Bursting Bubbles

By Dean Baker, In These Times. Posted May 28, 2003.

In 2000, President Clinton could legitimately boast of the "best economy in 30 years." Unemployment was low, wages were rising at all income levels, and the poverty rate was headed downward at a rapid pace. But after President Bush took office in 2001, the economy fell into recession, shedding jobs and causing real wage growth to slow and eventually stop altogether.

A convenient story explains this sharp economic reversal. According to the script, Clinton eliminated the deficit through progressive tax increases and spending restraint. This deficit reduction lowered interest rates and spurred an investment boom, which was the basis for the extraordinary growth of the late '90s. Then Bush came into office and quickly squandered the surplus with his tax cuts to the rich and military build-up. As a result, the deficit skyrocketed and the economy tanked.

It's a good story, but the reality is quite different. The Clinton boom was built on three unsustainable bubbles. One of them, the stock bubble, has already burst. The other two bubbles -- the dollar bubble and the housing bubble -- are still with us. The dollar bubble is starting to deflate, and the housing bubble is perhaps just now reaching its peak. These bubbles created the basis for the 2001 recession and the economy's continuing period of stagnation.

The basic facts of the economy's rapid deterioration over the last two years are widely known. After creating an average of more than 3 million jobs a year from 1996 to 2000, the economy has lost more than 2 million jobs since March 2001. This reversal has been associated with a rise in the unemployment rate from an average of 4 percent in 2000 to 6 percent today. The increase among African-Americans has been even larger, rising from 7.6 percent in 2000 to 10.9 percent in April, and larger yet for African-American teens, with the unemployment rate rising from just over 24 percent in 2000 to peaks as high as 35 percent in March. While real wages were growing at close to a 2 percent annual pace in 2000, wage growth has recently fallen to zero for most workers.

The economy's reversal was associated with a plunge in the stock market. The S&P 500 fell from a peak of more than 1,500 in March 2000, to lows of less than 800 in the past year. The tech-heavy Nasdaq took an even sharper plunge, falling from a peak of more than 5,000 in March 2000 to under 1,200 last summer. Adding to this picture is the reversal in the budget situation. The surplus of $236 billion in 2000 has given way to a deficit that may reach $500 billion in 2003.

Of course, the stock market downturn should not be included among the economic failings of the last two and a half years. That downturn really was just a healthy return to reality. The long stretch of new peaks that the market hit in the '90s should have been a warning of bad times ahead to anyone paying attention. Instead the boom was widely celebrated as evidence of a new era of unbounded prosperity. The failure by the Federal Reserve Board or the Clinton administration to take actions to stem the growth of the stock bubble laid the grounds for a train wreck; the only question up in the air was when it would hit.

While the day-to-day, or even month-to-month, movements of the market are erratic and unpredictable, there is an underlying relationship between the stock market and the economy. In principle, the stock market is putting a price on the future profits of corporate America. While no one can know the future with certainty, economists can plausibly forecast how high profits can go over a long horizon -- say 10 to 15 years.

When the market was hitting its peaks in 2000, the ratio of stock prices to corporate earnings exceeded 30-to-1, more than twice its historic average. No plausible explanation could ever have justified this sort of valuation. In order for the stock market peaks of 2000 to have made sense, it would have been necessary for profits to grow at close to twice their historic pace.

In short, any serious economic analyst should have been able to recognize the stock bubble of the late '90s. The fact that those in positions of responsibility either failed to recognize the bubble or chose to ignore it was a mistake with enormous consequences.

Liked this story? Get top stories in your inbox each week from AlterNet! Sign up now »