Trumped! A Nation on the Brink of Ruin... And How to Bring It Back

by David Stockman

  So in 2008, the money markets would have cleared, and any temporary expansion of the Fed’s balance sheet would have immediately shrunk once the crisis was over, and the discount loans were repaid.

  And, yes, at 10%, 15% or even 25% and a penalty spread to boot, they would have been paid off real fast.

  That’s what a real lender of last resort would look like. Janet Yellen’s crony capitalist flophouse is the very opposite.

  REAL BILLS AND THE TRUE EVIL OF KEYNESIAN CENTRAL BANKING: GOVERNMENT DEBT MONETIZATION

  By the same token, a real central bank of the pre-Keynesian era would not now own $4.5 trillion of government debt and guaranteed paper. In fact, it would own none at all because monetization of the public debt was never the purpose of central banking.

  The purpose was to liquefy business-loan books and the traded markets in real bills, which were essentially receivable-type claims on finished goods in the channels of distribution. Unlike government debt, the latter represented production already done and banking collateral that could be collected within a relatively short period of 30 to 90 days when the underlying goods were sold.

  In this context, the classic central bank’s discount window would generally do more volume when business and trade were flourishing and less when activity contracted. In that modality, it was the servant of market capitalism, not its taskmaster.

  Even more importantly, this kind of commercial collateral is self-limiting and anchored in goods that real businesses have already produced in anticipation of market demand. In essence, businesses issuing receivables paper were the actual risk takers. In order to generate finished products and trade bills, they had already made the decision to go long on raw materials, work-in-process, labor and other overheads.

  Needless to say, compared to government debt this kind of business-generated and working capital-based “credit” was a fish of an altogether different kettle. That is, real bills drawn on finished goods were not merely open-ended promises to pay on the unsecured credit of a business firm or on the account of future taxpayers; they were discounted streams of presently anticipated customer payments which could be readily assessed as to commercial quality, risk and collectability.

  Stated differently, in discounting commercial bills, central banks performed a higher banking function, not a macroeconomic management and central-planning mission. That meant that the free market was the ultimate determinant of the level and price of short-term business credit.

  Accordingly, if businessmen became too exuberant in the production of finished goods, the discount rate on commercial bills would rise sharply in order to draw additional funding into the market and in recognition that added risk inherent in an over-supplied goods market.

  Since the business cycle is ultimately an inventory stocking and de-stocking cycle, the implications were straightforward. Namely, that a mobilized discount rate on trade paper was an automatic governor of the business cycle—the unseen hand of Adam Smith, as it were.

  Contrary to the false Keynesian predicate, therefore, an honest free market does not have a recessionary death wish. An honest, variable price of money determined by supply and demand militates against the buildup of excesses, and causes a quick painful liquidation of losses when excesses do occur.

  There was another even more crucial aspect of pre-Keynesian central banking. To wit, it was strictly verboten to discount term debt and other less-liquid capital securities. So not only was central bank purchase of government bonds unthinkable; it was also true for equipment loans and corporate bonds, as well.

  What this meant in economic terms is that business-fixed capital had to be financed out of the private savings pool. The interest rate on time deposits or insurance company annuities, therefore, is what determined the cost of long-term loans and debentures; and the greater the demand for the latter, the higher the yield on the former, and vice-versa.

  The laws of supply and demand thus cleared capital markets. There was no artificial central bank bid, no falsification of yields and no diversion of cheap, subsidized credit into financial engineering games rather than productive assets. The modus operandi of capital markets, in fact, was to fund productive investment with a prospective return greater than the market price of capital, not rank speculations that would end up as malinvestments and losses.

  Moreover, if governments were to issue debt, such as for public works or war bonds, these had to be funded out of the same private savings pool. The two were in direct competition—so the price of debt or bond yields would reflect that effect.

  And that gets us to the true evil of Keynesian-era central banking. To wit, the only effective brake on the propensity of politicians in today’s social democracies to issue public debt is an honest capital market.

  This used to be called the “crowding-out effect.” It occurred when excessive government borrowing caused long-term interest rates to rise sharply, thereby leading to the cancellation of business investments that could no longer meet their rate-of-return hurdles.

  In a word, the likes of industrialists, homebuilders, construction companies and capital-equipment suppliers (and their employees, suppliers and communities) are the natural political constituencies that countervail the tendency of democratic politicians to grease the pork barrel and indulge the demands of organized recipients of entitlements and other subventions.

  Rising interest rates were an immediate signal that there is no fiscal free lunch. They gave efficacy to the historic fear of fiscal deficits among conservative politicians, and forced governments to make budgetary choices between curtailment of spending, increasing taxes or higher interest rates owing to greater borrowing.

  Alas, Keynesian central banking destroyed these fundamental checks and balances of fiscal governance. If nothing else, the past three decades of soaring public debt has proven in spades that the historic fear of “debt monetization” among the financially literate classes was well grounded.

  As I explained in The Great Deformation the resulting destruction of fiscal discipline did not happen overnight. On the one hand, the political system—especially among GOP rank-and-file politicians—was still populated with believers in the old-time religion of balanced budgets, and actually voted that way.

  That’s why in the early days of the Reagan administration, for example, Senate Leader Howard Baker labeled the huge supply-side tax cut as a “riverboat gamble.” He and the Senate GOP elders were only willing to entertain it if they got spending cuts first, and could see some path in the fiscal arithmetic to a balanced budget at an early date.

  Likewise, the Greenspan-era central bankers never explicitly acknowledged they were monetizing the public debt in increasingly greater proportions. All the bond buying was rationalized as simply a means to economic stimulus and coaxing more aggregate demand into the US economy in order to meet its Humphrey-Hawkins targets.

  But after Bernanke’s $1.3 trillion debt-buying blitz in 13 weeks after the Lehman event and then 93 straight months of ZIRP and an eventual 5X expansion of the Fed’s balance, the cat was effectively out of the bag.

  Notwithstanding the procedural niceties of monthly QE targets, federal-funds-rate targets and secondary market purchases of securities by the New York Fed from the primary dealers, the underlying truth is undeniable. Namely, that a high proportion of the exploding public debt after the financial crisis was monetized.

  The Fed and other central banks and their associated sovereign-wealth funds, in fact, now own upwards of 50% of the publicly traded Treasury and federally guaranteed GSE securities.

  So like Earnest Hemingway’s famous description of the route to bankruptcy, monetization of the public debt happened slowly at first, and then all at once. Ronald Reagan broke the taboo on giant fiscal deficits and, at length, Dick Cheney pronounced that they didn’t matter anyway.

  But it was the lapsed gold bug, Alan Greenspan, who opened the door to massive central bank bond purchases by expanding the Fed’s balance sheet from $200 billion to
$700 billion during his tenure at a time when it shouldn’t have been expanded at all, as we will explain in the next chapter.

  So doing, however, Greenspan fueled the epic $45 trillion financial bubble that crashed in 2008, thereby paving the way for his more doctrinaire Keynesian successors—Bernanke and Yellen—to go all in.

  Needless to say, there is no cure for the nation’s looming fiscal disaster under the current Keynesian central banking regime. It has turned the monetary and fiscal tables upside down.

  The Fed no longer has anything to do with the remit given to it by Carter Glass—one that was grounded in the central banking model of the day—to function as a “bankers’ bank” and to passively liquefy the market for real trade bills generated on the free market.

  Instead, it has morphed into a statist monster that is engaged in the two most destructive games imaginable. To wit, monetary central planning and monetization of the public debt.

  The former has already falsified the money and capital markets, destroyed honest price discovery, turned Wall Street into a gambling casino and the C-suites of corporate America into financial engineering and strip-mining operations which are sucking the financial lifeblood from the Main Street economy.

  Likewise, the latter has eliminated any vestige of fiscal rectitude in the political system. That is evidenced by the fact that Washington has spent $2 trillion on unfunded wars and has legislated not a single material entitlement reform or tax increase during the entirety of this century—even as it was adding upwards of $15 trillion to the public debt.

  The utter lack of prospect for change was well underscored during the presidential candidate acceptance speeches at the recent party conventions. Hillary Clinton embraced a laundry list of Bernie Sanders’ free stuff and Donald Trump hardly mentioned the ticking fiscal time bomb that he will inherit if elected.

  This simply proves, however, that as a practical matter it is too late for conventional fiscal-improvement plans and laundry lists of spending cuts, entitlement reforms and revenue-raising measures. That’s because the natural constituencies for fiscal retrenchment have been destroyed by a central bank committed to open-ended monetization of the public debt.

  Yet in that baleful reality there is also a hint of the way forward. When the coming recession and subsequent financial crash finally destroys the credibility of the current Keynesian central banking regime there will be an opportunity for a fundamental reset of the central banking function.

  Needless to say, the very worst thing to do would be to opt for some “rules-based” version of what the Fed is doing today. I have in mind here a special place in monetary hell for Professor Taylor’s crypto-Keynesian rule for pegging interest rates.

  According to Taylor, it’s all real simple. Just peg the money-market rate at its appropriate Humphrey-Hawkins level—calculated via some arithmetic hocus-pocus based on gaps between actual and targeted levels of unemployment and inflation. That is to say, he would have the Fed jump from the Keynesian frying pan into the Friedmanite fires while shackled in mathematical chains.

  By contrast, the best thing to do would be to revive the great Carter Glass and his original central banking model. That is to say, abolish the FOMC and discretionary intervention in financial markets by the Fed, and also ban it from owning, borrowing or collateralizing in any other way treasury debt and other federally guaranteed paper.

  In one fell swoop that would put an end to the twin evils—monetary central planning and monetization of the public debt—that today threaten capitalist prosperity and democratic government. So doing, it would revive honest price discovery in the money and capital markets, thereby purging them of the cheap carry-trade finance and drastically underpriced hedging insurance on which the entire regime of Bubble Finance is based.

  At length, the immense stock- and bond-market bubbles of the present era would be deflated and capital markets would revive as a venue for real money savers to meet productive asset investors and borrowers and strike an honest, economically warranted price.

  Likewise, the C-suites of corporate America would go back to investing in the future of their companies, not financial-engineering maneuvers designed to cause a pop in their stock prices and an early harvest from their stock options.

  So, too, politicians tempted to pile more onto the nation’s already-staggering public debts would have a clarifying experience that has been AWOL essentially since 1994 when Greenspan capitulated to the bond vigilantes.

  To wit, they would see interest rates rise in the government bond market in response to more public-debt issuance and hear a crescendo of complaints about “crowding out” by businessmen and other capital users. “Price discovery” would supplant fiscal free lunches even in the halls of government.

  At the end of the day, all that should remain of the monster that now inhabits the Eccles Building is the lender-of-last-resort function. But its remit would be the one designed by Carter Glass, not the massive mission creep embedded in the rolling financial coup d’état staged by Greenspan-Bernanke-Yellen since 1987.

  Accordingly, eligible borrowers would be precluded from bringing treasury debt, Fannie/Freddie securities, corporate bonds, real estate loans, junk bonds, ETFs or any other capital-markets securities to the discount window. In other words, nothing of what the Keynesian central planners have piled on to the $22 trillion of central bank balance sheets around the world.

  As a result, capital markets would be made honest again because every scrap of paper traded there would be fully at risk. There would be no repo-style daisy chains in which inflated bonds are treated as “assets” that become the collateral for still more debt, even more speculator bids and yet-higher prices and more collateral.

  At the same time, eligible paper would consist entirely of claims on business receivables and finished inventory. That is, late-stage working capital that already reflects new value-added production and the ground-level risk assessments of the entire chain of supply.

  Moreover, here is where the PhDs would take their leave and the green eye shades would take their seats. Unlike the insane growth of credit since 1987—from about $8 trillion to $64 trillion—there could be no artificial credit inflation under a Glassian central bank. That is, so long as under its foundation law eligible collateral was restricted to high quality, late-stage business working capital, and those standards were upheld by a rigorous credit review process.

  Needless to say, this not only implies the repeal of Humphrey-Hawkins, but also a strong mandate in the new Fed charter that is explicitly not in the business-cycle-management business. Nor is its job in anyway related to macroeconomic performance and the level or rate of growth in GDP, jobs, housing, car sales or anything else in the goods-and-services economy.

  The fact is, gains in output, living standards and sustainable wealth are outcomes produced by workers, entrepreneurs, savers, investors, inventors and speculators on the free market. They are not a gift of the central bank or any other state action. A Main Street economy in Flyover America that has ground to a halt and is buried in unpayable debts is surely proof of that.

  CHAPTER 5

  Trump Isn’t All Wrong About Trade Deficits—How Washington’s Money Printers Betrayed American Workers

  NEEDLESS TO SAY, THE LACK OF GOOD JOBS LIES AT THE BOTTOM OF THE wealth and income drought on Main Street, and recent jobs report provide still another reminder.

  During the last seven months, goods-producing jobs have been shrinking again, even as the next recession knocks on the door. These manufacturing, construction and energy/mining jobs are the highest paying in the U.S. economy and average about $56,000 per year in cash wages. Yet it appears that the 30-year pattern shown in the graph below—lower lows and lower highs with each business cycle—is playing out once again.

  So even as the broadest measure of the stock market—the Wilshire 5000—stands at 11X its 1989 level, there are actually 20% fewer goods-producing jobs in the United States than there were way back then.
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  This begs the question, therefore, as to the rationale for the “Jobs Deal” we referenced in Chapter 1 and why Donald Trump should embrace a massive swap of the existing corporate and payroll taxes for new levies on consumption and imports.

  The short answer is that it’s necessary to ameliorate the giant monetary-policy mistake initiated by Greenspan 29 years ago. The latter left Main Street households buried in debt and stranded with a simultaneous plague of stagnant real incomes and uncompetitively high nominal wages.

  It happened because at the time that Mr. Deng launched China’s great mercantilist export machine during the early 1990s, Alan Greenspan was more interested in being the toast of Washington than he was in adhering to his lifelong convictions about the requisites of sound money.

  Indeed, he apparently checked his gold-standard monetary principles in the cloak room when he entered the Eccles Building in August 1987. Not only did he never reclaim the check; he embraced its opposite—the self-serving institutional anti-deflationism of the central bank.

  This drastic betrayal and error resulted in a lethal cocktail of free trade and what amounted to free money. It resulted in the hollowing out of the American economy, because it prevented American capitalism from adjusting to the tsunami of cheap manufactures coming out of China and its East Asian supply chain.

  The full extent of the Fed’s betrayal of Flyover America can only be fathomed in relationship to the counterfactual To wit, what would have happened in response to the so-called “China price” under a regime of sound money in the United States?

  The Fed’s Keynesian economists and their Wall Street megaphones would never breath a word of it, of course, because they have a vested interest in perpetuating inflation. It gives inflation-targeting central bankers the pretext for massive intrusion in the financial markets and Wall Street speculators endless bubble-finance windfalls.