Federal Reserve

In a speech at the Mises Institute, former Reagan budget director David Stockman explains in detail what happened in 2008, what's happening today, and what's likely to happen, and why.

"The last $600 billion of C.P. is where the real crony capitalist stench lies. There were two huge users of the finance company C.P. sector – this last $600 billion – GMAC and G.E. Capital. At the time of the crisis, G.E. Capital had asset footings of $600 billion, most of which were long-term highly illiquid and sometimes sketchy corporate and commercial real estate loans. In violation of every rule of sound banking, more than $80 billion of these positions were funded in the super-cheap commercial paper market. This maneuver, of course, produced fat spreads on G.E.'s loan book and big management bonuses, too. But it also raised to a whole new level the ancient banking folly of mismatching short and hot liabilities with long and slow assets. Under free-market rules, an inability to roll $80 billion in C.P. would have forced G.E. Capital into a fire sale of illiquid loan assets at deep discounts, thereby, incurring heavy losses and a reversal of its prior phony profits. Or in the alternative, it could have held the loan book and issued massively dilutive amounts of common stock or subordinated debt to close its sudden funding gap. Either way, G.E. shareholders would have taken the beating they deserved for overvaluing the company's true earnings and for putting reckless managers in charge of the store.
So my point is that the financial meltdown during those eventful weeks was not triggered by the financial equivalent of a comet from deep space, but resulted from leveraged speculation that should have been punishable by ordinary market rules.
Viewed very broadly, or more broadly, the carnage on Wall Street in September 2008 was the inevitable crash from a 40-year financial bubble spawned by the Fed after Nixon closed the gold window in August 1971. As time passed, the Fed's market-rigging and money printing actions had become increasingly destructive, leaving the banking system ever more unstable and populated with a growing bevy of too-big-to-fail institutions. The 1984 rescue of Continental Illinois, the 1994 Mexican Peso crisis bailouts, the Fed's 1998 life-support operation for long-term capital were all just steps along the way to September 2008. Then, at that point, faced with a collapse of its own handiwork, Washington panicked and joined the Fed in unleashing an indiscriminant bail-out capitalism that has now thoroughly corrupted the halls of government even as it has become a debilitating blight on the free market."

I'm not sure Washington panicked. I think they used this manufactured crisis as an excuse to take taxing and spending to a new level.

"Now monetization, as I'm sure you all know, can be done in two ways. First, there is out-right monetization as is now being conducted by the Fed through its POMO program; that is, it's daily purchase of $4 billion to $8 billion of treasury debt. Indeed, the Fed's Q.E.2 bond purchases of late have been so massive that it is literally buying treasury paper in the secondary market almost as fast as new bonds are being issued. During January, for example, fully 40 percent of the Fed's $100 billion bond buy was from numbers of F Series of bonds that were less than 90 days old. Needless to say, putting brand new treasury bonds in the Fed's vault before they have paid even a single coupon is functionally equivalent to printing greenbacks. After all, under this type of high-speed round trip, virtually all the coupons from newly issued bonds will end up as incremental profit at the Fed and be remitted back to the Treasury at year end. Hence, the money never leaves. Stated differently, in the present era of massive quantitative easing, newly issued treasury securities amount to non-interest bearing currency without the circulation privilege.
But over the last several decades, the preferred course has been indirect monetization. That is the world's legion of willing mercantilist exporters from China to the Persian Gulf have printed their own money in vast quantities, ostensively to peg their exchange rates, but with the effect of absorbing trillions of U.S. treasury paper. To be sure, the people's money warehouse in China and those in other mercantilist lands are pleased to label these accumulations as sovereign wealth portfolios. But the fact is these hordes of sequestered dollars are not classic monetary reserves derived from a true sustainable surplus on current account. Instead, they are simply the book entry offset to the inflated local money supplies that have been emitted by this global convoy of peggers; that is, the mercantilist nation central banks tethered to the Fed."

The description of indirect monetization is instructive.

"In fact, foreign central banks hold $2.6 trillion of U.S. treasuries at the New York Fed, while the Fed itself owns $1.2 trillion of treasury debt. Add in at least a half trillion more treasury paper that is officially held elsewhere and you have the startling fact that about $4.5 trillion, or 50 percent of all the publically held federal debt ever issued, has now been sequestered by central bankers. With such a mighty bid from the world's central bankers, we have thus experienced what our classically trained forbearers held to be impossible, a prolonged era of fiscal deficits without tears."

And we're going to have to pay the price. 

"To be sure, lowering the burden of taxation on the American economy is a compelling idea from both a philosophical and an economic policy viewpoint. But deficit-financed tax cuts are a politician's snare and illusion. Such fiscal actions do not actually reduce tax payments; they just defer the timing. Moreover, the evidence of the last 30 years shows that preemptive tax cuts don't actually, quote, "starve the beast," not withstanding the popularity of this nostrum among certain K Street philosophers whose day job involves panhandling outside the Ways and Means Committee hearing room."

They still promote starve the beast? You got to be kidding me.  Stockman shows how the budget numbers are even worse than they appear.

"It's widely known, of course, that the Bush income tax rate cuts expire promptly at midnight on December 31, 2012, causing a $200 billion per year pickup in the revenue baseline thereafter, at least in the projections. But what also happens on January 1, 2012, is that the $100 billion abatement of payroll taxes abruptly expires and so does the so-called AMT patch. The latter means that the number of taxpayers facing the alternate minimum tax jumps from four million to 33 million, causing the projected annual revenue take to rise from $34 billion under the patch, temporary, to $129 billion, permanent. Likewise, the 15 percent tax rate in corporate dividends will jump to 40 percent in 2013. The estate tax goes back up. All the tax credits that are now in place expire and so forth.
Taken together, the December Christmas tree contained temporary tax provisions worth 3.8 percent of GDP, the equivalent of $650 billion annually, that will have completely expired by 2014. The resulting big uptick in revenue seems antiseptic enough when viewed on the computer screen. However, were these provisions to expire in real life, upwards of 100 million different taxpayers would take a hit. Consequently, most of these tax breaks won't expire; their due date will just be kicked down the road a couple of years as part of the annual, quote, "rinse and repeat exercise" –
(Laughter)
– which now passes for budget making.
The picture is not much different on the spending side. Something called the Doc Fix has been enacted repeatedly; a measure which temporarily waives the 20 percent drop in Medicare fees built into current law. Now upon passage, the politicians collect their election year medications from the grateful physicians lobby while taking credit for a $30 billion future annual spending reduction when the waiver expires. But, of course, it won't.
Likewise, under extended unemployment benefits, 10 million workers get various, quote, "extended tiers" of the Unemployment Insurance Program at an annual cost of $150 billion. But under current law, nearly two-thirds of this cost is deemed temporary; meaning that out-year budget projections only show $50 billion of annual expense. The reality, however, is that to avoid a cold-turkey shock, Congress has repeatedly voted extensions at the 11th hour and will again in 2012." 

Everybody knows this temporary spending will be renewed.