An Inconvenient Truth

Dean Baker writes:

The truth is often painful but nonetheless it is important that we live in the real world. Just as little kids have to come to grips with the fact that there is no Santa Claus, it is necessary for millions of liberals, including many who think of themselves as highly knowledgeable about economic matters, to realize that President Clinton’s policies sent the economy seriously off course.

In Washington it is common to tout the budget surpluses of the Clinton years as some momentous achievement, as though the point of economic policy is to run budget surpluses. Of course the point of economic policy is to produce an economy that improves the lives of the people in a sustainable way. Clinton badly flunked this test.

The Clinton economy was driven by a stock bubble. This is not a debatable point. The ratio of market-wide stock prices to corporate earnings was well over 30 to 1 at the peak of the bubble in 2000. This is more than twice the historic average.

This run-up in stock prices drove the economy in two ways. First, since any good huckster could make millions selling shares in dot.whatever, we had many hucksters starting nutball businesses that never had a prayer of making a profit. This is not much of a long-run economic strategy, but in the short-term it led to an increase in investment.

The other way that the bubble drove the economy is through the wealth effect on consumption. The run-up in stock prices generated roughly $10 trillion in bubble wealth. The wealth effect from stock is usually estimated to be 3-4 cents on the dollar. This would mean that the bubble generated between $300 billion to $400 billion annually in additional consumption. This would have been 3-4 percent of GDP at the time ($480 billion to $560 billion annually in today’s economy). This is born out in the Commerce Department’s data, which show that the saving rate fell from close to 7 percent at the start of the 1990s to around 2.0 percent at the peak of the bubble in 2000.

This was the economy that President Clinton handed to President Bush in January of 2001. It was an economy that was being carried by an unsustainable bubble that in fact already was in the process of deflating at the time Bush took office. The S&P 500 was more than 10 percent below its 2000 peak, and the NASDAQ was down by more than 40 percent on the day that Bush took office. This pretty much guaranteed the recession that began in March of 2001 just as the collapse of the housing bubble placed President Obama in the middle of terrible recession in January of 2009.

The 2001 recession was the main reason that the surplus vanished in the 2002 fiscal year. Directing tax cuts to the wealthy was a foolish policy response to the downturn, but it was reasonable to turn to fiscal stimulus after the collapse of the stock bubble just as it was reasonable for President Obama to turn to fiscal stimulus after the collapse of the housing bubble. The Bush tax cuts did provide a boost to the economy; although they would have provided a larger boost if this money had been directed at moderate and middle-income people or devoted to long-term investments such as education and infrastructure.

The growth of the housing bubble eventually provided the boost needed to recover from the 2001 recession, just as the stock bubble propelled growth in the 1990s. As the economy got back near full employment in 2006 and 2007, the deficits shrank to sustainable levels.

However, while the deficits were sustainable in the later years of the Bush presidency, the housing bubble was not. Its collapse gave us the most predictable economic disaster in human history, even if all our top economists somehow didn’t see it.

To have a sustainable growth path we have to reverse one of the other central policies of the Clinton years, the over-valued dollar. This policy, which was put in place when Robert Rubin became Treasury Secretary, ensured that we would have large trade deficits. The trade deficits were good news for Wall Street with its obsession over inflation. It was also good news for companies looking to move operations overseas to take advantage of cheap labor.

However, the high dollar was terrible news for the country’s workers who were placed at an enormous competitive disadvantage. It resulted in the loss of more than 4 million manufacturing jobs. It was also bad news for anyone who doesn’t think that bubbles are a clever way to drive the economy.

Rubin and his allies control the Democratic Party with their money at the moment. Their financial power will not be easily overcome. However, it is important that people understand that the Rubin-Clinton team is every bit as much about redistributing money from the rest of us to the very rich as the Republicans.

The big difference is that, unlike the Republicans, the Rubin-Clinton crew believes that the rich should have to pay their taxes. That’s something, but until there is someone in this debate who isn’t pushing policies that redistribute before-tax income upward, the vast majority in this country can only lose.