Poised for Prosperity?

golden years

Poised for Prosperity?

Drawing the right lessons from the past quarter-century

May 15, 2015

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This article appears in the Spring 2015 issue of The American Prospect magazine. Subscribe here.

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History doesn’t repeat itself, but as Mark Twain famously suggested, it occasionally rhymes.

About 15 years ago, I partnered with Janet Yellen—who has since gone on to bigger and better things—to write a short book titled The Fabulous Decade. The decade, of course, was the 1990s, or more specifically, the period beginning in 1992 or 1993 and ending in 2000—by common consent the most successful period in U.S. economic history since the 1960s. The questions for this article are whether, how, and to what extent current preconditions and policy settings resemble those that prevailed around President Bill Clinton’s inauguration day, whether the good times are about to roll again, and what policy adjustments may be needed to usher in a new period of prosperity.

At first, these questions may seem preposterous. Having endured the financial crisis, the Great Recession, and the tortoise-slow recovery since 2009, most Americans have lowered their expectations. Few are feeling ebullient about the economy—never mind envisioning a second coming of the Clinton prosperity. Once you start thinking about it, however, the macroeconomic conditions of 2014–2015 bear several striking resemblances to those of 1992–1993. Which raises a fascinating question: Might another “fabulous decade” be possible? The economic policies pursued in the 1990s were not perfect, but on balance they surely helped make the decade fabulous. More important, they offer lessons about both what we should do and what we shouldn’t do now.

 

The Way Things Were—And Are

Not many Americans were happy about their economy in 1992. According to a Wall Street Journal/NBC News poll in September, fully 86 percent of respondents thought—incorrectly—that the country was still in a recession, which may have been the main reason President George H.W. Bush was not re-elected. Nonetheless, the seeds of future success had been sown, and several of them have striking parallels with today.

For openers, the recession of 1990–1991 had produced significant industrial restructuring. People called it “downsizing” at the time because firms were trumpeting their ability to get by with less labor, but it might have been described more accurately as “survival of the fittest.” Recessions prune the economic trees, sometimes ruthlessly. Note that such pruning was far more ruthless in the punishing 2007–2009 recession, leaving much of American industry today leaner and probably also meaner than it was in 1991.

Second, though not widely recognized at the time, the U.S. economy was already growing smartly. Over the last three quarters of 1991 and first three quarters of 1992, real GDP grew at an annual rate of 3.3 percent. Speaking about not being widely recognized at the time, how many Americans realize that growth over the last three quarters of 2014 averaged 4.1 percent? And this comparison makes no allowance for the fact that the economy’s underlying growth trend is almost certainly lower now.

Third, even though few people gave Bush and the Democratic Congress much credit at the time, the Budget Enforcement Act of 1990 had started the federal government down the path to smaller deficits—which would become a hallmark of the Clinton administration. Recent fiscal-policy decisions have looked (and been) both chaotic and hyper-partisan. But the federal budget deficit has plummeted from about $1.3 trillion in fiscal year 2011 to under $.5 trillion (just 2.6 percent of GDP) estimated for fiscal year 2015.

AP Photo/J. Scott Applewhite

U.S. President Bill Clinton responds to questions during a news conference on Friday, October 8, 1999. 

While fiscal policy was tightening in the 1990s, the Federal Reserve under Chair Alan Greenspan had its foot pressed firmly on the monetary policy accelerator. The Fed reduced the real federal funds rate to zero around mid-1992 and held it there until February 1994. More recently, the Fed under Ben Bernanke pushed the nominal federal funds rate down to zero by December 2008, and it is still there. Bernanke then followed with trillions of dollars of “quantitative easing” and other measures designed to push down long-term interest rates. Chair Janet Yellen has (so far) maintained those hyper-expansionary policies, although the Fed is expected to start “exiting” soon.

In 1992, all of these factors—industrial restructuring, strong growth, fiscal consolidation, and easy money—were portents of things to come. Might history be poised to rhyme?

Perhaps the signal achievement of the 1990s was the Fed’s “soft landing.” A central bank is said to achieve a soft landing when, as in the Goldilocks tale, it tightens just enough—not too little, and not too much—to “land” the economy at full employment without pushing inflation either too high or too low. It’s an elusive goal, rarely achieved, but the Federal Reserve accomplished it in 1994–1995.* By the end of 1995, the unemployment rate was 5.6 percent, inflation was around 3 percent, and real GDP growth was running around 3.25 percent. At the time, that looked pretty close to perfect. Today, Yellen and the Federal Open Market Committee (FOMC) are seeking to engineer another soft landing—this time with unemployment near 5.25 percent and inflation near 2 percent. How well they do over the next few years will be crucial to America’s economic health.

The shift toward smaller budget deficits, which started under the first President Bush and continued and strengthened under Clinton, also bears emphasis. Proposing and eventually enacting the Omnibus Budget Reconciliation Act between February and August of 1993 induced a strong bond market rally that brought the 30-year Treasury bond rate down more than 160 basis points, stimulating the economy in the process. By contrast, President Barack Obama’s American Recovery and Reinvestment Act of 2009 pushed fiscal policy toward stimulus. But sometime in 2010, U.S. fiscal policy debates switched toward restraint even as monetary stimulus intensified. Interest rates have since dropped to historic lows. So in terms of the fiscal-monetary policy mix, there is a certain resemblance between 1992–1997 and 2010–2015: tight fiscal policy and easy money. One obvious difference, however, is that with long-term rates already so low, there is no prospect of spurring the economy with another bond market rally.

In that 2001 book, Yellen and I also discussed a series of favorable supply shocks from 1995 to 1998 that helped the U.S. economy grow faster without rising inflation. Without going into details, they were:

  • a sharp moderation in health-care inflation in 1994–1995;
  • declining oil prices in 1997–1998;
  • a tech boom, centered on new information and communications technologies, which raised the productivity growth rate starting in 1995; and
  • a rising dollar for most of the period.

Except for productivity growth, which has been miserable of late, the parallels here are striking. Health-care prices have been in remission for years now; they have stopped inflating faster than other prices. The price of oil fell nearly 50 percent between June–July 2014 and February 2015. The value of the dollar has been rising. Each of these developments is disinflationary. Indeed, the Fed’s current concern is whether inflation is falling too low.

Favorable supply shocks permit economies to achieve some combination of slower inflation and faster growth—the precise opposite of stagflation. As growth accelerated and unemployment fell from 1996 to 1999, but inflation did not rise, the Greenspan Fed took most of the gains in the form of higher growth and more jobs rather than in lower inflation. This aspect of history seems likely to be repeated, at least partially, since the Fed today wants inflation to rise, not fall. In principle, the Fed should take more than 100 percent of the gains from recent supply shocks in the form of more jobs. Consistent with that, the FOMC has stated that it will be “patient” about raising rates and would welcome a modest overshoot of normal full employment.

It also helps to have a stock market boom, which Clinton certainly enjoyed, especially in the last two years of his presidency. But remember that while the Clinton prosperity did get extra “legs” from the Internet bubble of 1998–2000, the economic boom predated the stock market bubble. Of course, the Clinton boom ended soon after the stock market crashed. Obama has also presided over a huge rise in stock prices, which hit rock bottom early in his presidency. Whether the stock market is now “bubbly” has been under debate for several years. We’ll see. But it is important to remember that, while the stock market crash that started in 2000 destroyed a great deal of wealth, its impact on the national economy was minor. In particular, not a single major financial institution failed, and the mini-recession of 2000–2001 was short and shallow.

In the 1990s, a happy combination of rapidly rising tax revenue (fueled partly by higher tax rates, but mainly by faster growth and huge capital gains) and spending restraint (based on the highly partisan 1993 budget law and subsequent bipartisan agreements) brought the federal budget deficit down from $290 billion in fiscal year 1992 to approximate balance in fiscal year 1997 and then to a stunning $236 billion surplus in 2000—a swing of 6.8 percent of GDP. While that looks like “fiscal drag” of nearly a percentage point of GDP per year, a great deal of it reflected the economy’s strength rather than restrictive fiscal policy. By comparison, the federal budget deficit declined by 5.3 percent of GDP between fiscal years 2011 and 2015 (as currently estimated). That’s a faster pace of deficit reduction than in the 1990s despite far less robust economic growth. Many observers, including me, think fiscal drag after 2011 was excessive—and is one major reason why the recovery in GDP was so slow.

Since my interest here is in parallels between the 1990s and today, I should add one more item to the list, even though Yellen and I ignored it in our book: The seemingly inexorable upward climb of income inequality came to a halt during Clinton’s second term. For example, the Gini coefficient for U.S. household income—a summary measure of inequality—rose almost every year from 1980 to 1994, and again from 1998 to 2012, but it was unchanged between 1994 and 1998. Why?

AP Photo/Khue Bui

President Clinton speaks with Federal Reserve Board chairman Alan Greenspan, right, and Treasury Secretary Lawrence Summers, far left.

Part of the interruption—probably a minor part—can be attributed to some egalitarian policies pursued by the Clinton administration, such as an increase in the progressivity of the income tax and a huge expansion of the Earned Income Tax Credit. For example, using a better measure of poverty than the official one, a team of poverty researchers at Columbia University estimated that, between 1993 and 2000, poverty fell by 5.5 percentage points, of which only 1.3 points were due to more generous tax-transfer programs. Based on that estimate and on past evidence that inequality rises in slumps and falls in booms, most of the pause in inequality was probably due to the extraordinarily tight labor markets of the later Clinton years. I mentioned earlier that 1995 ended with the national unemployment rate at 5.6 percent, which was widely believed to approximate full employment at the time. But by December 1997, unemployment was down to 4.7 percent, and by December 1999, it was just 4.0 percent. In fact, the unemployment rate hovered in a tight range around 4 percent for the 19 months from August 1999 through February 2001—the only 4 percent unemployment period since the late 1960s.

Tight labor markets have many positive side effects, including higher real-wage increases. One of them is that they reduce inequality. The reasons are hardly mysterious. As labor becomes scarcer, employers find job vacancies harder to fill. So they start pursuing potential workers more aggressively, even training them as needed. Because firms get less choosy, employment and wage prospects for people on the lower rungs of the job ladder improve. Consider this one striking indicator: The employment rate of never-married mothers with a high school education or less leaped from 51 percent in 1992 to 76 percent in 2000 (and fell thereafter).

The tight labor markets of the late 1990s offset powerful centripetal forces that had been widening income disparities since the late 1970s. But those forces regained the ascendancy once slack returned to labor markets, and inequality has been rising ever since. Looking forward, a major question is whether the U.S. labor market will tighten sufficiently to act as a check on rising inequality. That hasn’t happened yet, but it’s possible.

 

Lessons from the Fabulous Decade

Yellen and I concluded our book with five lessons for macroeconomic policy-makers. Many, but not all, of them appear to be relevant today. Listed briefly, they were as follows (with updates to the current situation):

First, a mix of tight fiscal policy and easy monetary policy can produce a pro-investment environment based on low real-interest rates. We have that mix today.

Second, well-designed fiscal rules can constrain government spending, as happened in the 1990s. Federal spending has also been tightly constrained since 2010, though I doubt anyone would call the methods “well-designed.” If there has been any progress toward a more rational fiscal policy, it’s been well hidden.

Third, it is at least possible to “fine-tune” the macroeconomy—as Greenspan appeared to do successfully. Given (a) the depth of the Great Recession, (b) the spectacle of hyper-partisan fiscal policy, and (c) the fact that the Fed is now more or less out of ammunition, I’m not sure anyone sees fine-tuning as possible now. But Yellen, the current tuner-in-chief, surely remembers the 1990s.

Fourth, a dual mandate—for low inflation and low unemployment—helps the central bank produce better macroeconomic outcomes. If any doubts about this survived the 1990s, the contrast between growth in the United States and stagnation in the Eurozone since the Great Recession should have dispelled them. I do not mean to imply that different central-bank mandates is the only reason why the U.S. has outperformed Europe. But I am amazed every time I hear calls to change the Fed’s mandate to inflation-only, like the European Central Bank’s. We should emulate them?

Fifth, what is normally called a fiscal contraction—higher taxes and/or lower spending—need not slow the economy. One possibility is that monetary easing offsets the fiscal contraction. Another is that the exchange rate depreciates and exports boom. A third is that fiscal consolidation might kick off a bond market rally. Unfortunately, none of these scenarios are plausible today. The Fed is looking to tighten monetary policy, the dollar is appreciating, and bond rates are already extremely low.

 

Did the Clinton Prosperity Lead to Future Problems?

Before proceeding, I should address the criticism, sometimes heard, that many of our subsequent problems were the legacy of the Clinton boom.

Start with the obvious element of truth in the critique: that the tech-stock bubble of 1998–2000 was wild, unsustainable, and bound to end badly—as it did. That’s true. But, as noted above, the stock market crash appeared to cause only minor damage.

A second potential worry was that the Fed’s experiment with low unemployment was bound to come to grief. Inflationary consequences are delayed, but they do arrive, critics claimed. (Does that sound familiar?) This belief was soundly refuted by the data. The long period of unemployment rates under 5 percent lasted from May 1997 through August 2001, and there was no acceleration of inflation either during or after.

Other critics have attributed the unsustainable housing-price bubble of 2000–2006 to a hangover from the Clinton boom—money frightened away from the stock market allegedly went into housing. This claim conveniently ignores a few pertinent facts. For example, even after the bust, house prices never returned to their 2000 levels, so it wasn’t all illusory. And the truly horrendous mortgage-lending practices didn’t start until well into the administration of George W. Bush.

Finally, Clinton is sometimes blamed for the lax regulation that led to the financial crisis. There is a germ of truth here: Not much distance was visible between the Clinton Treasury and the famously deregulatory Greenspan Fed. But critics who make this claim often focus on the removal of the Glass–Steagall wall between commercial banking and investment banking in 1999. I debunked this idea in my book After the Music Stopped. In truth, virtually none of the bad practices leading up to the crisis were enabled by mergers between commercial banks and investment banks. Virtually all originated with “pure” banks such as Bank of America (at that time) or “pure” investment banks like Bear Stearns and Lehman Brothers.

Mentioning deregulation does, however, bring up the one big time bomb left by the departing Clinton administration: the outrageous ban on the regulation of derivatives in the Commodity Futures Modernization Act of 2000. This amazingly irresponsible action allowed a veritable cornucopia of wild and woolly derivatives to develop and flourish without adult supervision. The rapid unraveling of many of these contracts in the financial crisis was one reason the Great Recession was so great.

 

Lessons from the Recent Decade

Experience since 2007 has taught us several bitter lessons that the Fabulous Decade did not. The list of possible lessons from the crisis and its aftermath is long, but I would highlight these six:

The first is perhaps so obvious that it doesn’t need stating: It can happen here. When the 1990s ended, few people imagined the United States would ever be in danger of returning to depressionary conditions. And that false sense of security was bolstered when the stock market crash of 2000–2003 caused so little harm. Now we know better. It was a close call.

Second, we now understand that Reinhart-Rogoff recessions are worse than Keynesian recessions. The two types are not entirely different; they both feature a drop in aggregate demand. But a Reinhart-Rogoff recession includes a serious banking or financial crisis that not only destroys wealth (hence reducing spending) but also destroys portions of the financial system (thereby damaging the economy’s credit-granting mechanisms) and leaves mountains of debt in its wake (thus requiring massive deleveraging). So such recessions tend to be deeper and longer than Keynesian recessions, and to be followed by more sluggish, drawn-out recoveries. We now know that the United States is not immune from Reinhart-Rogoff recessions.

We also know, or rather some of us know, that Hyman Minsky was largely right. I have often heard it said that, prior to the financial crisis, macroeconomists thought finance didn’t matter for the “real economy.” That is about as wrong as wrong can be. But what is true is almost as bad. The predominant intellectual view prior to the crisis was that financial markets are efficient and self-correcting—if occasionally a bit wild. The central concepts of finance were therefore equilibrium, rational expectations, and market efficiency. Decades earlier, Minsky had argued against this view—mostly to deaf ears. The central concepts of finance, in his view, should be recurrent cycles of boom and bust enabled by, among other things, myopic financial-market participants with strong tendencies to forget the past and go to extremes.

The efficient-markets hypothesis supported the aforementioned view that little or no financial regulation was necessary—indeed, that regulation was likely to do more harm (e.g., by stifling innovation) than good (e.g., by enhancing safety and stability). Perhaps the most egregious manifestation of this attitude was the ban on regulating derivatives. By contrast, Minsky believed that financial markets need regulatory restraints to enhance safety and soundness. How tight those restraints should be is a matter of continuing debate.

As one specific example, I think most macro-economists were astounded to learn that financial fraud and near-fraud could rise to macroeconomic proportions. Dishonesty has always existed in markets (and elsewhere). But when it came to the national economy, I think most of us thought fraud and near-fraud lived in the rounding error. The subprime--mortgage crisis taught us how wrong this could be. Here’s something no one would have believed in 2001: The new Consumer Financial Protection Bureau might save us from a future recession.

Implicit in the lessons of the 1990s was the idea that, when it came to managing the macroeconomy, monetary policy was in charge—and would suffice. In the United States, that meant leaving the job to the Fed. The Great Recession taught us that when things get really bad, conventional monetary policy (manipulating the short-term interest rate) might be insufficient and might need supplementation from unconventional monetary policy and even fiscal policy. As mentioned above, the Fed had lowered the federal funds rate virtually to zero by December 2008, but found that near-zero interest rates were insufficient to pull the economy out of the ditch, even with assistance from the large fiscal stimulus of 2009–2010. Since then, the Fed has deployed various combinations of quantitative easing and “forward guidance” (central-bank talk). It has also practically begged Congress to help out with more fiscal stimulus—or at least not to hurt the economy with ill-timed deficit reduction.

 

What’s Next?

The only honest answer to a question like that, of course, is that nobody knows. And that is my answer. But let me close by indulging in a fantasy exercise. Let’s suppose that, starting about now, the United States were to be blessed with a combination of good luck and good policy, as happened in the 1990s. What would the “good policy” part look like?

It would start with the Federal Reserve executing its exit strategy well enough to get us close to the “perfect soft landing” discussed earlier. This is probably the most important item on my list and, although many things could go wrong, there is a reasonable chance we might get it. If we do, 2016 or 2017 might resemble, say, 1995 or 1996—and Janet Yellen will be lionized as Alan Greenspan was.

Next, and closely related, we must achieve and then maintain (at least for a while) labor markets that are tight enough both to yield real-wage gains for ordinary workers and to halt the trend toward ever-increasing inequality—all without causing much inflation. Wishful thinking? Perhaps. But we accomplished exactly that in the late 1990s, and today’s slower growth trend makes it easier to “eat up slack.” But, like then, the Fed must not flinch.

Third, because labor’s bargaining power is probably even weaker now than it was in the 1990s, tighter labor markets, while helpful, may not be enough to do the job. If so, we will need some new policy initiatives to combat inequality. The current political environment precludes that, but there’s another election next year.

Fourth, we need to stand guard lest financial regulations (principally, Dodd–Frank) be rolled back. Recent developments on this front are not encouraging—nor is past history. (Remember Minsky.) But we must try. Frequent use of the presidential veto pen may be necessary.

Finally, and this one really does sound like wishful thinking, Congress needs to get rational, stop slashing the current budget, and start paying more attention to long-run budget issues. Two stand out: too little revenue and too much spending on entitlements. Regarding the former, a carbon tax would be a great choice. Regarding the latter, returning Social Security to actuarial balance is the easy part; policy-makers need to save only about 1 percent of GDP. The giant headache is health-care spending—unless the recent cost moderation persists. Here is one place where we could use some good luck to accompany and support good policy.

All this may seem like an impossible dream. Perhaps it is. But in 1992, the fabulous decade seemed impossible, too. 

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