In These Times, May 9, 2003
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Where is the best place to go for good advice about the stock market and the economy? The Wall Street Journal, Business Week, Fortune? If it is late 1999 and the stock market is soaring to record highs, the correct answer is In These Times. In December 1999, when the economic and political establishment was singing the praises of the “new economy” and promising an era of unparalleled prosperity, In These Times ran “After the Fall,” a cover story by Dean Baker, which explained that a stock market crash was inevitable. Baker also warned of some of the consequences of the crash—downsized 401(k) retirement plans, a funding crisis for defined-benefit pension plans, shriveling endowments for universities and foundations, and a recession pushing the unemployment rate up past 6 percent.
During the ’90s boom, Baker was one of the few economists who clearly identified the stock market bubble. But no one in a position of power was willing to listen, even though the main thrust of the argument rested on basic arithmetic. Remarkably, the same “experts” who led the nation into the bubble are still dominating public debate on the economy.
So In These Times is willing to break with the conventional wisdom again. In the first of a special two-part series on the economy, Baker explains how related bubbles in the property and currency markets have yet to burst, and how that prospect could severely hamper our quality of life for years to come.
In 2000, President Clinton could legitimately boast of the “best economy in 30 years.” Unemployment was low, wages were rising at all income levels, and the poverty rate was headed downward at a rapid pace. But after President Bush took office in 2001, the economy fell into recession, shedding jobs and causing real wage growth to slow and eventually stop altogether.
A convenient story explains this sharp economic reversal. According to the script, Clinton eliminated the deficit through progressive tax increases and spending restraint. This deficit reduction lowered interest rates and spurred an investment boom, which was the basis for the extraordinary growth of the late ’90s. Then Bush came into office and quickly squandered the surplus with his tax cuts to the rich and military build-up. As a result, the deficit skyrocketed and the economy tanked.
It’s a good story, but the reality is quite different. The Clinton boom was built on three unsustainable bubbles. One of them, the stock bubble, has already burst. The other two bubbles—the dollar bubble and the housing bubble—are still with us. The dollar bubble is starting to deflate, and the housing bubble is perhaps just now reaching its peak. These bubbles created the basis for the 2001 recession and the economy’s continuing period of stagnation.
The basic facts of the economy’s rapid deterioration over the last two years are widely known. After creating an average of more than 3 million jobs a year from 1996 to 2000, the economy has lost more than 2 million jobs since March 2001. This reversal has been associated with a rise in the unemployment rate from an average of 4 percent in 2000 to 6 percent today. The increase among African-Americans has been even larger, rising from 7.6 percent in 2000 to 10.9 percent in April, and larger yet for African-American teens, with the unemployment rate rising from just over 24 percent in 2000 to peaks as high as 35 percent in March. While real wages were growing at close to a 2 percent annual pace in 2000, wage growth has recently fallen to zero for most workers.
The economy’s reversal was associated with a plunge in the stock market. The S&P 500 fell from a peak of more than 1,500 in March 2000, to lows of less than 800 in the past year. The tech-heavy Nasdaq took an even sharper plunge, falling from a peak of more than 5,000 in March 2000 to under 1,200 last summer. Adding to this picture is the reversal in the budget situation. The surplus of $236 billion in 2000 has given way to a deficit that may reach $500 billion in 2003.
Of course, the stock market downturn should not be included among the economic failings of the last two and a half years. That downturn really was just a healthy return to reality. The long stretch of new peaks that the market hit in the ’90s should have been a warning of bad times ahead to anyone paying attention. Instead the boom was widely celebrated as evidence of a new era of unbounded prosperity. The failure by the Federal Reserve Board or the Clinton administration to take actions to stem the growth of the stock bubble laid the grounds for a train wreck; the only question up in the air was when it would hit.
While the day-to-day, or even month-to-month, movements of the market are erratic and unpredictable, there is an underlying relationship between the stock market and the economy. In principle, the stock market is putting a price on the future profits of corporate America. While no one can know the future with certainty, economists can plausibly forecast how high profits can go over a long horizon—say 10 to 15 years.
When the market was hitting its peaks in 2000, the ratio of stock prices to corporate earnings exceeded 30-to-1, more than twice its historic average. No plausible explanation could ever have justified this sort of valuation. In order for the stock market peaks of 2000 to have made sense, it would have been necessary for profits to grow at close to twice their historic pace.
In short, any serious economic analyst should have been able to recognize the stock bubble of the late ’90s. The fact that those in positions of responsibility either failed to recognize the bubble or chose to ignore it was a mistake with enormous consequences.
The stock market bubble added more than $8 trillion of paper wealth to the economy. This stimulated the economy in two ways. First, when families see the value of their stock portfolios rise, they spend more, since they feel less need to put money aside for retirement or their kids’ education. Just as the textbooks would predict, consumption boomed and savings fell through the floor in the late ’90s and 2000.
The stock bubble also stimulated the economy through its effect on investment. Contrary to myth, firms rarely finance new investment by issuing shares of stock. However, the ’90s boom was an exception to this rule. With Internet start-ups able to raise billions of dollars by selling shares on the Nasdaq, companies were using stock to finance new investment in a big way. Soaring stock prices fed directly into an investment boom concentrated in telecommunications and other high-tech sectors. Investment in equipment and software rose by more than $300 billion between 1996 and 2000, an increase of more than 45 percent.
The bursting of the bubble threw this process into reverse. This was seen most clearly with investment, which in both 2001 and 2002 was down by more than $140 billion from its peak in 2000. As we now know, much of the tech investment of the boom years was wasted on wild schemes that will never prove profitable. The tech sectors continue to have vast amounts of overcapacity, which will depress investment in semiconductors, telecommunications, and related sectors for years to come.
Consumption has fallen back somewhat, but not as much as might have been expected, given the loss of more than $8 trillion in paper wealth in the stock market. Consumption has stayed strong in the post-crash world because of a second asset bubble. As was the case in Japan in the ’80s, the stock market bubble of the late ’90s was accompanied by a housing bubble. The rise in home prices since 1995 has outpaced the overall rate of inflation by more than 30 percentage points. This sort of run-up in home prices has no precedent in the post-war era. The surge in home prices has created more than $3 trillion in new housing wealth, as compared to a situation in which home prices had just kept pace with inflation.
Like stock wealth, housing wealth also spurs consumption. Families see the rising value of their homes as a source of wealth that they can draw upon to meet their needs. They have been drawing on this wealth with a vengeance in the past two years, as plunging interest rates have led to an unprecedented surge in mortgage borrowing. As a result, the ratio of mortgage debt to home equity is at near-record highs.
This situation is frightening for two reasons. First, as a short-run matter, if housing prices fall sharply in some of the areas where the effects of the bubble are largest (for example the Boston, New York, Washington, and San Francisco areas), new home buyers (and those who recently refinanced their mortgages and took money out) could find they have negative equity in their homes. If someone borrows $270,000 to buy a $300,000 home, and the price falls by one-third, this leaves them owing $70,000 more than the home is worth. When this happens, there is a huge incentive to just let the mortgage holder foreclose on the home. If this were to happen on a large scale, the survival of many banks and financial institutions would be at risk.
The current high levels of mortgage debt are a problem for another reason. The population is aging, and many families are getting near retirement. With the front end of the baby boomers approaching 60, many homeowners should be near to paying off their mortgage. The demographics indicate that mortgage debt should be lower than it has been in prior decades. But on the contrary, many baby boomers are likely to hit retirement––after having just lost much of the wealth in their 401(k)s due to the stock market crash––and discover that their homes are worth much less than they had expected. These older baby boomers really need to be saving to ensure themselves a sufficient income in retirement, but the illusory wealth created by the housing bubble is preventing them from recognizing this fact.
While the housing bubble has its own logic, it is an outgrowth of the stock bubble. It began as a result of people using their newly created stock wealth to purchase better homes. This started home prices on an upward path, leading people to buy homes in anticipation of continually rising prices. The bubble will persist as long as people expect home prices to rise. When they lose this expectation, housing prices will fall back to more normal levels.
The ’90s stock bubble is also partially responsible for other recent problems. One is the switch from surpluses to deficits at both the federal and state levels. The federal government collected almost $120 billion in capital gains tax revenue at the peak of the stock bubble in 2000, most of which came from gains on stock sales. When stock prices plunged, capital gains revenue did also. It is now projected at $51 billion in 2003. Many states, especially California, were similarly affected by the stock crash.
The wave of corporate accounting scandals was also an outgrowth of the bubble. In an era in which corporations were routinely putting out profit projections that defied common sense, it was virtually inevitable that some executives would take the additional step to outright fraud. This was entirely predictable, since every prior speculative bubble has also been accompanied by large-scale financial fraud.
To make matters worse, a third bubble from the ’90s is also still with us––the dollar bubble. The Clinton administration deliberately pursued a “strong dollar” policy. This had the desirable short-term effect of restraining inflation and raising domestic living standards by making imports cheaper for people in the United States. (An undesirable short-term effect was the devastation of U.S. manufacturing.) However, in the long-term, the strong dollar policy is unsustainable. As a result of its massive bill for imports, the United States is currently borrowing more than $550 billion a year from abroad (approximately 5.3 percent of GDP), since it is buying much more from abroad than it is selling. This borrowing is paid for by selling off U.S. assets. If the trade deficit remains at its current level, within a decade foreigners will own the entire stock market, much of the government debt and many of our homes.
At some point, the dollar will have to fall significantly to bring the deficit down to a sustainable level. When this happens, the resulting rise in import prices will contribute to a rise in the inflation rate and a deterioration in domestic living standards. If the Federal Reserve Board raises interest rates to prevent an increase in the inflation rate, then the impact of the falling dollar will be especially painful, as higher unemployment, which accompanies higher interest rates, will be an inevitable result.
The triple bubble economy of the late ’90s presents the most difficult set of economic problems since the Great Depression. The solutions are neither simple nor painless, but—just as was the case with the New Deal—big problems can open the door to big solutions.