Updated January 2021
BOOK REVIEW: THE GREAT DEFORMATION
David Stockman, a US Congressman in the late 1970's and President Reagan's budget director up until 1985, later became one of the early partners in the Blackstone Group and then ran his own private equity firm for almost twenty years. In "The Great Deformation" he examines the financial and political systems which have transferred power and wealth to those at the very top of Wall Street and banking and left the US economy and financial system with fragile underpinnings.
In the Great Deformation Stockman presents a simple thesis. The price of money, the interest rate, determines the price of assets. He examines the deformation created in financial markets, free market capitalism and the US economy by monetary central planning from the Federal Reserve, fiscal stimulus from the US government, and crony capitalism in Washington. His detailed analysis is backed by the best available source materials, Federal Reserve data, Census data and academic analyses. He knows Washington from the inside. While some of his analysis may be open to debate most is mainstream data which, if anything, is overly optimistic.
The publication of "The Great Deformation" in April 2013 was met with widespread criticism by the financial press and numerous pundits, particularly Paul Krugman, an ardent Keynesian who repeatedly argues that debt and deficits don't matter. The numbers which Stockman presents to support his thesis were not addressed Krugman then "The Great Deformation" quickly faded into relative obscurity and was rarely mentioned further in the mainstream financial press. Stockman's analysis is not all that unique or extreme. Much of what he says has been said by Bill Gross, Jeremy Grantham, Niall Ferguson, Paul Volcker, Jim Rogers, John Hussman, James Grant, Ray Dalio and other financial luminaries. What Stockman has provided is an organized and very detailed framework for understanding what has gone wrong with the financial underpinnings of the US government, the Federal Reserve, and US financial markets over the last three decades.
"The Great Deformation" is presented in five sections spread across 34 chapters, and 748 pages. This review provides a synopsis of the key themes in each section and highlights a few anecdotes and data. Part I, "The Blackberry Panic of 2008", disputes Federal Reserve Chairman Ben Bernanke's claim that central banking can best manage free market capitalism. Stockman sees central banking as central planning not dissimilar from communist based central planning. In his analysis the Fed has been the creator of bubbles and financial crises and the results of its actions have crushed the interest rate mechanism and price price discovery in free markets. It has, however, been effective in boosting asset prices and compensation on Wall Street and in banking. Wall Street and Washington promote the idea that the government and the Federal Reserve can repair a failing economy when, in Stockman's analysis it is a failing government and Federal Reserve policy which are crushing what remains of Main Street prosperity. The Federal Reserve is a privately owned bank owned by other privately owned banks and meets with the heads of the largest US investment banks monthly.
The September 2008 Wall Street crisis "did not arrive mysteriously on a comet from deep space, …instead, it grew out of decades during which Washington defied the rules, corrupting the nation's financial condition…and permitting rampant special interest plunder of the public purse and conducting a financial casino out the Fed's headquarters in Washington." The nation was not struck by a deadly "contagion" that required the suspension of the rules of free market capitalism and bailouts and the real economy wasn't doing poorly in 2007 and 2008. Government data show the US economy grew 2.0% in 2007 and 1.1% in 2008. It grew 2.3% in 2020 but that's still 1% below average US GDP growth. In 2008 Main Street banks weren't in trouble, Wall Street investment banks were at risk of insolvency as a result of their incessant and highly levered speculation.
At the time of the 2008 crisis, AIG, an insurance company with extensive investment subsidiaries, was structurally incapable of starting a contagion since 90% of AIG was solvent. Yet, AIG received $160 billion of bailout money, saddling taxpayers with business enterprise losses which would have hit earnings and executive and trader bonuses at AIG. Not surprisingly, Hank Paulson, our Treasury Secretary at the time and before that the CEO of Goldman Sachs, was the spearhead for the bailouts and made sure Goldman was protected from AIG. AIG had written "naked" CDS contracts for many of the securities Goldman held. CDS's are a form of insurance. Naked means that the CDS's had no money backing them if the securities they guaranteed failed and they are considered highly risky. CDS contracts allowed Goldman to get high credit rankings for debt which was actually of low quality, sell it to institutions, and take much more risk with leverage. "Too-big-to-fail" was conveniently introduced by Paulson as a replacement for free market capitalism and the risk of loss created by Wall Street's actions.
Once the Fed got into the "stock market propping and Wall Street coddling business" as tools of monetary policy, it was unable to let markets return to free market conditions and has been unable to do so through 2020. Under Greenspan's and later Bernanke's direction the nation's central bank, the Fed orchestrated the financial markets, the Treasury yield curve, bank lending, mortgage rates, the dollar's exchange rate, US Treasury borrowing costs, and much more. This sweeping usurpation of economic power and mission creep into the "prosperity management business" was in total violation of the canons of free market capitalism as well as the Fed's legal mandates.
What was collapsing in 2008 were the profits from failing loans and speculative securities held or issued by Goldman Sachs, BofA, Morgan Stanley, JPMorgan, American Express, Citibank, and huge lending companies like GE Capital and GMAC. Bernanke, a student of the Great Depression, noted the collapse of the money supply, panicked and claimed that an economic collapse might occur. Sheila Bair, head of the FDIC, fought hard to stop fear-mongering about "systemic" risk but received little help and much opposition from Treasury Secretary Paulson and head of the New York Fed, Tim Geithner (Bair, S., "Bull by the Horns", Free Press, 2012). She persistently argued that the FDIC commercial banking system wasn't going to collapse and that investment banks should not be rescued. Her claims are well-documented by Special Inspector General for TARP oversight, Neil Barofsky (Bailout: How Washington Abandoned Main Street While Rescuing Wall Street, Free Press, 2012).
Part II, "The Reagan Era Revisited: False Narratives For Our Times", examines how the passage of TARP by a Republican administration was a stark repudiation of free market capitalism and limited government that had been Republican ideology. Fiscal profligacy began with Nixon's removal of a link between the US dollar and gold established at Bretton Woods at the close of WWII and ushered in an era of "deficits don't matter" under future administrations. Although Reagan stood for fiscal restraint during Reagan's second term federal outlays averaged 21.7% of GDP compared to 19.3% during Lyndon Johnson's "guns and butter" extravagance in the 1960's. Federal outlays in the budget of Republican George W. Bush soared to 25% of GDP, a post WWII record.
During the 1970's the Federal budget was balanced most of the time, revenues matched expenditures, but Fed Chairman Burn's easy money strategies fomented double digit inflation by 1979. This was cured by Fed Chairman Volcker's double digit interest rates in the early 1980's and he was not well liked by Wall Street or Washington. What followed after Volcker was a massive exercise in Keynesian budget expansion and borrowed prosperity, the start of "The Great Deformation".
The five-fold gain in the S&P between 1987 and 2000 has been celebrated as the unfolding of Reagan prosperity but it actually measured the arrival of central bank driven bubble finance, the falsification of asset prices, and a false prosperity purchased with debt, speculation, and offshoring. By the year 2000 the US was living well beyond its means and that only accelerated in the 2000's. In Autumn 2008 the nation's multi-decade debt binge hit its natural limits and collapsed.
Growth in US debt was the result of "the triumph of the warfare state" and the "triumph of the welfare state". Reagan offered a virtually unlimited military budget based on the idea that the US had to insure its first strike capability against the Soviets. The Pentagon then poured hundreds of billions into equipping and training a conventional armada appropriate for invasion and occupation and used in Desert Storm in 1991. It had little to do with first strike capability. Reagan's tax cuts reduced revenues, shifted taxes to the middle class and turned the federal budget into a tool of economic stabilization requiring ever increasing federal debt and postponing painful deficit reductions that never arrived. Other nations were willing to buy US debt and the dollar because it boosted their exports to the US.
Part III, "New Deal Legends and The Twilight of Sound Money", examines myths about the New Deal and Franklin Roosevelt (FDR), the New Deal's legacy, and the American financial system up through the 1960's. The New Deal fueled the growth of government power and the crony capitalism which thrives upon it. Contrary to the claims of Paul Krugman and other Keynesians, the giant programs of fiscal stimulus and money printing after the 2008 financial crisis were not based on their effectiveness during the Great Depression. FDR debased the US dollar, confiscated gold from private citizens, and disconnected the financial discipline gold brings to fiat paper currency. Virtually everyone at that time believed that gold-redeemable money was the foundation of capitalism including the president's most senior financial advisor from Wall Street, James Warburg, and his Treasury Secretary, Henry Morgenthau.
New Deal historians never mention that 50% of the huge collapse in industrial production, the heart of the Great Depression, had already reversed under Hoover by September 1932 nor do they mention that in 1939 the unemployment rate was as high as it was during 1932. The US economy hadn't recovered by 1940. Before Franklin Roosevelt became president in 1932 the banking crisis was over and what remained was a modest clean up, mostly in country banks badly hurt by the collapse in agriculture. No bank holiday was necessary. The New Deal was a grab bag of politically motivated experiments and gimmicks and did little to revive the economy or create wealth. Many of the programs inflated prices in agricultural products and distributed patronage to FDR's supporters. FDR was unschooled in economics and ignored his economic advisors, focusing on political gains. His programs were carefully executed for political advantage and got him reelected in 1936.
The Social Security Act of 1935 disguised a regressive payroll tax as retirement insurance and the payroll tax was born. As it is in 2016 it subtracts 15% from employee paychecks, has reduced hiring and lead to today's fictional "Trust" funds in Social Security and Medicare as of 2016. FDR's economic policies were best summed up by Secretary Morgenthau in 1939, "We have tried spending money. We are spending more than we have ever spent before and it does not work." The fiscal trends which alarmed the Treasury Secretary, however, were worrisome only by the standards of the past. During FDR's six peacetime budgets, federal spending never even reached 10% of the national economy versus over 20% today and the federal debt averaged 3.9% of GDP as opposed to 106% in 2016.
WWII was financed by taxation and forced saving due to rationing. Federal spending reached 44% of GDP during 1943 through 1945 and fiscally conservative Treasury Secretary Morgenthau tripled the federal tax burden from 8% of GDP in the late 1930's to 24% by 1945. US citizens saved via war bonds and most of the cost of WWII was paid for by savings. The Keynesian argument today is that federal debt outstanding reached 125% of GDP at the end of the war, about 20% above its level in 2013, and thus this supposedly shows debt is harmless. Never mentioned, however, is that public plus private debt combined actually declined during WWII due to greatly increased savings.
Government data puts the lie to the endlessly repeated Keynesian claim that WWII was a splendid exercise in debt finance. While Eisenhower and Kennedy supported balanced budgets and sound money by the late 1960's Lyndon Johnson and a congressional majority were willing to abandon the ancient taboo against deficit finance during peacetime and adopted the inflationary Keynesian concept that debt stimulates economic growth. It definitely stimulates currency debasement. This led to a rapid outflow of gold from the US and in 1971 Nixon took the US dollar off a link to the value of gold at $35/ounce since US gold reserves were being cleaned out by France and other countries repatriating their US dollars for gold.
Part IV, "The Age of Bubble Finance", examines the rise of Wall Street, debt and speculation as the underpinnings for the US economy. Corporations became involved in financial engineering to boost stock prices, leveraged buyouts saddled corporations with debt, housing prices rose rapidly as Wall Street and the US government became involved in financing mortgages and the financial system blossomed with complex and risky financial instruments and derivatives. When the US dollar was delinked from gold and inflation was set loose by cheap credit from the Fed double digit inflation emerged by the late 1970's. Since then the US dollar has lost about 40% of its value versus a basket of foreign currencies.
After 1995 financial markets gradually morphed into casinos and lost their role in price discovery. Leverage with cheap borrowed money was added to financial markets and the US economy without adding to society's output or wealth, greatly boosting asset prices and benefitting speculators at the top of the economic ladder. Speculators were pleased to call rapidly rising debt "stimulus" but it was just more debt. A major contributor to this deformation was the evolution of financial futures markets from early agricultural futures exchanges which served an economic purpose to levered casinos. Complex derivative contracts were tied to financial assets, currencies, interest rates, and stock indexes and settled in cash rather than the delivery of a commodity for cash. This allowed unlimited size and bets tied to financial markets.
From the October 1987 crash to the present the Fed has repeatedly acted to prevent panics and sell-offs in financial and housing markets by lowering interest rates, lending to banks, and increasing money supply. Their theory is that these stimulate the US economy and fix failures in financial markets. The Fed's easy money policies not only created buying panics and crashes but each rescue drove the next deformation. The Fed intervened after the 1987 crash, the 1990 recession, the 1997 collapse of Long Term Capital Management, the Y2K panic prior to 2000, the internet/tech collapse of 2000 through 2002, and the Fed fostered the 2003 through 2006 housing bubble that led to the equity market and real estate collapse at the center of the 2008 financial crisis. As of 2016 the Fed has left rates at or near record lows despite promising a return to normal interest rates by 2011. Any attempt by markets to engage in price discovery has been fought by the Fed with its primary objective being to maintain or increase asset prices.
Wall Street now sees the Fed as a financial concierge, supplying cash and liquidity to markets and monetizing the ever growing Federal debt at borrowing rates half historical averages thereby allowing politicians to spend far more than the government brings in from taxes. This has resulted in a doubling of the US national debt from about $10 trillion in 2008 to aound $28 trillion at the end of 2020 depending upon how Federal debt is measured. Wall Street's derivative and mortgage securitization apparatus led to the 2008 collapse in housing prices and was not the result of a free market. Greenspan disingenuously attributed the rampant financial manias all around him as the verdict of the free market, not the result of the Fed's cheap money and speculation. He completely changed his narrative in 2015 and then began arguing tthat gold is superior to the US dollar and high US debt will lead to severe economic problems in the future. The traditional rules of capitalist wealth creation, inspiration, perspiration, and patience, were superseded by effortless financial gains from leveraged financial speculation with the lowest borrowing rates in US history, well below inflation. When the financial and housing markets collapsed in 2008 the Fed focused on reviving Wall Street as rapidly as possible through interest rates near 0%, quantitative easing programs, repos, currency swaps and other maneuvers.
The Fed's bubble finance policies from 1987 through the present deluded Main Street America into believing it was far wealthier than was actually the case. US savings rates collapsed from around 8% during 1955 through 1986 to 2% to 3% in the first decade of the 2000's. As of 2020 American's are dissaving. In inflation adjusted terms median US income is close to where it was in 1980 and Main Street has seen few of the gains accruing to those on Wall Street.
Bloated consumption growth is among the principle deformations now afflicting the American economy. This deformation was enabled by a parabolic rise in debt with total credit market debt outstanding doubling from $25 trillion to $50 trillion between 1999 and 2007. The Fed has made almost no comments about this stunning eruption of borrowing by households, businesses, and the US government. Debt growth, not honest economic growth, now supports the US economy. Daily repos by the Fed boost investment bank balance sheets, interest rates below the rate of inflation support speculation, the Fed's balance sheet is at least $4.5 trillion in 2020 versus $800 million in 2008 , currency swaps support foreign banks and manipulate exchange rates, accounting and regulatory standards have been weakened, and rapidly rising US Treasury debt has become essential for the US economy to show any growth. The Fed promotes the theory that stimulus, just debt, and a wealth effect from rising prices in asset markets will revive the economy and strong growth will supposedly soon reappear driven from demand by consumers.
Further adding to the deformations were booms in mergers and acquisitions created by cheap money, the LBO and junk bond collapse of the late 1980's, the removal of Glass-Steagull in 1999, it had separated commercial and investment banks since 1934, the relabeling of LBO's as private equity in the 2000's, and the reclassification of investment banks in 2008 as bank holding companies. The latter allowed large US banks to qualify for bailouts and government support. The Fed has created the illusion of prosperity by driving up asset prices under Greenspan, Bernanke and Yellen through providing cheap unlimited debt along with new tax-favored rules for levered speculative balance sheets and valuing assets.
Common stock prices have also been driven up since 2008 by an ever shrinking pool of available shares. Corporate borrowing at low interest rates feeds stock buybacks. Buybacks reduce the
number of tradable shares and result in the division of earnings per share across fewer shares, thereby boosting apparent earnings. This has allowed top management to cash in large stock and option grants they award themselves and they have done so at very high rates for several years. Buyout and buyback transactions drained nearly $2.3 trillion of corporate equity between 2002 and 2008 with $800 billion of stock retired in 2007 alone. The buyback binge accelerated after 2008 and in 2015 over 106% of the net income of the corporations in the S&P 500 went to buybacks and dividends, not into growing companies. Speculation and leverage have become deeply embedded and institutionalized in the current "age of bubble finance" as Stockman calls it.
Part V, "Sundown in America: The End of Free Markets and Democracy", examines Mitt Romney and Bain Capital and how private equity speculators bought, sold, flipped, and stripped businesses rather than building businesses the old fashioned way. Stockman deconstructs the finances involved in Obama's "green energy capers" in Solandra, Fisker automotive, and Tesla, the GM bailout and crony capitalism in the auto industry, and the collapse in bread winner jobs in America. He concludes that what lies ahead is a US economic crisis and wrenching dislocations in financial markets and real estate.
Stockman ran a private equity firm for 17 years and describes private equity as based on maximizing debt loads, extracting cash, cutting head counts, skimping on capital spending, outsourcing production, and then packaging the hollowed out companies for an IPO at the earliest and most profitable exit point that cash can be withdrawn. Four of the ten Bain Capital "home runs" ended up in bankruptcy. Private equity LBO's extract rather than create value and Stockman describes them as a "rent a balance sheet" ploy and a dangerous form of leveraged gambling greatly aided by the Fed's ultra-low interest rate policies.
The main beneficiary of the Fed's ultra-low interest rate policies is the US government. On the eve of the 2008 crisis the annual interest on the US debt was running at $1.420 trillion annually but after four years of interest rate suppression by 2013 the annual deficit had shrunk to $985 billion thanks to much lower interest payments for the US government. Hurt, however, are savers and conservative bond buyers who saw their yields from interest reduced by about $450 billion annually. The US faces a structural problem and it isn't one caused by a normal business cycle. The doubling of US national debt since 2008 has served to artificially inflate the GDP and mask the deformation and its economic consequences from Main Street.
Fisker and Tesla are essentially failing vanity projects for Silicon Valley billionaires supported by taxpayers and another deformation of competitive free markets. The auto industry is engaged in developing commercially viable electric cars as it has developed the automobile since its inception and there is no need for government intervention and support. The auto industry did fine without it for most of last century. In 2009 Tesla received $465 million in federal money and put it into the development of the Model S. Tesla had already lost about $500 million building and selling around 2000 Tesla roadsters and by mid-2012 Tesla had racked up $750 billion of net losses and nearly $1 billion of negative cash flow from its new Model S. In October 2012 Tesla received a delay from the government on repaying its loans. In 2016 it continued to do financial maneuvers to stay afloat and had branched out into the solar panel and battery business. Its survival as a business is by no means certain as of 2021 and it's yet to make a profit and go off of US government support.
A faux prosperity had been achieved in 2016 by the Fed's relentless reflation of asset prices. In December 2007 breadwinner jobs paying an average of $50,000 per year generated more than 65% of earned wage and salary income and it's probably a little under $60,000 in 2021. Almost all of the jobs created since 2008 have been low paying, part-time or temporary. Breadwinner jobs have barely grown. Government statistical data is so optimistic that if a person works 1 hour per month for at least $20 they are counted as employed. The Fed's monetary policies are all about fueling the speculative urges of Wall Street and allowing the US government to run up the Federal debt, a spend now pay later plan. They are not about helping Main Street despite Fed claims to the contrary.
Stockman concludes his examination of the deformations created by the Federal Reserve and US government by proposing thirteen possible solutions. All seem very unlikely to come about. These include restoring sound money and a gold-backed dollar, abolishing deposit insurance, implementing a "super Glass-Steagull", abolishing incumbency and the electoral college, requiring each two year Congress to balance the budget, removing the government from macroeconomic management of the economy, abolishing social insurance, bailouts and subsidies, abolishing the minimum wage, reining in the Defense Department, imposing a wealth tax on the top 10%, reducing the federal debt to 30% of GDP and instituting universal taxes on consumption. In Stockman's view the cure for the Great Deformation is a return to sound money and fiscal rectitude.
Stockman's analysis makes it quite clear that investors as of 2012 or 2021 should not assume that current record high prices for stocks, bonds or real estate will remain as high as they are. The composition of financial markets and the role of central banking and the US government in the economy and financial markets is totally different than it was up until the 1980's and has pumped up market prices. Thus, the long-term return numbers generated by financial markets and real estate over the past two to three decades should not be relied upon as certain guides to future returns in these asset classes. Multiple deformations have altered the price discovery mechanism in free markets.