The Great Deformation (83 page)

The Fed's radical interest rate repression campaign, which fostered this unprecedented debt explosion, was thus an utterly misbegotten enterprise. The very notion that the central bank would deliberately peg the money market rate at 1 percent was just plain off the deep end; it defied all historical canons of sound finance.

The end result was a vicious financial bubble that exploded from its inner tensions and instabilities in September 2008. Yet the Fed couldn't explain why the Wall Street meltdown happened owing to a singular reality: the stock market had been propped up all along by a financial engineering binge that had been enabled by the Fed's own policies.

WHEN HELICOPTER BEN CRIED WOLF ABOUT DEFLATION

The unwinding of the massive Greenspan debt bubble implicated an extended deleveraging cycle in which the phony growth of the bubble years would be given back and there would be persistent downward pressure on consumer prices. But a modest reprieve from the relentless forty-year rise in the cost of living, which meant that a dollar saved in 1971 was now worth just twenty-five cents, would have been beneficial to much of society. Wage workers and retirees whose incomes had not even kept up with the understated CPI-U (consumer price index for all urban consumers) would have especially benefited.

This kind of slow, constructive deflation owing to the end of the American debt binge, however, would not have been even remotely comparable to the 30 percent drop in consumer prices after the 1929 crash, nor would it have triggered a depressionary collapse of output and employment (see
chapter 29
).

In truth, Professor Bernanke was exploiting his reputation as a Depression scholar to peddle the Keynesian canard that price stability—that is, zero inflation plus or minus—is a bad thing. Indeed, Bernanke had gone fully Orwellian: what “deflation” meant to the money printers at the Fed
was the absence of 2 percent “inflation.” Through some economic alchemy that has never been proven, they insisted that the way to get more jobs and output growth was to debauch the money by 2 percent each year; that is, reduce the dollar's purchasing power by 50 percent over a standard working lifetime.

This was the second time that Bernanke had played the “deflation” card. Back in 2002–2003, he had provided exactly the same rationale for the Fed's first round of panicked interest rate cutting. Freshly appointed to the Fed, he had hinted darkly about a 1930s-style deflation. But the actual data soon proved that to be balderdash.

Goods and services inflation was still very much alive and kicking and remained so right through the last days of the Greenspan bubble. The aforementioned $4 trillion debt-swollen gain in nominal GDP during 2000–2007, for example, was rife with inflation. More than half of this figure, $2.2 trillion, did not represent real output gains; it simply quantified the impact of the very rising prices that Professor Bernanke had claimed would soon be smothered in a vortex of deflation.

Bernanke's howling at the specter of deflation, in fact, proved to be loony: the CPI actually increased at a 2.7 percent annual rate during the five years through 2007, and that rate wasn't benign. It meant that inflation would steal nearly 60 percent of the dollar's purchasing power every thirty years. So there was a menace in the price trend: with the cost-of-living rising stoutly, it put “paid” to Bernanke's “deflation” warnings.

That should have also roundly discredited the Fed's radical interest rate cutting campaign, which was predicated almost exclusively on Bernanke's phony deflation scare. Instead, Professor Bernanke got promoted in 2005 to the top economic job in what was ostensibly a “sound money” Republican White House.

To their everlasting discredit, Karl Rove and the Bush apparatchiks around him could administer a litmus test on abortion to any schedule-C job seeker who came along. Yet they did not know they had brought a Keynesian money printer into their midst, an unabashed believer in Big Government who had publicly described exactly how to drop money out of a helicopter.

THE GREENSPAN-BERNANKE MONEY-PRINTING SPREE WAS A DUD: WEAKEST GROWTH IN HALF A CENTURY

All of the Fed's money printing and interest rate repression during this period did not do much for the economy of Main Street, either. During the seven-year period through the 2007 peak, national output adjusted for inflation
expanded at just 2.3 percent per year. That was the lowest seven-year rate of GDP growth since the 1930s, meaning that the Fed's wild money printing produced a dud.

What it actually generated, instead, was a lot of spending from borrowed money and very little growth in real investment and earned incomes. In fact, the three consuming sectors of the American economy—personal consumption (PCE), residential housing, and government expenditures—accounted for virtually all of the growth. These sectors expanded by $4.1 trillion between 2000 and 2007, thereby accounting for a remarkable 98 percent of the entire gain in nominal GDP.

Debt growth in all three of these sectors was exceedingly robust. On the margin, therefore, much of the gain in the GDP “print” during the Greenspan boom was simply a feedback loop: the higher GDP “prints” embodied in roundabout fashion the debt being injected into the spending side of the economy by the central bank.

In contrast to the debt-funded spending side, growth on the investment and income side was punk. Real spending for fixed plant and equipment, for example, rose at only a 1.7 percent annual rate during these seven years and actually by less than 1 percent when the Great Recession period “payback” is averaged in. Likewise, real private wage and salary incomes grew at just 1.6 percent annually—a plodding rate which obviously begs the question of how real personal consumption spending managed to grow at nearly twice that rate, or by about 2.8 percent, during the same period.

There was really no mystery. The US economy was now getting deeply entangled in an accounting illusion. Part of the extra margin of household spending compared to private wages and salaries reflected cash that was being dispensed from home ATM machines and recorded in the drawdown of the savings rate. But there was also a huge supplement to household consumption which came through the debt economy's back door; that is, from the spend out of transfer payments and government payroll disbursements.

As detailed in
chapter 29
, most of the growth in these latter categories was not owing to the honest “repurposing” of national income that occurs when transfer payments are funded with taxes. Instead, it was derived from public sector borrowings; that is, new money supplied by foreigners and their central banks or from the printing-press-funded purchases of Treasury debt by the Fed.

Notwithstanding Republican White House cheerleading, therefore, it was transfer payments—which grew at double the rate of private wages—and government payrolls that comprised the fastest growing slice of the
income pie. During the seven-year Greenspan bubble these disbursements rose from $1.8 trillion to $2.8 trillion, and accounted for nearly half of the nation's entire pre-tax income gain. That was hardly an indicator of booming capitalist prosperity.

When government borrowing of this magnitude occurs on the free market, of course, there is an offset. Interest rates are forced up and interest-sensitive spending on capital goods and consumer durables soon buckles, thereby short-circuiting any tendency of legislators to imbibe in free lunch economics. As previously detailed, the trick that made the faux prosperity of the Greenspan era possible was the nation's giant current account deficit with the rest of the world. The latter reached a peak of $750 billion and 6 percent of GDP in 2006, underscoring that the prosperity of the Greenspan bubble years was being imported on container ships from East Asia and funded by soaring indebtedness to the rest of the world.

By the end of the Greenspan bubble, therefore, the United States was getting poorer by about $2 billion each and every day, owing to its hemorrhaging current account and the orgy of consumption which it enabled. Yet the financial system had become so divorced from the Main Street economy that even as the latter grew poorer, the value of financial assets and especially the stock market averages clambered to new highs on the back of corporate financial engineering gone wild.

$13 TRILLION OF FINANCIAL ENGINEERING GAMES AND THE SIMULACRUM OF PROSPERITY

The stock market's daily narrative, especially as conveyed by financial TV, only appeared to embody the traditional focus on corporate profits and the business outlook. In reality, the proximate drivers of the stock averages were Wall Street financial engineering games: mergers, stock buybacks, and LBOs. These transactions generated the arithmetic of EPS growth by shrinking the share count, thereby giving Wall Street traders financial rabbits to chase.

The massive capital markets churning attendant to financial engineering maneuvers, however, was rooted in state policy, not the free market. The common catalyst was cheap and ample debt, the Greenspan-Bernanke Put, and the tax-favored status of leveraged balance sheets. After the Fed's easing panic began in 2001, these catalysts caused the pace of financial engineering transactions to accelerate and never look back.

Altogether, the value of M&A transactions in the United States over the years 2001 through 2008 totaled about $8 trillion, along with $2.5 trillion of stock buybacks and another $2.5 trillion of LBOs. During the course of the
Greenspan bubble, therefore, these financial engineering deals cumulated to $13 trillion.

Moreover, all three types were designed to drive up the price of existing common stock by shrinking the pool of available shares. Wall Street thus cycled a sum equivalent to the nation's entire GDP into these stock market transactions. Yet none of this raised a dime of new equity capital for productive investment.

This point goes to the heart of the bubble finance fostered by the Greenspan-Bernanke Fed. The purpose of secondary share trading on the free market is to create sufficient liquidity for savers and investors so that there is a dynamic capital market that companies can tap when they need funds for growth. By contrast, aside from the temporary insanity of the dotcom IPOs, there were only trivial amounts of primary equity raised during the entire run of the two Greenspan stock market booms.

The trading frenzy which peaked in 1999–2000 and then again in 2006–2007 consisted almost entirely of secondary market speculation where the driving force was the opposite of capital raising; which is to say, stock prices were being lifted by the liquidation of shares through buybacks, buyouts, and M&A takeovers. Even in the latter case, the overwhelming majority of M&A deals were for cash, not shares of the acquiring company, as had been the case historically.

In fact, the “Flow of Funds” data published by the Federal Reserve reveals that the maestro presided over a two-decade trend of corporate equity decapitalization. During the entire span between 1988 and 2008, there were only three years in which nonfinancial businesses actually raised net equity, and those were during the recession of the early 1990s. After that, the rate of net equity withdrawal from the business sector soared as the Fed's prosperity management model became increasingly more aggressive.

Thus, nonfinancial corporations extinguished $300 billion of net equity during 1988–1994, owing to the excess of buybacks and cash M&A takeovers compared to new equity issuance. This was followed by nearly $700 billion of net equity liquidation during the next seven years. So, while this latter period coincided with the tech boom, corporate equity was actually being drastically shrunk, the mantra of growth notwithstanding.

But it was after the Fed slashed interest rates in 2001, causing business debt issuance to explode, that the cash-out of corporate equity went parabolic. Buyout and buyback transactions drained nearly $2.3 trillion of corporate equity out of the system over the period 2002–2008. In 2007 alone, the “Flow of Funds” reports show that “net new equity issues” amounted to negative $800 billion. Hurtling this much buyback cash at a rapidly
diminishing supply of common stock levitated the stock market to the wholly artificial and unsustainable peaks of 2007–2008.

Needless to say, the Bernanke Fed was sleepwalking, furtively looking-out for deflationary goblins as it went along. Accordingly, it did not notice that the balance sheets of corporate America were being strip-mined in a manner similar to the mortgage-driven assault on household balance sheets. In fact, owing to these financial engineering transactions there had been nearly $3.5 trillion of corporate equity withdrawal, or CEW, during the two decades ending in 2008. Thus did the avalanche of credit enabled by the Fed warp and weaken the financial foundations of the nation's private economy.

STRIP-MINING CORPORATE CASH:

THE FREE MARKET DIDN'T DO IT

The rise in equity prices which resulted from these financial engineering maneuvers did not increase the national wealth. Nor did these transactions promote economic efficiency, job growth, or improved corporate management. Beyond that, there was a still more insidious aspect; namely, the false impression promoted by Wall Street and often echoed by the maestro himself that financial engineering and equity liquidation on this massive scale was a good thing because it was the work of the free market.

The idea at work here was that takeovers and buyouts arise from the so-called market for corporate control and represent the verdict of the marketplace just as in the case of a successful product or invention. Consequently, it is claimed that shareholder interests are served when poorly run companies are taken over by more competent managements. Likewise, society is said to benefit from economic efficiency gains when equity-incentivized LBO executives squeeze out waste and sloth from “underperforming” companies.