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Friday, April 05, 2013

BOOK REVIEW: The Great Deformation

The Great Deformation - David Stockman, 712 pages (742 pages with notes and index)

Reading has its rewards. Sometimes those rewards involve work to skip past some fluff to get to the rewards. Sometimes, gaining those rewards requires ignoring annoying, awkward, archaic phraseology and repeated, grating, mixed metaphors. A few times, gaining those rewards requires plowing through hundreds of pages of annoying, awkward, archaic phraseology and mixed metaphors with few signs of editing involved in the publishing process.

Such is the case with David Stockman's book The Great Deformation. Most Americans probably have Stockman mentally filed in their "woodshed" bucket, after he was publicly "taken to the woodshed" early on in his stint as Director of the Office of Management and Budget in the Reagan Administration for making on the record comments to the effect that many of the tax and spending numbers of the first year's budget didn't add up. He served in OMB for four years, left in 1985 and held positions at Solomon Brothers, Blackstone Group and, most recently, his own private equity fund.

Stockman's background in both budget related politics and private investment combined with a willingness to stray from scripted conventional wisdom and party lines gives him a nearly guaranteed platform for commenting on current issues in those areas, especially when failures in those areas have destroyed trillions in paper wealth. The Great Deformation is Stockman's attempt to explain recent financial failures not as unpredictable, unavoidable asteroids from the financial beyond but as direct consequences of specific political mistakes made over time across the political spectrum that were mis-represented at the time then converted into fable or forgotten completely by present day politicians, businesses and voters alike. His take and some of his prescriptions are not new but he does provide some unique specifics to support the theory.

What's Wrong with the Book

When the right content is addressed by the right author with the right background and right "voice", one not only gets a book worth reading but a good book. Some of the more famous financially themed books in this "good books worth reading" category might include:

  • Liar's Poker - Michael Lewis -- concise, entertaining insight into the culture of Wall Street
  • Bad Money -- Kevin Phillips -- concise, even-handed analysis of the takeover of America by FIRE
  • 13 Bankers -- Simon Johnson and James Kwak -- concise diagnosis of the regulatory conflicts that produced our TBTF system
  • Bull By The Horns -- Sheila Bair -- detailed analysis of the triumph of fear / panic over rationality in the 2008 meltdown
Unfortunately, it is also possible for the right content to be addressed by the right author with the right background with many of the "right" details and still yield an awkward, poorly organized and often difficult to read tome. The Great Deformation would have to be added to this category. The book contains more than a handful of outright grammatical errors that were clearly missed because they passed a spell-check. One can overlook a handful of typos amid 714 pages. It's harder to skip past a repeated list of trite phrases, mixed metaphors and archaic words that annoy the reader rather than serve the material. Examples include:

  • "the canyons of Wall Street" (I stopped counting the occurrences)
  • "owing to the exigencies of wartime" (repeated twice within 3 sentences, page 197)
  • statist (used as a pejorative so often it loses any bite)
  • "Yet the September 2008 meltdown was a financial cyclone which struck mainly within the vertical canyons of Wall Street, and would have burned out there in short order." (cyclones burn out? what other types of canyons are there?)
  • crushed the inflationary fires (extinguished? squelched? but not "crushed")
  • "hayseed coalition" (pejorative term Stockman coined to refer to southern and rural / agricultural blocs Stockman believed FDR plied with pork in exchange for support for his New Deal)
  • "Tricky Dick" (okay, we know you're an equal opportunity Democratic / Republican basher and Nixon was multi-dimensional scum but Nixon succeeded at making his own name a pejorative, any elaboration just detracts from the point and cheapens the impact of the book)
After 714 pages, the annoyance of the reader produced by the author's repeated use of the phraseology "it cannot be gainsaid" amid these other literary tics cannot be gainsaid.

What's Right with the Book

After providing his own narrative on disastrous policy decisions and craven political manipulations dating from the days leading up to FDR's inauguration to the present, Stockman concludes the book with his own 38 page political and financial prescription for much of what ails the country. Readers might agree with most of those conclusions or might dismiss them entirely as completely wrong or just highly improbable. Stockman himself states outright that our constitutional processes have been corrupted so far beyond their normal self-correcting range that any positive outcome is exceedingly unlikely.

If the book is so annoying to read and its conclusion is such a downer, why read it? First, the voice of the narrative and its organization can annoy but Stockman still provides numerous political and economic insights worth reading. More importantly, those insights suggest a common theme that Stockman's own conclusions seem to overlook or discount as too unrealistic for a cynical, jaded public. Is it possible Stockman missed the point of his own book?

Here are summaries of some of the key points.

Correction or Contagion

The Great Deformation starts with the recent 2008 meltdown by recounting many aspects of the story already covered in books such as Bull By the Horns and 13 Bankers. At the time, many Americans and some politicians and regulators publicly expressed doubt that the failures at Bear Stearns, then Lehman, then Indy Mac, then WashMu, then Citi and finally AIG truly constituted a systemic risk to the financial system or the larger economy. Stockman reviews the $180 panic-driven bailout of AIG and articulates a persuasive argument that AIG was in no way an existential risk to the system. AIG's corporate structure had all of the actual valuable stable assets trapped in a variety of state-regulated insurance entities whose regulations prevented those assets from being scooped up into the holding company that lost the farm betting on CDS assets.

In essence, AIG's structure acted like a honeycomb, preventing cells with valuable assets from being raided by one bad cell and sold at fire-sale prices (depressing prices of similar assets of other institutions) to cover losses from bad bets made in another cell of the honeycomb. Traders in that cell and its customers / investors DESERVED to lose their equity but the spiral between fire sales in one subsidiary to hide losses in another could have never gotten started enough for those losses to amount to more than 10 percent of AIG's total assets -- losses AIG and some of its CDS customers such as Goldman Sachs could have easily afforded.

Stockman's analysis also includes a similar breakdown of the losses exposed in GE Capital's balance sheet that triggered a similar Fed/Treasury sponsored rescue when no taxpayer assets were at risk -- only the bonus checks of GE executives. GE claimed it suddenly became unable to raise $25 billion dollars required between September and December 2008 to cover the rollover of a series of short term loans so it demanded $30 billion in bailout money. As Stockman points out, that $25 billion wasn't coming due all at once and wasn't even subject to call -- the obligations were fixed maturity loans with the $25 billion spread across over ninety days. The $25 billion amounted to less than 8 percent of GE's equity and could have been raised in a variety of ways, but each alternative would have diluted earnings per share and impacted bonuses based on EPS related measures.

Unfortunately, the decision makers were operating in an information bubble of their own making that reinforced their fear and paranoia rather than allowing someone to spend two hours saying "Okay, wait a minute, let's draw this on a whiteboard and talk through this..." Stockman coined his own term for the self-induced insanity of the 2008 meltdown -- he termed it the BlackBerry Panic of 2008.

Correction or Contagion - The Prequel

After starting the book with a debunking of the AIG as contagion theory, a subsequent chapter addresses what Stockman termed "New Deal myths" Americans learned about the Great Depression and the New Deal policies that helped end it -- the major point being that New Deal policies did nothing to end the Depression. Again, this is not a new theory but details provided by Stockman provide crucial insights that tie back to fears about modern-day bank failures and systemic risk. The history of the Great Depression that we all know that's actually wrong as summarized by Stockman boils down to these bullets:

  • speculation on Wall Street led to bank failures
  • bank failures triggered local economic failures, job losses and collapsed prices
  • bank failures became so common that the entire system was steadily grinding to a halt between 1929 and 1932
  • the system completely froze up in March 1933, leading FDR to cure the problem by declaring a bank holiday
  • after correcting problems with the banks, subsequent New Deal programs used government spending to stimulate the economy, create jobs and re-inflate prices
  • buildup to WWII in 1939 and 1940 provided one final stimulus before full war goosed a full recovery
The reality summarized by Stockman is substantially different:

  • WWI made the US the world's bread basket while European farmland was engaged in other uses
  • Europe remained dependant on US food exports after the war due to crippled infrastructure and industry
  • US lending to Europe after war's end to the early 1920s further propped up US food exports
  • a rapid withdrawal of US lending reduced demand for US crops virtually overnight, triggering job losses and economic contractions in US agricultural communities
  • economic contraction in agricultural boomtowns and export cities led to bank runs and failures but depositors didn't remove their money from the SYSTEM, they simply withdrew it from "bad banks" and moved it to other banks
  • 10,000 of the 12,000 banks that failed throughout the 1920s were in communities of 2500 or less
  • losses across all banks from 1920 to 1932 only amounted to about 3 percent of deposits
  • bank runs weren't even a major problem in 1933 leading up to FDR's inauguration until 14 days before inauguration
  • the governor of Michigan declared a one week bank holiday after issues arose at a Detroit bank controlled by Edsel Ford and Goldman Sachs, leading to fear among politicians about wider failures
  • FDR was asked by Hoover to make some public comment in those last two weeks to provide a sense of continuity of monetary policy to calm fears
  • FDR refused to say ANYTHING, which then did lead to runs in the last two weeks prior to inauguration
  • FDR's "bank holiday" did absolutely nothing to alter the financial integrity or regulatory structure of the banks -- it was the 1930s equivalent of the "health check" performed on the TBTFs after the 2008 crisis
If you believe Stockman's narrative, the key learning for modern times would be that politicians and regulators should recognize that DEPOSITORS do have some ability to distinguish between bad banks and a bad system. If a city is served by 10 banks and word gets out that ONE bank is in danger of going under, a "run" on that bank that tanks that bank while moving the funds to other banks isn't a systemic risk to the system, that's Mr. Market punishing the greedy and stupid. Government involvement is not only unneeded, it is counter-productive because it protects investors of the failed bank from experiencing the full pain of their own mistakes.

Nixon - The Gift That Keeps On Giving

If your current impression of Richard Nixon is that of someone who was among the most craven, corrupt, and scheming bastards who ever held office and destroyed Americans' trust in government via the Watergate scandal, you might have to recalibrate your scale after reading Stockman's narrative about Nixon's decisions on the gold standard, monetary policy and outright manipulation of the economy for political reasons. As Stockman summarizes it, Nixon entered office with a full charge of paranoia about re-election in 1972, paranoia that leaders in the Fed might take actions that would slow the leading up to his re-election as he suspected they did in 1960, a determination to do anything he could to stimulate the economy and a desire to completely ignore everything happening in international currency markets.

In January 1970, Nixon appointed Arthur Burns as Fed Chairman and gave Burns and his own economic staff very clear directions -- I want a booming economy by July 1972 in time for the fall election. He was also very specific about what he DIDN'T care about. From page 117,

Richard Nixon did not recognize the stakes, nor trouble himself with the weighty implications of the decisions at hand. In fact, as revealed in the private papers of his inner circle, Nixon treated these issues with stunning insouciance. Thus, after about a year in the Oval Office, he instructed Haldeman to screen out the topic entirely: "I do not want to be bothered with international monetary matters and will not need to see the reports on international monetary matters in the future."

At that time, the US economy was already over-extended with inflation around 6 percent (unheard of in the prior 30 years of peacetime statistics) and unemployment at 4 percent (near "full employment" according to most economists at that time and the present). Nevertheless, Burns complied and expanded the Fed's balance sheet by 11 percent in both 1970 and 1971 in part by buying up government debt to inject money into the economy.

In late 1970, a two month strike of auto workers against GM that began in September caused a 4.2 percent drop in GDP for 4Q1970. However, after the strike was settled, orders to re-fill pipeline inventories and dealer lots spiked GDP for 1Q1971 by 11 percent. However, the 11 percent recovery from a one-time, clearly explainable, clearly isolated dip of 4.2 percent didn't sooth Nixon's paranoia. Republicans had lost 9 House seats in the 1970 November mid-term election. He only cared about re-election in 1972.

By mid-1971, Nixon's politically driven over-stimulus had created huge trade deficits that led foreign economies to hold vastly larger pools of US dollars which led them to begin trying to convert them back to gold at various world exchanges at the agreed upon price of $35 / ounce. At that point, so many additional dollars had been injected into the economy out of thin air that any attempt to redeem even a fraction of that jump in overseas dollars from the skyrocketing trade deficit would have exposed the debasement of the dollar that had already occurred. Nixon and team, already voluntarily oblivious to worldwide currency risks, then opted to abandon the existing Bretton Woods agreement that pegged all participating international currencies to the US dollar in exchange for the US honoring convertability of dollars to gold at $35.00 per ounce. IN THE SAME POLICY ANNOUNCEMENT, the Nixon Administration also imposed a 90-day freeze on most wages and prices.

The details and timing of the so-called "Nixon Shock" may be a distant memory from 2013 but the consequences are still intimately familiar to most Americans. Unfortunately, as Stockman summarizes, the CAUSES of those consequences were poorly understood by the public and purposely obscured by politicians at the time and have subsequently been misconstrued or lost to the fog of history ever since. In 2013, most Americans likely believe the huge spikes in inflation between 1972 and 1975 were due to the OPEC oil embargo. In reality, prices for nearly ALL commodities spiked worldwide. This is exactly what one would expect when an economy already expecting to operate at full tilt continues to try to obtain raw materials to meet demand in a world where prices have been replaced with question marks.

Nixon got his white hot economy by July 1972. His Fed chairman made an appearance on his Oval Office tapes delivering the future of the US economy as political booty with these words: "I have done everything in my power to help you as President, your reputation and standing in American life and history... No one has tried harder to help you." Nixon got his landslide re-election victory in November 1972. Stockman summarizes what the rest of us got very effectively on pages 110-111:

Yet as wards of the state, the central banks were now indentured to its policy imperatives rather than to the superintendence of sound money. That was proven in spades by the inflationary debacle that exploded during the very first decade of floating. Indeed, by the end of the 1970s it was evident there wasn't much about the international currency exchanges which resembled the theoretical "free market."


Buying government bills and bonds without the external discipline of redeemability, the Fed injected massive liquidity into the Wall Street banking system -- where more and more of it ended up in speculative finance, not the real economy.


Given the dominant position of the US economy and the dollar at the time, the fatal danger was that the Fed had now been positioned to emit unlimited credit through the US banking system. The only real restraint was the willingness of the rest of the world to accumulate and hold dollar assets. As it turns out, other nations were mighty willing. The flood of dollars into the global economy did not cause its exchange rate to collapse because mercantilist central banks bought dollars hand over fist to suppress the exchange rates of their own currencies. -----------------------------------------

The Rest of the Book in Two Paragraphs

The summaries in the previous sections reflect the first 278 pages of the 712 page book through chapter 13. The remaining chapters provide NUMEROUS details about the mechanics of schemes used for leveraged buyouts, MEWs (mortgage equity withdrawals that tempted consumers into over-leveraging their real estate equity) and CEWs (corporate equity withdrawals used by major corporations to hide the dilution of massive stock options expenses for execs under the guise of "returning earnings to shareholders"). One chapter takes on the Mitt Romney record at Bain Capital and the illusion that Bain's tactics did ANYTHING to create jobs or strengthen the economy. Precisely at the point in that chapter when the reader is likely to start thinking, "Hello? Pot? Kettle?", Stockman jumps tracks in the chapter and addresses the cause and outcome of his own epiphany regarding the value of LBOs and the entire financial charade that Wall Street has become.

In a nutshell, Stockman worked at Solomon Brothers then Blackstone Group then finally his own private equity firm between 1985 and 2005. His own firm wound up cobbling together a collection of auto parts related companies with Stockman personally doing much of the M&A paperwork. His firm took a controlling share of the resulting LBO Frankenstein firm then installed Stockman as CEO to run it. Within a couple of years, a credit squeeze on Ford and GM triggered a squeeze on their suppliers like Stockman's firm, eventually triggering its bankruptcy and his firing as CEO in 2005. In 2007, Stockman and other execs were indicted for reporting numbers which failed to conform to some draft accounting rule. The indictment was dropped in 2009 but not before Stockman spent significant time reviewing his own M&A paperwork preparing a defense. Stockman says that review made clear what a rickety, debt-laden house of cards his own work had created. Legal or not, it became clear to Stockman how destructive the LBO game he had been playing really was. As Stockman summarizes it, he was as blind (maybe willfully blind?) to the damage he was creating as anyone else until he happened to be thrown from the wreckage to gain a new perspective, only to see other bigger riskier players somehow survive and roar back with more paper profits after getting bailed out by the government.

Conclusions about Conclusions

Stockman ends The Great Deformation with his own list of prescriptions for what ails America, ranging from

2) abolish deposit insurance
4) elimination of incumbency and setting House, Senate and Presidential terms to 6 years
5) mandatory 2-year horizons for budget balancing
7) abolish social insurance, bailouts, and economic subsidies
9) create a means-based security net and abolish the minimum wage
12) impose a one-time 30 percent wealth tax

You know, pretty simply stuff. (smirk) Stockman himself is pretty sanguine about the likelihood of these types of major reset measures ever getting implemented. That's probably why the chapter prior to the conclusion is entitled Sundown in America. However, Stockman's conclusions seem to overlook two key elements behind all these stories. One is that virtually all players involved in finance and its regulation seem to become mesmerized by absolute numbers at the worst possible times. When a silver haired executive knocks on your door at the Fed or Treasury saying "Psssst, Ben, I got me a problem -- a $10 billion dollar problem," it's easy to cue a Jimmy Stewart scene of someone scrambling in a panic over the staggering sum of $10 billion "missing" dollars.

But stop the film. Is $10 billion "material" in a bank claiming to be worth $100 billion with one trillion dollars in "assets"? Not if the firm is truly worth $100 billion and not if the firm has adequate reserves. Individual stock prices for large cap firms rise and fall 5-7 percent in a single day on a regular basis with nothing more than rumors or analyst hype to explain the change. Why should a company's shareholders be safeguarded from taking a 10% hit when their company does something REALLY REALLY DUMB? When in doubt, convert all the numbers to percentages then look again.

What works for regulators and politicians should also work for investors. Unless a firm is relatively small or just launched a brand new product with no competition, growth rates for revenue or profit that exceed 10-12 percent in an economy that only grows 1-4 percent cannot be sustained without competition showing up or some sort of financial "engineering." PERIOD.

The second conclusion missing from Stockman's summary stems from two observations viewed together:

  • the tinkering attempted by politicians and central bankers is generally aimed at pretty small scale stuff from a macro perspective -- a point off unemployment, a half-point up in GDP, etc.
  • exponential growth of bad results from bad tinkering seems to take root much more effectively than exponential growth of good outcomes from good tinkering
American voters already suspect as much -- at least about the nine out of ten programs they think are benefiting "everyone else." If public figures like Stockman can debunk the need of one company to obtain a $180 billion dollar handout in a few paragraphs, surely there's a way to improve financial literacy enough to avoid the temptation to tinker 10 out of 10 times. What's more important America? Cutting your taxes five percent or risking having ALL of your dollars (not just those few after-tax dollars saved) worth 20 percent less in five years because we printed money to cover the lost tax revenue?