Stockman (10) Price of Gold

David Stockman notes that in 1832, the dollar’s gold content was set at $20.67 per ounce and it was not altered for a century. There had been zero dollar deflation for a century, and the dollar’s gold value in international commerce had never varied except during war.

Why do we assume that inflation is normal.

Under a regime of sound money, it is not possible for public debt to appreciate for long stretches of time.

This truth is illustrated by the glorious reign of the 23 percent British console, a perpetual bond of the British government. First issued in 1757, it remained in circulation until 1888. Other than temporary wartime fluctuations, the price of the 3 percent console did not change for 131 years. Accordingly, no punter got rich riding the console on leverage, yet no saver lost his shirt by owning it for it yield. The console was a sound public bond denominated and payable in sound money.

Stockman (9) Bank Reserves

Milton Friedman has blamed the Fed for tightening money too much following the 1929 share market crash. David Stockman disagrees. He notes that Excessive reserves in the banking system rose from $35 million in 1935 to $100 million in 1931 and ultimately to $525 million in 1933. The tenfold expansion of excessive reserves in the banking system was proof that banking system had not been parched with liquidity, but was actually awash in it.

M1 money did drop by about 25 percent over the same period as excess reserves soared tenfold. This meant the money multiplier had crashed. It was merely the arithmetic effect of a nearly 50 percent decline of the commercial loan book, as billions of loans were liquidated.

David Stockman

Stockman (7) Agriculture

David Stockman says that small state senators have a disproportionate weight in American governance. The farm programs are anachronistic and economically stupid and could not survive without this raw power politics. It has been ineffective in preventing the shrinking of the agriculture sector.

In 1935, there were 35 million people on 7 million farms, who accounted for about a quarter of national output. Today there are few than 2 million Americas on the farm, there are less than 250,000 remaining commercial-scale agricultural enterprises and farm outputs represent a mere 4 percent of GDP. The New Deal did not restore farm prosperity. Instead it conferred undeserved windfall rents on a privileged segment of rural crony capitalists for generations to come.

Stockman (6) GMAC

In his book The Great Deformation, David Stockman suggests that crony capitalism reached its zenith in the government response to the crisis in commercial paper market. The worst example was General Motors Acceptance Corporation (GMAC).

When a financial company lends long and illiquid and funds itself with short-term hot money, it needs to regularly charge its income statement with a lost reserve for the inevitable, violent moments of financial crisis when short-term money rates spike or funding dries up complete. GMAC had not done this, although it was leveraged at more than 10 to 1 and funded with massive amounts of short-term commercial paper. Although it was a purveyor of subprime auto loans, it had no ability to absorb even minor losses on its loans.

When the crisis hit, GMAC had to write down $25 billion of its loans. By every rule of capitalism, an enterprise as foolish, dangerous, predatory, and insolvent as GMAC should have been completely liquidated. Instead it remained on federal life support due to taxpayer funds and guarantees.

The economy did not benefit. There was no shortage of solvent banks, thrifts, and finance companies to serve the author and housing finance needs of creditworthy borrowers.

Stockman (5) Main Street Banks

In his book The Great Deformation, David Stockman argues that the Main Street Banks were not at risk during the GFC. The Treasury and the Fed had claimed that if they had not acted, business pay rolls would be skipped and ATMs would go dark. This was a false panic.

The Main street commercial banking system was well insulated from the contagion on Wall Street. They held about $2 trillion of residential mortgages, but these were mostly prime quality, and they stayed in the loan book, rather than being sliced and diced into tradable securities. Any losses would be charged to loan reserves, not sold at fire-sale prices on the crashing market for securitised paper. Most of their business loans occupied the senior slot, or the highest ranking, in the borrowers business. The risk of less was modest.

The heart of the false panic was rooted in the money market mutual funds sector. Total short-term deposits at the time of the crisis had reached $3.8 trillion, so the run on these funds was scary. In practice, the run amounted to little more than movement of cash between different types of money market funds. The money flowed out of the funds that operated in commercial paper into the government only money market funds. The rest went into CDs and other band deposits, so the money remained in the banking system, not under the mattress.

Stockman (4) Banking Crisis 1933

In his book The Great Deformation, David Stockman argues that Franklin Roosevelt created the banking crisis of 1933. On the eve of his inauguration, most of the US banking system was still solvent, including the great money center banks of New York: the Chase Nation Bank, First National Bank, and the Morgan Bank. There had been no bank runs on Wall Street, because the great banks had been fully and adequately collateralised on the stock loans and were sitting on cash reserves up to 20 percent of their deposits.

The run of bank failures was largely contained within the border of the oversized agricultural industrial export economy. When they collapsed, over-loaned banks in industrial boom towns like Chicago , Detroit Toledo, Youngstown Cleveland and Pittsburgh had taken heavy hits.

In the agricultural hinterlands, the problems went back to the agricultural boom caused by the disruption of European agriculture during the 1914-18 war. This resulted in an orgy of land speculation. Once the agricultural lands in Europe came back into production in 1920, farm prices dropped dramatically and continued sinking for the rest of the decade. Thousands of small banks that had been caught up into the land boom failed. Most of these were small rural banks located in small towns. This was partly the result of anti-branch laws that rural legislators had forced on the state. These small banks were insolvent and had to be closed.

After the 1929 share market crash, the rate of bank failure increased significantly, but were not national in scope. They were concentrated in the agriculture and industrial interior and were centred on cities or banking chains which had indulged heavily in speculative real estate lending and other unsound practices. In contrast, the Great Loop banks remained solvent and experienced no lines at their teller windows. When banks failures shifted eastward, it was among newly formed “trust banks” which had been charted under state law with far less stringent requirements for capital and cash reserves than was the case with the nation banks. By the time of the election, bank failure had slowed significantly.

Prior to his inauguration Roosevelt created uncertainty by remaining silent about his plans for gold and the currency. Twenty percent of the nation’s gold stock was withdrawn. Once in power he announced a four-day bank holiday. However, when the banks were opened, they continued operating without any significant changes. Within the following ten days, nearly all of the hoarded currency had flowed back into the banking system, and the Feds gold reserves soon reached pre-crisis levels.

Stockman (3) Great Depression

In his book The Great Deformation, David Stockman gives some interesting background on the 1930s Depression. He argues that Ben Bernanke does not understand its cause.

The Great Depression was not caused by the banking crisis. The US depression was rooted in the collapse of global trade, not in some flaw of capitalism or any of the other uniquely domestic afflictions on which the New Deal programs were predicated.

The American economy had been thoroughly internationalised after 1914, and had grown in leaps and bounds as a great export machine and prodigious banker to the world. While it lasted, the export boom of 1914-29 generated strong gains in domestic incomes, which in turned fuelled the post-war rise of the new durables industries like autos and home appliances. The tremendous expansion of export and durables output also triggered the greatest capital spending boom in history. Auto production capacity rose from under 2 million units in 1920 to nearly 6 million in 1929, while completely new industries like radios and washing machines were born almost overnight.

The American economy had been supersized for continuous expansion of exports, but that was its Achilles heel. When international trade collapsed after 1929, the manufacturing and capital goods industries collapsed rapidly.

A crucial element in the expansion of American exports was the $10 million of foreign bonds underwritten by Wall Street. This was the equivalent of $1.5 trillion in today’s values. It was these extensive borrowings which allowed many American export customers to finance their purchases, not unlike the Chinese have been funding the purchase of their exports during the last decade.

The problem was that this growth was not sustainable. When the stock market crashed, this financial fuelled chain of economic expansion snapped and violently unwound. Sales of author dropped like a stone from 5.3 million units in 1929 to 1.4 million vehicles in 1932. This 75% drop in auto sales cascaded through the auto supply chain with devastating impact. The collapse of these growth industries caused a huge cut back in business investment.

The Depression was not caused by a mysterious disappearance of domestic demand as the Keynesian model claims. It was caused by this massive contraction of international trade. After 1929, politicians and bankers all over the world made the problem worse, by raising barriers to trade and financial transfers.

The New Deal pushed pulled and reshuffled the supply of the domestic economy, but it could not regenerate the external markets upon which post -1914 American prosperity had vitally depended.

Stockman (2) Investment Banks

David Stockman argues in the Great Deformation that the big investment banks were not worth saving.

Twenty-five years earlier these firms had been undercapitalised white-shoe advisory houses with balance sheets, which were tiny and benign. They had grown into giant ultra-leveraged hedge funds, with just a small side operation in regulated securities underwriting and merger and acquisitions advisory services. This shift followed a transition from partnership to a limited liability companies through IPOs in the 1990s. Their profitability was generated by massive trading operations supported by balance sheets that were leveraged 30 to 1 and dangerously dependent on volatile short-term funding.

Goldman Sachs held assets of $1 trillion, but much of their massive wholesale funding had maturities of less than thirty days, and some of that was as short as a week, and even overnight. When Bear Stearns hit the wall in March 2088, it was rolling over $60 billion of funding every morning. This rollover funding was dirt cheap, because lenders had no rollover obligation and were often fully secured.

On the other side of their balance sheets, these de facto hedge funds held assets, which were generally more illiquid, longer term, and subject to credit and market value risk, which generated substantially higher yields. Due to this duration and credit mismatch, the profit spread per dollar of assets was considerable.

When the crash came, these shonky balance sheets came under attack. The investment bankers complained about short sellers, but they were really undermined by plain sellers. These houses of cards should have been allowed to collapse, as an example for an entire generation of money managers, but Bernanke and Paulson body checked the free market before it could do its work.

They panicked because they were afraid that the crisis would spill over into main street banking. Stockman says this was not a risk, because the run on wholesale funding was mostly confined to Wall Street. During the crisis, there were no runs on well-managed commercial banks and thrifts, because their assets were invested in safe US Treasury debt and government-guaranteed mortgage securities. Other loans were carried on their banking books, rather than trading accounts. The irony was that the Wall Street mortgage securitisation machine had sucked all the worst of the subprime mortgages of the balance sheets of community lending institutions.

The claim that their vestigial capabilities in mergers and acquisitions and in underwriting stocks and bonds should be preserved was ludicrous. Neither of these businesses required meaningful amounts of capital, and there always dozens of pedigreed Wall Street veterans waiting to hang out a boutique investment banking shingle to pick up the slack.

David Stockman (1) AIG

I can remember when David Stockman was Ronald Reagan’s budget director. At that time, I was impressed with his stand for economic principle over political expediency, so I was interested when I picked up a copy of his latest book from my local library. The book is called The Great Deformation: The Corruption of Capitalism in America.

The book is very long, rambles in places, and it could have benefited from a thorough editing, but he has some intriguing thing to say. His overall theme is crony capitalism and the harm it has done. He begins by explaining why the bail out of the insurance giant called AIG was unnecessary.

In the previous decades, Hank Greenburg had grown AIG through a series of mergers and takeovers of insurance companies all over the world. AIG had taken over a string of large life and casualty insurers including Western National, SunAmerica, Hartford Steam and Boiler, and American General. AIG’s total assets went from $140 billion into $450 billion in three years.

When Lehman Brothers collapsed, AIG went to the government requesting a rescue, Hank Paulson claimed that AIG had to be saved, or insurance policies all over the world would be worthless, and ordinary people would be left at risk of disaster with no insurance cover. Paulson claimed that AIG was entwined with the global system touching business and consumers alike. Stockman says this was a lie designed to scare Congress into action to benefit the investment banks.

The reality was that AIG had become a glorified insurance mutual fund. It had grown to be a giant by acquisitions and investments, but it did not have automatic access to the assets sequestered in its far-flung subsidiaries. They were protected by by state insurance commission rules designed to protect policyholders and ensure solvency.

At the time of the crisis, 90 percent of AIG was solvent and no danger to the financial system, or anyone else. Its $800 billion balance sheet consisted mostly of high-grade stocks and bonds that were domiciled in a manner that prevented contagion. Its massive high-grade assets were parcelled out into scores of insurance subsidiaries subject to legal and regulatory jurisdictions scattered all over the globe. These lockups protected policyholders and ensured that there could be no asset stripping action by the liquidators of the AIG holding company. The insurance subsidiaries were asset rich. The liabilities of these companies were the future claims of the policyholders, which come slowly over time. There could not be a panic “run” by policyholders, because their claims would mature over months and years.

The real problem with the AIG holding company was that it had been guaranteeing some of the toxic derivatives created by the big five investment banks. These were domiciled exclusively in the AIG holding company. These obligations could have been readily liquidated in bankruptcy without any disruption to the insurance companies, their solid assets, or their policyholders. Instead of allowing this to happen, AIG was given $180 billion dollars of taxpayer’s money.

Congressional investigators later found that the $400 billion of Credit Default Swap (CDS) insurance issued by AIG were held by a small number of the world largest financial institutions, but virtually none of it was held by main street banks, so they were shielded from an AIG collapse. For the financial institutions that did hold the CDS insurance, the worst-case loss would have been only a few months bonus accrual. AIG was not a risk to the financial system. What was a risk was the bonuses of the staff at the big fie investment banks. Not surprisingly, nearly $20 billion was paid to Goldman Sachs, where Hank Paulson had previously worked. This was the equivalent of eight months profit and bonus accrual for the company.

Washington threw stupendous amounts of money at AIG in a great panic, pretending to save the world, but the main beneficiaries were their mates in the investment banks.

Scary stuff.

David Stockman cover AIG in this talk at the Metropolitan Club.