The Great Deformation Read online

  Episodes of abrupt decline in the stock market averages and other financial asset prices were therefore distinctly unwelcome because they threatened to undermine the “wealth effect” that was implicit in the Fed’s new modus operandi. So an embrace of “Too Big to Fail” steadily crept into the Fed’s prosperity agenda. It was made official by Greenspan’s panicked interest rate cutting and arrangement for a Wall Street subscribed bailout of a reckless gambling hall called Long-Term Capital Management (LTCM) during the minor financial turbulence triggered by the Russian default in August 1998.

  Then and there, the “Greenspan Put” was confirmed; that is, the Fed would now pleasure Wall Street with unlimited liquidity and other interventions in order to prop up the stock market averages in the event of a deep sell-off. The road to the Wall Street meltdown of September 2008 was now guaranteed. The only question was when it would occur and what lesser bubbles and busts would occur in the interim.

  After the September 1998 LTCM intervention, the insidious idea of shielding financial markets from alleged “systemic risk” contagions became an open objective of monetary policy. Yet this promise of a financial safety net under the market was ultimately self-defeating: it functioned to vastly embolden Wall Street speculators and leverage artists, meaning that the amplitude of financial bubbles and busts would now be all the greater. It also meant that if the Greenspan Put were exercised, financial losses owing to bailouts would inevitably be socialized, thereby putting the innocent American public squarely, albeit involuntarily, in harm’s way.

  THE FED’S HORRID BAILOUT OF LTCM

  The Fed’s horridly indefensible rescue of Long-Term Capital Management became the paradigm for what has become a permanent régime of bailouts and central bank rigging of the nation’s money and capital markets. To be sure, unwise financial market interventions by Washington had ample precedent, reaching back to the rescue of the money-center banks during the 1994 Mexican peso crisis, the 1984 takeover of Continental Illinois Bank, the 1979 (first) bailout of Chrysler, and the early 1970s bailouts of Franklin National Bank, Penn Central, and Lockheed, among others.

  But at least these had been long-standing national institutions with tens of thousands of employees. By contrast, LTCM was a Greenwich-based financial gambling shop that had been in existence less than four years, had a few hundred employees, and supplied nothing useful to the economy except easily replicable trading services. Its Fed-arranged bailout thus had an insidious implication: if in its wisdom the Fed determined that systemwide financial stability was imperiled, then the merits of the firm being rescued were irrelevant—no matter how odious its behavior might have been.

  Long-Term Capital Management, in fact, was an egregious financial train wreck that had amassed leverage ratios of 30 to 1 in order to fund giant speculative bets in currency, equity, bond, and derivatives markets around the globe. The sheer recklessness and scale of LTCM’s speculations had no parallel in American financial history, easily dwarfing the worst financial pyramids and gambling schemes erected before the 1929 crash by the likes of Samuel Insull, Goldman Sachs, and the American Founders Group, among many notorious others. In short, LTCM stunk to high heaven, and had absolutely no claim on public authority, resources, or even sympathy.

  Its tower of leveraged speculation had been enabled by Wall Street’s premier financial institutions through massive credit extensions—more than $100 billion. Through every available channel, including prime brokerage, repo desks, and over-the-counter swaps, Wall Street had raced to pump more debt into LTCM’s incomprehensible trades. Given those frightful facts, any central bank worth its salt (say, one run by a Paul Volcker) would have permitted, even encouraged, LTCM to undergo a swift and harsh demise.

  In pursuit of its prosperity agenda, however, the Greenspan Fed had fallen prey to the spurious doctrine that bull market speculation was evidence of general economic health. Indeed, by keeping the stock indices high and climbing, the Fed presumed it could ensure robust and unending GDP growth, a complete reversal of earlier central banking traditions that worried about “irrational exuberance” on the stock exchanges and embraced the need to timely remove the “punch bowl” before speculation got out of hand.

  In a sharp rebuke to the Fed’s initial 1990s exercise in bubble finance, the turmoil triggered in global financial markets by the Russian default in August 1998 took the stock averages down by nearly 20 percent in a matter of weeks. While this unexpected market swoon put LTCM and legions of lesser speculators on the ropes, such jarring corrections had previously been largely accepted as a necessary and natural check on greed, debt, and delusion in the financial markets.

  In its recently acquired and purportedly superior wisdom, however, the Greenspan Fed nullified this 1998 market correction entirely by a burst of money printing and a sharp reduction in interest rates, in the context of a perfectly healthy and expanding economy (see chapter 15). When this dramatic but artificial easing of money market conditions was coupled with the $3 billion collection from Wall Street dealers arranged by the New York Fed for LTCM, it became quickly evident that the “bottom” was in and that henceforth speculators would be riding a one-way escalator ever higher.

  During the next fifteen months, the S&P 500 soared by 50 percent, but not because the profit outlook for American companies had suddenly improved by half. Rather, Wall Street had come to believe that investment errors would no longer be punished and that the risk of loss and the interest expense of carrying leveraged trading positions had been dramatically reduced.

  Accordingly, valuation multiples on stocks and other equities rose sharply, meaning that the same earnings were now worth a lot more. In fact, just before the dot-com bubble finally broke, the multiple on the NASDAQ had reached 100 times earnings, a level which was nearly sixfold greater than average historical valuations. These nearly lunatic stock prices reflected Wall Street’s growing confidence that it had a “friend at the Fed” which could be relied upon to choke off any unwelcome downdraft in asset prices.

  This financial safety net became known as the “Greenspan Put,” and according to Wall Street’s pitchmen it tilted the stock market toward much reward and little risk. Yet the frothy bull market which it engendered did not evidence a new era of vibrant capitalist prosperity, even if the fawning financial press endlessly proclaimed it. What had arisen, instead, was an ersatz capitalism, a financial régime in which the stock market averages reflect expected monetary juice from the central bank, not anticipated growth of profits from free market enterprises.

  Worse still, by ingratiating itself to Wall Street in this manner, the Fed had broadcast an unmistakable message: namely, that there was no imaginable limit to the amount of speculative excess and reckless leverage it would tolerate and backstop if necessary. There was no other plausible inference. The financial recklessness which had been embodied in LTCM was without peer.

  A few months later the dot-com bubble reached a fevered top in March 2000—the index for such issues having risen by 900 percent in a mere half decade. Even the Greenspan Put could not sustain the sheer madness that gripped large precincts of the NASDAQ at its parlous peak. Still, the Fed did not grasp how stock prices had gotten to such extreme levels in the first place, nor that its cheap money policies and TBTF promises had eviscerated the natural mechanisms by which financial market speculation is held in check.

  Indeed, in response to a barely measurable downturn in the GDP metrics during 2001, the Federal Reserve unleashed a renewed torrent of money printing over the next several years, thereby driving down short-term interest rates to 1 percent, a level which had not been seen since the Great Depression. Soon the cycle of one-way speculation returned with a vengeance, fueling a boom in real estate and mortgage lending that had no precedent.

  During the midst of the housing boom, of course, Fed policy makers insisted that nothing was amiss. Notwithstanding the 100 percent increase in national housing prices since the turn of the century, and the white-hot gains of 2
00 to 300 percent being recorded in many “sand state” markets, there simply was no visible bubble, according to both Alan Greenspan and his successor, Ben Bernanke.

  By their lights, the meteoric rise in housing prices reflected nothing more than a buoyant economy and public confidence in Washington. What they neglected to note, however, was that housing prices were up in the nosebleed section of economic history precisely because the Fed had pushed interest rates down into its sub-basement.

  Between early 2002 and mid-2005, the Fed had aggressively rolled out the welcome wagon for speculators, driving inflation-adjusted interest rates in the United States to patently absurd levels. During that forty-month span, when the annualized consumer price index (CPI) increase averaged about 2.6 percent, the rate on short-term borrowings was only 1.5 percent. This meant that real interest rates were negative, and not just for a month or two, but for the better part of four years. Likewise, the real rate on the 10 year Treasury bond also descended to historic lows.

  In the parlance of the financial markets, the Fed’s sustained spree of interest rate repression had reduced “cap rates” to all-time lows, meaning that their inverse, the price of financial assets, had been goosed to all-time highs. The Fed was thus running an out-and-out bubble machine, bloating the American economy with more cheap debt than ever before imagined.

  In fact, between 2002 and 2007 total credit market debt (public and private) outstanding grew by a staggering $18 trillion, or five times more than the $3.5 trillion gain in GDP during the same period. It was only a matter of time before the American economy buckled under the load.

  CHAPTER 2

  FALSE LEGENDS OF DARK ATMS AND FAILING BANKS

  WHEN THE GREAT FINANCIAL BUBBLE FINALLY BURST IN SEPTEMBER 2008, AIG’s credit default insurance was shockingly exposed as bogus. Given this evidence of utterly reckless and massive speculation, the Fed was handed, as if on a platter, one final chance to restore a semblance of capital market discipline.

  By that late hour, however, the Fed was not even remotely interested in financial discipline. The Greenspan Put had now been superseded by the even more insidious Bernanke Put. In defiance of every classic canon of sound money, the new Fed chairman had panicked in the face of the first stock market tremors in August 2007 (see chapter 23), and thereafter the S&P 500 had become an active and omnipresent transmission mechanism for the execution of central bank policy. Consequently, after the Lehman event the plummeting stock averages had to be arrested and revived at all hazards. Accordingly, the bailout of AIG was first and foremost an exercise in stabilizing the S&P 500.

  The cover story, of course, was the threat that a financial contagion would ripple out from the corpus of AIG, bringing disruption and job losses to the real economy. As has been seen, however, there was nothing at all “contagious” about AIG, so Bernanke and Paulson simply peddled flat-out nonsense in order to secure Capitol Hill acquiescence to their dictates and to douse what they derisively called “populist” agitation; that is, the noisy denunciation of the bailouts arising from an intrepid minority of politicians impertinent enough to stand up for the taxpayer.

  But this hardy band of dissenters—ranging from Congressman Ron Paul to Senator Bernie Sanders—was correct. Everyday Americans would not have lost sleep or their jobs, even if AIG’s upstairs gambling patrons had been allowed to lose their shirts. Still, the bailsters peddled a legend which has persisted; namely, that in September 2008 the nation’s financial payments system was on the cusp of crashing, and that absent the bailouts American companies would have missed payrolls, ATMs would have gone dark, and general financial disintegration would have ensued. But this is a legend. No evidence has ever been presented to prove it because there isn’t any.

  Had Washington allowed nature to take its course in the days after the Lehman collapse on September 15, the only Wall Street furniture which would have been broken was the potential bankruptcy of Goldman Sachs and Morgan Stanley, the two remaining investment banks. Needless to say, the utterly myopic investment banker who was running the US government from his Treasury office wasted not a second ascertaining whether the public interest might diverge from Goldman’s stock price under the circumstances at hand.

  According to his memoirs, Secretary Paulson already “knew” on the very morning Lehman failed that the last two investment banks standing needed to be rescued at all hazards: “Lose Morgan Stanley, and Goldman Sachs would be next in line—if they fell the financial system might vaporize and with it, the economy.”

  Tendentious and sophomoric would be a more than generous characterization of that apocalyptic riff. Yet groundless as it was, the fact that Paulson and his posse treated it as truth is deeply revealing. It underscores the extent to which public policy during the bubble years had been taken captive by the satraps and princes seconded to the nation’s capital by Wall Street. Such self-serving foolishness would never have been uttered in earlier times, not even by the occasional captain of industry or finance who held high financial office.

  Certainly President Eisenhower’s treasury secretary and doughty opponent of Big Government, George Humphrey, would never have conflated the future of capitalism with the stock price of two or even two dozen Wall Street firms. Nor would President Kennedy’s treasury secretary, Douglas Dillon, have done so, even had his own family’s firm been imperiled. President Ford’s treasury secretary and fiery apostle of free market capitalism, Bill Simon, would have crushed any bailout proposal in a thunder of denunciation. Even President Reagan’s man at the Treasury Department, Don Regan, a Wall Street lifer who had built the modern Merrill Lynch, resisted the 1984 bailout of Continental Illinois until the very end.

  Once the Fed plunged into the prosperity management business under Greenspan and Bernanke, however, the subordination of public policy to the pecuniary needs of Wall Street became inexorable. No other outcome was logically possible, given Wall Street’s crucial role as a policy transmission mechanism and the predicate that rising stock prices would generate a wealth effect and thereby levitate the national economy.

  Not surprisingly, the Goldman Sachs “occupation” of the US Treasury coincided almost exactly with the Fed’s embrace of financialization, leverage, and speculation as crucial tools of monetary management. Its legates in Washington during this era, Robert Rubin and Hank Paulson, never once agonized over violating free market rules. They simply assumed that the good of the nation depended upon keeping the Wall Street game up and running.

  Nor did the Goldmanites have even the foggiest appreciation of why the old fashioned guardians of the public purse, like Bill Simon, had been so resolutely anti-bailout. To his great credit, Simon appreciated the insidious effects of bad precedent and rightly feared that once the floodgate was opened crony capitalism would flourish. He also understood that every crisis would be portrayed as a one-time exception and that once officials started chasing market-driven brush fires, the policy process would quickly degenerate into analytics-free, seat-of-the-pants ad hocery and would frequently even border on lawlessness.

  In fact, that is exactly what happened in the signature bailout episodes during Goldman’s occupation of the Treasury. The $20 billion bailout of the Wall Street banks during the 1994 Mexican peso crisis orchestrated by Secretary Rubin was not only unnecessary, but was done against overwhelming opposition on Capitol Hill. In the end, the American taxpayer was thrown into the breach by Treasury lawyers who tortured an ancient statute governing the Economic Stabilization Fund until it coughed up billions for a bailout of Mexico and its Wall Street lenders. In so doing, Rubin simply thumbed his nose at Congress, implying that the greater good of Wall Street trumped the democratic process.

  Likewise, the entire Paulson-led campaign to bail out Wall Street during the September 2008 crisis was an exercise in pushing the limits of existing law to the breaking point. Lehman was not bailed out mainly because Washington officials had not yet found a loophole by the time of its Sunday-night filing. But as the crescendo of p
anic intensified, the Treasury and Fed miraculously found enough legal daylight by Tuesday to rescue AIG.

  Throughout the ordeal Paulson and his posse viewed themselves as glorified investment bankers, empowered to use any expedient of law and any drain on the public purse that might be needed to ensure the survival of the remaining Wall Street firms. Rampaging around the globe and browbeating bankers and governments alike on behalf of their half-baked merger schemes, they defiled the great office of US Treasury Secretary like never before.

  GOLDMAN AND MORGAN STANLEY: THE LAST TWO PREDATORS STANDING

  This was a blatant miscarriage of governance. As will be seen, at that late stage of the delirious financial bubble which had overtaken America, Goldman Sachs and Morgan Stanley had essentially become economic predators. Their bankruptcy would have resulted in no measureable harm to the Main Street economy, and possibly some gain. It would have also brought the curtains down on a generation of Wall Street speculators, and sent them packing in disgrace and amid massive personal losses—the only possible way to end the current repugnant régime of crony capitalist domination of the nation’s central bank.

  Goldman and Morgan Stanley helped generate and distribute hundreds of billions in toxic assets—mortgage-backed securities and CDOs based on subprime mortgages—that were now resident on the balance sheets of a wide gamut of Main Street institutions like corporate pension funds and insurance companies, along with institutional investors spread all over the planet. The TARP and Federal Reserve funds that were pumped into Goldman and Morgan Stanley, however, did nothing to ameliorate the huge losses being incurred by these gullible customers.