Web Extra: Read an Excerpt of David Stockman's New Book

Moreover, this liquidation process exhibited an exceedingly precise focus that was completely inconsistent with Washington's spasmodic arm waving about "contagion." Specifically, the asset fire sales were not coming from the old-fashioned "whole loan" books (loans made to homeowners but never securitized by Wall Street) of the nation's eight thousand commercial banks and thrifts. This was because the response of conventional deposit banks to deteriorating mortgage performance was to boost loan loss reserves, not dump mortgage paper on the open market.

By contrast, the housing and real estate–based assets held by the Wall Street "investment banks" consisted preponderantly of securitized mortgages and related synthetic and derivative instruments. The book value of these "assets" had been artificially inflated from the get-go, based on implausibly optimistic default assumptions with respect to the underlying mortgage pools.

Moreover, these pools had also been drained of value time and again by the fee extractions taken at each step along the route to securitization and sale. This sequence of fee scalping included mortgage origination, packaging of these loans into mortgage-backed securities, repackaging of MBSs into CDOs, and even further repackaging of CDOs into CDOs squared.

As a consequence of the "run" in the wholesale funding market, however, this whole misbegotten edifice was being rectified. The toxic securitized mortgages and derivatives were being marked down to realistic value. Likewise, the wholesale funding market was being taught a harsh lesson on the consequences of the type of reckless lending which had permitted tiny investment banks to grow into trillion-dollar giants.

At the same time, the prices of investment bank capital securities were experiencing shocking declines, as illustrated by Goldman's stock price dive from $200 per share to less than $50 in a matter of months. In short, the dangerous business model on which these ultra-leveraged hedge funds were based was being purged from the financial system. Indeed, Lehman and Merrill were already down, and Goldman and Morgan Stanley were on the ropes.

Mr. Market was thus on the cusp of being four-for-four in eliminating these dangerous ultra-leveraged gambling operations. Unfortunately, Chairman Bernanke and Secretary Paulson drastically misconstrued this healthy run in the wholesale banking sector. Not only did they view it as a threat to the Fed's wealth effects model of monetary central planning, but they also saw it as a replay of the Great Depression–era bank runs.

As will be seen in chapter 8, however, it was nothing of the kind. Contrary to Chairman Bernanke's faulty and self-serving scholarship, the famous bank runs of 1930–1933 were not the result of monetary policy mistakes by the Fed after 1929. Instead, they were the ineluctable consequence of the wartime and postwar debt booms from 1914 to 1929 and the vast crop of insolvent borrowers which they fostered.

Likewise, Washington's massive intervention in September 2008 could not thwart a Great Depression 2.0 because the collapse of Wall Street could not have caused one. There had been no economic Armageddon looming, only a long cycle of debt liquidation, shrinking living standards, and austerity— or exactly the outcome we have experienced anyway.

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