The New Deal’s True Legacy

Chapter 9 – The Great Deformation – The Corruption of Capitalism in America

by David Stockman

The new deal did not address the causes of the depression,  even if its work relief and other humanitarian measures did ameliorate for millions of citizens the terrible costs of its unnecessary prolongation.

Still, most of this safety net consisted of ad hoc programs, such as the WPA, which were never institutionalized and did not survive the 1930s. What did survive is a destructive legacy of fiscal profligacy and crony capitalist abuse of state power. Policy measures like Fannie Mae, deposit insurance, social insurance, the Wagner Act, the farm programs, and monetary activism share a common disability. They fail to recognize that the state bears an inherent flaw that dwarfs the imperfections purported to afflict the free market; namely, that policies undertaken in the name of the
public good inexorably become captured by special interests and crony capitalists who appropriate resources from society’s commons for their own private ends. Roosevelt’s unprincipled and unbridled activism is a powerful case in point. Orthodox historians have positioned FDR as the scourge of “economic royalists” and the champion of the common man. He was neither.

In fact, he was the patron saint of crony capitalism. As a power-driven politician he recognized no rules or standards for public policy or any particular limits on the role of the state. Indeed, FDR
has been nearly defied for being a “pragmatist” who experimented until he found something that “worked.” Accordingly, it was only a matter of time before the very capitalists that FDR professed to despise captured for their own ends the programs he legitimized in the name of the public good.


Fannie Mae is a classic crony capitalist progeny of the New Deal that began life in 1938, quite innocently, as still another ad hoc New Deal program to boost the depression-weakened housing market. It grew into something quite different: a monster that deeply deformed and corrupted the nation’s entire financial system seventy years later.

The policy aim of Fannie Mae was “forcing water to flow uphill” in the residential mortgage market so that low-rate thirty-year home mortgages became available to wage-earning households of modest means. Such mortgages did not then exist for a good reason: they were not economic. No prudent local bank or thrift would take the underwriting risk. Fannie Mae would thus override the market’s veto by turning local banks and thrifts into government contractors or agents, rather than mortgage debt underwriters. Accordingly, they would be relieved of their aversion to the risk of default loss by means of a Washington-funded “secondary market.”

The latter would purchase these commercially unappealing mortgage loans for cash, enabling local bankers to reloan this cash again and again in a government-supported rinse and repeat cycle.

Meanwhile, the default losses that the market refused to underwrite would be shifted to taxpayers, since Fannie Mae’s funding would implicitly depend on the public credit of the United States. The slowly recovering residential housing sector would thus receive the kind of booster shot much favored by the New Dealers.

What Fannie Mae also did, unfortunately, was to start the home mortgage market down a slippery slope. This included separating the loan origination process from the long-term servicing and ownership of the resulting mortgage, in an alleged financing “innovation” that would give rise to predatory mortgage-broker boiler rooms a few generations down the road.

Likewise, it opened the door to the funding of home loans in the global markets for U. S. sovereign debt, rather than out of the savings deposits of local bank customers. This became possible because Fannie Mae took on quasi-sovereign status, meaning that investors were funding the general credit of the United States, not the specific risk of local mortgage borrowers and separate residential markets.

There were several crucial upgrades in ensuing decades to the original New Deal scheme before it reached its stunning dénouement in Washington’s panicky $6 trillion nationalization and bailout in September 2008.

Among these milestones were LBJ’s maneuver to put Fannie “off-budget” in 1968 in order to hide its exploding use of Uncle Sam’s credit card.

LBJ’s so-called privatization plan, in turn, paved the way for Fannie to morph into a hybrid entity called a GSE (government-sponsored enterprise) in which ownership was private but its debt issues were implicitly government guaranteed. Politicians and policy makers who inherited FDR’s “anything that works” mantle were pleased to describe the GSEs as creative “public/private partnerships.”

They were no such thing. The GSEs were actually dangerous and unstable freaks of economic nature, hiding behind the deceptive good-housekeeping seal afforded by their New Deal–sanctioned mission to support middle-class housing. This was especially the case after Fannie’s initial public offering and subsequent ability to tap the public capital markets for virtually limitless funds.

Another crucial step was Wall Street’s perfection of the mortgage securitization model. This “innovation” vastly improved Fannie’s ability to sweep up mortgages originated by local bankers on a massive wholesale basis, and then guarantee and package them for distribution into increasingly broad and liquid national and international capital markets. When this was combined with high speed computerized underwriting in the 1990s, disasters like Countrywide Financial became inevitable. As time passed, the evolution of the Fannie Mae monster only got more fantastical. Thus, the rise of the worldwide T-bill standard generated a nearly inexhaustible appetite among mercantilist central banks for US government or quasi-government GSE paper. These vast monetary roach motels were not exactly honest “markets” for mortgage loans from Cleveland or Fort Myers, but GSEs went into overdrive supplying the unquenchable thirst of foreign central banks for dollar liabilities, especially when heavy currency pegging began after 1994.

Not surprisingly, when Treasury Secretary Hank Paulson’s fabled bazooka failed and Washington had to nationalize the GSEs, foreign central banks and other state institutions owned more than $2 trillion of American home mortgages, including upward of $1 trillion domiciled at the People’s Printing Press of China.

In short, Fannie Mae’s journey started in 1938 with a Washington, DC, filing cabinet containing a few thousand mortgage notes which had been gussied up and christened as the nation’s “secondary mortgage market.” Yet the progeny of this innocent filing cabinet ended up eighty years later scattered around the globe in the trust accounts of Norwegian fishing villages and as a trillion-dollar stash in the central bank vault of Red China.

In the interim, massive social costs and economic losses built up inside the housing marketplace and became ripe to explode. As detailed more fully in chapter 20, the whole GSE scheme functioned to underprice mortgages, undermine lending standards, over qualify home buyers, fuel greedy broker predation, and fund a speculative climate.

In the process, the principal assets of the American middle class, family residences, were turned into an ATM machine and became the object of frenzied buying, selling, and serial refinancing. Unfortunately, this ruinous journey was far more inexorable than it was merely accidental.

At each step along the way, powerful special interest groups—mortgage bankers, real estate developers, home builders, building material suppliers, Wall Street underwriters, law and title firms, appraisers, and brokers— drove policy toward their own benefit. These changes, elaborations, enlargements, and aggrandizements had a common purpose: namely, to enable the Fannie Mae (and Freddie Mac) mortgage-financing machine to harvest ever greater volumes, profits and fees.

Indeed, the Fannie Mae saga demonstrates that once crony capitalism captures an arm of the state, its potential for cancerous growth is truly perilous. More importantly, it underscores that the resulting carnage can be vastly disproportionate to the alleged social ill that justified the original policy intervention.

In this case, the housing market had essentially recovered before Fannie Mae opened its doors. After hitting bottom at 125,000 units per year in 1931–1933, the volume of new starts had nearly tripled by the late 1930s. By then, it was by no means evident that the nation’s remaining willing lenders and solvent borrowers were producing the wrong answer with respect to the number of housing starts. So fiddling with an arbitrary goal of higher housing starts, the New Dealers gave birth to what eventually became a crony capitalist monster, and that was all.


The Social Security Act of 1935 had virtually nothing to do with ending the depression, and if anything it had a contractionary impact. Payroll taxes began in 1937 while regular benefit payments did not commence until 1940.

Yet its fiscal legacy threatens disaster in the present era because its core principle of “social insurance” inexorably gives rise to a fiscal doomsday machine. When in the context of modern political democracy the state offers universal transfer payments to its citizens without proof of need, it offers thereby to bankrupt itself—eventually.

By contrast, a minor portion of the 1935 legislation embodied the opposite principle—namely, the means-tested safety net offered through categorical aid for the low-income elderly, blind, disabled and dependent families. These programs were inherently self-contained because beneficiaries of means-tested transfers simply do not have the wherewithal—that is, PACs and organized lobbying machinery—to “capture” policy-making and thereby imperil the public purse.

To the extent that means-tested social welfare is strictly cash-based, as was cogently advocated by Milton Friedman in his negative income tax plan, it is even more fiscally stable. Such purely cash based transfers do not enlist and mobilize the lobbying power of providers and vendors of in-kind assistance, such as housing and medical services.

Social insurance, on the other hand, suffers the twin disability of being regressive as a distributional matter and explosively expansionary as a fiscal matter. The source of both ills is the principle of “income replacement” provided through mandatory socialization of huge population pools.

On the financing side, the heavy taxation needed to fund the scheme has been made politically feasible by the mythology that participants are paying a “premium” for an “earned” annuity, not a tax. Consequently, payroll tax financing is deeply regressive because all participants pay a uniform rate regardless of income. At the same time, benefits are also regressive because those with the highest life-time wages get the greatest replacement. This regressive outcome is only partially ameliorated by the so-called “bend points” which provide higher replacement on the first dollar of covered wages than on the last.

The New Deal social insurance philosophers thus struck a Faustian bargain. To get government funded pensions and unemployment benefits for the most needy, they eschewed a means test and, instead, agreed to generous wage replacement on a universal basis. To fund the massive cost of these universal benefits they agreed to a regressive payroll tax by disguising it as an insurance premium. Yet the long run results could not have been more perverse.

The payroll tax has become an anti-jobs monster, but under the banner of a universal entitlement organized labor tenaciously defends what should be its nemesis. At the same time, the prosperous classes have gotten a big slice of these transfer payments, and now claim they have earned them—when affluent citizens should have no proper claim on the public purse at all.

Accordingly, social insurance co-opts all potential sources of political opposition, making it inherently a fiscal doomsday machine. It was only a matter of time, for example, before its giant recipient populations would capture control of benefit policy in both parties, and most especially coopt the conservative fiscal opposition.

Within a few decades, in fact, Republican fiscal scruples had vanished entirely. This was more than evident when Richard Nixon did not veto but, instead, signed a 20 percent Social Security benefit increase on the eve of the 1972 election. Worse still, the bill also contained the infamous “doubleindexing” provision which since then has generated massive hidden benefit increases by over-indexing every worker’s payroll history.

The fiscal cost of relentless universal benefit expansion has driven an epic increase in the payroll tax. The initial 1937 payroll tax rate was about 2 percent of wages, but after numerous legislated benefit increases, the addition of Medicare in 1965, the Nixon benefit explosion and the Carter and Reagan era payroll tax increases, the combined employer/employee rate is now pushing 16 percent (including the unemployment tax).

Accordingly, Federal and state payroll taxes for social insurance generate $1.2 trillion per year in revenue—four times more than the corporate income tax. So with the highest labor costs in the world, the U.S now imposes punishing levies on payrolls. It thus remains hostage to a political happenstance— that is, the destructive bargain struck eight decades ago when high tariff walls, not containerships loaded with cheap goods made from cheap foreign labor, surrounded it harbors.

Yet there is more and it is worse. The current punishing payroll tax is actually way too low—that is, it drastically underfunds future benefits owing to positively fictional rates of economic growth assumed in the 75-year actuarial projections. As a result, the benefit structure grinds forward on automatic pilot facing no political opposition whatsoever. In the meanwhile, the fast approaching day or reckoning is thinly disguised by trust fund accounting fictions.

In truth the trust funds are both meaningless and broke. Annual benefit payouts already exceed tax receipts by upward of $50 billion annually, while the so-called trust funds reserves—$3 trillion of fictional treasury bonds accumulated in earlier decades—are mere promises to use the general taxing powers of the US government to make good on the rising tide of benefits.

The New Deal social insurance mythology of “earned” annuities on “paid-in” premiums that have been accumulated as trust fund “reserves” is thus an unadulterated fiscal scam. In reality, Social Security is really just an intergenerational transfer payment system. Moreover, the latter is predicated on the erroneous belief that new workers and wages can be forever drafted into the system faster than the growth of benefits. During the heady days of 1967, for example, Paul Samuelson and his Keynesian acolytes in the Johnson Administration still believed that the American economy was capable of sustained growth at a 5 percent annual rate.

The Nobel Prize winner thus assured his Newsweek column readers that paying unearned windfalls to current social security beneficiaries was no sweat: “The beauty of social insurance is that it is actuarially unsound. Everyone . . . is given benefit privileges that far exceed anything he has paid in . . .”

Samuelson rhetorically inquired as to how was this possible and succinctly answered his own question: “National product is growing at a compound interest rate and can be expected to do so as far as the eye can see . . . Social security is squarely based on compound interest. . . . the greatest Ponzi game ever invented.”

When 5 percent real growth turned out to be a Keynesian illusion and output growth decayed to 1–2 percent annual rate after the turn of the century, the actuarial foundation of Samuelson’s Ponzi game came crashing down. It is now evident that Washington cannot shrink, or even brake, the fiscal doomsday machine that lies underneath.

The fiscal catastrophe embedded in the New Deal social insurance scheme was not inevitable. A means-tested retirement program funded with general revenues was explicitly recommended by the analytically proficient experts commissioned by the Roosevelt White House in 1935. But FDR’s cabal of social work reformers led by Labor Secretary Frances Perkins thought a means-test was demeaning, having no clue that a means-test is the only real defense available to the public purse in a welfare state democracy. When the American economy was riding high in 1960, Paul Samuelson’s Ponzi was extracting payroll tax revenue amounting to about 2.8 percent of GDP. A half century later, after a devastating flight of jobs to East Asia and other emerging economies, the payroll tax extracts two-and-one half times more, taking in nearly 6.5 percent of GDP. So the remarkable thing is not that wooly-eyed idealists who drafted the 1935 act succumbed to social insurance’s Faustian bargain at the time. The puzzling thing is that 75 years later—with all the terrible facts fully known—the doctrinaire conviction abides on the Left that social insurance is the New Deal’s crowning achievement. In fact, it is its costliest mistake.


Another untoward legacy of the New Deal is the 1933 enactment of the great banking abomination known as “deposit insurance.” The keenest financial minds of the time vehemently opposed deposit insurance because they well understood the inherent dangers of fractional reserve banking, or what really amounts to borrowing short and lending long.

Financial conservatives of that era believed that effective discipline on bankers had to come from the liability side of their balance sheets. Bankers could be prevented from taking reckless credit risk, or foolishly mismatching short-term liquid deposits with too many illiquid long-term loans and investments, it was believed, only if they faced continuous depositor scrutiny and the threat of deposit withdrawals, even a “run” on the bank when all else failed.

Certainly that was the view in 1933 of the intrepid leader of the Senate banking committee, Carter Glass. It was also the position taken by the American Bankers Association, as well as by such distinctively less banker friendly experts as the original draftsman of the Federal Reserve Act, Professor H. Parker Willis of Columbia University. And not to be overlooked, either, is the fact that deposit insurance was also strongly opposed by Franklin D. Roosevelt himself.

It was only after months of legislative haggling that the Faustian bargain finally materialized. Hailing from the hardscrabble state of Alabama, which had been especially devastated by bank failures, Congressman Henry B. Steagall represented the populist demand for deposit insurance to protect the “little guy.” At the same time, the final bill incorporated a regulatory régime for the asset side of the banking system designed by Carter Glass and Professor Willis.

These latter restrictions famously centered on the separation of investment and commercial banking. But they also included restrictions on bank holdings of illiquid real estate and corporate securities, the prohibition of interest on checking accounts, and the remainder of what came to be known as the Glass-Steagall regulatory régime. The implicit theory of this two-headed compromise, therefore, was that the heavy inducement to risk taking and moral hazard, owing to taxpayer insurance of deposit liabilities, would be offset by strict safety and soundness regulation of banking operations and balance sheet holdings. In effect, traditional marketplace discipline on the deposit and liability side of bank balance sheets would be supplanted by strict regulation of their asset side.

At the time, the “Steagall” and the “Glass” components of the 1933 banking legislation seemed firmly harnessed. The US House of Representatives was a hotbed of anti-banker sentiment during the 1930s, while Senator Carter Glass was a deeply knowledgeable and stern taskmaster.

Even Wall Street grudgingly deferred to him. So the Glass-Steagall legislative fusion seemed immune to banker-sponsored dilution or repeal, and it was on that understanding that Carter Glass, the foremost banking expert of his time, reluctantly embraced deposit insurance.

In the fullness of time, however, it turned out to be just another Faustian bargain which came a cropper. Once the world went on the T-bill standard and inflation soared in the 1970s, Senator Glass’s carefully designed harness on the asset and operating side of commercial banking came under relentless pressure for liberalization. The Great Inflation of the 1970s which followed Nixon’s demolition of Bretton Woods, in fact, destroyed the political foundation of Glass-Steagall; that is, a régime of bad money very quickly spawned a parallel régime of bad banking. The reason is that high inflation flushed the liquid deposits out of banks while crushing the fixed-rate assets that were stranded in them.

A key feature of Glass-Steagall had been interest rate ceilings on bank deposits (Regulation Q). These were designed to discourage banks from aggressively expanding their loan books and then funding them with deposits obtained from their competitors by chasing interest rates higher. This ceiling arrangement was deeply offensive to free marketers, but Senator Glass had well understood that competitive efficiency had to be sacrificed to banking safety, given the moral hazard of deposit insurance and fractional reserve banking.

When Arthur Burns ignited the fires of inflation for Nixon’s reelection party, however, Regulation Q caused a perverse outcome that the gold standard Senator from Virginia probably never imagined; namely, a flight of deposits out of the banking system into unregulated money market funds that could offer higher rates. The latter, in turn, were able to invest their inflows in the choicest assets of the banking system, such as highgrade commercial paper and Treasury bills.

At the same time, soaring inflation caused massive mark-to-market losses on the core fixed-rate assets that the commercial banking system did retain, such as long-term Treasury bonds and mortgages. This brutal squeeze not only endangered the solvency and viability of the banking system, but it also generated a more sympathetic reception in Washington for the banking industry than at any time since the 1920s.

It would be no exaggeration to say that Richard Nixon and Arthur Burns were the real executioners of Glass-Steagall—and fully two decades before the Gramm-Leach-Bliley repeal act was even drafted. Ostentatiously displaying their wounds from the Great Inflation, in fact, the banks relentlessly pleaded for flexibility to pursue riskier business while also getting Regulation Q lifted.

The desire on Capitol Hill to help alleviate the squeeze on hometown banks and thrifts is what really fueled the deregulation drive during the Reagan era. For instance, the landmark Garn–St. Germain bill of 1982 conferred vastly expanded asset powers, such as real estate development lending and junk bond investments, on the massively insolvent savings and loan industry.

While the Senate side of this legislative duo had an affinity for free market doctrine, the decisive voice was that of Congressman Freddie St. Germain of Rhode Island. The latter was a practical politician who rarely met a lobbyist he could not accommodate.

If you would like to read more of this chapter go here and move to page 10 of 26.

%d bloggers like this: