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 were 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 Im not reluctant to try again. Having read Grants continuously since 1988, Ive learned theres no shame whatsoever in being early even often!
The Triumph of Politics was published early, mainly in the unflattering sense that Id 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 Ill 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 Revolutions 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 Feds actual balance sheet, but something more ethereal, like perhaps its state of mind.
My libertarian screed thus omitted money while cataloging the Reagan Revolutions 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 historys 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 Streets own money man, Secretary Rubin.
In fact, the fiscal equation was just then tumbling into a fatal descent. And it is here lets pinpoint the exact date at Greenspans 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 decades 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 deficits 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 Americas 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 governments 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 Friedmans 90th birthday is thus replete with irony. Said Bernanke in November 2002: Youre right. We did it. Were very sorry…we wont 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 Fords moving assembly line, central station electric power, the railroads, canals, the steam engine, the spinning jenny, and, while we’re at it, lets throw in the wheel, too!
The Feds 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 historys 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.
February 11, 2010