The Forgotten Cause of Sound Money

by David Stockman

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 –


– 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.


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

So please help me welcome Mr. David Stockman.


STOCKMAN: Well, thank you, Lew.

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


– 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.


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.


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 –


– when was all was said and done.


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.


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 –


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


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.


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, 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 –


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


– 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 –


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.


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.


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


– 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.


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 –


– 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.


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.


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 –


– there’s more.


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.


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” –


– 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.”


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 –


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


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 –


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


One never knows.


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 –


– 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.”


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.


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.


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.