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Chris Martenson: Welcome to another Peak Prosperity Podcast. I am your host, of course, Chris Martenson. Today we are speaking with a guest that I am especially keen to have on to interview today, Mr. David Stockman, economic policy maker, politician, and financier.

Mr. Stockman represented southern Michigan in the U.S. House of Representatives from 1976 to 1981, later served as the Director of the Office of Management and Budget in the Reagan Administration, and was the youngest Cabinet member of the 20th century. Since then he has held executive positions in many of the most influential banking, buyout, and private equity firms, including the Blackstone Group and Salomon Brothers. He is the author of a brand new book coming out in April of 2013, The Great Deformation: The Corruption of Capitalism in America, which is a blunt and sometimes delightfully and deservedly-scathing examination of the various monetary and policy blunders that have put us in a rather unfortunate position.

Welcome, David. It is a real honor to have you with us today.

David Stockman: I am very happy to be with you.

Chris Martenson: Your book covers a lot of ground, from bubble economics to the end of free markets, to where we are likely headed and why. Where the prologue is the credit-bubble formed in the early 1980s and carefully nurtured by the Fed, I would like to begin with the opening act – Scene One of the current crisis – which occurred in 2008, by reading this passage from your book. It's in the introduction:

You wrote, “Then, when the Fed’s fire hoses started spraying an elephant soup of liquidity injections in every direction and its balance sheet grew by $1.3 trillion in just thirteen weeks compared to $850 billion during its first ninety-four years, I became convinced that the Fed was flying by the seat of its pants, making it up as it went along. It was evident that its aim was to stop the hissy fit on Wall Street and that the thread of a Great Depression 2.0 was just a cover story for a panicked spree of money printing that exceeded any other episode in recorded human history.”

Well, a hissy fit on Wall Street. The current story line is that these actions actually saved the world and even made money for the taxpayer. Maybe you have a different take on that.

David Stockman: That is the mainstream story, the accepted wisdom. It is totally wrong; it has gotten us into huge trouble in terms of a Fed that is out of control. Buying $85 billion dollars of government debt a month four years or more into an alleged recover. Deficits that are still 7% of GDP – which is off the charts compared to anything people thought was plausible even ten or twenty years ago – when you are several years again into an alleged recovery. Basically this is a measure of how far we drifted. One of the reasons I wrote this book and have tried to unwind and retrace eighty years of history, going back to the founding of the Fed and the New Deal through all the other chapters we go through, is to counteract this massive – what I call “recency bias,” to use wonk-speak. We are doing things that are so crazy, that are so inconsistent with the accumulated financial wisdom of mankind for centuries and centuries, literally, that we have lost track of how far off the deep end we are.

The starting point is the urban legends, the pure mythology about what happened around and about the Lehman bankruptcy on September 15, 2008. We were not on the verge of Great Depression 2.0; that was Bernanke’s utterly erroneous take on it because he claims to be a scholar of the Great Depression. Frankly, one of the things I take on in the book is that he is not a scholar of the Great Depression; he is a math modeler, and essentially took Milton Freedman’s erroneous interpretation of what the Fed did or did not do in 1930 and 1931 and pasted that into his monographs, which are basically statistical noise.

The idea that we were on the verge of a Great Depression 2.0 is utterly wrong, and as a result of that, they flailed about justifying every kind of unusual, extraordinary, and horrendous action, bailing out everybody in sight. That is a defining moment in our time, because you can't believe anything that is said anymore.

I go through some of these – AIG was not a contagious financial disease that was going to take the world economy down. It was a gambling joint at the holding company that could have easily been bankrupted, and the banks that bought the so-called “credit-default swap insurance” from AIG could have taken a couple of billion dollar hits each – they were all big global banks – and that would have been the end of the story. Some traders and bank executives would have lost their bonus, but the point I make in the book is that everyday Americans and Main Street would not have lost their jobs or their income or their insurance. All of these insurance subsidiaries of AIG were separate legal entities, most of them regulated (for better or worse) by state insurance commissioners and therefore subject to fairly stringent capital standards and also restrictions on either asset or cash withdrawals. So the idea that all of these insurance subs were going to be raided for cash and the assets sold in order to pay off the debt of the holding company at AIG, the $100 billion or more worth of credit default insurance that was written, is just completely erroneous. One of the many urban legends.

And I go on to cover the rest of them – the money market funds, ATMs going dark, payrolls not met, commercial paper, GE having a crisis of funding – and none of this is true. It needs to be carefully reviewed, because if people realize that the establishment policy makers in the Treasury and the Fed are telling a Big Lie with a capital B and L, then maybe we can start to understand that we are drifting towards a pretty unfortunate place.

Chris Martenson: I would agree with that. I like your use of the word mythology here, because part of the mythology – they talked about AIGs losses – is $180 billion, for instance, but somehow you had to dig to discover that. These were derivative losses, and derivatives are a zero-sum gain. In truth, for every loss there was a gain, so it was not just like AIG lost $180 billion; somebody made that $180 billion on the other end of that. What we were really doing was allowing those people who made those bets with AIG to not have to lose out on their bet through counterparty risk. This is really an extraordinary overturning of what free market capitalism is supposed to be like – rugged individualism, the whole American mythology.

You, in your book, describe these bailouts, particularly around AIG and other things like that, maybe GM, as well as a de facto coup d’état by Wall Street. How did you mean that?

David Stockman: Well, I meant at that moment in time that such a panic was created in Washington by Paulson, basically. I call him the most dangerous unguided missile ever to reign down on the free market from the third floor of the Treasury. Wrong guy for the job. He had an attention span of five minutes, he was emotionally unglued, and I call it the “Blackberry panic of 2008.” He is running around looking at his Blackberry, watching the stock price of Goldman drop, the stock price of Morgan Stanley drop, credit-default drop, and other credit instruments tanking, and basically concluded this has to be the end of the world because he could not imagine that a financial system can go through a liquidation and clean itself, which is the way financial systems always worked before the 1930s.

That is where it starts. And because of the panic, basically you had Bush clueless sitting in the White House scared to death because he really did not understand anything. You had the Congress utterly buffaloed. A lot of these guys wanted to vote “no,” they thought it was outrageous. The first vote went down. What did they do? They brought them in, told them even greater lies, amped up the panic to a level that was shrill beyond any kind of reasonable presentation. And essentially ran the government, and Bernanke was part of it.

Bernanke does not understand financial markets. He has been wrong on everything he said since sub-prime started raising its ugly head in 2005/2006, Never mind, it is contained. Well it was in 2006/2007, Never mind, it will not spill over onto the rest of the housing market, but it did. In 2007/2008 The housing market is taking a breather but it will be okay, utterly wrong. He has been wrong every call, every turn of the way. In fact, since he went on the Fed in 2002, waving his arms about some terrible deflation that was going to afflict the economy, therefore he talked Greenspan into the crazy 1% interest rate and hand-over-fist government debt buying.

You had two people I say who were unglued, who were wrong, out-of-control panicked, who spread the panic in Washington. In other words, it was not a contagion in the financial system; it was a panic in Washington. Once Washington panicked, then it spilled over onto Wall Street and the rest of the system. But you can hold those two people responsible.

Chris Martenson: Indeed we will. What would have happened however, if these firms had been allowed to fail? Often it has been said – and what they were echoing at the time, and I still read about it today — people say it would have brought the system down. Do you agree?

David Stockman: I know. I dispute that, and I go through it to the best degree I can.

The fundamental starting point is, I believe, that the meltdown was in the vertical canyons of Wall Street only – it was on the so-called investment banks of the moment, starting with Bearn Stearns, Lehman, Merrill, Goldman, and Morgan Stanley. It was a run on wholesale funding, because these investment banks were recklessly financed. They had built their balance sheets; Goldman was over a trillion, Morgan Stanley was over a trillion, the others were close except Bear [Stearns], funded on basically hot overnight money on the liability side, and piled up with every kind of odd good and bad and indifferent asset that Wall Street could assemble and gather during the bubble times of 2006, 2007, and 2008.

When the housing market cratered and the CDOs and other derivative securities had been secured, and housing began to fall in value, those were all sitting on the balance sheets of these hedge funds in Wall Street. Basically they were then faced with a run on their overnight funding. They were repo’ing everything. They had huge amounts of commercial paper outstanding, and when it was clear they were going to take big write-offs on those so-called “toxic” assets, then the funding began to dry up. When the funding began to dry up, then the perception that they were not liquid spread rapidly and one thing led to another.

The point is, they could have easily gone down in bankruptcy. We did not need Goldman, we did not need Morgan Stanley, regular-way bankruptcy would have worked. Out of that, probably thirteen new companies would have been formed over the next couple of years out of the remnants of Goldman – there was a lot of talent there. One group would have hung out an M&A shingle, another would have set up a credit-trading hedge fund, and another would have gotten into the underwriting business, because it does not take any capital anyway.

The whole point was, this was not going to spread to the Main Street banks, because Main Street banks did not own the toxic assets, and I demonstrated this. They owned prime-quality whole- loan mortgages, but not the securitized CDO/CDO squared, MBS and every other variety of that. That was all manufactured in the “meth labs,” as I call them, of Wall Street.

Therefore, the idea that we could not allow the meltdown to burn out in the canyons of Wall Street is the fundamental point of demarcation. That is where I draw the line, and to demonstrate, I go through the balance sheets, by the way, of commercial banks in America as of September 2008. You can go through the $11 trillion worth of assets they had category by category, and what you will find is, they had no toxic CDO/CDS etc. to speak of. What they had basically was loans, some of them which would have been bad, but they would have basically been written down and worked out over years. There was no overnight selling panic. They had persistency of funding – in other words, they had a large deposit base and there was no retail run. They were not in the wholesale funding market, in the repo and unsecured commercial paper market, where the Wall Street hedge funds were.

Chris Martenson: Let us get back to this idea of a de facto takeover, in essence, by Wall Street. What I saw was that there was this panic; billions and billions of dollars came. Allegedly Goldman Sachs did not want the money but sort of took it anyway, and so forth. What I noted was in 2009, Wall Street banks and bonuses were back to records, profits were back to records. Where was truly the crisis? I saw an extraordinary amount of money go in Wall Street’s direction, and I saw most of that flow out into bonus pools and other things. What really happened there?

David Stockman: You are exactly right. Essentially there was a cleansing run on the wholesale funding market in the canyons of Wall Street going on. It would have worked its will, just like JP Morgan allowed it to happen in 1907 when we did not have the Fed getting in the way. Because they stopped it in its tracks after the AIG bailout and then all the alphabet soup of different lines that the Fed threw out and then the enactment of TARP, the last two investment banks standing were rescued, Goldman and Morgan [Stanley], and they should not have been. As a result of being rescued and having the cleansing liquidation of rotten balance sheets stopped, within a few weeks and certainly months they were back to the same old games, such that Goldman Sachs got $10 billion dollars for the fiscal year that started three months later after that check went out, which was October 2008. For the fiscal 2009 year, Goldman Sachs generated what I call a $29 billion surplus – $13 billion of net income after tax, and on top of that $16 billion of salaries and bonuses, 95% of it which was bonuses.

Therefore, the idea that they were on death’s door does not stack up. Even if they had been, it would not make any difference to the health of the financial system. These firms are supposed to come and go, and if people make really bad bets, if they have a trillion dollar balance sheet with six, seven, eight hundred billion dollars worth of hot-money short-term funding, then they ought to take their just reward, because it would create lessons, it would create discipline. So all the new firms that would have been formed out of the remnants of Goldman Sachs where everybody lost their stock values – which for most of these partners is tens of millions, hundreds of millions – when they formed a new firm, I doubt whether they would have gone back to the old game. What happened was the Fed stopped everything in its tracks, kept Goldman Sachs intact, the reckless Goldman Sachs and the reckless Morgan Stanley, everyone quickly recovered their stock value and the game continues. This is one of the evils that comes from this kind of deep intervention in the capital and money markets.

Chris Martenson: Now this moral hazard, as you are referring to here, how do we get our arms around this? My perception is that 2008 was a warning shot across the bow. In fact, it glanced off the steel decking, it was that close. We should have learned something from it. My perception is, there has been a little recovery of the bank balance sheets courtesy of the Fed, and we have about a hundred trillion more in derivatives. The value at risk ratio are still indecipherable to me, but they do not look like they have come down a whole lot.

The London Whale story sort of exemplified that; reinforced this perception I have that the banks did not learn anything from it except that if they get in trouble again they will be bailed out again. So they are back to being as risky as possible because that is where the money is. Is that a misguided perception? Am I missing something?

David Stockman: No, you are absolutely right. In fact, it is a lot worse. The banks quickly worked out their solvency issues because the Fed basically took it out of the hides of Main Street savers and depositors throughout America. When the Fed panicked, it basically destroyed the free-market interest rate – you cannot have capitalism, you cannot have healthy financial markets without an interest rate, which is the price of money, the price of capital that can freely measure and reflect risk and true economic prospects.

Well, once you basically unplug the pricing mechanism of a capital market and make it entirely an administered rate by the Fed, you are going to cause all kinds of “deformations” as I call them, or “mal-investments” as some of the Austrians used to call them, that basically pollute and corrupt the system. Look at the deposit rate right now, it is 50 basis points, maybe, for six months. As a result of that, probably $400-500 billion a year is being transferred as a fiscal maneuver by the Fed from savers to the banks. They are collecting the spread, they've then booked the profits, they've rebuilt their book net worth, and they paid back the TARP basically out of what was thieved from the savers of America.

Now they go down and pound the table and whine and pout like JP Morgan and the rest of them, you have to let us do stock buy backs, you have to let us pay out dividends so we can ramp our stock and collect our stock option winnings. It is outrageous that the authorities, after the so-called “near death experience of 2008” and this massive fiscal safety net and monetary safety net was put out there, is allowing them to pay dividends and to go into the market and buy back their stock. They should be under house arrest in a sense that every dime they are making from this artificial yield group being delivered by the Fed out of the hides of savers should be put on their balance sheet to build up retained earnings, to build up a cushion. I do not care whether it is fifteen or twenty or twenty-five percent common equity and retained earnings-to-asset or not, that is what we should be doing if we are going to protect the system from another raid by these people the next time we get a meltdown, which can happen at any time.

You can see why I talk about corruption, why crony capitalism is so bad. I mean, the Basel capital standards, they are a joke. We are just allowing the banks to go back into the same old game they were playing before. Everybody said the banks in late 2007 were the greatest thing since sliced bread. The market cap of the ten largest banks in America, including from Bearn Stearns all the way to Citibank and JP Morgan and Goldman and so forth, was $1.25 trillion. That was up 30x from where the predecessors of those institutions had been. Only in 1987, when Greenspan took over and began the era of bubble finance – slowly at first then rapidly, eventually. To have the market cap grow 30x – and then on the eve of the great meltdown — see the $1.25 trillion to market cap disappear, vanish, vaporize in panic in September 2008 only a few months later, $1 trillion of that market cap disappeared in to the abyss and panic, and Bear Stears is going down, and all the rest.

This tells you the system is dramatically unstable. In a healthy financial system and a free capital market, if I can put it that way, you are not going to have stuff going from nowhere to $1.2 trillion and then back to a trillion practically at the drop of a hat. That is instability; that is a case of a medicated market that is essentially very dangerous and is one of the many adverse consequences and deformations that result from the central-bank dominated, corrupt monetary system that has slowly built up ever since Nixon closed the gold window, but really as I say in my book, going back to 1933 in April when Roosevelt took all the private gold. So we are in a big dead-end trap, and they are digging deeper every time you get a new maneuver.

Chris Martenson: I want to talk a little bit more about this deformative medication that we are under at this point in time. When I opened the paper up just a week ago and I read about the latest FOMC meeting, it was a bunch of the same words I had been reading for a while – they are going to continue with $85 billion dollars a month of stimulative easing. Here is my context for this: If you had dropped me into today from ten years ago, I would have freaked out at reading that, because it is a really staggering condition we are under. Let us set some context here: Stock is at an all time high, junk bonds and other bond funds at all time highs, not just near but all-time-ever record highs. With financial assets pumped up to perfection, as it were, the Fed’s still putting $85 billion a month in. In your words, what risk are we running with the Fed pursuing this policy of $85 billion a month of hot money being put into the system?

David Stockman: One, it is sheer lunacy. Secondly, your perception is exactly right. It points to the enormous debilitating power of the recency bias that exists in the daily narrative, the talking heads and financial media and the policy makers who scurry around the process. Twenty years ago, it would be a raving maniac who would have thought that four years into a recovery the Fed was buying almost half of the MBS that is being issued and a fairly good chunk of the Treasury.

What we have to do is not assume the people in charge know what they are doing. In fact, we have to assume that, as Einstein said, when you do the same thing over and over and expect a different result it is a sign of insanity. It seems to me they just reflated the same damn bubble, I would point out that this week the S&P crossed 1566. Guess what? That is 2%, which is a rounding error in the scheme of things, higher than the S&P 500 was 4725 days ago. In other words, 13 years ago we were at the same point, and then we had a massive collapse in dot-com, $5 trillion dollars’ worth of household stock and mutual funds evaporated. They pumped the bubble back up again in 2007 and the peak in early 2008. We were back in the 1560 range. The bubble broke again in another $7 trillion with I&Is and now they have pumped the bubble back up for the third time and we have gotten back to where we were 4700 some days ago.

That is a system that is not stable, not functional, and not rational, and it is only a question of when this one rolls over. When it does, the selling panic will be every bit as bad or worse than anything we have had before. Because this time, not only is it stocks and high yield junk bonds and so forth – even commercial real estate has bounded back substantially – but we have this massive bond-market bubble underlying the whole thing. When the bond market rolls over, it will bring everything down with it.

Chris Martenson: Junk bonds yielding 5.6%. It is incredible, absolutely incredible. I am looking at the front page of the Financial Times today, and it was screaming that heading S&P crosses into record closing high. I suppose this is meant to signal to all of us everything has been mended, safe to get back in the pool. I am particularly intrigued by one of the anecdotes in your book; it is about automation and the fictional means by which it stock price magically recovered in the aftermath of the Great Crisis. It might serve as some context for this stock run, meaning the degree to which we have inflated stock values where we see a price that is higher but the value may not have necessarily increased. Could you walk us through that automation example?

David Stockman: Yeah. I can use that one, but let me go to a bigger picture.

Chris Martenson: Sure.

David Stockman: One of the themes of the book is that we have the Fed – this kind of central-bank dominated market has created massive financial engineering in three different channels. One, stock buybacks, which has been enormous. Second, leverage buyouts, which are also huge. Third, constant M&A transactions that end up creating companies that do not work and in five or six years then they write it all off and unwind it. What I am trying to show is that low interest rates and the huge bias in the tax code for deductible debt as a form of capital rather than equity has created almost a giant Ponzi scheme constantly working in the heart of the financial economy.

I point out that between 2002 and 2007, the last time – and we can do the same statistics here for this cycle – there was $13 trillion worth of combined stock buybacks, cash M&A deals, and leveraged buyouts. All of that massive cash on the margin was pretty much either borrowed by companies that borrowed money in order to buy back their stock, or it was essentially a use of their cash for dividends rather than paying down their debt.

The point I am making is the whole market is working to liquidate the base of stock to reduce the shares outstanding in order to create the illusion that earnings per share are going up. I have gone through company after company to demonstrate that this is really what is going on in the capital market today. It is important because the theoretical reason for capital markets is to raise primary capital for companies that want to grow, want to expand, want to invest in real productive business assets. We are not raising any new equity today. In fact, I show during the Greenspan era we know what MEW is, mortgage equity withdrawal, which was huge in the household sector that was $5 trillion. I show that there was about $3 trillion, $2.5 trillion of what I call CEW, corporate equity withdrawal.

On a net basis, and it is all in the flow of funds that is put out quarterly by the Fed at least, you have that from the early 1990s to 2008 if you add all the new stock issues IPOs and secondarys and you subtract all the buybacks and stock liquidations from cash takeovers, whether LBOs or corporate deals, we basically liquidated $2 to $3 trillion dollars of the equity base. Now why do they do this? Many of the companies I look at, Hewlett Packard being a great example, that is a disaster area and it is a pure victim of this kind of marketplace dynamic. Most of these companies basically – over the last four or five years – have bought in 20-35% of their stock through constant massive buyback programs. Then, if you look at the share count over time, it does not decrease by that much, because they then issue huge wads of new stock options to the CEO.

There is a real game going on here, and it is all a deformation that results from the kind of monetary policy we have. In an honest environment, when the tax code was indifferent to debt or equity and where free market interest rates were not managed and pegged, I do not believe there is a remote chance that we would see corporations buying back one or two trillion dollars worth of stock a year. I do not think we would see much of the M&A that goes on, which is really just a financial engineering game that is not creating value added in the economy or even gains for the shareholders over time. We have real, as I say, deformations coming out of a badly mangled capital market.

Chris Martenson: Thank you for that context on the stock market. I agree people really should look well past the heading numbers of corporate earnings. Even at the macro level, we might know that corporate earnings are sitting at about 11% of GDP and sustainably they have never been able to hang higher than 6%. There is something going on there, and you have given us some insight into part of it. There is some gaming going on there, and this deformation caused by ultra-cheap money – well, we are on our way to $20 trillion dollars in debt.

On the fiscal side of the story and the deformation that happens there, I would like to again just take a small quote from your book. This is from the chapter Sundown in America and you wrote, “In fact, what elected officials desperately needed over the last several decades were intervals of double-digit interest rate flare-ups, even rates which reach 20%. High interest rate episodes are the market signal to politicians that vivify the true cost of deficit finance and thereby give them reason to say no to tax cuts and spending increases financed with red ink.” You are articulating what you said is the real evil of the Greenspan/Bernanke regime. What is going on on the fiscal side as a consequence of all this?

David Stockman: Well, one, it is important to emphasize there are many evils and many distortions and negative adverse effects that stem from ultra-low, ridiculously low interest rates, zero effectively for the money-market short-term funds. Beyond the financial engineering that we have talked about, one of the biggest is that it is anesthetized all the politicians. Like driving the yield curve to such a rock-bottom level where you can actually, last time I checked, borrow 5-year money at eighty basis points or ninety, and you can borrow 3-year money in the thirty basis, forty basis point level, and shorter term for almost nothing. It means that they run the debt up enormously, but the interest bill gives the deceptive appearance of being manageable and low.

Therefore, Bernanke has been a great enabler and he has contributed beyond a measure to the paralysis that we have in the system today. Then they continue to build the debt and thereby increase the exposure. One way or another, sooner or later, interest rates are going to normalize. In fact, there will probably be a massive panic in the other direction at some point. Then we are going to be buried in $20 trillion of debt or more – and it is going to $30, and we can talk about that.

With interest rates rising, the politicians then will be utterly frozen in fear, because when that happens, one point on interest on a debt that is over $20 trillion is $200 billion. They cannot figure out how to raise taxes and cut spending by $200 billion on penalty of death if you put them all in a room. We are just painting ourselves into a horrendous corner. The fiscal equation therefore is going to ultimately bring the system down.

The CBO (Congressional Budget Office) says, well, let us not worry so much, we are going to have a big rebound in the next four years. They have the economy growing at 4% and all of a sudden it hits full employment in 2017, we are at the [maximum] potential GDP, and it stays there forever. Therefore, in the next ten years we are going to create 17 million jobs; we are going to have a period from 2009 to 2023 where there is no recession. Fourteen years without a recession and we have had a recession every fifty months since time immemorial.

What I am saying is, the problem is double or triple what is being projected for so-called “current law” today by CBO. The true ten-year-out or so, plus or minus, rolling into the early 2020s, is $15 to $20 trillion, and it is so giant, so massive, so embedded, that the ability of the