The Emperor is Naked: David Stockman
Source: Karen Roche and JT Long of
The Gold Report
A "paralyzed" Federal Reserve Bank, in its "final days," held
hostage by Wall Street "robots" trading in markets that are
"artificially medicated" are just a few of the bleak observations
shared by David Stockman, former Republican U.S. Congressman and
director of the Office of Management and Budget. He is also a
founding partner of Heartland Industrial Partners and the author
The Triumph of Politics: Why Reagan's Revolution Failed
and the soon-to-be released
The Great Deformation: How Crony Capitalism Corrupts Free
Markets and Democracy.
The Gold Report
caught up with Stockman for this exclusive interview at the
recent Recovery Reality Check conference.
The Gold Report:
David, you have talked and written about the effect of
government-funded, debt-fueled spending on the stock market. What
will be the real impact of quantitative easing?
We are in the last innings of a very bad ball game. We are coping
with the crash of a 30-year-long debt super-cycle and the
aftermath of an unsustainable bubble.
Quantitative easing is making it worse by facilitating more
public-sector borrowing and preventing debt liquidation in the
private sector-both erroneous steps in my view. The federal
government is not getting its financial house in order. We are on
the edge of a crisis in the bond markets. It has already happened
in Europe and will be coming to our neighborhood soon.
What should the role of the Federal Reserve be?
To get out of the way and not act like it is the central monetary
planner of a $15 trillion economy. It cannot and should not be
The Fed is destroying the capital market by pegging and
manipulating the price of money and debt capital. Interest rates
signal nothing anymore because they are zero. The yield curve
signals nothing anymore because it is totally manipulated by the
Fed. The very idea of "Operation Twist" is an abomination.
Capital markets are at the heart of capitalism and they are
not working. Savers are being crushed when we desperately need
savings. The federal government is borrowing when it is broke.
Wall Street is arbitraging the Fed's monetary policy by borrowing
overnight money at 10 basis points and investing it in 10-year
treasuries at a yield of 200 basis points, capturing the profit
and laughing all the way to the bank. The Fed has become a
captive of the traders and robots on Wall Street.
If we are in the final innings of a debt super-cycle, what is the
catalyst that will end the game?
I think the likely catalyst is a breakdown of the U.S. government
bond market. It is the heart of the fixed income market and,
therefore, the world's financial market.
Because of Fed management and interest-rate pegging, the
market is artificially medicated. All of the rates and spreads
are unreal. The yield curve is not market driven. Supply and
demand for savings and investment, future inflation risk
discounts by investors-none of these free market forces matter.
The price of money is dictated by the Fed, and Wall Street merely
attempts to front-run its next move.
As long as the hedge fund traders and fast-money boys believe
the Fed can keep everything pegged, we may limp along. The minute
they lose confidence, they will unwind their trades.
On the margin, nobody owns the Treasury bond; you rent it.
Trillions of treasury paper is funded on repo: You buy $100
) in Treasuries and immediately put them up as collateral for
overnight borrowings of $98M. Traders can capture the spread as
long as the price of the bond is stable or rising, as it has been
for the last year or two. If the bond drops 2%, the spread has
been wiped out.
If that happens, the massive repo structures-that is, debt
owned by still more debt-will start to unwind and create a panic
in the Treasury market. People will realize the emperor is
Is that what happened in 2008?
In 2008 it was the repo market for mortgage-back securities,
credit default obligations and such. In 2008 we had a dry run of
what happens when a class of assets owned on overnight money goes
into a tailspin. There is a thunderous collapse.
Since then, the repo trade has remained in the Treasury and
other high-grade markets because subprime and low-quality
mortgage-backed securities are dead.
Walk us through a hypothetical. What happens when the fast-money
traders lose confidence in the Fed's ability to keep the
They are forced to start selling in order to liquidate their
carry trades because repo lenders get nervous and want their cash
back. However, when the crisis comes, there will be insufficient
private bids-the market will gap down hard unless the central
banks buy on an emergency basis: the Fed, the European Central
Bank (ECB), the people's printing press of China and all the rest
The question is: Will the central banks be able to do that
now, given that they have already expanded their balance sheets?
The Fed balance sheet was $900 billion (
) when Lehman crashed in September 2008. It took 93 years to
build it to that level from when the Fed opened for business in
November 1914. Bernanke then added another $900B in seven weeks
and then he took it to $2.4 trillion in an orgy of money printing
during the initial 13 weeks after Lehman. Today it is nearly $3
trillion. Can it triple again? I do not think so. Worldwide it's
the same story: the top eight central banks had $5 trillion of
footings shortly before the crisis; they have $15 trillion today.
Overwhelmingly, this fantastic expansion of central bank footings
has been used to buy or discount sovereign debt. This was the
mother of all monetizations.
Following that path, what happens if there are no buyers? Do the
governments go into default?
The U.S. Treasury needs to be in the market for $20B in new
issuances every week. When the day comes when there are all
offers and no bids, the music will stop. Instead of being able to
easily pawn off more borrowing on the markets-say 90 basis points
for a 5-year note as at present-they may have to pay hundreds of
basis points more. All of a sudden the politicians will run
around with their hair on fire, asking, what happened to all the
What do the politicians have to do next?
They are going to have to eat 30 years worth of lies and by the
time they are done eating, there will be a lot of mayhem.
Will the mayhem stretch into the private sector?
It will be everywhere. Once the bond market starts unraveling,
all the other risk assets will start selling off like mad,
Does every sector collapse?
If the bond market goes into a dislocation, it will spread like a
contagion to all of the other asset markets. There will be a
I think everything in the world is overvalued-stocks, bonds,
commodities, currencies. Too much money printing and debt
expansion drove the prices of all asset classes to artificial,
non-economic levels. The danger to the world is not classic
inflation or deflation of goods and services; it's a drastic
downward re-pricing of inflated financial assets.
Is there any way to unravel this without this massive
I do not think so. When you are so far out on the end of a limb,
how do you walk it back?
The Fed is now at the end of a $3 trillion limb. It has been
taken hostage by the markets the Federal Open Market Committee
was trying to placate. People in the trading desks and hedge
funds have been trained to front run the Fed. If they think the
Fed's next buy will be in the belly of the curve, they buy the
belly of the curve. But how does the Fed ever unwind its current
lunatic balance sheet? If the smart traders conclude the Fed's
next move will be to sell mortgage-backed securities, they will
sell like mad in advance; soon there would be mayhem as all the
boys and girls on Wall Street piled on. So the Fed is frozen; it
is petrified by fear that if it begins contracting its balance
sheet it will unleash the demons.
Was there some type of tipping that allowed certain banks to
front run the Fed?
There are two kinds of front-running. First is market-based
front-running. You try to figure out what the Fed is doing by
reading its smoke signals and looking at how it slices and dices
its meeting statements. People invest or speculate against the
Fed's next incremental move.
Second, there is illicit front-running, where you have a
friend who works for the Federal Reserve Board who tells you what
happened in its meetings. This is obviously illegal.
But frankly, there is also just plain crony capitalism that is
not that different in character and it's what Wall Street does
every day. Bill Dudley, who runs the New York Fed, was formerly
chief economist for Goldman Sachs and he pretends to solicit an
opinion about financial conditions from the current Goldman
economist, who then pretends to opine as to what the economy and
Fed might do next for the benefit of Goldman's traders, and
possibly its clients. So then it links in the ECB, Bank of
Canada, etc. Is there any monetary post in the world not run by
The point is, this is not the free market at work. This is
central bank money printers and their Wall Street cronies
perverting what used to be a capitalist market.
Does this unwinding of the Fed and the bond markets put the
banking system back in peril, like in 2008?
Not necessarily. That is one of the great myths that I address in
my book. The banking system, especially the mainstream banking
system, was not in peril at all. The toxic securitized mortgage
assets were not in the Main Street banks and savings and loans;
these institutions owned mostly prime quality whole loans and
could have bled down the modest bad debt they did have over time
from enhanced loan loss reserves. So the run on money was not at
the retail teller window; it was in the canyons of Wall Street.
The run was on wholesale money-that is, on repo and on unsecured
commercial paper that had been issued in the hundreds of billions
by financial institutions loaded down with securitized toxic
garbage, including a lot of in-process inventory, on the asset
side of their balance sheets.
The run was on investment banks that were really hedge funds
in financial drag. The Goldmans and Morgan Stanleys did not
really need trillion-dollar balance sheets to do mergers and
acquisitions. Mergers and acquisitions do not require capital;
they require a good Rolodex. They also did not need all that
capital for the other part of investment banking-the underwriting
business. Regulated stocks and bonds get underwritten through
rigged cartels-they almost never under-price and really don't
need much capital. Their trillion dollar balance sheets,
therefore, were just massive trading operations-whether they
called it customer accommodation or proprietary is a distinction
without a difference-which were funded on 30 to 1 leverage. Much
of the debt was unstable hot money from the wholesale and repo
market and that was the rub-the source of the panic.
Bernanke thought this was a retail run à la the 1930s. It was
not; it was a wholesale money run in the canyons of Wall Street
and it should have been allowed to burn out.
Let's get back to our ballgame. What is to keep the U.S.
population from saying, please Fed save us again?
This time, I think the people will blame the Fed for lying. When
the next crisis comes, I can see torches and pitch forks moving
in the direction of the Eccles building where the Fed has its
Let's talk about timing. On Dec. 31, the tax cuts expire, defense
cuts go into place and we hit the debt ceiling.
That will be a clarifying moment; never before have three such
powerful vectors come together at the same time- fiscal triple
First, the debt ceiling will expire around election time, so
the government will face another shutdown and it will be
politically brutal to assemble a majority in a lame duck session
to raise it by the trillions that will be needed. Second, the
whole set of tax cuts and credits that have been enacted over the
last 10 years total up to $400-500B annually will expire on Dec.
31, so they will hit the economy like a ton of bricks if not
extended. Third, you have the sequester on defense spending that
was put in last summer as a fallback, which cannot be changed
without a majority vote in Congress.
It is a push-pull situation: If you defer the sequester, you
need more debt ceiling. If you extend the tax expirations, you
need a debt ceiling increase of $100B a month.
What will Congress do?
Congress will extend the whole thing for 60 or 90 days to give
the new president, if he hasn't demanded a recount yet, an
opportunity to come up with a plan.
To get the votes to extend the debt ceiling, the Democrats
will insist on keeping the income and payroll tax cuts for the
99% and the Republicans will want to keep the capital gains rate
at 15% so the Wall Street speculators will not be inconvenienced.
It is utter madness.
It is like chasing your tail. How does it stop?
I do not know how a functioning democracy in the ordinary course
can deal with this. Maybe someone from Goldman Sachs can come and
put in a fix, just like in Greece and Italy. The situation is
really that pathetic.
Greece has come up with some creative ways to bring down its
sovereign debt without actually defaulting.
The Greek debt restructuring was a farce. More than $100B was
held by the European bailout fund, the ECB or the International
Monetary Fund. They got 100 cents on the dollar simply by issuing
more debt to Greece. For private debt, I believe the net
write-down was $30B after all the gimmicks, including the
front-end payment. The rest was simply refinanced. The Greeks are
still debt slaves, and will be until they tell Brussels to take a
Going back to the triple-witching hour at year-end, if the debt
ceiling is raised again, when do we start to see government
layoffs and limitations on services?
Defense purchases and non-defense purchases will be hit with
brutal force by the sequester. As we go into 2013, there will be
a shocking hit to the reported GDP numbers as discretionary
government spending shrinks. People keep forgetting that most
government spending is transfer payments, but it is only
purchases of labor and goods that go directly into the GDP
calculations, and it is these accounts that will get smacked by
the sequester of discretionary defense and non-defense
I would think to unemployment numbers as well.
They will go up.
Just take one example. According to the Bureau of Labor
Statistics monthly report, there are 650,000 or so jobs in the
U.S. Postal Service alone. That is 650,000 people who pretend to
work at jobs that have more or less been made obsolete and
redundant by the Internet and who are paid through borrowings
from Uncle Sam because the post office is broke. Yet, the
courageous ladies and gentlemen on Capitol Hill cannot even bring
themselves to vote to discontinue Saturday mail delivery; they
voted to study it! That is a measure of the loss of capacity to
rationally cognate about our fiscal circumstance.
In the midst of this volatility, how can normal people preserve,
much less expand their wealth?
The only thing you can do is to stay out of harm's way and try to
preserve what you can in cash. All of the markets are rigged or
impaired. A 4% yield on blue chip stocks is not worth it, because
when the thing falls apart, your 4% will be gone in an hour.
But if the government keeps printing money, cash will not be
worth as much, either, right?
No, I do not think we will have hyperinflation. I think the
financial system will break down before it can even get started.
Then the economy will go into paralysis until we find the
courage, focus and resolution to do something about it. Instead
of hyperinflation or deflation there will be a major financial
dislocation, which means painful re-pricing of financial
How painful will the re-pricing be? I think the public already
knows that it will be really terrible. A poll I saw the other day
indicated that 25% of people on the verge of retirement think
they are in such bad financial shape that they will have to work
until age 80. Now, the average life expectancy is 78. People's
financial circumstances are so bad that they think they will be
working two years after they are dead!
Finally, what is your investment model?
My investing model is ABCD: Anything Bernanke Cannot Destroy:
flashlight batteries, canned beans, bottled water, gold, a cabin
in the mountains.
Thank you very much.
is a former U.S. politician and businessman, serving as a
Republican U.S. Representative from the state of Michigan
1977-1981 and as the director of the Office of Management and
Budget under President Ronald Reagan 1981-1985. He is the author
The Triumph of Politics: Why Reagan's Revolution Failed
and the soon-to-be released
The Great Deformation: How Crony Capitalism Corrupts Free Markets
Stockman was the keynote speaker at last weekend's Casey
Research Recovery Reality Check Summit. This event featured
legendary contrarian investor Doug Casey, high-end natural
resource broker Rick Rule,
New York Times
bestselling author John Mauldin and 28 other financial
luminaries. Over the three-day summit, they provided investors
with asset-protection action plans and actionable investment
advice. And even if you were unable to attend, you can still hear
every recorded presentation in the Summit Audio Collection. Learn
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