The Great Deformation (68 page)

So instead of addressing the growing deformations of the American economy after the dot-com crash, the Fed choose to repeat the same failed trick; that is, it once again cranked up the printing presses with the intent of driving down interest rates and thereby reviving speculative carry trades in stocks and other risk assets.

Needless to say, it succeeded wildly in this wrong-headed game plan: by pushing interest rates down to the lunatic 1 percent level during 2003–2004, the Fed sent a powerful message to Wall Street that the Greenspan Put was alive and well, and that the carry trades now offered the plumpest spreads in modern history. Under the Fed's renewed exercise in bubble finance, asset prices could be expected to rumble upward, whereas overnight funding costs would remain at rock bottom.

That is exactly what happened and the equity bubble was quickly reborn. After hitting bottom at about 840 in February 2003, the S&P 500 took off like a rocket in response to virtually free (1 percent) money available to fund leveraged speculation. One year later the index was up 36 percent, and from there it continued to steadily rise in response to reported GDP
and profit growth, albeit “growth” that would eventually be revealed as largely an artifact of the housing and consumer credit boom which flowed from the very same money-printing policies which were reflating the equity markets.

In the event, the S&P 500 crossed its old tech bubble high of 1,485 in May 2007 and finally peaked for a second time at 1,560 in October of that year. Accordingly, in one fell swoop the Fed cancelled the painful lessons that had been absorbed by stock market punters in 2000–2002, juicing the markets sufficiently to cause the S&P 500 to rise by 85 percent during just fifty months. By late 2007, the belief in instant riches from stock market gains was again alive and well on both Wall Street and Main Street.

Utilizing the institutionalized channels of stock market levitation outlined in
chapter 21
, the Fed thus enabled households to recover all of their $5.6 trillion loss on stock and mutual fund holdings from the dot-com crash. Indeed, this benchmark was achieved by late 2006. As even greater unsustainable gains were clocked by the stock averages thereafter, the paper wealth of American households continued to rise to new record levels. By early 2008, the value of household stock and mutual fund holdings reached $14.2 trillion. So, once again, the old-fashioned virtue of thrift was mocked by the prosperity managers at the Fed. The message repeated over and over in the minutes of monthly Fed meetings was that the economy was strong because Americans were again spending everything they earned and all they could borrow.

Meanwhile, the Fed would levitate financial markets so that household asset values would keep rising parallel to the growth of household debt. Society's savings function would be handled by the swelling army of Chinese industrial serfs, whose wardens at the People's Printing Press of China could not seem to get enough Treasury bonds and Fannie Maes.

WHEN ALAN SHRUGGED:

150 MONTHS OF IRRATIONAL EXUBERANCE

Needless to say, Lucy moved the football again during the Wall Street financial crisis. By year-end 2008, the household ledgers showed equity and mutual fund holdings had plunged from more than $14 trillion to only $9 trillion. This meant that $5 trillion of stock market wealth had disappeared—for the second time. Moreover, the reflated equity bubble of 2003–2008 had been built on an even shakier foundation of speculation and hopium than had been the dot-com bubble.

The S&P 500 went through a violent correction in 2008–2009, breaking through the old Greenspan bottom by early 2009 and eventually plunging
to 675 on March 9. The sheer mayhem of central bank manipulation of the stock market was starkly evident at this panic bottom. During the dark hours of early March 2009, the S&P 500 was an incredible 10 percent lower than it had been twelve years earlier at the time of Greenspan's irrational exuberance speech of December 1996.

In hindsight, that famous speech might have better been designated as
Alan Shrugged
. The Fed was on a destructive path, but refused to even acknowledge it. Consequently, irrational exuberance was the order of the day during the 150 months following the Greenspan speech.

Never before in history had the nation's financial system been pummeled by two gigantic bubbles and two devastating crashes in such a brief interval. That Greenspan's heir apparent managed to detect the Great Moderation at the midpoint of this cycle of financial violence was only added testimony to the degree to which monetary policy had become unhinged.

It was no longer plausible, therefore, to describe the New York Stock Exchange, NASDAQ, and the various venues for equity derivatives as a free market for raising and trading equity capital issues. Instead, they were violently unstable casinos, ineptly stage-managed by a central bank that had now become addicted to the printing press and a timorous vassal to the raw forces of Wall Street speculation.

WHEN BERNANKE WENT BERSERK:

THIRTEEN WEEKS OF MONEY-PRINTING MADNESS

Still, the hapless monetary central planners were not done with their bubble making. Indeed, the Bernanke Fed had not only forgotten the wisdom of Greenspan 1.0, but positively scorned it. Running the printing presses like never before in all of historical time, the Fed did succeed in spotting the football one more time, inflating its third equity bubble in fifteen years.

By now the routine was familiar. In a state of feverish panic which made the Greenspan Fed after Black Monday seem like a model of deliberation, the Bernanke Fed expanded its balance sheet at a pace which sober historians someday will describe as simply berserk. As of the week ending September 3, 2008, the Fed's balance sheet stood at $906 billion, a level it had taken ninety-four years to build up to after it opened its doors for business in October 1914.

Now, driven by the panicked demands for relief from Wall Street speculators and their agents in the US Treasury department, the Fed added another $900 billion to its balance sheet in just seven weeks. Ninety-four years of reasonably deliberative history was thus replicated in three fortnights of panic inside the Eccles Building.

And still the madness continued. By the week of December 10, just thirteen weeks after the Lehman failure, the Fed's balance sheet stood at $2.25 trillion. The nation's central bank had thus expanded its footings by 2.5X in what amounted to the blink of a historical eye.

The root of Bernanke's staggering monetary deformation is that in the years since October 1987 the nation's central bank has effectively destroyed the free market in interest rates. Once the Fed embraced easy money and prosperity management through the Wall Street–based wealth effects, the character of interest rates changed fundamentally—rates became a bureaucratically administered value emanating from the FOMC, not a market-clearing price representing the true supply and demand for money and debt capital.

Owing to the destruction of free market interest rates, a modern Wall Street panic and its aftermath unfolded in a manner which is the very opposite of the principles of sound finance manifested during the great panic that erupted on Wall Street precisely 101 years earlier in October of 1907. The Fed was not then run by a math professor from Princeton, nor did the nation even have a central bank.

J. P. MORGAN AND THE PANIC OF 1907:

HOW FREE MARKET INTEREST RATES FELLED THE SPECULATORS

Wall Street was managed during those tumultuous weeks by the great financier J. P. Morgan. Presiding over the markets from his library in midtown Manhattan, Morgan did not have a printing press, but he did possess the extraordinary financial wisdom garnered during a lifetime of high finance in an era when money was a fixed weight of gold, and interest rates were the price which cleared the free market.

In a word, Morgan knew that Wall Street was rotten with speculative excesses which had built up during the previous decade, and that market-clearing interest rates were needed to cleanse the system. Accordingly, during the most heated weeks of the Panic of 1907 the benchmark interest rate of the day—the call money rate—soared by 3 to 5 percentage points on some days, and reached a level of nearly 25 percent at the crisis peak.

In this setting, J. P. Morgan presided over a financial triage that saved only the truly solvent, not an indiscriminate Bernanke-style bailout which propped up all the speculative excesses which had triggered the crisis in the first place. Accordingly, as the call money rate soared, margin loans were systematically called, and the punters of the day were felled without mercy.

Among the financially departed were copper barons, several highly leveraged
railroads, legions of real estate speculators, and numerous poorly funded trust banks. The toll also included thousands of stock market operators who had built fortunes on margin loans.

Needless to say, after the smoke cleared from the battleground, the financial follies of the day had been burned out of the system and bullish enthusiasm went into an extended dormancy. The stock market did not regain its September 1906–1907 peaks for another five years, and by then the US economy had grown by nearly 30 percent.

BEN BERNANKE AND THE PANIC OF 2008:

HOW SOCIALIST INTEREST RATES REWARDED THE SPECULATORS

By contrast, the distinguishing hallmark of the September 2008 panic is that the Bernanke Fed shut down the money market instantly, thereby preventing free market interest rates from making their appointed cleansing rounds. Thus, on the Friday before Lehman failed, the overnight Libor rate—the closest thing to a true money market interest rate—stood at 2.1 percent and was in the range that had prevailed for most of the previous summer. The Lehman news caused it to spike to 6.2 percent on Tuesday, a mere flicker by the standards of J. P. Morgan's day.

Nevertheless, this modest upwelling of open market interest rates set off alarm bells on Wall Street, and soon the cronies of capitalism were demanding a huge dose of socialist intervention to flatten interest rates. Mr. Market's initial attempt to ignite the cleansing flame of rising rates was doused on the spot by the Fed's emergency lending fire hoses. Interest rates quickly fell back.

Rates then spiked a second time to 6.5 percent on September 30 when the first TARP vote failed, but thereafter they were literally flattened by the Fed's flood of liquidity. Overnight Libor thus subsided to 2 percent by October 10, then to under 1 percent by the end of the month, and finally to 15 basis points—a comic simulacrum of a price for money—by the end of December 2008.

Nearly four years later, Libor still remained at that exact level, a lifeless victim of the Fed's foolish tidal wave of fiat money. It goes without saying that speculators in J. P. Morgan's time did not come out of hiding for several years after the grim reaper of free market interest rates had passed through the canyons of Wall Street. By contrast, it took only about a hundred stock market trading sessions under the free money régime of the Bernanke Fed until speculators concluded that the “all clear” had been sounded.

Indeed, observing the abject way the Fed bowed to the demands of Wall Street in the days after Lehman, speculators concluded that the nation's
twelve-person monetary politburo, holed up night and day in the Eccles Building, feared another hissy fit on Wall Street more than anything else. And for good reason. Never before had overnight wholesale money been literally free, nor had a central bank ever promised that it would remain free for the indefinite future.

CHARLIE BROWN LUNGES AGAIN:

THE FED'S THIRD STOCK MARKET BUBBLE

With the free market interest rate mechanism deeply impaired if not destroyed, and downside risk virtually eliminated from the price of equities and other risk assets, the stock market bounded upward by 50 percent from its post-crisis bottom by March 2010. It didn't matter that the Main Street economy was still underwater. At that point, real GDP was still 3 percent below its 2007 cyclical peak, while payroll employment was off by 7 million jobs and industrial production was lower by 10 percent.

So it was evident that Wall Street was not pricing a conventional economic recovery. Instead, Wall Street was pricing in a brimming confidence that it could compel the Fed to continue supplying monetary juice for the indefinite future.

The punters were not mistaken. By early 2012 the S&P index reached 1,300 and was therefore up by nearly 100 percent from its March 9, 2009, reaction low. Once again, stock prices seemed to be growing to the sky. But also, once again, not really. The S&P 500 index had first crossed the 1,300 level thirteen years earlier in March 1999. Charlie Brown was now lunging at the football for the third time.

The Fed's data for household balance sheets nailed the story. By year-end 2011, when the Fed was well along inflating its third equity bubble, the figure for household stock and mutual fund holdings stood at $12.7 trillion. That was uncannily identical to the $12.7 trillion level posted in December 1999.

So three equity bubbles notwithstanding, Main Street America had spent a decade going nowhere, even as it was violently whipsawed along the way. Still, the idea of instant riches was kept alive by the Fed's continuous attempts to levitate the stock market. Moreover, the Fed's press releases and other smoke signals now added an especially nasty twist to its bubble syndrome; namely, that Charlie Brown would be forced to lunge at the Fed's third equity bubble, whether he wanted to or not, because the nation's central bank made it perfectly clear that it intended to eliminate all the alternatives.