Notes – The Great Deformation, Part III, “New Deal Legends”

The Great Deformation: The Corruption of Capitalism in America

by David A. Stockman, published 2013

Chapter 8
Stockman doesn’t go into much detail on where the boom ending in 1929 came from, but he does provide an interpretation of why the bust lasted so long and went so deep– the forcible closing off of international trade via protectionist policies and the undermining of the global gold-backed monetary regime by American and European governments alike.

In Stockman’s telling, American president Herbert Hoover was a mostly free enterprise and sound money kind of guy who wanted to avoid inflationist solutions to the economic slump. By 1932 the economy had liquidated the bulk of the malinvestments in excess inventories and capital assets and was ready to turn toward genuine recovery. This process only took as long as it did because ill-reasoned policies like the Smoot-Hawley Act in the United States and similar nationalistic policies in European states along with uncertainty about the British plans to keep the gold-backed pound sterling in place hampered international trade flows. According to Stockman, the United States between 1914 and 1929 had become, much like China circa 1994-2012, a major exporter of capital and consumer goods to the rest of the world particularly in response to trade and economic disruptions of industry and agriculture in European economies during the First World War. The US economy was geared up to provide steel, cotton, cereal grains and other commodities to the rest of the world and had a hard time adjusting output to meet domestic demand when the collapse came in 1929.

Then came FDR and his unique brand of economically inane autarkic nationalist policy. Stockman faults FDR for prolonging, nay, creating, the actual Depression singlehandedly. First, FDR began his presidency by fomenting a banking crisis and declaring a major bank holiday which Stockman saw as unnecessary. As Stockman tells it, the 12,000 some bank failures in the United States during this period mostly occurred in over leveraged regional/rural banks centered around the agricultural and export-oriented areas of the economy representing at most 3% of banking system deposits. Major money center banks in financial centers such as New York never faced a solvency crisis, making FDRs response a solution to a nonexistent problem and therefore a serious problem-creating blunder itself.

Second, FDR torpedoed the London Conference on international monetary mechanisms, throwing the whole system into chaos and instigating another round of protectionist measures at home and abroad. Third, he arbitrarily decided to undermine the US’s own commitment to a constant redeemability ratio for the dollar, creating further fear and uncertainty in the economy. And finally, he created a cartel system (National Recovery Administration) which served to freeze prices, arbitrarily shift capital around the economy and buy votes as necessary but did nothing to create the kind of stable conditions preferred by business people and entrepreneurs attempting to make capital investments to serve anticipated consumer demand.

The Depression was a recession that was working itself out despite the protectionist political measures put in place which made adjusting the structure of production to domestic rather than foreign needs, but then FDR came along and made the economy his plaything as he tinkered according to his whims and played power broker on the side. That’s what turned the recession into a true Depression.

Chapter 9
Fannie Mae, which was envisioned as a way to revitalize a moribund middle class housing market during the Great Depression by creating a “secondary market” for uneconomic 30 year mortgages at subsidized interest rates, has in the 75 years since its founding led to the total corruption and now nationalization of the home loan market. The creation of the secondary market divorced mortgage underwriting from mortgage servicing as it allowed for mortgages to be easily issued, packaged up and sold to investors as government-backstopped financial products. Further, it resulted in local savings funding local housing investments being transformed into a national and now international market, with the final result being that “Red China” bankrolls $1T+ of the federal home loan market due to balance of payment issues tied to competitive currency issuance.

Social Security, rather than being the crowning social achievement of the New Deal, was its greatest fiscal folly and has created an embarrassing Ponzi legacy that is with us even today. The systems actuarial projections were based on an impossible 5% continual GDP growth rate. The payroll tax used to fund it has proved “regressive” and continues to grow over time, with a current 6.5% of GDP consumed by the tax. The $3T of “trust fund reserves” have been lent out and spent by other parts of the government and represent nothing more than future taxes due.

In so many words, the innovation of deposit insurance combined with the Glass-Steagall act, a bout of inflationary monetary policy which destroyed the profitability of traditional deposit lending under Glass-Steagall and then a round of “deregulations” designed to create new areas of profitability for banks at the expense of growing moral hazard resulted in the utter corruption of the system and the inevitability of a major financial meltdown as witnessed in 2008.

With the outbreak of war in Europe in 1914 and the initiation of a war loan program by the United States government, US farms became the breadbasket of the world. They took on massive debt to expand capital machinery and bring additional acreage into cultivation which resulted in growing farm output prices. When the war ended, the capital investments, including the debt overhang, remained. The financial collapse in the 1930s further exacerbated the situation, leaving farmers as a desperate coalition looking for a political solution to their contractual obligations.

With the nations farmers the hardest hit by the twin spikes of failing cash flow and high debt burdens, they became a powerful voting bloc that got FDR elected which allowed for the cartelization of the farming industry to take place. The thought was that cartelizing the industry and pushing up farm and farm output prices would result in a return to prosperity as rural buyers bought manufactured products from city centers. With their programs in place, the farming lobby was then willing to trade votes for growth and maintenance of these subsidies and controls going forward into the future.

The “Thomas Amendment” created four options for expanding the money supply via currency issuance or gold or silver content debauchery. This inflationary response was seen as the proper antidote to too much debt and too little money and political authorities of the day figured it would give them a free pass to avoid the pains of the bust following the ill-gotten gains of the boom.

FDR channeled the $2.8B windfall from his emergency dollar “revaluation” against gold into his Exchange Stabilization Fund, which the Secretary of the Treasury was then able to disburse at his discretion, turning him into what Stockman calls a “money czar” much like Hank Paulson and Neil Kashkari during TARP.

Chapter 10
In this chapter, Stockman argues that World War II and the Korean War were the last wars to be mostly financed by current taxation in the US. WWII in particular saw a rise in household saving and a decline in household indebtedness that offset the massive rise in public indebtedness. He attributes this in part to the fact that wartime command economy measures dictated that there was little to consume on store shelves, in part to the fact that the government’s propaganda campaigns for war bond drives were a success and in part because the government had adopted an arbitrary bond yield peg that lowered investment returns in competing assets and made government bonds more attractive as a conservative savings vehicle.

Stockman claims that William McChesney Martin, who headed the Fed through the 1950s, was a “tribune of sound money” and saw it as his mission to restrain credit expansion and tame the inflation rate, rather than to stoke it like modern Fed heads. He also claims that the Fed only lent on liquid commercial receivables during this era, compared with the present where the Fed has become a warehouse for illiquid claims on real assets.

Chapter 11
Stockman argues that President Eisenhower was the “last of the fiscal Mohicans” dedicated to trimming federal budgets and making government spending respectful of tax revenue means. At the same time, a growing chorus of voices on the right and the left begin arguing for a “new economics”, Keynesian government planning of the macro economy, to not only fight recessions but “fine tune potential GDP” during recoveries and booms. This theory comes at the expense of sound money and has a pro-inflation bias.

Chapter 12
Following World War I, Great Britain attempted to return to the pre-war parity between the pound Sterling, gold and the US dollar despite a massive inflation during the war years. At the same time, the British government embarked on an expansion of its domestic welfare programs which ultimately broke the back of the pound culminating in the London gold conference in 1931 which proved the futility of maintaining the old exchange ratios in the face of inflationary chaos.

At the end of World War II, the United States attempted to take the lead with a gold-backed dollar as the world’s reserve currency in a new arrangement, the gold exchange standard, engineered at the Bretton Woods conference in 1944. Of course, the architect of this scheme was the exact same architect of the doomed British plan (monetary and social policy), the imperious Lord Keynes. And rather than a true gold standard, what Keynes wrought was a feeble attempt to hide dollar inflation by creating a scheme where foreign exchange was to be exchanged for dollars, not gold, which was ostensibly suppose to allow additional credit and currency to be pyramided atop the same amount of gold reserves at formal exchange rates.

For a time, this precarious system seemed to work, helped along by the US-led international “gold pool” which sought to exchange gold against currency to calm price increases in the private London gold market.

However, the decision to engage in fiscal expansionism in the US via welfare spending increases and costly wars abroad (ie, Vietnam) all financed by deficit spending rather than real tax increases led to an unhinged inflation and a boiling London gold market. The international gold pool was quickly depleted in a series of panics in the late 1960s, eventually culminating in Nixon’s infamous closing of the US gold window.

This “guns and butter” policy, led by the intellectual disciples of Keynes ensconced in major US universities, was the final nail in the coffin of sound money in the US, and perhaps even the world, and ushered in a new era of freely floating currencies, chronic deficits, massive credit expansion and a seemingly never-ending series of financial and economic bubbles that we are all living with the consequences of today– ironically, the media at the time was fooled into believing this “enlightened” policy had permanently tamed the (government-policy induced) business cycle.

Chapter 13
Milton Friedman, hailed as a staunch libertarian and champion of small government politics and free market economics, gave intellectual blessing to the greatest economic bastardization of all time– the transformation of the gold standard US dollar, once and for all, into the “T-bill Standard”.

Friedman’s erroneous analysis of the cause of the Great Depression — a crashing M1 money supply caused by an overly tight Federal Reserve — led him to faith in a new standard for monetary policy, a simple inflation targeting of 3% per annum, with the market smoothing out the rest. Friedman believed that if the Fed could credibly adhere to a uniform rate of inflation over time, the business cycle could be banished and the economy would be free to grow without abatement and without the restrictive context of a gold-backed currency.

This new policy proved its danger almost immediately with the out of control inflation of the 1970s and opened the door for unending deficit finance by the federal government. And while Friedman had hoped for a series of Fed chairmen who would objectively guide the M1 money supply along this path (a strategy destined to failure because it turns out the Fed doesn’t control M1, market demand for loanable funds does) instead the office has been inhabited by activist acolytes since the tight money days of Volcker.

The current global monetary regime of competitive free floating currencies is truly without precedent and much of the modern US’s largesse was financed by willing mercantilist politicians in foreign trading partner nations. It remains to be seen what happens to this system when one or more countries reach the end of their rope, domestically, and are not longer willing to import the United States’ inflation as they export their wealth to foreigners for consumption.

Notes – The Great Deformation – Part I, The Blackberry Panic Of 2008

The Great Deformation: The Corruption of Capitalism in America

by David A. Stockman, published 2013

I received a copy of David Stockman’s 2013 analysis of the mechanics of the 2008 financial crisis and its aftermath as a gift from a friend and sat down to read the first 50 pages, Part I.

I think Stockman attempts to make several key points as a set up to the remainder of this lengthy tome:
-the mainstream/regime narrative of an incipient economic crisis catalyzed by a financial collapse originating in Wall Street credit markets controlled by major Wall Street institutions (such as Morgan Stanley and Goldman Sachs) is one part baseless lie and one part clueless ignorance of facts on the ground at the time
-there was a crisis, for these particular institutions, which was a result of years of non-value adding financial and accounting chicanery enabled by Fed Chairman Greenspan’s infamous “put” and the crisis would’ve resulted in the liquidation of these firms assets (and the termination of their managers) into abler hands which would’ve been a good thing for competitive financial markets and the capitalist economy as a whole
-this crisis was not only averted by the frantic lobbying of connected officials in Congress, the Treasury and other regulatory agencies by crony executives in the affected firms, but these same executives and officials worked in concert to turn the bailout moment into a massive payday/profit opportunity; most of the people making decisions about this in the government, particularly in the Treasury and the Fed, were inexperienced, miseducated or otherwise rank amateurs with little understanding of the context of their decisions or their consequences beyond the immediate moment
-the scale of the bailouts in terms of pure dollars was completely without precedent or connection to actual costs and risks present in the system at the time
-memoirs of officials and executives involves in the bailout discussions published extemporaneously do not make a substantial case for their decisions based off of data available about the period years later
-much of the decision-making at the time, by concerned executives as well as captured officials, seems to be dominated by the twin desire to avoid taking responsibility for mistakes made in the past (thereby looking foolish) and to continue the illusion of the viability of the system based on these mistakes going forward

“All the rest,” as it has been said, “is illustration.”

There were parts of the narrative I found confusing to follow at times. Its possible I didn’t read clearly, but in several instances it seemed like on one page or at the beginning of a chapter Stockman would be arguing that the potential capital losses of a particular company were small enough relative to their total balance sheet that they could easily sweat the loss from a survival standpoint and then on the next page or at the end of the chapter, he seemed to suggest the same loss was so sizable that it would threaten the viability of the enterprise itself.

I think there was a lot of question-begging in the narrative as well. Stockman builds a decent logical case for why there was no “contagion” that could spread from Wall Street (the financial markets) to Main Street (the rest of the economy) that would result in a general economic depression. But his argument always rests on the costs being shifted to various government backstop agencies and funding sources which could make things like commercial lending and payroll finance markets “money good”. It isn’t explained where these institutions would come by the required funds necessary to remain in operation without a bout of money printing (bailouts) and how this is different than the bailouts Wall Street received.

That leads to another concern I have with the overall thesis, which is that somehow, what happens on Wall Street is arbitrary and doesn’t affect greater economic outcomes. While I agree with the notion that purging the financial system of bad debts and bad business models during periods of crisis is a process of economic health rather than economic illness, I so far fail to see how the repricing and reorganization of economic capital taking place in these markets would not result in similar repricings and reorganizations of capital investment throughout the economy as a whole. Stockman details several multi billion dollar examples of ” predatory financial practices” in which members of Main Street America were able to finance lifestyles they couldn’t prudently afford the costs of and it seems like these are prime (or subprime, as it were) examples of assets that would need to be repriced and reorganized into abler hands. The gutters of both Streets would be filled with the purged excess, and it would eventually drain.

Annoyingly, Stockman repeatedly exalts “our political democracy” and even conflates its goodness and functioning with free market capitalism. For me, this is a fundamental flaw in reasoning and defining terms that throws his entire analysis into suspicion, at least from the standpoint of his analytical framework operant and his own agenda in terms of desired social outcomes. I don’t think Stockman and I are on the same page, in other words.

So far, Stockman’s book expects a lot of prior knowledge on behalf of the reader. He doesn’t begin the book outlining his economic or financial theories, nor his concept of the purpose of government. We intuit bits and pieces of it as he proclaims this bad, that person good, this event horrid, etc. But he never really says “I’m from the School of X” or gives a summary of the key principles necessary to follow his analysis. Therefore, it comes off as strenuously assertive rather than rigorously logical. And I think part of Stockman’s goal is to spread blame in a bipartisan fashion, while building bridges and giving accolades in an “independent” manner. So far, though, it seems arbitrary due to this lack of explanation about his framework.

The Best Interview On Gold, The Gold Market And Investment Implications I’ve Ever Read

In “What is the key for the price formation of gold?” at GoldSwitzerland.com, SF-based software developer Robert Blumen covers a lot of fascinating and, to my eyes, original ground in an interview with the site’s host.

This has got to be the best interview on the subject of gold in general, the functioning of the gold market and the implications for investors that I’ve ever come across. Blumen not only covers these specific subjects related to gold, but also discusses the Chinese economy, the US economy and the state of monetary and fiscal affairs and even the attitudes of value investors, demonstrating thoughtful familiarity with all he touches. Blumen is well-versed in Austrian economic philosophy and applies this theory to the various practical considerations resulting in surprising new perspectives on common themes.

It’s a long interview and it will only fully reward those determined to dive all the way in. Here’s an excerpt:

There are two different kinds of commodities and we need to understand the price formation process differently for each one. The first one I’m going to call, a consumption commodity and the other type I’m going to call an asset.

A consumption commodity is something that in order to derive the economic value from it, it must be destroyed. This is a case not only for industrial commodities, but also for consumer products. Wheat and cattle, you eat; coal, you burn; and so on. Metals are not destroyed but they’re buried or chemically bonded with other elements making it more difficult to bring them back to the market. Once you turn copper into a pipe and you incorporate it hull of a ship, it’s very costly to bring it back to the market.

People produce these things in order to consume them. For consumption goods, stockpiles are not large. There are, I know, some stockpiles copper and oil, but measured in terms of consumption rates, they consist of days, weeks or a few months.

Now for one moment I ask you to forget about the stockpiles. Then, the only supply that could come to the market would be recent production. And that would be sold to buyers who want to destroy it. Without stockpiles, supply is exactly production and demand is exactly consumption. Under those conditions, the market price regulates the flow of production into consumption.

Now, let’s add the stockpiles back to the picture. With stockpiles, it is possible for consumption to exceed production, for a short time, by drawing down stock piles. Due to the small size of the stocks, this situation is necessarily temporary because stocks will be depleted, or, before that happens, people will see that the stocks are being drawn down and would start to bid the price back up to bring consumption back in line with production.

Now let’s look at assets. An asset is a good that people buy it in order to hold on to it. The value from an asset comes from holding it, not from destroying it. The simplest asset market is one in which there is a fixed quantity that never changes. But it can still be an asset even when there is some production and some consumption. They key to differentiating between consumption and asset is to look at the stock to production ratio. If stocks are quite large in relation to production, then that shows that most of the supply is held. If stocks are small, then supply is consumed.

Let me give you some examples: corporate shares, land, real property. Gold is primarily an asset. It is true that a small amount of gold is produced and a very small amount of gold is destroyed in industrial uses. But the stock to annual production ratio is in the 50 to 100:1 range. Nearly all the gold in the world that has ever been produced since the beginning of time is held in some form.

Even in the case of jewelry, which people purchase for ornamental reasons, gold is still held. It could come back to the market. Every year people sell jewelry off and it gets melted and turned into a different piece of jewelry or coins or bars, depending on where the demand is. James Turk has also pointed out that a lot of what is called jewelry is an investment because in some parts of the world there’s a cultural preference for people to hold savings in coins or bars but in other areas by custom people prefer to hold their portable wealth as bracelets or necklaces. Investment grade jewelry differs from ornamental jewelry in that it has a very small artistic value-added on top of the bullion value of the item.

So, now that I’ve laid out this background, the price of a good in a consumption market goes where it needs to go in order to bring consumption in line with production. In an asset market, consumption and production do not constrain the price. The bidding process is about who has the greatest economic motivation to hold each unit of the good. The pricing process is primarily an auction over the existing stocks of the asset. Whoever values the asset the most will end up owning it, and those who value it less will own something else instead. And that, in in my view, is the way to understand gold price formation.

Many of the people who follow and write about this market look at it as if it were a consumption market and they look at mine supply and industrial fabrication as the drivers of the price as if it were tin, or coal, or wheat. People who look at gold as if it were a consumption market are looking at it the wrong way. But now you can see where the error comes from. In many financial firms gold is in the commodities department, so a commodities analyst gets assigned to write the gold report. If the same guy wrote the report about tin and copper, he might think that gold is just the same as tin and copper. And he starts by looking at mine supply and industrial off-take.

I wonder if more equity analysts or bond analysts were active in the gold area, if they would be more likely to look at it the same way they look at those assets.