Four Deformations of the Apocalypse

By David Stockman

July 31 (NYT) — If there were such a thing as Chapter 11 for politicians, the Republican push to extend the unaffordable Bush tax cuts would amount to a bankruptcy filing. The nation’s public debt — if honestly reckoned to include municipal bonds and the $7 trillion of new deficits baked into the cake through 2015 — will soon reach $18 trillion. That’s a Greece-scale 120 percent of gross domestic product, and fairly screams out for austerity and sacrifice. It is therefore unseemly for the Senate minority leader, Mitch McConnell, to insist that the nation’s wealthiest taxpayers be spared even a three-percentage-point rate increase.

Yet another ‘expert’ with fear mongering with ‘the US is the next Greece’ nonsense. So much for whatever positives may be left of his legacy.

More fundamentally, Mr. McConnell’s stand puts the lie to the Republican pretense that its new monetarist and supply-side doctrines are rooted in its traditional financial philosophy. Republicans used to believe that prosperity depended upon the regular balancing of accounts — in government, in international trade, on the ledgers of central banks and in the financial affairs of private households and businesses, too. But the new catechism, as practiced by Republican policymakers for decades now, has amounted to little more than money printing and deficit finance — vulgar Keynesianism robed in the ideological vestments of the prosperous classes.

At least they are practical enough to add to aggregate demand when needed.
Does anyone think there is an excess of demand that calls for a tax hike?
Any call for a tax hike on ‘fairness’ should be ‘paid for’ with at least an offsetting tax cut somewhere.

This approach has not simply made a mockery of traditional party ideals. It has also led to the serial financial bubbles and Wall Street depredations that have crippled our economy. More specifically, the new policy doctrines have caused four great deformations of the national economy, and modern Republicans have turned a blind eye to each one. The first of these started when the Nixon administration defaulted on American obligations under the 1944 Bretton Woods agreement to balance our accounts with the world. Now, since we have lived beyond our means as a nation for nearly 40 years, our cumulative current-account deficit — the combined shortfall on our trade in goods, services and income — has reached nearly $8 trillion. That’s borrowed prosperity on an epic scale.

That’s been adding to our real terms of trade and standard of living on an epic scale, and, ironically, the rest of the world is fighting to continue it while we are pressing to end it. Go figure!

It is also an outcome that Milton Friedman said could never happen when, in 1971, he persuaded President Nixon to unleash on the world paper dollars no longer redeemable in gold or other fixed monetary reserves. Just let the free market set currency exchange rates, he said, and trade deficits will self-correct.

He was right. It continuously self corrects to reflect rest of world savings desires of $US financial assets.

It may be true that governments, because they intervene in foreign exchange markets, have never completely allowed their currencies to float freely. But that does not absolve Friedman’s $8 trillion error. Once relieved of the discipline of defending a fixed value for their currencies, politicians the world over were free to cheapen their money and disregard their neighbors.

Yes, to our advantage!

In fact, since chronic current-account deficits result from a nation spending more than it earns, stringent domestic belt-tightening is the only cure.

Leave it to Dave to promote a cure for prosperity.

When the dollar was tied to fixed exchange rates, politicians were willing to administer the needed castor oil, because the alternative was to make up for the trade shortfall by paying out reserves, and this would cause immediate economic pain — from high interest rates, for example. But now there is no discipline, only global monetary chaos as foreign central banks run their own printing presses at ever faster speeds to sop up the tidal wave of dollars coming from the Federal Reserve.

It’s not from the Fed, Dave, it’s from the Treasury deficit spending and private deficit spending.

The second unhappy change in the American economy has been the extraordinary growth of our public debt. In 1970 it was just 40 percent of gross domestic product, or about $425 billion. When it reaches $18 trillion, it will be 40 times greater than in 1970. This debt explosion has resulted not from big spending by the Democrats, but instead the Republican Party’s embrace, about three decades ago, of the insidious doctrine that deficits don’t matter if they result from tax cuts.

Public sector deficits = non govt savings of those financial assets. And the unemployment rate and inflation rate are telling us federal deficits are too small to provide the savings demanded by the rest of us.

In 1981, traditional Republicans supported tax cuts, matched by spending cuts, to offset the way inflation was pushing many taxpayers into higher brackets and to spur investment. The Reagan administration’s hastily prepared fiscal blueprint, however, was no match for the primordial forces — the welfare state and the warfare state — that drive the federal spending machine. Soon, the neocons were pushing the military budget skyward. And the Republicans on Capitol Hill who were supposed to cut spending exempted from the knife most of the domestic budget — entitlements, farm subsidies, education, water projects. But in the end it was a new cadre of ideological tax-cutters who killed the Republicans’ fiscal religion.

And over the next 10 years inflation came down from over 12% to 3%, even with all the deficit spending because savings desires were even higher, and continue to grow geometrically due to tax advantaged pension contributions, etc.

Through the 1984 election, the old guard earnestly tried to control the deficit, rolling back about 40 percent of the original Reagan tax cuts. But when, in the following years, the Federal Reserve chairman, Paul Volcker, finally crushed inflation,

Volcker did not crush inflation. If anything, his high rates added to business costs and unearned income long after inflation turned down due to positive supply shocks in the energy markets, helped by the dereg of natural gas in 1978 that did the lion’s share of cutting the demand for crude for electricity generation.

enabling a solid economic rebound, the new tax-cutters not only claimed victory for their supply-side strategy but hooked Republicans for good on the delusion that the economy will outgrow the deficit if plied with enough tax cuts. By fiscal year 2009, the tax-cutters had reduced federal revenues to 15 percent of gross domestic product, lower than they had been since the 1940s. Then, after rarely vetoing a budget bill and engaging in two unfinanced foreign military adventures, George W. Bush surrendered on domestic spending cuts, too — signing into law $420 billion in non-defense appropriations, a 65 percent gain from the $260 billion he had inherited eight years earlier. Republicans thus joined the Democrats in a shameless embrace of a free-lunch fiscal policy.

Not my first choice for Federal spending, but certainly did the trick of turning the economy in 2003.

The third ominous change in the American economy has been the vast, unproductive expansion of our financial sector. Here, Republicans have been oblivious to the grave danger of flooding financial markets with freely printed money and, at the same time, removing traditional restrictions on leverage and speculation. As a result, the combined assets of conventional banks and the so-called shadow banking system (including investment banks and finance companies) grew from a mere $500 billion in 1970 to $30 trillion by September 2008.

The real problem with the financial sector is that it preys on the real economy with both a massive brain drain and a drain of other real resources as well.

But the trillion-dollar conglomerates that inhabit this new financial world are not free enterprises. They are rather wards of the state, extracting billions from the economy with a lot of pointless speculation in stocks, bonds, commodities and derivatives. They could never have survived, much less thrived, if their deposits had not been government-guaranteed and if they hadn’t been able to obtain virtually free money from the Fed’s discount window to cover their bad bets.

They didn’t get free money to cover their bad debts. All losses were deducted from shareholder value. Some banks lost all shareholder funds and were liquidated or sold (with the FDIC realizing losses after the shareholders were wiped out)
Functionally, tarp was regulatory forbearance, not a federal expenditure.

The fourth destructive change has been the hollowing out of the larger American economy. Having lived beyond our means for decades by borrowing heavily from abroad, we have steadily sent jobs and production offshore. In the past decade, the number of high-value jobs in goods production and in service categories like trade, transportation, information technology and the professions has shrunk by 12 percent, to 68 million from 77 million. The only reason we have not experienced a severe reduction in nonfarm payrolls since 2000 is that there has been a gain in low-paying, often part-time positions in places like bars, hotels and nursing homes.

Not true. The trade deficit is an enormous benefit. For a given size govt, it allows for lower taxes/higher deficits so Americans can have enough spending power to buy both all we can produce at full employment plus whatever the rest of the world wants to sell us. In 1999/2000, unemployment fell below 3.8%, even as the trade deficit soared to $380 billion.

It is not surprising, then, that during the last bubble (from 2002 to 2006) the top 1 percent of Americans — paid mainly from the Wall Street casino — received two-thirds of the gain in national income, while the bottom 90 percent — mainly dependent on Main Street’s shrinking economy — got only 12 percent. This growing wealth gap is not the market’s fault. It’s the decaying fruit of bad economic policy.

Agreed!!! However this has nothing to do with the rest of what he’s been droning on about. In fact, higher deficits are usually result in stronger economies which are associated with lower income inequality.

The day of national reckoning has arrived. We will not have a conventional business recovery now, but rather a long hangover of debt liquidation and downsizing — as suggested by last week’s news that the national economy grew at an anemic annual rate of 2.4 percent in the second quarter. Under these circumstances, it’s a pity that the modern Republican Party offers the American people an irrelevant platform of recycled Keynesianism when the old approach — balanced budgets, sound money and financial discipline — is needed more than ever.

No, we need a full payroll tax holiday, $500 per capita revenue sharing for the states, and an $8 transition job for anyone willing and able to work.

David Stockman, a director of the Office of Management and Budget under President Ronald Reagan, is working on a book about the financial crisis.

23 Responses

  1. Do foreign government holdings, central bank reserves, foreign bank dollar deposits, and foreign company holdings count as private sector savings in the identity, public deficit = private savings?

  2. Warren Mosler: “That’s been adding to our real terms of trade and standard of living on an epic scale, and, ironically, the rest of the world is fighting to continue it while we are pressing to end it. Go figure!”

    I’ve asked this question before but would like to hear Warren’s opinion as well.

    Why the rest of the world would send real resources to US in exchange of USD? Why do they find USD so valuable?

    Tom Hickey explained it, if I remember correctly, with the fact that USD was the world reserve currency and the oil prices are in USD. What does world reserve currency mean?
    Professor Mitchell said, in regard with China, that the Chinese needed USD because they wanted to better place themselves in the world trade.

    1. If I could credibly add an extra digit to the left of the number representing the account balance on your bank statement would you be happier? Even before you actually used it to increase your consumption? Ever heard of a miser?

      These little numbers on pieces of paper bring a great deal of joy and comfort and confidence to a lot of people. It either shows how far-sighted human beings are or how short-sighted. Not sure which.

    2. rvm, the Saudis invoice petroleum in dollars so countries must accumulate dollars through export or buy them in the fx market. However, this is less important than the decision of the oil exporters to save in dollars. If they received dollars and trade them for euros, for example, it would not matter that much that oil is priced in dollars. But they do want to save in dollars.

      China and other Asian countries desire to save in dollars, too, for different reasons having to do with their situations. For example, China doesn’t want to have all the funds in earns from exports entering its own economy too quickly, so it sterilizes them by saving them in the US. This adds to the US capital account surplus and allows the US to run a larger trade deficit than would otherwise be sustainable without an increasing capital account surplus

      This has to do with the dollar being the global reserve currency to some degree, but that it turn depends on the US being being the global super-economy and superpower. Countries that export to the US want to save in dollars to increase the US capital account surplus to keep trade going. This is dollar hegemony. It goes along with political hegemony.

      When savers in US dollars perceive weakness in the US, then they get concerned about the value of their savings in dollars. When the value of the dollar started falling due to the combined large trade deficit and budget deficit, China started complaining. The twin deficit hypothesis predicts that when the trade deficit and budget deficit increase too much then there can be a devaluation. This would only be the case if the resulting domestic surplus (due the accounting identity) generated excessive effective demand relative to real output capacity at full employment, which would be inflationary. Far from the case now.

      A reserve currency can be thought of as the currency against which other things are valued (priced). Global commodity prices are generally quoted in dollars and global markets trade in predominantly in a reserve currency. The dollar is the primary reserve currency. The Deutsche Mark (DM) used to be secondary reserve currency, in the sense that a great deal of international commerce was conducted in the DM. The euro has effectively replaced the DM as the secondary reserve currency.

      In the fx market the dollar has a constant value of 1, and currency changes are generally measured relative to the dollar, so that the euro would be quoted as 1.xx, such as 1.36. Of course, that is nothing but a convention, but it indicates the position and status of the dollar.

      When gold was the numeraire, its value was established in dollars (the US agreed to trade a dollar for a specified amount of gold). This was called “sound money,” because gold was the real reserve. There really is no real reserve now that there is no longer convertibility.

      When the world went off the gold standard, the dollar remained as the constant. The dollar is now the numeraire, as it were, now that gold convertibility is off the table and only the dollar remains. The dollar can be converted to gold through purchase, but the US no longer guarantees to supply a specified amount of gold at the exchange window. This makes the sound money folks uncomfortable.

      Because of this “reserve” status, countries other than the US use the dollar to defend their currencies in the fx market, which figures value relative to the dollar. The Asian countries learned the hard way that it behoved them to save a large store of dollars for this purpose, so they became net savers in dollars after the crisis passed. Now they are loaded up to defend their currencies with saved dollars. (Alan Greenspan called this “the global savings glut” that he claimed was a primary factor leading to the financial crisis.)

      The primary factor here is stability. The US is considered to be the most stable country and economy. Therefore, people want to save in dollars, especially when there is instability elsewhere.

      The US is not only the criterion of stability. It is also the world’s largest economy and runs a persistent trade deficit, so it is the world’s market. Other countries are happy to save in dollars in order to accommodate that deficit, so they they can export their stuff here. Americans are, or course, happy to have real goods in exchange for paper. (That’s a bit simplistic since multinationals are involved and there are intertwined relationships.)

      This reliable capital surplus allows the US to run a higher than usual trade deficit without affecting the value of the dollar. A country’s current account deficit (CAD) must be offset exactly by its capital account surplus. If savers are unwilling to save in a country’s currency, that limits the trade deficit that a country can run.

      This was controlled by the balance of payments under a gold standard, when countries had to pay for imports in gold and exporters actually received gold in return for goods. That ended when Nixon shut the gold window in 1971. Now adjustments are made through floating rates, based on changes in different countries’ relative economic and financial position.

      The concern of deficit hawks, who tend to be left-over “sound money” people, is that dollar savers will lose confidence in the US and flee the dollar, resulting in higher interest rates in the US due to both imported inflation as import prices rise and the need to raise interest rates to fight inflation and attract foreign capital that is no longer interested in saving in dollars.

      On the other hand, US exports would rise, and US employment would increase. The deficit hawks think that the increase in employment would lead to more bargaining power of labor and demand for higher wages, also fueling inflation.

      As I understand it, the MMT’ers are saying that any changes would a gradual and adjustments would be automatic. Inflationary pressure would not become problematic until employment would begin to reach the limit of real capacity to produce. Then MMT would use the principles of functional finance to release pressure by withdrawing funds from the economy through increased taxes and decreased government discretionary spending.

      Hope I got all that right. Please correct me if I went off the rails.

      1. “Did Gold actually physically change hands? I don’t think so.”

        Actually, it did. In the old days on ships. Under Bretton Woods, the daily settlement was done in a vault many stories beneath the FRBNY building downtown. I actually got to see this in the 60’s, so I can verify it first-hand. There were a couple of “gnomes” down there moving the gold bricks from cubicle to cubicle according to the manifest. They were wearing steel-cased boots in case they dropped a kilo brick on their foot. Pretty amazing.

      2. Did Gold actually physically change hands? I don’t think so. I think we persuaded our trading partners that it was safer in Ft. Knox. So even under the “gold standard” it was just account entries.

        Whenever I hear a friend or acquaintance espouse the gold standard, I always ask, why Gold, and not Ruthenium? The latter of which is growing in value due to increasing industrial uses. Soon the other party will admit that its due to the historical perception of value in Gold, which stems from its difficulty to counterfeit, leading to a high confidence factor that its value wouldn’t be corrupted.

        Couple the “confidence factor” with the fact that it never really changed hands, it was just account entries, and I’ve had pretty good success debunking gold-standard believers. At least to my face.

      3. I once asked Jude Wanisky what would happen if we discovered that gold caused cancer and no one wanted it any more.
        He said we’d just have to find something else to replace it.

      4. I’ve long suspected nations like china pretty much know that they can target exports to a given nation by buying its currency.

        the channel most people look at is that by buying a currency that currency is stronger than it otherwise was which makes your exporters more ‘competitive’ through the cost channel.

        so when a nation wants to target exports to the euro zone, for example, it might buy euros with its local currency.

  3. “Why the rest of the world would send real resources to US in exchange of USD? Why do they find USD so valuable?”

    Basically, because we’re willing to direct them to make things we’re no longer excited about making ourselves, and they’re desperate and thrilled to learn how to do.

    This is sustainable only as long as our expertise cushion is maintained, which occurs ONLY when we put our freed up labor hours to work inventing more insanely great things to either maintain or widen the gap between our/their developmental and capability curves.

    As Warren & others are always reminding us, the currency involved is only scorekeeping.
    Unfortunately, our famous, systemic Yankee ingenuity platform is now fixated on examining the nominal currency balance residing in our fiscal naval. Anyone worried about balancing the US fiscal budget is being about as anal and off course as they come.

    Any policy wag who wants to just sit in the middle of the fiscal policy road is going to eventually see his entire country get run over by predictably growing traffic.

  4. Tom, wrt Romer, I think this is a bad sign again (Lew being the first)…she was not a deficit hawk. PS Great write up above.

    Rvm, I look at the US trade deficit as consisting of the two pillars:

    1. Oil Interests (20B/mo.)
    2. China (20B/mo.)

    For the oil interests, think of the Biblical manna.

    For China, its good business for them and supports Chinese full employment. They are happy with Treasury Bonds and other high grade USD Fianacial Assets in return as there is no cost of carry (think US property taxes/industrial depreciation if they tried to “invest” the USD here in domestic USA).

  5. The 4 definitions of economist apoplexy. Yep, wash ’em up and get ’em ready; I’m about to lay some gold standard reality on the unwashed masses. Think I’ll check to see if my direct deposit went through first. Arrgh! Why did I put a Danish on my mousepad???? WHERE are the damn napkins???

  6. Warren:

    Simply surrounding yourself with like minded people doesn’t mean you’re right. The biggest mistake you can make is thinking that your minions are “smart” because they agree with you, and others, like David Stockman, are wrong because they don’t. Yes, you understand reserve accounting. Congratulations! That doesn’t indicate that your policies are well advised or that you’ve considered the unintended consequences. Quite frankly, your “policies” are so simplistic with such little regard for the long term ramifications to be laughable. If you want to be taken seriously, stop talking about your policies and instead just focus on reserve accounting. Mention that with a change in the laws that govern the treasury, the United States wouldn’t need to issue “debt” at all…just pay some rate on reserves. Every time you’re interviewed or speak publicly, you start with the concept that we need to spend more or tax less. You immediately loose people. Instead, start with the explanation as to what a deficit in a fiat currency really means. Then, and only then, talk about TAX CUTS only. More spending or payroll tax holidays make you come off as a kook and you’re immediately dismissed. This is why you have the same 10 people always commenting on your website and the same limited audience for your message…SMALL.

  7. A Note on the Importance of Building Wealth

    There are many wonderful people who cringe when we mention wealth creation and wealth building. This is understandable when so much of the money making activities around us are destructive to humanity and the earth.

    This is why it is very important to make a clear distinction between making money and building wealth.

    Wealth has to do with abundance. Nature is constantly building wealth. The trees, birds, deer, mountain lions, bumble bees, and earth worms are all part of building and feasting on abundant wealth. Being productive in their own self-interest automatically benefits the whole. There is a symbiotic relationship between individual prosperity and collective well being. For people, building real wealth is the same. It’s about being productive in alignment with nature and the divine, and enjoying the fruits of our labor. Respectful of each other, respectful of the whole.

    Money, on the other hand, is simply a tool. In the right hands, money can be used to build more wealth and a wonderful world. In other hands, it can be used to destroy wealth. As a matter of fact, whenever it is not used to build wealth, then it gets used to destroy wealth. There is no middle ground.

    When people make money by destroying wealth, we all suffer, directly or indirectly. An economy that is based on making money by destroying wealth is what we at Solari call a “tapeworm economy” because it drains and eventually kills its host. We also call it a “negative return on investment economy” because from the point of view of the dolphins, trees and children, the net result is negative.

    Left to its own devices, the central leadership of the tapeworm economy will grow more and more powerful, increasingly draining or destroying our families and community resources worldwide.

    On the other hand, when people make money by building real wealth, we all benefit.
    First, we benefit from living in a sustainable, beautiful environment where people and animals and plants can thrive – this is the natural byproduct of real wealth building.

    Second, and even more importantly, we benefit from a weakened tapeworm — this is a bonus byproduct of real wealth building, which actually shifts power and money out of tapeworm central.

    The first is not possible without the second. To have a wonderful world, we must purge the tapeworm and build real wealth in our communities. To purge the tapeworm, we must weaken the tapeworm, and strengthen our local immunity. Unless and until we do both, we will all be increasingly at risk.

    Fighting or confronting the tapeworm, filing lawsuits and signing petitions will not weaken it. We cannot count on Congress, the Supreme Court, the corporate media, or the White House to decrease or curtail its power. Sadly, all of our efforts to date to stop the tapeworm’s destructive behavior have, if anything, only fueled the tapeworm. It is stronger and more voracious than ever.

    And simply pulling out of the tapeworm economy will not decrease its power in the slightest – the tapeworm will keep centralizing and amassing political and economic power, with or without us, makes no difference.

    The way to stop an army is to cut off its fuel supply. The way to cut off the tapeworm’s fuel supply is to pull out of the tapeworm economy and earnestly turn to building wealth and political power in our respective communities and personal networks, worldwide. The tapeworm thrives on centralization and behind the scenes secret deals, so the initial thrust is to decentralize the power and wealth, and then grow it transparently, sustainably, and abundantly at the local level.

    Since our global financial system is highly leveraged, if only 1% of 1% of our communities make this shift, it is enough to tip the scale so that all communities will be safe enough to purge the tapeworm and follow suit.

    To transform our world, we must first transform how the money works, beginning in our own back yard, building up our own assets.

    Building real wealth is not only wonderful, it is a critical point of leverage for shifting from a negative economy to a positive economy, from a negative world at risk to an abundant world at peace.

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