The Great Deformation

by David Stockman

  Needless to say, by the mid-1990s Greenspan had apparently unlearned everything he had previously known about financial bubbles and the terrible consequences of unchecked speculative manias. His previous conviction that by 1929 it had been “too late” and that the boom should never have been fostered in the first place was likewise abandoned, if not explicitly recanted.

  So it happened that the revisionist doctrines of Greenspan 2.0 took shape during the maestro’s initial decade at the helm of the Fed. Not only did he shed his long-standing philosophical opposition to monetizing the federal debt, but also Greenspan 2.0 readily succumbed to pressure to feed the Wall Street dealers with a continuous flow of fresh cash.

  WALL STREET’S NEW CONCIERGE:

  HOW BUBBLE FINANCE WAS BORN

  The Fed’s capitulation to Wall Street in an economic environment which was strongly deflationary had incendiary effects in the capital and money markets. The continuous minting of fresh cash stimulated rampant credit growth by means of the shadow banking system’s rehypothecation multipliers and through fractional reserve lending by conventional banks.

  This outpouring of new credit was overwhelmingly used for speculation in real estate and financial assets, rather than finished goods. On the margin, the latter were increasingly priced by deflationary East Asian labor. This meant that businesses, expecting the price of goods and components to fall, did not build anticipatory stocks as they had during the 1970s. Excessive credit growth was thereby channeled to asset markets, not the goods and services in the CPI.

  At the same time, there was growing realization among traders that the Fed stood ready to inject massive dollops of cash into the primary dealer market in the event of an unexpected market setback; that is, undergird the stock market with the Greenspan Put. This encouraged bolder and even more leveraged carry trades, a catalyst which accelerated asset price appreciation still further and generated even more collateralized debt creation.

  The Fed’s embrace after 1994 of speculation-friendly monetary policy also generated effects that reached far beyond the stock exchanges. As indicated, it enabled Wall Street to extend the tentacles of financialization deep into the nation’s home finance market through thousands of mortgage boiler rooms operated out of rented Main Street storefronts. These shoestring brokers were wholly dependent upon the generous warehouse credit lines extended by Wall Street, but with no skin in the game they became dangerous dispensers of bad housing credit.

  These egregious mortgage-funding arrangements were by no stretch of the imagination an invention of the free market. No banker in his right mind would have funded financial warehouses stuffed with billions of illiquid mortgages of dubious credit quality, unless he was confident that the Fed would keep interest rates pegged to its stated policy targets. Only when the Fed functioned as Wall Street’s reliable concierge would dealers have sufficient time to securitize and unload these vast accumulations of raw assets to the unsuspecting. Indeed, under a Volcker-type monetary régime wherein the markets were always at risk for unexpected changes in central bank policy, it is virtually certain that the mortgage boiler rooms, and legions of like and similar vehicles of credit-based speculation, would never have gotten off the ground.

  Likewise, strip malls, office buildings, and McMansion subdivisions sprang up across the nation in great profusion based on acquisition, development, and construction (ADC) loans that violated every canon of sound lending. These so-called ADC facilities were habitually underwritten at more than 100 percent of costs, allowed developers to extract huge up-front fees and profits, and depended for repayment entirely on “takeout” financing at property prices which far exceeded the present value of available cash flows.

  Again, this kind of dodgy financing was rooted in the Fed’s monetary largesse. Even the small community banks which originated these cheap construction-period credit lines were confident that upon project completion, borrowers could access low-cost takeout financing from the Wall Street securitization machine.

  In hindsight, these egregious financial excesses beg a great unanswered question: Why did Chairman Greenspan permit this vast financial sector deformation to metastasize during the years leading to the dot-com crash and later the housing crash? After all, these bubbles were a virtual replay of the 1920s financial mania he had so accurately diagnosed.

  THE 1990S BORROWED PROSPERITY

  AND THE MYTH OF CHINESE SAVERS

  The maestro had taken tea at Ayn Rand’s gold standard salon after working hours, but made his living during the day as an industrial economist. During two decades of practicing this craft he learned to read the entrails of orders, inventories, shipments, and unit costs more expertly than virtually all of his peers—a practice that continued during his tenure at the Fed.

  With each passing year, however, the price of scrap iron and the level of containerboard inventories were less relevant: the steel industry was turning into a rust bucket and the demand for industrial packaging migrated from the upper Midwest to Guangdong Province.

  So the somewhat benign readings issuing from the old economy’s entrails provided false comfort. They showed moderately expanding output, subdued inflation, and falling unit labor costs. More than 30 million new jobs were added between 1987 and 2000, for example, while business plant and equipment spending more than doubled in real terms, and consumption spending grew at a real rate of 3.5 percent annually. Adding frosting to the cake, the exploding technology boom emanating from Silicon Valley implied an unprecedented outbreak of technological innovation and entrepreneurial vigor.

  At the end of the day, however, the 1990s technology boom left a dazzling trail in the financial firmament, but it provided only a tiny boost to output and jobs down at ground level. Moreover, away from the flashy precincts of high tech the national economy was deeply bifurcated: sectors subject to international trade experienced external competitive shocks like never before in American history. At the same time, most of the gains in the domestic service sector were fueled by debt, capital gains, and government spending.

  In the former instance, there were about 22 million jobs in the nation’s agricultural, manufacturing, forestry, mining, and energy industries on the eve of Black Monday. After a decade-long macroeconomic boom during the 1990s, however, the job count in these tradable goods sectors had actually declined by 7 percent, and that was just a warm-up for the crushing blows experienced by the tradable goods sector when the China export machine reached full power in the decade which followed. During the first twelve years of the twenty-first century, employment shrank drastically to only 14 million jobs and the tradable gross share of output dropped to preindustrial–era levels.

  The apparent jobs boom during the thirteen years ending in June 2000 skewed almost entirely to secondary and tertiary activities, not primary production. The big jobs growth categories included gains of 20 percent in real estate and finance, 24 percent in retail, 33 percent in construction, 41 percent in leisure and hospitality, and nearly 60 percent in health and education services. In essence, the nation was consuming, borrowing, and financing its way to prosperity.

  More crucially, the principal manifestations of this financial deformation according to Greenspan 2.0 were attributable to the verdict of the free market. That which was going terribly wrong, such as the explosion in the national leverage ratio or the collapse of the trade accounts, could therefore be ignored or at least dismissed as the superior wisdom of the unseen hand.

  As will be seen, Greenspan carried this to a ludicrous extreme. Even after leaving the Fed, he continued to dismiss the collapse of the nation’s trade accounts and the consequent offshoring of huge chunks of the middle-class economy as clinically explainable market outcomes. There was nothing untoward or even unnatural about this devastation, Greenspan 2.0 argued. Instead, the market of global savers had somehow voluntarily decided to invest in massive hoards of US investment securities.

  Greenspan even invented a specious concept called the “home bias” to
explain the soaring current account deficits which resulted from his own cheap dollar policies. Explicating this thesis in his memoirs, the maestro explained that a “decline in home bias is reflected in savers increasingly reaching across national borders to invest in foreign assets. Such a shift causes a rise in the current account surpluses of some countries and an offsetting rise in the deficit of others.”

  The part he didn’t explain was why most of these newly mobilized cross-border “surpluses” were coming from poor people who had just emerged from the rice paddies of East Asia. Nor was it evident why the US assets purchased with these “savings” were heavily concentrated in central banks that unabashedly pegged their currencies to promote exports. The fact that the ultimate users of these “savings” were increasingly indebted US households wasn’t explained, either.

  In short, Greenspan’s “home bias” theory boiled down to a convoluted rationalization for the explosion of household debt, which had risen from a historical trend of 45 percent of GDP prior to 1980 to more than 80 percent by the turn of the century, and ultimately to 100 percent of GDP before the final housing bubble burst in 2008. But that lamentable development, Chairman Greenspan insisted, was due to the intrepid multitudes of “savers” who populated the export economies of East Asia, not low interest rates and easy money at home.

  Having just emerged from the poverty of the villages and rice paddies, these skinflints, according to the maestro, had virtually forced the United States to run large current account deficits. The profligate overconsumption of imports by American consumers was thereby explained. American households ended up deep in debt because the unseen hand of the free market had ordered it.

  Undoubtedly, Greenspan 1.0 would have rejected the home bias theory as rank nonsense. The American economy was not being pleasured by one billion rampaging Chinese savers. Indeed, the well-known patterns of true global capital mobility that had obtained under the pre-1914 gold standard pointed in exactly the opposite direction.

  This relevant stretch of financial history demonstrated that the so-called home bias had been abandoned not in the 1990s, as Greenspan propounded, but in the 1870s. And it had been abandoned not by the poorest nations, but by the richest.

  For the better part of a half century before the First World War, English capitalists had flooded the far-flung lands of the British Empire as well as the United States, Argentina, China, and Latin America with their excess savings. There was nothing new about capital exports.

  Yet, as a true expression of capital mobility under a régime of sound money, the British, and to a lesser extent the French, savings outflow of this period had a distinguishing hallmark which put the lie to Greenspan’s implausible revisionism. English capitalists had sent their savings abroad to invest in productive assets like railroads, mines, and factories which could be expected to produce a return. That was a far cry from the present era, where capital was being exported by mercantilist central bankers and their domestic wage slaves, not genuine capitalists.

  More importantly, these purported “savings” ended up stuffing the kitchens, closets, and living rooms of American households. Needless to say, the US Treasury bonds taken back by the mercantilist central bankers were the obligations of unborn American taxpayers, not income-producing assets.

  While it lasted, this borrowed prosperity gave enough buoyancy to the traditional economic indicators such that their weakening “internals” could be glossed over. The Bureau of Labor Statistics archives show, for example, that 22 million jobs were added to nonfarm payrolls between the mid-1990 and the mid-2000 cyclical peaks. The startling reality was that only 3 percent of these 22 million jobs were generated by the technology industries, even when inclusively measured.

  There were about 800,000 new jobs in the computer design and engineering sector, for example, but that was only part of the story. These gains were substantially offset by 20 percent employment shrinkage in the actual manufacture of computers, peripherals, and electronic components. When all was said and done, the tech boom produced more financial fireworks than domestic economic growth; it was not the next great mass-production industry like textiles or automobiles.

  The Greenspan mantra of growth, technology, and free markets was thus fatally incomplete. Technology was generating miracles of invention, but only a modest addition to economic output and a pittance of new jobs. As will be later shown, the vaunted jobs growth of the 1990s was based mainly on old-style service sector jobs in retail, bars, restaurants, beauty parlors, municipal agencies, and real estate brokerages, to name a few. Underlying surging demand for these services was the bubble finance of stock market gains and household and business debt.

  BLINDED BY THE EXUBERANCE:

  WHEN STOCK PRICES GREW TO THE SKY

  The 1990s ballyhoo about the resurgence of free market prosperity was a case of mistaken identity. What was actually happening was an unsustainable boom fueled by the massive rise of household and business debt and capital gains windfalls of unprecedented magnitude.

  Front and center was a bull market eruption of the stock markets that dwarfed the legendary mania of the 1920s and defied any semblance of rationality relative to the actual economics of the 1990s. As it happened, it required about twenty-four months after Black Monday for the equity markets to regain their composure and the stock index to retrace its August 1987 high.

  But even upon restabilization in 1989, the stock market was not cheap by any historical benchmark. With the S&P 500 at about 350, the broad market index was trading nearly spot-on its historic average at 14.5X earnings.

  A decade later, the stock index was in an altogether different financial universe. It had quadrupled to 1,470 and represented an unprecedented 28.5X the actual 1999 earnings of the 500 companies in the S&P index. This valuation multiple was sheer lunacy. The earnings growth trend during the prior decade had been solid but not spectacular, rising at an annual rate of just under 8 percent. So the raging bull market of 1999–2000 was valuing the stock market at nearly four times its earnings growth rate.

  While the Fed leadership could not bring itself to even utter the bubble word, any junior securities analyst not caught up in the mania could have explained it. Even high-growth companies with a sustainable product, cost, or technology advantage were not ordinarily valued at more than twice their earnings growth rate, or at a so-called PEG (price-earnings to growth) ratio of two times.

  Self-evidently, therefore, the PEG ratio of four for the entire S&P was beyond the pale. This was especially so because even the S&P’s modest earnings growth rate during the 1990s had been achieved largely through profit margin expansion—something that could not occur indefinitely because by the end of the decade, corporate profit margins were at their highest point in forty years.

  If any further proof was needed that the stock market was in a nose-bleed section of financial history, it only had to be recalled that this bountiful valuation multiple had been applied not just to the fleet-footed companies comprising the so-called “new economy,” but to the earnings of the entire range of bread and butter firms which made up the S&P 500, including smokestacks, airlines, grocery chains, and utilities. In fact, only 20 percent of the S&P 500 could be even vaguely described as technology growth companies.

  The true mania, of course, raged in the technology sector itself. When it reached its frenzied peak in March 2000, the NASDAQ index stood at 100X earnings, causing Mr. Market to finally throw in the towel. Even then, the Fed maintained its vow of silence, although it no longer mattered.

  By early 2003 the bull market was a smoldering carcass, with the S&P down 45 percent and the NASDAQ off by 80 percent. This collapse was testimony enough that the Fed had fostered a stock market bubble of historic proportion. The final punctuation point, if one is needed, lies in the fact that more than a decade later the NASDAQ index remained 40 percent below its dot-com bubble high, and the S&P finished 2011 at a level it first crossed way back in March 1999.

  WALL STREET’S IRR
ATIONAL EXUBERANCE ATTACK: HOW GREENSPAN THREW IN THE TOWEL

  The Fed’s willful disregard of the financial bubbles its policy engendered is glaringly evident in Greenspan’s treatment of the whole “irrational exuberance” episode in his memoirs. The gist of his narrative, written with the hindsight of a half decade and yet another bubble in the housing sector, was that the bullish madness of the 1990s was an outcome driven by the free market and that the Fed had been powerless to stop it.

  As to the latter point, William McChesney Martin would have been spinning in his grave at the implication that the Fed no longer controlled even its own punch bowl. As a student of the 1929 crash, Martin would have recognized easy money–fueled speculation when he saw it, just as Greenspan 1.0 had done in his 1966 essay.

  Martin would have also rejected as patently absurd the notion that the 1990s stock market mania was simply the work of the market’s unseen hand. Yet, whether out of memory lapse or guile, Greenspan 2.0 never questioned that assumption. He preferred to believe that thousands of buyers and sellers engaged in price discovery on the free market had bid equity market prices to a madcap four times the growth rate of earnings all on their own.

  Ensnared in this false premise, Greenspan’s explanations for the mania are so threadbare as to be actually illuminating. Better than almost anything else, they reveal how it happened that the nation’s central bank, dominated by a lapsed devotee of sound money, fostered a debilitating financialization of the American economy.

  Greenspan’s famous irrational exuberance speech of December 5, 1996, had not slowed the rampaging bull one bit, and for obvious reasons. His warning constituted just a single paragraph fragment which suggested that the Fed really didn’t care about bubbles—if output, jobs, and inflation were not adversely impacted. Furthermore, the clear implication was that no adverse impact was likely since, as the chairman pointedly noted, even the brutal “stock market break of 1987 had few negative consequences for the economy.”