The Great Deformation

by David Stockman

  One of the longest sustained GDP expansion cycles on record began after the third quarter of 1982, when the Volcker cure had finally crushed the inflationary fires. During the following thirty-one quarters through mid-1990, real GDP expanded on an uninterrupted basis and for all practical purposes the US economy reached full employment by the end of the period.

  In fact, the real GDP growth over this expansion averaged 4.3 percent per annum: the highest rate for any comparable period after the Second World War save for Johnson’s artificial “guns and butter” boom ending in 1968. Still, cumulative deficits during this exceptional cyclical recovery cycle—fiscal 1983 through fiscal 1990—totaled $1.5 trillion. That was a previously unimaginable result in a peacetime economy.

  Moreover, by the eighth year of the expansion, the federal deficit was still over 4 percent of GDP. In short, it is not reasonable to expect a better macroeconomic backdrop than this eight-year expansion, yet spending remained close to 22 percent of GDP and revenues were at 18 percent of GDP right up to the downturn in the second half of 1990. The deficit gap was plain and simply structural—the result of policy choices, not a weak economy.

  Notwithstanding this eight-year string of positive GDP quarters, the federal borrowing requirement had averaged 4.2 percent of GDP. That figure was literally off the charts compared to pre-1980 experience. During the quarter century prior to Reagan’s election, the federal deficit had averaged only 1.0 percent of GDP, and that interval included four separate recessions rather than a continuous up-cycle of expansion.

  So the “grow your way out” theory had been invalid from the very beginning. Yet by embracing it in the decades since then, congressional Republicans have transformed their real job, managing the finances of the US government, into a sub-branch of statist pretension; that is, centrally managing the growth of the private economy through chronic fiddling with taxes.

  THE TRUE REAGAN LEGACY:

  FISCAL FREE LUNCHES FOR ALL

  These numbers are bad enough, yet they fail to capture the more significant fiscal legacy of the Reagan Revolution. The more profound outcome was that the old-time taboo against chronic deficit finance in peacetime had been jettisoned by the Republican Party. At least since the New Deal, the GOP had been its champion and enforcer in the push and pull of what had been a tolerable two-party equilibrium in budget politics.

  By contrast, the nation’s fiscal equation would now be drawn and quartered. Even as the liberal spenders continued to push outlay levels higher, the conservative party would become chronically prone to pull the revenue level lower.

  The fiscal data for the twelve years of Republican rule under Reagan and Bush show how completely the deficit finance taboo had been routed. There was red ink for twelve straight years, a pattern never before experienced in peacetime. As indicated, cumulative deficits during the period totaled $2.4 trillion, causing the national debt to triple.

  A decade earlier, George Shultz and other Republican advocates of business-style Keynesian policies had convinced Nixon to embrace deficit spending in the guise of a “full employment budget.” Yet they had at least insisted on a rule of longer-term discipline; that is, any countercyclical deficits incurred during periods of business downturn were to be compensated by surpluses during the expansion phase of the cycle.

  Under the new Reagan-Bush dispensation, however, it was all deficits, all the time. In fact, the average federal deficit during this twelve-year period was 4.3 percent of GDP, a level never even imagined by the most aggressive liberal Keynesians before 1980.

  Surveying the giant deficits which had already been incurred by 1986 and the prospects for more of the same into the indefinite future, I found these developments alarming. In my White House memoir entitled The Triumph of Politics, I complained that the White House “was holding the American economy hostage to the politics of high spending and the doctrine of low taxes.”

  From the vantage point of early 1986, it seemed certain that “the resulting massive buildup of public debt would eventually generate serious economic troubles … the White House claimed a roaring economic success…. Yet how can economic growth remain high and inflation low for the long run when the Administration’s policy is to consume two-thirds of the nation’s net private savings to fund the Federal deficit?”

  It had been no exaggeration, therefore, to suggest that the nation had experienced a “lapse into fiscal indiscipline on a scale never experienced in peacetime. There is no basis in economic history or theory for believing from this wobbly foundation a lasting era of prosperity can actually emerge … At some point global investors will lose confidence in our easy dollars and debt financed prosperity, and then the chickens will come home to roost.”

  Except that they didn’t. Instead, for two long decades the nation seemed to be blessed with nearly uninterrupted real GDP growth, low and declining inflation, and a sustained bull market in financial and real estate assets with no parallel in prior history. The accompanying boom in mass consumption was startling in its breadth and opulence.

  Later we would learn that this was all a simulacrum of prosperity: a house of cards that would collapse with stunning speed and violence. Yet while it lasted, this faux prosperity reinforced the wrong-headed narrative that the Reagan Revolution had been a success; that the 1981 tax cut bill had been the incubator of two decades of prosperity; and that fiscal deficits didn’t matter.

  As has been indicated, the massive Republican deficits after 1980, which reached their ultimate conclusion in George W. Bush’s final trillion-dollar-bailout-nation era, had not been “on the level.” Beneath the economic surface, the pernicious force of printing-press money had been gathering volcanic momentum since 1971. And it was this unprecedented monetary deformation which finally accounted for both the debt-fueled illusion of prosperity and for the long, extended deferral of the day of fiscal reckoning.

  CHAPTER 7

  WHY THE CHICKENS DIDN’T

  COME HOME TO ROOST

  The Nixon Abomination of August 1971

  BY THE LATE 1980S, THE COMBINATION OF A STRONG ECONOMY and big deficits presented a conundrum which the old-time fiscal religion could not explain. In violation of all the classical canons of sound fiscal policy, the deluge of Reagan-era red ink was being readily financed, with no apparent boost to inflation or interest rates and no visible harm to economic growth and investment.

  This macroeconomic hall pass was a pivotal development in the fiscal unraveling which has now engulfed the nation. It gave birth to the fatuous Cheney theorem—that Ronald Reagan proved deficits don’t matter—and gave it credence, too. Republican politicians came to embrace it because the empirical evidence did not refute it. In the epigrammatic phrase of the great French monetary economist Jacques Rueff, the door had been opened to “deficits without tears.”

  The GOP was thus relieved of the conservative party’s true calling in a modern welfare state democracy; that is, hard labor on the oars of fiscal rectitude. Indeed, with the fear of deficits gone, the GOP drifted into what amounted to Keynesianism for the prosperous classes. Tax cutting became its preferred tool for macroeconomic stimulus and for nursing private enterprise to a more vigorous performance path than it might achieve on its own.

  There was an irony in this because it made the state and its politicians, rather than the free market economy, the arbitrator of how much growth and prosperity was possible. Any shortfall from the potential growth rate stipulated by the GOP’s supply-side oracles became an excuse for further deficit financed tax cuts. Worse still, K Street became the breeding ground for the manifold instruments of this Keynesian-style tax stimulus, thereby placing Washington deep in the business of dispensing “incentives,” allocating capital, and superintending the ebb and flow of growth and jobs among industries and regions.

  But this was a giant lurch onto the wrong path. It stripped American democracy of healthy two-party competition on the matter of fiscal rectitude versus state largesse. It opened up a destructiv
e dynamic in which the Democrats manned the state’s ramparts of spending while the Republicans tunneled through its foundation of income.

  As previously suggested, the false narrative about the Reaganite golden age and the nation’s current fiscal incontinence are rooted in a common source; namely, the Nixon abomination of August 1971. In jettisoning the monetary anchor of the Bretton Woods gold exchange standard, Nixon paved the way for the eventual deformation of central banking. There emerged in lieu of sound money a makeshift monetary régime that spread around the globe and created a thirty-year interregnum in which trillions of Washington’s debt emissions were warehoused in the vaults of the world’s central banks. The economic sting of massive treasury borrowing was thereby anesthetized.

  This is the reason why post-1980 fiscal deficits did not give rise to the classic economic dislocations. There was no enduring domestic interest rate and investment crunch, for example, because Uncle Sam’s deficits were being monetized and exported, not financed out of the nation’s savings pool. After the 1980s consumer prices did not surge either because the central banks of the rapidly growing East Asian mercantilists were more than happy to import unwanted inflationary dollars via their currency-pegging operations.

  So the irony was large. The Reagan era’s wild fiscal misfire on defense, taxes, and domestic spending had been essentially sterilized by another financial deformation; namely, the floating paper dollar monetary arrangement that Nixon and John Connally had forced on the world after August 1971. The story of that travesty powerfully amplifies why the Reagan Revolution was not a golden age of free market capitalism but only a way station on the road to the BlackBerry Panic of 2008.

  THE DIRTY SECRET OF FLOATING CURRENCIES

  The conservative economists who advised Republicans to jettison Bretton Woods were reflexive free marketers who suffered from monetary amnesia; that is, they ignored the fact that the massive war inflation of 1914–1918 had ended the classic gold standard and changed the fundamental nature of money, making it an artifact of state policy. Failing to note that money would be heavily manipulated by the central banking branches of the world’s sovereign states, they erroneously viewed the floating-rate system as a good thing because the free market would purportedly set currency exchange rates.

  Yet as wards of the state, the central banks were now indentured to its policy imperatives rather than to the superintendence of sound money. That was proven in spades by the inflationary debacle that exploded during the very first decade of floating. Indeed, by the end of the 1970s it was evident that there wasn’t much about the international currency exchanges which resembled the theoretical “free market.”

  The global currency markets had already become havens of “dirty float” where state manipulation of exchange rates was the modus operandi. Likewise, the only thing “free” about the new arrangement was that the Fed now had a fantastic new license to freely expand its balance sheet at rates never before imagined, and with a result that the conservative economists had not even remotely anticipated. Buying government bills and bonds without the external discipline of redeemability, the Fed injected massive liquidity into the Wall Street banking system—where more and more of it ended up in speculative finance, not the real economy.

  So there was nothing “progressive” about the post–Bretton Woods monetary arrangements. In closing the gold window, Tricky Dick brought sound, redeemable money to an unceremonious end, and not because he was a modernizing monetary reformer aiming to rid the system of the “barbarous relic” which even Keynes had been forced to embrace in 1944.

  Instead, Nixon was a crass, nationalistic politician who put his own reelection above all other considerations, including the nation’s obligation to keep the dollar honest and repay its external debts in a fixed weight of gold. Monetary arrangements must last for the ages if they are to be credible, but according to the cynical Nixonian template, no obligation was admissible which might cause an uptick in the unemployment rate before November 1972.

  As will be seen, the Bretton Woods gold exchange standard was fundamentally flawed, so it was only a matter of time before it fell at the hand of a bombastic White House occupant like Johnson or Nixon. Still, when it was finally jettisoned, its indispensable core function of imposing a rough discipline on each nation to live within its means was also lost. What was not even dimly grasped in 1971 was that the demise of Bretton Woods had unshackled the central banks in a manner never previously experienced in modern financial history.

  Given the dominant position of the US economy and the dollar at that time, the fatal danger was that the Fed had now been positioned to emit unlimited credit through the US banking system. The only real restraint was the willingness of the rest of the world to accumulate and hold dollar liabilities.

  As it turned out, other nations were mighty willing. The flood of dollars into the global economy did not cause its exchange rate to collapse because mercantilist central banks bought dollars hand over fist in order to suppress the exchange rates of their own currencies. This massive, prolonged hoarding of dollar liabilities by foreign central banks had never been foreseen by the conservative economists who championed floating rates.

  Indeed, the willingness of statist leaders in East Asia and the Persian Gulf to endlessly swap the resource endowments of their lands and the labor of their people for dollar IOUs, in their pursuit of a flawed mercantilist model of growth and prosperity, knew no historical precedent. It is one of the great deformations on which the modern global economy rests precariously.

  After August 1971, this monetary deformation gathered inexorable momentum and girth, one step at a time. Eventually, like a hungry parasite, it would ingest US Treasury and agency debt with gluttonous abandon.

  As will be seen, there was no stopping this great monetary deformation because the nation’s conservative party failed to comprehend and rectify it at every step along the way. After Nixon and Burns incited the global commodity price explosion of the 1970s, Republicans rationalized the Fed’s continued production of excess dollars on the feckless grounds that inflation had to be “financed” and could only be brought down slowly.

  In February 1986, a Republican White House essentially fired Paul Volcker—the one Fed chairman who had actually brought down inflation decisively and had restored a semblance of sound money. In the 1990s, an unabashedly Republican Fed chairman compounded the Reagan fiscal mishap by opening the monetary floodgates, enabling a devastating collapse of the nation’s current account and tradable goods sector.

  After the turn of the century, still another Republican White House populated the nation’s central bank with Wall Street–pleasing money printers who confused rank speculation with genuine investment, and a giant debt bubble with sustainable prosperity. When the monetary bubble finally collapsed in September 2008, a Republican treasury secretary closed ranks with a GOP-appointed cabal at the Fed to unleash a wave of free money so immense that it has effectively destroyed the free market in finance. With friends like that, sound money needed no enemies.

  THE TURNING POINT: LBJ’S “GUNS AND BUTTER” ASSAULT ON SOUND MONEY

  As will be seen in Part III, the demise of sound money reaches back to the Great War and FDR’s embrace of economic nationalism in 1933. But what triggered the final destruction of Bretton Woods was LBJ’s “guns and butter” fiscal policies. Beginning in 1966, the US economy began to dramatically overheat, owing to LBJ’s unprecedented spree of “borrow and spend.” In these circumstances, the Fed’s great tribune of sound money and long-serving Fed chairman, William McChesney Martin, urged Johnson to pay for his budget-busting adventures with taxes on the people, not freshly minted credit from the central bank.

  LBJ not only stubbornly refused to raise taxes, but also literally manhandled the Fed chairman, forcing him to monetize the rapidly expanding federal deficit. Not surprisingly, the Fed’s balance sheet was soon transformed from a model of prudence into a vehicle of pell-mell monetary expansion. In fact, whe
n it succumbed to LBJ’s bullying in 1966, the Fed’s holdings of government debt stood at just $44 billion. Yet by the time Paul Volcker arrived, fire hose in hand, in August 1979 it had nearly tripled to $120 billion.

  These central bank purchases of government bonds, of course, were funded with new Federal Reserve credit to the banking system which was conjured out of thin air. The resulting 8 percent annual growth of new bank reserves for more than a decade was an unfathomable departure from historic monetary discipline. During the previous quarter century of stable, noninflationary economic expansion, for example, the Fed’s balance sheet had edged up at just 2.8 percent per year.

  NIXON’S MONETARY POLICY:

  “GIVE US MORE MONEY, ARTHUR”

  Although Martin had reluctantly caved to LBJ’s bullying, Nixon took office with a deep grievance against the Fed chairman and availed himself of the first opportunity to get rid of him. Leaving no doubts about his expectations of his replacement, Nixon offered Arthur Burns a “vote of appreciation in advance for low interest rates and more money” at his swearing-in ceremony in January 1970.

  On his way out the front door of the Eccles Building, the outgoing Fed chairman minced no words: “We are in deep trouble. We are in the wildest inflation since the Civil War.” Martin’s words, obviously, could not have been more prophetic.

  Professor Arthur F. Burns had not spent a lifetime pandering to power, however, in order to be swayed now, even by the ringing admonition of the greatest central banker the nation had yet known. Nixon wanted more money, and Burns did not disappoint.

  In fact, the White House’s infamous tape-recording system memorialized Burns’ complete surrender of monetary policy to Nixon’s reelection imperatives. In a private meeting before the 1972 election, the Fed chairman resorted to what can only be described as abject groveling as he assured Nixon that the Fed would not undo him again—something Tricky Dick fervently believed it had done during the election of 1960.