somnolent institutional fund mangers, who were its clients, would suffer a loss, all of 3 percent.

Well, that should have been a so-what moment except then all the other lending 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 would not be rolled over due to money market redemptions.

But this outcome, too, was a so-what. Nowhere was it written that G.E. Capital or Bank One’s credit card conduit, to pick two heavy users of this 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 G.E., jumped on the phone to Secretary Paulson and yelled “fire.” Soon the Fed and the 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 cry. First, about $1 trillion of the $2 trillion in outstanding commercial paper was of the so-called ABCP type, asset-backed commercial paper, 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 upfront by selling these loan packages to their own conduits. In short, had every single ABCP conduit — and there was a trillion — been liquidated for want of commercial paper funding in the fall of 2008 — and over the past three years most have been — not a single consumer would have been denied a credit-card authorization or a car loan. His or her bank would have merely booked the loan as an on-balance-sheet asset rather than an 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 this sector was industrial company C.P., the kind of facility that some blue chip companies did use to fund their payroll. But there was not a single industrial company in America then issuing commercial paper which did not also have a standby bank line behind its C.P. 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 back-up lines, and none refused. In short, there never was a chance that payrolls wouldn’t be met.

The last $600 billion of C.P. is where the real crony capitalist stench lies. There were two huge users of the finance company C.P. sector — this last $600 billion — GMAC and G.E. Capital. At the time of the crisis, G.E. Capital had asset footings of $600 billion, most of which were 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, of course, produced fat spreads on G.E.’s loan book and 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 $80 billion in C.P. would have forced G.E. 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 the loan book and issued massively dilutive amounts of common stock or subordinated debt to close its sudden funding gap. Either way, G.E. shareholders would have taken the beating they deserved for overvaluing the company’s true earnings and for putting reckless managers in charge of the store.

So my point is that 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 very broadly, or more broadly, the carnage on Wall Street in September 2008 was the inevitable crash from 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 long-term capital were all just steps along the way to September 2008. Then, at that point, faced with a collapse of its own handiwork, Washington panicked and joined the Fed in unleashing an indiscriminant bail-out capitalism that has now thoroughly corrupted the halls of government even as it has become a debilitating blight on the free market.

So in this context, the linkage between printing-press money and fiscal profligacy merit special attention. Now, there are no fiscal rules at all. And already we have had Cash for Clunkers, Cash for Caulkers —

(Laughter)

— and under the homeowner’s credit, Cash for Convicts —

(Laughter)

— because it seems like 2,000 or 3,000 people filed who didn’t really need a home at the moment.

In any event, 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 U.S. government debt itself. The sheer budgetary facts are bracing enough. It needs to be recalled that fiscal year 2011, now under way, will encompass not a recession bottom but the 6th through the 9th 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 will be borrowed — 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 the deficits only half this size were expected for the current year as recently as last spring.

Not withstanding a full year of green shoots and booming stocks, however, Washington embraced a monumental round of new fiscal stimulus in December, as you all recall. The result was a trillion-dollar Christmas tree festooned with fiscal largess for every citizen, inclusive of the quick as well as the dead. Moreover —

(Laughter)

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 tranchet 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 stampeded. In fact, the United States is clocking a 10 percent of GDP deficit for the third year running because this latest fling of budgetary excess is just another episode in the epical collapse of U.S. 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 been gainsaid. Under the ancient regime of fixed exchange rates and currency convertibility, fiscal deficits without tiers simply were 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 of monetary reserves. And if the 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.

But 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 money. But there could never be a drain on U.S. monetary reserves because dollar claims are not convertible. The infernal engine of the fiat dollar, therefore, has had numerous lamentable consequences, but among the worst is that it facilitated open-ended monetization of the U.S. government’s debt.

Now monetization, as I’m sure you all know, can be done in two ways. First, there is out-right monetization as is now being conducted by the Fed through its POMO program; that is, it’s daily purchase of $4 billion to $8 billion of treasury debt. Indeed, the Fed’s Q.E.2 bond purchases of late 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 numbers of F Series of bonds that were 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. Hence, the money never leaves. 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, ostensively to peg their exchange rates, but with the effect of absorbing trillions of U.S. treasury paper. To be sure, the people’s 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 hordes 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 this global convoy of peggers; that is, the mercantilist nation central banks tethered to the Fed.

That this convoy is a potent mechanism for monetizing the U.S. 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 to 2 percent of British GDP. Likewise, in 1959, at the peak of Bretton Woods, the U.S. held $20 billion of gold reserves against GDP of $500 billion. Again, at about 4 percent of GDP, the hard monetary reserves needed to operate the system were extremely modest.

Now 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, for example, 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 case of surplus countries, 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 Freidman inspired, trade account balances 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.

(Laughter)

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 its GDP, and then insist over a period of years and decades that it did not manipulate its exchange rate. Still, today, there can be little doubt that China and other mercantilist exporters operate massive monetary warehouses where they deposit treasury bonds acquired during their endless dollar-buying campaigns.

Moreover, the U.S. Treasury Department can now stop splitting hairs about whether China is a currency manipulator because China just admitted it. Recently, the vice chairman of the People’s Bank of China, Yi Gang, asked a good question: Why do we have so much base money, he wondered. Said Mr. Yi, answering his own question, quote, “The central bank buys up foreign exchange inflows. If it didn’t, the Yuan wouldn’t be so stable.” Hmm.

(Laughter)

Nowhere — now, I would say, there’s one for the Guinness book of understatements —

(Laughter)

— if I ever saw one.

So at the end of the day, American lawmakers had been freed of the classic monetary constraints. There is no monetary squeeze and there is no reserve asset drain. The Fed always supplies reserve to the banking system to fund any and all private credit demand at policy rates that are invariably low. The notion of fiscal, quote, “crowding out” thus belongs to the museum of monetary history.

At the same time, the seemingly limitless emission of dollar claims by the U.S. 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 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.

(Laughter)

In fact, foreign central banks hold $2.6 trillion of U.S. treasuries at the New York Fed, while the Fed itself owns $1.2 trillion of treasury debt. Add in at least a half trillion more treasury paper that is officially held elsewhere and you have the startling fact that about $4.5 trillion, or 50 percent of all the publically held federal debt ever issued, has now been sequestered by central bankers. With such a mighty bid from the world’s central bankers, we have thus experienced what our classically trained forbearers 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 Chaney summed up the new reality, postulating that, quote, “Reagan proved deficits don’t matter.” He proved nothing. He proved no such thing, of course. The Republican politicians of the George W. Bush-era had most assuredly discovered that they could borrow with relative impunity. Soon, the GOP transformed the policy based idea of lower marginal income tax rates from the Reagan era into a faith-based religion of tax cutting anywhere, anytime, for any reason. So intense was the reawakening that the floor of the U.S. House became thronged with fiscal holy rollers, throbbing and shaking and jerking and gesticulating —

(Laughter)

— as they exercised section after section of the revenue code. By the time Bush and the congressional Republicans were through in fiscal 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 an economic policy viewpoint. But deficit-financed tax cuts are a politician’s snare and illusion. Such fiscal actions do not actually reduce tax payments; they just defer the timing. Moreover, the evidence of the last 30 years shows that preemptive tax cuts don’t actually, quote, “starve the beast,” not withstanding the popularity of this nostrum among certain K Street philosophers whose day job involves panhandling outside the Ways and Means Committee hearing room.

(Laughter)

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 state and warfare state were getting heavier, not lighter. Here, the GOP’s Neo-Con war department and its domestic porker division were busy, too, pushing federal spending-to-GDP ratio to record levels. In this respect, the Neo-Cons deserve a special chapter in the annals of fiscal infamy. Having pushed the American Empire to take its stand on real estate of dubious merit historically, that is the bloody plains of the Tigris, 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 which they could not win and would not end. The cumulative tab for Iraq and Afghanistan now stands at $1.26 trillion. And therein lies a stark tribute to the efficacy with which Professor Friedman’s contraption absorbs the federal debt. The fact is America’s conservative party, so called, did not even break a sweat as it debt-financed what were assuredly two of the most elective foreign policy misadventures ever undertaken.

Again, the contrast with canons of classical finance helps crystallize the picture. Writing in 1924, Hartley Withers, imminent editor of The Economist and keeper of vignettes of wisdom on matters of money and central banking, lamented that British finances were in shambles because the government had broken all the rules of proper 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 people’s savings at an honest wage for capital, it had resorted to massive inflation of bank credit and issuance of paper money — shin plasters, as they were known then — to pay His Majesty’s bills. Withers took special aim at England’s first war chancellor, Lloyd George, thundering as follows, quote, “It is difficult to exaggerate the evil effects of the economic crime — 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 when a million enemy soldiers were bivouacked across the channel. Now, a hundred years later, monetizing the expense of pursuing a tall man and a hundred followers lost in the high Himalayas apparently doesn’t even rank as a misdemeanor.

(Laughter)

That’s how far we’ve come.

It was in the domestic spending arena, however, where the newly liberated Bush Republicans put the peddle to the metal. 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 in the ’90s, the size of the domestic welfare state had drifted upwards but 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. Now apologists, such as Newt Gingrich, had excused Reagan’s mega deficits 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 2000, however, the big three entitlements alone costs $740 billion or 7.5 percent of GDP. The time for fundamental reform is 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 for prescription drugs, courtesy of Big Pharma; and Social Security rolled along without even a sideways glance from the anti-spenders. 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 commercial admonishes —

(Laughter)

— there’s more.

(Laughter)

In that modest 15 percent corner of the federal budget, known as domestic discretionary spending, Bush-era Republicans went on a veritable rampage. Homeland security spending, for example, soared fivefold, from $13 billion in 2000 to $59 billion in 2009. Likewise, outlays for veteran 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. Steaming 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, quote, “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.

(Laughter)

That’s evident in the numbers.

During this same eight years, housing and community development spending also doubled to $60 billion, along with a 75 percent rise in transportation, a swelling of farm support programs, and enactment of a $60 billion energy bill providing subsidies for solar, wind, fuel cells, clean coal, fusion, ethanol — the exact menu Republicans once held could best be sorted out by the free market.

In all, domestic spending during fiscal 2008 came in at a record $2.3 trillion. After 30 years of a rolling referendum on the welfare state, then the verdict was clear — eight years of Republican government had brought the burden of domestic spending to 15.8 percent of national income, a figure materially higher than the average during the last period of unified Democratic government under Carter. Thus, while the impact of the Reagan revolution on the size of the U.S. government has always been immeasurably immodest, it was now totally erased.

The sorry Republican record on fiscal matters is not merely a morality tale. When the conservative party and 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 assured its perpetuation. Consider, for example, how the two-party free-lunch competition has perverted the basic budgeting process. Here, the basic tool of long-term fiscal policy, the so-called 10-year budget projection, has been utterly corrupted by the need of both 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 which looks like progress. Unfortunately, this baseline outlook is now useless as it is riddled with fiscal booby traps, as I call them, in the form of major costly entitlement and tax law provisions that expire in an arbitrary cliff-wise fashion one, two or three years down the road.

It’s 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, at least in the projections. 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 alternate minimum tax jumps from four million to 33 million, causing the projected annual revenue take to rise from $34 billion under the patch, temporary, to $129 billion, permanent. Likewise, the 15 percent tax rate in corporate dividends will jump to 40 percent in 2013. The estate tax goes back up. All the tax credits that are now in place expire and so forth.

Taken together, the December Christmas tree contained temporary tax 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 100 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, quote, “rinse and repeat exercise” —

(Laughter)

— which 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 which temporarily waives the 20 percent drop in Medicare fees built into current law. Now upon passage, the politicians collect their election year medications from the grateful physicians lobby while taking credit for a $30 billion future annual spending reduction when the waiver expires. But, of course, it won’t.

Likewise, under extended unemployment benefits, 10 million workers get various, quote, “extended tiers” of the Unemployment Insurance Program at an annual cost of $150 billion. But under current law, nearly two-thirds of this cost is deemed temporary; meaning that out-year budget projections only show $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, estate tax, dividends, business credits and so forth. This means that baseline revenue is only about 16 to 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 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 to 8 percent of GDP. Now, that would amount to about $7 trillion in new bond issuance over the next five years alone and take the total public debt in the United States to over 100 percent of GDP.

There’s no telling, of course, as to 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 afore-mentioned $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 has 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 the U.S. 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.”

(Laughter)

In any event, the already baleful deficit projections would grow by trillions more under 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 not withstanding choice of stimulants, Republicans, too, believe the U.S. 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, again and again.

It is here that the true fiscal nightmare arises owing to the possibility that this mainstream outlook is completely erroneous and that the nation’s deep economy ills are rooted in the massive excess debt burden accumulated on the U.S. 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, lower 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 U.S. credit market debt essentially stopped growing in late 2007 at a level slightly above $50 trillion compared to $14.3 trillion of GDP. During the three years since late 2007, total debt growth has been 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 growth has gained only $530 billion during the 36 months since the peak; meaning that the annualized growth rate has only been 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, June 2009, the rate of money GDP growth has been only 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 that latter date. At a 3.5 percent lower 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.

Now 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 of $400 billion annually. Stated differently, the current policy deficit may actually be in the $2 trillion 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 drain on the monetary system that traditionally accompanied fiscal deficits. Secondly, to the extent that it fueled a debt super cycle that swelled from 1980 until 2008 that generated a false prosperity and bubble-derived fiscal windfalls that have now evaporated.

Shortly after Nixon closed the gold window in August 1971, Secretary Connelly — many of you recall him —

(Laughter)

— famously told an assemblage of foreign central bankers that, quote, “The dollar is our currency but it’s your problem.”

(Laughter)

Of course, the esteemed secretary had studied at the “Wright Patman School of Texas Finance,” of course, and not the University of Chicago. But he nevertheless shared Professor Friedman’s assurance that floating the dollar would eliminate the meddlesome problem of the U.S. current account deficit; that is, such trade objections as might be needed would be done by non-dollar 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 U.S. was free to go 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 consecutive years of deep current account deficits at 3 percent to 5 percent of GDP, external deficits, which now have accumulated to more than $7 trillion since the late 1970s.

Now the fly in the 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-styled monetarism. Thereby, retaining their export surpluses, the mercantilist exporters have accumulated treasury bonds from the back hall. Accordingly, the $9 trillion of current global Forex reserves, mostly held by the afore-mentioned 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 around.

They are also what made the U.S. balance sheet go parabolic. For a century after the resumption of convertibility in 1879, the ratio of total U.S. debt, both private and public, to national income was remarkably stable. Despite cycles of war and peace, and 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 ratio, national level ratio broke out to the upside and never looked back. By the middle 1990s, it had reached 2.6 times and then 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 which amounts to a nationwide LBO.

Now 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 $22 billion under the Golden Constant, i.e., 1.6 times $14.5 trillion of GDP. But today, it is actually $52 trillion, or 3.6 times.

Now Wall Street bulls and Keynesian economists, to indulge in a redundancy, insist that this extra $30 billion of debt is no sweat. Presumably, they would otherwise not be forecasting 10 years of standard growth 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 parabolic departure from the Golden Constant, Gold 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 government. If this were true, it would be a pity. Had our benighted financial forebears only known better, they would have levered up the U.S. economy 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 —

(Laughter)

— rather than his son, Albert Gore Jr of Hollywood.

(Laughter)

One never knows.

(Laughter)

The alternative possibility, however, is that our financial 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 this, it was off to the races. When the debt super cycle apogee came in 2007, it took $4 trillion of debt growth that year alone to produce just $700 billion of incremental GDP. At that point, the debt-to-income ratio had climbed — debt-to-income growth ratio had climbed to six times. And shortly thereafter, the man from Citigroup finally stopped dancing, as you all remember.

The evaporation of artificially inflated income growth and the bursting of the asset bubbles, which inexorably follow this kind of debt super cycle, have arrived at their appointed time. And the financial condition of the household sector suggests that the postulated Austrian moment may have a hang time measured in years or even a decade, not months or a quarter. 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 way 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 —

(Laughter)

— were $730 billion or about 45 percent of GDP. But today, the far older baby boom-led household sector has shed almost no pounds 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. 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 might look a lot more plausible. The fact is organic income is not growing at even 3 percent.

A shocking point buried in the statistics in our government-Medcaided 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 the 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 were down for even three months, let alone nearly 2.5 years.

Consequently, we have been able to keep up the appearance of consumption spending growth, even if tepid, only by resort to Uncle Sam’s credit card. Specially, the gap between wages, which are still down, and spending, which is up, has been filled by government transfer payments, all of which were funded on the margin with new borrowings. Transfer payments have risen by nearly $500 billion from the Q3 2008 rate. Thus, the Fed and its global convoy of monetary Roach Motels have been the source of the entire intervening game in U.S. 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 more normal rates, rates compatible with a Keynesian recovery rather than an Austrian deflation. Well, as the man also said, “Good luck with that one, too.”

(Laughter)

The January non-farm payroll number was $130.5 million, a figure first reached in November 1999, 12 years ago. And that is the encouraging part of the story.

(Laughter)

Way back then, there were 72 million — I call them bread-winner jobs in the U.S. economy — that is jobs in manufacturing, construction, distribution, finance, insurance, real estate, information technology, the professions and white collar services. Average pay levels were $50,000 per year in today’s dollars. A decade later, in February 2011, there were only 65 million of these same bread-winner jobs left in the economy, 10 percent less. To be sure, this large drain was offset by a six-million job gain over the decade in what I call 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 were 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 in health, education, social services during all of 2000 to 2007, the rate has now dropped to less than $20,000 per month as the fiscal noose has tightened. That leaves what might be termed the part-time economy, 35 million jobs in retail, bars, restaurants, hotels, personal 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 bellboys and bar hops, this segment supports no families and funds no savings, even if it does give Wall Street economists something to count.

Now none of this bodes well for a spirited Keynesian recovery or even a toothless one. Accordingly, the U.S. economy is likely stuck in an extended Austrian moment and the U.S. government deficit is likely beached in the $1.5 to $2 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 Friedman’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 China economy — the China rural economy, the only one it ever had, was prostrate under the weight of 45 million dead from starvation and far more debilitated and destitute, owing to the great helmsman’s economic follies. By underwriting a 40-year debt super cycle, however, the newly unshackled Fed fueled unstinting American demand for the output of east China’s rapidly expanding export factories. 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 the Keynesian hours for quasi-slave pay rates, this army of refugees from Miles 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 contra-factual. Had Nixon kept the gold window open, China would have accumulated bullion, not bonds. America would have experienced deflationary austerity, not inflationary bubbles. And federal deficits — fiscal deficits would have mattered a lot. 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, which has metastasized since 1971, may be approaching its end game. By all appearances, Mile’s great rural swamp has now pretty much been drained. Global wages will therefore start rising because even Wal-Mart has not been able to discover another country inhabited by millions of $1-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, if not violence. If it stops buying the bond, at what price can trillions more of federal debt 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.”

Thank you.

(Applause)

Former Congressman David A. Stockman was Reagan’s OMB director, which he wrote about in his best-selling book, The Triumph of Politics. His latest book is The Great Deformation: The Corruption of Capitalism in America. He was an original partner in the Blackstone Group, and reads LRC the first thing every morning.

The Best of David Stockman

Is Romney really a job creator? Ronald Reagan’s budget director, David Stockman, takes a scalpel to the claims.

Bain Capital is a product of the Great Deformation. It has garnered fabulous winnings through leveraged speculation in financial markets that have been perverted and deformed by decades of money printing and Wall Street coddling by the Fed. So Bain’s billions of profits were not rewards for capitalist creation; they were mainly windfalls collected from gambling in markets that were rigged to rise.

Nevertheless, Mitt Romney claims that his essential qualification to be president is grounded in his 15 years as head of Bain Capital, from 1984 through early 1999. According to the campaign’s narrative, it was then that he became immersed in the toils of business enterprise, learning along the way the true secrets of how to grow the economy and create jobs. The fact that Bain’s returns reputedly averaged more than 50 percent annually during this period is purportedly proof of the case – real-world validation that Romney not only was a striking business success but also has been uniquely trained and seasoned for the task of restarting the nation’s sputtering engines of capitalism.

Except Mitt Romney was not a businessman; he was a master financial speculator who bought, sold, flipped, and stripped businesses. He did not build enterprises the old-fashioned way – out of inspiration, perspiration, and a long slog in the free market fostering a new product, service, or process of production. Instead, he spent his 15 years raising debt in prodigious amounts on Wall Street so that Bain could purchase the pots and pans and castoffs of corporate America, leverage them to the hilt, gussy them up as reborn “roll-ups,” and then deliver them back to Wall Street for resale – the faster the better.

That is the modus operandi of the leveraged-buyout business, and in an honest free-market economy, there wouldn’t be much scope for it because it creates little of economic value. But we have a rigged system – a regime of crony capitalism – where the tax code heavily favors debt and capital gains, and the central bank purposefully enables rampant speculation by propping up the price of financial assets and battering down the cost of leveraged finance.

So the vast outpouring of LBOs in recent decades has been the consequence of bad policy, not the product of capitalist enterprise. I know this from 17 years of experience doing leveraged buyouts at one of the pioneering private-equity houses, Blackstone, and then my own firm. I know the pitfalls of private equity. The whole business was about maximizing debt, extracting cash, cutting head counts, skimping on capital spending, outsourcing production, and dressing up the deal for the earliest, highest-profit exit possible. Occasionally, we did invest in genuine growth companies, but without cheap debt and deep tax subsidies, most deals would not make economic sense.

In truth, LBOs are capitalism’s natural undertakers – vulture investors who feed on failing businesses. Due to bad policy, however, they have now become monsters of the financial midway that strip-mine cash from healthy businesses and recycle it mostly to the top 1 percent.

The waxing and waning of the artificially swollen LBO business has been perfectly correlated with the bubbles and busts emanating from the Fed – so timing is the heart of the business. In that respect, Romney’s tenure says it all: it was almost exactly coterminous with the first great Greenspan bubble, which crested at the turn of the century and ended in the thundering stock-market crash of 2000-02. The credentials that Romney proffers as evidence of his business acumen, in fact, mainly show that he hung around the basket during the greatest bull market in recorded history.

Needless to say, having a trader’s facility for knowing when to hold ’em and when to fold ’em has virtually nothing to do with rectifying the massive fiscal hemorrhage and debt-burdened private economy that are the real issues before the American electorate. Indeed, the next president’s overriding task is restoring national solvency – an undertaking that will involve immense societywide pain, sacrifice, and denial and that will therefore require “fairness” as a defining principle. And that’s why heralding Romney’s record at Bain is so completely perverse. The record is actually all about the utter unfairness of windfall riches obtained under our anti-free market regime of bubble finance.

RIP VAN ROMNEY

When Romney opened the doors to Bain Capital in 1984, the S&P 500 stood at 160. By the time he answered the call to duty in Salt Lake City in early 1999, it had gone parabolic and reached 1270. This meant that had a modern Rip Van Winkle bought the S&P 500 index and held it through the 15 years in question, the annual return (with dividends) would have been a spectacular 17 percent. Bain did considerably better, of course, but the reason wasn’t business acumen.

The secret was leverage, luck, inside baseball, and the peculiar asymmetrical dynamics of the leveraged gambling carried on by private-equity shops. LBO funds are invested as equity at the bottom of a company’s capital structure, which means that the lenders who provide 80 to 90 percent of the capital have no recourse to the private-equity sponsor if deals go bust. Accordingly, LBO funds can lose 1X (one times) their money on failed deals, but make 10X or even 50X on the occasional “home run.” During a period of rising markets, expanding valuation multiples, and abundant credit, the opportunity to “average up” the home runs with the 1X losses is considerable; it can generate a spectacular portfolio outcome.

In a nutshell, that’s the story of Bain Capital during Mitt Romney’s tenure. The Wall Street Journal examined 77 significant deals completed during that period based on fundraising documents from Bain, and the results are a perfect illustration of bull-market asymmetry. Overall, Bain generated an impressive $2.5 billion in investor gains on $1.1 billion in investments. But 10 of Bain’s deals accounted for 75 percent of the investor profits.

Accordingly, Bain’s returns on the overwhelming bulk of the deals – 67 out of 77 – were actually lower than what a passive S&P 500 indexer would have earned even without the risk of leverage or paying all the private-equity fees. Investor profits amounted to a prosaic 0.7X the original investment on these deals and, based on its average five-year holding period, the annual return would have computed to about 12 percent – well below the 17 percent average return on the S&P in this period.

By contrast, the 10 home runs generated profits of $1.8 billion on investments of only $250 million, yielding a spectacular return of 7X investment. Yet it is this handful of home runs that both make the Romney investment legend and also seal the indictment: they show that Bain Capital was a vehicle for leveraged speculation that was gifted immeasurably by the Greenspan bubble. It was a fortunate place where leverage got lucky, not a higher form of capitalist endeavor or training school for presidential aspirants.

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Former Congressman David A. Stockman was Reagan’s OMB director, which he wrote about in his best-selling book, The Triumph of Politics. He was an original partner in the Blackstone Group, and reads LRC the first thing every morning.

The Best of David Stockman

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Learn more and register now to lock in early-bird pricing — you don’t want to miss this conference.

Alex Daley: Hello. I’m Alex Daley. Welcome to another edition of Conversations with Casey. Today our guest is former Reagan Budget Director and Congressman David Stockman. Welcome to the show, David.

David Stockman: Glad to be here.

Alex: So we’re here in Florida talking at the Recovery Reality Check Casey Summit. What do you think: is the United States economy on the road to recovery?

David: I don’t think we are at the beginning of the recovery. I think we are at the end of a disastrous debt supercycle that has gone on for the last thirty or forty years, really. It started when Nixon defaulted on our obligations under Bretton Woods and closed the gold window. Incrementally, year after year since then, we have been going in a direction of extremely unsound money, of massive borrowing in both the private and the public sector. We now have an economy that is saturated with debt: $54 trillion or $53 trillion — 3.5 times the GDP — way off the charts from where it was for a hundred years prior to the beginning of this. The idea that somehow all of that debt is irrelevant, as the Keynesians would tell us, is fundamentally wrong — and the reason why the economy can’t get up off the mat.

We’re doing all the wrong things. We’re adding to the problem, not subtracting. We are not allowing the debt to be worked down and liquidated. We’re not asking people to save more and consume less, which is what we really need to do. And so therefore I think policy is just making it worse, and any day now we will have another recurrence of the kind of economic crisis we had a few years ago.

Alex: You paint a very stark picture, but if people just stop spending, start saving, won’t companies like Apple see their earnings hurt? Won’t the stock market then start to tumble, people’s net worth fall? Isn’t that a negative cycle that feeds on itself?

David: Sure it does, but you can’t live beyond your means because it’s pleasant. It’s not sustainable. Clearly the level of debt that we have is not sustainable. We have a whole generation — the Baby Boom — that’s about ready to retire, and they have no retirement savings. We have a federal government that is bankrupt, literally. Its [debt is] $16 trillion and growing by a trillion a year. Something’s going to give. We can’t pay for all these entitlements. There won’t be the revenue generation in the economy to do it.

So as a result of that, we are deluding ourselves if we think we can just continue to spend. Look at the GDP that came out in the first quarter of this year. It was only 2.2%. Most of it was personal consumption expenditure, and half of that was due to a drawdown of the savings rate, not because the economy was earning more income or generating more real output. It was because of a drawdown of savings. That is exactly the wrong way to go — an indication of how severe the crisis is going to be.

I’m not saying the economy should stop spending entirely. I’m only saying you can’t save 3% of GDP and spend 97% if you are going to get out of this fix. As the savings rate goes up both in the public sector (which means reduction of spending and the deficit) and the household sector (to seriously reduce debt burden, which has not really happened) we are going to, on the margin, spend less, save more. It will slow down the economy. It will undermine profits, I agree. But profits today are way overstated. They’re based on a debt-bloated economy that isn’t sustainable.

Alex: So we can only live beyond our means for so long, as any family knows.

David: Yes.

Alex: Now, the government can reduce its expenses at any time by simply reducing spending, and it can reduce debt if it brings in more tax revenue. That’s austerity — I think that’s how they refer to it. But won’t austerity cause massive joblessness? Won’t there be millions more people in this country not receiving a paycheck?

David: Yes, but the critique, the clamoring and clattering that you hear from the Keynesians (or even mainstream media, which is pretty clueless economically) that austerity is bad forgets the fact that austerity isn’t an elective course. Austerity is something that happens to you when you’re broke. And yes, it is painful and spending will go down and unemployment will go up and incomes will be impaired, but that is a consequence of the excess debt creation that we’ve had for the last thirty years. So austerity is what happens when you break the rules.

And somehow we have this debate going on. They’re making a mistake. They chose the wrong strategy. Do you think Greece chose the wrong strategy with austerity? No. No one would lend them money. That’s why they ended up in the place they were. Do you think that Spain today is teetering on the brink because they said, “Oh, wouldn’t it be a good idea to have austerity?” No, they had a gun to their head. They were forced to do this because the markets would not continue to lend, and even now their interest rate is again rising. The markets are losing confidence, and unless the ECB prints some more money and bails them out some more, they are going to have austerity. So the austerity upon us is the backside of the debt supercycle we had for the past thirty years. It’s not discretionary.

Alex: Austerity hasn’t been forced upon us yet. The dollar is up, people are continuing to buy Treasuries — both nations and banks are buying Treasuries. To all extents and purposes, people are continuing to show massive confidence in the US government, lend it money at extremely cheap interest rates, and letting it build up its debt.

So you are advocating that, unlike Greece or Spain taking it to the edge and having austerity forced on them, we should volunteer for austerity today? Instead of just kicking the can down the road and living high a little bit longer, until the bill collectors finally come knocking? Why go today, why start austerity now instead of doing what Greece did and going as long as you possibly can?

David: Because Greece is a $300 billion economy. Tiny. A rounding error in the great scheme of things. It’s — last time I checked — about eight and a half months’ worth of Walmart sales. Okay? That’s a little different than when you have the $15 trillion heartland of the world economy, and the $11 trillion Treasury market which is at the center of the whole global financial system buckle and falter. That’s the risk you’re taking if you say, “Maana. Kick the can; let’s just wait for something good to happen.”

This market isn’t real. The two percent on the ten-year, the ninety basis points on the five-year, thirty basis points on a one-year — those are medicated, pegged rates created by the Fed and which fast-money traders trade against as long as they are confident the Fed can keep the whole market rigged. Nobody in their right mind wants to own the ten-year bond at a two percent interest rate. But they’re doing it because they can borrow overnight money for free, ten basis points, put it on repo, collect 190 basis points a spread, and laugh all the way to the bank. And they will keep laughing all the way to the bank on Wall Street until they lose confidence in the Fed’s ability to keep the yield curve pegged where it is today. If the bond ever starts falling in price, they unwind the carry trade. They unwind the repo, because then you can’t collect 190 basis points.

Then you get a message, “Do not pass go.” Sell your bonds, unwind your overnight debt, your repo positions. And the system then begins to contract — exactly what happened in September and October of 2008. Only, that time it was an unwind to the repo on mortgage-backed securities and CDOs and so forth. That was a minor trial run for the great unwind that is going to happen when the Treasury market is finally shattered with a lack of confidence because, on the margin, no one owns a Treasury bond: they just rent it on borrowed money. If the price starts falling, they’ll get out of that trade as fast as they got out of toxic CDOs.

Alex: So when people run away from the US, they will run away all at once.

David: Well, if they run away from the Treasury, it sends compounding forces of contagion through the entire financial system. It hits next the MBS and the mortgage market. The mortgage market then scares the hell out of people about the housing recovery, which hasn’t happened anyway. And if there isn’t a housing recovery, middle-class Main-Street confidence isn’t going to recover, because it is the only asset they have, and for 25 million households it’s under water or close to under water.

Alex: We saw something much like that in 2008. All the markets correlated. Stocks went down. Bonds went down. Gold went down with them. It sounds like what you’re saying is that the Fed is effectively paying bankers to stay confident in the Fed, and that the moment that stops — either because the Fed stops paying them or something else shakes their confidence — this all goes down in one big house of cards?

David: Yes, I think that’s right. The Fed has destroyed the money market. It has destroyed the capital markets. They have something that you can see on the screen called an “interest rate.” That isn’t a market price of money or a market price of five-year debt capital. That is an administered price that the Fed has set and that every trader watches by the minute to make sure that he’s still in a positive spread. And you can’t have capitalism if the capital markets are dead, if the capital markets are simply a branch office — branch casino — of the central bank. That’s essentially what we have today.

Alex: Last night you told our audience that if you were elected president, the first thing you would do is quit. Or at least demand a recount, I believe were your words, which I thought was telling. Are you saying there are no policy changes we could make today that would get us out of this? Or at least that wouldn’t get you assassinated?

David: Yeah, there is a paper blueprint. People who believe in sound money and fiscal responsibility, that you create wealth the old-fashioned way through savings and work and effort and not simply by printing money and trading pieces of paper — there is a plan that they could put together. One would be to put the Fed out of business. You don’t have to “end the Fed,” although I like Ron Paul’s phrase. You have to get them out of discretionary, active, day-to-day meddling in the money markets. Abolish the Open Market Committee.

The Fed has taken its balance sheet to $3 trillion. That’s enough for the next 50 years. They don’t have to do a damn thing except maybe have a discount window that floats above the market, and if things get tight, let the interest rate go up. People who have been speculating will be carried out on a stretcher. That’s how they used to do it. It worked prior to 1914. That’s the first step: abolish the Open Market Committee. Abolish discretionary monetary policy.

Let the Fed, if you’re going to keep it — I don’t even know that you need to do that, but if you are going to keep it — be only a standby source. As Bagehot said (Walter Bagehot, the great 19th-century British financial thinker): provide liquidity at a penalty rate to sound collateral.

Now, that’s what J.P. Morgan did in 1907, in the great crisis of 1907, from his library. He didn’t have a printing press. He didn’t bail out everybody. He didn’t do what Bernanke did and say: “Stop the presses, freeze everybody, and prop up Morgan Stanley and Goldman Sachs and all the rest of the speculators.” The interest rate, the call-money interest rate, which was the open-market interest rate at the time, some days went to 30, 40, 70% — and they were carrying out the speculators left and right, liquidating margin debt, taking out the real estate speculators. Eight or ten railroads went bankrupt within a couple of months. The copper magnates got carried out on their shields.

This is the only way a capital market can work, but it needs an honest interest rate. And we have no interest rate, so therefore we solve nothing and we have the kind of impaired, incapacitated markets that we have today. They’re very dangerous, because they’re all dependent on twelve people. It is what I call “the monetary Politburo of the Western world,” and they are just as dangerous as the Politburo in Beijing or the Politburo of memory in Moscow.

Alex: A twelve-person Open Market Committee determining the future of our economy by manipulating rates. Sounds like central planning to me.

David: It is. They are monetary central planners who are attempting to use the crude instrument of interest-rate pegging and yield-curve manipulation and essentially buying debt that no one else would buy, in order to keep this whole system afloat. It’s Ponzi economics. Anybody who had financial training before 1970 would instantly recognize this as Ponzi economics. It is only because of the last twenty years we got so inured to prosperity out of the end of a printing press and massive incremental debt that people lost sight of the fundamental principles of sound money, which, there’s nothing arcane about it. It’s just common sense. It is not common sense to think that 50, 60, 70% of all the debt that’s being created by the federal government can be bought by the Federal Reserve, stuffed in a vault, and everybody can live happily ever after.

Alex: So the government has certainly put us in a precarious position, but I don’t think they alone have put America in this position, have they? You mentioned consumer debt becoming a major burden on the economy. How do we shed ourselves of that? I mean, the federal government can repudiate its debts if we walk away from it. We might see a few wars or something from that. It could inflate its way out of it. It can tax its way out of it. But how do households get out from under the debt burden that they have today?

David: Well, it’s very tough, and they were lured into it by bad monetary policy when Greenspan panicked in December 2000. The interest rate was 6.5%; we had an economy that was threatened by competitors around the world. We needed high interest rates, not low. He panicked after the dot-com crash, and as you remember in two years they took the interest rate all the way down to 1%, and they catalyzed an explosion of mortgage borrowing, which was crazy.

When they cut the final rate down to 1% in May, June 2003, in that quarter — the second quarter of 2003 — the run rate of mortgage borrowing was $5 trillion at an annual rate. That was nuts! There had never been even a trillion-dollar annual rate of mortgage borrowing previously. In that quarter the run rate was $5 trillion, 40% of GDP. Why? Because the Fed took the rate down to 1%. Floating-rate product got invented everywhere. Anybody that had a pulse was being given mortgage loans by the brokers. The mortgage brokers didn’t have any capital or funding. They went to Wall Street. They got warehouse lines, and the whole thing got out of control. Millions of households were lured into taking on debt that was insane, and now we have a generation of debt slaves.

There are 25 million households in America who couldn’t move if they wanted to, because their mortgages are under water. They cannot generate a down payment and the 5% or 6% broker fee that you need to move. So we’ve got 25 million households immobilized, paralyzed, and worried every day about when they are going to lose property, because of what the Fed did. It’s a terrible indictment.

Alex: Mobility itself is the American dream, isn’t it? It’s the ability to pick up and find work and then move and do all that. So now we have people who are slaves to their debt. How do we get ourselves out of this? Is this just a matter of personal financial discipline? Is there a policy move that can happen?

David: It’s policy. If we don’t do something about the Fed, if we don’t drive the Bernankes and the Dudleys and the Yellens and the rest of these lunatic money-printers out of the Federal Reserve and get it under the control of people who have at least a modicum of sanity, we are just going to bury everybody deeper.

It’s unfortunate. The American people are as much a victim of the Fed’s massive errors as anything else. People were not prudent when they took on debt at 100% of the peak value of their property at some moment in 2004 and 2005. They were lured into it. But now we’re stuck with something that didn’t need to happen.

Alex: The Federal Reserve was founded in 1914, and it saw America through World War I, World War II. It saw America through Vietnam, saw America through the biggest boom in the economic history of the world. Yet now, today, you are calling for the abolishment of the Fed. Wasn’t the Fed here the entire time that America was a prosperous, growing, wealthy, technology-driven nation? What’s changed?

David: The greatest period of growth in American history was 1870-1914 — the Fed didn’t exist. Right after 1870, when we recovered from the Civil War we went back on the gold standard. It worked pretty well. World War I was a catastrophe for the financial system. The Fed financed it, but I don’t give them any credit for that, okay? We shouldn’t have been in that war. It was a stupid thing to get involved in. But once we got involved in it, the Fed printed money like crazy, it facilitated borrowing, set the groundwork for the boom of the 1920s and the collapse of the 1930s.

Even then though, we had great minds who coped with reality in a pragmatic way in the Fed. Even Marriner Eccles wasn’t all that bad. He stood up to Truman in 1951, when Truman wanted to force the Fed to continue to peg interest rates at 2% or 2.5% when inflation was 5%. Then we had William McChesney Martin: brilliant, pragmatic. He wasn’t some kind of gold-standard guy in a pure sense, but a pragmatic guy who understood that prosperity had to come out of private productivity, out of investment, out of risk-taking, and the Fed had to be very careful not to allow speculation to start or inflation to get ignited. In 1958, he invented the phrase, “The job of the Fed is to take the punchbowl away.” And we had a small recession. Six months after the recession was over he was actually raising the margin rate on the stock-market loans in order to quell speculation, and raising interest rates so that the economy didn’t start to inflate again.

Now that was the regime we had until, unfortunately, Lyndon Johnson came along with his “guns and butter,” took William McChesney Martin down to the ranch, and beat the hell out of him and forced him to capitulate. But here’s the point I would make: In 1960, at the peak of what I call the golden era — the twilight of fiscal and financial discipline — we had $30 billion on the balance sheet of the Fed. It had taken 45 years to build that up. Then, as they began to rapidly expand the balance sheet of the Fed during the inflation of the ’70s and the ’80s, even then it took us until September 2008 — the Lehman collapse — to get to $900 billion. Had the balance sheet only grown at 3%, which is what the capacity of the economy to grow, I think, really is, it would have been $300 billion, so they were overshooting.

Alex: We’re three times where we should be.

David: Where we should have been by the Lehman crisis event. In the next seven weeks, this crazy lunatic who’s running the Fed increased the balance sheet of the Fed by $900 billion, in seven weeks. In other words, they expanded the balance sheet of the Fed as rapidly in seven weeks as it had occurred during the first 93 years of its existence. And that’s not all, as they say on late night TV: in the next six weeks they added another $900 billion. So in thirteen weeks they tripled the balance sheet of the Fed.

Alex: Wow, that’s an incredible…

David: So no wonder we are in totally uncharted waters, and it’s being run by people who are clueless as to how to get out of the corner they’ve painted this country into. They really ought to be run out of town on a rail.

Alex: I think you’d find that a lot of our viewers would agree with you on that one. You know, the average American is suffering. It looks like the average American is going to have to suffer more to get us out of this, but it seems like the only thing the Fed is interested in these days is propping up the stock market. Why is that? Where does that come from?

David: The Fed has taken itself hostage with this whole misbegotten doctrine of wealth effects, which was created by Greenspan. In other words, if we get the stock market going up and we get the stock averages going up, people feel wealthier, they will spend more. If they spend more, there is more production and income and you get a virtuous circle. Well, that says you can create wealth through speculation. That can’t be true, because if it is true, we should have had a totally different kind of system than we’ve had historically.

So they got into that game, and then the crisis came in September, 2008. They panicked and pulled out the stops everywhere. As I said, tripled the balance sheet in thirteen weeks, [compared to what] they had done in 93 years. They are now at a point where they don’t dare begin to reduce the balance sheet, begin to contract, or they’ll cause Wall Street to go into a hissy fit. They are afraid to death of Wall Street going into a hissy fit, so essentially, the robots and the boys and girls and the fast-money traders on Wall Street run the Fed indirectly.

Alex: So, in the 1960s, the Fed is taking away the punchbowl. Sounds like in 2010 the Fed is the one adding the alcohol. They are afraid to stop, lest everybody riot.

David: Yes, they got the party going, and they’re afraid to stop it. As a result of that you have a doomsday machine.

Alex: At some point we are going to be forced to stop. Market forces will kick in and Europe and China and India will stop lending us money.

David: Yes. As I say, when the crisis comes in the Treasury market, it will be the great margin call in the sky. They’ll start unwinding all of the carry trades, all of the repo. Asset prices generally will be affected, because this will ricochet and compound through the system.

Alex: When does this happen?

David: People looked at the housing market and the mortgage market way back in 2003 — there were some smart people looking at this. They looked at the run rate of gross mortgage issuance, the $5 trillion I was talking about, and said: “This is insane, this is off the charts, this is so far beyond anything that has ever happened before, something bad is going to come of this.” It’s obvious, if you pour debt into markets… I mean a lot of people leveraged 98%, or whatever they were doing at the time with so-called mortgage insurance, and just high loan to value ratios. They were driving up prices, and so there was a housing-price boom going on. It was sucking the whole middle class into speculation. So that’s the nature of the system, and now they don’t know how to unwind it.

Alex: That’s a pretty stark picture. So as an individual investor, what are we to do? How do we protect ourselves in this type of situation? Should I be owning bonds and staying out of stocks? Should I be owning stocks?

David: No, I would stay out of any security markets. These are unsafe markets at any speed. It’s all tied together. As I was saying when the great margin call comes and they start selling the Treasury bond, they’ll take everything else with it. Real estate is priced off Treasuries. Mortgaged-backed securities are priced off Treasuries. Corporates are priced off Treasuries. Junk bonds are priced off Treasuries. Everything. The stock market will go into a panic. We don’t know when the timing will come — we’ve never been in a world where there is $15 trillion worth of central-bank balance sheets, like we have today. The only thing I think you can conclude is preservation is the only thing you are about as an investor. Forget about yield. Forget about return. Just keep yourself liquid and preserve your capital, because you can’t predict the day when, as I say, the great margin call in the sky comes down.

Alex: So if it’s not about coming out ahead, it’s about coming out not behind everybody else. It’s just losing a little less. What’s the most effective way to do that? Do you want to hold cash? Alternative options?

David: Yes. I don’t even think there’s nothing wrong with owning Treasury bills. I mean, if you want to get, for a one-year Treasury, what is the thing now? Twenty basis points or something?

Alex: So when the great Treasury crash comes, I should own Treasury bills?

David: Well, it doesn’t mean the price of the Treasury is going to crash, no.

Alex: Okay, so we are just going to see interest rates skyrocket on new issues. The US government is not going to be able to borrow.

David: That’s why you’re short. If you’re in a thirty-day piece of paper, you’re not going to lose principal.

Alex: What happens to the dollar in all of this? If I’m holding dollar denominated assets –?

David: Well, the dollar, in theory, people would think is going to crash. I don’t think it is because all the rest of the currencies in the world are worse.

Alex: So once again, America is not that bad off.

David: Well, we’re bad off because when the financial markets reprice drastically, it’s going to have a shocking effect on economic activity. It’s going to paralyze things. It’s going to finally cause consumption to come down. It’s going to cause government spending to be retracted.

You know, the Keynesians are right. Borrowing does add to GDP accounts. But it doesn’t add to wealth. It doesn’t add to real productivity, but it does add to GDP as it’s calculated and published — because GDP accounts were designed by Keynesians who don’t believe in a balance sheet. So they said, “If the public sector and the household sector are borrowing, let’s say, $10 trillion next year, run it though GDP, you’ll get a big bump to GDP.” But sooner or later your balance sheet will collapse. They forgot about that one. So my point is that we’ve gone through a thirty-year expansion of the balance sheet, an artificial growth in GDP; now we’re going to have to be retracting the collective balance sheets. That means that GDP will not grow. It may even contract, and no one’s prepared for that.

Alex: So the economy will collapse. The dollar will be okay, because we still need a medium of exchange and the dollar is the least-bad currency in the world. How does gold fit into the picture? Do you think that gold is a good asset?

David: Yes, I think that gold is a good asset. It’s the only currency that anybody is going to believe in after a while.

Alex: Okay, so maybe hold that as an insurance policy. Do you own gold yourself?

David: Yes, as an insurance policy.

Alex: Where else do you invest in today?

David: I’m preserving capital. I’m in cash. I don’t think the risk of the system is worth it.

Alex: So you are practicing what you preach, 100%?

David: Yes.

Alex: That’s great. It’s good to hear. This is excellent advice for our subscribers as well, to consider that there’s a lot of potential energy built up in the system. You’ve articulated it well, a lot of painful policy moves ahead of us, and probably something that makes 2008 look like a preview, if you will.

David: It was just a warm-up.

Alex: Just a warm-up. Thank you very much.

David: Thank you.

Former Congressman David A. Stockman was Reagan’s OMB director, which he wrote about in his best-selling book, The Triumph of Politics. He was an original partner in the Blackstone Group, and reads LRC the first thing every morning.

The Best of David Stockman

Recently: David Stockman on Crony Socialism

A "paralyzed" Federal Reserve Bank, in its "final days," held hostage by Wall Street "robots" trading in markets that are "artificially medicated" are just a few of the bleak observations shared by David Stockman, former Republican U.S. Congressman and director of the Office of Management and Budget. He is also a founding partner of Heartland Industrial Partners and the author of The Triumph of Politics: Why Reagan’s Revolution Failed and the soon-to-be released The Great Deformation: How Crony Capitalism Corrupts Free Markets and Democracy. The Gold Report caught up with Stockman for this exclusive interview at the recent Recovery Reality Check conference.

The Gold Report: David, you have talked and written about the effect of government-funded, debt-fueled spending on the stock market. What will be the real impact of quantitative easing?

David Stockman: We are in the last innings of a very bad ball game. We are coping with the crash of a 30-year–long debt super-cycle and the aftermath of an unsustainable bubble.

Quantitative easing is making it worse by facilitating more public-sector borrowing and preventing debt liquidation in the private sector – both erroneous steps in my view. The federal government is not getting its financial house in order. We are on the edge of a crisis in the bond markets. It has already happened in Europe and will be coming to our neighborhood soon.

TGR: What should the role of the Federal Reserve be?

DS: To get out of the way and not act like it is the central monetary planner of a $15 trillion economy. It cannot and should not be done.

The Fed is destroying the capital market by pegging and manipulating the price of money and debt capital. Interest rates signal nothing anymore because they are zero. The yield curve signals nothing anymore because it is totally manipulated by the Fed. The very idea of "Operation Twist" is an abomination.

Capital markets are at the heart of capitalism and they are not working. Savers are being crushed when we desperately need savings. The federal government is borrowing when it is broke. Wall Street is arbitraging the Fed’s monetary policy by borrowing overnight money at 10 basis points and investing it in 10-year treasuries at a yield of 200 basis points, capturing the profit and laughing all the way to the bank. The Fed has become a captive of the traders and robots on Wall Street.

TGR: If we are in the final innings of a debt super-cycle, what is the catalyst that will end the game?

DS: I think the likely catalyst is a breakdown of the U.S. government bond market. It is the heart of the fixed income market and, therefore, the world’s financial market.

Because of Fed management and interest-rate pegging, the market is artificially medicated. All of the rates and spreads are unreal. The yield curve is not market driven. Supply and demand for savings and investment, future inflation risk discounts by investors – none of these free market forces matter. The price of money is dictated by the Fed, and Wall Street merely attempts to front-run its next move.

As long as the hedge fund traders and fast-money boys believe the Fed can keep everything pegged, we may limp along. The minute they lose confidence, they will unwind their trades.

On the margin, nobody owns the Treasury bond; you rent it. Trillions of treasury paper is funded on repo: You buy $100 million (M) in Treasuries and immediately put them up as collateral for overnight borrowings of $98M. Traders can capture the spread as long as the price of the bond is stable or rising, as it has been for the last year or two. If the bond drops 2%, the spread has been wiped out.

If that happens, the massive repo structures – that is, debt owned by still more debt – will start to unwind and create a panic in the Treasury market. People will realize the emperor is naked.

TGR: Is that what happened in 2008?

DS: In 2008 it was the repo market for mortgage-back securities, credit default obligations and such. In 2008 we had a dry run of what happens when a class of assets owned on overnight money goes into a tailspin. There is a thunderous collapse.

Since then, the repo trade has remained in the Treasury and other high-grade markets because subprime and low-quality mortgage-backed securities are dead.

TGR: Walk us through a hypothetical. What happens when the fast-money traders lose confidence in the Fed’s ability to keep the spread?

DS: They are forced to start selling in order to liquidate their carry trades because repo lenders get nervous and want their cash back. However, when the crisis comes, there will be insufficient private bids – the market will gap down hard unless the central banks buy on an emergency basis: the Fed, the European Central Bank (ECB), the people’s printing press of China and all the rest of them.

The question is: Will the central banks be able to do that now, given that they have already expanded their balance sheets? The Fed balance sheet was $900 billion (B) when Lehman crashed in September 2008. It took 93 years to build it to that level from when the Fed opened for business in November 1914. Bernanke then added another $900B in seven weeks and then he took it to $2.4 trillion in an orgy of money printing during the initial 13 weeks after Lehman. Today it is nearly $3 trillion. Can it triple again? I do not think so. Worldwide it’s the same story: the top eight central banks had $5 trillion of footings shortly before the crisis; they have $15 trillion today. Overwhelmingly, this fantastic expansion of central bank footings has been used to buy or discount sovereign debt. This was the mother of all monetizations.

TGR: Following that path, what happens if there are no buyers? Do the governments go into default?

DS: The U.S. Treasury needs to be in the market for $20B in new issuances every week. When the day comes when there are all offers and no bids, the music will stop. Instead of being able to easily pawn off more borrowing on the markets – say 90 basis points for a 5-year note as at present – they may have to pay hundreds of basis points more. All of a sudden the politicians will run around with their hair on fire, asking, what happened to all the free money?

TGR: What do the politicians have to do next?

DS: They are going to have to eat 30 years worth of lies and by the time they are done eating, there will be a lot of mayhem.

TGR: Will the mayhem stretch into the private sector?

DS: It will be everywhere. Once the bond market starts unraveling, all the other risk assets will start selling off like mad, too.

TGR: Does every sector collapse?

DS: If the bond market goes into a dislocation, it will spread like a contagion to all of the other asset markets. There will be a massive selloff.

I think everything in the world is overvalued – stocks, bonds, commodities, currencies. Too much money printing and debt expansion drove the prices of all asset classes to artificial, non-economic levels. The danger to the world is not classic inflation or deflation of goods and services; it’s a drastic downward re-pricing of inflated financial assets.

TGR: Is there any way to unravel this without this massive dislocation?

DS: I do not think so. When you are so far out on the end of a limb, how do you walk it back?

The Fed is now at the end of a $3 trillion limb. It has been taken hostage by the markets the Federal Open Market Committee was trying to placate. People in the trading desks and hedge funds have been trained to front run the Fed. If they think the Fed’s next buy will be in the belly of the curve, they buy the belly of the curve. But how does the Fed ever unwind its current lunatic balance sheet? If the smart traders conclude the Fed’s next move will be to sell mortgage-backed securities, they will sell like mad in advance; soon there would be mayhem as all the boys and girls on Wall Street piled on. So the Fed is frozen; it is petrified by fear that if it begins contracting its balance sheet it will unleash the demons.

TGR: Was there some type of tipping that allowed certain banks to front run the Fed?

DS: There are two kinds of front-running. First is market-based front-running. You try to figure out what the Fed is doing by reading its smoke signals and looking at how it slices and dices its meeting statements. People invest or speculate against the Fed’s next incremental move.

Second, there is illicit front-running, where you have a friend who works for the Federal Reserve Board who tells you what happened in its meetings. This is obviously illegal.

But frankly, there is also just plain crony capitalism that is not that different in character and it’s what Wall Street does every day. Bill Dudley, who runs the New York Fed, was formerly chief economist for Goldman Sachs and he pretends to solicit an opinion about financial conditions from the current Goldman economist, who then pretends to opine as to what the economy and Fed might do next for the benefit of Goldman’s traders, and possibly its clients. So then it links in the ECB, Bank of Canada, etc. Is there any monetary post in the world not run by Goldman Sachs?

The point is, this is not the free market at work. This is central bank money printers and their Wall Street cronies perverting what used to be a capitalist market.

TGR: Does this unwinding of the Fed and the bond markets put the banking system back in peril, like in 2008?

DS: Not necessarily. That is one of the great myths that I address in my book. The banking system, especially the mainstream banking system, was not in peril at all. The toxic securitized mortgage assets were not in the Main Street banks and savings and loans; these institutions owned mostly prime quality whole loans and could have bled down the modest bad debt they did have over time from enhanced loan loss reserves. So the run on money was not at the retail teller window; it was in the canyons of Wall Street. The run was on wholesale money – that is, on repo and on unsecured commercial paper that had been issued in the hundreds of billions by financial institutions loaded down with securitized toxic garbage, including a lot of in-process inventory, on the asset side of their balance sheets.

The run was on investment banks that were really hedge funds in financial drag. The Goldmans and Morgan Stanleys did not really need trillion-dollar balance sheets to do mergers and acquisitions. Mergers and acquisitions do not require capital; they require a good Rolodex. They also did not need all that capital for the other part of investment banking – the underwriting business. Regulated stocks and bonds get underwritten through rigged cartels – they almost never under-price and really don’t need much capital. Their trillion dollar balance sheets, therefore, were just massive trading operations – whether they called it customer accommodation or proprietary is a distinction without a difference – which were funded on 30 to 1 leverage. Much of the debt was unstable hot money from the wholesale and repo market and that was the rub – the source of the panic.

Bernanke thought this was a retail run à la the 1930s. It was not; it was a wholesale money run in the canyons of Wall Street and it should have been allowed to burn out.

TGR: Let’s get back to our ballgame. What is to keep the U.S. population from saying, please Fed save us again?

DS: This time, I think the people will blame the Fed for lying. When the next crisis comes, I can see torches and pitch forks moving in the direction of the Eccles building where the Fed has its offices.

TGR: Let’s talk about timing. On Dec. 31, the tax cuts expire, defense cuts go into place and we hit the debt ceiling.

DS: That will be a clarifying moment; never before have three such powerful vectors come together at the same time – fiscal triple witching.

First, the debt ceiling will expire around election time, so the government will face another shutdown and it will be politically brutal to assemble a majority in a lame duck session to raise it by the trillions that will be needed. Second, the whole set of tax cuts and credits that have been enacted over the last 10 years total up to $400–500B annually will expire on Dec. 31, so they will hit the economy like a ton of bricks if not extended. Third, you have the sequester on defense spending that was put in last summer as a fallback, which cannot be changed without a majority vote in Congress.

It is a push-pull situation: If you defer the sequester, you need more debt ceiling. If you extend the tax expirations, you need a debt ceiling increase of $100B a month.

TGR: What will Congress do?

DS: Congress will extend the whole thing for 60 or 90 days to give the new president, if he hasn’t demanded a recount yet, an opportunity to come up with a plan.

To get the votes to extend the debt ceiling, the Democrats will insist on keeping the income and payroll tax cuts for the 99% and the Republicans will want to keep the capital gains rate at 15% so the Wall Street speculators will not be inconvenienced. It is utter madness.

TGR: It is like chasing your tail. How does it stop?

DS: I do not know how a functioning democracy in the ordinary course can deal with this. Maybe someone from Goldman Sachs can come and put in a fix, just like in Greece and Italy. The situation is really that pathetic.

TGR: Greece has come up with some creative ways to bring down its sovereign debt without actually defaulting.

DS: The Greek debt restructuring was a farce. More than $100B was held by the European bailout fund, the ECB or the International Monetary Fund. They got 100 cents on the dollar simply by issuing more debt to Greece. For private debt, I believe the net write-down was $30B after all the gimmicks, including the front-end payment. The rest was simply refinanced. The Greeks are still debt slaves, and will be until they tell Brussels to take a hike.

TGR: Going back to the triple-witching hour at year-end, if the debt ceiling is raised again, when do we start to see government layoffs and limitations on services?

DS: Defense purchases and non-defense purchases will be hit with brutal force by the sequester. As we go into 2013, there will be a shocking hit to the reported GDP numbers as discretionary government spending shrinks. People keep forgetting that most government spending is transfer payments, but it is only purchases of labor and goods that go directly into the GDP calculations, and it is these accounts that will get smacked by the sequester of discretionary defense and non-defense budgets.

TGR: I would think to unemployment numbers as well.

DS: They will go up.

Just take one example. According to the Bureau of Labor Statistics monthly report, there are 650,000 or so jobs in the U.S. Postal Service alone. That is 650,000 people who pretend to work at jobs that have more or less been made obsolete and redundant by the Internet and who are paid through borrowings from Uncle Sam because the post office is broke. Yet, the courageous ladies and gentlemen on Capitol Hill cannot even bring themselves to vote to discontinue Saturday mail delivery; they voted to study it! That is a measure of the loss of capacity to rationally cognate about our fiscal circumstance.

TGR: In the midst of this volatility, how can normal people preserve, much less expand their wealth?

DS: The only thing you can do is to stay out of harm’s way and try to preserve what you can in cash. All of the markets are rigged or impaired. A 4% yield on blue chip stocks is not worth it, because when the thing falls apart, your 4% will be gone in an hour.

TGR: But if the government keeps printing money, cash will not be worth as much, either, right?

DS: No, I do not think we will have hyperinflation. I think the financial system will break down before it can even get started. Then the economy will go into paralysis until we find the courage, focus and resolution to do something about it. Instead of hyperinflation or deflation there will be a major financial dislocation, which means painful re-pricing of financial assets.

How painful will the re-pricing be? I think the public already knows that it will be really terrible. A poll I saw the other day indicated that 25% of people on the verge of retirement think they are in such bad financial shape that they will have to work until age 80. Now, the average life expectancy is 78. People’s financial circumstances are so bad that they think they will be working two years after they are dead!

TGR: Finally, what is your investment model?

DS: My investing model is ABCD: Anything Bernanke Cannot Destroy: flashlight batteries, canned beans, bottled water, gold, a cabin in the mountains.

TGR: Thank you very much.

Reprinted from The Gold Report with permission from David Stockman.

Former Congressman David A. Stockman was Reagan’s OMB director, which he wrote about in his best-selling book, The Triumph of Politics. He was an original partner in the Blackstone Group, and reads LRC the first thing every morning.

The Best of David Stockman

Author and former OMB director David Stockman sits down with the Daily Ticker to explain Obama’s latest election year scheme to give re-fi’s to select underwater mortgage holders. It’s nothing but another bailout for JP Morgan, Wells Fargo, and other big underwriters of 2nd mortgages and home equity loans, since ultimately these ‘homeowners’ are going to default. This is where 40 years of government meddling in the housing market has gotten us. This scam is all about wealth redistribution and is the worst kind of crony socialism, says Stockman. (6:31)

Former Congressman David A. Stockman was Reagan’s OMB director, which he wrote about in his best-selling book, The Triumph of Politics. He was an original partner in the Blackstone Group, and reads LRC the first thing every morning.

Former Ronald Reagan OMB director David Stockman joined us on The Dylan Ratigan Show today to explain explicitly why both Mitt Romney and Newt Gingrich are incredible offenders and beneficiaries of corporate communism or, as he likes to call it, “crony capitalism.”

He specifically laid out the atrocious track record that is displayed by Mitt Romney and Bain Capital’s ability to make hundreds of millions of dollars on leveraged buyouts (just to name one illustrative example: buying and selling the Yellow Pages from the Italian government.)

The most important thing about the Stockman indictment of Romney and Gingrich is that it also speaks to the Obama administration’s similar characteristics, through the lens of Geithner and Summers. He points specifically to the failure to reform our banking system, and the massive expansion in too big to fail financial institutions since the financial crisis as the single greatest risk to the Western economy, as well as the greatest cause of distorted incomes, poverty, and unemployment.

Stockman proves that it’s not about the identity of the politicians, it’s about understanding the distinction between aligned interests between investors, entrepreneurs and inventors working together to solve problems – this in contrast with the misaligned interests, crony capitalists and corporate communists who use use access to power to extract money for themselves at the expense of our nation and the world as a whole.

Here’s the segment, and the full transcript is below:

Dylan: Well, just about four hours now until tonight’s debate and the economy may well actually make it to center stage here. It’s certainly a favorite talking point for both of the big GOP hopefuls right now, not to mention the President himself. New data out today shows that 83% of Americans now say they are dissatisfied with the current economy – looked to poverty, looked at wealth and equality, looked to unemployment.

We figure if the 1% has all the money, the other 16% must just be confused in that number. How could anyone be satisfied when, according to Gallup, more than 26% of us are unemployed or underemployed? Just the latest example of the split in the country between those that have and those that do not have and, more importantly, those that are working together in alignment to help each other and those that are screwing each other over, you know what I’m saying?

I want to bring in former OMB Director under President Reagan, David Stockman, a man who is one of the most aggressive advocates of capitalism and one of the aggressive opponents of crony capitalism. I just want to continue the conversation we were having, David…

David: Sure.

Dylan: …about the education Newt and Mitt are giving us as they try to attack each other – your assessment of their indictments of one another.

David: Well, you know, Freddie Mac and Fannie Mae were a cesspool of crony capitalism; we could go on about that. So Newt was hypocritical in taking money from Freddie Mac and pretending they needed a historian. Why does a cesspool of crony capitalism need a historian? Okay?

Dylan: Yes.

David: But when you look over on the other side, I think, unfortunately, Romney was disingenuous when he said that he got a graduate education in company creation, job creation, and growing economy as an LBO artist. Let me tell you why.

Dylan: Because people that invest money, we were just out in Silicon Valley, lots of folks there invest money all the time, they start businesses, what’s the difference between what Mitt Romney was doing and what –

David: Because leverage buyouts are just financial speculation. I was in the business for the same period he was and I would not pretend that I learned anything during that time that tells me how to improve the U.S. economy or how to even build companies or create jobs. What I learned was how to strip-mine the cash out of a country, a company to pay the debt. What I learned was how to powder up the pig in order to sell it in the quickest IPO or the best buyer you could do.

Dylan: Did you make good money?

David: Made some very large gains in some cases and had some bankruptcies in others. So the point, though, is leverage buyouts are not about growing an economy. And when you look at the record of Bain Capital, that’s what it shows. Now, everybody’s aware of the five companies that went bankrupt, they put in $100 million, they took out $500 million within a year or two, these five companies including Georgetown Steel went bankrupt. Okay, that happens. And frankly, if you’re in that business and you want to be a speculator, fine. If you want to own a casino, fine. If you want to own a brothel, fine. I believe in a free economy. But you shouldn’t pretend that somehow this gives you superior qualifications to figure out how to run the economy. Now, let’s look at the other two companies on the other side to give some idea what leverage buyouts really do. They have…

Dylan: Well, slow it down, though, because this is an important lesson. Walk us through it, if you don’t mind.

David: Well, they had – Bain Capital had two other companies where they invested $100 million and they also…

Dylan: $100 million of their own money.

David: Of the fund, of the fund –

Dylan: So they’re managing other people’s money.

David: Right, right. And they put in $100 million and they took out $500 million. And in these two companies, they were spectacular successes. One was called Experian; they bought it for $1 billion in September 1996. Two months later, they sold it for $1.7 billion. They bought it cheap from TRW, a big conglomerate. I don’t think there was an auction. Two months later before they even moved into the house or painted the kitchen or even crossed the front door, they sold it to a British company that was run by Margaret Thatcher’s former Staff Director. So I would…

Dylan: How’s that for crony. I mean, come on.

David: So look, they made $200 million in two months, so good for them. That’s great speculation. I’d call that an inside job. Now, the other one was that they bought the Yellow Pages in 1997 from the utility in Italy. They put…

Dylan: Which means if you’re going to do that, you have a relationship with the government if you’re buying something from the government for cheap, yes?

David: I would guess there was a relationship because they put in $17 million and three years later they took out $350 million, they made 22 times their money on the Yellow Pages at the time we had the dotcom bubble and technology was all the rage.

Dylan: And the Yellow Pages was a 22-bagger.

David: Yeah, how can you make a 22-bagger in the Yellow Pages unless you bought it really cheap, you were part of a crony capitalist crowd that took it over on the cheap, which was the case. They were involved with Berlusconi and all the rest of them. Let’s call that the “Italian Job.”

Dylan: Okay.

David: So when you look at the record, $100 in and – $200 in a billion out.One was an Italian Job, one was an inside job, and five were a screw job. And that’s how you make a billion dollars.

Dylan: And that’s a way to make money but that is a fraudulent way to represent the narrative of American just capitalism.

Tim: So the question is, is there anything – can Romney, can any of these candidates draw a distinction between sort of crony capitalism and capitalism because I think the left is all about blurring those two together. Because Obama will do the crony capitalism while attacking capitalism at the same time. It seems like Gingrich certainly can’t make that distinction given his record, but is there – can Romney do it to…

Dylan: Or do we, the Press, have to do it? I mean, that’s really what we’re trying to…

David: I think the Press can do it and I think Ron Paul’s doing it. Now, whether you like what he has to say or not, he’s been consistent over the years and over the years. Let the free market work. Now, if we would only get back to letting the free market work – and, frankly, Obama’s been just as bad – they didn’t do anything about a banking system that’s more out of control today than it was when they came in. They put into the key economic jobs Summers and Geithner and all of the rest of them, Bernanke, who had caused the problem in the first place.

Dylan: So how do we solve this? One at a time, one at a time.

Sam: How did these people cause the problem in the first place? It was buy regulation. I mean, so this is…

Dylan: Let him answer, let him answer.

David: It was not deregulation. It was mainly free money from the Fed, almost zero interest rates, massive encouragement for people to leverage, speculate, and then…

Dylan: And the swaps market.

David: …well, but the reason those worked is you had the Greenspan put and the Bernanke put which told speculators borrow 99 cents, buy 100 cents worth of speculative assets, and don’t worry that anything bad is going to happen because the Fed has your back. That’s what caused this.

Imogen: What you’re saying is he’s done absolutely nothing since 2008.

David: We have done nothing.

Imogen: Is it – okay, so is it going to take worldwide financial meltdown thanks to the Euro zone, say…

David: Absolutely.

Imogen: …for a reset meeting because it sounds to me that – surely, we’re going to hit rock bottom somewhere.

David: No, we’re doing the same thing over and over. The top six banks in 2008 had $6 trillion of assets in the United States; they now have $9 trillion. The top three banks in France have $6 trillion of assets and the GDP is only $2.5 trillion. We have got banks everywhere in the world that are out of control, stuffed with bad asses being propped up by the central banks, the ECB and the Feb, and they’re playing this game of kick the can and pretend that everything’s rosy.

Dylan: So put yourself in the American people’s position. So now – because you and I are obviously in full agreement on the – it’s the basic theme of Greedy Bastards as a book, it’s the theme of this TV show, which is that there’s this system with both political parties facilitating a totally distorted capital market with banking, trade, and taxes. If you look here in reality at a President who has facilitated a complete cover up of all that with his apparatus and two potential aspirants, one who’s on the take in the classic crony capitalism sense of Fannie and Freddie (I’m your historian), and another one who really is doing the closest masquerade of a capitalist by buying businesses and hiring people and firing people, but the unwritten component is that his motivation is not to create value or the business’s motivation is not to create value, it’s to extract money using other people’s money. As we are all learning this, it becomes remarkably frustrating for the American voter, let alone the people sitting around here and anywhere else, to reconcile it. So I’m interested on your thoughts of how we can apply pressure to all three of these people – the President, Mitt Romney, and Newt Gingrich to talk about the elephant in the room.

David: Well, the elephant in the room is really the Federal Reserve. The problem behind all this is the tri-fecta of almost free money. When debt has an interest rate on it of zero overnight or for the short term or 2% for ten years, you’re encouraging people to build up leverage and speculate. It doesn’t help Main Street, it only showers gains [cross-talking 09:04]. It makes the finance sector bigger and that doesn’t help the economy. It’s just churning.

Sam: You saying that capital constraints – you’re saying that any type of regulations about speculation, those would be irrelevant.

David: No.

Sam: The only issue here is cheap money. Is that what you’re saying?

David: One issue is cheap money and the second thing is the banks. The banks are not free enterprise institutions. They’re wards of the state, they need to be strictly regulated, we need to bring back Glass-Steagall, and we need to get banks out of trading. Banks should be in the business of taking deposits and lending.

Dylan: Right.

David: If you want to be Goldman Sachs, give up your bank charter…

Dylan: Right, and be a man. Be a man.

David: And be – if you want to speculate, be a hedge fund, which is what they are, then do that, but don’t have the Fed window, don’t have deposit insurance, which their bank has…

Dylan: And then walk around like you’re a tough guy, Mr. Capitalist, while you’re taking out of the back. Anyway, thank you very much. Come back sooner rather than later. You’re also set the table perfectly for Governor Spitzer’s visit tomorrow. There’s scorched earth here today. Nice to see you, Sam. Nice to see you, Tim. Nice to see you, Imogen. I look forward to seeing tonight’s debate to hear these two throw housing and unemployment at one another. Interesting times.

Reprinted from DylanRatigan.com with permission from David Stockman.

Former Congressman David A. Stockman was Reagan’s OMB director, which he wrote about in his best-selling book, The Triumph of Politics. He was an original partner in the Blackstone Group, and reads LRC the first thing every morning.

BILL MOYERS: Welcome. This week we’re continuing our exploration of Winner-Take-All Politics: How Washington Made the Rich Richer and Turned its Back on the Middle Class. If you missed our first installment, you’ll find it at our website, BillMoyers.com.

Now this is only the second broadcast of our new series, yet we’ve already made our choice for the best headline of the month. Here it is:

"Citigroup Replaces JPMorgan as White House Chief of Staff."

Behind that headline is a tangled web.

The new chief of staff is Jack Lew. He used to work for the giant banking conglomerate Citigroup. His predecessor as chief of staff is Bill Daley, who used to work at the giant banking conglomerate JPMorgan Chase. Daley was maestro of the bank’s global lobbying and the chief liaison to the White House.

Bill Daley replaced Obama’s first chief of staff, Rahm Emanuel, who once worked for a Wall Street firm where he was paid a reported $18.5 million in less than three years.

The new chief of staff, Jack Lew, comes from Obama’s Office of Management and Budget, where he replaced Peter Orszag, who now works as vice chairman for global banking at the giant conglomerate Citigroup. Still following me?

It’s startling the number of high-ranking Obama officials who have spun through the revolving door between the White House and the sacred halls of investment banking.

But remember, it was Bush and Cheney’s cronies in big business who helped walk us right into the blast furnace of financial meltdown. Then they rushed to save the banks with taxpayer money.

But of course, Bush and Cheney aren’t the only ones to have a soft spot for financiers. Bankers seem to come and go pretty frequently at the White House. President Obama may call them "fat cats" and stir the rabble against them with populist rhetoric when it serves his purpose, but after the fiscal fiasco, he allowed the culprits to escape virtually scot-free. And when he’s here in New York, he dines with them frequently and eagerly accepts their big contributions.

Like his predecessors, Obama’s administration has also provided the banks with billions of low-cost dollars they used for high-yielding investments to make big profits.

It’s a fact. The largest banks are actually bigger than they were when he took office. And earned more in the first two-and-a-half years of his term than they did during the entire eight years of the Bush administration.

And get this: President Obama’s new best friend, according to The New York Times, is Robert Wolf. They play golf, basketball, and they talk economics when Wolf is not raising money for the President’s re-election campaign. Now, just who is Robert Wolf? Well, he’s top dog at the U.S. branch of the giant Swiss bank UBS, the very bank that helped rich Americans evade taxes. Here, Senator Carl Levin describes some of the tricks used by UBS:

SENATOR LEVIN: Here, Swiss bankers aided and abetted violations of U.S. tax law by traveling to this country with client code names, encrypted computers, counter-surveillance training, and all the rest of it, to enable U.S. residents to hide assets and money in Swiss accounts.

BILL MOYERS: Quite a tangled web. One man who has strong views on all these cozy ties between Wall Street and Washington is David Stockman.

In the 1970s, he was a young Republican congressman from Michigan and an early proponent of supply-side economics – some call it trickle down.

You know the theory; if you cut taxes on the wealthy, while cutting government, the economy will take off, money trickling down and creating millions of jobs.

It was the centerpiece of Ronald Reagan’s 1980 campaign for president.

RONALD REAGAN: There is enough fat in the government in Washington that if it was rendered and made into soap, it would wash the world.

BILL MOYERS: Once in the Oval Office, President Reagan made David Stockman his budget director.

DAVID STOCKMAN: When President Reagan gave me this job he pointed to that budget which is some thousands and thousands of pages long, and he said go through it from top to bottom with a fine tooth comb and unless you can find a persuasive demonstration why funds must be spent, cut those budgets.

BILL MOYERS: Stockman helped Reagan usher in the largest tax cut in U.S. history, a cut that mainly favored the rich. But things didn’t go exactly as they planned them. The economy sagged, and in 1982 and ’84, Reagan and Stockman agreed to tax increases.

In 1985 Stockman left government and wrote a book critical of his own years in power: The Triumph of Politics: The Inside Story of the Reagan Revolution. He then took his economic expertise to Wall Street and became an investment banker. Thirty years later, he’s writing a new book, with the working title The Triumph of Crony Capitalism.

I sat down with him to talk about how politics and high finance have turned our economy into a private club for members only.

What do you mean by crony capitalism?

DAVID STOCKMAN: Crony capitalism is about the aggressive and proactive use of political resources, lobbying, campaign contributions, influence-peddling of one type or another to gain something from the governmental process that wouldn’t otherwise be achievable in the market. And as the time has progressed over the last two or three decades, I think it’s gotten much worse. Money dominates politics.

And as a result, we have neither capitalism or democracy. We have some kind of –

BILL MOYERS: What do we have?

DAVID STOCKMAN: We have crony capitalism, which is the worst. It’s not a free market. There isn’t risk taking in the sense that if you succeed, you keep your rewards, if you fail, you accept the consequences. Look what the bailout was in 2008.

There was clearly reckless, speculative behavior going on for years on Wall Street. And then when the consequence finally came, the Treasury stepped in and the Fed stepped in. Everything was bailed out and the game was restarted. And I think that was a huge mistake.

BILL MOYERS: You write, quote, "During a few weeks in September and October 2008, American political democracy was fatally corrupted by a resounding display of expediency and raw power. Henceforth, the door would be wide open for the entire legion of Washington’s K Street lobbies, reinforced by the campaign libations prodigiously dispensed by their affiliated political action committees, to relentlessly plunder the public purse." That’s a pretty strong indictment.

DAVID STOCKMAN: Yeah and, but on the other hand, I think you would have to say it was fair. When you look at what came out of 2008, the only thing that came out of 2008 was a stabilization of these giant Wall Street banks. Nothing came out of 2008 that really helped Main Street. Nothing came out of 2008 that addressed our fundamental problems, that we’ve lost a huge swath of our middle class jobs. Nothing came out of 2008 that made financial discipline or fiscal discipline possible.

It was justified as sort of expediency. We need to do this. We need to stop the contagion. But it wasn’t thought through as to what the long-term implications of this would be.

BILL MOYERS: How did you see it playing out?

DAVID STOCKMAN: I think there was a lot of panic going on in the Treasury Department. I call it "The Blackberry Panic." They were all looking at their Blackberries, and could see the price of Goldman Sachs or Morgan Stanley dropping by the hour. And somehow they thought that was thermostat telling them that the economy was coming unraveled.

I don’t believe that was right. I think what was going on was simply a huge correction that was overdue on Wall Street. The big leverage hedge funds on Wall Street that called themselves investment banks weren’t really investment banks. They were just big trading operations using 30, 40 to one leverage. And it was that that was being corrected.

But they used the occasion of the Wall Street banking crisis to create the impression that this was the beginning of a kind of black hole the whole economy was going to drop into. I think that was wrong.

And it was that fear that led Congress to do anything they wanted. You know, the Congress gave them a blank check.

BILL MOYERS: Not at first, don’t you remember, Congress first refused to approve the bailout, right?

DAVID STOCKMAN: And then, the stock market dropped 600 points because all of the speculators on Wall Street all of a sudden began to think, "Hey, they might let capitalism work. They might let the rules of the free market function."

BILL MOYERS: You mean by letting them fail.

DAVID STOCKMAN: Yes.

BILL MOYERS: If they let them fail?

DAVID STOCKMAN: I think if they let them fail it wouldn’t have spread to the rest of the economy. There wouldn’t have been another version of the Great Depression. There weren’t going to be runs on the bank. We weren’t going to have consumers lined up in St. Louis and Des Moines and elsewhere worried about their bank. That’s why we have deposit insurance, the FDIC. But it would have been a big lesson to the speculators that you’re not going to be propped up and bailed out,

You’re not going to have the Fed as your friend. You’re not going to have the Treasury with a lifeline. You’re going to have to answer to the marketplace. And until we get that discipline back into our financial system, the banks are just going to continue to grow, continue to speculate and find new ways to make easy money at the expense of the system.

BILL MOYERS: President Bush, he was still in office then.

DAVID STOCKMAN: Yes.

BILL MOYERS: He said, I have to suspend the rules of the free market in order to save the free market.

DAVID STOCKMAN: You can’t save free enterprise by suspending the rules just at the hour they’re needed. The rules are needed when it comes time to take losses. Gains are easy for people to realize. They’re easy for people to capture. It’s the rules of the game are most necessary when the losses have to occur because mistakes have been made, errors have been made, speculation has gone too far. The history has always been – and this is why we had Glass-Steagall and a lot of the legislation in the 1930s.

BILL MOYERS: Glass-Steagall was the provision –

DAVID STOCKMAN: The division of banks between the commercial banking and investment banking and insurance and other –

BILL MOYERS: So that you, the banker, could not take my deposits and gamble with them, right?

DAVID STOCKMAN: That’s exactly right. And we need not only a reinstitution of Glass-Steagall, but even a more serious limitation on banks. And what I mean by that is, that if we want to have a way for, you know, average Americans to save money without taking big risks and not be worried about the failure of their banking institution, then there can be some narrow banks who do nothing except take deposits, make long-term loans or short-term loans of a standard, business variety without trading anything, without getting into all of these exotic derivative instruments, without putting huge leverage on their balance sheet.

And we need to say simply, that if you’re a bank and you want to have deposit insurance, which ultimately, you know, is backed up by the taxpayer – if you’re a bank and you want to have access to the so-called "discount window" of the Fed, the emergency lending, then you can’t be in trading at all.

Now, on the other hand, if they want to be a hedge fund, then they’ve got to raise risk capital and they have to take the consequences of their risks, both to the good side and the bad side. And until we really approach that issue, and dismantle these giant, multi-trillion dollar balance sheet banks, and separate retail and deposit insured banking from just financial companies, we’re going to have recurring bouts of what we had in 2008.

And they haven’t even begun to address that, and it’s so disappointing to see that the Obama administration, which in theory should’ve had more perspective on this than a Republican administration under Bush, to see that one, they appointed in the key positions the same people who brought the problem in: Geithner and Summers and all of those, and secondly, that Obama did nothing about it.

It could have easily – they could have begun to dismantle a couple of these lame duck institutions, Citibank would have been a good place to start. But they did nothing. They passed Dodd-Frank, which said, now we’re going to have everybody write regulations – tens of thousands of pages that you know, it was a full employment act for accountants and lawyers and consultants and lobbyists. But they didn’t go to the heart of the problem. If they’re too big to fail, they’re too big to exist. And let’s start right with that proposition.

BILL MOYERS: You’ve described what other people have called the financialization of the American economy, the growth in the size and the power of the financial industry. What does that term mean to you, financialization? And why should we care that it’s happened?

DAVID STOCKMAN: Because what it means is that a massive amount of resources are being devoted, being allocated or being channeled into pure financial speculation that has no gain to society as a whole, has no real economic contribution to the process by which GNP is created, GDP is created and growth occurs.

By 2007 40 percent of all the profits in the American economy were coming from finance companies. 40 percent. Historically it was 15 percent.

So the financialization means that as we attracted more and more resources and capital, and we made speculation easier and easier, and we funded it with almost free overnight money, managed and manipulated by the Fed, that’s how the economy got financialized. But that is a casino. Casinos – they’re, you know, places for people to go if they want to speculate and wager. But they’re not part of a healthy, constructive economy.

BILL MOYERS: What do you mean by the free money that banks are using overnight?

DAVID STOCKMAN: Well, by that we mean when the Fed, the Federal Reserve sets the so-called federal funds rate at ten basis points, where it is today, that more or less guarantees banks can go into the Fed window, the discount window, and borrow at ten basis points.

And then you take that money and you buy a government bond that is yielding two percent or three percent. Or buy some corporate bonds that are yielding five percent. Or if you want to really get aggressive, buy some Australian dollars that have been going up. Or buy some cotton futures. And this is really what has been going on in our markets.

The cheap funding, which is guaranteed by the Fed, the investment of that cheap funding into speculative assets and then pocketing the spread. And you can make huge amounts of money as long as the music doesn’t stop. And when the music stops then all of a sudden, the cheap, overnight money dries up. This is what’s happening in Europe today. This is what happened in 2008.

And then people are stuck with all these risky assets, and they can’t fund them. They owe cash to the people they borrowed overnight from or on a weekly basis. That’s what creates the so-called contagion. That’s what creates the downward spiral. Now, unless we let those burn out, it’ll be done over and over. In other words, if, you know, if a lesson isn’t learned, then the error will be repeated over and over.

BILL MOYERS: Stockman says the modern bailout culture took off under President Bill Clinton. It was engineered with the help of Federal Reserve Chairman Alan Greenspan and top economic advisors at the Treasury, Larry Summers and Robert Rubin.

BILL CLINTON: The American people either didn’t agree or didn’t understand what in the world I’m up to in Mexico.

DAVID STOCKMAN: I think it started with the bailout of the banks in 1994 during the Mexican Peso Crisis.

REPORTER: For investors it was a sight for sore eyes. Mexico’s stock market actually soaring instead of plummeting for the first time in weeks. All this, an immediate reaction to news of a major international aid package – nearly half of it from Washington.

DAVID STOCKMAN: That was allegedly designed to help Mexico. It was $20 billion with no approval from Congress that was used, I think inappropriately out of a Treasury fund. And why were we doing this? It’s because the big banks were too exposed to some bad loans that they had written in Mexico and elsewhere.

BILL MOYERS: Wall Street banks. U.S. banks.

DAVID STOCKMAN: Wall Street banks. Wall Street banks. The banks of the day, Citibank, Bankers Trust, the others that existed at that time. And so the idea got started that Washington would be there with a prop, with a bailout, with a helping hand. And then the balls start rolling down the hill.

DAN RATHER: The Federal Reserve Bank of New York has taken highly unusual action to head off what could have been a severe blow to world economies.

BILL MOYERS: When the hedge fund Long Term Capital Management blew up in 1998, it was big news.

REPORTER: Dan, the Long Term Capital fund lost billions in the recent market turmoil and last night, stood on the brink of collapse.

DAVID STOCKMAN: Long Term Capital was an economic train wreck waiting to happen. It was leveraged 100 to one. It was in every kind of speculative investment known to man. In Russian equities, in Thailand bonds, and everything in between. And it was enabled by Wall Street.

REPORTER: An emergency meeting was organized by the Federal Reserve last night, here at its New York office. At the table, more than a dozen of Wall Street’s biggest bankers and brokers including David Komansky, Chairman of Merrill Lynch, Sandy Weill of Travelers and Sandy Warner of JP Morgan. One by one the firms each agreed to kick in more than $250 million to bail out Long Term Capital before its troubles sent shockwaves through the banking system.

DAVID STOCKMAN: Why did the Fed step in, organize all the Wall Street banks, and kind of sponsor this bailout? Because all of the Wall Street banks that enabled Long Term Capital to grow to this giant size, to have 100 to one leverage, by loaning them money. So when the Treasury and the Fed stepped in and bailed out, effectively, Long Term Capital and their lenders, their enablers, it was another big sign that the rules of the game had changed and that institutions were becoming too big to fail.

Fast forward. We go through one percent interest rates at the Fed in the early 2000s, we go through the housing bubble and collapse.

BILL MOYERS: Following the 2008 economic meltdown came the mother of all bailouts.

GEORGE W. BUSH: Good morning. Secretary Paulson, Chairman Bernanke and Chairman Cox have briefed leaders on Capitol Hill on the urgent need for Congress to pass legislation approving the Federal government’s purchase of illiquid assets such as troubled mortgages from banks and other financial institutions.

BILL MOYERS: The Bush administration came to the rescue of some of the county’s largest financial institutions, to the tune of 700 billion tax-payer dollars.

DAVID STOCKMAN: We elect a new government because the public said, you know, "We’re scared. We want a change." And who did we get? We got Larry Summers. We got the same guy who had been one of the original architects of the policy in the 1990s, the financialization policy, the too big to fail policy.

Who else did we get? We got Geithner as Secretary of the Treasury. He had been at the Fed in New York in October 2008 bailing out everybody in sight. General Electric got bailed out. Morgan Stanley, Goldman Sachs, all of the banks got bailed out, and the architect of that bailout then becomes the Secretary of the Treasury. So it’s another signal to the financial markets that nothing ever changes. The cronies of capitalism are in charge of policy.

BILL MOYERS: You name names in your writing. You identify several people as the embodiment of crony capitalism. Tell me about Jeffrey Immelt.

DAVID STOCKMAN: He is the poster boy for crony capitalism. Here is GE, one of the six triple-A companies left in the United Sates, a massive, half-trillion dollar company, massive market capitalization. I’m talking about the eve of the crisis now, in September, 2008.

Suddenly, when the commercial paper market starts to destabilize and short-term rates went up. He calls up the Treasury secretary with an S.O.S., "I’m in trouble here. I need a lifeline." He had recklessly funded a lot of assets at General Electric Capital in the overnight commercial paper market. And suddenly needed a bailout from the Treasury. Within days, that bailout was granted.

And therefore, General Electric was able to avoid the consequence of its foolish lend long and borrow short policy. What they should have been required to do when the commercial paper market dried up – that was the excuse. They should’ve been required to offer equity, sell stock at a highly discounted rate, dilute their shareholders, and raise the cash they need to pay off their commercial paper.

That would’ve been the capitalist way. That would’ve been the free market way of doing things. And in the future they would’ve been less likely to go back into this speculative mode of borrowing short and lending long. But when we get to the point where the one triple-A, a multi-hundred billion dollar company gets to call up the secretary, issue the S.O.S. sign and get $60 billion worth of guaranteed Federal Reserve and Treasury backup lines, then we are, you know, our system has been totally transformed. It is not a free market system. It is a system run by powerful, political and corporate forces.

BARACK OBAMA: Thank you. Thank you.

BILL MOYERS: So when you saw that President Obama had appointed Jeffrey Immelt, as the head of his Council on Jobs and Competitiveness, what went through your mind?

DAVID STOCKMAN: Well, I was in the middle of being very disgusted with what my own Republican Party had done and what Bush had done and the Paulson Treasury. And then when I saw this, I got the title for my book, “The Triumph of Crony Capitalism.”

BARACK OBAMA: And I am so proud and pleased that Jeff has agreed to chair this panel, my Council on Jobs and Competitiveness, because we think GE has something to teach businesses all across America.

DAVID STOCKMAN: If you have a former community organizer who was trained in the Saul Alinsky school of direct democracy, appointing the worst abuser, the worst abuser of crony capitalism, GE, who came in and begged for this bailout, to head his Jobs Council, when obviously GE’s international corporation, they’ve been shifting jobs offshore for decades, then it becomes so obvious that we have a new kind of system, and that we have a real crisis.

BILL MOYERS: Where is the shame? Shouldn’t these people have been at least a little ashamed of running the economy and the financial system into the ditch and then saying, "Come lift me out?"

DAVID STOCKMAN: Yes. You know, I think that’s part of the problem. I started on Capitol Hill in 1970s. And as I can vividly recall, corporate leaders then at least were consistent. They might’ve complained about big government, or they might’ve complained about the tax system.

But there wasn’t an entitlement expectation that if financial turmoil or upheaval came along, that the Treasury, or the Federal Reserve, or the FDIC or someone would be there to back them up. That would’ve been considered, you know, it would’ve been considered, as you say, shameful. And somehow, over the last 30 years, the corporate leadership of America has gotten so addicted to their stock price by the hour, by the day, by the week, that they’re willing to support anything that might keep the game going and help the system in the short run avoid a hit to their stock price and to the value of their options. That’s the real problem today. And as a result, there is no real political doctrine ideology left in the corporate community. They are simply pragmatists who will take anything they can find, and run with it.

BILL MOYERS: So this is what you mean, when you say free markets are not free. They’ve been bought and paid for by large financial institutions.

DAVID STOCKMAN: Right. I don’t think it’s entirely a corruption of human nature. People have always been inconsistent and greedy.

But I think it’s been the evolution of the political culture in which there have been so many bailouts, there has been so much abuse and misuse of government power for private ends and private gains, that now we have an entitled class in this country that is far worse than you know, remember the welfare queens that Ronald Reagan used to talk about?

We now have an entitled class of Wall Street financiers and of corporate CEOs who believe the government is there to do what is ever necessary if it involves tax relief, tax incentives, tax cuts, loan guarantees, Federal Reserve market intervention and stabilization. Whatever it takes in order to keep the game going and their stock price moving upward. That’s where they are.

BILL MOYERS: You were disaffected with the party of your youth, the Republican Party, because it has because – it’s become dogmatic on so many of these issues and no longer listens to evidence and facts. I’m disaffected with the party of my youth because that Democratic Party served the interest of the working people in this country like Ruby and Henry Moyers. And so many people feel the same way. How do we overcome this pessimism about the American future? “The Wall Street Journal” had a headline on an op-ed piece that said, "The End of American Optimism." A recent survey said only 15 percent of the people were satisfied about the direction of the American people. I mean, this is a serious situation, is it not?

DAVID STOCKMAN: I think it is. And – but we also have to recognize the pessimism that the public reflects in the surveys and polls is warranted. In other words the public isn’t being unduly pessimistic. It’s not been overcome with some kind of a false wave of emotion. No. I think the American public sees very clearly the current system isn’t working, that the Federal Reserve is basically working on behalf of Wall Street, not Main Street.

The Congress is owned lock, stock and barrel by one after another, after another special interest. And they logically say how can we expect, you know, anything good to come out of this kind of process that seems to be getting worse. So how do we turn that around? I think it’s going to take, unfortunately a real crisis before maybe the decks can be cleared.

BILL MOYERS: What would that look like?

DAVID STOCKMAN: It will take something even more traumatic than we had in September 2008.

BILL MOYERS: But on the basis of the record, the lessons of the past. The experience you have just recounted and are writing about. Do you see any early signs that we might turn the ship from the iceberg?

DAVID STOCKMAN: No. I think we’ve learned no lessons. We really have not restructured our financial system. The big banks that existed then that were too big to fail are even bigger now. The top six banks then had seven trillion of assets, now they have nine or ten trillion.

Rather than go to the fundamentals which have been totally neglected – we’ve simply kind of papered over the current system and continued the game of having the Federal Reserve and the Treasury if necessary prop up all of this leverage and speculation, which isn’t helping the economy.

And when we talk about zero interest rates. That’s not helping Main Street. Our problem in this economy is not our interest rates are too high. The zero interest rates are just more fuel for leverage speculation for what’s called the carry trade and that is causing windfall benefits to the few but it’s leaving the fundamental problems of our economy in worse shape than they’ve ever been.

BILL MOYERS: No one I know has a better understanding of the see-saw tension in our history between democracy and capitalism.

Capitalism, you accumulate wealth and make it available. Democracy being a brake, B-R-A-K-E, on the unbridled greed of capitalists. It seems to me that democracy has lost and that capitalism is triumphant – crony capitalism in this case.

DAVID STOCKMAN: And I think it’s important to put the word crony capitalism on there. Because free-market capitalism is a different thing. True free-market capitalists never go to Washington with their hand out. True free-market capitalists running a bank do not expect that every time they make a foolish mistake or they get themselves too leveraged or they end up with too many risky assets that don’t work out, they don’t expect to go to the Federal Reserve and get some cheap or free money and go on as before.

They expect consequences, maybe even failure of their firm, certainly loss of their bonuses, maybe the loss of their jobs. So we don’t have free-market capitalism left in this country anymore. We have everyone believing that if they can hire the right lobbyist, raise enough political action committee money, spend enough time prowling the halls of the Senate and the House and the office buildings, arguing for their parochial narrow interest – that that is the way that will work out. And that is crony capitalism. It’s very dangerous and it seems to be becoming more embedded in our system.

BILL MOYERS: So many people say, “We’ve got to get money out of politics.” Or as you said, “Money dominates government today.”

DAVID STOCKMAN: Well look, I think the financial industry, over the two or three year run up to 2010 spent something like $600 million. Just the financial industry, the banks, the Wall Street houses and some hedge funds and others. Insurance companies. $600 million in campaign contributions or lobbying.

That is so disproportionate, because the average American today is struggling to make ends meet. Probably working extra hours in order, just to keep up with the cost of living, which is being driven up unfortunately by the Fed.

They don’t have time to weigh into the political equation against the daily, hourly lobbying and pressuring and you know, influencing of the process. So it’s asymmetrical. And how do we solve that? I think we can only solve it by – and it’ll take a constitutional amendment, so I don’t say this lightly. But I think we have eliminate all contributions above $100 and get corporations out of politics entirely.

Ban corporations from campaign contributions or attempting to influence elections. Now, I know that runs into current free speech. So the only way around it is a constitutional amendment to cleanse our political system on a one-time basis from this enormously corrupting influence that has built up. And I think nothing is really going to change until we get money out of politics and do some radical things to change the way elections are financed and the way the process is influenced by organized money. If we don’t address that, then crony capitalism is here for the duration.

BILL MOYERS: David Stockman, thank you very much for sharing this time with us.

Reprinted from BillMoyers.com with permission from David Stockman.

Former Congressman David A. Stockman was Reagan’s OMB director, which he wrote about in his best-selling book, The Triumph of Politics. He was an original partner in the Blackstone Group, and reads LRC the first thing every morning.

This talk was delivered at the New York Historical Society on May 8, 2011.

It took 200 years to build and perfect the classic gold standard system; then it was destroyed in about seven weeks when the Guns of August 1914 thundered across Europe; and now I am allotted seven minutes to resurrect it. Fortunately, Churchill's defense of democracy also applies to the daunting task at hand: To wit, the classic gold standard is the worst possible monetary system — except for all of the alternative inflation-generating, savings-destroying, debt-breeding, bubble-emitting and boom and bust-prone systems which have been tried in the 100 years since its demise. Hence, we offer six present day monetary vices which are curable by gold:

1. First, the gold standard wouldn't have allowed the US to incur nearly 40 straight years of massive current account deficits and to live high on the hog for decades by running a $7 trillion tab against its neighbors. Indeed, before Richard Nixon and Milton Friedman instituted their floating rate fiat money contraption in August 1971, nations were compelled to live within their means. Chronic profligacy and current account deficits resulted in a drain of gold abroad, causing a domestic contraction including tighter credit, higher interest rates and deflation of prices, wages and demand — pressures which encouraged a speedy return to virtuous living and payments balance.
2. The gold standard tamed the demon of debt by delegating the pricing of money to the marketplace of savers and borrowers, not to an administrative board of interest rate riggers and manipulators. Consequently, a national leveraged buyout wasn't possible under gold: the sky high interest rates needed to induce extra savings tended to harshly discourage binges of cheap money borrowing. Thus, the national leverage ratio — the sum of public and private debt divided by GDP — was 1.6 times in 1870, and was still 1.6 times a century later. Since 1971, however, the Fed has found repeated excuses to drive real interest rates toward zero or negative — a maneuver which has generated explosive debt growth the easy way; that is, not by coaxing it from savers but by manufacturing bank credit out of thin air. Consequently, America had a full-fledged LBO and now its leverage ratio is off the charts at 3.6 times GDP. This means that our $15 trillion national economy is being crushed under $52 trillion of debt — a figure $30 trillion larger than would have obtained under the golden constant.
3. The gold standard was an honest regulator of Wall Street greed. Under gold, we did not seek Bernanke-style faux prosperity by levitating the Russell 2000; nor did we crucify Main Street on a cross of obscurantist theory like the Taylor Rule whereby the Fed naively gifts Wall Street with limitless zero-cost funding for leveraged speculations in commodities, currencies, derivatives and equities; nor did we punish people who invest in savings accounts out of an abundance of caution while placing a central bank "put" under those who speculate with reckless abandon. Moreover, unlike the Fed's money bubbles and crashes, which heavily punish Main Street, the so-called "panics" of the gold standard era — those of 1873, 1884, 1893 and 1907 — had the opposite aspect. They were largely sequestered on Wall Street and were rooted not in gold but in the glaring defects of the civil war era National Banking System. The latter drained nationwide banking reserves to the Wall Street call money market where it periodically fueled stock buying manias — but these episodes were quickly ended when deposits reflowed back to the country banks at harvest time, causing call money rates to soar and panic to supplant euphoria on the stock exchanges.
4. The gold standard made the world safe for fractional reserve banking. To be sure, banking — which is to say, scalping a profit from the interest spread between loans and deposits — is the world's second oldest profession. While arguably doers of god's work, banksters become positively dangerous when backed by a sugar daddy central bank — like the Fed or the People's Printing Press of China — willing to supply all the reserves needed for the endless inflation of bank credit and the destructive asset bubbles which follow. Under the gold standard, by contrast, commercial bank deposits and currency notes were convertible into gold on demand, and central bank reserve injections into the banking system were firmly checked by requirements to cover such liabilities with gold at a 35-50 percent ratio. Indeed, the folly of the Fed's recent manic reserve creation was even foreseen by the father of fiat money, Milton Friedman of Chicago, and by its grandfather, too — Irving Fisher of Yale. Both supported 100% reserve banking in lieu of the monetary discipline of gold. So give us gold or give us 100% reserve banking — but not fractional reserve gambling halls superintended by a Princeton math professor with a printing press.
5. The gold standard made the world safe for fiscal democracy because chronic budget deficits generated immediate pain. If financed from savings, deficits caused higher interest rates and squeezed-out private investment; and if financed by central bank credit, they caused a deflationary drain on gold. Nowadays, however, central banks have become monetary roach motels — places where treasury bonds go in but never come out. Consequently, sovereign debt has been drastically underpriced, causing Washington lawmakers to borrow lavishly and without fear.
6. Finally, the gold standard protected Main Street from the boom and bust of credit cycles. Such disturbances never issue from the people's work, saving, investment and enterprise, but always and everywhere they originate in the banking system and the speculative precincts of Wall Street. So the central bankers' "Great Moderation" is a myth — refuted by the compelling evidence that these gosplanners of fiat money do not tame the business cycle but intensify and exacerbate it is. Their printing presses fueled the stagflationary 1970s, the real estate bust of the late 1980s, the dot-com frenzy which followed, history's greatest housing bubble which came next, and the "risk-on" mania of recent months. Among all the arguments against gold, the claim that it would worsen the business cycle is, on the evidence of 40 years now, surely the most specious.

Former Congressman David A. Stockman was Reagan’s OMB director, which he wrote about in his best-selling book, The Triumph of Politics. He was an original partner in the Blackstone Group, and reads LRC the first thing every morning.

Someone has to stop the Fed before it crushes what remains of America’s main street economy. Last Friday morning alone it launched two more financial sector pumping operations which will harm the real economy, even as these actions juice Wall Street’s speculative humors.

First, joining the central banking cartels’ market rigging operation in support of the yen, the Fed helped bail out carry traders from a savage short-covering squeeze. Then, green lighting the big banks for another go-round of the dividend and share-buyback scam, it handsomely rewarded options traders who had been front-running this announcement for weeks.

Indeed, this sort of action is so blatant that the Fed might as well just look for a financial vein in the vicinity of 200 West St. [Goldman Sachs (GS) headquarters], and proceed straight-away to mainline the trading desks located there. In fact, such an action would amount to a POMO [Permanent Open Market Operations] – so it is already doing just that!

In any event, the yen intervention certainly had nothing to do with the evident distress of the Japanese people. What happened is that one of the potent engines of the global carry-trade – the massive use of the yen as a zero cost funding currency – backfired violently in response to the unexpected disasters in Japan.

Accordingly, this should have been a moment of condign punishment – wiping out years of speculative gains in heavily leveraged commodity and Emerging Markets currency and equity wagers, and putting two-way risk back into the markets for so-called risk assets. Instead, once again, speculators were assured that in the global financial casino operated by the world’s central bankers, the house always has their back – this time with an exchange rate cap on what would otherwise have been a catastrophic surge in their yen funding costs.

Is it any wonder, then, that the global economy is being pummeled by one speculative tsunami after the next? Ever since the latest surge was trigged last summer by the Jackson Hole smoke signals about QE2, the violence of the price action in the risk asset flavor of the week – cotton, met coal, sugar, oil, coffee, copper, rice, corn, heating oil and the rest – has been stunning, with moves of 10% a week or more.

In the face of these ripping commodity index gains, the Fed’s argument that surging food costs are due to emerging market demand growth is just plain lame. Was there a worldwide fasting ritual going on during the months just before the August QE2 signals when food prices were much lower? And haven’t the EM economies been growing at their present pace for about the last 15 years now, not just the last seven months?

Similarly, the supply side has had its floods and droughts – like always. But these don’t explain the price action, either. Take Dr. Copper’s own price chart during the past 12 months: last March the price was $3.60 per pound – after which it plummeted to $2.80 by July, rose to $4.60 by February and revisited $4.10 per pound a few days ago.

Copper, generic one-year futures chart, weekly

That violent round trip does not chart Mr. Market’s considered assessment of long-term trends in mining capacity or end-use industrial consumption. Instead, it reflects central bank triggered speculative tides which begin on the futures exchanges and ripple out through inventory stocking and de-stocking actions all around the world – even reaching the speculative copper hoards maintained by Chinese pig farmers and the vandals who strip-mine copper from the abandoned tract homes in Phoenix.

So Thursday evening’s short-covering panic in the yen forex markets, and the subsequent panicked response by the central banks, wasn’t just a low frequency outlier – the equivalent of an 8.9 event on the financial Richter scale. Rather, it is the predictable result of the lunatic ZIRP [Zero Interest Rate Policy] monetary policy which has been pursued by the Bank of Japan for more than a decade now – and with the Fed, Bank of England and European Central Bank not far behind.

For two decades now Japan has suffered from a real estate asset deflation which followed the collapse of its spectacular 1980’s financial bubble – but not price deflation on consumer goods and services. In fact, Japan’s headline Consumer Price Index was 94.1 in 1990 compared to 99.8 during the last quarter of 2010. Thus, during the past 20 years there has been a slight CPI inflation (0.3% annually) – notwithstanding the incessant deflation-fear mongering of the Keynesian commentariat.

To be sure, Japan’s so-called “core” CPI is down several points during that long period, but by all accounts the Japanese people have been eating, driving and heating their homes for the past two decades on a regular basis. Accordingly, they have paid slightly more for mostly imported food and energy and slightly less for everything else. But the overall consumer price index has been flat, meaning that real interest rates have been zero for the better part of a decade now.

And that’s the evil. Free money has not reflated domestic real estate because Japan’s bubble era prices were absurdly high and can’t be regained, and because Japanese real estate – both residential and commercial – is still heavily burdened with debt which cannot be repaid. Yet market economies – even Japan’s cartelized kind – are not disposed to look a gift horse in the mouth: Free money always finds an outlet, and the pathway of choice has been the transformation of the yen into a global “funding” currency.

This sounds antiseptic enough, but it means that in its wisdom the Bank of Japan has invited the whole world – everyone from Mr. and Mrs. Watanabe to state-of-the-art London hedge fund traders – to short the yen in order to finance speculations in the Aussie dollar, the big iron and copper miners, cotton futures, the Brent/WTI spread, and an endless procession of like and similar speculative cocktails.

Yet as the speculators rotate endlessly from one risk asset class to the next they can remain supremely confident that their yen carry cost will remain virtually zero. Yen interest rates will not go up because the BOJ is intellectually addicted to ZIRP, and because, in any event, it dare not surprise the market with an interest rate hike, thereby triggering a violent unwind of the very yen carry trades it has fostered.

In short, the BOJ is sitting on a financial fault line. Thursday afternoon’s rip to 76 yen to the dollar was not the work of a fat finger; instead, it represented a real-time measure of the furies bottled up in the financial system due to Japan’s foolish rental of its “funding currency” to global speculators. Having long ago urged the BOJ to embrace this absurd monetary policy, it is not surprising that Bernanke and his confederates have come to the rescue – for the moment.

It is only a matter of time, however, before the yen explodes under the next bout of short seller’s pressure, and then the lights will really go out on Japan Inc. In the meantime, ordinary people around the world will get less food per dollar from Wal-Mart and speculators, basking in the wealth effect, will have even more dollars to spend at Tiffany & Co. (TIF).

In this context, there can also be little doubt that the Fed is trying really hard to transform the dollar into a “funding” currency, too. In the name of fighting a phantom deflation, the nation’s central bank has kept interest rates absurdly low – transforming the dollar into a weakling even against the misbegotten Euro, and therefore something which speculators can more safely short.

But just like the case of Japan, there is no sign of CPI deflation in the USA. Our headline CPI index has gone from 130.7 in 1990 to 218.1 in 2010 – marking a 2.6% annual inflation over the past two decades. And, no, it hasn’t slowed down much during the Bernanke era of deflation phobia.

In fact, the headline CPI index has risen at a 2.4% rate in the last ten years, hardly a measureable de-acceleration; and it has gained at a 2.2% rate in the last five years – a rate at which, as Paul Volcker rightly observed, the purchasing power of the dollar would be cut in half during the typical American’s working lifetime. Even since the alleged June 2009 recession bottom, the headline CPI has climbed at a 2.1% annual rate.

So there is no deflation – just a simulacrum of it based on the observation that the CPI less food and energy has randomly fluttered around the flat-line on several recent monthly readings. It is not obvious, of course, that the rise of this index at a 1.1% annual rate during the last 20 months of recovery is a bad thing – for at that rate we begin to approach the idea of honest money. But the spurious circular logic embedded in the Fed’s focus on this inflationless inflation index is self-evident upon cursory examination of its internals.

Fully 40% of the CPI less food and energy is owner’s equivalent rent – the one price that is actually deflating and which is doing so precisely due to the Fed’s own policies. Residential rents are falling or flat because the market is being battered with a) millions of involuntary rental supply units owing to the wave of home mortgage foreclosures, and b) an extraordinary shrinkage in the number of rental units demanded due to the doubling-up, and even tripling-up, of destitute households.

Thus, the destructive result of the Fed’s earlier destructive housing and consumer credit bubble became the excuse for embracing a zero interest rate policy which is self-evidently fueling even more destruction; namely, the rape of middle class savers; the current severe food and energy squeeze on lower income households; the illusion in Washington that Uncle Sam can comfortably manage $14 trillion in debt because the interest carry is close enough to zero for government purposes; and the next round of bursting bubbles building up among the risk asset classes.

Moreover, the Fed soldiers on with its serial bubble-making, even though it is evident that the hallowed doctrines of modern monetary theory and the inherently dubious math of Taylor rules have failed completely.

Indeed, the evidence that the Fed no longer has any clue about the transmission pathways which connect the base money it is emitting with reckless abandon (e.g. Federal Reserve credit) to the millions of everyday pricing, hiring, investing and financing outcomes on Main Street sits right on its own balance sheet. Specifically, if the Fed actually knew how to thread the needle to the real economy with printing press money it wouldn’t have needed to manufacture $1 trillion in excess bank reserves – indolent entries on its own books for which it is now paying interest.

So in the present circumstances, ZIRP and QE2 amount to a monetary Hail Mary. There is no monetary tradition whatsoever that says the way back to U.S. economic health and sustainable growth is through herding grandma into junk bonds and speculators into the Russell 2000.

Admittedly, the junk bond financed dividends being currently extracted by the Leveraged Buyout Kings from their debt-freighted portfolios may enable them to hire some additional household help and perhaps spur some new jobs at posh restaurants, too. Likewise, the 10% of the population which owns 80% of the financial assets may use their stock market winnings to stimulate some additional hiring at tony shopping malls.

That chairman Bernanke himself has explained in so many words this miracle of speculative GDP levitation, however, does not make it so. The fact is, if transitory wealth effects add to current consumer spending, they can just as readily subtract from it on the occasion of the next “risk-off” stampede to the downside. Indeed, the proof – if any is needed – that cheap money fueled asset inflations do not bring sustainable prosperity lies in the still smoldering ruins of the U.S. housing boom.

In truth, the Fed’s current money printing spree has no analytical foundation, and amounts to seat-of-the-pants pursuit of a will-o’-wisp – the idea of a perpetual bull market. Like the BOJ, the Fed has thus made itself hostage to the global speculative classes, and must repeatedly inject new forms of stimulus to keep the bubbles rising.

This is the only possible explanation for its preposterous decision last week to allow the Big Banks to resume dissipating their meager capital accounts by paying “normalized” dividends and by resuming large-scale stock buybacks. These are the same financial institutions that allegedly nearly brought the global economy to its knees in September 2008, according to the Fed chairman’s own words.

In what is no longer secret testimony to the FCIC (Financial Crisis Inquiry Commission), Bernanke claimed that the Wall Street meltdown “was the worst financial crisis in global history” and that “out of maybe 13… of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.”

That testimony was recorded just 15 months ago, but the financially seismic events it references have apparently already faded into the dustbin of history. Still, even if the dubious proposition that the banking system has fully healed were true, what did the Fed hope to accomplish besides goosing the S&P 500 via speculative rotation into the bank indices?

Well, there are no other plausible explanations. Certainly the stated theory – namely, that by green lighting disgorgements of capital today the Fed’s action will facilitate bank capital raising and new lending in the future – merits a loud guffaw. The fast money has already priced in whatever dividend increases and share buybacks may occur before the next banking crisis, but the last thing these speculators expect is a new round of dilutive capital issuance by the banks. Stated differently, the bid for bank stocks unleashed by the Fed’s relief action is predicated on speculators’ pocketing any near-term “surplus” capital, not leaving it in harm’s way on bank balance sheets.

Moreover, even if the Fed’s action had the effect of bolstering, not depleting, bank capital the larger issue is why does our already massively bloated banking system need more capital in any event? The reflexive answer is that this will help restart the flow of credit to Main Street, but it doesn’t take much digging to see that this is a complete non-starter.

The household sector is still saddled with massive excess debt – unless you believe that the credit bubble of recent years is the sustainable norm. The fact is, prior to the Fed’s easy money induced national LBO, debt-to-income ratios at today’s levels were unthinkable. In 1975, for example, total household debt – including mortgages, credit cards, auto loans and bingo wagers – was about $730 billion or 45% of GDP. During the 1980’s, however, this long-standing household leverage ratio began a parabolic climb, and never looked back. By the bubble peak in Q4 2007, total household debt had reached $13.8 trillion and was 96% of GDP. Yet after 36 months of the Great Recession wring-out, the dial has hardly moved: household debt outstanding in Q4 2010 was still $13.4 trillion, meaning that it has shrunk by the grand sum or 3% (entirely due to defaults) and still remains at 90% of GDP or double the leverage ratio that existed prior to the debt binge of the past three decades.

So the banking system does not need more capital in order to increase credit extensions to the household sector. In fact, the two principal categories of household debt – mortgage loans and revolving credit, continue to decline as American families slowly shed unsupportable debt. The only reason total household debt appears to be stabilizing in recent quarters is that student loan volumes are soaring, but this growth is being funded entirely by the Bank of Uncle Sam now that private bank loan guarantees have been eliminated.

Indeed, the startling fact is that the approximate $1 trillion of student loans outstanding – subprime credits by definition – now exceed the $830 billion of total credit card debt by a wide margin. While this latest student loan bubble will end no better than the earlier credit bubbles, the larger fact remains that the household sector is only in the early stages of deleveraging. Not the least of the motivating forces here is that the leading edge of the household sector – the 78 million strong baby boom generation – appears to be figuring out that it is not 1975 anymore, and that retirement and old age are approaching at a gallop.This obvious household deleveraging trend remains a mystery to the Fed and to the Wall Street stock peddlers who occasionally moonlight as economists. One recent airball offered up by the latter is that the ratio of debt to disposable personal income (DPI) has dropped materially, and that this proves the household sector has been healed financially and is ready to borrow again. Specifically, the household debt-to-DPI ratio has fallen to 116% from a peak of 130% in late 2007.

Never mind that this measure of household finances stood at just 62% back during the healthier climes of 1975. It is evident that even the modest improvement in this ratio during the last three years is a statistical illusion. It turns out that the debt-to-DPI ratio is improving mainly because the denominator has gained about $885 billion or 8.3% since the end of 2007.

Yet this gain in DPI has nothing whatsoever to do with an improved debt carrying capacity in the household sector. Thanks to the more or less continuous riot of Keynesian stimulus in Washington since early 2008, we have had a tax holiday and a transfer payment bonanza. Specifically, in the three years since the Q4 2007 peak, personal taxes are down at a $312 billion annual rate (which adds to DPI, an after-tax measure) and transfer payments are up by a $572 billion annual rate.

Both of these are components of DPI, and taken together ($884 billion) they account, quite astoundingly, for 99.8% of the DPI gain since Q4 2007. Moreover, it does not take a lot of figuring to see that these trends won’t last. The Federal tax take is now less than 15% of GDP – the lowest level since 1950 – and will be rising year-after-year in the decade ahead, as will personal tax burdens at the state and local level.At the same time, the 30% surge in transfer payments over the last three years is mostly done. Unemployment insurance payments – which accounted for much of the rise – will be flat or shrinking in the near future, and various one-time low income programs have already expired. Moreover, the bulk of the current $2.3 trillion in transfer payments goes to elderly and poverty level households which carry negligible portions of the $13.4 trillion in household debt, in any event.

By contrast, the ratio of household debt to private wage and salary income – a far better measure of debt carrying capacity – has not improved at all. Household debt amounted to 255% of private wage and salary income at the peak of the credit boom in late 2007, and was still 251% in Q4 2010. At the end of the day, the household debt-to-DPI ratio improved solely because Uncle Sam went on a borrowing spree and temporarily juiced DPI with tax abatements and transfer handouts.

In short, banks don’t need more capital to support household credit because the latter is still shrinking, and will continue to do so for a long time to come. Moreover, it might as well be said in this same vein that the business sector don’t need no more stinking debt, neither!

At the end of 2005 – before the credit bubble reached its apogee – the non-financial business sector (both corporate and non-corporate entities) had total credit market debt of $8.3 trillion, according to the Fed’s flow of funds data. By the end of 2007, this total had soared by 25% to $10.4 trillion. But contrary to endless data fiddling by Wall Street economists, the business sector as a whole has not deleveraged one bit since the financial crisis. As of year-end 2010, business debt was up a further $500 billion to $10.9 trillion.

The whole propaganda campaign about the business sector becoming financially flush rests on an entirely spurious factoid with respect to balance sheet cash. Yes, that number is up a tad – from $2.56 trillion in Q4 2007 to $2.86 trillion at the end of 2010. Still, this endlessly trumpeted gain in cash balances of $300 billion is more than offset by the far larger gain in business sector debt – meaning that, on balance, the alleged nest egg of cash held by American business is simply borrowed money!

At the end of the day, $10.9 trillion is a lot of debt in absolute terms, but based on the Fed’s data on the market value of business sector assets, it is also crystal clear that the relative burden of business debt has been rising, not falling. At the bubble peak in late 2007, business sector assets were valued at $41.5 trillion but alas this figure had shrunk to $36.9 trillion by the end of last year. The grim reaper of real estate deflation has done its work in the business sector, too.

Consequently, total business debt now amounts to 29.4% of business assets – a considerable rise from the 25.2% ratio at the bubble peak in late 2007. What the bullish cheerleaders of recovery constantly forget is that in an epochal deflation like the present one, debts remain at their contractual amounts, even as asset values wither.

So the real question regarding the Fed’s green light for bank dividends and buybacks is quite clear. Banks don’t need more capital to make new loans to households and business. What they actually need is to preserve their current artificially bloated retained earnings accounts in order to protect the taxpayers from the next – virtually certain – banking meltdown.

In this light, the Fed’s action is especially meretricious. If it weren’t in such a hurry to juice the stock market and thereby keep the illusion of recovery going, it might have considered extending the regulatory sequester on bank capital for a few more quarters or even years – thereby preserving a shield for the taxpayers until it has been demonstrated by the passage of time, not by the passing of phony stress tests, that the American banking system is truly out of the woods.

After all, the bottled-up profits currently alleged to be resident in the banking system have not been expropriated by the Fed; they have just been temporarily sequestered – a condition that these wards of the state should gladly endure in return for continued access to taxpayer backed deposit insurance and the Fed’s borrowing widow, as well as their license to engage in the lucrative business of fractional reserve banking. Indeed, the fast money should be as capable of pricing in any “excess” capital in the banking system, as it has already been in goosing bank stocks in anticipation of higher profit distributions.

And it is here where the historical data on Bernanke’s 12 out of 13 crashing financial dominoes essentially speaks its own cautionary tale. At the peak of the credit and housing boom in 2006, these 13 most important financial institutions booked $110 billion of net income, and disgorged more than $40 billion of that amount in dividends and stock buybacks.

Would that these fulsome profits and attendant distributions had been real and sustainable, but the historical facts inform otherwise. By 2007, the groups’ profits had dropped to $64 billion, and then in 2008, the ten institutions which survived to year-end reported a staggering loss of $56 billion. Moreover, if the massive losses incurred by the bankrupt three – WAMU, Wachovia, and Lehman – during their final, unreported stub quarter are added to this tally, group losses for the year would approach $80 billion.

The unassailable truth here is that in 2006 and 2007 the banks were disgorging phantom profits to their shareholders. When the crunch came in 2008, bank capital had been badly depleted by these unwarranted dividends and stock buybacks, and soon Mr. Bernanke was running around with his limited shock of hair fully ablaze.

The danger, of course, was buried in the balance sheets all along. Back in their 2006 heyday, the top 13 financial institutions had $10.2 trillion of total assets – and a not-inconsiderable portion of that figure was worth far less than book value, as ensuing events proved. Today the nine banks which are the survivors and assigns of these 13 institutions still have $10.1 trillion in asset footings – hardly a measureable reduction despite the goodly amount of write-offs which have been taken in the interim.

The Fed’s foolish wager – and it is foolish because there is no real purpose other than a momentary boost to bank shares – is that this once toxic waste-ridden $10 trillion balance sheet is now squeaky clean. Yet why would any sane observer embrace that dubious proposition?

While the banks have been relieved of mark-to-market accounting, they are still knee-deep in the very asset classes whose ultimate recoverable value remains exposed to the real estate meltdown. Residential housing prices are now clearly in the midst of a double dip, and rates of new construction and existing unit sales are spilling off the bottom of the historical charts.

Still, the banking system holds $2.5 trillion of residential mortgages and home equity lines – plus $350 billion of construction loans and more than a trillion of mortgage backed securities. Maybe they have enough reserves to cover the remaining sins in this $4 trillion kettle of residential debt, but betting on housing bottoms has been a widow-maker for several years now – and there is nothing on the horizon to suggest that this epochal bust will not make a few more.

Likewise, the banking system is carrying $1 trillion of commercial real estate loans, and the open secret is that “extend and pretend” refinancing is the primary underpinning of current book values. Similarly, the Fed has rigged the steepest yield curve in modern times, but it is a fair bet that as it is gradually forced to normalize interest rates, current record net interest margins will be squeezed. And it is also probable that some of the $2.7 trillion of government, corporate and other securities owned by the banking system may be worth less than par in a world where money rates are more than zero.

In short, a banking system that by the lights of the Fed was on the verge of extinction just 28 months ago could not possibly have gotten well in the interim. In shades of 2006, the nine survivors did report net income of $54 billion in the year just ended, and it is these retained earnings that have purportedly brought bank capital ratios to the pink of health. Then again, the cynic might wonder whether the trading book and yield curve profits of 2010 might not vanish just as fast as did the mortgage origination, securitization and trading profits of 2006-2007.

One thing is certain, however, and that is that these behemoths are now truly too big to fail. At the end of 2006, the asset footings of the Big Six – JPMorgan (JPM), Bank of America (BAC), Wells Fargo (WFC), Citigroup (C), Morgan Stanley (MS), and Goldman Sachs (GS) – were $7.1 trillion. Saving the system through shotgun marriages, our financial overloads have permitted the group to grow its assets during the interim by 30% to $9.2 trillion.

If you believe that these massive financial conglomerates are a clear and present danger to the American economy, you might opine that they are too big to exist, as well. But even from a more quotidian angle – unless you have rented the banking index for a trade – it’s pretty easy to see that so-called banking profits currently being booked should have remained under regulatory sequester for a few more economic seasons, at the very least.

Reprinted from Minyanville with the permission of the author.

Former Congressman David A. Stockman was Reagan’s OMB director, which he wrote about in his best-selling book, The Triumph of Politics. He was an original partner in the Blackstone Group, and reads LRC the first thing every morning.

The Henry Hazlitt Memorial Lecture at the 2011 Austrian Scholars Conference.

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 which 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 grand-daddy 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%!

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 # 1 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 upfront 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 did use to fund their payroll. But there was not a single industrial company in America then issuing commercial paper which 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 U.S. government debt itself.

The sheer budgetary facts are bracing enough. It needs to 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% of national income.

These elephantine figures mark a big lurch southward — since a deficit only half this size was 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% of GDP deficit for the third year running because this latest budgetary fling is just another episode in the epochal collapse of U.S. 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 U. S. 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 the U.S. 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% 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 U.S. 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 national central banks tethered to the Fed.

That this convoy is a potent mechanism for monetizing the U.S. 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% of British GDP.

Likewise, in 1959 at the peak of Bretton Woods, the U.S. held $20 billion of gold reserves against a GDP of $500 billion. Again, at about 4% 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% 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 U.S. 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 which 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 U.S. 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 treasury debt that is officially held elsewhere and you have the startling fact that about $4.5 trillion or 50% 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 re-awakening that the floor of the U.S. 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% of GDP — the lowest level since 1950 and far below the 18.4% 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 pre-emptive 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 State and Warfare State was getting heavier, not lighter.

Here the GOP's neo-con 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 neo-cons deserve their own special chapter in the annals of fiscal infamy.

Having pushed the American Empire to take its stand on real estate of dubious merit historically — that is, the bloody plains of the Tigris-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 which 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 cannons 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% 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% of GDP after having averaged 15.2% 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% 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 mega-deficits 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% 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 anti-spenders. Consequently, outlays for the Big Three entitlements doubled to $1.425 trillion or 10.1% 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 is more! In that modest 15% 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% rise in spending on transportation, a swelling of farm support programs and enactment of a $60 billion energy bill providing subsidies for solar, wind, fuel cells, clean coal, fusion and ethanol — the exact menu 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% of national income — a figure materially higher than the 15.2% average during the last period of unified Democrat government under Carter. Thus, while the impact of the Reagan Revolution on the size of the U.S. 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 insured 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% of GDP this year to 3% by 2015 — a trend which 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 pick-up in the revenue baseline thereafter. But what also happens on January 1, 2013 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% tax rate on corporate dividends will jump to 39.6% in 2013.

Similarly, the estate tax rises from 35% on $5 million to 55% 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 child care, higher education and much more. Taken altogether, the December Christmas tree contained temporary tax relief provisions worth 3.8% 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 which 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 which temporarily waives the 20% 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 $30 billion future spending reduction 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% 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% 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% of GDP.

That would amount to about $7 trillion in new bond issuance over the next 5 years, and take total public debt in the United States to over 100% of GDP.

There is no telling, of course, as to 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% over the next decade — or double the 1.7% average during the past decade. Finally, it projects that the U.S. 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 U.S. 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 U.S. 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 grce. 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 U.S. 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% 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%, and was actually just 3.2% in the most recent quarter.

By contrast, the new White House budget projects money GDP growth of 5.6% per annum over the next five years — meaning that nominal GDP would reach $20 trillion by then. At a 3.5% 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 super-cycle 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 U. S. current account deficit; that is, such trade adjustment as might be needed would be done by the non-dollar 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 U.S. 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% of GDP — external deficits which have now cumulated 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 U.S. balance sheet go parabolic. For a century after resumption of convertibility in 1879, the ratio of total U.S. 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 1.6X.

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 2.6X, and then 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 which 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 3.6X 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 10 years of standard growth rates with no recession, and would not be capitalizing corporate earnings at the conventional 15X 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 USA 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 it was off the races. When the debt super-cycle apogee came in 2007, it took $4 trillion of debt growth to produce a gain of just $700 billion of GDP. At the point, the debt-to-income growth ratio had climbed to 6.0X, and shortly thereafter the man from Citigroup finally stopped dancing.

The evaporation of artificially inflated income growth and the bursting of the asset bubbles which inexorably followed this kind of debt super-cycle 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% since the final quarter of 2007. However, only $380 billion or 4% 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% 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% 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% assumption about money GDP growth would look more than plausible. The fact is, organic income is not growing at even 3%.

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%. But private wages and salaries are still $100 billion or 2% 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 along nearly two and one-half 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 which have been the source of the entire intervening gain in U.S. 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 U.S. 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% less. To 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 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 U.S. economy is likely stuck in an extended Austrian moment and the U.S. 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 Friedman'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 China 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 super-cycle, 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 contra-factual. 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 which has metastasized since 1971 may be approaching its end game. By all appearances, Mao's great rural swamp has now pretty much been drained.

Global wages will therefore start rising because even Wal-Mart has not been able to discover another country inhabited by millions of $1 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 bonds, 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.

Former Congressman David A. Stockman was Reagan’s OMB director, which he wrote about in his best-selling book, The Triumph of Politics. He was an original partner in the Blackstone Group, and reads LRC the first thing every morning.

If Warren Buffett
wants to tarnish his golden years emitting the gushing drivel that
appears in today’s New York Times, he has undoubtedly
earned the privilege. But even ex cathedra pronouncements by the
Oracle of Omaha are not exempt from the test of factual accuracy.
Specifically, his claim that “many of our largest industrial
companies, dependent upon commercial paper financing that had disappeared,
were weeks away from exhausting their cash resources” is unadulterated
urban legend. Nothing remotely close to this ever happened.

The fact is,
there was about $2 trillion in commercial paper outstanding on the
eve of the Lehman failure. And it’s true that funding of this short-term
paper was highly dependent upon money market funds that suffered
multi-hundred billion outflows after First Reserve broke the buck
owing to its holdings of toxic Lehman paper. So it’s accurate to
say that the commercial paper market had seized up and that massive
amounts of maturing paper had no ability to roll.

But those specific
facts about the condition of the CP market do not remotely prove
that the nation’s great industrial corporations were on the
edge of an economic black hole or that Main Street would have experienced
crippling waves of defaulted payrolls for lack of cash. Indeed,
even a cursory review of the composition of the $2 trillion CP market
as of September 2008 shows that the “blowup” was actually
about losses on reckless bets by a few thousand money managers,
not the availability of ready cash to millions of Main Street businesses.

In the first
instance, well less than $400 billion of the total CP outstanding
consisted of industrial corporation paper – that is, funding
of the kind that might have been ordinarily used to cover payrolls
and similar operating expenses. But let some enterprising graduate
student investigate the limited universe of investment grade industrial
companies then accessing the CP market. How many of these issuers
lacked unused back-up revolving credit lines at the banks –
for which they had been paying “standby” fees year in
and year out for just such a contingency as the Lehman event seizure
in the CP market? The answer is virtually none: The great industrial
companies to which Buffett refers used CP because it was cheaper
(even with 15 bps of standby revolver fees), not because they wished
to put their enterprise in harms way every 45 days. Moreover, there
is not a shred of evidence that any bank even threatened to default
on contractual obligation to fund these back-up lines.

The next crucial
fact is that the entire balance of commercial paper then outstanding
– some $1.6 trillion – had nothing whatsoever to do with
funding business payrolls or heat and light bills. Instead, it consisted
entirely of the short-term liabilities of the shadow banking system
– funding that permitted the financial arbitrage profits on
which the whole system was based.

The largest
single piece was about $1 trillion of asset-backed commercial paper
(CP-ABS). Said assets consisted of auto loans, student loans, credit
card loans, and the like, which retail financial institutions had
originated, securitized, and sold into CP-ABS conduits that they
sponsored. The whole point to this money shuffle was that, on average,
the wholesale funding that could be accessed through the CP-ABS
market was cheaper than the retail funding banks could obtain on
their own balance sheets. The result was higher profit spreads on
the auto paper originated by the banks, not funding for the payroll
costs of the army of clerks who processed the loans.

Because the
securitized ABS market has now shrunk to a shadow of its former
self, it can be definitively said that nothing was flushed down
an economic black hole in the fall of 2008 or at any time since.
Not one auto loan has even been denied and not one credit card authorization
request has even been disapproved because the CP-ABS market disappeared.
Instead, such loans are now largely funded and retained on the balance
sheets of the banking system originators – which, drowning in excess
reserves anyway, haven’t broken a sweat. What has disappeared are
the arbitrage profits that banks were raking off from foolish money
fund managers who have finally seen that the “enhanced yield”
they were obtaining from CP-ABS paper was not evidence of a better
mousetrap – just their own cupidity.

The remaining
$600 billion or so of CP outstanding was issued by non-bank Finance
Companies like GE Capital, G-MAC, and CIT Group. Here’s where
the urban legend gets positively malodorous. At the time of the
crisis, these companies were knee-deep in the ancient scam of lending
long and slow (i.e. illiquid) and borrowing short and hot. The resulting
yield curve arbitrage generated fulsome accolades and bonuses for
the portfolio managers and executives – until the mullet money
in the CP market violently scampered off the deck.

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the rest of the article

November
18, 2010

Tuesday night’s
election result was a victory for deep partisan stalemate, polarization,
dysfunction, and acrimony throughout the halls of government. The
market badly wanted a Republican victory, and sometimes you get
what you wish for. Unfortunately, Mr. Market’s innocent dreams
of a more “business friendly” government will turn out
to be a nightmare of fiscal profligacy on a scale that’s virtually
unprecedented in modern history.

It’s now guaranteed
that the hapless soul who succeeds to the White House in January
2013 will preside over a nation with $15 trillion of reported public
debt, that is, debt at 100% of GDP and counting. On top of that
will be tens of trillions more in unfunded (and unreported) entitlement
liabilities – the financial burden of which will only intensify
as the baby boomers become fully retired. Worse still, Obama’s
successor will have no way to stop the headlong rush into national
bankruptcy he or she will inherit from this week’s earthquake because
the specious ideological shibboleths of both parties will have poisoned
the only policy tools – tax increases and entitlement cuts – that
can make a difference.

To see why
this scenario will play out, start with the bloodbath in the House.
The only specie of Democrat that’s even entertained the notion of
entitlement reform was the Blue Dog Democrat. As of this morning,
that particular specie is extinct. The remnant of the Democratic
caucus consists of aging, hard-core liberals who have spent a political
lifetime accumulating anti-Republican bile against the policies
of Reagan and the Bushes. Now, they’ll play the only card they have
left – fostering hysteria among elderly voters about social security
cuts.

The Democrat’s
prospects for success are excellent and the reasons will shortly
be evident. The gumption-challenged group of statesman appointed
to the president’s deficit commission by the pols of both parties
will soon issue the big cop-out – opining that Social Security
has a long-term funding problem, but not one that requires immediate,
deep cuts in current benefits. That proposition, of course, is a
convenient dodge that rests on the fiction of trust-fund accounting.

The fact is,
the Social Security trust fund has $3 trillion of paper IOUs issued
by the Treasury Department over the last 70 years, but not one dime
of real money. Over that time span, we collected a modest excess
of payroll taxes over current-year benefit payments, and spent the
excess cash on cotton subsidies, student loans, and aircraft carriers.
It’s all long gone.

The truth is,
the Social Security program is a $700 billion per year inter-generational
transfer payment program in which lifetime taxes paid by current
recipients bear only a faint and arbitrary relationship to benefits
now being received. So when the retirement “insurance”
and trust-fund fictions are cut away, the underlying program cries
out to be means-tested. To be sure, that would amount to a default
on the implicit social compact that has undergirded the program
since its inception. But in the context of the massive fiscal retrenchment
which is now unavoidable, there’s no rational alternative.

This is made
starkly evident by viewing the alternatives. The only other element
of the domestic budget of comparable size is the $600 billion we
spend on means-tested safety-net programs including Medicaid. Yet
unlike in the early days of the Reagan Administration when the president
could fairly make points about the abuses of what he called welfare
queens, today’s facts are very different. The safety net programs
were substantially reformed in 1981, and then thoroughly tightened
once again under President Clinton’s bipartisan welfare reform.
Any additional savings are thus likely to be in the tens of billions,
not the hundreds of billions actually needed.

Moreover, the
burden of safety-net spending is now likely to rise for decades
into the future because we’re inextricably mired in a failed national
economy. It turns out that there was no miracle of economic growth,
productivity and prosperity over the last several decades –
even if Wall Street stock peddlers and Republican orators still
cling to that illusion. What we had, instead, was serial bubble
after bubble – fueled by a tsunami of public and private debt
and printing-press money.

The deflationary
aftermath will be with us for years, and so will low single-digit
GDP growth, chronic double-digit unemployment rates, and swollen
levels of economic hardship among the lower ranks of society. In
that context, we won’t see the recent tripling of food stamp and
unemployment compensation expenditures recede in the conventional
cyclical manner, nor can we grow our way out of the currently ramped-up
level of safety-net spending. Like much else, the current $600 billion
social safety net is the new normal.

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November
9, 2010

Reagan White
House budget guru David Stockman talks to Lloyd Grove about the
dangers of ignoring the deficit, why Bernanke, Geithner and Summers
must be fired ASAP – and his support for Ron Paul.

Federal Reserve
Chairman Ben Bernanke “is a math teacher, he’s not a central
banker,” former White House Budget Director David Stockman
scoffs. “He is so caught up in his equations that I think he’s
extremely dangerous – the worst Fed chairman we’ve ever
had.”

In the flat,
dry accents of the Michigan farm boy he once was, Stockman tells
me: “How can he believe that stimulating more credit creation
and more borrowing can possibly solve the problem of a housing sector
that’s drowning in debt and a federal government that’s
on the edge of insolvency?…

“He is
the greatest enabler of Wall Street speculation and of the disasters
that brewed both before the financial crisis of 2008 and are brewing
again, and I would blame the Bush White House. I would lay this
right at the doorstep of Karl Rove. How did they vet the appointment
of a new Fed chairman and not even read the black-and-white writings
of this Bernanke fellow who said, ‘If push comes to shove,
I’ll print money until the cows come home. I’ll drop it
out of helicopters!’ This is Republican doctrine? This is sound
money?” Stockman concludes: “The Wall Street casino is
simply a consequence of what Bernanke is doing, and for that alone,
he should be removed from office.”

As Stockman
explains why Bernanke should be fired immediately – along with
Treasury Secretary Timothy Geithner and President Obama’s chief
economic adviser, Larry Summers – he sips a cappuccino at The
Little Nell bar in Aspen, Colorado, site of the Aspen Institute’s
weeklong Ideas Festival, which ended on Sunday.

“Summers,”
Stockman continues, dispatching his next victim, “has had in
his whole life only one idea – and it’s wrong. The idea
is: No matter what state we are in the cycle – you’re
entering a recession, coming out of the recession or facing one
down the road – stimulate the economy, add to the federal debt,
basically borrow from the future in order to create false gains
today.”

As for Geithner,
“he has basically been a bag carrier for Wall Street –
in fact, his shoulders are a little stooped,” Stockman says.
“I don’t think he’s really fit to occupy the office
he’s in. He has no real philosophy. I don’t see any evidence
that he’s understood financial history or public policy going
back decades and decades. It’s all seat-of-the-pants, make
judgments on the fly: Try something, and if it doesn’t work,
try something else…He might make a third-rate investment banker,
but he certainly shouldn’t be Secretary of the Treasury.”

The other patrons
pay no attention to the silver-haired gadfly at the corner table
who’s making smart remarks about the powers that be. At 63
– casually dressed in a dark patterned shirt that is draped
over his belt to conceal his spreading belly – Stockman looks
like any of the other wealthy senior citizens who populate this
posh resort town.

But he was,
in his day, President Reagan’s “boy wonder” and fiscal
hatchet man, the most famous (or infamous, depending on your outlook)
budget director in American history. In the notorious episode that
prompted an angry Reagan to “take him to the woodshed,”
as the encounter was spun at the time, Stockman confided his misgivings
about an intellectually dishonest, politically corrupt federal budget
process to William Greider in The Atlantic Monthly. "None
of us really understands what’s going on with all these numbers,"
Stockman told Greider in 1981 – an utterance so refreshing
and unprecedented, coming as it did from a top government official,
that a Washington, D.C., dance company presented an avant-garde
ballet inspired by Stockman’s truth-telling.

Since leaving
government and politics in the mid-1980s, he has made millions as
an investment banker – he was a founding partner, with Steve
Schwartzman and Pete Peterson, of the Blackstone Group – and
later became the target of Justice Department and Securities and
Exchange Commission investigations into what the government alleged
was his fraudulent stewardship of a failed auto parts company. Criminal
charges were dropped last year for lack of evidence, and a few months
ago Stockman settled the SEC’s civil suit by paying $7.19 million
in penalties and fines.

“It wasn’t
a pleasant experience, but I also knew what the facts were,”
Stockman tells me.

Does he believe
he was targeted because of his celebrity?

“It’s
very hard to figure out how they pick and choose their cases,”
he answers. “I’m just glad to have all this over – to
have the Justice Department drop the case because they realized
they couldn’t defend it, and to have the SEC drop most of the
charges they made. I’m not going to second-guess why they got
involved, but after tens of millions of pages of documents and two
or three years of investigation and millions of dollars of legal
expenses, both the SEC and the Justice Department ended up dropping
the case. That says something.”

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the rest of the article

July
13, 2010

This article
was written by David Stockman, who was elected to U.S. House of
Representatives for the 95th Congress and was reelected in two subsequent
elections, serving from January 1977 until his resignation January
1981. He then became Director of the Office of Management and Budget
under President Ronald Reagan, serving from 1981 until August 1985.
He was the youngest cabinet member in the 20th century. After leaving
government, Stockman joined Wall St. investment bank Salomon Bros.
and later became a founding partner at New York-based private equity
firm, The Blackstone Group. He left Blackstone in 1999 to start
his own private equity fund, Heartland Industrial Partners, L.P.,
based in Greenwich, CT.

My proposition
today is that we’re in a fiscal calamity caused by the further,
and perhaps, final triumph of politics. Admittedly, I issued this
very same forecast awhile back – 23 years ago to be exact. But
I’m not reluctant to try again. Having read Grant’s continuously
since 1988, I’ve learned there’s no shame whatsoever in
being early – even often!

The Triumph
of Politics was published early, mainly in the unflattering sense
that I’d not completed my homework. I was hip to statist fiscal
and regulatory evils, but had only dimly grasped the Austrian masters’
wisdom on money; that is, in printing money backed by nothing, central
banks inherently threaten prosperity. So today I’ll add the
proposition that fiscal decay is the inevitable step-child of the
very monetary rot that the Austrians – Mises, Hayek, Rothbard –
so deplored.

My tardiness
on money perhaps owes to the Reagan Revolution’s disinterest.
Secretary Don Regan averred that sound money could be readily attested
by the height of the Dow while his deputy, a monetarist, gauged
it by the width of M2.

Even Alan Greenspan,
that is, Greenspan version 1.0, urged not to worry. Gold, he assured
Ronald Reagan, was meant to anchor – not the Fed’s actual
balance sheet, but something more ethereal, like perhaps its state
of mind.

My libertarian
screed thus omitted money while cataloging the Reagan Revolution’s
lesser shortcomings. These included gargantuan deficits, subsidies
for favored Republican constituencies like farmers, homebuilders
and exporters, a complete whiff on entitlements, and protectionism
for dying industries like steel and textiles – even for a motorcycle
company whose ticker symbol, fittingly, was HOG.

Then, too,
there were tax giveaways to real estate, oil and gas, and, come
to think of it, to any other worthy industry with the foresight
to hire a pair of Gucci loafers domiciled on K-street. On top of
this, came the big defense budgets at a peacetime record 7% of GDP.
Deep Federal deficits thus stretched as far as the eye could see.

Yet, I didn’t
perceive that this already alarming fiscal ledger would be further
aggravated by two looming tectonic shifts. Oddly enough, these financial
temblors were rooted in history’s most consequential pair of
train cars.

The first was
the sealed car that took Lenin to Moscow in 1917 – a 75-year trip
to hell and back that finally ended in 1991 when a Moscow politician,
whose normal confrontations were with a Vodka bottle, was inspired
to mount a Soviet tank and command the Red Army to stand down. Promptly
thereupon the US defense budget was stood down, too, dropping overnight
to approximately 3% of GDP – half its prior size.This unexpected
game changer coupled with marginal tinkering on taxes and spending
computed out to a balanced budget. Soon enough, the fiscal all-clear
horn was sounded by no less than Wall Street’s own money man,
Secretary Rubin.

In fact, the
fiscal equation was just then tumbling into a fatal descent. And
it is here – let’s pinpoint the exact date at Greenspan’s
“irrational exuberance” call in December 1996 – where
the Austrian men separate themselves from the Keynesian and Friedmanite
boys. The latter continued to quibble about how to measure money,
whether it was growing too fast or slow and if more or less financial
regulation was needed.

Peering through
a different frame, however, the Austrian notes that US money GDP
was about $10.0 trillion at the time the Maestro let his exuberant
cat out of the bag. Under an honest monetary regime this nicely
rounded number might have stalled-out indefinitely – owing to the
Great East Asian Deflation just then gathering a head of steam.

The truth is,
the extraordinary force of economic nature represented by the mercantilist
export machine that sprung up in East Asia in the late 20th century
was profoundly deflationary. Absent puffed-up domestic credit, the
in-coming Asian trade would have flattened American employment,
wages, incomes and prices. In so doing, it would have kept money
GDP bottled-up at around $10 trillion, thereby denying the next
decade’s debt-fueled rise in both output and prices which took
money GDP to $14 trillion.

By Austrian
lights, then, this $4 trillion difference represents counterfeit
GDP, owing to the false conversion of unsupportable borrowings into
current income – debt which is now being forcibly liquidated. This
bubble-driven inflation of money GDP also caused government revenues
to swell unsustainably, thereby camouflaging for more than a decade
the fiscal deficit’s actual, far more frightful, aspect.

There’s no
mystery in this contra-factual history. With money anchored to a
standard, say gold, the armada of containerships steaming from the
Pacific Rim into Long Beach would have brought massive trade deficits,
but also would have set in motion their own correction. Taking flight
in the opposite direction, gold bullion, not paper dollars, would
have been on the backhaul to East Asia.

In turn, an
old-fashioned drain on America’s gold would have obviated a
lot of fatuous jawing about the Chinese being seven-feet-tall economically
or excessively addicted to an alleged financial opium called “over-saving."
Instead, without need for a single meeting of the open market committee,
the loss of gold would have presently caused a sharp contraction
of domestic bank reserves, a shrinkage of loans by an approximate
10 times multiple thereof and a sharp rise in the rate of interest
on the dollar markets.

Admittedly,
consumption, imports, money wages, jobs and cost-bloated domestic
enterprises would have all been laid low by such hard money discipline.
But having thus been put to the mat, a nation of aging and now over-priced
workers – and bankers, too – wouldn’t have found it expedient
to live high on the hog. Instead, they would have discovered the
“new normal” of higher savings, fewer credit cards, lower
consumption, and slimmer paychecks – all on their own and about
a decade sooner.It goes without saying that believers in the elixir
of counterfeit money and credit, which is to say Keynesians, monetarists,
and Goldman Sachs (GS) partners, will dismiss all this as flat-earth
doctrine – fossilized ideas pre-dating the discovery of government’s
wondrous power to manage the macro-economy.

Still, a doctrine
that holds out the state as an agent of economic betterment suffers
from some deep flaws of its own. Decades of experience show, for
example, that fiscal stimulus is an exercise by which one class
and region steals from another. But the worse flaw is the hallowed
central bank doctrine that deflation is always bad. In fact, wrong-headed
deflation fighting is what generated the boom of the 1920s and the
subsequent bust – a scenario repeated almost exactly during the
last decade.

The famous
quote from "Bubbles Ben" about the Fed at Milton Friedman’s
90th birthday is thus replete with irony. Said Bernanke in November
2002: “You’re right. We did it. We’re very sorry…we
won’t do it again.” But the Fed did it again, generating
the most massive speculative bubble ever. And this time the Fed
even assured that if a bubble should ever break, it would stand
ready to – well – rinse and repeat!

Here, the Austrians
note that the central bankers’ allergy to deflation is rooted not
in sound economics, but in weak politics; in the catering to the
pressures of promoters, speculators and borrowers. In fact, the
Austrians showed that deflations owing to powerful secular cost-reduction
trends – whether based on new technologies, new economic geographies,
or new forms of enterprise – are healthy. They raise real incomes
and wealth, even as they cause commodity prices to fall.

Thus, the East
Asian export machine far outranked every other cost-crasher in recorded
history. It bested the Internet, Walmart (WMT), Henry Ford’s
moving assembly line, central station electric power, the railroads,
canals, the steam engine, the spinning jenny, and, while we’re at
it, let’s throw in the wheel, too!

The Fed’s
strategy in the face of the Great East Asian Deflation, then, was
exactly upside down. It should have raised interest rates and liquidated
credit in order to encourage a deflation of domestic wages, prices,
and corporate cost structures which were no longer competitive or
viable in the new global markets. But by keeping interest rates
absurdly low on the pretext that the “core” CPI Index
was, as it was pleased to say, “well-anchored," the Fed
thwarted the fundamental economic adjustments that were vital for
the American economy to regain its footings.

The “panic
of 2008," therefore, wasn’t a random policy error, nor was
it caused by the machinations of overly-bonused bankers. In fact,
the massive quantities of unsupportable debt and the vast malinvestments
in housing, banking, shopping malls, office buildings, and Pilates
studios, too, which came crashing down last September, were rooted
in history’s other star-crossed rail car. That was the gilded
club car which in November 1910, had secretly whisked away Senator
Nelson Aldrich and his coterie of Morgan, Rockefeller and Kuhn Loeb
bankers to a duck-hunting blind on Jekyll Island, Georgia.

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February
11, 2010