Four years ago at the beginning of the last American presidential campaign, the US economy was enjoying a nine-year expansion: strong growth, low unemployment and inflation, rising incomes, a soaring stock market, and large federal budget surpluses. At the time, many observers from both left and right accorded the policies of the Clinton administration - in particular its support for significant deficit reduction - at least partial credit for the economy's strong performance.
Today, the US economy appears poised for another period of high growth following a spectacular stock market correction, a painful recession, and an anaemic recovery characterised by persistent job losses, stagnant incomes and ballooning budget deficits. The economy's performance and future prospects will be big issues in this year's presidential campaign. The Republicans will claim that Bush's economic policies, in particular the two large tax cuts of 2001 and 2003, have triggered renewed economic expansion, while the Democrats will argue that these policies have caused large job losses, rising income inequality and huge budget deficits. The debate is sure to be heated and not very enlightening.
Luckily for those trying to understand what has really happened, a new book, In an Uncertain World: Tough Choices from Wall Street to Washington, by Robert Rubin, secretary of the treasury for most of the Clinton presidency, provides a compelling and largely dispassionate analysis of recent US economic history. Another book, The Roaring Nineties: A New History of the World's Most Prosperous Decade, by Joseph Stiglitz, a chairman of the council of economic advisers during President Clinton's first term, confuses the picture with an analysis that, while occasionally insightful, is marred by inconsistencies and exaggerations. I worked alongside both Rubin and Stiglitz during the first Clinton term. I served as chair of the council of economic advisers between 1993 and 1995 and succeeded Rubin as the president's national economic adviser and chair of the national economic council in 1995 and 1996. I recommended Stiglitz's appointment as a member of the council of economic advisers in 1993 and his subsequent appointment as its chair when the president asked me to succeed Rubin. As a central member of the president's economic team during his first term, I have first-hand knowledge of the policymaking process and the different positions of the participants.
Both books devote considerable attention to President Clinton's 1993 economic plan and its impact on the economy. When Clinton's economic team met with him for the first time in early 1993, the federal deficit amounted to nearly 5 per cent of GDP, the federal debt was growing much faster than output, and long-term budget projections were deteriorating. There were huge deficits as far as the eye could see, indicating that even if the economy enjoyed a strong recovery - not judged likely at the time - deficits would persist, acting as a drag on economic growth. All of us presidential advisers, including Stiglitz, believed that the deficits were not sustainable in the long run and that a serious deficit reduction programme was essential. The president agreed.
The president's decision was a politically courageous one. As Rubin argues, this decision, like several others during Clinton's eight years in office, exhibited his willingness to exchange short-term political gain for potential - but unguaranteed - long-term economic gain. President Bush has shown no such willingness. Contrary to what Stiglitz argues, the president understood both the dangers of deficit reduction when the economy was weak (as it was in 1993) and the uncertainties about how deficit reduction would affect interest rates and growth over time as the economy recovered. Clinton's advisers warned him that reducing the deficit through cutting spending or increasing taxes could slow the economy in the short run. We also predicted that reducing the deficit would reduce long-term interest rates, thereby stimulating investment and growth over time, but cautioned that the links between deficit reduction, long-term interest rates and investment, were uncertain both in timing and in size.
Both Rubin and Stiglitz agree that the most heated debates among the president's economic advisers at the time concerned the size and composition of the deficit reduction package. The larger the package, the greater the sacrifices the president would have to make in his spending plans for education, health and infrastructure and in his plans for a middle-class tax cut. But the smaller the package, the less its likely effects on long-term interest rates and investment. Along with Stiglitz and Alan Blinder, the other member of the council of economic advisers, I was counted among the deficit doves, counselling a less ambitious deficit reduction target both because the economy was weak and because of the policy choices that might be necessary to achieve a larger target. But the president ultimately opted for a more aggressive target, convinced by Lloyd Bentsen (treasury secretary from 1993-94), Rubin, and Al Gore that a bold target was necessary to restore investor confidence in the federal government's commitment to fiscal responsibility. They argued that long-term interest rates were likely to fall further and faster as a result of greater confidence. In a thinly veiled attack on Rubin, Stiglitz states in his book that the confidence effect is the refuge of those who cannot find better arguments, allowing the "businessman turned politician" to go unchallenged in policy advice. In contrast, Rubin argues in his book that the effect of the Clinton deficit reduction plan on business and consumer confidence may have been even more important than its direct effect on interest rates. Like Stiglitz, I questioned the confidence argument in 1993, and I still haven't found evidence to validate it.
Despite media attention on the debates between deficit hawks and deficit doves, the actual differences between us - at most $100bn over five years - were not economically significant in a $7 trillion economy. What was significant was our unanimous support for a multi-year, backloaded deficit reduction plan based on conservative economic assumptions and embodying both spending cuts and tax increases including some kind of energy tax and a higher tax rate on top income earners.
Early in his White House career, Stiglitz earned a reputation for having a political "tin ear" for failing to understand the political realities that constrain economic policy choices. Such realities drove the president's decision to embrace the ambitious deficit reduction target. Shortly after his election, the Republican members of congress had announced that they would not support his plan whatever it contained. So its fate depended entirely on a razor-thin Democratic majority, with a large contingent of so-called "blue-dog" Democrats committed to aggressive deficit reduction. Several Democrats even indicated that they would vote against any economic package with a deficit reduction target of less than $500bn over five years. So whatever the president thought about the market confidence argument, he was in part nudged by his own party to pursue a bold deficit reduction path, even though it required him to postpone his middle-class tax cut, to give up his ambitious infrastructure spending programme, and to opt for a retroactive income tax hike for the richest Americans and a small gasoline tax for all. I argued strongly against the retroactive tax increase on both economic and political grounds, but it proved impossible to find another acceptable policy measure to hit the $500bn goal. (Had a few more Senate Democrats been willing to accept a smaller deficit reduction target, the president's economic plan might not have included such measures, and the Democrats might not have lost their majority in the House of Representatives in the 1994 election.)
What role did Clinton's deficit reduction play in the resurgence of the US economy in the mid-1990s? While acknowledging that economic causation is complex and that many factors contributed to the strong economy of the 1990s, I believe, as does Rubin, that without the policy changes ushered in by the 1993 economic plan, the robust recovery of the 1990s would have been choked off by rising structural deficits and higher interest rates. Stiglitz grudgingly, and somewhat inconsistently, admits that deficit reduction accelerated the decline in interest rates but claims that the recovery would have occurred anyway. He did not make that argument in 1993. He maintains, without evidence, that if Clinton had devoted less revenue to deficit reduction and more to spending on R&D, education, and infrastructure - out of the question given congress - the economy's growth potential in 2000 might have been even stronger. While possible, I think this is highly unlikely. Finally, in a jarring inconsistency, Stiglitz argues on one page of his book that deficit reduction may be bad for long-run economic growth and on the next page that deficits hamper long-run economic growth.
Stiglitz may be a Nobel laureate in economics, but Rubin's analysis is more consistent with economic logic and hard evidence. Long-term interest rates fell sharply in the year between the announcement and enactment of Clinton's economic plan. And the plan resulted in a big increase in national saving as the deficit declined. National saving increased by almost 3 per cent of GDP between 1992 and 1997, and this fed the increase in national investment that sustained the expansion during the second half of the decade. Whether through an increase in national saving, a decrease in interest rates or a combination of both, Clinton's deficit reduction package stimulated investment and fostered growth. At the time, Stiglitz appeared to draw the same conclusion.
Although Rubin and Stiglitz disagree on whether Clinton's deficit reduction plan went too far, they both applaud the president's courageous decision to oppose the balanced budget amendment which was a key objective of the Republican congress elected in 2004. I agree: indeed, I championed the amendment's defeat and consider it to be one of the Clinton administration's major political and economic achievements. This amendment would have required the federal government to balance its budget annually regardless of the state of the economy. As Rubin notes, such an amendment would have violated "all known wisdom about economic policy by compelling the government to cut spending or raise taxes in a recession, substituting pro-cyclical policies for the counter-cyclical ones required." Clinton was under enormous political pressure from many conservative Democrats to support this amendment but was strongly urged by his economic team to oppose it. For a while it seemed like a very close call, but ultimately he heeded the impassioned pleas of his economic advisers and made the economically wise policy choice. In an ironic twist of fate, this decision, like the president's decision to co-operate with the Republican congress to balance the federal budget during his second term, proved immensely beneficial to his successor. Without the budget surpluses bequeathed to him by the Clinton administration and the flexibility provided by the defeat of the balanced budget amendment, Bush's ill-advised 2001 and 2003 tax cuts would have been unthinkable.
Another key objective of the Republican-dominated congress after 1994 was a reduction in the capital gains tax. Stiglitz attacks the Clinton administration for also advocating this objective and suggests that only the council of economic advisers under his leadership opposed it. But the administration did not advocate a reduction in the capital gains tax, although the president was less negative about such a move than most members of his economic team. Rather, it accepted such a cut as a politically necessary condition to reach a balanced budget deal with congress. As Rubin points out, in 1997 the administration threatened to veto a reduction in the capital gains tax to prevent a concerted Republican effort to reverse the expansion of the earned income tax credit for low-income working families. This expansion had been a core achievement of the president's 1993 economic plan and, along with the increase in the tax rate on top income earners, had helped to make federal income taxes more progressive.
Nor was the treasury itself an advocate of a capital gains tax cut. Like Stiglitz and other members of the president's economic team, including myself, Rubin repeatedly questioned the wisdom of such a cut. He did not believe it would have much effect on either saving or investment. He also believed that it would reduce tax revenues significantly over the long run, although it might well increase them in the short run as investors responded to lower rates by changing the composition of their stock holdings. Stiglitz shared these concerns but his opposition to a reduction in the capital gains tax was more voluble and, after he left the administration, much more public. In addition, like me, he had strong reservations about the distributional effects of such a cut, describing the one finally passed in 1997 as the "most regressive tax cut imaginable and one that was completely inconsistent with what the Democratic party had traditionally stood for." Unfortunately, many congressional Democrats either advocated or acquiesced in this cut - another political reality that Stiglitz fails to mention. And it was a key feature of the bipartisan multi-year plan to achieve a balanced budget approved by congress and signed by the president in 1997. This plan generated growing budget surpluses by the end of the 1990s.
Stiglitz makes a convincing case that the 1997 capital gains tax cut added air to the stock market bubble. It was yet another factor lowering the cost of stock market transactions and stimulating excessive trading and speculation by investors who focused only on short-term trends. Rubin does not speak of a bubble, but he does agree that financial markets are subject to periodic excesses, and he does haltingly admit that this was the case in US equity markets by the late 1990s. Rubin points to greed, fear and complacency - constants of human nature - as the underlying cause of such excesses and suggests that the 1990s bubble was no exception. I share his assessment. After much soul-searching, he also concludes that there was little that policymakers could have done to prevent or even moderate it.
Although Stiglitz acknowledges that policymakers cannot be blamed for the "irrational exuberance" at the heart of the bubble, he argues that they can be blamed for "feeding the frenzy." He attacks Alan Greenspan, chairman of the Federal Reserve Board, for failing to raise the limits on what investors could borrow from their brokers to purchase stock, noting that in 1996, Greenspan had argued that this was the way to get rid of a bubble. (I also believe that the Fed should have raised the limits in 1999.) And Stiglitz argues with some justification that Greenspan may have unintentionally added froth to financial markets by applauding the productivity gains of the new economy.
But Stiglitz goes much further in laying blame for the bubble on bad policy decisions. Indeed, his language sometimes seems to imply that policy errors caused the bubble. He argues repeatedly that "misguided deregulation, misguided tax policies, and misguided accounting practices" were all deeply implicated in the bubble. He is especially critical of the successful efforts of the administration and congress to oppose the inclusion of stock option grants to employees as a compensation expense in corporate accounts. Stiglitz led a vigorous but unsuccessful effort by the council of economic advisers to support the inclusion of stock options in financial accounts. But the overwhelming political pressure from the high-technology industry led Arthur Levitt, chairman of the securities and exchange commission (SEC), to champion a watered-down rule that required companies to report in footnotes to their financial statements only the number of options they granted. Stiglitz cites Levitt as saying that this was the biggest mistake of his tenure at the SEC. But Stiglitz does not prove his assertion that the failure to include stock options as a compensation expense was a significant cause of the 1990s bubble. Certainly, once the bubble was underway, the accounting treatment of options, along with the huge option grants, inflated reported earnings estimates. On the other hand, the footnote information about options in company accounts should have been sufficient to allow careful investors to make the necessary adjustments. Rubin does not comment on this debate directly, but he asserts his belief that stock options, "if properly used," can serve a useful purpose in giving employees a long-term ownership stake in their companies. I agree. I am also not persuaded that the stock options issue played a big role in the 1990s bubble. Accounting experts continue to disagree on this critical question.
Stiglitz also points to flawed financial market deregulation - in particular the repeal of the Glass-Steagall Act - as another cause of financial market excesses. Under the leadership of the treasury, the Clinton administration championed this repeal, thereby eliminating regulatory distinctions between commercial and investment banks and allowing mergers between the two. According to Stiglitz, the end of these distinctions expanded the already considerable opportunities for conflicts of interest in the financial services industry and triggered a "race to the bottom in ethics." Rubin acknowledges that following deregulation, the major financial firms engaged in practices that are troubling in retrospect - like allocating the right to purchase the available shares in initial public offerings of new stock to favoured customers, and failing to build secure firewalls between stock analysts and investment bankers. But he correctly observes that these practices were well known to industry participants and regulators and were not considered problems until after the bubble had burst and triggered a search for explanations of what went wrong and why. Rubin also maintains that despite potential conflicts of interest, most professionals in both financial services and accounting firms did not intentionally mislead investors. In contrast, Stiglitz argues that "in many cases" bankers and analysts knowingly deluded the public. I agree with Rubin's more measured assessment. Like him, I think that the irrational exuberance that gripped the markets at the end of the 1990s created powerful incentives not to dwell on common but troublesome practices, which probably reinforced, but did not cause, the bubble. Unlike Stiglitz, I remain convinced that the repeal of Glass-Steagall has enhanced competition and efficiency in the financial services industry.
Despite their disagreements, Stiglitz and Rubin are united in their criticisms of the economic policies of the Bush administration - criticisms that I wholeheartedly share. Both believe that the large budget surpluses projected at the end of the 1990s should have been used to pay off the debt of the federal government and so prepare for borrowing needs that will arise when the baby boom generation begins to retire in significant numbers. They identify the 2001 and 2003 Bush tax cuts as the major factor behind the unprecedented reversal in the nation's fiscal fortunes - from a projected ten-year surplus of more than $5.6 trillion in early 2001 to a projected ten-year deficit of over $5 trillion today, according to several independent analysts. They question both the Keynesian and the supply-side logic of these tax cuts, arguing that they do not deliver much "bang for the buck" in stimulating demand in the short term and do not act as an incentive on saving and investment in the long term. Indeed, as Rubin points out, the congressional budget office and the joint committee on taxation - both with leadership appointed by the congressional Republican majority - recently concluded that the Bush tax cuts, including the deficits that they have created, are likely to reduce rather than increase the economy's growth over the next decade. Stiglitz is more outspoken than Rubin about the distributional consequences of the Bush tax cuts, while Rubin devotes more attention to the possible negative effects of fiscal disarray on market confidence. But both believe that the long-run fiscal outlook is bleak and could trigger a sharp fall in the dollar and a spike in interest rates if foreigners lose confidence in US economic policies. Stiglitz may believe that the Clinton administration took deficit reduction too far in the 1990s but, like Rubin, he is convinced that the Bush administration has taken deficit creation to new and unsustainable heights.
Apparently Paul O'Neill, who served as Bush's treasury secretary until he was asked to resign in late 2002, agrees with this assessment. According to Ron Suskind's recent book, The Price of Loyalty, O'Neill repeatedly warned Bush that the country was moving towards a fiscal crisis. But O'Neill's warnings were dismissed by Vice-President Cheney, who argued that "Reagan proved deficits don't matter." O'Neill paid for his unwanted advice with his job. But under realistic assumptions, large budget deficits - more than 5 per cent of GDP, excluding the social security and medicare trust funds - are projected every year through the next decade, right up to the time when the first baby boomers begin to retire. Future budgetary imbalances will be so large that the risk of severe adverse consequences - including a sharp loss in investor confidence in US economic policies, a sell-off of US securities, a precipitous decline in the dollar, a sharp rise in interest rates and a rapid contraction in economic growth - must be taken seriously. And even if these risks do not materialise, large budget deficits will require a combination of lower private investment and greater indebtedness to the rest of the world. Either way, Americans' claims on the nation's future output and their future living standards will be reduced as a result of Bush's budgetary profligacy.
Meanwhile the president takes no responsibility for the fiscal mess he has created. His most recent budget calls for making his tax cuts permanent - which would amount to more than three times the cost of making the social security system solvent over the next 75 years. He promises to halve the deficit as a percentage of GDP by sharp reductions in federal spending on everything but defence and homeland security. But his proposals are neither politically realistic nor economically sound. Nonetheless, his calls for spending cuts with continued tax relief, that disproportionately benefit the wealthy, reveal the Republican goal that has guided his administration from the start: to starve the federal government of the revenues necessary to fund social programmes that benefit middle and lower-income families. Bush has undermined the fragile political consensus behind fiscal responsibility that emerged in the 1990s and is willing to threaten the nation - with adverse spillover effects around the globe - to realise this ideological objective.
