[A-List] US economy: Stiglitz analysis

["Michael Keaney" <michael.keaney@xxxxxx>]

The fruits of irrationality

In the 90s investment boom the US put too much money into dud dotcoms and
too little into public services

Wednesday September 24, 2003
The Guardian

· Joseph Stiglitz observed the hubris infecting the US economy in the 1990s,
first as chairman of President Clinton's council of economic advisers and
then as chief economist of the World Bank. In the first of two extracts from
his new book, the Roaring Nineties, the Nobel Prize winning economist
explains how the boom sowed the seeds of the US's present economic
difficulties.

In the Roaring Nineties, growth soared to levels not seen in a generation.
Newspaper articles and experts proclaimed that there was a new economy, that
recessions were a thing of the past and that globalisation was going to
bring prosperity to the whole world.

But toward the end of the decade, what seemed to be the dawn of a new era
began to look more and more like one of those short bursts of economic
activity, or hyperactivity, inevitably followed by a bust, which had marked
capitalism for 200 years. Except that this time, the bubble - the boom in
both the economy and the stock market - was greater, and so too were its
consequences; the new era was a new era for the United States and the whole
world. Thus the bust that followed was a downturn not only for the US but
for much of the world.

This was not the way it was supposed to be. The end of the cold war left the
US as the sole superpower, and it marked the victory of the market economy
over socialism. The world was no longer divided on ideological grounds. It
may not have been the end of history, but at least it was supposed to be the
beginning of a new era - and for a few years that seemed to be the case.

Not only had capitalism triumphed over communism; the American version of
capitalism, based on an image of rugged individualism, seemed to have
triumphed over other, softer, fuzzier versions. At international meetings,
we boasted of our success and preached to the sometimes envious economic
leaders of other countries that if they would only imitate us, they too
could enjoy prosperity like ours.

Everybody seemed to be benefiting from this new world order, this Economia
Americana which brought unprecedented capital flows - sixfold increases to
emerging markets in six years - unprecedented trade - an increase of over
90% over the decade - and unprecedented growth.

But Americans should face up to the fact that in the boom were planted some
of the seeds of destruction, seeds which would not yield their noxious
fruits for several years. We had not intended to plant these seeds - we had
not even known that we were doing so. On the contrary, we believed we were
planting the foundations of a prosperity that would continue into the
future.

Echoes of tulip mania

What were these seeds of destruction? The first was the boom itself: it was
a classic bubble, asset prices unrelated to underlying values, of a kind
familiar to capitalism over the centuries. Bubbles are based on a certain
irrational exuberance, and perhaps not since the days of tulip bulb mania
had the irrationality of the market been more in evidence, as investors paid
billions of dollars for companies that had never shown a profit - and likely
never would.

No one - not the president, the secretary of the treasury, or the chairman
of the Federal Reserve - can be blamed for this irrational exuberance; but
they can be blamed for not dealing with the consequences, and in some cases,
for feeding the frenzy. After a faint effort to let the air out of the
bubble, the Fed simply added to the hype.

Bad accounting provided bad information, and part of the irrational
exuberance was based on this bad information. We knew that the accounting
systems had a major flaw, and that the system of chief executive officers'
compensation provided incentives to take advantage of the limitations in our
accounting systems.

We knew that those responsible for accounting, the accounting firms, faced
conflicts of interest in providing good and reliable information. But short
term and special interests prevailed over the long term and general
interests. Not only did they stop efforts at improving matters; tax laws and
securities legislation actually made matters worse.

Distorted incentives combined with irrational exuberance induced America's
new financial behemoths to provide the finance that underwrote the bubble;
they made billions from the initial public offerings and the deceptive
boosting of their favoured stocks, even if gains had to come at the expense
of someone - in most cases, ordinary shareholders.

To add froth to the frenzy, taxes on capital gains were cut. Those who
earned their money by speculating and winning on the stock exchange were the
heroes of the day, and were to be taxed more lightly than those who earned
their bread by the sweat of their brow. With speculation thus especially
blessed more money poured in, and the bubble was inflated even further.

Misguided deregulation and bad tax policies were at the core of the 1991
recession, and misguided deregulation, misguided tax policies and misguided
accounting practices are at the core of the current downturn.

American investors had trusted the corporate auditors, and the auditors had
betrayed that trust. Similarly, investors had trusted the Wall Street
analysts about which stock to buy and those analysts too had betrayed that
trust.

Our emerging understanding of the 1990s requires that we admit - to
ourselves and the world - that we were engaged in a misguided attempt to
achieve growth on the cheap.

Instead of curbing consumption to finance our boom, the US borrowed heavily,
year after year from abroad, at a rate of more than a billion dollars a day.
We did this to fill the widening gap between what we were saving and what we
were investing - a gap that opened in earnest under Ronald Reagan but grew
under George Bush Sr and Bill Clinton, and has reached new dimensions under
the new President Bush.

We made some good long-run investments - both in the private sector and in
the public, but too much of our investment went into wasteful private
expenditures - the dotcoms that didn't pan out, the fibre-optic cables that
were not needed. It is still not clear how much of the private so-called
investment of the 1990s was sheer waste, but even if we consider only a
fraction of the erosion in stock values is attributable to bad investments,
the figure must be in the hundreds of billions of dollars.

By contrast, too little of our investment went to address vital public
needs, in education, in infrastructure, in basic research. We provided tax
credits and deductions for higher education, but most of the middle class
kids who benefited were already going to college; the credits and deductions
did make their parents' lives easier, but it was unlikely to have much
effect on enrolments. The money could have been better spent targeting the
very poor, for whom money is a real obstacle - whose parents do not pay
taxes.

Most ironic in the age of the new economy, we also underinvested in research
which underlay the new economy. We were, in part, living off past ideas -
break throughs of an earlier day such as transistors and lasers. We were
counting on foreign students to come up with scientific advances while our
best students were putting together financial deals.

Of all the mistakes we made in the Roaring Nineties, the worst were caused
by a lack of standing by our principles and a lack of vision.

Lessons to be re-learned

We had principles. As the administration came into office, most of us knew
what we were against. We were against Reagan conservatism, we knew there
needed to be a larger and different role for government, that we needed to
be more concerned for the poor and for providing education and social
protection for all, and we needed to protect the environment. The
shortsighted focus on finance, on the deficit, made us push this agenda
aside.

The central lesson that emerges from this story of boom and bust - that
there needs to be a balance between the role of government and the markets -
is one which evidently the world has had to learn over and over again. When
countries got that balance right they grew strongly - America through much
of its history, East Asia in the sixties, seventies and eighties. When
countries got that balance wrong, veering either toward too much or too
little government, disaster awaited. Although the failures of excessive
government - evidenced by the collapse of the communist system - are the
most dramatic, there are failures on the other side as well. If we in the
Clinton administration sometimes lost that balance, matters have become even
worse in the next administration - with the predictable consequences that
our economy's performance has become worse.

The challenge today is to regain that balance, to learn the lessons of the
tumultuous decade of the nineties and the years that have followed.

The warning came too soon

It was at a black-tie event in Washington in December 1996 that Alan
Greenspan first uttered those attention-grabbing words, "irrational
exuberance".

It was an impressive, wide-ranging speech, though Greenspan had so trained
himself to speak enigmatically like the Delphic oracle - what came to be
called "Fedspeak" - that it made the eyes of those untrained in deciphering
what he meant, or might have meant, glaze over.

One of the topics on which he touched was the sudden plunge in real estate
prices that had triggered Japan's descent into a broad state of economic
paralysis. It was hard to put a precise value on something like real estate,
Greenspan observed, and therefore hard to know when a speculative market
might be due for a sudden contraction. It was also hard, he added, to know
when such a contraction might prove to be a disaster for the economy at
large.

Greenspan had no answers that night, only questions; but one of his
questions made a memorable impression: "How do we know," he asked, "when
irrational exuberance has unduly inflated asset values ..."

When I approached him after his speech to discuss several of the ideas that
he had thrown out, it was clear that he was fixated on the "irrational
exuberance" remark. He knew that the pundits would know it was the United
States rather than Japan that he had in mind. He was worried about the stock
market, which was having a blowout year. And if Greenspan was worried, the
business and financial world had reason to worry. The following day, stock
markets reeled in Tokyo, Sydney, Hong Kong, Amsterdam and London, as well as
New York. Shares of General Motors, IBM and Dupont all fell by 2% or more as
investors steeled themselves for a possible interest rate increase.

And then ... nothing happened. The labour department released statistics
indicating slow job growth; signs of inflation failed to materialise, even
later when unemployment continued its downward march; the Fed did not in
fact raise interest rates; and the stock market continued to climb setting
records with almost boring regularity for the next four years, until the
bubble burst.
Many thought it was the responsibility of the Fed not only to prevent
inflation but to stabilise the economy, and this meant doing something about
the bubble. The failure is all the more puzzling because Greenspan had
recognised that there was a bubble in 1996, and seemingly had tried to do
something about it. But if there was a bubble in 1996, surely the run-up of
the stock market in the final years of the century must have been truly
disturbing?

·Extracted from The Roaring Nineties: Seeds of Destruction, Joseph Stiglitz;
published October 2, Allen Lane; £18.99

Copyright Joseph Stiglitz 2003