The Great Deformation (64 page)

To be sure, in the new vocabulary of prosperity management, as dispensed in the Fed's post-meeting communiqués, all this bond buying was explained in highly antiseptic terms. Conjuring vast amounts of new cash out of thin air in order to pay Wall Street for its bond purchases, the nation's central bank maintained it was merely effectuating an “accommodative policy stance” and “easing financial conditions.”

Yet these words had no inherent economic meaning; they were just a smoke screen obscuring the plain fact that during the 2001–2002 stock market slump, the Fed pumped $120 billion into primary dealer accounts for no good reason. The purpose all along was to salve Wall Street's self-inflicted financial wounds resulting from the speculative excesses of the equity bubble.

Moreover, the floor under the stock averages resulting from the Fed's flood of cash could not be justified as a desperate last-ditch bulwark to forestall calamity. In fact, the February 2003 market bottom at 840 on the S&P 500 represented nearly a 9 percent compound annual rate of gain for the period stretching all the way back to Black Monday in October 1987.

Was that not enough? In fact, this 9 percent annual rise was the highest consecutive sixteen-year rate of stock price gain in recorded history! Accordingly, there was no reason at all for the Fed to worry about the stock averages or to flood Wall Street with so much cash that a new bubble was inevitable. Indeed, there are fewer things more striking about the deformation of the nation's financial system after August 1971 than this episode.

There was no valid economic emergency. Notwithstanding the 2000–2002 equity market bust, Main Street had only been modestly set back and could have recovered in a healthy, sustainable manner, even if halting, on its own steam. By contrast, there was every reason to purge the borrow, spend, gamble, and get-rich-quick regimen that the Fed had implanted in the American economy. The painful losses from the stock market bust
could have served as a powerful catalyst, had gamblers and speculators been left to lick their wounds without hope of more juice from the central bank.

In short, the dot-com bust was the last chance for the Fed to pivot and liberate the American economy from the corrosive financialization it had fostered. A determined policy of higher interest rates and renunciation of the Greenspan Put would have paved the way for a return to current account balance, sharply increased domestic savings, the elevation of investment over consumption, and a restoration of financial discipline in both public and private life.

Needless to say, the Fed never even considered this historic opportunity. Instead, it chose to double-down on the colossal failure it had already produced, driving interest rates into the sub-basement of historic experience. This inexorably triggered the next and most destructive bubble ever.

CHAPTER 16

 

W
HEN THE FED FINISHED ITS EASING CYCLE IN JUNE 2003,
short-term money rates were at 1 percent and had been slashed by more than 85 percent in just thirty months' time. Needless to say, this kind of unprecedented, madcap policy action cries out for an explanation.

The short answer is that by the turn of the century the nation's central bank had come in complete thrall to Wall Street. In part this was due to the Fed's embrace of a faulty monetary theory; that is, the notion that it could micromanage the vast US economy to prosperity by rigging interest rates and periodically flooding the primary dealers with freshly minted cash. Unfortunately, this had almost nothing to do with the real challenges then confronting the American economy.

These growing structural headwinds included massive trade deficits, rapid offshoring of jobs and output from the tradable goods sector, swiftly rising levels of household debt, a collapsing domestic savings rate, and a buildup of vast overcapacity in some of the bubble sectors like telecoms. None of these genuine challenges, however, could be ameliorated by 1 percent interest rates; they all required less consumption and higher savings, not a cheap money–fueled buildup of even more debt.

Yet the Fed's insensible slashing of interest rates in the wake of the dotcom bust to levels not seen since the Great Depression cannot be entirely explained by the ideological conceits of the nation's new monetary politburo. By 2001–2003, a more insidious force had captured control of monetary policy.

During the thirty years after Camp David, a powerful bull market culture had arisen on Wall Street and spread across the land, based on the proposition that stock prices grow to the sky and that vast riches are obtainable
through parabolic gains in the value of financial assets and real estate. Now, as the twenty-first century dawned, the Fed literally was afraid to unsettle the raging bull.

So, as prosperity management through ultralow interest rates became settled Fed policy, not only was it exactly the wrong cure for the real problems of overconsumption and too much borrowing, but it also rewarded what had become an addiction in the markets. Indeed, the Fed's aggressive money-printing campaigns over the prior three decades had finally contaminated the very warp and woof of the financial system. It had spawned a speculative bull-market culture like the world had never before seen.

FABULOUS RICHES AND EFFORTLESS GAINS:

HOW SAVING BECAME OBSOLETE

The idea took root, first in the trading precincts of Wall Street and then across the land, that quick riches were there for the taking. The spectacular gains being routinely garnered in the stock market seemed to imply that the traditional rules of capitalist wealth creation—inspiration, perspiration, and patience—had been superseded. Now there was a shortcut to fabulous riches based on effortless gains from leveraged financial speculation.

Get-rich-quick schemes always abound along the margins of capitalist economies, even financially healthy ones. But the Fed's new prosperity management model resulted in an aberrational period of massive and unsustainable financial asset appreciation, owing largely to a drastic rise in valuation multiples. Not surprisingly, there is not even a hint that the self-assured mandarins who ran the FOMC ever once stopped to consider whether the scorching stock price gains its policies were fueling could be damaging to the nation's financial culture.

This phenomenon of multiple expansion—the proposition that an asset which had been worth five times its cash flow yesterday was now worth fifteen times that very same cash flow—was hardly a novel development. It had been at the heart of the late 1920s stock market boom, and had been repeatedly warned about by sound money commentators of the era such as the venerable Benjamin Anderson, chief economist of Chase Bank.

There is no evidence, however, that Greenspan 2.0 ever revisited any aspect of the 1920s stock market bubble, let alone the drastic inflation of valuation multiples which had eventually brought it to ruin. Indeed, among all the ruminations about stock market bubbles contained in nearly a decade's worth of published FOMC minutes there is not even a grade-school discussion of the 1929 crash, by Greenspan or anyone else.

It was as if the 1966 insights of Greenspan 1.0 had been flushed down the memory hole in the basement of the Eccles Building. Consequently,
when the Fed succumbed to its easing panic after the LTCM crisis, it did not even remotely recognize that the subsequent run-up in PE multiples followed the identical parabolic rise which had occurred during the final months before October 1929.

In fact, a cursory review of pre-Keynesian commentary from the 1920s would have put the Greenspan Fed into a cold sweat, even if these voices did belong to long defunct economists of an earlier era. Keynes had once used this expression to ridicule any and all wisdom predating his own, but in this instance Benjamin Anderson, Professor Willis, and many of their sound money contemporaries had quite plainly seen the disaster of 1929 coming.

In their view, the 1920s Federal Reserve System fostered way too much private credit. As previously documented, much of this excess had flowed into the call loan market on Wall Street. It grew fourfold after 1922 and had nearly doubled in size, from 4 percent to 9 percent of GDP, in the final fifteen months before the crash. Even Herbert Hoover had fretted about the stock mania fueled by call money speculators.

In his scintillating but long-ignored history of the boom and bust of that era, Benjamin Anderson noted that once the Fed triggered the speculative credit bubble and the broker loan boom went unchecked, the stock market collapse was only a matter of time: “With the renewal of the Federal Reserve cheap money policy late in the summer of 1927, a sharp acceleration of the upward movement of stock prices began … a great collapse was certain the moment that doubt and reflection broke the spell of mob contagion …”

The 1998–2000 replay was not much different, except this time hot money had taken more sophisticated forms. Speculators did not need to pile up margin loans, because now they could obtain more extensive and even cheaper leverage in the form of stock options and futures and an inexhaustible supply of OTC-based wagers crafted by their Wall Street prime brokers.

Needless to say, by the time the stock market bubble reached its fevered top, the Fed and its staff were so pleased with their own prowess in managing the nation's economy that they had scant use for musty historical narratives. So when the initial Greenspan bull market finally reached its traumatic end, the Fed became focused on reviving Wall Street as rapidly as possible. It never even considered the possibility that the dot-com crash had been a blessing, and that the more urgent need in its aftermath was to thoroughly purge this bull market culture and its now engrained tendency toward speculative excess.

So the way was paved for an even more virulent new round of bubble finance. An equity market boom which lasted almost continuously for the
better part of two decades had inculcated vast popular delusions about financial returns. Indeed, the final NASDAQ blow-off generated such immense, almost freakish, capital gains that even the thundering stock market collapse of 2000–2002 could not extinguish the gambling impulses these windfalls had fostered on Wall Street and Main Street alike.

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.