The Great Deformation (52 page)

Never again were trade accounts between nations properly settled, and most especially in the case of the United States. As previously indicated, the cumulative current account deficit since 1971 exceeds $8 trillion, meaning
that Americans have borrowed one-half “turn” of national income from the rest of the world in order to live permanently beyond their means.

These massive US trade deficits have actually become a way of life since Camp David, yet they were not supposed to even happen. Professor Friedman advised the Nixon White House at the time that market forces would actually eliminate the incipient US trade deficit by “price discovery” of the “correct” market clearing exchange rates.

In this manner, floating exchange rates would continuously rebalance the flows of merchandise trade, direct investment, portfolio capital, and short-term financial instruments according to the changing circumstances of each nation. A global variant of Adam Smith's “unseen hand” would supplant the financial stabilization and trade settlement functions of the old-fashioned gold standard that the discarded Bretton Woods system had been built upon.

In short, international markets would be cleared by the continuous repricing of exchange rates. This meant that deficit countries would suffer currency depreciation and surplus countries the opposite, thereby maintaining international payments equilibrium.

As previously demonstrated, this seemingly enlightened, pragmatic, and market-driven arrangement didn't work in practice. As it turned out, Adam Smith's unseen hand never even reported for work after Professor Friedman's floating-rate contraption was put into global operation.

Instead of floating with market forces, exchange rates have been chronically and heavily manipulated by governments. This is especially the case with respect to the mercantilist nations of Asia in pursuit of an “export your way to prosperity” economic growth model.

In pegging their currencies far below market-clearing levels in monomaniacal pursuit of export advantage, Japan, China, South Korea, and the caravan of imitators along the East Asian rim accumulated more and more dollars. They then parked these excess dollars in Treasury bills and bonds, and sequestered the latter in the vaults of their central banks.

Over the years, these staggering accumulations of dollar liabilities have been labeled as “foreign exchange reserves” in deference to the wholly archaic notion that the dollar is a “reserve currency.” But the $7 trillion of dollar liabilities now held by foreign central banks are not classic monetary reserves at all.

The classic system's monetary reserves were designed to function as international petty cash accounts; that is, world money in the form of gold was available to clear temporary imbalances in trade and capital flows between national currency areas. But the current system does not need petty
cash reserves to clear international account imbalances because the latter can persist indefinitely so long as mercantilist nations peg their currencies.

Consequently, the more apt characterization of these vast dollar accumulations is that they are vendor-supplied export loans to the American economy. Like any other vendor loan, they are designed to enable American customers to collectively purchase foreign goods and services far in excess of their actual earnings on current production.

This continuous stream of vendor loans was heavily channeled into Treasury bonds and bills, along with the implicitly guaranteed paper of Fannie Mae and Freddie Mac. Thus, the true foundation of the post–Bretton Woods monetary system was US government debt. The latter became the medium of exchange which permitted Americans to consume far more than they produced, while enabling the developing Asian economies to export vastly more goods than their customers could afford.

Indeed, with the passage of time the swap of mercantilist nation exports for US government paper became embedded as the modus operandi of the global economy. Milton Friedman's monetary contraption has thus become a ravenous consumer of Uncle Sam's debt emissions, an outcome that the idealistic professor had apparently never even contemplated.

By the end of 2012, however, the facts were unassailable. After three decades of “deficits don't matter” fiscal policy, the nation's publicly held debt amounted to $11.5 trillion. Yet as indicated, a stunning $5 trillion, or nearly 50 percent, of that total was not held by private investors either at home or overseas. Instead, it had been sequestered in the vaults of central banks, including the Federal Reserve and those of major exporters.

MONETARY ROACH MOTELS:

THE BONDS WENT IN BUT NEVER CAME OUT

This freakish central bank accumulation of dollar liabilities, in turn, was the result of the greatest money-printing spree in world history. In essence, we printed and then they printed, and the cycle never stopped repeating. In this manner, the massive excess of dollar liabilities generated by the Fed were absorbed by its currency-pegging counterparts, and then recycled into swelling domestic money supplies of yuan, yen, won, ringgit, and Hong Kong dollars.

As the US debt-based global monetary system became increasingly more unstable in recent years, central bank absorption of incremental Treasury debt reached stunning proportions. Thus, United States publicly held debt rose by $6 trillion between 2004 and 2012, but upward of $4 trillion, or 70 percent, of this was taken down by central banks.

It could be truly said, therefore, that the world's central banks have morphed into a global chain of monetary roach motels. The bonds went in, but they never came out. And therein lays the secret of “deficits without tears.”

American politicians thus found themselves in the great fiscal sweet spot of world history. For several decades to come, they would have the unique privilege to issue bonds, notes, and bills from the US Treasury without limit. Only in the foggy future, when the world finally ran out of mercantilist rulers willing to swap the sweat of their people for Washington's profligate debt emissions, would fiscal limits reemerge.

As it happened, not all American politicians immediately recognized that they had essentially died and gone to fiscal heaven. Hence in the first half of the 1990s, under George H. W. Bush and then President Bill Clinton, old-guard Republicans joined bourbon Democrats in the enactment of comprehensive fiscal plans that did actually reduce spending and raise new tax revenues.

But Bill Clinton's courageously balanced budgets were the last hurrah of the old fiscal orthodoxy. These outcomes rested on a frail reed of personal conviction among politicians who had learned the fiscal rules of an earlier era.

In the emerging world of American crony capitalism, however, fiscal orthodoxy based on mere conviction untethered to real-world economic and financial pressures was not destined to survive. Instead, the assembled lobbies of K Street would soon have their way with the nation's public purse.

In due course, the revenue base would be depleted in the name of spurring the growth of everything from ethanol plants to private aircraft to the gross national product itself. Meanwhile, the spending side of the budget became swollen with new subventions to the sick-care complex, the housing complex, the education behemoth, the farm subsidy harvesters' alliance, and the alphabet soup of energy alternatives.

In the larger scheme of things, the nation's descent into permanent fiscal profligacy during the late twentieth century should not have been surprising. The historical record prior to the T-bill standard quite clearly demonstrates that fiscal discipline had never really depended upon the fortitude of principled statesmen.

GREENSPAN'S BORROWED PROSPERITY

After the Greenspan Fed abruptly abandoned its 1994 effort to impose a mild semblance of monetary discipline, the world's T-bill-based monetary system was off to the races. Frenetic money pumping by the Fed was reciprocated
by even more aggressive currency pegging in East Asia, most especially in China, where the exchange rate was devalued by nearly 60 percent at the beginning of Mr. Deng's export campaign in 1994.

Fueled by this reciprocating monetary engine of central bank printing presses, the world economy was soon booming and the US current account deficits swelled to massive proportions. Thus, the current account deficit of $114 billion in 1995 was already an alarming 1.6 percent of GDP, but that was just a warm-up for the coming binge of borrowed prosperity.

Thereafter, the US current account deficit with the rest of the world went parabolic, rising to $416 billion, or 4.2 percent, of GDP by the year 2000. Indeed, for the entire 1990s decade the nation's cumulative deficit with the world was $2.0 trillion—a giant loan from abroad that bought a lot of designer jeans, personal computers, granite-top kitchen counters, gaschugging SUVs, and luxury cruises that American households had not actually earned.

Yet the borrowing binge fostered by the Greenspan Fed was just getting warmed-up. American overspending financed by exporter nation loans attained nearly riotous proportions after the turn of the century, reaching, a peak current account deficit of $800 billion, or 6.1 percent, of GDP in 2006.

For the decade ending in 2011, cumulative borrowings from the rest of the world tripled from $2 billion in the 1990s to $6 trillion. And so America's garages, pantries, media rooms, and second homes filled up with even more stuff bought on the prodigious flow of credit generated by the world's T-bill-based monetary system.

In the fullness of time, floating-rate money led to fiscal profligacy on a scale never before imagined. Spending without the inconvenience of taxing opened the door to state subventions, bailouts, and endless tax breaks throughout the length and breadth of the American economy.

But the plenary mobilization of the state and all its agencies and organs of intervention, including the prosperity management régime of the central banking branch, is what fueled the rise of crony capitalism. It is a longstanding truism of political science that focused, organized special interests will always trump the diffuse public interest. So once raiding the Treasury and leveraging Wall Street and the banking system were deemed to be the pathway to the greater good, K Street lobbies and political action committees (PACs) captured the instruments of policy and extracted the resources of the public purse like never before.

So the irony was abundant. Friedman the historian was dead wrong on the gold standard and the Fed's responsibility for the Great Depression. Accordingly, the libertarian economist from the University of Chicago, more than any other single intellectual, fostered the Nixonian breakdown of
monetary integrity and helped crush the last age of fiscal rectitude so painstakingly restored by Dwight D. Eisenhower.

Proffering what is by the hindsight of history a spurious rule of money supply growth, Friedman gave birth to the T-bill standard and a massively disordered and unbalanced international system in which mercantilist governments swap the labor of their people and natural resources of their lands for “money” which is merely dollar-denominated American debt.

Worse still, the later process became the foundation for the age of bubble finance, a great financial deformation that resulted in a Wall Street crescendo of speculation and rent seeking that had no historical parallel. Neither did Friedman's folly.

PART IV

THE AGE OF BUBBLE FINANCE

 

CHAPTER 14

 

N
IXON'S ESTIMABLE FREE MARKET ADVISORS WHO GATHERED AT
the Camp David weekend were to an astonishing degree clueless as to the consequences of their recommendation to close the gold window and float the dollar. In their wildest imaginations they did not foresee that this would unhinge the monetary and financial nervous system of capitalism. They had no premonition at all that it would pave the way for a forty-year storm of financialization and a debt-besotted symbiosis between central bankers possessed by delusions of grandeur and private gamblers intoxicated with visions of delirious wealth.

In fact, when Nixon announced on August 15, 1971, that the dollar was no longer convertible to gold at $35 per ounce, his advisors had barely a scratch pad's worth of ideas as to what should come next. The nationalists led by Treasury Secretary Connally wanted our trading partners to absorb a sharp devaluation of the dollar. Hence, the illegal 10 percent surtax on imports was to remain in place until they sued for peace.

Others led by Fed chairman Arthur Burns believed that the shocking announcements from Camp David would be merely a catalyst for international negotiations to “reset” the existing Bretton Woods system. The gold parity would be set at a more realistic (higher) level and this would be coupled with more favorable (lower) dollar exchange rates against the other major currencies. Once Bretton Woods was “reset,” the Burns traditionalists believed that the advantages of fixed exchange rates and global financial stability and discipline could be preserved.

And the free markets faction led by George Shultz didn't think any follow-up plan was even necessary. Instead, following Nixon's Sunday evening announcement that he was unplugging Bretton Woods, they apparently thought that the “market” would take over the very next morning. No sweat.

THE POST–CAMP DAVID BOLLIX

In fact, the aftermath was thoroughly bollixed. Lacking any semblance of a plausible game plan, the Nixon administration stumbled around for another twenty months seeking to modulate the chaos it had unleashed.