Below is the transcript for the podcast with David Stockman: Blame the Fed!
Chris Martenson: Welcome to another PeakProsperity.com podcast. I am your host, of course, Chris Martenson. And today, we are speaking with a particularly interesting guest, Mr. David Stockman — economic policy maker, politician, financier. Mr. Stockman represented Southern Michigan in the US House of Representatives from 1976 to 1981, later served as the Director of the Office of Management and Budget, the OMB in the Reagan administration, and was the youngest cabinet member of the twentieth century. Since then, he’s held executive positions in many of the most influential banking, buyout, and private equity firms, including the Blackstone Group and Solomon Brothers. He has many other accomplishments too numerous to list here. Welcome, David. It’s an honor to have you as our guest today.
David Stockman: Very happy to be with you.
Chris Martenson: Well, great. Let’s start with where we currently are as a nation. Although the US is arguably in the same fiscal and economic pickle as much of Europe, Japan, other developed countries. So, perhaps, let’s just leave open in our minds the possibility that the US is a component of a larger structural problem. With that said, for the past several years, you’ve been publicly making the case there are no easy fixes here, no monetary adjustments or fiscal tweaks that can save the day. So what are the structural conditions you see that lead to these conclusions? How did we get here?
David Stockman: Well, I think we had a thirty-year debt spree that is unparalleled in modern history or recorded history. In 1980, our total debt- (public and private) -to-GDP-ratio was about 1.6 times. That had been sustained, more or less, for the last hundred years. It was kind of the golden constant, if you want to use that term. Today, our debt to GDP ratio is 3.6 times. There’s two turns more of debt on the national economy.
We effectively had, over the last thirty years, a national LBO – a leverage buyout of the whole economy. And this is important if you look at the difference between our historic leverage ratio, which seemed to be compatible with a stable and usually growing economy, notwithstanding periods, obviously, of boom and bust. But at 1.6 times, we would have about twenty-two trillion of debt (public and private) on the US economy today. We actually have fifty-two [trillion] at 3.6 times. So the extra two turns have put on the economy — households, business, government, we can go through the different sectors — roughly thirty trillion in debt that’s being lugged around by the US economy as it struggles to stay even, to say nothing of recovery today. And until that massive over-leveraging is worked down and reduced and liquidated, which will take years and years in a painful process, we’re not going to get back on track as an economy.
Chris Martenson: So if we could summarize, it was simply too much debt, here we are after — I started tracking this from the fifties — it really sort of started. But it took off, as I noted in the charts, around 1970. And so if we look at the decades from ’70 to ’80 to ’90 to 2000, 2010, we look across those decades, we can see that debt was growing far faster than GDP — the total credit market debt you’re referring too — far faster than GDP, and that, just, you can build a very simple spreadsheet that proves that model is not sustainable, yet we’re trying to sustain it, I think, in official actions and monetary actions, stimulus, all of this.
David Stockman: I would like to comment on that, because I think that is dead on, and it’s exactly the point I’ve tried to make many times. If you go back to the 1970s before this leverage ratio took off, before the real national LBO got going, if you had dollar GDP expansion, it tends to be accompanied by about a dollar-fifty of debt, so the ratio stayed about the same. By the time we got to the late ‘90s, we were adding two and a half to three dollars of debt for every dollar of GDP. And we reached the peak of all this in 2007, during which we increased credit market debt by four trillion and GDP by about seven hundred million. So we were pushing six dollars of debt into the economy, nearly, for every dollar of GDP that was coming out the other end. That was the end point. That’s when the system buckled; that’s when the music stopped.
Obviously, we had the huge crisis the next year, and the meltdown, and so forth. Now, since then, we’ve been treading water. Basically, private debt has been liquidated to some degree; the shadow banking debt has been massively liquidated. But it’s been replaced by public debt. And so we have gained no ground whatsoever in terms of the total debt burden on the economy. We’ve just shifted it. And so now the crisis is moving from too much leverage on the household sector and in the shadow banking system in 2007, 2008 to the sovereign debt crisis that we have in 2011 and for many years to come. Because that’s really the end game. I would say one way to describe all this is that we’re nearing, if not at, the Keynesian end game.
Chris Martenson: The Keynesian end game. So where we came through a period where we put on four trillion of debt [and] got seven hundred billion of economic activity for our troubles. Here we are, we’re pumping money in like crazy, we’re stimulating like crazy. I think a position I happen to share with you is that I’m not a fan of either monetary or fiscal stimulus, the tools we seem to be enamored with to try and get out of this mess. What’s wrong with a little stimulus in a time of need, and what is the Keynesian end game?
David Stockman: Well, stimulus, it’s very well demonstrated right now that there’s no multiplier effect, there is no pump priming going on. Stimulus is simply borrowing from next year or next decade or next generation through the credit of the United States; some money to hand out, like this ridiculous holiday on the payroll tax. So people spend for twelve months and then you’re back to where you started. And this makes no sense whatsoever. And the idea that now is being pushed by the White House is just symptomatic of how far our thinking has gone off into the ditch here. They’re proposing, even though Social Security is bleeding and last year we had seventy billion more — and by that I mean the fiscal year that just ended in September — seventy billion more went out the door for Social Security checks than came in in the payroll tax.
Notwithstanding that, Obama wants to have a one-year holiday to reduce three out of the six points that the people pay in the payroll tax so that they what…? Can go out and buy some more Happy Meals that they don’t need or some Coach bags that they can’t afford. Because one year later, they’re going to be right back paying the higher rate. This makes no sense. It is really primitive Keynesian thinking that says all we have to do is drop money from a helicopter and that’ll pump up spending and then that’ll get the machinery of the economy going. The problem with that view is it ignores the fact there’s a balance sheet, as well as an income statement, in the economy. And if you get to the edge of your balance sheet, if you use up the credit, so to speak, or the credit card, then additional stimulus only buries you deeper and it does move the economy forward.
Chris Martenson: Well, the federal government, of course, is expanding its balance sheet like mad. And I think the Federal Reserve is enabling that. It certainly did with QE2 and indirectly, with QE1 – buying all that MBS paper – where was all that money going to go?
David Stockman: Right.
Chris Martenson: It’s going into Treasuries, obviously, in part. And so here with Operation Twist, they’re just enabling the federal government to take advantage of some long borrowing at that, what I consider to be, abnormal, grotesquely distorted rates that do not really seem to take the risk into account in the pricing. So we’ve got the federal government really blowing its balance sheet out at this point in time. How does that story end, in your mind?
David Stockman: Well, it ends badly. But I think we have to go right to the source. You’ve hit on it. It is the Federal Reserve and it’s the current leadership of the Federal Reserve. As far as I’m concerned, Bernanke is the monetary Darth Vader. He has destroyed the bond market. Because fundamentally, in a healthy capitalist system, the interest rate in the money market and in the longer-term capital market is the price of money and the price of capital. And if the pricing system isn’t working, if it’s been totally crushed, disabled, manipulated, rigged, medicated, everything that the Fed has done with QE1, QE2, zero interest rates, Operation Twist, all the rest of this insanity, then we’ve destroyed the ability of the capital market to function and we’re giving false signals in every direction. One, we’re saying you can count on the fact that overnight money is going to be free or close to zero through 2013. That is an open invitation to speculators to put on a carry trade, because the Fed isn’t going to surprise you with your ninety-eight cents on the dollar that you’re carrying the trade with, borrowing overnight, so that you can carry a two- or three- or four-percent return asset, or speculate in currencies or all of the other so called risk assets, and pocket the ARB. Now, this is really crazy.
It is totally undermining the healthy function of a capitalist economy. Now, beyond that — and here’s where I get to the fiscal issue — it’s hard enough for politicians to face the music, to dispense bad news, to make hard choices, allocate pain to constituencies whether it’s spending cut or tax increase. But when the Fed destroys the bond market, which is the benchmark for the whole capital market, and tells the Congress that you can borrow money for two years at eighteen basis points, which is — as far as Washington’s concerned — that’s a rounding error. It’s the same as free. Or you can borrow five-year money, which you can right now — I’m looking at the screen — at .78, at less than one point. When you’re giving that kind of signal, then there is no incentive, there’s no motivation for people to walk the plank and face down this monster of a fiscal deficit and imbalance that we have.
So the Fed has been the great enabler. The many, many costs to this policy that we’ve had — and we could talk about those — but one of them that is not remarked upon enough is that it has destroyed the government bond market and therefore, undermined the fiscal governance process in this country, because Washington thinks you can kick the can down the road, the debt is more or less free, and we’ll get around to solving the problem. But today, let’s not make any tough choices. That’s where we are.
Chris Martenson: Absolutely. I see it that way, as well. There’s two things that I think Bernanke was really doing in his policies. One was, as you mentioned, enabling, I believe, a false sense of security on the spending side because after all, if money is free it’s really not a big problem here. Look, our interest costs are dropping. On the other side, I think what he was really doing was helping to recapitalize banks. You give them free money and let them park it back with you and give them a quarter point on it, and I know it’s not a lot, but that was part of it, buying their assets off of them at par or something close to par, not market rates, I’m going to suggest here. That’s helping to recapitalize the banks. So guess what? He helped recapitalize bank balance sheets for the bad decisions they’d made so we got the whole moral hazard story looming there.
On the other side, what he’s done is he’s taken everybody who was prudent, everybody who was a saver, everybody who is on a fixed income or is relying on some sort of an income stream, and forced them to live at negative real rates of return for a number of years, and it looks like he’s set to continue that program. I think there’s social costs here for his actions that go well beyond just the financial world. I think, from where I look, I see real damage happening to what I’m going to call the prudent portions of our society. How do you see it?
David Stockman: I agree with that a hundred percent. You know, the banking system has been saved on the back of the savers of the United States. We have totally destroyed any incentive for thrift, for deferred gratification. The Fed has become more Keynesian than Keynes. And to think that a Republican White House appointed this Bernanke guy who had, you know, he was recorded everywhere at that point as talking about dropping money out of helicopters. There was no doubt he was an out-and-out Keynesian. They appoint him, and here is what we get. Now, the fact is, if you were going to bail out the banking system with this kind of transfer — I calculate it at three or four hundred billion a year — the suppression of interest rates on depositors, on the seven trillion or so of deposit base that we have, is at least three or four hundred billion a year. And that’s the same thing as taxing the public by three or four hundred billion and redistributing it to banks based on the distribution of their deposit base.
That wouldn’t get one vote. Okay, in other words, what I’m saying is, if it were done in a proper way as a fiscal transfer, put before the democracy to review and vote up or down, it would be voted down, overwhelmingly. It would be shouted down. It would not even see the light of day out of committee, to say nothing of the floor of the House or Senate. And yet, we have twelve people who can sit on the open market committee and affect a half-trillion-dollar transfer arbitrarily. They haven’t been elected, they haven’t been authorized to do this, they’re totally twisting and exaggerating their mandate, their so called "dual mandate." This ought to be grounds for a serious constitutional crisis, if nothing else. The Fed is operating as the central planning agency of the US economy. It is exercising plenary power from stem to stern in the US economy, and that is not the kind of system, 1) that’ll work, or 2) that’s compatible with all of our traditional notions of a private sector of a free market economy, of a distinction and separation between the realm of the State and the realm of private activity.
You cannot say enough about the danger of the deluded people who were running the Federal Reserve, and that’s why I’m so happy to see, finally, the Republicans waking up and the letter that came out a couple days ago warning them no more of this, you’ve done too much already. At least there’s a dawning recognition that we have a profound constitutional crisis emerging as a result of the Gang of Four. Yes, there’s twelve people on the open market committee. It’s the Gang of Four — Dudley, Bernanke, Yellen, and Evans — who have seized power in this country and really need to be called out.
Chris Martenson: You know, I think that this most recent Fed announcement, which just came out on September 22nd, I guess, or 21st, and it was around Operation Twist. That was a real disappointment to Wall Street. I think we’re seeing that on some of our screens today and yesterday, obviously, and maybe across the world. So maybe they did get a little bit of the message that, you know, you talked about some of the political and social risks that exist in this. I’d like to talk a bit about the economic and financial or monetary risks that occur. And I don’t really ascribe to any particular school of economics, but there is one quote from Ludwig Von Mises of the Austrian school that does stick with me because it rings true. And that quote is that, “There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved.” I can’t find a lot of fault in that. I’ve analyzed that statement a lot, and it feels like we’re fully down that path at this point in time. What are the financial and — particularly the ones I’m most concerned with here — the monetary risks that you see in our current trajectory?
David Stockman: Well, there are big risks. But I think that quote is spot on. It was never more applicable than to our recent past. And it’s important to dwell on it, to focus on it, because the reason we have this crazy thrashing about by the Fed today, and by Washington with the front door stimulus, the back door stimulus, the absurdity of one-year tax holidays on payroll taxes that we desperately need, and so forth, is there is not a proper understanding of what caused the crisis in the fall of 2008, what caused the meltdown. And the answer is, it grew out of the preceding unsustainable reckless boom, exactly as Mises said. And as a result of failing to understand that, we have an implicit theory, which I think is remarkable in the mainstream of Keynesian policy makers or just politicians who would like to help, and that is that they don’t know where this crisis came from.
It was like a one-in-a-hundred-year flood; maybe it was a contagion that came in on a comet from deep space. But they have no explanation for it; it was bad luck. It hurt us so now let’s dig our way out and use the balance sheet of the Fed, the balance sheet of the federal government to compensate until we get back to normal. Well, that’s absolutely wrong, that we’re in a depressed economy right now because in 2003, -4, -5, and -6 and -7, we had an overheated bubble economy that wasn’t real, wasn’t sustainable, that created millions of jobs based on the margin credit extensions that couldn’t be sustained. And all of that was taken back by Mr. Market in 2007 and 2008 when the first debt liquidation started. And therefore, we’re totally on the wrong track, if we’re trying to restore demand that was never honest demand, or legitimate demand based on earned income and production in the first place.
And that fundamental issue is why policy has gone off the deep end and become so dangerous. Because now, they’re just pouring gasoline on the fire, as I think we all believe. Why would they think at the Fed that with the economy as sick as it is, the housing market as damaged as it is, that if you could get thirty basis points more on the long-term mortgage rate that somehow this is going to make everything better? And Operation Twist is, I would say, further evidence of ritual incantation. The Fed is so locked into this erroneous Keynesian world view that it’s indulging in a ritual incantation just doing the same thing over and over and over, when almost anyone who thinks about it can see why twenty or thirty basis points — if they can get that from Operation Twist — [would] solve anything that the last four or five hundred basis points of interest rate reduction haven’t solved, and what are the negative consequences of going in and manipulating and distorting the fundamental capital market of the world for thirty basis points? It’s not even a close question. It’s an evidence that they’re locked into almost insane policy making.
Chris Martenson: Well, so we’ve got the Federal Reserve headed by Bernanke. They’ve maybe [been] prescribing some excellent cures. Unfortunately, they have the wrong diagnosis, with ritual incantations. So Bernanke, is he Darth Vader, or is he a witch doctor? We’ve got some good metaphors to work with here.
David Stockman: Maybe we could apply both of them. But you know, I think, if you look at Operation Twist, there’s also an irony to it, which I think people who are trying to understand what’s happened, not just in the last year or two but the last decades or few, would be interested in. And that is the original Operation Twist, ironically, which I think was implemented in February or March 1961, was done as a valiant effort — although misguided — to protect the gold dollar, okay? It was still under the old exchange rate, and the threat at that point was there was a lot of hot money flowing out of the US because they worried about the expansionary fiscal policy and new economics of the new administration coming in — and properly so — Kennedy and all of those Keynesian advisors he had from Harvard. And so the Treasury, which was still run by orthodox people — including Douglas Dillon, who became Secretary of the Treasury — came up with an expedient whereby they could sharply raise short-term interest rates.
They pressured the Fed to do that in order to stem the outflow of hot money and support the dollar and support the waning days of the gold exchange standard. And, on the other hand, [they] wanted to push down the long-term interest rate to encourage investment and growth. But the point is, today, the aim is the opposite. Bernanke’s trying to destroy the dollar with Operation Twist and all the other monetary medicine that he’s dispensed. And yet, it didn’t work in 1961, for a good purpose. And today, to reincarnate Operation Twist as part of this capital market and currency market destruction that’s underway, I think is quite ironic.
Chris Martenson: It’s interesting. You know, I think it was a little over a year ago in the New York Times, you had an op-ed piece titled “The Four Deformations of the Apocalypse.” And if I paraphrase, you essentially said that Democrats lean towards, maybe, 'tax and spend' and the Republicans lean towards 'borrow and spend,' but that there’s really no effective daylight between their spending habits. Certainly there is, if we look at marginal priorities for where the money goes, but not in terms of either the amounts of the long term — even short term — fiscal prudence. What’s the reality of the situation? And how, when, or even why will economic or fiscal reality finally gain purchase with our decision makers?
David Stockman: Well, you know, that’s the heart of the crisis. It’s deep and stubborn. And it begins with the fact that after the early 1980s, we developed two free lunch parties in this country. The Democrats were always the free-lunch party of the welfare state and the Great Society programs and so forth. And the job of the Republican party, which was accomplished pretty reasonably under Eisenhower and, actually, initially under Nixon, who then finally threw in the towel and went totally Keynesian, but at least in 1969, he was attempting to maintain some fiscal discipline. So the job of the Republican party was to be the party that said no, the party that was the watchdog of the Treasury, the party that raised for the public the issue of fiscal discipline and the consequences of not maintaining it.
Well, after 1980, I was a supply sider, but not a free-lunch supply sider. And when the free-lunch version of supply sides set in and then became party doctrine, we ended up by 2010 with both parties wanting to give away the credit of the United States. The Democrats with more spending or defending the spending was their entitlements that were growing insupportably like Medicare or Social Security. And the Republicans cutting taxes randomly, continuously, and under every imaginable economic circumstance without offsetting spending cuts or a total framework of fiscal discipline. So we get to the point today where you now have Republicans saying no taxes, any way, any shape, any form, when the revenue is at fifteen percent of GDP, the lowest in history. And you have the Democrats defending what I call the twenty-four-percent line; that’s where spending is. And you have the President a few days ago threatening to veto a bill if it reforms entitlements and is put on his desk and it doesn’t tax the rich at the same time.
Now, that is a prescription for Banana Republic fiscal policy at best, and even more irresponsibility if you look at the real facts. Now, why did we get into a situation where our democracy became deformed and both parties became free-lunch parties and we no longer have a fiscally conservative party left? I blame it on the Fed. I blame it on the 1971 decision by Nixon to close the gold window and let the dollar float. Because out of that has evolved — or morphed — a central banking policy in the world that absorbs unlimited amounts of government debt. And so we went on what I call the 'T-bill standard' or the 'federal debt standard.' And the other central banks of the emerging mercantilist Asian economies — Japan, Korea, and now, especially, the People’s Printing Press of China — have absorbed this massive emission of debt that otherwise would’ve created powerful negative consequences that would’ve forced politicians to act long ago. But as long as the debt… In other words, higher interest rates, pressure for inflationary monetary policy, and the actual appearance of price inflation. But we got away for twenty or twenty-five years with, you know, to use the phrase, “deficits without tears.” And because all the bonds on the margin were being absorbed by the central banks.
Where we are today is that the central banks of the world own five trillion of Treasury paper, from bills to thirty-year bonds. That’s half of the ten trillion outstanding. So I refer to this system, the Fed and all its subsidiary central banks, as a chain of monetary roach motels. The bonds go in; they never come out. That has totally distorted the capital markets of the world in fiscal policy making. In the last few years, especially. More than half of the debt, even though on average, half of it is owned by central banks and other official institutions, well more than half has been absorbed by the central banks in the last few years.
And so, as a result of that, the reckless irresponsibility of the two free-lunch parties has had no check. And as a result, the positions have become politically institutionalized. I mean, the Republicans can’t help themselves on the tax issue because nothing bad has happened so far, and, as Chaney said inappropriately, they have the view that deficits don’t matter. And so far, they haven’t, because the central banks have absorbed it all. But I think we’re at the end of the road for this monetary roach motel chain, as well. China is red hot with inflation. The People’s Printing Press is going to have to let the currency rise. When they stop pegging, they will therefore be buying less Treasury paper and one bid is removed from the market. I hope the Fed is done with any additional balance-sheet expansion. And if they don’t expand the balance sheet, then on the margin they won't be able to absorb incremental debt issuance by the Treasury.
Other central banks are in the same position. So that’s why we’re coming now into a very dangerous phase, because we had a twenty-five year, let’s say, interregnum, here, where the consequence of massive debt issuance was not felt in the real economy in the short term, so that there would be a feedback that would cause at least some politicians to want to change course. Now, we have the central banks out of business and massive debt flow in both Europe and here that’s turning into the sovereign debt crisis, and that’s just another name for the fact that there isn’t enough private, legitimate private savings in the world to absorb debt at this issuance rate.
Chris Martenson: You know, I’m right with you on all this, because for years — and it’s gone on longer than I ever thought it could — but I’ve been watching with alarm the custody account at the Fed, which is really just a measure of the reserve balances growing in central banks across the world…
David Stockman: Sure, right. That’s three trillion right now.
Chris Martenson: Yeah, and it’s not just a little bit. This is like twenty, twenty-three, twenty-five percent year-over-year growth for years.
David Stockman: Right, right.
Chris Martenson: It’s an astonishing compounding that’s happening there.
David Stockman: Yeah, and add, if I could, just then add the 1.7 trillion of Treasury paper on the Fed’s balance sheet, and therefore, you have close to five trillion of the real outstandings. But actually, it’s worse than that, because if you take all the mortgages back, the GSE paper, that’s just a back-door form of Federal debt anyway, now that we’ve guaranteed the security holders with the bailout in September 2008. So if you look at the real sovereign and quasi-sovereign issuance of the United States, a massive share of it — both Treasury paper, per se, and the MBS paper, is in the Fed in the other central banks of the world. And if it were that simple, well, let’s just get it over with and have the governments issue trillions of new debt, drop it out of the air from the helicopter, and put it in the central banks. Now, we know, historically, that you can’t print your way to prosperity. And that’s essentially what policy amounts to today.
Chris Martenson: Right. And so assuming we can’t do that – and I’m in agreement with you that that can’t persist forever and that we might be very close to the end of the road on that — my question here is, essentially what we’re talking about then is a massive debt deflation if we’re going to write down — let’s throw a number out there — if the US has maybe twenty or thirty trillion of excessive total credit market debt, has to walk that off, what kind of economic impacts are we talking about? What happens to unemployment? How much does GDP actually contract, let alone not grow all that, right? So what do you think happens there if we really walk down that path of austerity?
David Stockman: Well, I think that’s where the gloomy outlook materializes in living color. I think the unemployment rate is actually higher than nine percent right now. It’s only nine percent on a mathematically calculated basis because we’re driving people out of the labor force, because they lose hope that it’s worthwhile to look for a job, or we lure them into not looking with unemployment insurance; one of the two. So I think we’re over double digits right now. Even if you take the labor force participation rate of two years ago and divide that into the number of jobs that exist right now, you’ll find that you get a double digit result. I think we’re going to stay at double digits from now till as far as the eye can see. I think we’re going to have a crisis of incomes in our private economy, because sooner or later, the ninety-nine weeks of unemployment’s going to run out. The safety net is under tremendous pressure, and that’s one side of the equation.
The other side of the equation is, I don’t see why we have any growth at all. The only growth that we&rsq