[The 2011 Henry Hazlitt Memorial Lecture, given on March 12 at the Austrian Scholar's Conference. An MP3 audio file of that lecture is available for download.]
The triumph of crony capitalism occurred on October 3rd, 2008. The event was the enactment of TARP — the single greatest economic-policy abomination since the 1930s, or perhaps ever.
Like most other quantum leaps in statist intervention, the Wall Street bailout was justified as a last-resort exercise in breaking the rules to save the system. In the immortal words of George W. Bush, our most economically befuddled President since FDR, "I've abandoned free market principles in order to save the free market system."
Based on the panicked advice of Paulson and Bernanke, of course, the president had the misapprehension that without a bailout "this sucker is going down." Yet 30 months after the fact, evidence that the American economy had been on the edge of a nuclear-style meltdown is nowhere to be found.
In fact, the only real difference with Iraq is that in the campaign against Saddam we found no weapons of mass destruction; by contrast, in the campaign to save the economy we actually used them — or at least their economic equivalent.
Still, the urban legend persists that in September 2008 the payments system was on the cusp of crashing, and that absent the bailouts, companies would have missed payrolls, ATMs would have gone dark and general financial disintegration would have ensued.
But the only thing that even faintly hints of this fiction is the commercial-paper market dislocation. Upon examination, however, it is evident that what actually evaporated in this sector was not the cash needed for payrolls, but billions in phony book profits, which banks had previously obtained through yield-curve arbitrages that were now violently unwinding.
At that time, the commercial-paper market was about $2 trillion and was heavily owned by institutional money-market funds — including First Reserve, which was the granddaddy with about $60 billion in footings. Most of this was rock solid, but its portfolio also included a moderate batch of Lehman commercial paper — a performance enhancer designed to garner a few extra "bips" of yield.
As it happened, this foolish exposure to a de facto hedge fund, which had been leveraged 30-to-1, resulted in the humiliating disclosure that First Reserve "broke the buck," and that the somnolent institutional fund managers who were its clients would suffer a loss — — all of 3 percent!
This should have been a "so what" moment — except then all of the other lemming institutions who were actually paying fees to money-market funds for the privilege of getting return-free risk decided to panic and demand redemption of their deposits. This further step in the chain reaction basically meant that some maturing commercial paper could not be rolled over due to these money-market redemptions.
But this outcome, too, was a "so what": nowhere was it written that GE Capital or the Bank One credit-card conduit, to pick two heavy users of the space, had a Federal entitlement to cheap commercial paper — so that they could earn fat spreads on their loan books.
Regardless, the nation's number one crony capitalist — Jeff Immelt of GE — jumped on the phone to Secretary Paulsen and yelled "fire"! Soon the Fed and FDIC stopped the commercial-paper unwind dead in its tracks by essentially nationalizing the entire market. Even a cursory look at the data, however, shows that Immelt's SOS call was a self-serving crock.
First, about $1 trillion of the $2 trillion in outstanding commercial paper was of the so-called ABCP type — paper backed by packages of consumer loans such as credit cards, auto loans, and student loans. The ABCP issuers were off-balance sheet conduits of commercial banks and finance companies; the latter originated the primary loans, and then scalped profits up front by selling these loan packages into their own conduits.
In short, had every single ABCP conduit been liquidated for want of commercial-paper funding — and over the past three years most have been — not a single consumer would have been denied a credit-card authorization or car loan. His or her bank would have merely booked the loan as an on-balance sheet asset — rather than off-balance sheet asset.
The only noticeable difference on the entire financial planet would have been that a few banks wouldn't have been able to scalp profits from unseasoned loans. In this instance, it appears that President George W. Bush did, in fact, bomb the village to save it!
Another $400 billion of the sector was industrial-company commercial paper — the kind of facility that some blue-chip companies used to fund their payroll. But there was not a single industrial company in America then issuing commercial paper that did not also have a standby bank line behind its CP program. Moreover, since these companies had been paying a 15 or 20 basis-point standby fee for years, their banks had a contractual obligation to fund these backup lines, and none refused. There was never a chance that payrolls would not be met.
The last $600 billion of CP is where the real crony capitalist stench lies. There were three huge users in the finance-company sector — CIT, GMAC, and GE Capital. At the time of the crisis, the latter had asset footings of $600 billion — most of it long-term, highly illiquid, and sometimes sketchy corporate and commercial real-estate loans.
In violation of every rule of sound banking, more than $80 billion of these positions were funded in the super-cheap commercial-paper market. This maneuver fattened spreads on GE's loan book and produced 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.
Under free-market rules, an inability to roll its $80 billion in commercial paper 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; or in the alternative, it could have held on to its loan book, and issued massively dilutive amounts of common stock or subordinated debt to close its sudden funding gap.
Either way, GE's shareholders would have taken the beating they deserved for over-valuing the company's true earnings and for putting reckless managers in charge of the store.
So the financial meltdown during those eventful weeks was not triggered by the financial equivalent of a comet from deep space — but resulted from leveraged speculation that should have been punishable by ordinary market rules.
Viewed more broadly, the carnage on Wall Street in September 2008 was the inevitable crash of a 40-year financial bubble spawned by the Fed after Nixon closed the gold window in August 1971. As time passed, the Fed's market-rigging and money-printing actions had become increasingly destructive — leaving the banking system ever more unstable and populated with a growing bevy of Too Big to Fail institutions.
The 1984 rescue of Continental Illinois; the 1994 Mexican peso crisis bailouts; the Fed's 1998 life-support operation for LTCM — were all just steps along the way to the fall of 2008.
Then, faced with the collapse of their own handiwork, Washington panicked and joined the Fed in unleashing an indiscriminate bailout capitalism that has now thoroughly corrupted the halls of government, even as it has become a debilitating blight on the free market.
In this context, the linkage between printing-press money and fiscal profligacy merits special attention. In the post-TARP world, there remain no fiscal rules at all, and already we have had cash for clunkers, cash for caulkers, and under the homebuyer's credit, cash for convicts.
Indeed, my belief is that the subprime meltdown was only a warm-up. The real financial widow-maker of the present era is likely to be US government debt itself.
The sheer budgetary facts are bracing enough. It needs be recalled that fiscal year 2011, now underway, will encompass not a recession bottom but the sixth-through-ninth quarter of recovery. During this interval of purported rebound, however, the White House now projects red ink of $1.645 trillion. This means that 43 cents on every dollar spent will be borrowed, thereby generating a financing requirement just shy of 11 percent of national income.
These elephantine figures mark a big lurch southward — since deficits only half this size were expected for the current year as recently as last spring. Notwithstanding a full year of green shoots and booming stocks, however, Washington embraced a monumental round of new fiscal stimulus in December.
The result was a trillion-dollar Christmas tree festooned with fiscal largesse for every citizen — inclusive of the quick as well as the dead. Moreover, this bounty was extended without prejudice to each and every social class — with workers, the unemployed, the middle class, the merely rich, and billionaires, too, getting a share.
It would be foolish in the extreme to dismiss this budgetary eruption as a fit of transient exuberance — even if by the president's own admission the White House was in a shellacked state of mind, and in no position to restrain December's bipartisan stampede. In fact, the United States is clocking a 10-percent-of-GDP deficit for the third year running because this latest budgetary fling is just another episode in the epochal collapse of US financial discipline that began 40 years ago at Camp David.
That the demise of the gold standard should have been as destructive of fiscal discipline as it was of monetary probity can hardly be gainsaid. Under the ancient regime of fixed exchange rates and currency convertibility, fiscal deficits without tears were simply not sustainable — no matter what errant economic doctrines lawmakers got into their heads.
Back then, the machinery of honest money could be relied upon to trump bad policy. Thus, if budget deficits were monetized by the central bank, this weakened the currency and caused a damaging external drain on monetary reserves; and if deficits were financed out of savings, interest rates were pushed up — thereby crowding out private domestic investment.
Politicians did not have to be deeply schooled in Bastiat's parable of the seen and the unseen. The bitter fruits of chronic deficit finance were all too visible and immediate.
During the four decades since the gold window was closed — the rules of the fiscal game have been profoundly altered. Specifically, under Professor Friedman's contraption of floating paper money, foreigners may accumulate dollar claims or exchange them for other paper monies.
But there can never be a drain on US monetary reserves because dollar claims are not convertible. This infernal engine of fiat dollars, therefore, has had numerous lamentable consequences but among the worst is that it has facilitated open-ended monetization of US government debt.
Monetization can be done in two ways. First, there is outright monetization, as is now being conducted by the Fed through its POMO program; that is, its daily purchase of $4–$8 billion of Treasury debt. Indeed, the Fed's QE2 bond purchases have been so massive that it is literally buying Treasury paper in the secondary market almost as fast as new bonds are being issued. During January, for example, fully 40 percent of the Fed's $100 billion bond buy was from CUSIP numbers less than 90 days old.
Needless to say, putting brand new Treasury bonds in the Fed's vault before they have paid even a single coupon is functionally equivalent to 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.
Stated differently, in the present era of massive quantitative easing, newly issued Treasury securities amount to non-interest-bearing currency without the circulation privilege.
But over the last several decades, the preferred course has been indirect monetization; that is, the world's legion of willing mercantilist exporters from China to the Persian Gulf have printed their own money in vast quantities — ostensibly to peg their exchange rates, but with the effect of absorbing trillions of US treasury paper.
To be sure, the peoples' money warehouse in China and those in other mercantilist lands are pleased to label these accumulations as sovereign wealth portfolios. But the fact is, these hoards of sequestered dollars are not classic monetary reserves derived from a true, sustainable surplus on current account. Instead, they are simply the book-entry offset to the inflated local money supplies that have been emitted by the global convoy of peggers — that is, mercantilist nation central banks tethered to the Fed.
That this convoy is a potent mechanism for monetizing US debt is readily evident by way of contrast with classic monetary systems anchored on a true reserve asset. At the peak of its glory before the Guns of August 1914 laid it low, the sterling-based gold standard operated smoothly with a London gold reserve amounting to 1–2 percent of British GDP.
Likewise, in 1959 at the peak of the Breton Woods, the United States held $20 billion of gold reserves against a GDP of $500 billion. Again, at about 4 percent of GDP, the hard monetary reserves needed to operate the system were extremely modest.
The reason for parsimonious reserve quantities under the gold standard was the fact of continuous settlement of trade accounts via the flow of monetary assets. In the case of a balance-of-payments deficit, 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.
In the cases of surpluses, the adjustments were in the opposite direction. Most importantly, with real economies constantly in adjustment, central-bank balance sheets stayed lean and mean.
By contrast, under the contraption that Professor Friedman inspired, trade account imbalances are never settled. They just grow and grow and grow — until one day they become the object of fruitless jabbering at a photo-op society called G-20.
In all fairness, Professor Friedman did not envision a world of rampant, dirty floating. Indeed, it would have taken a powerful imagination to foresee four decades ago that China would accumulate $3 trillion of foreign-currency claims, or more than 50 percent of GDP, and then insist over a period of years and decades that it did not manipulate its exchange rate!
Still, there can be little doubt that China and the other mercantilist exporters operate massive monetary warehouses where they deposit Treasury bonds acquired during their endless dollar-buying campaigns. Moreover, the apparatchiks at the US Treasury Department can now stop splitting hairs about whether China is a "currency manipulator" or not. It seems China just admitted to it.
Recently, the vice chairman of the People's Bank of China, Yi Gang, asked, "Why do we have so much base money?" Said Mr. Yi while answering his own question, "the central bank buys up foreign exchange inflows. If it didn't, the Yuan wouldn't be so stable." Now there's one for the Guinness Book of Understatements!
So at the end of the day, American lawmakers have been freed of the classic monetary constraints. There is no monetary squeeze and there is no reserve-asset drain. The Fed always supplies enough reserves to the banking system to fund any and all private credit demand at policy rates that are invariably low. The notion of fiscal "crowding out" thus belongs in the museum of monetary history.
At the same time, the seemingly limitless emission of dollar claims by the US central bank results not in a contractionary drain of monetary reserves from the domestic banking system, but in an expansionary accumulation of these claims in the vaults of foreign central banks. In less polite language, a growing portion of the Federal debt has ended up in what amounts to a global chain of monetary roach motels: places where Treasury bonds go in but they never come out.
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