Plunder and Blunder; How the 'Financial Experts' Keep Screwing You

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 U.S. economy over the last 15 years. The stock bubble propelled the strongest period of economic growth since the late 1960s. The housing bubble lifted the economy from the wreckage of the stock bubble and sustained a modest recovery, at least through 2007. However, financial bubbles by definition aren't sustainable, and when they collapse, they cause enormous social and economic damage.

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 mattered  -- 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.