Stockman's Right – U.S. Is Setting Stage for New Financial Crisis

The narrative favored by politicians, regulators and bureaucrats is that private banks caused the financial crisis of 2008. The Federal Reserve Chairman and Treasury Secretary stopped the market panic and a repeat of the Great Depression, then politicians and regulators implemented a plan that will maintain a sound financial system. The economic ship of state is stable, under full steam and accelerating.

In his new book and related New York Times article, President Ronald Reagan's outspoken budget scold David Stockman argues that political and regulatory interference in mortgage markets caused the financial crisis, and then the Federal Reserve Chairman and Treasury Secretary panicked politicians into an unnecessary and unfair bailout. The political and regulatory steps taken in the aftermath all exacerbated financial and economic instability. The economic ship of state is adrift, held afloat by Fed-inflated bubbles and moving forward only relative to other global economies, but easily sunk by modest external waves or internal turbulence.

Stockman concludes that "The future (of the global economy) is bleak … These policies have brought America to an end-stage metastasis. The way out would be so radical it can't happen … When the latest bubble pops, there will be nothing to stop the collapse." Stockman recommends a flight to cash before then. However, he argues the large universal banks – which Stockman would break up – will only be recipients should they be once again bailed out in spite of the Dodd-Frank countermeasures to "too big to fail."

Most equity market participants reject Stockman's prognosis, preferring to bask in the glow of the raging bull stock and bond markets and forecasts of a continued housing recovery, but he is certainly not alone in his pessimism. Since the U.S. economic recession technically ended four years ago, the federal government has been running annual deficits of about $1 trillion, with the Fed financing about two-thirds to three-fourths of that amount. The Fed justifies this massive intervention by arguing that unemployment remains weak and inflation is dormant.

Generally the steeper the recession the greater the rebound, but after four years of unprecedented monetary and fiscal stimulus real GDP growth has been half the average of  prior U.S. Post war recoveries. The modest improvement in job growth reflects people giving up more than new hires, as labor force participation is the lowest since the Carter Administration. If measured the same way as in Europe the comparable U.S. unemployment rate is currently 15.8% .The dormancy of inflation largely reflects the weak recovery.

Most analysts would agree that a return to the historical long-term annual rate of growth in real GDP of about 3% is the elixir for both employment and budget deficits. President Obama's budget assumes real growth will accelerate to 3.4% and the Pollyannaish CBO assumes 4%. But increases in government spending, whether financed with monetized deficits or taxes, failed to produce growth in the U.S. and Europe, just as they previously did in Japan.

Technology expert Robert Gordonthinks a long-term growth rate of 1%-2% is more realistic.But the immediate problem is that total factor productivity, a measure of the efficiency with which capital and labor is used that should have rebounded to over 6% by now is barely positive. Government policies could offset that, but the policies of the last four years and those currently being considered are – as Stockman argues – universally anti-growth.

Government policies that force lenders to give mortgages to consumers with minimal down payments and provide government loans for all college expenses, the Fed's negative real interest rates and federal tax policies all helped drive the aggregate household saving rate down to zero. Given that government budget deficits currently offset business savings, total U.S. domestic saving turned negative for the first time since 1934.

Low interest rates should stimulate business to borrow and invest, but the current policy environment discourages business investment and expansion. The reluctance of business to invest is what made the Great Depression "great" and is now at its lowest level since then for similar reasons. The tax reform discussion is focused on "fairness" and "closing loopholes" (i.e., reducing investment incentives except for politically favored firms and industries).

In this environment, banks typically load up on government debt or that of their sponsored enterprises or favored businesses, enticed by low or no capital requirements and other politically motivated regulations. The Cypriot banks failed and defaulted on the claims of uninsured depositors because they were enticed by high yields and no capital requirements on Greek debt. The widespread insolvency of the Euro zone banks – ongoing denials of politicians and ministers notwithstanding – reflects excessive debt-financed government spending of the host countries with little to show for it.

It is not contagion from Cypriot banks that American depositors have to worry about, but the same thing happening here. From the Fed's Flow of Funds data, about a quarter of depository institution assets – about $3 trillion - are invested in mostly long-term securities in search of yield and encouraged by lower capital requirements. This is the same yield curve play forced upon federally chartered thrifts by regulations limiting them to fixed-rate mortgages, causing their demise when interest rates rose.

Banks think they can sell these securities quickly when rates start to rise. That's also Chairman Bernanke's strategy for a similar Fed portfolio. Who will buy these securities isn't obvious, but don't worry, because the government isn't: the hundreds of economists at the Financial Stability Oversight Council doing stress tests are forbidden from testing what happens if interest rates rise on the premise that the Fed can prevent that.

Bankers didn't cause the Great Recession and they aren't the reason for the economy's failure to rebound. President Richard Nixon purportedly wisecracked that the U.S. economy was so strong that it was virtually impossible for politicians to kill it. That's currently the best argument for the optimistic scenario. But Margaret Thatcher's recent obituaries remind us that her policies restored a moribund near-death British economy. Stockman's compelling analysis of the U.S. economy reminds us that the same decline is not only possible here, but likely.  

Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates and an executive scholar at the Burnham-Moores Center for Real Estate of the University of San Diego.