The Great Deformation

by David Stockman

  At the end of the day, the first Greenspan stock market bubble had exhibited a greater amplitude and duration that any pervious mania in financial history. Consequently, during the interval between 1983 and 2000, the get-rich-quick paradigm migrated from the margins to the very center stage of the national economy.

  ORIGINS OF THE GREENSPAN BUBBLE:

  THE CURSE OF UNSOUND MONEY

  The nation’s get-rich-quick culture reached a fevered pitch during Greenspan’s dot-com mania and housing bubble, but it was rooted in the monetary deformations which arose from Camp David. Slowly, but progressively and ineluctably, the Friedmanite floating money contraption poisoned, deformed, and destabilized the capital markets. The resulting radical oscillations of the equity cycle eventually fostered the illusion that stock prices grow to the sky.

  In fact, the sequence of goods inflation in the 1970s, and then asset inflation in the late 1980s and thereafter, compounded the illusion. Owing to the first phase, equity markets were depressed. During the next phase of printing-press money, they became manic. Eventually they crashed. As these permutations played out during the four decades after 1971, the free market’s price discovery mechanism became the servant of rent-seeking speculation rather than an agent of capital efficiency and economic growth.

  The first phase occurred during the decade between mid-1972 and August 1982. It was the era of the Great Inflation and was therefore a terrible time for equities. The period’s soaring CPI and double-digit interest rates crushed the PE multiple, and appropriately so. Nominal earnings were being eroded by runaway inflation, meaning that they should be capitalized at a less generous rate.

  Accordingly, the PE multiple on the S&P 500 was cut in half, dropping from 20X in 1972 to a modern low of 10X a decade later. Not surprisingly, even substantial growth in nominal EPS during the 1970s was not enough to offset this huge contraction of valuation multiples. Thus, when the US economy finally hit bottom in August 1982 after the Volcker monetary crunch finally tamed the Great Inflation, the S&P 500 index stood at 110. This was the very same level it had registered in August 1972. Needless to say, zero nominal stock price gain during a decade of soaring inflation resulted in a 50 percent decline in the real value of investor holdings.

  It was not by coincidence, therefore, that Business Week ran its famous cover story declaring the death of equities near the end of this lost decade. By then investors had been demoralized for so long that they viewed the stock market with loathing. Yet this was merely the beginning of the disorder in the equity market arising from the August 1971 demise of sound money.

  When Volcker’s determined campaign to crush inflation succeeded, it had the coincident effect of generating a second round of equity market distortion. This time it was in the form of rebound euphoria. As the rate of inflation fell, investors reduced their discount on future earnings. Accordingly, the stock market’s PE multiple snapped back toward more traditional levels, causing the stock averages to soar.

  This sudden, sharp reawakening of equities after their decade-long malaise was duly incorporated into the “morning in America” theme by the 1984 Reagan reelection campaign. But the stock market liftoff from its 1982 bottom was not a testament to supply-side tax cuts; it was essentially attributable to the Volcker disinflation and the robust expansion of PE multiples which it catalyzed.

  By late 1986, for example, the S&P 500 had surged by nearly 90 percent from its trough level, yet earnings per share for the index composite had gone nowhere. After having bottomed at about $14 per share in 1982, S&P profits were still only $15 per share by 1986. So what caused the stock market to pop was not the pace of earnings growth, but the valuation multiple. During this period it rose from a deeply subpar reading of ten times earnings to a very healthy seventeen times.

  In financial terms, the market was removing the inflation penalty that had been priced into stock valuations during the Great Inflation, thereby normalizing the capitalization rate for corporate earnings. That completely rational adjustment, however, generated enormous windfall gains for investors who were prescient enough to get back into the stock market upon the initial success of Volcker’s campaign to restore some semblance of sound money.

  To be sure, the free market does not preclude windfall profits: inventions, discoveries, and entrepreneurial breakthroughs can generate staggering first-mover profits. But what was unfolding in the equity markets now were capricious windfall gains and losses owing to the machinations of the central bank, not bursts of creativity and destruction emanating from Schumpeterian entrepreneurs. The mid-1980s rebound of the stock market PE multiple was thus merely the first of many bullish eruptions rooted in monetary distortions, not sustainable free market prosperity.

  Contrary to White House propaganda at the time, therefore, the Reagan Revolution had not unleashed a new era of booming growth and profits. The stock market euphoria had arisen from a one-time valuation adjustment in response to disinflation. For the time being, equities were back because sound money had been partially restored.

  To his great credit, President Reagan had rejected the advice of his political advisors to waffle on Volcker’s brutal round of monetary restraint. As previously explained, however, it was a victory that did not last long and for a reason that the president did not even remotely recognize. When the famous Don Regan–Jim Baker swap (Baker from White House chief-of-staff to treasury secretary; Regan from treasury secretary to chief-of-staff) occurred in early 1985, it meant that Texas-style economics took over the Treasury and, with it, administration economic policy.

  JOHN CONNALLY’S REVENGE: THE PLAZA ACCORD OF 1985 AND THE RETURN OF TEXAS DOLLAR TRASHING

  Jim Baker, who hailed from Houston, Texas, had no particular convictions about inflation and money, but he did skew heavily toward the Connally-style insistence that the job of the Fed, above all else, was to stimulate the economy with low interest rates. During his four years as chief of staff he also became expert at maneuvering around Ronald Reagan’s core policy instincts.

  It was only a matter of time, therefore, before the new treasury secretary would end the president’s principled commitment to sound money. By the same token, Paul Volcker, the architect of the singular monetary triumph of modern times, found himself out of a job. In fact, Texas economics grabbed control of monetary policy within months of Baker’s appointment, culminating in the ill-fated Plaza Accord of September 1985. Not by coincidence, the days of the initial, healthy equity market recovery were soon numbered as well.

  Sound money had been on the road to recovery with the CPI hitting a two-decade low of 1.5 percent in the year ended May 1986. But the dollar’s sharp plunge after the Plaza Accord caused import prices to steadily rise, and soon Volcker’s hard-won victory over inflation was in jeopardy. One year later in May 1987 the CPI was already 4 percent higher, forcing Greenspan’s hand within weeks of arriving at the Fed and triggering the monetary tightening moves which led to Black Monday.

  GREENSPAN’S FORTY-FOUR-MONTH EASING CAMPAIGN: RE-BIRTH OF THE BULL, 1987–1992

  The next phase of the stock market deformation was the raging bull market of the second half of the 1990s. The planking for this speculative explosion, however, was laid between 1987 and 1992 when Greenspan eschewed the Volcker playbook in favor of coddling Wall Street and massively monetizing the Republican deficits in the face of resurgent inflation.

  Greenspan’s prolonged easing campaign was not only utterly unjustified, but it also gave birth to the false narrative underpinning the bull market; namely, that the nation’s central bank could deftly smooth out the business cycle, elicit an improved trade-off between inflation and employment and propel higher trend growth in productivity and real GDP, thereby establishing the basis for a sharp upward re-rating of stock market valuation multiples.

  In pursuit of this false narrative, Greenspan shed his sound money views once and for all in favor of a hybrid of Keynesian macroeconomics and ad hoc interest rate pegging. Needless to say, this w
as exactly the wrong way forward: resurgent inflation and the burdensome Reagan deficits actually called for a bracing round of monetary austerity and unrestricted headroom for free market interest rates to purge the nascent bubble of debt and speculation.

  As it happened, the dollar-bashing policies of the Baker Treasury generated a renewed inflationary cycle, while the massive Reagan deficits were putting heavy upward pressures on interest rates. So 1988 was the perfect time for another episode of Volcker-like resolve: the Fed had all the policy reasons it needed to get out of the government debt market and force a steep, market-clearing rise in interest rates.

  Instead, the Greenspan Fed opted to temporize, delay, and adjust interest rate policy in tepid baby steps, and the reason for this drastic error is not hard to divine: Alan Greenspan was not about to bite the hand that had anointed him. Behind all of his econ-speak was an embrace of Republican triumphalism that was utterly unwarranted and which contracted all the sound money principles that he had once held. It is no exaggeration to say, therefore, that the Greenspan apostasy was the crucial turning point on the road to the BlackBerry Panic of 2008.

  The abandonment of sound money was already evident during the Fed’s half-hearted campaign, begun in the spring of 1988, to reverse the surging gains in consumer prices. During the next year the Fed raised interest rates numerous times, but always in bit-sized increments of 25 basis points that did not surprise or disturb Wall Street. Unlike Volcker, however, the Greenspan Fed lost its nerve in May 1989 on the first hint that macroeconomic conditions were weakening.

  At that point in time, the CPI was still rising at a 6 percent annualized rate, but the Fed threw in the towel anyway and began an easing campaign that would last for the another forty-four months, through February 1993. In this manner, it eschewed the double-digit interest rates that would have been required to decisively quash inflation. Yet it did so not because the US economy was too weak to bear the needed financial discipline.

  In fact, the unemployment rate was then just 5 percent and real GDP growth averaged nearly 3 percent during the four quarters after the Fed began its 1989 easing campaign. The real reason for capitulation, therefore, was not that the economy was falling out of bed but that after Black Monday Greenspan had come to reflexively dread another stock market melt-down, and was determined to prevent it at all hazards.

  The Greenspan Fed’s fear of disturbing Wall Street also allowed the Reagan deficits to go unaddressed during the final year of the Gipper’s reign. This cemented the legend that deficits don’t matter and enabled the GOP to abandon its job as the agent of fiscal rectitude in American democracy. In fact, had the Fed pursued even a vague semblance of honest monetary policy it would have forced a financial crisis in 1988, crushing both the incipient bull market and the Reagan economic legacy.

  Under the circumstances, a sound money policy would have also forced the US Treasury to crowd hard into the nation’s modest savings pool to finance the still swollen Reagan deficits. That would have pushed interest rates sharply higher, generating carnage in the government bond market and bringing the so-called bond vigilantes out in full strength. Rather than becoming impaled upon his foolish campaign statement to “read my lips,” George H. W. Bush would have been required to take ownership of a sweeping emergency deficit reduction plan during 1988 that most assuredly would have included major tax increases as well as painful cutbacks in defense and entitlements.

  The road not taken would have quashed the subsequent legend that Reaganomics was a roaring success because the Fed’s refusal to finance the deficit would have precipitated a severe recession, leaving the Main Street economy as bad off in 1989 as it had been in 1981. Likewise, had Reagan been forced to sign an emergency deficit cutting plan on his way out the White House door, the Gingrich wing of the GOP would have had no stab-in-the-back case on which to ride to power. Crucially, the roaring bull market of the 1990s could not have happened without the Greenspan Put that was sealed by a long easing campaign during 1989–1992.

  As it happened, of course, the Greenspan Fed elected to stuff more government bonds into the vaults of the nation’s central bank. During its forty-four-month-long easing campaign, the Fed expanded its holdings of government debt by $70 billion, or more than 30 percent. In hindsight, this turned out to be a crucial fiscal bridge: in short order the People’s Printing Press of China and the remaining convoy of mercantilist currency-pegging central banks joined the treasury bond–buying binge, paving the way for two decades more of deficits without tears.

  Meanwhile, the Greenspan Fed’s 44-month bond buying campaign gave birth to a quasi-Keynesian policy rationale that could not have been better suited to bolstering the Wall Street machinery of speculation and the bull market culture on Main Street. Thus, when Greenspan’s easing campaign began in May 1989 the CPI was up by 5.4 percent over the prior year and fairly cried out for a hard slam on the monetary brakes. But Greenspan cranked up the printing presses anyway because the former industrial economist and forecaster had become smitten with the Fed’s giant macroeconomic model of the US economy.

  As seen in chapter 14, even the hapless Arthur Burns had concluded the model was worthless, but now it was being embraced by his former student for a stunningly anti-capitalist reason; namely, to permit the Fed to go into the monetary central planning business, guiding the US economy based on the Keynesian worldview embedded in the Fed model.

  In the spring of 1989 the Fed’s model forecast that the galloping rate of CPI gains would begin slowing in the years ahead. So when the Fed began easing right into the jaws of 5 percent inflation, the rationale for violating every known rule of sound money was purely Keynesian: based on the prospective easing of inflation the Fed now had more leeway to “accommodate a higher level of employment and output.”

  This new stance was expressed in the matter-of-fact prose of Fedspeak, but it embodied a shocker: while quietly financing the giant Reagan deficits, the Fed was embracing a gussied-up version of the Phillips curve—that is, averring that with inflation receding in the future, it had more room to stimulate job growth in the present. The rout of Greenspan 1.0 was now complete. The Fed would henceforth monetize more and more of the public debt in order to stimulate aggregate demand and therefore more GDP growth and jobs as long as inflation was within acceptable bounds.

  Self-evidently, it was no longer the case that a large volume of government debt “can be sold to the public only at progressively higher interest rates,” as the Maestro had once insisted in his 1966 essay. Back then he had also observed that “government deficit spending under a gold standard is severely limited” but that “the abandonment of the gold standard made it possible for … [governments] to use the banking system as a means to an unlimited expansion of credit …”

  Needless to say, Greenspan’s about-face during the 44-month easing campaign won accolades from the Keynesian professoriate and the Wall Street speculators alike. Yet he had also observed in his now “non-operative” essay that “the law of supply and demand is not to be conned. As the supply of money increases … prices must eventually rise.”

  As it happened, the American public was not conned. Greenspan incurred the worst inflation record of any previous Fed chairman during his first four-year term, save for the hapless Arthur Burns. The CPI increased by an annual average of 4.6 percent during this period, a rate of inflationary erosion that would have cut the value of the dollar in half every fifteen years.

  The period from August 1987 through mid-1991 provides a true test of Greenspan’s monetary policy, because it predated the tidal wave of wage deflation which rolled in from China and East Asia in the final years of the twentieth century. The results show that Greenspan 2.0 had become a closet inflationist and that the credit he was accorded for subduing inflation later in his tenure was undeserved.

  The assertion in Greenspan 1.0 that “prices must eventually rise” had resonance far beyond the miserable performance of the CPI during this period. The pre-Keynesi
an sound money tradition had recognized that inflation of asset prices was an equally untoward result of printing press money and that the resulting collapse of financial bubbles would do immense and unnecessary economic harm.

  Yet that’s exactly where the new Greenspan monetary doctrines would now lead—that is, to the most virulent and sustained financial asset inflation in recorded history. Indeed, in the hindsight of history it is evident that his post–Black Monday panic and subsequent refusal to crush the renewed inflationary spiral were telling, and powerfully so. These actions reassured Wall Street speculators that they were not likely to face a Volcker-style crunch, and that the Fed was now more focused on supporting the stock market than on enforcing monetary discipline.

  This conclusion was reinforced by the Fed’s incremental dithering on interest rates between May 1989 and the end of 1992. During this forty-four-month-long easing campaign, the Fed cut interest rates by tiny increments (25 basis points) on no less than two dozen separate occasions.

  In this manner, the federal funds rate was walked down an exceedingly steep slope—from a starting point of 9.75 percent all the way down to 3 percent in December 1992. Needless to say, Wall Street got excited: the S&P 500 rose from 300 to 450 during that period, or by nearly 50 percent. At the same time, there had never been an easing campaign that resulted in such a prolonged and deep cut in interest rates with so little justification in the entire history of the Federal Reserve. Not surprisingly, a deeply symbiotic relationship between the central bank and the stock market became firmly implanted during the Fed’s 675-basis-point march toward money market rates which were so low as to leave interest rates at negative readings after inflation.