On Stockman And Liquidation

David Stockman’s New York Times Op-Ed has ruffled a lot of feathers. Paul Krugman disliked it, calling Stockman a cranky old man and criticising Stockman for throwing out a load of meaningless numbers that sound kind of scary, but are less so in context. Krugman is right on both counts, but what Krugman overlooks is Stockman’s excellent criticism of crony capitalism, financialisation, systemic rot and Wall Street corruption of Washington, something Stockman has seen from the inside as part of the Reagan administration.

The Important Part
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.

There are plenty of other writers who have pointed to this problem of propping up casino finance, including myself. But very few of them are doing so on the pages of the New York Times. So while it’s rather disappointing to see Stockman railing against deficits when the evidence shows capital and labour markets are still very slack even with large deficits, and while it’s rather disappointing to see him making technically-incorrect claims about the United States being “bankrupt” -- sovereign lenders controlling their own currency cannot go bankrupt -- we should not throw the baby out with the bathwater. Stockman is a cranky old man -- but when it comes to drawing attention to real-world problems with crony capitalism, he’s doing a fine job.

Many will say that just letting the banks liquidate was not an option. I tend to disagree -- depositors could have been protected, and a new part-nationalised banking system could perhaps have been built and capitalised just as quickly as the old dinosaurs were bailed out -- but even if we assume liquidation to be impossible there are plenty of other options to bring the financial sector to heel. It is extremely disappointing to see the Obama administration fail to go after the banks in any meaningful way. The administration could have tried to break up the TBTF megabanks, reimpose Glass-Steagall, impose the Volcker Rule, fire failed management. Perhaps even try to impose the Chicago Plan. Without Fed liquidity, the US banking sector is toast, so almost any reform is possible.

Instead the banks took their bailouts without any discipline, and guess what? We’ve had even more systemic corruption, carrying on in the same pre-2008 mould -- the London Whale, Ina Drew, Kweku Adoboli, the theft of segregated deposits by MF Global, even while financial sector stocks have soared. Central banks have reinflated the markets, but with the same people who created the last bust still in charge, it looks much more like a reinflated bubble than a road to lasting prosperity. Papering over the cracks…

The result of that is soaring corporate profits while employment and wages remain depressed. Feast for Wall Street, famine for Main Street. Obama may deploy plenty of populist rhetoric, but outcomes speak for themselves:

Stockman has actually gone further in the past, criticising the toothlessness of Dodd-Frank in dealing with the problem of Too Big To Fail, and even endorsing a return to Glass-Steagall and the banning of corporate campaign donations. This 30-minute video is really worth watching.

In the long run, I think it will become patently clear that throwing liquidity at the financial system won’t solve anything other than immediate liquidity concerns. The rot was too deep. The financial sector needed real reform in 2008. It still needs it today.