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The Story of a Bubble

1.

For our purposes, the “fabulous Nineties” can be bracketed by two major political events. The fall of the Berlin Wall on November 9, 1989, marked the end of the cold war and the beginning of a period of geopolitical optimism. The Soviet empire disintegrated, the great powers unified Germany, and Europe began its movement to a common currency. The end of the period came on September 11, 2001, when the age of terrorism began, and the security anxieties of the cold war were replaced by altogether different ones.

Economic history seldom has the dramatic discontinuities of political events, and changes in economic fortunes often have complex roots. Good economic history requires not only a sound understanding of how the economy functions but also attention to institutional details, such as how monetary and fiscal policy decisions are made, as well as the impact of events such as the attacks of September 11, 2001, or the economic impact of the war in Iraq and its aftermath.

When we interpret the Nineties, it is natural for us to rely on histories written by economists who witnessed the events firsthand. Two books that will serve as excellent sources for this period are The Fabulous Decade, a careful analysis of national economic policy first published in 2001 by Alan Blinder and Janet Yellen, and The Roaring Nineties, a comprehensive review of the last decade by Joseph Stiglitz.1

All three authors are distinguished academic economists who worked in different government agencies during the 1990s. Alan Blinder served in President Clinton’s Council of Economic Advisers (CEA) in 1993 and 1994; he then became a governor and vice-chairman of the Federal Reserve from 1994 until 1996, when he returned to Princeton University. Janet Yellen was a governor of the Federal Reserve from 1994 until 1997, and she then served as chair of the CEA from 1997 to 1999; she is now at the University of California at Berkeley.

The book by Blinder and Yellen has a relatively narrow focus. It seeks to explain why the 1990s were so successful from a macroeconomic point of view—one that takes into account the behavior of the major economic aggregates such as output, unemployment, and productivity. Their analysis proceeds by considering economic statistics for the period; by using two different econometric models to assess the effects of economic shocks during the 1990s on both consumption and investment; and by drawing on detailed transcripts of Federal Reserve meetings.

Most economists at the CEA and the Federal Reserve are highly qualified, but Joseph Stiglitz is unique in being the only Nobel Prize winner who was also the chief economist to the President of the United States, whom he served from 1995 to 1997. Stiglitz then served as chief economist of the World Bank between 1997 and 2000. His academic writings have emphasized how “asymmetric information”—situations where one side of a transaction has better information than the other—distorts market signals and produces market failures.

Stiglitz’s book is part economic analysis, part memoir, and part social commentary. Whereas Blinder and Yellen celebrate the economic successes of the 1990s, Stiglitz is much more ambivalent about the accomplishments of the period. He has more complaints about than compliments for the economic policies of the 1990s and holds that the Clinton administration failed to live by its principles:

Of all the mistakes we made in the Roaring Nineties, the worst were caused by a lack of standing by our principles and lack of vision…. Why did we fail to follow through on our principles?… We were… I think, in part a victim of our own seeming success. At the beginning of the administration, the bold, broad-gauged agenda to address America’s problems was put aside in favor of a single-minded focus on deficit reduction.

The Clinton administration’s concentration on reducing deficits was part of what Stiglitz feels was the misguided “ascendancy of finance.” In his view, the Clinton officials were excessively concerned about the performance of the stock and bond markets because investment banker Robert Rubin headed the Treasury Department. Stiglitz is not the only person to have made that observation. James Carville, President Clinton’s first campaign manager, quipped a few years ago, “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.”

In fact, the scandals of finance are a good example of the asymmetric-information syndrome whose study Stiglitz pioneered. This syndrome was pandemic in the late 1990s when analysts like Salomon Smith Barney’s Jack Grubman touted stocks that were hardly viable while, behind the scenes, his firm raked in billions in underwriting fees. Other examples were corporate managers of Enron, WorldCom, and other companies; they knew much of the truth about their companies’ finances, while the public and even sophisticated analysts did not. This asymmetric information allowed a handful of insiders to enrich themselves while defrauding shareholders. According to a study by the Financial Times, corporate insiders from the top twenty-five bankrupt companies took $3.3 billion in stock sales, bonuses, and other compensation even as their firms were spiraling into insolvency.2

Indeed, the ability of corporate managers to hide financial information about their companies from those who own the companies—the shareholders—is a truly bizarre situation for which there is little justification. Corporations keep multiple sets of accounts—one set for published financial accounts, a second and unpublished set of books for tax purposes, and in many cases a third set of books for the managers themselves. In essence, corporations get to choose the yardstick by which they measure the profits that they publish. Under current law they have no obligation to reveal tax returns, and stockholders have no right to obtain them. One important reform that would illuminate the true state of corporate finances would be to require corporations to publish their tax returns. This would allow investors to assess profits by a standard yardstick.

The reader should be warned that, as Stiglitz states, his “is not a book of investigative reporting.” In his passion for revisiting the history of the Nineties, Stiglitz occasionally stretches the interpretation of events, and his arguments are sometimes overstated or inaccurate. One example is a tendency to exaggerate the extent to which Keynesian theories are accepted doctrine.3 Some schools of economics hold that Keynesian views—for example, on the role of fiscal and monetary policies in affecting real output and unemployment—are dead wrong, or even dead. Skeptics of Keynesian views include those who lean toward the “real business cycle” approach, which holds that technological shocks rather than shocks to spending produce business cycles. While I would argue that these critics of modern Keynesian economics have an unconvincing case, it is a major mistake to assume that they do not exist.

2.

The economic turning points of the Nineties are less dramatic than the political events—the fall of the Berlin Wall and September 11—that bracketed the decade. For simplicity, I will use the Clinton years between 1993 and 2000 as the primary period of analysis.

Table 1 shows, in the top panel, the four major indicators of the business cycle. These factors show the short-run movements of the economy and indicate the extent to which the economy is living up to its economic potential and making use of its labor and capital resources. The bottom panel shows the major “structural indicators”—the underlying forces that determine the long-run strength and growth prospects of the economy, as well as its fiscal health and its ability to improve the living standards of the population over the longer term.

One of the major contributors to prosperity in the 1990s was structural—the peace dividend made possible by the end of the cold war. Defense spending as a share of gross domestic product (GDP) declined by 2.6 percent, which is equivalent to $280 billion at today’s income level. This bonanza allowed private consumption to grow rapidly and helped to balance the nation’s books.

During the supply-side years under the Reagan administration, there were persistent federal budget deficits, averaging 3.5 percent of GDP. The first major steps toward reducing the deficit were taken by the first Bush administration in 1990 in the form of a small tax increase, and by congressional legislation that limited spending increases and tax cuts. But the Clinton administration pushed through the most visible fiscal correction in 1993, with a major and narrowly won program of tax cuts and spending reductions. The turnaround in the budget was surprising and dramatic. From a peak deficit of 5 percent of GDP in late 1992, the budget actually went into a surplus of 2 percent of GDP in 2000.

A third structural factor, and the most important for long-run economic growth and for the increase in wages and living standards, concerns growth in productivity—or output per hour worked. While the supply-side years are often touted as the “unshackling of American capitalism,” the 1980s in fact had a miserable productivity growth of only 1.8 percent per year. This rate rose sharply in the “fabulous” Nineties, and, much to the surprise of many, has continued to increase during the last three years.

While these structural indicators form the backdrop of long-run economic performance, the business cycle makes the headlines and drives election results. Table 1 shows four major factors that are central to the business cycle: the inflation rate, the rate of growth of real GDP, the unemployment rate, and the rate of growth of employment. The striking feature of the Nineties was that each of the major cyclical indicators improved, often sharply, as compared to the supply-side period. For example, real GDP growth rose from 2.8 percent per year to 3.7 percent per year, and employment growth rose from 1.6 percent per year to 2.4 percent per year.

These changes in percentage points may seem trivially small. In reality, because of their compounding effects, small differences in the rate of growth make big differences in the actual levels of income and output. The small improvement during the 1990s of the annual growth rate of employment from 1.6 to 2.4 percent would translate into a higher growth of employment, totaling eight million jobs. Similarly, the higher growth of real output during the 1990s implies that total output at the end of the period was about $700 billion per year higher, which amounts to about $7,000 per American household per year.

The sources of the economic boom of the 1990s are the major topic of the study by Blinder and Yellen. Why, they ask, did the recovery last so long? Why did unemployment decline so much? What kept inflation in check?

The major difficulty in answering such questions lies in the economy’s complex and evolving structure. How do the short-term interest rates set by the Federal Reserve affect other interest rates? How do interest rates affect asset prices, such as stock prices, housing prices, and the foreign exchange rate of the dollar? What are the effects of changes in interest rates, exchange rates, and wealth on the spending of consumers, on business investment, and on trade with other countries?

  1. 1

    The earlier volume by Stiglitz on the world economy, Globalization and Its Discontents (Norton, 2002), was reviewed by Benjamin M. Friedman in these pages, August 15, 2002.

  2. 2

    See Ien Cheng, “Barons of Bankruptcy,” Financial Times, July 31, 2002.

  3. 3

    A good example of Stiglitz’s misinterpretation of Keynesian economics is his analysis of the International Monetary Fund (IMF): “Of course, this was why the IMF was founded, under the intellectual aegis of Keynes: to provide countries with the money necessary for expansionary fiscal policy in an economic downturn.” This is a misreading of the IMF’s history. Conceptually, the IMF is the international analogue of a central bank. It was designed to provide financial resources so that countries could adjust without exchange-rate adjustments. The IMF may decide to browbeat countries about their fiscal policies, but its instruments are purely monetary. Stiglitz argued in Globalization and Its Discontents that the IMF often inappropriately required countries to impose restrictive fiscal policies, particularly in the East Asian crisis of 1997– 1998. There is much merit in his views on this subject, but I am unaware of any evidence that its creators ever envisioned the IMF as a fiscal authority. For an early statement of the purposes of the IMF, see Robert Triffin, “National Central Banking and the International Economy,” The Review of Economic Studies, Vol. 14, No. 2. (1946–1947), p. 53.

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