David Stockman: The Bubble Finance Cycle——What Our Keynesian School Marm Doesn’t Get. Parts 1 & 2

Source: http://davidstockmanscontracorner.com/the-bubble-finance-cycle-what-our-keynesian-school-marm-doesnt-get/

Part 1

The world of Bubble Finance economies created by the Fed and other central banks is fundamentally different than that prevailing under the “Lite Touch” monetary policies which preceded the Greenspan era.

Those essentially reactive and minimally invasive central bank intrusions into the money and capital markets prevailed from the time of the Fed’s 1951 liberation from the US Treasury by the great William McChesney Martin through September 1985. That’s when the US Treasury/White House once again seized control of the Fed’s printing presses and ordered Volcker to trash the dollar via the Plaza Accord. In due course, the White House trashed him, too.

The problem today is that the PhDs running the Fed have an economic model which is a relic of the Lite Touch era. It is not only utterly irrelevant in today’s casino driven system, but is actually tantamount to a blindfold. It causes them to look at a dashboard full of lagging indicators like jobs and GDP components, while ignoring the explosive leading indicators starring them in the face on CNBC.

In a word, the rate of stock buybacks and M&A deals is 100X more important than the monthly jobs print, housing starts or retail sales.

The clueless inhabitants of the Eccles Building do not recognize that they have created a world in which Wall Street supersedes main street; and in which the monetary inflation that eventually brings the business cycle to a halt is soaring financial asset prices, not wage rates and new car prices.

During the Light Touch era recessions were triggered by sharp monetary tightening that caused interest rates to surge. This soon garroted business and household borrowing because credit became too expensive. And this interruption in the credit expansion cycle, in turn, caused spending on business fixed assets and household durables to tumble (e.g. auto and appliances), setting in motion a cascade of recessionary adjustments.

But always and everywhere the pre-recession inflection point was marked by a so-called wage and price spiral resulting from an overheated main street economy. Yellen’s Keynesian professors in the 1960s called this “excess demand”, and they should have known.

Professor James Tobin in particular, Yellen’s PhD advisor, had been the architect of a virulent outbreak of this condition during his tenure in the Kennedy-Johnson White House. He had been a pushy advocate of massive fiscal deficits under the guise of full employment accounting, and then had encouraged Johnson to unmercifully browbeat William McChesney Martin until he relented and monetized LBJ’s massive flow of “guns and butter” red ink.

Indeed, according to some historians Tobin and the White House Keynesians worked LBJ into a fiery rage about Martin’s reluctance to run the printing press, and had him summoned to the President’s Texas ranch for the “treatment”. As one journalist described it,

And in 1965, President Lyndon B. Johnson, who wanted cheap credit to finance the Vietnam War and his Great Society, summoned Fed chairman William McChesney Martin to his Texas ranch. There, after asking other officials to leave the room, Johnson reportedly shoved Martin against the wall as he demanded that the Fed once again hold down interest rates. Martin caved, the Fed printed money, and inflation kept climbing until the early 1980s.

This is to say, free market economies really don’t “overheat” on their own motion. The old fashioned kind of wage and price spirals happened because even Lite Touch central banks did not allow financial markets to fully and continuously clear.

Instead, they tended to sit on the front end of the yield curve too heavily and for too long. This tendency prevented the market from rationing excess demands for loanable funds through a flexible free market interest rate. A rising price for credit, of course, would curtail borrowing and induce additional savings and less spending, thereby preventing the general economy from getting out of balance.

In the era of Light Touch monetary policy, therefore, the Fed caused every recession, including when it accommodated artificial economic booms generated by war spending during Korea and Vietnam. That’s why it was perennially criticized by sound money advocates for being “behind the curve”.

Nevertheless, in attempting to belatedly catch-up the Fed invariably was forced to throw on the monetary brakes, as is was usually described. In due course, the rise of idle labor and industrial capacity would cause product price inflation to cool and union pressure for excessive wage hikes to abate.

At length, the wage-price spiral would settle back to a point low enough relative to the recent past to satisfy the FOMC that it was safe to supply new reserves to the banking system, and thereby restart the process of credit expansion.

The big difference between the relative success of Lite Touch monetary policy during the Martin era prior to LBJ’s 1965 ukase and the disaster of the 1970s under Arthur Burns and William Miller was a matter of degree.

William McChesney Martin had experienced first hand the Fed induced financial boom of the 1920s and the thundering bust of the Great Depression. He was therefore extremely reticent to use the monetary accelerator during expansions and was quick to tap the brakes after the recovery got started.

He did this within months of the 1958 rebound and famously described his moves to raise interest rates and increase stock market margin loan requirements as “taking away the punch bowl just when the party is getting started.”

By contrast, Arthur Burns was a pipe-smoking economist who had pioneered business cycle studies at Columbia University during the 1930s and 1940s, and as fate had would have it, was also Milton Friedman’s PhD advisor.

Unlike Martin, Burns was an arrogant prig who thought he could read the business cycle tea leaves better than Mr. Market. He was also a coward who craved political power, publicity and praise.

An historical ill-wind was blowing, therefore, the day he hitched his star to the power-mad Richard Nixon in the Eisenhower White House, and then rode to power after the 1968 election. But soon after being appointed Fed Chairman in January 1970, he was hauled into the oval office by Tricky Dick’s praetorian guard and told in no uncertain terms that his sole mission at his new berth in the Eccles Building was to generate a rip-roaring economic boom by the time of the 1972 election.

Burns complied with supine enthusiasm. Soon a virulent domestic wage and price spiral was underway compounded by a global commodities boom, including the then shocking surge of oil prices in late 1973. This was all blamed on nefarious political maneuvering by the Saudis and the newly ascendant OPEC cartel, but it was nothing of the kind.

As I documented in detail in The Great Deformation, the Nixon-Burns monetary explosion caused such a huge surge in US imports that it literally absorbed all available capacity to produce oil, copper, soybeans, iron ore, polyethylene, rubber, industrial tallow etc. and manufactured goods throughout the global economy.

It was a massive worldwide demand shock emanating from the Eccles Building on the Potomac. The historical data clearly show how it was  transmitted through a booming expansion of US bank credit which, in turn, financed massive artificial  demand for capital goods and consumer goods alike.

At length, even the craven Burns had to end the party, throwing on the monetary brakes hard and thereby triggering the deepest recession of the post-war period as of that time. Undoubtedly, his courage quotient had risen sharply after Nixon was Watergated out of office.

Nevertheless, the “stop and go” business cycle pattern of the Lite Touch era of monetary policy was now well established. However, rather than being taken as a warning sign that central bank management of the business cycle was an inherently dubious proposition, the expanding colony of economists on Wall Street and in Washington took the Nixon-Burns disaster as a challenge to do more, not less.

Soon they had equipped themselves with computer based econometric models that aspired to capture and connect all of the moving parts and the entirety of the short-run ebb and flow of the then trillion dollar US economy.  Henceforth, Fed policy would avoid the extremes of Burnsian stop and go by equipping the FOMC to forecast the future direction of the macroeconomy and deftly calibrate its policies accordingly.

This was Lite Touch on a mainframe. It was destined to fail but Milton Friedman and his disciples launched an historic detour that eventually led to the Greenspan/Bernanke/Yellen era of Bubble Finance and the resulting crisis of growth, democracy and capitalism which now weighs heavily upon us.

The Friedmanesque detour, in a word, was the massive, continuous and egregious export of US dollar liabilities to the rest of the world after Nixon closed the gold window at Camp David in August 1971. It was that disastrous act—–advocated and vouchsafed to Nixon by Professor Friedman—–of unshackling the Eccles Building from its need to husband the nation’s gold reserves that had unleashed the Nixon/Burns re-election party in 1972.

Had the US honored its Bretton Woods obligations to redeem for gold the huge overhang of unwanted dollars that had built-up abroad owing to the Keynesian policies of the 1960s, and especially due to the dollar trashing policies of Professor Tobin, there would have been a hair-curling Nixon Recession in 1972, and the world would have been spared his reelection and the monetary mayhem which followed.

Indeed, within a few years even Arthur Burns recognized the immense mistake that had been made a Camp David and advocated a return to some version of a fixed exchange rate and gold convertibility anchor on the FOMC.  But it wasn’t to be.

By then the Nixon-Ford White House was crawling with Professor Friedman’s disciples, most especially an insufferably pedantic professor of labor relations from the Chicago Business School, George Shultz, who shared Friedman’s naïve view that the Fed could be trusted with an unfettered printing press. That is, that an organ of the state should be put in charge of the most important pricing mechanism in all of capitalism——price discovery in the money and capital markets—-in order to foster capitalist prosperity.

What it actually fostered, however, was the greatest binge of monetary profligacy known to history, and there is a simple indicator that measures it precisely. Namely, the gigantic and continuous current account deficits that emerged after the 1970s—–and which have now cumulated to $8 trillion and counting.

In an anchored system of sound money the above graph could have never happened. The outflow of gold or other reserve assets in response to this borrowing hemorrhage would have stopped the money printers at the Fed short decades ago. And Alan Greenspan would have never discovered the figurative printing press in the basement of the Eccles Building at the time of the October 1987 stock market crash because the latter never would have happened under a regime of sound money and an shackled central bank.

Nor is this merely a historical curiosity. The flip side of the massive US current account deficits has been a reciprocal explosion of central bank balance sheets on a worldwide basis. That’s because foreign central banks—especially those of mercantilist oriented Asian state driven economies and the Persian Gulf oil exports—–were under unrelenting pressure to peg their currencies by purchasing excess dollars and expanding their own money supplies.

Not incidentally, that is exactly what Professor Tobin prescribed to the rest of the world during the 1960s. To wit, if you are accumulating too many unwanted dollars there is a simple solution: Man-up and run your own printing press, thereby sequestering unwanted dollar liabilities on your own balance sheet.

That is exactly what has happened since the mid-1990s and is the reason why the James Tobin version of Keynesian bathtub economics has become such a destructive force.

What it did was obliterate the economic borders on which the entire apparatus of central bank demand management policies are based and made irrelevant the dashboard of lagging economic indicators that our Keynesian school marm so blindly tracks.

Global Central Bank Balance Sheet Explosion

Part 2


In Part 1 of The Bubble Finance Cycle we demonstrated that a main street based wage and price spiral always proceeded recessions during the era of Lite Touch monetary policy (1951 to 1985). That happened because the Fed was perennially “behind the curve” and was therefore forced to hit the monetary brakes hard in order to rein in an overheated economy.

So doing, it drained reserves from the banking system, causing an abrupt interruption of household and business credit formation. The resulting sharp drop in business CapEx, household durables and especially mortgage-based spending on new housing construction caused a brief recessionary setback in aggregate economic activity.

To be sure, that discontinuity and the related unemployment and loss of output was wholly unnecessary and by no means a natural outcome on the free market.

Under a regime of free market interest rates, in fact, the pricing mechanism for credit would have operated far more smoothly and continuously, meaning that credit-fueled booms would be nipped in the bud. Flexible, continuously adjusting money market rates and yield curves would choke off unsustainable borrowing and induce an uptake in private savings due to higher rewards for the deferral of  current period spending.

Accordingly, the recessions of the Lite Touch monetary era were mainly a “payback” phenomenon that reflected the displacement of economic activity in time caused by monetary intervention. That is, the artificial “stop and go” economy lamented by proponents of sound money was a function of central bank intrusion in the pricing of money and the ebb and flow of credit.

During bank credit fueled inflationary booms, businesses tended to over-invest in fixed assets and inventory and to over-hire in anticipation that the good times would just keep rolling along. But when the central bank was forced to correct for its too heavy foot on the monetary accelerator (i.e. the provision of fiat credit reserves to the banking system) and slam on the credit expansion brakes, businesses dutifully went about reeling-in the prior excesses.

The 1972-1973 boom and subsequent steep recession through early 1975 was a classic case in point. But it is essential to recall that this was a monetary boom fueled from the Eccles Building, not the consequence of some nefarious plot by the newly ascendant OPEC cartel or even an “oil shortage” driven breakdown of economic growth.

The problem was not a shortage of petroleum but a flood of credit and the inflated spending which resulted from it. In fact, during the  24 months after Camp David in August 1971 the Fed under Arthur Burns accommodated a 36% expansion of bank credit. This $200 billion blizzard of new bank lending amounted to a staggering 20% of GDP at the time, and represented an unprecedented short term rate of credit growth that was only duplicated once again in the future——that is, by the red suzerains of Beijing after the global trade collapse in the fall of 2008.

In any event, the global economy reached a red hot pace of expansion in 1972-1974, which in the main was due to the locomotive pull of the Nixon-Burns credit and spending boom in the domestic US economy.

For example, non-oil imports to the US rose by 15% the first year after Camp David and then accelerated to 22% growth in 1973 and 28% growth in the 12 months ending in August 1974. These giant gains in imported goods were literally off the charts, and far beyond the capacity of the world market to supply from existing capacity.

So the blistering US demand ignited production booms around the world, factory operating rates rose and supply chain backlogs surged everywhere on the planet.

Thus, it was a storm of money and credit expansion which generated the first commodity bubble after 1971, not the OPEC cartel alone or even primarily. For if the problem had been just the putative rigging of price by the oil cartel—–and the crude price did rise from $1.40 per barrel to $13 during this period—–there is no way to explain the dozens of parallel commodity booms during this same 2-3 year time frame.

To wit, there was no evidence of a cartel arrangement in the markets for rice, copper, pork bellies, iron ore and industrial tallow, for example. Yet between 1971 and 1974, rice rose from $10 to $30 per hundredweight, while pork bellies tripled from $0.30 per pound to $1.

Likewise, the cost of a ton of steel scrap soared from $40 to $140; tin jumped from $2 to $5 per pound; and the price of coffee rocketed up nearly eightfold, from 42 cents to $3.20 per pound. Even industrial tallow caught a tailwind, rising from 6 cents to 20 cents per pound, and pretty much the same order of magnitude gains were reflected in the price of corn, copper, cotton, lead, lumber and soybeans.

In any event, when Nixon went into his terminal Watergate descent, Fed Chairman Arthur Burns——–who as a matter of belief was an inflation hawk but had been a pusillanimous accommodator when it had come to hardball politics in the Nixon White House—-got his nerve back and threw on the monetary brakes.

Accordingly, the double digit bank credit growth described above came to a screeching halt. It grew by only 1.2% in 1975.

The resulting sharp recession was described at the time as the deepest since the 1930s, but there were really not many parallels. Housing construction did suffer a sharp retrenchment owing to the drying up of mortgage credit and business investment spending had also declined moderately.

Yet on the core component of the US economy—consumer spending, which even then accounted for two-thirds of GDP—there was virtually no reduction.

As more fully explained in The Great Deformation, the peak-to-trough decline in real terms was just 0.7 percent.

This was hardly the stuff of a near depression and not even in the same ballpark as the 20% decline in real household consumption which had occurred during the Great Depression. Instead, the heart of the 1974-1975 downturn was a sweeping liquidation of industrial and commercial inventories, which accounted for fully two-thirds of the drop in real GDP.

Moreover, that under underappreciated fact followed exactly from the type of inflationary boom that had now been made possible by the destruction of Bretton Woods.

To wit, during 1972-1973 the drastic escalation of global commodity prices discussed above led to a scramble by businesses to buy forward and accumulate buffer stocks of raw materials, components and finished goods before prices escalated even further.

This forward buying and accumulation of inventories was at the heart of the post-Camp David boom and bust cycle.

When the monetary expansion was finally halted by the Fed in late 1974 and pricing pressures subsided,  businesses then violently disgorged these same inventories during the subsequent correction phase.

Accordingly, what is reported as a deep 3% peak-to-trough decline in real GDP during the 1973-1975 recession cycle was only a 1% decline based on final sales. All the rest of the deep recession reflected the destocking of what had been excessive inventories in the first place.

Stated differently, the GDP numbers for 1972-1973 were bloated by excess inventory production, and then the figures for the following two years were debited by their liquidation. Over any reasonable period of time, nothing was lost and nothing was gained.

This rather persuasive evidence that inflationary monetary policy does not enhance long-term growth but only destabilizes the inventory cycle never sunk in among policy makers.

In fact, when the downturn did break the commodity speculation cycle and cause the rate of CPI increase to temporarily dip under 5%, Burns and the Ford White House did exactly the wrong thing: they launched a new round of “stimulus” and soon rekindled an even more virulent inflation.

In fact, after coming to a screeching halt in 1975 due to the Fed’s  extraction of reserves from the banking system, bank credit expanded by 10% in 1976 and then by 15% each in 1978 and 1979. At length the wage price spiral was off to the races again.

Eventually Paul Volcker had to tame the double digit inflation that resulted from the Burns/Miller credit acceleration.

And while Volcker displayed remarkable finesse and courage in refusing to “accommodate” the raging inflationary spiral with reserve injections——-which had been Burns’ principle sin during 1973-1974—–he only succeeded in sharply dampening the inflationary spiral; he did not end the stop and go cycle of the Lite Touch monetary era.

That was done by Alan Greenspan, but not in a good way. When Mr. Deng discovered the printing presses in the basement of the People’s bank of China and launched his nation into a credit-fueled mercantilist growth model, it was Mao’s former communist colleague, not Milton Freidman disciples at the Fed, who broke the domestic wage and price spiral that had shaped the business cycle and driven the Fed’s reactive behavior during the era of Lite Touch monetary policy.

In a word, Mr. Deng drained China’s rice paddies and their hundreds of million of subsistence laborers, bringing them in a tumultuous rush into an industrial infrastructure complete with gleaming new export factors and port facilities that were constructed overnight with cheap printing press capital.

At the time, the resulting flood of cheap goods on the world market was called the “China price”. It soon became an object of venomous attack by the usual industrialists, labor leaders and professional protectionists who saw vast swaths of the US manufacturing base being outsourced to China. But the putative Ayn Rand disciple at the helm in the Eccles Building didn’t know the difference between free trade and free money.

Accordingly, Greenspan failed to recognize that as the paddies were being drained in China and throughout its EM supply chain that real wages in tradeable goods industries were falling all around the world. If free trade was to be maintained, therefore, domestic US wages had to fall in real terms, and the US cost structure had to be deflated in order to stay competitive in global markets.

The very last thing the US economy needed in the face of this epochal shift in the labor cost curve was easy domestic credit and the maintenance of an artificially high and unsustainable consumption level based on borrowed money. But that was the essence of the entire Greenspan era of 19 years, and puts the lie to his fatuous claim that he had tamed inflation.

Between 1993 when the China export binge got started in earnest and 2006, the US CPI rose by 40% or at nearly a 2.6% annual rate. But given the floodtide of Chinese exports, it should have been falling.

What Greenspan actually did, therefore, was to inflate the main street economy with a tsunami of credit growth that enabled domestic consumption levels to remain well above what could be supported by market clearing wages and salaries. Specifically, total US credit outstanding tripled from $15 trillion to $42 trillion during Greenspan’s last 13 years, while the household leverage ratio was driven almost vertically upward.

The Household Leverage Ratio Is Still Off The Charts - Click to enlarge

Needless to say, all of this emission of new dollar liabilities would have ordinarily resulted in the crash of the US dollar and a surging exchange rate in China and its newly mobilized EM supply chain. But having discovered that communist party power could be better preserved from the end of a printing press rather than the barrel of a gun, as Mao had erroneously preached, the red suzerains of Beijing were not about to allow Milton Friedman’s naïve belief in freely floating currencies to will out.

Instead, they turned the global FX market into the dirtiest float imaginable by means of a massive and continuous effort to peg the RMB at artificially low levels, thereby accumulating trillions of so-called dollar reserves in the process.

Indeed, China’s FX reserves went from essentially zero in 1993 to $4 trillion over the next two decades, but not out of prudent FX management policies. It happened owing to nearly lunatic expansion of its own monetary system and domestic credit.

China’s reciprocal credit binge put an end to the US domestic wage and price spiral because it meant that no amount of dollar liability emissions by the Fed would result in a classic “overheated” domestic economy. That is, the total absorption of US labor supply and manufacturing capacity as had occurred during the business cycles of the 1960s and 1970s.

Now there was nearly unlimited mandufacturing capacity and labor supply in the China/EM supply system and a virtually  bottomless vault in which to sequester unwanted dollars at the People Printing Press of China.

As it happened, in fact, Greenspan’s phony disinflation success led to the Fed’s embrace of fully mobilized and massively intrusive monetary policy in the guise of the Great Moderation and the wealth effects theory of financial asset levitation. In due course, Greenspan’s self-aggrandizing but purely experimental forays of massive central bank intrusion in the financial markets were supplanted by the hard-core Keynesian model of Bernanke and Yellen.

Alas, they operated under the grand illusion that a domestic wage and price spiral would tell them when the domestic GDP bathtub was filled to the full employment brim, and therefore when to lift their foot from the monetary accelerator.

It never happened, and they never did. The era of Lite Touch monetary policy was by now ancient history.

Next: Part 3, The New Catalyst of Recession——-Crashing Financial Assets, Not Spiraling Wages and Prices.