Knight-Ridder/Tribune Media Services, November 27, 2001
In economic history, great myths are often made and sustained not so much by the difficulty of the subject matter, but by the failure of the discussants to look at the readily available data. America's longest business cycle expansion, which has now been officially certified as running from March 1991 to March 2001, is a case in point.
In the folklore of the business press, a widely held explanation has already congealed for the upswing that led optimists to proclaim the emergence of a "new economy." The now conventional wisdom flows as follows: together with Congress, the Clinton Administration got the ball rolling by balancing the federal budget, and moving it towards surplus. This caused long-term interest rates to fall, which led to an investment boom -- especially in the high tech sectors -- as well as stimulating such interest-sensitive purchases as housing.
All that new investment caused productivity to grow by leaps and bounds. Since productivity -- the amount of goods or services that an hour of labor can produce -- is the basis of economic growth, this raised incomes across the spectrum. The virtuous circle was completed by the response of the Federal Reserve: because of the surge in productivity, we are told, the Fed didn't have to worry about rapid growth leading to accelerating inflation. Thus the Fed was able to lower short-term rates, and allow for a record-long expansion, with unemployment falling to a 30-year low of 3.9 percent.
Sounds plausible, doesn't it? And familiar. Now let's look at the numbers. Over the course of the business cycle, real (inflation-adjusted) interest rates on mortgages and high-grade corporate bonds fell by only 0.8 percent. This certainly doesn't look like enough to stimulate an investment or housing boom, and it wasn't. Housing barely increased at all, as a percentage of the economy. As for investment, if we look at both investment components of GDP (investment plus net exports), the investment share actually declined slightly.
Productivity growth did increase, as compared to the business cycle of the 80s. But it was still considerably lower than the growth of the 50s and 60s business cycles. If we adjust for the increased share of output that was used up in more rapid depreciation -- mostly computers and software -- the productivity growth of the 90s cycle does not even beat the 70s. And wage growth for a typical worker was a paltry 0.5 percent a year.
So much for the "new economy." Still, it was a long expansion, and a pleasant memory compared to what we are facing right now. So what was behind it, if the official story doesn't hold up to the numbers? Most importantly, there was a consumption boom that was driven by an enormous bubble in the stock market. Personal savings rates fell to zero as upper-income households -- the ones that hold stocks -- saw the value of these assets soar.
The Fed's change in policy allowed the expansion to continue. Prior to 1995, it would slow the economy when unemployment fell below 6 percent, on the theory that this was the best we could do. But this drastically important policy change -- even today, we have millions of additional jobs as a result -- could have been made at any time. It was not a result of 1990s productivity increases, but rather the Fed's belated realization that its prior theory was wrong.
Understanding the 1990s expansion, and its collapse, is vitally important to getting us out of the current recession. The evaporation of $8 trillion in stock market wealth translates into more than $300 billion in reduced consumption. This means we need a stimulus package more than twice as large as the one that Senate Democrats are proposing (the House Republican plan contained hardly any stimulus at all, consisting mostly of tax breaks for corporations and high-income households).
Diehard policymakers and economists -- including many Democrats -- still cling to the notion that fiscal conservatism brought us prosperity. They ache to resume paying off the entire national debt at the earliest opportunity. Many others welcome the re-inflation of the stock market bubble -- which still exists, and has lately been growing.
And while the Fed has been doing the right thing by lowering interest rates since the slowdown began, it could still revert to its old ways before the recovery is on track. This is especially true if our overvalued dollar -- another largely unnoticed bubble from the 1990s expansion -- were to drop sharply, raising the price of imports.
The new economy may be dead, but the mythology that created it survives. Let's hope that it doesn't cause us any further trouble.