The Great Conflagration

An Interview with David Stockman

An economic crisis fueled by debt is brewing, says David Stockman.

Flickr. An economic crisis fueled by debt is brewing, says David Stockman.

Octavian Report: Do you see there being any medium or long-term hope for entitlement reform? When does the U.S. deficit catastrophe come, and what are the triggers for it?

David Stockman: As outlined in my new book, Trumped, my fairly detailed calculations suggest that under a realistic scenario, Social Security trust funds — even as phony as they are; that accounting is just what I call “accounting confetti” — will be out of accounting income and assets in 2026.

So, from that point forward, there would be an automatic cutback. I calculate it’s as high as a third across the board for all 75 million people that will be receiving Social Security then, so my answer is: we’ll make it to the middle of the next decade if we’re lucky, but once it becomes more evident that you’re getting close to that point, that you’re drifting closer, the numbers will be hard to hide.

Then, I think, the panic will set in, and there will be a massive firestorm of political conflict. It certainly wasn’t raised in this election because Trump chose to pretend the entitlements aren’t a problem, and Hillary thinks we ought to lower the Medicare eligibility age and improve benefits. In other words, they took a total punt in 2016 but by 2020, we’re going to be so close to the edge that it’ll be impossible to ignore the elephant in the room.

The 2020’s, when the historians finally write up what happened in the decade, will be a non-stop conflagration over how to fund entitlements, how to cut entitlements, how to reform entitlements — a generational conflict between the workers paying and the retirees and disabled demanding their checks. I think it’s going to be something damn near a civil war, the likes of which we haven’t seen since the whole entitlement age began in the 1930’s with the New Deal. The 2020’s are going to be ground zero for the ultimate explosion of this whole unsustainable system.

OR: Why do you think these numbers have not produced this conflagration yet, even though we’re, according to your calculations, a decade away from zero hour?

Stockman: Basically because they’re kicking the can down the road. Both parties — in a bipartisan conspiracy of silence — just keep borrowing more money. We have $20 trillion of debt, or we will by the time the next president is sworn in; it’s $19.5 trillion today. That is up from $10 trillion when Obama took office, and less than $5 trillion at the turn of the century.

As long as you can keep borrowing money, as along as the Fed comes in and buys the bonds and drives interest rates to rock-bottom — so the cost of carrying this massive federal debt is artificially and unsustainably minimized — you can kick the can for a while. But at some point, the Fed is going to have to normalize interest rates. You can’t keep them at zero forever, or you’ll destroy the monetary system. If they normalize interest rates, which would mean 200, 300 basis points more, and if we have $20 trillion of public debt today, then there’s $10 billion baked into the cake for the next decade even according to CDOs.

So $30 trillion of debt is almost guaranteed, unless there is a huge reform of entitlements and defense spending. I don’t see that happening. So what happens if interest rates normalize on
$30 trillion of public debt? You don’t even have to have a slide rule, to say nothing of a hand calculator, to see that that’s $900 billion of additional interest expense.

That would be crushing. That would fundamentally sink the finances of the federal government. It would be an unsustainable crisis.

But as long as the Fed keeps spending the money, they’ll keep kicking the can. The Fed is the great enabler of the fiscally irresponsible Washington politicians who are just ignoring the demographic and entitlement time bomb.

OR: Is there a political solution for this?

Stockman: I think there is a solution. It’s kind of hard to see where it would come from politically today, but there needs to be a housecleaning of the Fed. The whole posse, let’s call it, of people there are dyed-in-the-wool Keynesians who think you can make wealth by suppressing interest rates and rigging the financial markets. At least Trump was right on that. He called them out on it. He said, “Yellen should be ashamed of herself.” He was absolutely right, but you need to do more than that.

The practical solution is you need to repeal Humphrey-Hawkins. There’s no way, sitting in the Eccles Building in Washington with a crude instrument of pegging the interest rate by 25 basis points either way, that you can guarantee full employment in a globally competitive free-trade world economy. Or that you can control inflation in a global financial system that obviously reaches well beyond any one central bank.

The whole thing is misbegotten. It ought to be repealed, we ought to eliminate the Federal Open Market Committee and their constant interventions in the market. We ought to ban the Federal Reserve from buying another dollar of government debt — flat out ban it — and put it back to the original 1913 charter that was given to them by Carter Glass, who was the author of the Federal Reserve Act, which is to be a stand-by source of liquidity at market-set rates. Not rates they peg, not rates they control, but market-set rates with a penalty spread on top of that.

If there is a speculative blow-off in the economy and there’s too much demand for debt, interest rates will soar. That will clear the market, and the Fed shouldn’t stand in the way; under the scheme that I’m talking about, they wouldn’t. But right now, what we have is monetary central planning.

We basically have a rogue central bank that has interrupted the fundamental pricing and price discovery processes of capitalism. If financial prices are wrong and falsified, if they are manipulated by 12 people, the repercussions go beyond imagination. There’s speculation everywhere, there’s too much debt everywhere, the federal government, as I’ve been saying, oblivious to the fact that it’s burying the country and future generations in debt.

All of these bad things happen when you don’t allow the free market to price interest rates in the money market or in the debt markets, or allow stock markets and other risk asset prices to find their true level in the free market.

I think the only way to cure it is, indeed, a thundering, crashing crisis. There’s no way they’re going to do it voluntarily. Certainly the Fed, after 93 months, can’t even get up the nerve to raise interest rates by 25 basis points, when the only impact will be on the financial markets. There’s no consumer in America who’s going to be impacted one way or another by 25 basis points. There’s no honest businessman in America who will factor his capital spending or his working capital levels based on whether the interest rate is 38 basis points or 62 basis points in the overnight market.

So the whole thing is a case of the central bank creating a monster bubble in the financial markets and now being petrified of bursting the bubble and having the next crash. But we will have it, it’s coming soon. The difference this time is that in the year 2000, in the peak of the dotcom collapse — a 60 percent collapse in the market with $7 trillion of equity lost — the Feds still had dry powder. So Greenspan plunged back in and in a 30-month period, he lowered the interest rate from six percent to one percent. We’d never been there before. He ignited the housing bubble. So the economy was off for a while. Then the housing bubble crashed, everybody was scared to death (allegedly) in October 2008, and the Fed came back again and went into this zero interest rate, and has been there for, as I say, 93 months. Massive bond buying, of a kind never imagined before. At the time Bernanke panicked at the Lehman crisis event, the balance sheet of the Federal Reserve was $900 billion and it had taken us 94 years to get there. Within seven weeks after Lehman, he had doubled it. Within 13 weeks, he almost tripled it.

Now, of course, it’s $4.5 trillion — five times what it was on the eve of the crisis. The reason I’m mentioning all of this is that the Fed bailed out the financial markets again. We got an even bigger bubble going this time — bonds and stocks — but the Fed is out of dry powder. They’re at zero. They can’t lower the interest rate below zero. If they try, I think they’ll create a political firestorm because it means you’re confiscating peoples’ savings. If you have a negative rate, because you’re charging them for the privilege of saving their own money. I don’t think they can go back into even a bigger round of QE because that would admit that the first round failed, and in my view, would cause a selling panic in the financial markets.

So, when this bubble bursts, whatever the catalyst is, it’s going to be some kind of black swan that no one can really necessarily predict as to the timing. But when it does, what’s going to cause panic in the financial markets is the realization that the Fed is more or less helpless, it’s out of tools, out of dry powder, and a natural correction is going to run its course. Not be stopped dead in the water like it was in March 2009, not reversed like it was in 2001 when Greenspan started the housing bubble. It’s not going to be arrested this time when the big decline starts in motion, and it’s a long way down, as far as I can see.

OR: Is there anything you recommend being long at the moment?

Stockman: I think the best thing to be long is gold. Because as this whole faulty central banking regime breaks down, more and more traders and investors on the margin are going to say, “I’ve got to have some insurance; I’ve got to have a place to hide if this whole thing really comes unwound, if the bubbles collapse entirely since they’re entirely financially rooted, and they’ll start buying gold and these markets have been destroyed.” Basically, the financial markets have been destroyed by the Fed; they’re now casinos. They’re just constant trolling by speculators looking for something that’s going up. When gold starts going up because fear that the central banks and the Fed are failing begins to set in, then gold will just keep going up, and the more it goes up, the more people are going to buy it. I think it’ll be a great speculative opportunity.

OR: Do you have a favorite way to play gold?

Stockman: I don’t think you have to get that complicated about it; if you’re really a sophisticated investor and you follow this, then maybe you can find some miners that will shoot the moon, but I don’t think you have to own physical gold. I don’t think the whole system is going to go up in smoke. You can just buy the ETF. There’s 15 different ways to play it, but the plain vanilla way is to buy the ETF and take it for a ride.

OR: How does the GOP go from Reagan to Trump in three decades?

Stockman: After 30 years, it lost its way entirely. It drew all the wrong lessons from the 1980’s, it came to embrace the idea that deficits don’t matter, that entitlements can be left to ride indefinitely into the future, that you can grow your way out of any fiscal problem. Reagan never really said that: it was a different environment, he had double-digit inflation, we needed to cut rates because of bracket creep. But after 30 years of being lost in the wilderness and giving up on the job of what the Republican party is supposed to do — which is to be the party of fiscal rectitude and sound money — you end up with a wildcard like Trump.