WEBVTT NOTE The Forgotten Cause of Sound Money 1 00:00:00.000 --> 00:00:06.000 Well, it's great to have as our Henry Hazlitt Memorial Lecturer this year, Mr. David Stockman. 2 00:00:06.000 --> 00:00:12.000 David's a graduate of Michigan State University. He did graduate work at Harvard University. 3 00:00:12.000 --> 00:00:17.000 He was elected to Congress three times from the state of Michigan. 4 00:00:17.000 --> 00:00:25.000 And back when I first went to work for Ron Paul in the reign of Jimmy the First, 5 00:00:25.000 --> 00:00:32.160 Outside of admiring our own boss, the Ron Paul staff always admired David Stockman. 6 00:00:32.160 --> 00:00:37.160 We got a chance to work with him on things like the draft, draft registration, and other 7 00:00:37.160 --> 00:00:38.160 issues. 8 00:00:38.160 --> 00:00:41.200 And in fact, among the Republican staffers, he was generally considered one of the most 9 00:00:41.200 --> 00:00:44.340 brilliant people ever to be elected to Congress. 10 00:00:44.340 --> 00:00:49.460 That might seem like faint praise, but it's actually not, actually not. 11 00:00:49.460 --> 00:00:54.920 So obviously the talent spotters for the Reagan administration had the same view. 12 00:00:54.920 --> 00:00:58.600 They brought him on board as director of the Office of Management and Budget. 13 00:00:58.600 --> 00:01:03.480 He was the youngest cabinet secretary in the 20th century when he took that job. 14 00:01:03.480 --> 00:01:06.640 Now, he was very unusual in that job. 15 00:01:06.640 --> 00:01:10.680 I would say unique in the Reagan administration and maybe unique in Republican politics at 16 00:01:10.680 --> 00:01:12.020 the presidential level. 17 00:01:12.020 --> 00:01:14.760 He actually tried to cut spending. 18 00:01:14.760 --> 00:01:22.360 And his opponents were people like Ed Mises, you know, the conservatives who always talked 19 00:01:22.360 --> 00:01:50.360 When he left that job, he wrote one of the most wonderful books ever written on American politics, I think The Triumph of Politics was a best seller, as I say a very significant book too, and in fact I hope he'll talk to us today about the book that he's writing right now about crony capitalism and the very unfortunate current American political and economic system. 20 00:01:50.360 --> 00:02:06.360 When David left the Reagan administration and finished his book, he went to work for Salomon Brothers and then he became a founding partner of the Blackstone Group, thereby proving the Republican staffer's view of him as smart some years before. 21 00:02:06.360 --> 00:02:16.360 He now runs his own investment bank, the Heartland Industrial Partners. 22 00:02:16.360 --> 00:02:38.360 David, we're so glad to have you here. It's an honor that you've flown down here and he's donating. There's no travel expenses or honorarium. He's doing this all on his own as a gift to the Mises Institute and a gift to us and everybody who will watch this on the internet and in the future on Mises.org. So please help me welcome Mr. David Stockman. 23 00:02:46.360 --> 00:02:56.440 Well, thank you, Lew, and let me start by saying like everyone miseducated in the 1960s, 24 00:02:56.440 --> 00:03:02.680 I've benefited enormously from economics in one lesson, the failure of the new economics 25 00:03:02.680 --> 00:03:10.520 and all the other work of Henry Hazlitt, but I have to confess that my miseducation was 26 00:03:10.520 --> 00:03:16.240 at Harvard Divinity School and the subject was not economics. 27 00:03:16.240 --> 00:03:24.480 But I did try to get economically miseducated anyway by auditing John Kenneth Galbraith's 28 00:03:24.480 --> 00:03:29.920 course on economics, not knowing at the time that I was going right to the heartland of 29 00:03:29.920 --> 00:03:30.920 error. 30 00:03:30.920 --> 00:03:37.860 Anyway, it seems that his lectures were exceedingly popular, something like a thousand students 31 00:03:37.860 --> 00:03:43.680 would fight outside the hall to get in, but I soon learned that it was for the entertainment 32 00:03:43.680 --> 00:03:45.140 value. 33 00:03:45.140 --> 00:03:52.540 The first 30 minutes or so were non-stop canned jokes about the stupidity of Republicans, 34 00:03:52.540 --> 00:03:59.380 of businessmen, of Wall Street, of most economists, and generally anyone who wasn't John Kenneth 35 00:03:59.380 --> 00:04:03.380 Galbraith. 36 00:04:03.380 --> 00:04:11.540 But of course, I came to these lectures for the substance which followed, and that was 37 00:04:11.540 --> 00:04:17.540 as can too, but only later did I learn that this part of the lecture was the real joke 38 00:04:17.540 --> 00:04:22.020 of the thing when all was said and done. 39 00:04:22.020 --> 00:04:28.100 Anyway, I escaped Harvard not being miseducated in economics. I went to work on Capitol Hill. 40 00:04:28.100 --> 00:04:34.580 I worked for a moderate Republican. We were allowed to read Newsweek in that office and 41 00:04:34.580 --> 00:04:41.500 So as a result, I became educated directly for the first time by Henry Hazlitt's columns 42 00:04:41.500 --> 00:04:43.220 week after week. 43 00:04:43.220 --> 00:04:51.180 And so it really is a great honor to try to give a lecture today that may update and incorporate 44 00:04:51.180 --> 00:04:58.380 and apply to the circumstances of the moment some of the enormous wisdom and fundamentally 45 00:04:58.380 --> 00:05:03.280 correct economics that he wrote about and stood for for so long. 46 00:05:03.280 --> 00:05:08.720 So I would start today by saying the triumph of crony capitalism occurred on October 3, 47 00:05:08.720 --> 00:05:15.800 208. The event was the enactment of TARP, the single greatest economic policy abomination 48 00:05:15.800 --> 00:05:23.640 since the 1930s, or perhaps ever. Like most other quantum leaps in status intervention, 49 00:05:23.640 --> 00:05:30.440 the Wall Street bailout was justified as a last resort exercise in breaking the rules 50 00:05:30.440 --> 00:05:32.600 to Save the System. 51 00:05:32.600 --> 00:05:39.280 In the immortal words of George W. Bush, our most economically befuddled president since 52 00:05:39.280 --> 00:05:47.240 FDR, I've abandoned free market principles in order to save the free market system. 53 00:05:47.240 --> 00:05:52.240 Now I've checked that out several times and he did say that, just in case anyone thinks 54 00:05:52.240 --> 00:05:55.480 I'm exaggerating. 55 00:05:55.480 --> 00:06:01.200 Based on the panicked advice of Paulson and Bernanke, of course, the president had the 56 00:06:01.200 --> 00:06:08.760 misapprehension that without a bailout, quote, this sucker is going down, unquote. 57 00:06:08.760 --> 00:06:14.920 Yet 30 months after the fact, evidence that the American economy had been on the edge 58 00:06:14.920 --> 00:06:19.080 of a nuclear-style meltdown is nowhere to be found. 59 00:06:19.080 --> 00:06:27.000 In fact, the only real difference with Iraq is that in the campaign against Saddam, we 60 00:06:27.000 --> 00:06:31.460 found no weapons of mass destruction. 61 00:06:31.460 --> 00:06:38.800 By contrast, in the campaign to save the economy, we actually used them, or at least their economic 62 00:06:38.800 --> 00:06:42.080 equivalent. 63 00:06:42.080 --> 00:06:48.360 Still the urban legend persists that in September 2008, this payment system was on the cusp 64 00:06:48.360 --> 00:06:55.040 of Crashing, and that absence of bailouts, companies would have missed payrolls, ATMs 65 00:06:55.040 --> 00:07:01.360 would have gone dark, and general financial disintegration would have ensued. 66 00:07:01.360 --> 00:07:06.760 But the only thing that even faintly hints at this fiction is the commercial paper market 67 00:07:06.760 --> 00:07:09.640 dislocation that occurred at the time. 68 00:07:09.640 --> 00:07:16.180 Upon examination, however, it is evident that what actually evaporated in this sector was 69 00:07:16.180 --> 00:07:23.660 is not the cash needed for payrolls, but billions in phony book profits which banks had previously 70 00:07:23.660 --> 00:07:30.660 obtained through yield curve arbitrages, which were now violently unwinding. 71 00:07:30.660 --> 00:07:35.540 At the time, the commercial paper market was about $2 trillion and was heavily owned by 72 00:07:35.540 --> 00:07:41.860 institutional money market funds, including First Reserve, which was the granddaddy, with 73 00:07:41.860 --> 00:07:44.760 about $60 billion in footings. 74 00:07:44.760 --> 00:08:00.080 Most of this was rock-solid, but its portfolio also included a moderate batch of Lehman commercial paper, a performance enhancer, I guess you might call it, designed to garner a few extra bips of yield. 75 00:08:00.080 --> 00:08:12.120 As it happened, this foolish exposure to a de facto hedge fund, which was leveraged 30 to 1, resulted in the humiliating disclosure that First Reserve broke the buck, 76 00:08:12.120 --> 00:08:16.880 and that the somnolent institutional fund managers who were its clients would suffer 77 00:08:16.880 --> 00:08:25.640 a loss, all of 3%. Well, that should have been a so-what moment, except then all the 78 00:08:25.640 --> 00:08:32.200 other lemming institutions who were actually paying fees to money market funds for the 79 00:08:32.200 --> 00:08:41.480 privilege of getting return-free risk decided to panic and demand redemption of their deposits. 80 00:08:41.480 --> 00:08:46.560 This further step in the chain reaction basically meant that some maturing commercial paper 81 00:08:46.560 --> 00:08:51.200 would not be rolled over due to money market redemptions. 82 00:08:51.200 --> 00:08:54.200 But this outcome, too, was a so-what. 83 00:08:54.200 --> 00:09:01.440 Nowhere was it written that GE Capital or Bank One's credit card conduit, to pick two 84 00:09:01.440 --> 00:09:08.120 heavy users of this space, had a federal entitlement to cheap commercial paper so that they could 85 00:09:08.120 --> 00:09:11.240 earned fat spreads on their loan books. 86 00:09:11.240 --> 00:09:17.960 Regardless, the nation's number one crony capitalist, Jeff Imelt of GE, jumped on the 87 00:09:17.960 --> 00:09:21.000 phone to Secretary Paulson and yelled fire. 88 00:09:21.000 --> 00:09:27.760 Soon, the Fed and the FIDIC stopped the commercial paper on wine dead in its tracks by essentially 89 00:09:27.760 --> 00:09:30.760 nationalizing the entire market. 90 00:09:30.760 --> 00:09:37.880 Even a cursory look at the data, however, shows that Imelt's SOS call was a self-serving 91 00:09:37.880 --> 00:09:44.280 Croc. First, about one trillion of the two trillion in outstanding commercial paper was 92 00:09:44.280 --> 00:09:51.200 of the so-called ABCP type, asset-backed commercial paper, paper backed by packages of consumer 93 00:09:51.200 --> 00:09:58.560 loans such as credit cards, auto loans and student loans. The ABCP issuers were off-balance 94 00:09:58.560 --> 00:10:04.840 sheet conduits of commercial banks and finance companies. The latter originated the primary 95 00:10:04.840 --> 00:10:12.400 Loans, and then scalp profits up front by selling these loan packages to their own conduits. 96 00:10:12.400 --> 00:10:18.960 In short, had every single ABCP conduit, and there was a trillion, been liquidated for 97 00:10:18.960 --> 00:10:24.840 want of commercial paper funding in the fall of 2008, and over the past three years most 98 00:10:24.840 --> 00:10:30.960 have been, not a single consumer would have been denied a credit card authorization or 99 00:10:30.960 --> 00:10:32.720 a car loan. 100 00:10:32.720 --> 00:10:39.300 His or her bank would have merely booked the loan as an on-balance sheet asset rather than 101 00:10:39.300 --> 00:10:41.240 an off-balance sheet asset. 102 00:10:41.240 --> 00:10:46.560 The only noticeable difference on the entire financial planet would have been that a few 103 00:10:46.560 --> 00:10:52.240 banks wouldn't have been able to scalp profits from on-season loans. 104 00:10:52.240 --> 00:10:58.000 In this instance, it appears that President George W. Bush did, in fact, bomb the village 105 00:10:58.000 --> 00:10:59.900 to save it. 106 00:10:59.900 --> 00:11:05.500 Another $400 billion of this sector was industrial company CP, the kind of facility that some 107 00:11:05.500 --> 00:11:12.020 blue-chip companies did use to fund their payroll. But there was not a single industrial 108 00:11:12.020 --> 00:11:19.020 company in America then issuing commercial paper, which did not also have a standby bank 109 00:11:19.020 --> 00:11:27.020 line behind its CP program. Moreover, since these companies had been paying a 15 or 20 110 00:11:27.020 --> 00:11:33.540 Basis Point Standby Fee for years, their banks had a contractual obligation to fund these 111 00:11:33.540 --> 00:11:39.700 backup lines and none refused. In short, there never was a chance that payrolls wouldn't 112 00:11:39.700 --> 00:11:46.940 be met. The last $600 billion of CP is where the real crony capitalist stench lies. There 113 00:11:46.940 --> 00:11:53.940 were two huge users of the finance company CP sector this last $600 billion, GMAC and 114 00:11:53.940 --> 00:12:01.020 and GE Capital. At the time of the crisis, GE Capital had asset footings of $600 billion, 115 00:12:01.020 --> 00:12:07.140 most of which were long-term, highly illiquid and sometimes sketchy corporate and commercial 116 00:12:07.140 --> 00:12:14.180 real estate loans. In violation of every rule of sound banking, more than $80 billion of 117 00:12:14.180 --> 00:12:20.300 these positions were funded in the super cheap commercial paper market. This maneuver, of 118 00:12:20.300 --> 00:12:39.300 of course produced fat spreads on GE's loan book and big management bonuses too, but it also raised to a whole new level the ancient banking folly of mismatching short and hot liabilities with long and slow assets. 119 00:12:39.300 --> 00:12:57.300 Under free market rules, an inability to roll $80 billion in CP would have forced GE Capital into a fire sale of illiquid loan assets at deep discounts, thereby incurring heavy losses and a reversal of its prior phony profits. 120 00:12:57.300 --> 00:13:04.420 Funds, or in the alternative, it could have held the loan book and issued massively dilutive 121 00:13:04.420 --> 00:13:11.460 amounts of common stock or subordinated debt to close its sudden funding gap. 122 00:13:11.460 --> 00:13:17.940 Either way, GE shareholders would have taken the beating they deserved for overvaluing 123 00:13:17.940 --> 00:13:24.500 the company's true earnings and for putting reckless managers in charge of the store. 124 00:13:24.500 --> 00:13:29.420 So my point is that the financial meltdown during those eventful weeks was not triggered 125 00:13:29.420 --> 00:13:37.220 by the financial equivalent of a comet from deep space, but resulted from leveraged speculation 126 00:13:37.220 --> 00:13:42.180 that should have been punishable by ordinary market rules. 127 00:13:42.180 --> 00:13:49.260 Viewed very broadly or more broadly, the carnage on Wall Street in September 2008 was the inevitable 128 00:13:49.260 --> 00:13:54.980 financial crash from a 40-year financial bubble spawned by the Fed after Nixon closed the 129 00:13:54.980 --> 00:14:00.980 gold window in August 1971. As time passed, the Fed's market rigging and money printing 130 00:14:00.980 --> 00:14:07.020 actions had become increasingly destructive, leaving the banking system ever more unstable 131 00:14:07.020 --> 00:14:14.620 and populated with a growing bevy of too-big-to-fail institutions. The 1984 rescue of Continental 132 00:14:14.620 --> 00:14:22.620 of Illinois, the 1994 Mexican peso crisis bailouts, the Fed's 1998 life support operation 133 00:14:22.620 --> 00:14:27.980 for long-term capital were all just steps along the way to September 2008. 134 00:14:27.980 --> 00:14:34.320 Then, at that point, faced with the collapse of its own handiwork, Washington panicked 135 00:14:34.320 --> 00:14:41.280 and joined the Fed in unleashing an indiscriminate bailout capitalism that has now thoroughly 136 00:14:41.280 --> 00:14:48.060 really corrupted the halls of government even as it has become a debilitating blight on 137 00:14:48.060 --> 00:14:49.780 the free market. 138 00:14:49.780 --> 00:14:57.080 So in this context, the linkage between printing press money and fiscal profligacy merits special 139 00:14:57.080 --> 00:14:58.620 attention. 140 00:14:58.620 --> 00:15:02.020 Now there are no fiscal rules at all. 141 00:15:02.020 --> 00:15:07.880 And already we have had cash for clunkers, cash for caulkers, and under the homeowners 142 00:15:07.880 --> 00:15:22.880 Cash for Convicts. In any event, my belief is that the subprime meltdown was only a warm-up. 143 00:15:22.880 --> 00:15:28.880 The real financial widow-maker of the present era is likely to be U.S. government debt itself. 144 00:15:28.880 --> 00:15:35.880 The sheer budgetary facts are bracing enough. It needs to be recalled that fiscal year 211, now underway, 145 00:15:35.880 --> 00:15:43.480 will encompass not a recession bottom, but the sixth through the ninth quarter of recovery. 146 00:15:43.480 --> 00:15:48.640 During this interval of purported rebound, however, the White House now projects red 147 00:15:48.640 --> 00:15:52.440 ink of 1.645 trillion. 148 00:15:52.440 --> 00:15:58.120 This means that 43 cents on every dollar will be borrowed, every dollar spent will be borrowed, 149 00:15:58.120 --> 00:16:04.200 thereby generating a financing requirement just shy of 11% of national income. 150 00:16:04.200 --> 00:16:10.720 These elephantine figures mark a big lurch southward since the deficits only half this 151 00:16:10.720 --> 00:16:15.380 size were expected for the current year as recently as last spring. 152 00:16:15.380 --> 00:16:21.600 Notwithstanding, a full year of green shoots and booming stocks, however, Washington embraced 153 00:16:21.600 --> 00:16:26.620 a monumental round of new fiscal stimulus in December, as you all recall. 154 00:16:26.620 --> 00:16:32.060 The result was a trillion-dollar Christmas tree festooned with fiscal largesse for every 155 00:16:32.060 --> 00:16:41.100 Citizen, inclusive of the quick as well as the dead. Moreover, this bounty was extended 156 00:16:41.100 --> 00:16:46.580 without prejudice to each and every social class, with workers, the unemployed, the middle 157 00:16:46.580 --> 00:16:52.140 class, the merely rich, and billionaires, too, getting a share. It would be foolish in 158 00:16:52.140 --> 00:16:58.660 the extreme to dismiss this budgetary eruption as a fit of transient exuberance, even if 159 00:16:58.660 --> 00:17:04.600 If by the President's own admission, the White House was in a shellacked state of mind and 160 00:17:04.600 --> 00:17:09.540 in no position to restrain December's bipartisan stampede. 161 00:17:09.540 --> 00:17:17.100 In fact, the United States is clocking a 10% of GDP deficit for the third year running 162 00:17:17.100 --> 00:17:25.620 because this latest fling of budgetary excess is just another episode in the epochal collapse 163 00:17:25.620 --> 00:17:31.300 of U.S. Financial Discipline that began 40 years ago at Camp David. 164 00:17:31.300 --> 00:17:36.580 That the demise of the gold standard should have been as destructive of fiscal discipline 165 00:17:36.580 --> 00:17:41.900 as it was of monetary probity can hardly be gainset. 166 00:17:41.900 --> 00:17:46.860 Under the ancient regime of fixed exchange rates and currency convertibility, fiscal 167 00:17:46.860 --> 00:17:55.020 deficits without tiers simply were not sustainable no matter what errant economic doctrines lawmakers 168 00:17:55.020 --> 00:18:02.020 got into their heads. Back then, the machinery of honest money could be relied upon to trump 169 00:18:02.020 --> 00:18:08.900 bad policy. Thus, if budget deficits were monetized by the central bank, this weakened the currency 170 00:18:08.900 --> 00:18:15.100 and caused a damaging external drain of monetary reserves. And if the deficits were financed 171 00:18:15.100 --> 00:18:20.660 out of savings, interest rates were pushed up, thereby crowding out private domestic 172 00:18:20.660 --> 00:18:22.820 Investment. 173 00:18:22.820 --> 00:18:28.940 Politicians did not have to be deeply schooled in Bastiat's parable of the seen and the 174 00:18:28.940 --> 00:18:30.380 unseen. 175 00:18:30.380 --> 00:18:37.460 The bitter fruits of chronic deficit finance were all too visible and immediate. 176 00:18:37.460 --> 00:18:41.500 But during the four decades since the gold window was closed, the rules of the fiscal 177 00:18:41.500 --> 00:18:44.100 game had been profoundly altered. 178 00:18:44.100 --> 00:18:50.340 Specifically, under Professor Friedman's contraption of floating paper money, foreigners 179 00:18:50.340 --> 00:18:56.500 Members may accumulate dollar claims or exchange them for other paper money, but there can 180 00:18:56.500 --> 00:19:03.100 never be a drain on U.S. monetary reserves because dollar claims are not convertible. 181 00:19:03.100 --> 00:19:11.060 The infernal engine of the fiat dollar, therefore, has had numerous lamentable consequences, 182 00:19:11.060 --> 00:19:17.620 but among the worst is that it facilitated open-ended monetization of the U.S. government's 183 00:19:17.620 --> 00:19:18.620 debt. 184 00:19:18.620 --> 00:19:25.340 Now, monetization, as I'm sure you all know, can be done in two ways. First, there is outright 185 00:19:25.340 --> 00:19:30.780 monetization, as is now being conducted by the Fed through its POMO program, that is, 186 00:19:30.780 --> 00:19:37.780 its daily purchase of 4 to 8 billion of Treasury debt. Indeed, the Fed's QE2 bond purchases 187 00:19:38.780 --> 00:19:45.780 of late have been so massive that it is literally buying Treasury paper in the secondary market 188 00:19:45.780 --> 00:19:52.740 Market, almost as fast as new bonds are being issued. During January, for example, fully 189 00:19:52.740 --> 00:20:00.020 40% of the Fed's $100 billion bond buy was from QCIP numbers, or that series of bonds, 190 00:20:00.020 --> 00:20:06.740 that were less than 90 days old. Needless to say, putting brand new Treasury bonds in the 191 00:20:06.740 --> 00:20:12.940 Fed's vault before they have paid even a single coupon is functionally equivalent to 192 00:20:12.940 --> 00:20:31.940 and printing greenbacks. After all, under this type of high-speed round trip, virtually all the coupons from newly issued bonds will end up as incremental profit at the Fed and be remitted back to the Treasury at year-end, hence the money never leaves. 193 00:20:31.940 --> 00:20:38.180 Stated differently, in the present era of massive quantitative easing, newly issued treasury 194 00:20:38.180 --> 00:20:44.880 securities amount to non-interest bearing currency without the circulation privilege. 195 00:20:44.880 --> 00:20:50.720 But over the last several decades, the preferred course has been indirect monetization. 196 00:20:50.720 --> 00:20:58.200 That is, the world's legion of willing mercantilist exporters from China to the Persian Gulf have 197 00:20:58.200 --> 00:21:04.800 have printed their own money in vast quantities ostensibly to peg their exchange rates but 198 00:21:04.800 --> 00:21:09.840 with the effect of absorbing trillions of U.S. Treasury paper. 199 00:21:09.840 --> 00:21:16.960 To be sure, the People's Money Warehouse in China and those in other mercantilist lands 200 00:21:16.960 --> 00:21:22.880 are pleased to label these accumulations as sovereign wealth portfolios. 201 00:21:22.880 --> 00:21:30.080 But the fact is these hordes of sequestered dollars are not classic monetary reserves derived 202 00:21:30.080 --> 00:21:34.040 from a true sustainable surplus on current account. 203 00:21:34.040 --> 00:21:39.240 Instead they are simply the book entry offset to the inflated local money supplies that have 204 00:21:39.240 --> 00:21:46.220 been emitted by this global convoy of peggers, that is the mercantilist nation central banks 205 00:21:46.220 --> 00:21:48.680 tethered to the Fed. 206 00:21:48.680 --> 00:21:54.480 That this convoy is a potent mechanism for monetizing the U.S. debt is readily evident 207 00:21:54.480 --> 00:22:00.880 by way of contrast with classic monetary systems anchored on a true reserve asset. 208 00:22:00.880 --> 00:22:07.760 At the peak of its glory, before the guns of August 1914 laid at low, the sterling-based 209 00:22:07.760 --> 00:22:15.000 gold standard operated smoothly with a London gold reserve amounting to 1 to 2% of British 210 00:22:15.000 --> 00:22:16.000 GDP. 211 00:22:16.000 --> 00:22:23.000 Likewise, in 1959, at the peak of Bretton Woods, the U.S. held 20 billion of gold reserves 212 00:22:23.000 --> 00:22:32.080 against GDP of 500 billion. Again, at about 4% of GDP, the hard monetary reserves needed 213 00:22:32.080 --> 00:22:38.600 to operate the system were extremely modest. The reason for parsimonious reserve quantities 214 00:22:38.600 --> 00:22:45.240 under the gold standard was the fact of continuous settlement of trade accounts via the flow 215 00:22:45.240 --> 00:23:12.240 and the outflow of monetary assets. In the case of a balance of payments deficit, for example, the outflow of reserve assets directly and immediately contracted domestic money markets and banking systems, setting in motion an automatic downward adjustment of domestic wages, prices and demand, and encouraging an upward move in exports and domestic production. 216 00:23:12.240 --> 00:23:16.640 In the case of surplus countries, the adjustments were in the opposite direction. 217 00:23:16.640 --> 00:23:22.240 Most importantly, with real economies constantly in adjustment, 218 00:23:22.240 --> 00:23:27.040 central bank balance sheets stayed lean and mean. 219 00:23:27.040 --> 00:23:31.640 By contrast, under the contraption that Professor Friedman inspired, 220 00:23:31.640 --> 00:23:35.040 trade account balances are never settled. 221 00:23:35.040 --> 00:23:38.040 They just grow and grow and grow 222 00:23:38.040 --> 00:23:47.240 until one day they become the object of fruitless jabbering at a photo op society called G20. 223 00:23:47.240 --> 00:23:53.400 In all fairness, Professor Friedman did not envision a world of rampant dirty floating. 224 00:23:53.400 --> 00:24:00.400 Indeed, it would have taken a powerful imagination to foresee four decades ago that China would 225 00:24:00.400 --> 00:24:08.160 would accumulate $3 trillion of foreign currency claims or more than 50% of its GDP and then 226 00:24:08.160 --> 00:24:15.800 insist over a period of years and decades that it did not manipulate its exchange rate. 227 00:24:15.800 --> 00:24:21.420 Still today there can be little doubt that China and other mercantilist exporters operate 228 00:24:21.420 --> 00:24:28.400 massive monetary warehouses where they deposit treasury bonds acquired during their endless 229 00:24:28.400 --> 00:24:34.200 and Business, Dollar Buying Campaigns. Moreover, the U.S. Treasury Department can now stop 230 00:24:34.200 --> 00:24:41.200 splitting hairs about whether China is a reserve, is a currency manipulator because China just 231 00:24:41.200 --> 00:24:47.800 admitted it. Recently, the Vice Chairman of the People's Bank of China, Yi Gang, asked 232 00:24:47.800 --> 00:24:54.800 a good question, why do we have so much base money? He wondered. Said Mr. Yi, answering 233 00:24:54.800 --> 00:25:01.600 in his own question, quote, the central bank buys up foreign exchange inflows. 234 00:25:01.600 --> 00:25:06.840 If it didn't, the yuan wouldn't be so stable. 235 00:25:06.840 --> 00:25:12.880 Nowhere now I would say there's one for the Guinness Book of Understatements if I ever 236 00:25:12.880 --> 00:25:14.720 saw one. 237 00:25:14.720 --> 00:25:21.360 So at the end of the day, American lawmakers have been free to the classic monetary constraints. 238 00:25:21.360 --> 00:25:26.820 There is no monetary squeeze and there is no reserve asset drain. 239 00:25:26.820 --> 00:25:31.820 The Fed always supplies reserves to the banking system to fund any and all private credit 240 00:25:31.820 --> 00:25:36.460 demand at policy rates that are invariably low. 241 00:25:36.460 --> 00:25:43.780 The notion of fiscal quote crowding out thus belongs to the museum of monetary history. 242 00:25:43.780 --> 00:25:48.640 At the same time, the seemingly limitless emission of dollar claims by the U.S. Central 243 00:25:48.640 --> 00:25:54.600 of Central Bank, results not in a contractionary drain of monetary reserves from the domestic 244 00:25:54.600 --> 00:26:05.600 banking system, but in an expansionary accumulation of these claims in the vaults of central banks. 245 00:26:05.600 --> 00:26:13.980 In less polite language, a growing portion of the federal debt has ended up in what amounts 246 00:26:13.980 --> 00:26:20.700 belongs to a global chain of monetary roach motels, places where treasury bonds go in, 247 00:26:20.700 --> 00:26:24.180 but they never come out. 248 00:26:24.180 --> 00:26:33.660 In fact, foreign central banks hold 2.6 trillion of U.S. Treasuries at the New York Fed, while 249 00:26:33.660 --> 00:26:38.300 the Fed itself owns 1.2 trillion of Treasury debt. 250 00:26:38.300 --> 00:26:43.700 Add in at least a half trillion more Treasury paper that is officially held elsewhere, and 251 00:26:43.700 --> 00:26:52.700 You have the startling fact that about $4.5 trillion or 50% of all the publicly held federal 252 00:26:52.700 --> 00:26:58.480 debt ever issued has now been sequestered by central bankers. 253 00:26:58.480 --> 00:27:03.660 With such a mighty bid from the world's central bankers, we have thus experienced what our 254 00:27:03.660 --> 00:27:10.900 classically trained forebearers held to be impossible, a prolonged era of fiscal deficits 255 00:27:10.900 --> 00:27:12.720 without tears. 256 00:27:12.720 --> 00:27:17.280 To be sure, it took American politicians a decade or so to realize that the old rules 257 00:27:17.280 --> 00:27:19.800 were no longer operative. 258 00:27:19.800 --> 00:27:24.280 Helped immeasurably by the collapse of the Soviet war machine, Orthodox Senate Republicans 259 00:27:24.280 --> 00:27:29.480 and Bourbon Democrats achieved for a fleeting moment the appearance of fiscal balance at 260 00:27:29.480 --> 00:27:31.480 the turn of the century. 261 00:27:31.480 --> 00:27:34.880 But it was not long before the cat was out of the bag. 262 00:27:34.880 --> 00:27:39.960 In making the case for the Bush tax cuts of 2001, then Vice President Cheney summed up 263 00:27:39.960 --> 00:27:45.200 But the new reality postulating that, quote, Reagan proved deficits don't matter. 264 00:27:45.200 --> 00:27:50.600 He proved nothing, he proved no such thing, of course, but Republican politicians of the 265 00:27:50.600 --> 00:27:59.440 George W. Bush era had most assuredly discovered that they could borrow with relative impunity. 266 00:27:59.440 --> 00:28:07.360 Soon the GOP transformed the policy-based idea of lower marginal income tax rates from 267 00:28:07.360 --> 00:28:15.360 from the Reagan era into a faith-based religion of tax cutting anywhere, anytime, for any reason. 268 00:28:15.360 --> 00:28:23.360 So intense was the reawakening that the floor of the U.S. House became thronged with fiscal holy rollers, 269 00:28:23.360 --> 00:28:32.360 throbbing and shaking and jerking and gesticulating as they exercised section after section of the revenue code. 270 00:28:32.360 --> 00:28:48.360 By the time Bush and the Congressional Republicans were through in fiscal 2009, the revenue had been reduced to 14.9% of GDP, the lowest level since 1950 and far below the 18.4% level extant when Ronald Reagan left office. 271 00:28:48.360 --> 00:29:01.360 To be sure, lowering the burden of taxation on the American economy is a compelling idea from both a philosophical and an economic policy viewpoint. 272 00:29:01.360 --> 00:29:07.360 But deficit-financed tax cuts are a politician's snare and delusion. 273 00:29:07.360 --> 00:29:14.360 Such fiscal actions do not actually reduce tax payments, they just defer the timing. 274 00:29:14.360 --> 00:29:22.360 Moreover, the evidence of the last 30 years shows that preemptive tax cuts don't actually, quote, starve the beast, 275 00:29:22.360 --> 00:29:29.360 notwithstanding the popularity of this nostrum among certain K Street philosophers 276 00:29:29.360 --> 00:29:34.360 whose day job involves panhandling outside the Ways and Means Committee hearing room. 277 00:29:36.360 --> 00:29:48.360 Indeed, even as the tax-cutting branch of the GOP busied itself giving every organized constituency in America some kind of special break, 278 00:29:48.360 --> 00:29:56.360 including incentives to Iowa pig farmers to distill motor moonshine that they were pleased to call ethanol, 279 00:29:56.360 --> 00:30:03.920 The dual fiscal burden of the American welfare state and warfare state were getting heavier, 280 00:30:03.920 --> 00:30:04.920 not lighter. 281 00:30:04.920 --> 00:30:13.960 Here, the GOP's neocon war department and its domestic porker division were busy too 282 00:30:13.960 --> 00:30:20.320 pushing the federal spending to GDP ratio to record levels. 283 00:30:20.320 --> 00:30:28.320 In this respect, the neocons deserve a special chapter in the annals of fiscal infamy. 284 00:30:28.320 --> 00:30:33.540 Having pushed the American empire to take its stand on real estate of dubious merit 285 00:30:33.540 --> 00:30:39.120 historically, that is, the bloody plains of the Tigris Euphrates and the desolate expanse 286 00:30:39.120 --> 00:30:45.240 of the Hindu Kush, they persisted for the better part of the decade in refusing to finance 287 00:30:45.240 --> 00:30:51.800 with Honest Taxation Wars which they could not win and would not end. 288 00:30:51.800 --> 00:30:58.040 The cumulative tab for Iraq and Afghanistan now stands at $1.26 trillion. 289 00:30:58.040 --> 00:31:07.120 And therein lies a stark tribute to the efficacy with which Professor Friedman's contraption 290 00:31:07.120 --> 00:31:09.420 absorbs the federal debt. 291 00:31:09.420 --> 00:31:15.920 The fact is, America's conservative party, so-called, did not even break a sweat as 292 00:31:15.920 --> 00:31:22.620 it debt-financed what were, surely, two of the most elective foreign policy misadventures 293 00:31:22.620 --> 00:31:24.120 ever undertaken. 294 00:31:24.120 --> 00:31:31.240 Again, the contrast with canons of classical finance helps crystallize the picture. 295 00:31:31.240 --> 00:31:38.160 Writing in 1924, Hartley Withers, eminent editor of The Economist and keeper of Badgett's 296 00:31:38.160 --> 00:31:44.040 and its wisdom on matters of money and central banking lamented that British finances were 297 00:31:44.040 --> 00:31:51.160 in shambles because the government had broken all the rules of proper war finance during 298 00:31:51.160 --> 00:31:53.880 its battle with the Hun. 299 00:31:53.880 --> 00:31:59.520 Rather than obtaining at least 50% of its revenue from current taxation and the balance 300 00:31:59.520 --> 00:32:06.120 from the people's savings at an honest wage for capital, it had resorted to massive inflation 301 00:32:06.120 --> 00:32:13.280 of Bank Credit and issuance of paper money, shin plasters, as they were known then, to 302 00:32:13.280 --> 00:32:15.840 pay his majesty's bills. 303 00:32:15.840 --> 00:32:21.220 Withers took special aim at England's first war chancellor, Lloyd George, thundering as 304 00:32:21.220 --> 00:32:30.600 follows, quote, it is difficult to exaggerate the evil effects of the economic crime that 305 00:32:30.600 --> 00:32:37.040 that he committed when in the spring of 1915 he imposed no taxation whatever to meet the 306 00:32:37.040 --> 00:32:40.400 massive deficit which faced him. 307 00:32:40.400 --> 00:32:47.400 So at the zenith of the monetary golden age, sound opinion held that it was an economic 308 00:32:47.440 --> 00:32:54.440 crime to run the printing presses even when a million enemy soldiers were bivouacked across 309 00:32:54.440 --> 00:33:07.440 Now, a hundred years later, monetizing the expense of pursuing a tall man and a hundred followers lost in the high Himalayas apparently doesn't even rank as a misdemeanor. 310 00:33:07.440 --> 00:33:09.440 That's how far we've come. 311 00:33:09.440 --> 00:33:18.440 It was in the domestic spending arena, however, where the newly liberated Bush Republicans put the pedal to the metal. 312 00:33:18.440 --> 00:33:34.440 During the Reagan era there had been a modicum of progress in throttling the domestic welfare state with domestic spending dropping to 13.4% of GDP after having averaged 15.2% of GDP during the Carter years. 313 00:33:34.440 --> 00:33:47.440 Moreover, after the next decade of divided government in the 90s, the size of the domestic welfare state had drifted upward but only a touch, clocking in at 13.5% of GDP by fiscal year 2000. 314 00:33:47.440 --> 00:33:53.880 2000. The frightening thing about the American fiscal future lays in what happened next with 315 00:33:53.880 --> 00:34:00.320 Republican control of both houses of Congress and the White House for six full years. Now 316 00:34:00.320 --> 00:34:06.120 apologists such as Newt Gingrich had excused Reagan's mega-deficits on the grounds that 317 00:34:06.120 --> 00:34:11.400 conservatives were not obligated to serve as tax collectors for the welfare state. And 318 00:34:11.400 --> 00:34:16.740 fair enough. With divided government during Reagan's entire eight years, the political 319 00:34:16.740 --> 00:34:22.140 Fiscal horsepower simply didn't exist to take on the three core entitlement programs, 320 00:34:22.140 --> 00:34:24.940 Social Security, Medicare and Medicaid. 321 00:34:24.940 --> 00:34:33.720 By fiscal 2000, however, the big three entitlements alone cost $740 billion, or 7.5% of GDP. 322 00:34:33.720 --> 00:34:39.700 The time for fundamental reform was long overdue, but a Republican policy offensive against 323 00:34:39.700 --> 00:34:43.820 the fiscal heartland of the American welfare state never came. 324 00:34:43.820 --> 00:34:49.460 Instead, Medicaid was actually expanded moderately at the behest of Republican governors, Medicare 325 00:34:49.460 --> 00:34:55.340 spending was swollen by a huge new entitlement benefit for prescription drugs courtesy of 326 00:34:55.340 --> 00:35:02.340 Big Pharma, and Social Security rolled along without even a sideways glance from the anti-spenders. 327 00:35:02.340 --> 00:35:13.340 Consequently, outlays for the big three entitlements doubled to $1.425 trillion, or 10.1% of GDP 328 00:35:13.340 --> 00:35:22.340 in Bush's final budget, thus upping the fiscal burden by one-third in only eight years. 329 00:35:22.340 --> 00:35:28.340 But wait, as the late-night commercial admonishes, there's more. 330 00:35:28.340 --> 00:35:36.340 In that most, in that modest 15% corner of the federal budget, known as domestic discretionary spending, 331 00:35:36.340 --> 00:35:40.340 Bush-era Republicans went on a veritable rampage. 332 00:35:40.340 --> 00:35:48.340 Homeland Security spending, for example, soared five-fold from $13 billion in 2000 to $59 billion in 2009. 333 00:35:48.340 --> 00:35:57.340 Likewise, outlays for veterans programs rose from $47 billion in 2000 to nearly $100 billion by 2009. 334 00:35:57.340 --> 00:36:02.340 Next there is the one President Reagan tried to abolish, the Department of Education. 335 00:36:02.340 --> 00:36:09.340 Steaming in the opposite direction, the Bush Republicans doubled it from $33 billion to $66 billion. 336 00:36:09.340 --> 00:36:17.340 While they touted this education spending explosion as evidence of, quote, compassionate conservatism, 337 00:36:17.340 --> 00:36:24.340 the more apt characterization is that once Republicans embraced yet another function for the American welfare state, 338 00:36:24.340 --> 00:36:30.340 they saw to it that no education lobby group would ever be left behind. 339 00:36:30.340 --> 00:36:33.340 That's evident in the numbers. 340 00:36:33.340 --> 00:37:03.340 During the same eight years, housing and community development spending also doubled to $60 billion along with a 75% rise in transportation, a swelling of farm support programs, an enactment of a $60 billion energy bill, providing subsidies for solar, wind, fuel cells, clean coal, fusion, ethanol. The exact menu Republicans once held could best be sorted out by the free market. In all, domestic spending during fiscal 2008 came in at a record 341 00:37:03.340 --> 00:37:10.820 2.3 trillion. After 30 years of a rolling referendum on the welfare state, then the verdict 342 00:37:10.820 --> 00:37:16.540 was clear. Eight years of Republican government had brought the burden of domestic spending 343 00:37:16.540 --> 00:37:23.860 to 15.8% of national income, a figure materially higher than the average during the last period 344 00:37:23.860 --> 00:37:30.060 of unified democratic government under Carter. Thus, while the impact of the Reagan Revolution 345 00:37:30.060 --> 00:37:37.140 on the size of the U.S. government has always been immeasurably modest, it was now totally 346 00:37:37.140 --> 00:37:38.620 erased. 347 00:37:38.620 --> 00:37:44.460 The sorry Republican record on fiscal matters is not merely a morality tale. 348 00:37:44.460 --> 00:37:51.060 When the conservative party and democracy embraces starve the beast on taxing and feed 349 00:37:51.060 --> 00:37:55.880 the beast on spending, then fiscal governance breaks down badly. 350 00:37:55.880 --> 00:38:01.360 You end up with two free lunch parties competing for the affections of the electorate, alternately 351 00:38:01.360 --> 00:38:05.320 depleting the revenue base and then pumping up the spending. 352 00:38:05.320 --> 00:38:08.640 Needless to say, this outcome bespeaks irony. 353 00:38:08.640 --> 00:38:13.560 Milton Friedman was an unrelenting foe of big government and the American welfare state, 354 00:38:13.560 --> 00:38:19.640 yet the global monetary contraption he inspired ensured its perpetuation. 355 00:38:19.640 --> 00:38:24.720 Consider for example how the two-party free lunch competition has perverted the basic 356 00:38:24.720 --> 00:38:30.080 Basic Budgeting Process. Here, the basic tool of long-term fiscal policy, the so-called 357 00:38:30.080 --> 00:38:36.800 10-year budget projection, has been utterly corrupted by the need of both parties to disguise 358 00:38:36.800 --> 00:38:42.760 the full measure of their profligacy. The most recent CBO baseline, for example, shows 359 00:38:42.760 --> 00:38:50.420 the federal deficit declining from 11% of GDP this year to 3% by 2015, a trend which 360 00:38:50.420 --> 00:38:56.700 Looks Like Progress. Unfortunately, this baseline outlook is now useless as it is riddled 361 00:38:56.700 --> 00:39:02.980 with fiscal booby traps, as I call them, in the form of major costly entitlement and tax 362 00:39:02.980 --> 00:39:09.980 law provisions that expire in an arbitrary, cliff-wise fashion one, two or three years 363 00:39:09.980 --> 00:39:15.340 down the road. It is widely known, of course, that the Bush income tax rate cuts expire 364 00:39:15.340 --> 00:39:21.980 expire promptly at midnight on December 31, 2012, causing a $200 billion per year pickup 365 00:39:21.980 --> 00:39:26.780 in the revenue baseline thereafter, at least in the projections. 366 00:39:26.780 --> 00:39:32.720 But what also happens on January 1, 2012, is that the $100 billion abatement of payroll 367 00:39:32.720 --> 00:39:38.280 taxes abruptly expires, and so does the so-called AMT patch. 368 00:39:38.280 --> 00:39:45.200 The latter means that the number of taxpayers facing the alternate minimum tax jumps from 369 00:39:45.200 --> 00:39:51.520 from $4 million to $33 million, causing the projected annual revenue take to rise from 370 00:39:51.520 --> 00:39:57.000 $34 billion under the patch, temporary, to $129 billion permanent. 371 00:39:57.000 --> 00:40:04.400 Likewise, the 15% tax rate in corporate dividends will jump to 40% in 2013, the estate tax goes 372 00:40:04.400 --> 00:40:10.160 back up, all the tax credits that are now in place expire and so forth. 373 00:40:10.160 --> 00:40:16.760 Adding together, the December Christmas tree contained temporary tax provisions worth 3.8% 374 00:40:16.760 --> 00:40:25.760 of GDP, the equivalent of $650 billion annually, that will have completely expired by 2014. 375 00:40:25.760 --> 00:40:32.720 The resulting big uptick in revenue seems antiseptic enough when viewed on the computer 376 00:40:32.720 --> 00:40:33.720 screen. 377 00:40:33.720 --> 00:40:39.840 However, were these provisions to expire in real life, upwards of 100 million different 378 00:40:39.840 --> 00:40:46.200 Taxpayers would take a hit. Consequently, most of these tax breaks won't expire. Their 379 00:40:46.200 --> 00:40:52.200 due date will just be kicked down the road a couple of years as part of the annual quote 380 00:40:52.200 --> 00:40:59.020 rinse and repeat exercise which now passes for budget making. The picture is not much 381 00:40:59.020 --> 00:41:04.100 different on the spending side. Something called the dock fix has been enacted repeatedly, 382 00:41:04.100 --> 00:41:09.380 a measure which temporarily waives the twenty percent drop in Medicare fees billed into 383 00:41:09.380 --> 00:41:15.580 current law. Now upon passage the politicians collect their election year medications from 384 00:41:15.580 --> 00:41:21.180 the grateful physician's lobby while taking credit for a thirty billion future annual 385 00:41:21.180 --> 00:41:28.180 spending reduction when the waiver expires, but of course it won't. Likewise under extended 386 00:41:28.180 --> 00:41:33.860 unemployment benefits ten million workers get various quote extended tiers of the unemployment 387 00:41:33.860 --> 00:41:40.660 Insurance Program at an annual cost of $150 billion, but under current law, nearly two-thirds 388 00:41:40.660 --> 00:41:46.180 of this cost is deemed temporary, meaning that out-year budget projections only show 389 00:41:46.180 --> 00:41:49.100 $50 billion of annual expense. 390 00:41:49.100 --> 00:41:55.140 The reality, however, is that to avoid a cold turkey shock, Congress has repeatedly voted 391 00:41:55.140 --> 00:42:01.200 extensions at the eleventh hour and will again in 2012. 392 00:42:01.200 --> 00:42:06.020 Going forward, there can be little doubt that the GOP is determined to forestall nearly 393 00:42:06.020 --> 00:42:12.060 all of the tax law expirations currently scheduled, including the rate cuts, capital gains, estate 394 00:42:12.060 --> 00:42:14.820 tax, dividends, business credits, and so forth. 395 00:42:14.820 --> 00:42:22.200 This means that baseline revenue is only about 16 to 17 percent of GDP according to current 396 00:42:22.200 --> 00:42:24.560 Republican policy doctrine. 397 00:42:24.560 --> 00:42:30.240 At the same time, when you remove the spending expiration booby traps, it appears that current 398 00:42:30.240 --> 00:42:39.240 The current policy for outlays is advocated by the Democrats, and most of the Republicans too, is about 24% of GDP. 399 00:42:39.240 --> 00:42:50.240 So if you go by the math of it, the current bipartisan policy path results in a permanent fiscal deficit of 7 to 8% of GDP. 400 00:42:50.240 --> 00:42:55.320 That would amount to about $7 trillion in new bond issuance over the next five years 401 00:42:55.320 --> 00:43:01.280 alone and take the total public debt in the United States to over 100% of GDP. 402 00:43:01.280 --> 00:43:07.400 There is no telling, of course, as to how much more of Uncle Sam's debt the monetary 403 00:43:07.400 --> 00:43:11.560 roach motels of the world can ultimately absorb. 404 00:43:11.560 --> 00:43:17.040 But since American politicians no longer fear deficits because they have been successfully 405 00:43:17.040 --> 00:43:29.920 There is one powerful factor, however, suggesting that the man with his the end is near sign 406 00:43:29.920 --> 00:43:32.520 may show up any day now. 407 00:43:32.520 --> 00:43:38.660 Specifically, the aforementioned 1.5 trillion per year of current policy deficits, as far 408 00:43:38.660 --> 00:43:46.300 as the eye can see, assumes that we are having a Keynesian moment, not an Austrian one. 409 00:43:46.300 --> 00:43:51.540 The new White House budget, for example, postulates that the Keynesian medication has worked like 410 00:43:51.540 --> 00:43:52.540 a charm. 411 00:43:52.540 --> 00:43:58.060 Thus, there will be no recession for the next 10 years, although we have averaged one every 412 00:43:58.060 --> 00:44:01.140 4.3 years since 1947. 413 00:44:01.140 --> 00:44:06.860 It also assumes that real GDP growth will average 3.2% over the next decade or double 414 00:44:06.860 --> 00:44:10.220 the 1.7% average during the past decade. 415 00:44:10.220 --> 00:44:15.060 Finally, it projects the U.S. economy will generate 20 million new jobs during the coming 416 00:44:15.060 --> 00:44:21.540 Decade compared to only 1.7 million during the last 10 years. 417 00:44:21.540 --> 00:44:28.580 As the man with the sign also said, good luck with that. 418 00:44:28.580 --> 00:44:34.940 In any event, the already baleful deficit projections would grow by trillions more under 419 00:44:34.940 --> 00:44:37.700 plausible economic assumptions. 420 00:44:37.700 --> 00:44:42.980 But the more crucial point is that the dead hand of Richard Nixon keeps showing up on 421 00:44:42.980 --> 00:44:49.980 on the Fiscal Playing Field. Echoing Tricky Dick, today's GOP has once again embraced 422 00:44:49.980 --> 00:44:56.980 the Keynesian faith, even if it has been robed in the ideological vestments of the prosperous 423 00:44:57.020 --> 00:45:04.020 classes, that is, in a preference to ameliorate cyclical weakness with tax cut stimulants 424 00:45:05.900 --> 00:45:11.740 rather than spending sprees. But notwithstanding choice of stimulants, Republicans too believe 425 00:45:11.740 --> 00:45:17.460 believe that the U.S. economy is in a conventional business cycle, and that the rebound remains 426 00:45:17.460 --> 00:45:25.060 much too fragile to tolerate any jarring fiscal actions. Thus, the renaissance Keynesian consensus 427 00:45:25.060 --> 00:45:31.760 will result in kicking the fiscal can down the road again, again, and again. It is here 428 00:45:31.760 --> 00:45:39.260 that the true fiscal nightmare arises, owing to the possibility that this mainstream outlook 429 00:45:39.260 --> 00:45:45.860 is completely erroneous, and that the nation's deep economic ills are rooted in the massive 430 00:45:45.860 --> 00:45:53.660 excess debt burden accumulated on the U.S. balance sheet after 1971. In that event, we 431 00:45:53.660 --> 00:46:00.620 would be in the midst of an Austrian debt deflation, not a Keynesian cyclical rebound. 432 00:46:00.620 --> 00:46:06.500 From a fiscal perspective, a prolonged debt deflation would be the coup de grace. That's 433 00:46:06.500 --> 00:46:13.300 That's because debt deflation crush nominal GDP growth owing to the evaporation of credit-fueled 434 00:46:13.300 --> 00:46:15.140 additions to spending. 435 00:46:15.140 --> 00:46:21.940 In turn, lower nominal GDP growth is bad news for revenues because what we tax, obviously, 436 00:46:21.940 --> 00:46:23.380 is money incomes. 437 00:46:23.380 --> 00:46:29.700 Moreover, the actual GDP data suggests that debt deflation is already resident in the 438 00:46:29.700 --> 00:46:30.780 numbers. 439 00:46:30.780 --> 00:46:36.700 Total U.S. credit market debt essentially stopped growing in late 2007 at a level slightly 440 00:46:36.700 --> 00:46:42.420 above $50 trillion compared to $14.3 trillion of GDP. 441 00:46:42.420 --> 00:46:49.020 During the three years since late 2007, total debt growth has been a tepid 1.5 percent annual 442 00:46:49.020 --> 00:46:53.740 rate with public debt growing much faster than this and financial and household sector 443 00:46:53.740 --> 00:46:56.740 liabilities actually shrinking. 444 00:46:56.740 --> 00:47:05.380 Not surprisingly, nominal or money GDP growth has gained only $530 billion during the 36 445 00:47:05.380 --> 00:47:13.180 months since the peak, meaning that the annualized growth rate has only been 1.2%. There is no 446 00:47:13.180 --> 00:47:19.940 three year streak that anemic anywhere in the data since the 1930s. Moreover, even if 447 00:47:19.940 --> 00:47:27.320 If you allow for the alleged rebound since June 2009, the rate of money GDP growth has 448 00:47:27.320 --> 00:47:34.100 been only 3.8% and was actually just 3.2% in the most recent quarter. 449 00:47:34.100 --> 00:47:40.740 By contrast, the new White House budget projects money GDP growth of 5.6% per annum over the 450 00:47:40.740 --> 00:47:48.620 next five years, meaning that nominal GDP would reach 20 trillion by that latter date. 451 00:47:48.620 --> 00:47:54.740 At a 3.5% lower rate, however, which has tripled the growth rate of the last three years and 452 00:47:54.740 --> 00:48:02.300 in line with the post-June 2009 rate of advance, money GDP would come in at only $18 trillion 453 00:48:02.300 --> 00:48:04.660 by 2016. 454 00:48:04.660 --> 00:48:10.140 Now this $2 trillion variance might be written off to wild blue speculation. 455 00:48:10.140 --> 00:48:15.740 Then again, at the current marginal federal tax yield, the implied revenue shortfall of 456 00:48:15.740 --> 00:48:35.140 The Infernal Engine of the Dollar may thus have been doubly diabolical on the fiscal 457 00:48:35.140 --> 00:48:36.140 front. 458 00:48:36.140 --> 00:48:42.780 First, it hooked the American political system on the Deficits Don't Matter Theorem by eliminating 459 00:48:42.780 --> 00:48:50.040 between the economically painful squeezes and drains on the monetary system that traditionally 460 00:48:50.040 --> 00:48:56.620 accompanied fiscal deficits. Secondly, to the extent that it fueled a debt super cycle that 461 00:48:56.620 --> 00:49:04.820 swelled from 1980 until 2008, it generated a false prosperity and a bubble-derived fiscal 462 00:49:04.820 --> 00:49:12.260 windfalls that have now evaporated. Shortly after Nixon closed the gold window in August 463 00:49:12.260 --> 00:49:21.840 In 1971, Secretary Connolly, many of you recall him, famously told an assemblage of foreign 464 00:49:21.840 --> 00:49:32.580 central bankers that, quote, the dollar is our currency, but it's your problem. 465 00:49:32.580 --> 00:49:40.000 Of course, the esteemed secretary had studied at the Wright-Patman School of Texas Finance, 466 00:49:40.000 --> 00:49:42.960 of course, and not the University of Chicago. 467 00:49:42.960 --> 00:49:51.080 But he nevertheless shared Professor Friedman's assurance that floating the dollar would eliminate 468 00:49:51.080 --> 00:49:57.460 the nettlesome problem of the U.S. current account deficit, that is, such trade adjustments 469 00:49:57.460 --> 00:50:05.240 as might be needed would be done by non-dollar speakers in the global economy. 470 00:50:05.240 --> 00:50:11.320 Spree now says otherwise and resoundingly so. Indeed, once relieved of the immediate pain 471 00:50:11.320 --> 00:50:17.560 of self-correcting contractionary drains on our domestic money markets and banking systems, 472 00:50:17.560 --> 00:50:25.600 the U.S. was free to go on a monumental borrowing spree denominated in the world's reserve currency. 473 00:50:25.600 --> 00:50:32.880 At the same time, there emerged up and down the East Asian main rulers enamored with a 474 00:50:32.880 --> 00:50:39.560 a development model amounting to export mercantilism. This scheme produced a plenitude of factory 475 00:50:39.560 --> 00:50:47.520 jobs and social quietude internally while generating massive external surpluses that 476 00:50:47.520 --> 00:50:55.000 could be recycled into vendor financing for ever-expanding export volumes. The resulting 477 00:50:55.000 --> 00:51:02.400 mutant symbiosis between the American economy and the East Asian mercantilist exporters 478 00:51:02.400 --> 00:51:07.280 spawned a long-term outcome that Milton Friedman held to be impossible 479 00:51:07.280 --> 00:51:13.160 under floating exchange rates. Namely, 33 consecutive years 480 00:51:13.160 --> 00:51:17.960 of deep current account deficits at three to five percent of GDP, 481 00:51:17.960 --> 00:51:21.320 external deficits which now have cumulated 482 00:51:21.320 --> 00:51:26.360 to more than seven trillion dollars since the late 1970s. 483 00:51:26.360 --> 00:51:30.080 Now the fly in the theoretical ointment, of course, is that by pegging their 484 00:51:30.080 --> 00:51:31.320 currencies 485 00:51:31.320 --> 00:51:37.320 The East Asian exporters and Persian Gulf oilies have permanently forestalled balancing their 486 00:51:37.320 --> 00:51:44.000 external accounts by accepting cheaper and cheaper dollars as prescribed by Texas-style 487 00:51:44.000 --> 00:51:45.240 monetarism. 488 00:51:45.240 --> 00:51:51.560 Thereby retaining their export surpluses, the mercantilist exporters have accumulated 489 00:51:51.560 --> 00:51:54.120 treasury bonds from the backhaul. 490 00:51:54.120 --> 00:51:59.840 Accordingly, the nine trillion of current global forex reserves, mostly held by the 491 00:51:59.840 --> 00:52:05.680 and the aforementioned peggers are not monetary reserves in any meaningful sense. 492 00:52:05.680 --> 00:52:11.200 They are effectively vendor-financed export loans, and they are what make the present 493 00:52:11.200 --> 00:52:13.560 economic world go round. 494 00:52:13.560 --> 00:52:18.240 They are also what made the U.S. balance sheet go parabolic. 495 00:52:18.240 --> 00:52:26.840 For a century after the resumption of convertibility in 1879, the ratio of total U.S. debt, both 496 00:52:26.840 --> 00:52:32.720 private and public to national income was remarkably stable despite cycles of 497 00:52:32.720 --> 00:52:38.360 war and peace and boom and bust this national leverage ratio oscillated 498 00:52:38.360 --> 00:52:46.200 closely about around 1.6 times call this remarkably stable ratio of total debt to 499 00:52:46.200 --> 00:52:52.360 national income the golden constant note further that after the events of August 500 00:52:52.360 --> 00:53:02.960 Since 1971, this heretofore stable national leverage ratio broke out to the upside and 501 00:53:02.960 --> 00:53:04.640 never looked back. 502 00:53:04.640 --> 00:53:11.960 By the middle 1990s, it had reached 2.6 times and then soared to 3.6 times national income 503 00:53:11.960 --> 00:53:15.120 by 2007, where it remains. 504 00:53:15.120 --> 00:53:22.200 Stated differently, we have added two full terms of debt on the national income since 505 00:53:22.200 --> 00:53:28.240 1980, an outcome which amounts to a nationwide LBO. 506 00:53:28.240 --> 00:53:34.320 Now the volume of incremental debt now being lugged about by the national economy owing 507 00:53:34.320 --> 00:53:37.480 to this debt spree is startling. 508 00:53:37.480 --> 00:53:44.520 In round dollar terms, total credit market debt would currently be 22 billion under the 509 00:53:44.520 --> 00:53:50.280 golden constant, i.e. 1.6 times 14.5 trillion of GDP. 510 00:53:50.280 --> 00:53:55.880 But today it is actually 52 trillion, or 3.6 times. 511 00:53:55.880 --> 00:54:02.720 Now Wall Street bulls and Keynesian economists, to indulge in a redundancy, insist that this 512 00:54:02.720 --> 00:54:07.000 extra 30 billion of debt is no sweat. 513 00:54:07.000 --> 00:54:13.100 Presumably they would otherwise not be forecasting 10 years of standard growth with no recession 514 00:54:13.100 --> 00:54:19.320 and would not be capitalizing corporate earnings at the conventional 15 times EPS. 515 00:54:19.320 --> 00:54:26.080 Put another way, by the lights of mainstream opinion, our parabolic departure from the golden 516 00:54:26.080 --> 00:54:35.960 constant of leverage apparently represents nothing more than a late blooming enlightenment, 517 00:54:35.960 --> 00:54:42.560 the shedding of ancient superstitions about the perils of too much debt in households, 518 00:54:42.560 --> 00:54:44.200 businesses and government. 519 00:54:44.200 --> 00:54:47.320 If this were true, it would be a pity. 520 00:54:47.320 --> 00:54:53.000 Had our benighted financial forbearers only known better, they would have levered up the 521 00:54:53.000 --> 00:55:00.040 U.S. economy long ago, producing unimagined surges of growth and wealth. 522 00:55:00.040 --> 00:55:06.640 Indeed, economic miracles like the Internet might have been generated at a far earlier 523 00:55:06.640 --> 00:55:10.720 time, say in 1950, not 1990. 524 00:55:10.720 --> 00:55:15.480 And it might have been invented by Senator Albert Gore Sr. of Tennessee, rather than 525 00:55:15.480 --> 00:55:28.360 The alternative possibility, however, is that our financial forebears actually knew a thing 526 00:55:28.360 --> 00:55:34.000 or two about finance. Perhaps they understood that in not settling our accounts with the 527 00:55:34.000 --> 00:55:41.640 world, we were merely borrowing GDP, not growing it. The numbers, in fact, suggest exactly 528 00:55:41.640 --> 00:55:48.640 During the era of the Golden Constant, about $1.50 a debt growth accompanied each dollar of GDP growth. 529 00:55:48.640 --> 00:55:57.640 By 1989, each dollar of GDP growth took $2.50 of debt increase, and by 1999, the ratio rose to $3.30. 530 00:55:57.640 --> 00:56:03.640 After this, it was off to the races. When the debt super-cycle Apogee came in 2007, 531 00:56:03.640 --> 00:56:11.300 In 2007, it took $4 trillion of debt growth that year alone to produce just $700 billion 532 00:56:11.300 --> 00:56:13.540 of incremental GDP. 533 00:56:13.540 --> 00:56:22.620 At that point, the debt-to-income growth ratio had climbed to six times. 534 00:56:22.620 --> 00:56:29.620 And shortly thereafter, the man from Citigroup finally stopped dancing, as you all remember. 535 00:56:29.620 --> 00:56:35.080 The evaporation of artificially inflated income growth and the bursting of the asset bubbles 536 00:56:35.080 --> 00:56:41.020 which inexorably followed this kind of debt super cycle have arrived at their appointed 537 00:56:41.020 --> 00:56:42.020 time. 538 00:56:42.020 --> 00:56:48.000 And the financial condition of the household sector suggests that the postulated Austrian 539 00:56:48.000 --> 00:56:54.680 moment may have a hang time measured in years or even a decade, not months or a quarter. 540 00:56:54.680 --> 00:56:59.640 First, the adjustment in household balance sheets to date has been in the marking down 541 00:56:59.640 --> 00:57:04.720 of housing assets, not any material shrinkage of debt outstanding. 542 00:57:04.720 --> 00:57:11.800 Specifically, household net worth has dropped by $9 trillion, or about 14% since the final 543 00:57:11.800 --> 00:57:13.480 quarter of 2007. 544 00:57:13.480 --> 00:57:20.480 However, only $380 billion, or 4% of this decline, is attributable to reduced debt. 545 00:57:20.480 --> 00:57:23.960 The rest is owing to shrinking asset values. 546 00:57:23.960 --> 00:57:28.520 So by the lights of the golden constant, we still have a long way to go. 547 00:57:28.520 --> 00:57:34.540 Indeed, back in 1975, when America's baby boomers were still young, total household 548 00:57:34.540 --> 00:57:42.320 debt, including mortgages, car loans, credit cards, and bingo wagers, were $730 billion, 549 00:57:42.320 --> 00:57:45.600 or about 45% of GDP. 550 00:57:45.600 --> 00:57:53.500 But today, the far older baby boom-led household sector now has shed almost no pounds since 551 00:57:53.500 --> 00:58:01.100 Since the crisis of 2008, total household sector debt outstanding is still $13.4 trillion, 552 00:58:01.100 --> 00:58:05.020 or 91% of GDP, double where we started. 553 00:58:05.020 --> 00:58:10.380 It is always possible, of course, that the 78 million baby boomers now marching straight 554 00:58:10.380 --> 00:58:15.320 away into retirement will hit the credit juice one more time. 555 00:58:15.320 --> 00:58:22.140 But the only household debt still growing is on the other end of the demographic curve. 556 00:58:22.140 --> 00:58:29.100 All student loans outstanding, subprime credits by definition, now total one trillion and 557 00:58:29.100 --> 00:58:33.100 exceed all of the nation's outstanding credit card debt. 558 00:58:33.100 --> 00:58:37.740 We've seen this movie before and it doesn't end happily. 559 00:58:37.740 --> 00:58:44.340 If in the future households have to earn, not borrow, what they spend, that 3.5% assumption 560 00:58:44.340 --> 00:58:49.540 about money GDP growth might look a lot more plausible. 561 00:58:49.540 --> 00:58:54.540 The fact is, organic income is not growing at even 3%. 562 00:58:54.540 --> 00:59:01.200 A shocking point buried in the statistics of our government-medicated recovery is that 563 00:59:01.200 --> 00:59:10.500 since the Q3-208 meltdown, personal consumption spending is up by $400 billion or nearly 4%. 564 00:59:10.500 --> 00:59:18.900 But private wages and salaries are still $100 billion or 2% below where they were before 565 00:59:18.900 --> 00:59:24.540 The Plunge. Again, these figures are nominal, not deflated dollars. Looking at the data 566 00:59:24.540 --> 00:59:31.700 since 1950, you can't find a period in which private money wages were down for even three 567 00:59:31.700 --> 00:59:37.420 months, let alone nearly two and a half years. Consequently, we have been able to keep up 568 00:59:37.420 --> 00:59:43.940 the appearance of consumption spending growth, even if tepid, only by resort to Uncle Sam's 569 00:59:43.940 --> 00:59:50.780 Times credit card. Specifically, the gap between wages, which are still down and spending, 570 00:59:50.780 --> 00:59:55.900 which is up, has been filled by government transfer payments, all of which were funded 571 00:59:55.900 --> 01:00:02.220 on the margin with new borrowings. Transfer payments have risen by nearly $500 billion 572 01:00:02.220 --> 01:00:10.180 from the Q3-208 rate. Thus, the Fed and its global convoy of monetary roach motels have 573 01:00:10.180 --> 01:00:16.100 have been the source of the entire intervening gain in U.S. personal consumption expenditures 574 01:00:16.100 --> 01:00:17.820 and then some. 575 01:00:17.820 --> 01:00:24.140 When all else fails, of course, the possibility remains that a rebound of job growth could 576 01:00:24.140 --> 01:00:31.220 revive wage and salary incomes and get the GDP juices flowing again at more normal rates, 577 01:00:31.220 --> 01:00:36.340 rates compatible with a Keynesian recovery rather than an Austrian deflation. 578 01:00:36.340 --> 01:00:41.580 Well, as the man also said, good luck with that one too. 579 01:00:41.580 --> 01:00:50.580 The January non-farm payroll number was 130.5 million, a figure first reached in November 580 01:00:50.580 --> 01:00:54.580 1999, 12 years ago. 581 01:00:54.580 --> 01:00:58.060 And that is the encouraging part of the story. 582 01:00:58.060 --> 01:01:04.800 Way back then there were 72 million, quote, I call them breadwinner jobs in the U.S. economy, 583 01:01:04.800 --> 01:01:09.600 That is jobs in manufacturing, construction, distribution, finance insurance, real estate, 584 01:01:09.600 --> 01:01:14.080 information technology, the professions and white collar services. 585 01:01:14.080 --> 01:01:18.280 Average pay levels were $50,000 per year in today's dollars. 586 01:01:18.280 --> 01:01:25.080 A decade later, in February 2011, there were only 65 million of these same breadwinner 587 01:01:25.080 --> 01:01:29.400 jobs left in the economy, 10% less. 588 01:01:29.400 --> 01:01:37.360 To be sure, this large drain was offset by a 6 million job gain over the decade in what 589 01:01:37.360 --> 01:01:42.000 I call the HES complex, Health Education and Social Services. 590 01:01:42.000 --> 01:01:49.360 But the 30 million total jobs in the HES complex have much lower average pay at about $35,000 591 01:01:49.360 --> 01:01:55.000 per year, so we were trading down, and their funding is almost entirely derived from the 592 01:01:55.000 --> 01:01:57.880 public purse, which is broke. 593 01:01:57.880 --> 01:02:04.180 Consequently, the era of robust job growth in the HES complex is nearly over. 594 01:02:04.180 --> 01:02:11.180 After experiencing job gains averaging $50,000 per month in health, education, social services 595 01:02:11.180 --> 01:02:18.300 during all of 2000-2007, the rate has now dropped to less than $20,000 per month as 596 01:02:18.300 --> 01:02:21.220 the fiscal noose has tightened. 597 01:02:21.220 --> 01:02:24.540 That leaves what might be termed the part-time economy. 598 01:02:24.540 --> 01:02:32.020 35 million jobs in retail, bars, restaurants, hotels, personal services and temp agencies. 599 01:02:32.020 --> 01:02:36.940 The average wage in this segment is just $19,000 per year. 600 01:02:36.940 --> 01:02:42.500 Thus, from the point of view of economic throw weight, not so much. 601 01:02:42.500 --> 01:02:48.620 Other than providing intermittent spells of gainful employment for bellboys and barhops, 602 01:02:48.620 --> 01:02:55.620 This segment supports no families and funds no savings, even if it does give Wall Street 603 01:02:55.620 --> 01:02:58.660 economists something to count. 604 01:02:58.660 --> 01:03:05.740 None of this bodes well for a spirited Keynesian recovery or even a toothless one. 605 01:03:05.740 --> 01:03:12.940 Accordingly, the U.S. economy is likely stuck in an extended Austrian moment, and the U.S. 606 01:03:12.940 --> 01:03:20.620 deficit is likely beached in the 1.5 to 2 trillion annual range as far as the eye can see. 607 01:03:20.620 --> 01:03:26.780 When it soon becomes evident that most of the 60 billion of appropriations so noisily 608 01:03:26.780 --> 01:03:33.500 cut by the House Republicans is mainly smoke and mirrors and a fiscal rounding error to boot, 609 01:03:33.500 --> 01:03:40.060 the test of Professor Friedman's floating rate fiat money contraption may finally come. 610 01:03:40.060 --> 01:03:46.300 Maybe there is room for trillions more of government bonds to be absorbed by the mighty bid of the Fed 611 01:03:46.300 --> 01:03:49.580 and its chain of monetary roach motels. 612 01:03:49.580 --> 01:03:57.420 But looking back to 1971, it seems possible that even the ever-visionary Richard Nixon 613 01:03:57.420 --> 01:04:03.740 did not then realize the ultimate consequence of closing the gold window 614 01:04:03.740 --> 01:04:08.220 and opening the door to China in such close couple. 615 01:04:08.220 --> 01:04:33.020 At that moment, the China rural economy, the only one it ever had, was prostrate under the weight of 45 million dead from starvation and far more debilitated and destitute owing to the great helmsman's economic follies. 616 01:04:33.020 --> 01:04:41.300 By underwriting a 40-year debt super-cycle, however, the newly unshackled Fed fueled unstinting 617 01:04:41.300 --> 01:04:48.400 American demand for the output of East China's rapidly expanding export factories. 618 01:04:48.400 --> 01:04:55.500 In so doing, it also drained China's stricken rice paddies of their nimble young fingers 619 01:04:55.500 --> 01:05:22.900 In this context, a clue to the next phase of this saga may lie in the contrafactual. 620 01:05:22.900 --> 01:05:31.380 Had Nixon kept the gold window open, China would have accumulated bullion, not bonds. 621 01:05:31.380 --> 01:05:38.260 America would have experienced deflationary austerity, not inflationary bubbles. 622 01:05:38.260 --> 01:05:42.900 And federal deficits, fiscal deficits, would have mattered a lot. 623 01:05:42.900 --> 01:05:49.940 Thus, today's terminally imbalanced world has evolved at complete variance with the 624 01:05:49.940 --> 01:05:55.980 The outcome that could have been expected under a regime of sound money. 625 01:05:55.980 --> 01:06:03.220 The risk is that the doomsday system for global money and trade, which has metastasized since 626 01:06:03.220 --> 01:06:08.560 1971, may be approaching its end game. 627 01:06:08.560 --> 01:06:15.300 By all appearances, Mao's great rural swamp has now pretty much been drained. 628 01:06:15.300 --> 01:06:21.140 Global wages will therefore start rising because even Walmart has not been able to discover 629 01:06:21.140 --> 01:06:27.360 another country inhabited by millions of $1 per day workers. 630 01:06:27.360 --> 01:06:33.280 In that environment, the people's printing press in China will have to drastically slow 631 01:06:33.280 --> 01:06:40.340 its creation of RMB and therefore its capacity to absorb Treasury bonds. 632 01:06:40.340 --> 01:06:46.860 This fellow traveling central banks throughout its feeder system of mercantilist exporters 633 01:06:46.860 --> 01:06:49.660 will likely follow its lead. 634 01:06:49.660 --> 01:06:54.440 At that point, the Fed will be the last bid standing. 635 01:06:54.440 --> 01:07:01.500 But if it keeps buying bonds, Mr. Market may be inclined to sell dollars with prejudice, 636 01:07:01.500 --> 01:07:03.200 if not violence. 637 01:07:03.200 --> 01:07:11.020 If it stops buying the bond, at what price can trillions more of federal debt find a 638 01:07:11.020 --> 01:07:20.020 place in real risk-based private portfolios? Either way, it will be a grand experiment. 639 01:07:20.020 --> 01:07:25.660 But as they say on television, it's definitely not something that should be tried at home. 640 01:07:26.660 --> 01:07:28.660 Thank you very much.