The Great Deformation

by David Stockman

  Yet the root problem was excess dollar liabilities. During 1967 alone, the nation’s central bank had increased its holdings of Treasury debt by 12 percent, and it had expanded its government debt purchases and bank reserve creation by 21 percent over the preceding twenty-four months. The associated flood of new dollar liabilities had no home, but LBJ refused to do the one thing that mattered most; namely, he did not ask the Fed to stop creating so many unwanted dollars by raising interest rates sharply and reversing the prodigious pace of money creation it had undertaken at the White House’s behest.

  Within a matter of weeks, therefore, the run on gold resumed, this time with even more ferocious intensity. And it was in the face of the free gold market’s clarion call for financial discipline that Johnson’s Keynesian economic advisors laid the planking for Tricky Dick’s subsequent commission of the actual dirty deed.

  After gold began hemorrhaging out of the London pool at $100 million per day on March 8, the Council of Economic Advisors chairman, Gardner Ackley, urged Johnson to close the gold window—and strand the Europeans high and dry with their vast dollar reserves—if they did not accept his proposal to sell their gold on an uncovered basis to defend America’s beleaguered currency. The implication was no less menacing than the British Treasury’s treachery of September 1931. Europeans would now be forced to take huge losses on the massive dollar-exchange holdings that they had accumulated over the years on the presumption that the dollar was as good as gold.

  To be sure, it took an even ruder Texan than Lyndon Johnson to tell the Europeans that the dollar was our currency, but their problem, as John Connally put it so famously three years later. Yet the remarkable fact remains that none of Johnson’s Keynesian advisors betrayed any recognition that it was their inflationary policies which had precipitated the crisis.

  As the end of the road neared, the smugly self-assured professoriate had no solution except to put goofy controls on the offshore activities of American citizens. Their position had been reduced to the embarrassingly trivial point that the commission of private acts of capitalism abroad by American tourists and businessmen was the cause of the market’s thundering stampede out of paper dollars and into gold.

  In the nick of time, a thin majority of the Senate approved an emergency measure repealing the vestigial requirement that Federal Reserve notes be backed with a gold cover of 25 percent. This meant that the Treasury now had access to nearly the full $12 billion of gold stocks reported at the end of 1967 to meet its obligations under Bretton Woods and defend the $35 parity.

  Then and there, Washington had one last opportunity to take a stand for sound money. By politically leveraging the nation’s humiliating loss of gold in order to drive tax increases and spending cuts through the Congress, and by empowering the Fed to bring the hammer down on inflation, which was then running at a 5 percent annualized rate, the run on gold could have been stopped. The framework of Bretton Woods could have been saved.

  Clearly the Europeans, especially the Germans, Swiss, and Dutch, were more than ready to cooperate with any reasonable and decisive effort by the United States to get its financial house in order. But when the gold out-flow hit $400 million on March 14, Johnson threw in the towel and shut down the gold pool.

  LBJ also proclaimed that the United States would defend the $35 gold price come what may, but that promise was entirely hollow. Henceforth, the only gold which would trade at $35 per ounce was between central banks, when and as Washington pleased.

  So-called enlightened economic opinion at the time considered the gold pool closure to be a matter of secondary moment. Already grand plans were under way to create a new form of IMF fiat money called special drawing rights, or SDRs. Yet IMF money, as logic would have suggested then and history would prove later, was inherently even more suspect than the politically compromised greenbacks which were being so unceremoniously dumped in favor of the barbarous relic.

  Unfortunately, the Keynesian consensus claimed more science than it actually possessed. The problem at hand was not a shortage of reserve assets in the global monetary system, as the professors argued. To the contrary, it was a shortage of financial discipline in the nation which had insisted that its own currency become the reserve asset in the new monetary system fashioned at Bretton Woods.

  Once the link between the dollar and London’s free market in gold was severed in March 1968, it was game over. The possibility that US financial discipline would ever again be revived was fatally diminished.

  THE CRUSH OF EMPIRE AND THE ROAD TO CAMP DAVID

  At the heart of the US financial profligacy was an unwillingness to pay for the huge and largely unacknowledged cost of empire. By the end of 1968, the outflow of funds to support the nation’s far-flung military enterprises, the hot war in Southeast Asia, and the growing network of security assistance and foreign aid had accumulated to $70 billion since the start of the 1960s. It would reach nearly $100 billion by the time Nixon closed the gold window at the US Treasury.

  By the lights of General Eisenhower, of course, this vast level of expenditure was not necessary to protect the national security, and most especially not that portion of it driven by the occupation of Vietnam. Still, as the free world’s hegemonic power and bulwark against those Kremlin factions which harbored aggressive intentions, the United States could have certainly afforded to invest a few percentage points of GDP in the cause of a stable, peaceful, and more prosperous global order.

  Yet what it could not do was fund a global empire on borrowed money. To be sure, spending abroad for military bases and economic aid did not automatically cause a balance of payments deficit, any more than did importing anchovies from the Peruvian fisheries or coffee from the Brazilian plantations. What did cause a payments deficit, however, was electing to incur these national security expenditures without earning a sufficient surplus in trade and services to offset the dollar outflow.

  As Great Britain had shown in the nineteenth century, an imperial power needed to earn a consistent current account surplus to fund its overseas enterprises, including both investments of private capital and the military projects of the state. That the United States could not operate a financially stable empire in the mid-twentieth century was therefore a tribute to muddled policy, not the inherent economics of venturing beyond its coastlines.

  In 1964, the United States had a $9 billion current account surplus excluding defense spending. But this figure declined to $4.5 billion by 1968 and rolled over into nearly a $1 billion deficit by 1972.

  At the same time, the drain of dollars to support the nation’s imperial footprint, including the land war in Asia and economic aid to vassals and puppets, escalated sharply, rising from just over $6 billion in 1964 to $12 billion eight years later. Due to this rapidly widening gap between diminishing civilian inflows and expanding national security outflows, of course, unwanted dollars piled up abroad at an accelerating rate.

  Since Washington was unwilling to implement a sharp retrenchment of the overheated domestic economy in order to pay for the cost of empire, its monetary reserves had steadily ebbed away, notwithstanding the valiant temporizing actions of the Kennedy Treasury. Thus, the nation’s gold stock, which had peaked at about $22 billion in 1959, had fallen to below $10 billion by the time of the March 1968 crisis.

  Worse still, short-term dollar liabilities held by foreign central banks continued rising and now totaled nearly $20 billion. This meant that the Bretton Woods “reserve currency” issuer had now drastically overdrawn its bank account and, like Great Britain in 1931, it did not have nearly enough gold to support the dollar debts it owed to foreigners.

  So in March 1968, having declared himself a lame duck in the face of withering domestic blowback against his Vietnam War adventure, the rudderless Johnson triggered the final run on the dollar by closing the London gold pool. This move predictably fueled rampant speculation against the dollar and caused unwanted private dollar holdings to be cashed in for marks and francs, instead of gol
d, at the principal foreign central banks. As these dumped dollars rapidly and visibly piled up on the counters at the central banks, the pressure to “short” the dollar only intensified.

  THE CORRELATES OF EMPIRE: SOUND FINANCES AT HOME

  The necessary correlates of empire abroad, in fact, were budget surpluses and fastidiously sound monetary policy at home. If it wished to quarantine the Soviet tank brigades deep in the interior of Eurasia and furnish the backward peoples of the globe with trousers, ballot boxes, and Coca-Cola, the United States could not afford to inflate its domestic demand and its bill for imported goods with cheap and easy credit.

  Yet between 1965 and 1968, when the US expeditionary force in Vietnam rose from 17,000 to 515,000, domestic bank credit grew at a robust 8.1 percent annualized rate. That was the opposite of what sound national finances called for under these circumstances.

  When Lyndon Johnson threw in the towel on the gold dollar and on his own political career, it marked a historic juncture in the evolution of crony capitalism. LBJ was the legatee of Roosevelt’s hayseed coalition and New Deal statism, having arrived on the scene three decades earlier as a congressman from the south Texas hill country championing the cause of government-supplied rural electric power.

  By the end of his presidency LBJ had vastly updated the New Deal, bringing its random form of statism to urban America through programs such as model cities, subsidized housing, the Job Corps, and mass transit aid while completing the loop on social insurance with the enactment of Medicare. Indeed, the Great Society was the “new” New Deal, reconstituted to reflect the migration of the Democratic political base to the north and to the cities.

  On its own, this Great Society expansion of the state would not have been fiscally fatal, even if it was wasteful, inequitable, and ineffective. The breakdown came in LBJ’s megalomaniacal attempt to extend the Great Society to the Mekong Valley.

  In this historically catastrophic venture, he expanded the warfare state by 40 percent from the Eisenhower Minimum, thereby squandering the $150 billion in constant-dollar fiscal headroom that Ike had recaptured. The result was “guns and butter” budgets, deficit-financed elective wars, and the abduction of the nation’s central bank into inflationary finance of the state’s fiscal excesses.

  The riots in the London free market for gold in late 1967 and early 1968 were a cogent warning that financial indiscipline was reaching the breaking point, and that sound money was imperiled. It was also a historic milestone, signifying that the two decades of soldiering in the cause of fiscal and monetary orthodoxy by Harry Truman, President Eisenhower, William McChesney Martin, and even John F. Kennedy’s Treasury Department had been for naught.

  So the final mile on the road to the Camp David default was embarked upon in March 1968. The so-called two-tier gold market which emerged from the crisis in the London market was destined to be short-lived because the dollar was no longer convertible on the demands of the citizenry, but only at the pleasure and convenience of the state.

  As has been seen, Richard Nixon soon found that meeting the nation’s obligation to pay its debts in gold and to uphold the Bretton Woods system were distinctly inconvenient to his own reason of state: reelection in 1972.

  Moreover, he had found a polyglot of economic advisors who persuaded him to discard the essence of the old-time Republican financial doctrine: the rule of balanced budgets and the gold standard of sound money. Accordingly, both parties would now embrace the prosperity management model, turning fiscal policy into a hapless stepchild of the jobs count and the GDP measurements, and giving a public policy rationalization to endless raids on the Treasury by special interest groups and crony capitalists.

  Worse still, severing the link to gold paved the way for the T-bill standard and a vast multi-decade spree of central bank debt monetization and money printing. Since a régime of floating-rate paper money had never been tried before on a global basis, the Keynesian professors and their Friedmanite collaborators can perhaps be excused for not foreseeing its destructive consequence.

  The record of the next several decades, however, eliminated all doubt. The combination of free markets and freely printed money gave rise to a toxic financial deformation; namely, the vast financialization of the world economy and the rise of endless carry trades, massive arrangements of speculative hedging, and monumental daisy chains of debts, owned by debts, owned by still more debts.

  CHAPTER 13

  MILTON FRIEDMAN’S FOLLY

  Rise of the T-Bill Standard

  THE STAGE WAS THUS SET FOR THE FINAL “RUN” ON THE DOLLAR and for a spectacular default by the designated “reserve currency” provider under the gold exchange standard’s second outing. And as it happened, the American people saw fit to install in the White House in January 1969 just the man to crush what remained of gold-based money and the financial discipline that it enabled.

  Richard M. Nixon, as we know, possessed numerous and notable flaws. Foremost was his capacity to carry a grudge against anyone whom he believed had caused him to lose an election, especially any economist, policy maker, or bystander who could be pinned with accountability for the mild 1960 recession that he believed responsible for his loss to John F. Kennedy.

  Nixon’s vendetta on the matter of the 1960 election literally knew no limits. For example, he insisted that a midlevel career bureaucrat named Jack Goldstein, who headed the Bureau of Labor Statistics (BLS), had deliberately spun the monthly unemployment report issued on the eve of the 1960 election so as to damage his campaign. Eight years later, Nixon informed the White House staff that job one was to determine if Goldstein was still at the BLS, and to get him fired if he was.

  It is not surprising, therefore, that Nixon rolled into the Oval Office obsessed with replacing Chairman Martin and bringing the Fed to heel. To be sure, his only real interest in monetary policy consisted of ensuring that the one great threat to Republican success, a rising unemployment rate, did not happen in the vicinity of an election.

  Yet it was that very cynicism which made him prey to Milton Friedman’s alluring doctrine of floating paper money. As has been seen, Nixon wanted absolute freedom to cause the domestic economy to boom during his 1972 reelection campaign. Friedman’s disciples at Camp David served up exactly that gift, and wrapped it in the monetary doctrine of the nation’s leading conservative intellectual.

  FRIEDMAN’S RULE OF FIXED MONEY SUPPLY GROWTH WAS ACADEMIC POPPYCOCK

  Those adhering to traditional monetary doctrine always and properly feared the inflationary threat of state-issued fiat money. So when the CPI reached the unheard of peacetime level of 6.3 percent by January 1969, it was a warning that the tottering structure of Bretton Woods was reaching a dangerous turning point and that the monetary foundation of the postwar world was in peril.

  But not according to Professor Milton Friedman. As was typical of the Chicago school conservatives, he simply brushed off the gathering inflationary crisis as the product of dimwits at the Fed. Martin’s “mistake” in succumbing to pressure to open up the monetary spigot to fund LBJ’s deficits, Friedman insisted, could be easily fixed. Literally, with the flick of a switch.

  According to Professor Friedman’s vast archive of historic data, inflation would be rapidly extinguished if money supply was harnessed to a fixed and unwavering rate of growth, such as 3 percent per annum. If that discipline was adhered to consistently, nothing more was needed to unleash capitalist prosperity—not gold convertibility, fixed exchange rates, currency swap lines, or any of the other accoutrements of central banking which had grown up around the Bretton Woods system.

  Indeed, once the central bank got the money supply growth rate into a fixed and reliable groove, the free market would take care of everything else, including determination of the correct exchange rate between the dollar and every other currency on the planet. Under Friedman’s monetary deus ex machina, for example, the unseen hand would silently and efficiently mete out rewards for success and punishments for failur
e in the banking and securities markets. The need for clumsy and inefficient regulation of financial institutions would be eliminated.

  Friedman’s “fixed rule” monetary theory was fundamentally flawed, however, for reasons Martin had long ago discovered down in the trenches of the financial markets. The killer was that the Federal Reserve couldn’t control Friedman’s single variable, which is to say, the “money supply” as measured by the sum of demand deposits and currency (M1).

  During nearly two decades at the helm, Martin learned that the only thing the Fed could roughly gauge was the level of bank reserves in the system. Beyond that there simply weren’t any fixed arithmetic ratios, starting with the “money multiplier.”

  The latter measured the ratio between bank reserves, which are potential money, and bank deposits, which are actual money. As previously indicated, however, commercial banks don’t create actual money (checking account deposits) directly; they make loans and then credit the proceeds to customer accounts. So the transmission process between bank reserves and money supply wends through bank lending departments and the credit creation process.

  Needless to say, the Fed couldn’t control the animal spirits of either lenders or borrowers; that was the job of free market interest rates. Accordingly, banks would utilize their reserves aggressively during periods of robust loan demand until borrower exuberance was choked off by high interest rates. By contrast, bank reserves would lie fallow during times of slumping loan demand and low free market rates. The “money multiplier” therefore varied enormously, depending upon economic and financial conditions.

  Furthermore, even if the resulting “money supply” could be accurately measured and controlled, which was not the case, it did not have a fixed “velocity” or relationship to economic activity or GDP, either. In fact, during deflationary times of weak credit expansion, velocity tended to fall, meaning less new GDP for each new dollar of M1. On the other hand, during inflationary times of rapid bank credit expansion it would tend to rise, resulting in higher GDP gains per dollar of M1 growth.