Editor’s Note: The following is an excerpt from Plunder and Blunder: The Rise and Fall of the Bubble Economy by Dean Baker, published by PoliPoint Press, 2009.
The stock market and housing bubbles were the central features of the
The economy had no problem with financial bubbles during its period of strongest and most evenly shared growth, the years from 1945 to 1973. It only became susceptible to bubbles after the pattern of growth had broken down — when most workers no longer shared in the benefits of productivity growth, and businesses no longer routinely invested to meet increased demand based on growing consumption. We don’t have enough evidence to say that bubbles are a direct outgrowth of inequality, but, again, we do know that bubbles weren’t a problem when income was more evenly distributed.
The bubbles were allowed to grow only because the people in a position to restrain them failed in their duties. The leading villain in this story is Alan Greenspan. Greenspan mastered the art of currying the favor of the rich and powerful and held top economic positions under five presidents of both political parties. He also managed to gain a near cult-like following among the media. As a result, most of the public is largely unaware of how disastrous the Fed’s policies under his tenure were for the economy and the country.
Most of the economics profession went along for the ride, somehow managing to miss a $10 trillion stock bubble in the 1990s and an $8 trillion housing bubble in the current decade. If leading economists had recognized these bubbles and expressed concern about the inherent risks, they could have alerted the public and forced a serious policy debate on the problem. Instead, the leading voices in the profession joined the chorus of Greenspan sycophants, honoring him as potentially the greatest central banker of all time.
The financial industry proved to be more incompetent and corrupt than its worst critics could have imagined. Did people who manage multi-billion dollar portfolios in the late 1990s really believe that price-to-earnings ratios would continue rising, even when they already exceeded 30 to 1? Or did these highly paid fund managers believe that PE ratios no longer matteredâ€¯ — as though people bought up shares of stock because the stock certificates were pretty?
It’s hard to understand how anyone who managed money for a living could have justified keeping a substantial portion of their funds in the ridiculously overvalued markets of 1999 and 2000. You could play the bubble, riding the wave up and dumping stock before the crash. But a buy-and-hold strategy in 1999 and 2000 was a guaranteed loser. In the late 1990s, Warren Buffet famously commented that he didn’t understand the Internet economy, and thus he pulled much of his portfolio out of the market. Buffet understood the Internet economy very well. He recognized a hugely overvalued stock market that was certain to crash. Why didn’t fund managers?
The financial industry’s conduct in the housing bubble was even worse. House prices had sharply diverged from a 100-year trend without any explanation. Furthermore, vacancy rates were at record highs and getting higher. In introductory economics, we teach students about supply and demand. If the excess supply keeps growing, what will happen to the price? Furthermore, inflation-adjusted rents weren’t rising through most of the period of the housing bubble. There will always be a rough balance between sales price and rent. When sales prices diverge sharply from rents, some owners become renters, reducing the demand for housing. Similarly, some owners of rental units convert them to ownership units, increasing the supply of housing.
Decreased demand and increased supply lowers the price; what part of that reality did the highly compensated analysts fail to understand? How could the CEOs of the country’s two huge mortgage giants, Fannie Mae and Freddie Mac, have been surprised by the housing bubble? The Wall Street wizards at Merrill Lynch, Citigroup, Bear Stearns, and elsewhere were probably even worse. Did they really have no idea that the bubble would burst and that a large amount of mortgage debt, especially subprime mortgage debt, would become nearly worthless? Did they think that this junk could be made to disappear through complex derivative instruments?
Wall Street sold these instruments to pension funds and other institutional investors. It also persuaded state and local governments to pay them billions of dollars in fees for issuing auction rate securities and for buying credit default swaps and other exotic financial instruments. In addition, many of the same institutional investors lost billions of dollars by holding the stock of companies like Merrill Lynch, Citigroup, and Bear Stearns, the value of which was driven into the ground by very highly paid executives.
The real problem is that the public, including many of the pension fund managers who were taken for a ride, still don’t understand what has happened. Perhaps the main reason for this confusion has been the quality of economic reporting. The media relied almost exclusively on the folks who got it wrong. The industry bubble-pushers and the bubble-deniers in policy positions were almost the only sources for economic reporting during the bubble years. The vast majority of the people who follow the news probably never heard anyone argue that the economy was being driven by a stock bubble in the 1990s or a housing bubble in the current decade. Such views simply were not permitted. (The New York Times deserves special mention as a media outlet that actively sought alternative voices, especially during the housing bubble.)
Knowingly or not, these outlets have covered up the extraordinary incompetence and corruption that allowed these bubbles to grow. For example, in a recent three-part series on the housing bubble, the Washington Post reported a claim from Alan Greenspan that he first became aware of the explosion in subprime mortgage lending as he was about to leave his post as Fed chair in January of 2006. According to the article, Greenspan said he couldn’t remember if he had passed this information on to his successor, Ben Bernanke.
This article makes it sound as though the explosion in subprime lending was an obscure piece of data only available to a privileged few. In reality, the explosion in subprime lending was a widely discussed feature of the housing market during the bubble years. If Greenspan was implying that he was unaware of this explosion, he was unbelievably negligent in his job as Fed chair. The notion that Greenspan would have to pass this information on to his successorâ€¯ — as though an economist of Bernanke’s stature could be unaware of such an important development in the economyâ€¯ — is equally absurd. In other words, the Post article helped Greenspan present a remarkably straightforward developmentâ€¯ — namely, the massive issuance of bad loansâ€¯ — as complex and confusing.
In the same vein, the Wall Street Journal provided cover for Treasury Secretary Henry Paulson by explaining how the collapse of Fannie Mae and Freddie Mac caught him by surprise. These two financial institutions hold almost nothing except mortgages and mortgage-backed securities. What did Mr. Paulson think would happen to them in a housing crash?
The secret of these two bubbles is that there is no secret. Anyone with common sense, a grasp of simple arithmetic, and a willingness to stand up against the consensus could have figured out the basic story. The details of the accounting scandals in the stock bubble and the convoluted financing stories in the housing bubble required some serious investigative work, but the bubbles themselves were there in plain sight for all to see.
The public should demand a real accounting. Why does the Fed grow hysterical over a 2.5 percent inflation rate but think that $10 trillion financial bubbles can be ignored? Where was the Treasury Department during the Clinton and Bush administrations? What about congressional oversight? Did no one in Congress think that massive bubbles might pose a problem? Why do economists worry so much more about small tariffs on steel and shirts than about gigantic financial bubbles? What exactly do the people who get paid millions of dollars by Wall Street financial firms do for their money? And finally, why don’t the business and economic reporters ask any of these questions?
The stock and housing bubbles have wreaked havoc on the economy and will cause enormous pain for years to come. We can’t undo the damage, but we can try to create a system that will prevent such catastrophes from recurring and that ensures that people responsible for these preventable events are held accountable. That would be a huge step forward.
Dean Baker is co-director of the Center for Economic and Policy Research.