David Stockman On 2008: "Hank Paulson's Folly: AIG Was Safe Enough to Fail" Part 1

America’s fantastic collective binging on debt, public and private, had no historical precedent

by David Stockman

A decisive tipping point in the evolution of American capitalism and democracy—the triumph of crony capitalism—took place on October 3, 2008. That was the day of the forced march approval on Capitol Hill of the $700 billion TARP (Troubled Asset Relief Program) bill to bail out Wall Street. This spasm of financial market intervention, including multi-trillion-dollar support lines provided to the big banks and financial companies by the Federal Reserve, was but the latest brick in the foundation of a fundamentally anti-capitalist régime known as “Too Big to Fail” (TBTF). It had been under construction for many decades, but now there was no turning back. The Wall Street bailouts of 2008 shattered what little remained of the old-time fiscal rules.

There was no longer any pretense that the free market should determine winners and losers and that tapping the public treasury requires proof of compelling societal benefit.Not when AAA-rated General Electric had been given $30 billion in taxpayer loans and guarantees to avoid taking modest losses on toxic assets it had foolishly funded with overnight borrowings that suddenly couldn’t be rolled over.

Even more improbably, Goldman Sachs had been handed $10 billion to save itself from alleged extinction. Yet it then swiveled on a dime and generated a $29 billion financial surplus—$16 billion in salary and bonuses on top of $13 billion in net income—for the year that began just three months later.

Even if Goldman didn’t really need the money, as it later claimed, a round trip from purported rags to evident riches in fifteen months stretched the bounds of credulity. It was reminiscent of actor Gary Cooper’s immortal 1950s expression of suspicion about Communism. “From what I have heard about it,” he told a congressional committee, “it isn’t on the level.”

Nor was Washington’s panicked bailout of Wall Street on the level; it was both unnecessary and targeted at the wrong problem. The so-called financial meltdown was not the real crisis; it was only the tip of the iceberg, the leading edge of a more fundamental economic malady. In truth, the US economy was heading for the wringer because a multi-decade spree of unsustainable borrowing, speculation, and financialization of the national economy was coming to an abrupt end.

In the years after 1980, America had undergone the equivalent of a national leveraged buyout (LBO). It was now saddled with $30 trillion more in combined public and private debt than would have been the case under the time-tested canons of financial discipline and prudence which prevailed during the nation’s long economic ascent. This massive debt burden had fueled a three-decade prosperity party by mortgaging the nation’s future. Now the bill was coming due and our national simulacrum of prosperity was over.

This rendezvous with the limits of “peak debt,” however, did not mean that the Main Street economy was in danger of collapse into an instant depression. That was the specious claim of the bailsters. What did threaten was a deeper and more enduring adversity. The demise of this thirty-year debt super cycle actually meant that it was payback time. Instead of swiping growth from the future, the American economy would now face a long twilight of debt deflation and struggle to restore household, corporate, and public sector solvency.

This abrupt turn in the road should not have been surprising. America’s fantastic collective binging on debt, public and private, had no historical precedent. During the century prior to 1980, for example, total public and private debt on US balance sheets rarely exceeded 1.6 times GDP. When the national borrowing spree reached its apogee in 2007, however, the $4 trillion of new debt issued by households, business, banks, and governments amounted to 6 times that year’s $700 billion gain in GDP. Plain and simple, what was being recorded as GDP growth was little more than faux prosperity borrowed from the future.

In fact, by the time of the financial crisis total US debt outstanding was $52 trillion and represented 3.6 times national income of $14 trillion. Accordingly, there were now two full turns of extra debt weighing on the nation’s economy. And the embedded math was forbidding: at the historic leverage ratio of 1.6 times national income, which had prevailed for most of the hundred years prior to 1980, total US public and private debt would have been only $22 trillion at the end of 2008.

So the nation’s households, businesses, and taxpayers were now lugging around the aforementioned $30 trillion in excess debt. This staggering financial burden dwarfed levels which had historically been proven to be healthy, prudent, and sustainable. TARP and all its kindred bailouts and the Fed’s ceaseless money printing could not relieve it. And Washington’s reckless use of Uncle Sam’s credit card to fund the Obama stimulus actually made it far worse by attempting to revive the false prosperity of the bubble years. The obvious question remains: Why did this plague of debt arise? Did the American people suddenly become profligate and greedy through a mysterious process of moral and social decay?

There is no evidence for the greed disease theory but plenty of reason to suspect a more foreboding cause. The real reason for the current crisis of debt and financial disorder is that public policy had veered into the ditch, permitting an unprecedented aggrandizement of the state and its central banking branch. In the process, the vital nerve center of capitalism, its money and capital markets, had been perverted and deformed. Wall Street has become a vast casino where leveraged speculation and rent seeking have displaced its vital function of price discovery and capital allocation.

The September 2008 financial crisis, therefore, was about the need to drastically deflate the Wall Street behemoths—that is, dangerous and unstable gambling houses—fostered by decades of money printing and market rigging by the Fed. Yet policy veered in the opposite direction, propping them up and thereby perpetuating their baleful effects, owing to a predicate that was dead wrong.

A handful of panic-stricken top officials, led by treasury secretary Hank Paulson and Fed chairman Ben Bernanke, proclaimed that the financial system had been stricken by a deadly “contagion” that had come out of nowhere and threatened a chain reaction of financial failures that would end in cataclysm. That proposition was completely false, but it gave rise to a fateful injunction—namely, that all the normal rules of free market capitalism and fiscal prudence needed to be suspended so that unprecedented and unlimited public resources could be poured into the rescue of Wall Street’s floundering behemoths...