The Great Deformation (13 page)

Apologists claim that the Reagan–Bush flood of red ink had nothing to do with the gains embedded in the GDP numbers, but, alas, the nation's GDP accounts were designed by Keynesian economists in the 1930s and 1940s. They most certainly believed that gross borrowings of the public sector are spent in a way that adds to GDP. Government wages and purchases, for example, go straight to GDP, and transfer payments also quickly end-up in the PCE (personal consumption expenditure) component of GDP. Since these three budget items doubled during 1980–1992 it is undeniable that the Reagan deficits gave a mighty boost to GDP.

Moreover, there wasn't much that resembled “supply-side” gains in the makeup of the GDP internals. Real private investment spending—the ultimate measure of supply-side growth—expanded at just 2.5 percent annually during the period. That was far below the 4.7 percent average for 1954–2000. Likewise, private sector productivity, another key supply-side metric, grew at only 1.7 percent per annum and therefore also at a lower rate than the postwar average.

By contrast, the demand side of the GDP accounts, consumption expenditures and government spending, grew nearly 25 percent faster than their long-term average. In combination, therefore, a weaker supply side and stronger demand side added up to nothing special; that is, a 3 percent average GDP growth rate during the twelve-year period which was dead-on the fifty-year average.

Traditional conservative economists, of course, would counter that deficit-fueled GDP growth is illusory because historically some part of deficit spending went into monetary inflation, not real growth, and some private investment spending was crowded out by higher interest rates owing to Uncle Sam's competition for savings.

In the new era of irredeemable floating dollars, however, this was no longer true. Much of the treasury debt issued to finance the deficit went into the vaults of central banks around the globe, and the spending they
financed went into fatter GDP accounts at home. There weren't many offsets.

Nixon famously declared himself to be a conventional Keynesian in 1971. But in striking down the international monetary discipline of the Bretton Woods system, he became much more; namely, the Keynesian godfather of the worldwide boom of the late twentieth century.

In fact, the vast new capacity of global central banks to monetize US treasury debt which inexorably evolved from Nixon's floating-dollar arrangement was laden with a supreme irony. Just one decade later it permitted the most conservative president in a generation to launch a deficit-financed Keynesian boom and get away with it.

GLORIOUS TO BE RICH IN CHINA AND TO BORROW MONEY IN AMERICA

The second spell of phony prosperity was also owing to Nixon's 1971 blow to global financial discipline. During Greenspan's first thirteen years at the Fed (1987–2000), the S&P 500 index rose from 300 to nearly 1,500. This humongous fivefold gain has been celebrated by Republican orators as the unfolding of the Reagan prosperity, but it actually measured the arrival of central bank–driven bubble finance: a false prosperity purchased with debt, speculation, and the offshoring of the tradable goods core of the American economy.

In 1994, Deng Xiaoping, the Chinese leader who was the driving force behind his country's radical economic transformation in the late twentieth century, declared it was “glorious to be rich.” His government would therefore ensure that much glory came to the new export factories of China's Guangdong Province. To that end, the People's Printing Press of China flooded the economy with newly minted renminbi (RMB) and lowered its exchange rate against the dollar by 60 percent.

Not surprisingly, millions of Chinese teenagers, trapped in the hopeless poverty created by Mao Zedong's disastrous experiments in farm collectivization and backyard industrialization, flocked to Mr. Deng's bright new factories in the east. Whether they came to get rich or just eat, they constituted the greatest migration of quasi-slave labor in human history.

Fueled by virtually cost-free labor, cheap capital and land, nonexistent environmental standards, and a newly trashed currency, the Chinese export machine took off like a rocket. During the decade ending in the year 2000, for example, annual US imports from China rose from $5 billion to $100 billion.

More importantly, China was only the newest entrant in the convoy of East Asian nations which had learned how to peg their currencies to the
floating dollar and thereby fuel a powerful new development model of export mercantilism. To spur ever rising exports of manufactures to the United States, they pegged their currencies cheap; and to keep these pegs intact, they bought and hoarded more and more US treasury bonds and bills.

This arrangement defied every tradition of sound international finance, and the harm was soon glaringly evident. During the nine years after 1991, the US trade accounts literally collapsed, with imports growing at 11 percent annually, or nearly double the gain in exports. The trade deficit thus surged from $66 billion in 1991 to $450 billion by the year 2000, thereby reaching nearly 5 percent of GDP. It was an unfathomable figure by the canons of classic finance because it was literally upside down. The reserve currency country was supposed to run a trade surplus and export capital to less developed trading partners, not incur massive deficits and drain capital from them.

By the turn of the century the United States was living far beyond its means, as measured by the cumulative trade deficit of nearly $2 trillion that had been incurred just since the 1991 recession. Under traditional fixed exchange rate discipline, the job of the central bank in these circumstances had always been to tighten money, raise interest rates, and curtail domestic demand sufficiently to eliminate the trade deficit and the associated loss of monetary reserves.

The Greenspan Fed did the just opposite, however, and thereby contradicted every gold standard speech that Alan Greenspan had ever delivered in his earlier incarnation. The result was an artificial domestic borrowing boom unprecedented in peacetime history. Between 1993 and 2001, credit market debt outstanding soared from $16 trillion to $29 trillion, representing an 8 percent annual growth rate.

Even a stable economy cannot sustain debt growth rates of that magnitude. In the 1990s, however, the US economy could not stand even a fraction of that debt growth rate because it was being battered by the greatest deflationary event in history; that is, the pegged currencies that enabled a tsunami of cheap labor and cheap manufactures out of the rice paddies of Asia.

The Fed's failure to respond appropriately to the great Asian deflation is evident in the fact that money GDP growth of $3.6 trillion during this eight-year period paled compared to the $13 trillion growth of credit market debt. In other words, there was $3.60 of debt growth for each dollar of added GDP. And it was getting worse, with credit market debt growth in 2001 alone of $2.2 trillion—6.5 times faster than money GDP.

The great prosperity celebrated in the late 1990s was thus nothing of the
kind, and in fact reflected an artificial domestic demand that was bloated by the massive Greenspan debt bubble. Moreover, this artificial domestic demand generated even greater imports and trade deficits, thereby further unbalancing the national economy.

The cure for excess demand and borrowing, of course, is higher interest rates. Yet after the 1991 recession ended, the Greenspan Fed never even returned interest rates to their prerecession levels. It thereby abdicated the historic job of sound central banking—namely, to lean hard against a current account deficit by curtailing domestic demand.

By late 1998, the US economy worked up a massive head of borrowed steam, and the nearly maniacal stock market finally faltered due to the Russian default and the LTCM crisis. Yet rather than letting the bubble wash out, the Fed charged ahead in the wrong direction, pegging short-term interest rates at 4 percent, a level far lower than at the start of the cycle and an inducement for the domestic debt binge to continue. In short, the nation was already living massively beyond its means, but the Greenspan Fed kept hitting the monetary accelerator, not the brakes.

This was really nothing more than Keynesian-style monetary activism—that is, operation of the Fed's printing presses based on whatever whims struck the fancy of its twelve-person open market committee, especially its chairman.

Their fancy, of course, was to purge the business cycle of its natural oscillations and deftly manage the American economy to ever greater heights of performance and prosperity. As the nation's self-appointed central planner, the Fed saw fit to translate its vague legislative mandates to pursue full employment and price stability into an open-ended license to meddle and micromanage.

Any perceived faltering in the growth of employment and output was to be countered by toggling its monetary joystick; that is, the interest rate on federal funds. The central banking branch of the state thereby took custody of the nation's economy.

Ronald Reagan came to Washington to liberate free enterprise. The greatest irony of his presidency, therefore, is the appointment of a Fed chairman who repudiated his essential purpose by institutionalizing a statist régime through the back door of activist monetary policy.

GREENSPAN'S JUNK ECONOMICS: THE CHINA PRICE AND THE FALLACY OF THE TAYLOR RULE

The particular fancy that preoccupied the Fed chairman was that the consumer price index (CPI) trend rate of inflation dropped from around 4 percent before the 1990 recession to about 2.5 percent by the second half of
the 1990s. Greenspan concluded that this was the result of a miracle of productivity and the Fed's skill at inflation fighting.

He therefore encouraged the open market committee to embrace a gussied up reincarnation of the Phillips curve trade-off between unemployment and inflation. The new monetarist variation was known as the Taylor rule, but it amounted to the same old demand-side error. It called for lower interest rates and a frothier party on Wall Street on the pretext that reduced inflation and available slack in potential output justified easier money. But this reasoning was upside down. The Taylor rule was mathematical junk posing as monetary science.

The consumer price index was rising at a slower rate not because of a miracle of domestic productivity or because the Fed had scored a roaring success in subduing domestic inflation. And most certainly it was not because the US economy was wallowing in unrealized “potential” output as fantasized by Professor Taylor, who had seen fit to name the rule in his own honor.

The downward pressure on the CPI was actually of exogenous origin. The epochal wage deflation generated by the Chinese export factories was rapidly destroying existing capacity in the American economy. This caused “potential” output to fall, not rise, as the Taylor rule enthusiasts erroneously claimed.

Indeed, the “China price” deflated the cost of both imported goods and import-competitive domestic manufactures so sharply that the average US price level should have actually been declining, not just rising less rapidly. Yet that did not happen. From December 1990 to December 2000 the average annual CPI increase was 2.7 percent, and exceeded 3 percent during the final two years.

Domestic price gains of nearly 3 percent annually were perverse because they thwarted the needed downward adjustment of domestic wages and production costs, an adjustment essential to preserving competitiveness and jobs. Moreover, monetary pass-through of the Asian deflation would have stretched the domestic buying power of nominal wages and bolstered real living standards.

Instead, the Fed showered the American economy with cheap debt, which amounted to a policy of fostering more consumption and less production. It also meant that the CPI index vaulted higher by 30 percent during the decade while employee compensation per hour rose by 35 percent. American workers thus barely kept up with the cost of living, even as they priced themselves out of the world market.

So the Fed's claim of taming inflation during the 1990s was valid arithmetically but was not benign economically. It drastically widened the
nominal wage gap with Mr. Deng's new export factories, paving the way for an even higher tide of imported manufactures and even more extensive destruction of the US production and employment base.

In short, Mr. Deng's “glorious to be rich” proclamation signaled the onset of a vast and powerful tide of global deflation in wages and prices. But the Greenspan Fed blew it. Rather than allowing the US economy to harvest the living standard gains of deflation and to adjust to the pains of falling nominal wages and profits, it declared a debt party.

THE FED'S $13 TRILLION DEBT PARTY

The 1990s American economy could ill afford to take on more debt and raise the leverage burden on national income. In fact, its capacity to generate income was declining on a permanent basis in the face of the Asian deluge, meaning that the Fed's policy of fostering massive growth of domestic debt was profoundly mistaken. Indeed, the Fed effectively took itself hostage. It required more and more credit-fueled consumption spending to make up for production and income which was being lost to the Asian export machine. Bubble finance became a substitute for real income and productivity.

The Fed's $13 trillion credit bubble during 1993–2001 also caused a phony boom on Wall Street. The soaring stock averages at the end of the decade in part reflected a near tripling of the valuation multiple (price-to-earnings [PE] ratio) on corporate earnings per share (EPS). This virtually unprecedented expansion of PE ratios implied that the growth potential of the US economy was accelerating.