Bursting Bubbles

Why the economy will go from bad to worse

Dean Baker

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.

Dean Bak­er is co-direc­tor of the Cen­ter for Eco­nom­ic and Pol­i­cy Research and co-author of Social Secu­ri­ty: The Pho­ny Cri­sis (Uni­ver­si­ty of Chica­go Press, 2000).
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