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A doorstop, but also a landmark,
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This review is from: The Great Deformation (Hardcover)
This is the most significant book of 2013.
It's rambling and endless. 700 pages feel like 1,700. Frankly, it's a bad read. Halfway through, you can already complete every sentence yourself, that's how bad Stockman repeats himself. I'm not sure all numbers check out. No editor ever got near this manuscript.
Before I continue with why this is the most significant book of 2013, some more bad news: The author's unifying theory is in my view quaint and irrelevant. For completeness allow me to rearrange what he believes the Great Deformation to be. It's spelled out on page 691: "In trying to improve upon the people's work on the free market, Keynesian professors from Heller to Laffer introduced the nations' politicians to the witch's brew of deficit finance, unleashing a great deformation; that is, a state which lacked any reason to stop the larceny of the K Street lobbies and the plunder of crony capitalist raiders from General Electric to Goldman Sachs, the cotton growers, the UAW, the timber barons, the ethanol distillers, the venture capital industry, the Medicaid mills, and the scooter chair manufacturers too."
The story he weaves is a dirge, a lament about loss of innocence. In his ideal world we'd still worship the lost religion of the gold standard and the US would be run by Ike Eisenhower. Ideally there would be no Fed at all, but if there was a Fed it would be busy undermining every economic recovery. There would be no financial futures exchanges and very little trading of any sort.
Don't let that put you off.
Despite doing his best to sound like Will Bonner sans the writing skills, despite himself, really, Stockman, has penned the only book currently in print that explains in plain English what's happened from 1992 to present, rather than 1913 to present. If you persevere till page 560, you will come across the following gem:
"we have a rigged system -a regime of crony capitalism- where the tax code heavily favors debt and capital gains, and the central bank purposefully enables rampant speculation by propping up the price of financial assets and battering down the cost of leveraged finance."
This is the unwitting, true thesis of the book. Its contribution, if you will. The problem he sets up is threefold
1. There is a large tax advantage to financing with debt rather than equity, because the cost of servicing debt can be carved out of your bottom line, reducing the tax a firm owes to the government. Modigliani and Miller are wrong, basically. Exactly the same holds for home ownership.
2. Tax on regular income (be it from dividends or from going to work every day) is much higher than tax on capital gains
3. The Fed perceives GDP growth to be its chief mandate and its only tool to achieve this is cheap money, which was duly delivered, and especially so when asset prices were endangered.
These three factors have unleashed the four horses of the last 20 years' financial apocalypse
1. 1992-2000 Tyco-style LBO acquisition bubble that aided and abetted but also fed off of the Internet bubble
2. The 1992-2008 private equity bubble that toward the end was 100% about Corporate Equity Withdrawal
3. The 2000-2008 GSE / mortgage broker / subprime / Wall Street / CDO housing bubble
4. The 1992- present corporate bond cum stock repurchase bubble to support stock option prices for CEOs and upper management.
Stockman describes these four bubbles from page 404 to 576. These 173 pages of the book are fact-packed, well-written, fast-paced, gripping, revealing and downright forensic in their description. They are almost a handbook for how to use debt financing, the tax regime and the Greenspan / Bernanke put to your advantage. As an added bonus, they provide a solid explanation for the soaring inequality in America: only a small fraction of the population is positioned to properly ride the four bubbles, via earning fees and rents rather than via actual exposure to the bubbles themselves.
I was like "what happened to the rambling old man from the first 400 pages" and then, on page 571, all was revealed: Stockman himself used to be a champion of Corporate Equity Withdrawal. A brush with bankruptcy, however, followed by a brush with the law, brought to a screeching halt his career that had weaved its way through Harvard, the US House of Representatives, the Reagan administration, Salomon Brothers, Blackstone and finally his own private equity shop. At that point he had the epiphany that he had sleepwalked to the dark side. Having been a practitioner of leveraging companies to within an inch of their existence, he is as good an author you could hope for to explain the financial deformation of the last 20 years.
He dedicates a full chapter to tearing Mitt Romney apart. He describes Romney's six biggest private equity deals, shows how every single one of them, while good for Bain capital, was actually a disaster for all other stakeholders and for the American economy and proceeds for the kill: his beef with Romney is not that he had acted in self-interest, pretty much like he himself had done. Rather, Stockman has pity for Romney because neither Romney nor the Republican party that nominated him as its presidential candidate ever understood that Romney did not make his money the old-fashioned capitalist way, using capital to build companies. The man made his money tearing them apart, very much at the expense of the American economy.
The evidence presented in favor is bulletproof, but like any "reformed sinner" Stockman does not want that to be his main thesis. He needs it to be part of a bigger, all-encompassing scheme. And that's why he does not get to the truly innovative part of his book till page 404. He wants you to hear his whole story first, the one about how the US government is the deformation. In his chosen order, here's a list of his major bullet points. While often controversial, and in my view more often than not wrong, they all made me think. The book starts from the very end, with three views on the "Blackberry Panic of 2008":
1. AIG needn't have been saved. As discussed, Stockman himself used to work for Blackstone and they looked very seriously into asset stripping a large insurer and the legal advice they got was that it could not be done. Insurance is regulated on a state by state basis. Just because the holding company needed help, the states were not about to allow the assets to be released that were backing up locally issued insurance contracts. Ergo, nobody was going to get hurt if AIG was let go other than Goldman, Deutsche and co.
MY VIEW: I only buy his argument outside the context of general meltdown. It's one thing to say "everybody would be getting their just desserts" which is a philosophical view and quite another to say "AIG was safe enough to fail" and to suggest that officials who had been in office for three to five years had a mandate to undo a system (love it or hate it) with a good 60 years of history behind it.
2. Main street banks would have survived the AIG / Wall Street meltdown because their books were clean.
MY VIEW: Again, unlikely. People would have pulled all their deposits from the main street banks (since all their other sources of liquidity would have dried up) who in turn would all be lining up at the Fed hoping it does a Bagehot and lends them money against their loan portfolios. The ATMs would indeed have gone dark. Hell, they were hours from going dark at my employer, RBS, when the UK government intervened in October of 2008. There must be many other examples.
3. Jeff Immelt was saved, not General Electric, when the Fed stepped in and guaranteed all Money Market funds and all commercial paper.
MY VIEW: Stockman's right about that one, no doubt. And the French banking system too, how did that escape Stockman? Money Market funds are still stuffed full of their paper. But he does get the story in about John Mack's wife getting a 200 million dollar assist from the US government on some silly venture of hers. Nice one.
Then Stockman travels back in time to take us to the origins of the "Great Deformation"
4. The Great Depression of the thirties had little to do with the gold standard and little to do with insufficient accommodation from the Fed that Bernanke apologized about in the famous speech to Friedman and Schwartz and everything to do with a collapse of US goods exports to overleveraged Europeans. A bit how China would suffer today if the world stopped buying cheap toys, expensive iPhones and everything in between, with the added kicker that when things went wrong 1. tariffs went up around the world that made it even harder for Americans to export and 2. the market stopped lending to Europeans anyway. As for the Friedman / Bernanke theory, he has the following to say: "The monetary populists of the 1920s and 1930s, including professor Fischer, had "cause and effect" backward. The sharp reduction after 1929 in the money supply was an inexorable consequence of the liquidation of bad debt, not an avoidable cause of the depression."
MY VIEW: I don't know enough, but I'm startled that this view is not discussed more widely. I read and thoroughly enjoyed "Lords of Finance" as well as Bernanke's papers and no mention is made of the collapse of European demand for American-manufactured products. "Wow" is all I have to say. I'm inclined to believe Stockman here when he says the lack of liquidity was a symptom rather than a cause. "Lack of demand," for sure, but quite impossible to fix if the demand used to come from abroad.
5. FDR wasted everybody's time with the New Deal because he was trying to address an exogenous problem domestically.
MY VIEW: blah. What do you want him to do? Germany is currently paying companies up to 20% of workers' salaries to keep them employed. What's the alternative? Why pay them 100% to stay at home? Yes, I know. Creative destruction. But with some type of time limit (much like unemployment insurance) it all makes sense.
6. FDR put in place the foundations for crony capitalism. By establishing Fannie Mae he put in the foundations of the "Housing Complex" that begat the housing crash of 2008. By establishing Social Security he put in place the first of many government-sponsored Ponzi schemes, a job that was finished for him by President Johnson with Medicare and Medicaid.
MY VIEW: We're talking some serious lead times there, no? A good 70 years. And how was FDR to guess what would happen to fertility rates, which are the true problem with Social Security (along with our general unwillingness to give up on stuff we feel entitled to)? This is ideology here, not economics. With all countries on the planet featuring some type of state retirement scheme and state-sponsored health service, the onus of proof here is with those who don't want Social Security, Medicare and Medicaid. Why should the US be the exception?
7. Bernanke had a predecessor in messing with market prices and toying with wealth effects. Under the tutelage of Irving Fischer, FDR had messed with the price of gold on a daily basis to support the prices of agricultural products. One of the main American exports to Europe had been grain. Grain prices during WWI had been in a bubble that makes anything we've seen since look tame. Farm income soared from $3.5 billion in 1913 to $9 billion in 1919. This, in turn, begat a bubble in land prices, which benefited from a positive feedback loop with the arrival of the tractor (15,000 in 1914 to 1 million in 1930) and inevitably a collapse when Europe could no longer import. Farm mortgage debts, however, still had to be serviced. If you substitute the farming lobby of 1930 for the banking lobby in 2008 and FDR himself for Bernanke you get the picture. FDR confiscated private gold and personally participated in the London fixing for the price of gold on a daily basis with a view to propping up the prices of agricultural products, presaging today's buying of bonds to support the housing market. For the record, FDR abandoned this effort within less than two years, while Bernanke is carrying on, almost five years since starting his bond-buying spree.
MY COMMENT: Wow. Why had I not read this anywhere else? I knew about the gold thing, but I have never seen it attributed to an attempt to support the price of agricultural goods. Is it true? It's perhaps not directly relevant to what's going on in the world, but I'm fascinated nonetheless.
8. Bernanke also had a predecessor in buying Treasuries. You guessed it, it was FDR. The US financed its wartime effort through Fed purchases of US Treasuries. The Fed carried on owning Treasuries until the early sixties, and in the necessary amount to cap interest rates. Capped interest rates (thanks to Fed-engineered rates repression), balanced budgets and inflation worked together to bring down the debt to GDP ratio from 125% to 30% over time.
MY COMMENT: I did not realise the Fed was buying Treasuries into the sixties. Hell, I was born in the sixties
9. Eisenhower was the last president who systematically balanced the budget and the last president who actively chopped the defence budget. What money he did spend on defence he spent very judiciously, on nuclear arms, which in Stockman's view won the cold war some thirty years later.
MY VIEW: Boring. Also, I'm reading "Balance" by Hubbard and Kane and their numbers highlight that as a percent of GDP defence actually has shrunk a fair bit since Ike was president.
10. Nixon ended the gold standard because he did not want to lose the 1972 election same way he'd lost to Kennedy in 1960.
MY VIEW: Perhaps. However, the gold standard was but a very useful sharia law of the market. Much like sharia law, once upon a time, and for the standard of its day, it had once been extremely effective and quite fair, if a bit harsh. But gold, like, sharia law, requires everybody to buy into the religion. By 1970 there just wasn't enough gold to go around to sensibly provide a backbone for the financial system of the world economy, while still trading at a price retaining some type of relation to its commercial value. Nixon was the president whose fate it was to break that link while doing what every politician in the history has done, which is to buy the public's approval with tax dollars. Dunno, maybe one day we'll do a monetary standard with fresh water or something. But the "T-bill standard" Stockman hates is the only game in town. Dollars backed by future tax receipts. Not sharia law, but American law. Go find me better.
11. Reagan (for whom Stockman was budget director, so he should know) did not much cut spending. Moreover, he did not have it in him to cut defence spending and actually left the US with twice the defence budget as Eisenhower in inflation-adjusted dollars, and the military spent that money on conventional military power, planting the seeds of the two gulf wars.
MY VIEW: Boring. Everybody knows Reagan is the father of the bond market. Hell, we shut down the day he died, to honor him. He probably borrowed a bit of money, then. But I do like the point that Bush 41 and 43 would not have been able to conduct their wars of choice without Reagan's re-armament campaign.
12. Cheap printed money from Greenspan and Bernanke's Fed, along with Friedmanesque freshwater free-market ideology fuelled speculative finance. Futures trading, which should have been used only to hedge the risks of agricultural producers, strayed into financial futures, allowed the financial sector to multiply exponentially in size, enabled the Salomon Brothers "bond arb" and led to the LTCM disaster and bailout of 1998. In turn, Greenspan's response to the 1998 debacle guaranteed the final blowup of the NASDAQ.
MY VIEW: Futures are margined. Even if all collateral is pledged, say, three times (and even today it isn't) it is unthinkable that financial futures can be anything but part of the solution, rather than the problem. Nul points, monsieur Stockman. The idea, furthermore, that speculators in New York hold an advantage over a guy who has access to physical assets, is ridiculous. Last I checked, the biggest grain traders on earth were Cargill, and God knows they trade the physical. Last I checked, the biggest oil traders on earth all own refineries and pipelines. I cannot stress how utterly wrong these arguments are. As recently as 1990, investment banking was very much a cottage industry and its participants were regularly allowed to go bust. Lehman, Shearson, Drexel spring to mind. More to the point, there's nothing wrong with trading, shorting and betting, provided there is no safety net for losers.
Frankly, I think in this instance Stockman is merely demonstrating a bias I recognise from my 20+ years in finance: he comes from the banking side of finance and he hates traders. This can be the only explanation for some of the worst points he makes in the whole book.
And he totally misses the biggest banking deformation of all: when Glass Steagall was repealed, it was not the banks that became investment banks, it was the opposite. The investment banks went into the business of giving loans, with the added kicker that they were all booked as swaps and other derivatives, allowing the profit (the NPV of years of Net Interest Margin) to be booked upfront and immediately turned into bonus. That is how come their balance sheets increased tenfold. Not because of cheap money. The entire derivatives thing goes over Stockman's head, frankly.
Finally, like all commentators, he has a fixation with the twentieth century concept of the balance sheet. Open your Bloomberg and look at Barclays. Balance Sheet is 1.5 trillion Sterling (roughly one UK GDP). Derivatives exposure is 80 trillion Sterling. More than fifty times UK GDP. The interconnectedness is the monster. The collateral to back up all these deals (and Barclays is but one player, by no means the largest) simply does not exist. Unfortunately Goldman don't publish the equivalent number, but I'd love to see what it is. Stockman is too old to appreciate any of this. It's in reading these chapters that you appreciate the book is largely historical, rather than current.
13. Two factors allowed the Greenspan Fed to carry this policy to its illogical conclusion. The fig leaf of its inflation mandate and the battering the price of manufactured goods took when China entered the world arena. Under the cover of constantly falling prices for manufactured goods, Greenspan could keep interest rates impossibly low and still meet his inflation target, when he had the option of higher interest rates and benign deflation. This road not taken represents one of the biggest deformations.
MY VIEW: Bang on
14. The Fed is a Keynesian agent, a "prosperity-oriented politburo." Printing money is no different than digging holes and filling them back up again, but it benefits the top 1% more than anybody else. And it's about as effective. Cheap financing has landed America, which accounts for 4% of the world's population with 40% of hotel rooms. QE has done nothing for middle America, with grocery sales still 10% lower than they were in 2007.
MY VIEW: Yes, yes, yes, but you need to be more nuanced. In moderation, all of the above is good. If your argument is that you will never achieve this moderation because the "politburo" is a branch of government and will be "captured" in a quest to borrow prosperity from the future at all costs, that's another story. In principle, however, why would you not want to have the instruments to control disasters? Why is it wrong to have policy?
More to the point, suppose there was a low corporate tax rate and suppose the capital gains tax was higher than income tax, would that not have negated the entire deformation argument? That's what I took away from pages 404 to 576.
Stockman carries on, and it's all in this vein. He does not much like the 800 billion stimulus, he is systematically abusive of Larry Summers, he likes Obama (and his auto bailout and green energy policy) about as much as he likes Romney.
In his conclusion he goes on to propose that we (surprise, surprise) end the Fed, end deposit insurance, reinstate Glass Steagall, enact term limits for politicians, abolish the three entitlement programs and substitute them with means-tested programs etc. etc. Ah, and he does not ask for the gold standard. After spending 300 pages lamenting the end of "sound money" there's zero mention of gold in the conclusions. Can't disagree, but it does sort of indicate that the 300 pages were mere posturing.
With all these caveats, this is by a country mile THE BEST book currently in print if you want to understand what happened from 1992 to 2012. It's also the worst book. There is no other.
The Great Deformation is a doorstop, but it's also a landmark.
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Initial post: 21 Oct 2013 01:31:03 BDT
Thanks for this fantastic review. I decided to buy the book and will only read the pages you recommend. Your review takes care of the rest. Many great pointers, like the investment banks becoming lenders following the GS walls being torn down, not the other way around. I wish I would have thought of that (now obvious) one myself.
In reply to an earlier post on 18 Jan 2014 17:43:07 GMT
Last edited by the author on 18 Jan 2014 17:43:38 GMT
Post enlightenment says:
Based on this and other Athan reviews he clearly could and if possible should write the definitive book on what happened from 1992 to 2014 in the world of high finance.
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