CHAPTER THIRTEEN
They Called It Rubinomics
I HAD FELT FOR SOME TIME that Al Gore would be a good presidential candidate and a good president. During the height of the focus on the Vice President in connection with a controversy around fund-raising practices in 1997, I had said to Gore’s chief of staff, Ron Klain—a former Supreme Court clerk who combines enormous intelligence with great political savvy—that if I were to leave Treasury before the end of the Clinton presidency, I would very much like to help the Vice President in his quest for the presidency. This was a period when Gore was under a lot of pressure, and I felt that perhaps even a small gesture of encouragement would be useful. Later that same day, we were all in the Oval Office in preparation for a meeting with a foreign leader, and the Vice President came over to where I was standing and elaborately helped me into my chair.
Gore can be awkward in interpersonal interactions—an unusual and unfortunate characteristic for someone in political life. But that awkwardness can be misleading. Gore is very bright, vigorous in his thinking, and possessed of a sharp and often self-deprecating wit that I very much enjoy. I remember when the Prime Minister of Poland was visiting Washington and had the usual meeting in the Oval Office with the President, the Vice President, and a few senior officials from each side. It was a busy time at the White House, with electoral politics very much on people’s minds, and I thought the meeting was probably a less than optimal use of the President’s time—though, in fairness, Poland was the poster child for economic reform in Eastern Europe. At the end of the meeting, the Prime Minister noted that there were many people of Polish extraction living in the United States. The Vice President looked at him with mock astonishment and said, “We had heard something about that.” I told the Vice President afterward that I had practically broken up, because in his own ironic way, Gore was making the point to the earnest Prime Minister that this was exactly why the meeting was taking place.
I tended to agree with Gore on most of his policy positions. He strongly opposed George W. Bush’s campaign proposals for a massive tax cut and for the partial privatization of Social Security. Gore had been a strong force for deficit reduction from the beginning of the administration, had worked hard on the Hill to pass the Mexican support program, and had very publicly supported trade liberalization, especially during the struggle to pass NAFTA—even though that had been politically difficult at times within the Democratic Party. He also had a strong focus on inner-city problems.
Gore’s greatest passion, of course, was the environment. I had entered the administration with great skepticism about what seemed to me absolutism on the part of at least some environmentalists. But Gore persuaded me that the threats to the environment were a serious danger and that environmental protection and economic growth were not necessarily a trade-off; that, indeed, long-term economic growth would depend on sensible environmental policy. I came to believe that measures of the gross domestic product would more accurately reflect economic output if environmental costs and benefits could be included—though that is not yet feasible, either politically or technically. I remember a long conversation we had in the Vice President’s West Wing office about global warming. Gore said that even if science didn’t provide certainty, the evidence was considerable that global warming was occurring, and measures to repair it would take a long time to have substantial effect. If we waited too long and the evidence turned out to be correct, the result could be an unpreventable catastrophe. And with risk of catastrophe, you cannot afford to be wrong. This was in a way analogous to the problem a trader faces when he has a position that is almost certain to produce a positive return but is so large that failure could put him out of business. That is a chance he can’t afford to take. And of course, with global warming, most experts believe that the risk of a catastrophe is real. Any sensible analysis of global warming seems to me to lead to the conclusion that putting effective preventive measures in place is imperative—though that still leaves questions about which ones make the most sense.
Unfortunately, rather than running primarily on the economic record of the Clinton-Gore administration, the Gore campaign took something of a populist tone. Income distribution is a critically important economic issue for any society; the question is the language you choose and the sense you convey with your words. At any time, but especially at a moment when people were broadly benefiting economically, language tinged with class resentment seemed to me politically and substantively counterproductive. If Gore were to win, his populist rhetoric in the campaign could hurt business confidence and investment, which was not the way to start a new administration.
All of this, of course, is a long-standing debate within the Democratic Party, which has its philosophical schisms just as the Republican Party does. I am not a political analyst, but I’ve been around this debate for many years, listening to the vigorous policy and political arguments on both sides. My view remained what I remember Hillary Clinton telling Bob Reich after the 1994 midterm election debacle: that the key in the general election is the 20 percent of swing voters in the middle of the electorate, and that class conflict is not an effective approach with those people. In response to this kind of criticism, Gore’s campaign strategists are quick to point out that Gore got more popular votes than Bush. But whatever one’s view of the outcome, I think the Gore campaign should have done better, given that he was running as an incumbent Vice President amid the best economic conditions in many decades.
AFTER BEING SOMEWHAT involved in the 2000 election, I didn’t give much thought to what role, if any, I would have in the policy debate going forward. But three events quickly got me reinvolved: the new administration’s tax cut proposals in early 2001, which I considered fiscally unsound; the Democrats’ need for economic policy advice from people they were comfortable working with; and the September 11 attacks. All of these factors pulled me back into the policy-making process. It’s useful to separate the history of the Great Fiscal Debate from current arguments around the question of whether deficits matter. After analyzing the issue, I’ll relate the story of how I reengaged with the debate.
The Great Fiscal Debate: More than anything else, it was my deeply troubled reaction to the administration’s tax cut proposals that led me to reengage. The tax bill, debated and passed in the first half of 2001, began a period in which tax cut advocates dismissed mainstream views about the direct and indirect effects of large tax cuts on the government’s fiscal position, the value of sound fiscal policy, and the harm caused by large, long-term structural deficits.
Conservatives often framed the debate over Bush’s proposals as a question of lower taxes versus more spending. (Here and throughout the chapter, my reference to conservatives is to those who, through the 1980s and 1990s, coalesced around fervent advocacy of the tax cuts as an overriding priority, rather than more traditional conservatives, who, whatever their social and other views, were strong advocates of sound fiscal policy.) The Concord Coalition, an organization dedicated to fiscal discipline, and led successively by two Republicans, former Commerce Secretary Pete Peterson and former Senator Warren Rudman, was advocating policies that once were at the core of the conservative movement and the Republican Party (and eschewed by most Democrats). One of the ironies of this period is that today those policies are opposed by many leading conservatives and supported by many Democrats.
If government didn’t give back the surpluses to the public in the form of a tax cut, leading conservatives argued, “Washington” would find a way to spend the money. Another version was that the surpluses were the people’s money and should be returned to them. These formulations are as politically shrewd as they are simplistic and in many ways misleading. Nobody likes what government does when it’s described as “spending.” Yet the major programs that make up the vast preponderance of government spending—from Social Security and Medicare to defense, law enforcement, education, and environmental protection—command widespread public support. In practice, even conservative supporters of tax cuts are reluctant to scale back these popular programs, and they even vote for increases at the same time as they inveigh against “spending.” These programs are the people’s programs, just as tax dollars are the people’s money. If tax cuts are not matched by spending reductions, they increase the size of the federal debt—a debt that is the people’s debt.
The Bush administration’s approach to tax cuts framed a new stage in the Great Fiscal Debate, an ongoing clash about the effects of fiscal discipline and of tax cuts on economic growth. This argument first affected policy in a significant way during the 1980 presidential campaign, when a group of conservative “supply-siders” attained prominence. The core of the supply-side theory was that lower marginal tax rates would cause people to “supply” more labor, working more and harder, which would increase growth—and the positive effect on growth would be so large that government tax revenue would actually increase rather than decrease in response to the tax cut.
George H. W. Bush, Ronald Reagan’s opponent for the Republican nomination in the 1980 election, referred to this as “voodoo economics.” And not all of Reagan’s advisers believed this theory. Some committed conservatives understood that reducing the size of government is difficult because of the popularity of most spending programs of significant size. Tax cuts seemed to offer a way around this political problem. If government’s revenues were squeezed, this line of reasoning went, spending could no longer grow and might even be forced to shrink. Despite that theory, spending throughout the 1980s, agreed to by both the Reagan administration and Congress, consistently and significantly exceeded levels necessary to offset the tax cuts. The result was the large deficits of the 1980s, deficits that kept increasing during the early 1990s and were projected by the outgoing administration in 1992 to grow even more in the years ahead.
For a government to run a cyclical deficit—a short-term and temporary deficit in conjunction with a recession or an economic slowdown—isn’t necessarily bad and at times may be entirely sensible. Keynesian economics explicitly advocates cyclical deficits produced by temporarily higher spending or temporarily lower taxes as a way of dealing with recessions. In the 1960s and ’70s, some liberal Democrats who accepted that theory also found in Keynesian economics a convenient argument for advocating permanent increases in programs. But the Reagan tax cuts, combined with the Reagan-era defense spending increases, created something different: large and intractable long-term structural deficits, which persisted even when economic conditions were good. The Walter Mondale campaign of 1984 and the Michael Dukakis campaign of 1988 both argued that the existence of this structural deficit was a significant, long-term threat to the American economy. Essentially, they didn’t get any response, because so few people understood the problem. Mondale told me some years later about his frustration at not being able to talk about the deficit in a way people could relate to.
By 1989, the deficit had begun to seriously affect the economy. People began to understand that deficits were contributing in some way to the difficult economic conditions of the very late 1980s and early 1990s, which changed the political dynamics of the issue. By 1992, the deficit was 4.7 percent of GDP—nearly $300 billion. Dealing with the deficit was a centerpiece of Clinton’s 1992 campaign. One of the reasons Clinton focused so intently on the deficit is that it not only was causing harm to the economy but was also undermining confidence in government, limiting its ability to deal with problems and issues that people cared about. Though he supported reductions in many areas, Clinton wanted government to be more active in others.
After Clinton took office, the Great Fiscal Debate mutated. In 1993, the debate was between supporters of Clinton’s economic plan—which included revenue increases, principally an income tax increase on the top 1.2 percent of taxpayers and a small gas tax—and opponents who argued that tax increases of any kind would harm the economy. Loyal supply-siders such as Jack Kemp and Paul Gigot of The Wall Street Journal argued that our economic program would harm the economy and lead to higher unemployment. Some were even more specific in their predictions. “I believe this will lead to a recession next year,” Newt Gingrich said at the time. “This is the Democrat machine’s recession and each one of them will be held personally accountable.”
The 1993 deficit reduction program was a test case for supply-side theory. Instead of the job losses, increased deficits, and recession the supply-siders predicted, the economy had a remarkable eight years—the longest period of continuous economic expansion yet recorded. Unemployment fell from more than 7 percent to 4 percent, accompanied by the creation of more than 20 million new private-sector jobs. Inflation remained low while GDP growth averaged 3.5 percent per annum. Productivity growth averaged 2.5 percent a year between 1995 and 2000, a level not seen since the early 1970s. Poverty rates went down significantly, including among Blacks and Hispanics, and incomes rose for both higher and lower earners. For the first time in nearly thirty years, the budget balanced in 1998.
President Clinton’s economic plan contributed greatly to these conditions. That success created an immense anger on the part of some conservatives, who saw a policy they decried lead to conditions they said wouldn’t occur. Ever since, they’ve been trying to find other ways to explain what happened to the economy and to denigrate Clinton’s accomplishment. During the 1990s, some moved to the position that the economy was booming for reasons they said had nothing to do with declining deficits and balanced budgets, and pointed instead to technological progress and trade liberalization (both of which were, indeed, also important, and promoted strongly by President Clinton). A number of supply-siders advanced the theory that the boom of the 1990s was a delayed reaction to Reagan’s 1981 tax cut.
My response was that you might as well give the credit to Herbert Hoover, though I do think in other respects, such as trade and some aspects of deregulation, the Reagan administration made meaningful contributions. George H. W. Bush’s administration also had important, constructive initiatives, in trade and—though not often cited by supply-side conservatives—the tax increases and new budget rules he put in place in 1990. These measures were a useful step toward reestablishing fiscal discipline, although far short of what was needed to stem the tide, with the result that actual and projected deficits were at very high levels—and growing—by the end of his administration.
By 2002, conservatives had a different argument: the collapse in stock prices that had followed the eighteen-year bull market showed that the 1990s hadn’t really been that healthy an economic period after all. In fact, the 1990s were years of extraordinarily favorable and sound economic conditions, but extended good times almost always produce imbalances that lead to a period of adjustment. Of course, the view that some adjustment was probably inevitable still left an important debate about what policies would best serve to minimize the duration and severity of that adjustment and best position us for the long term. I felt that our policy choices during this difficult period of adjustment did neither.
In 1994, the Democrats lost control of Congress. After the election, conservatives took the political offensive, pushing for big new tax cuts to be paid for with deep reductions in Medicare and other programs. These proposed spending cuts, which were highly unpopular, faded away after the government shutdowns in 1995. However, the tax cut proposals remained—which showed how unwilling the proponents of tax cuts usually are to take the political heat for actually cutting specific programs in a way commensurate with the reduction in tax revenues. Because specific proposals to cut the budget step on toes, conservatives often advocated ameliorating the effects of their tax cuts through “dynamic scoring”—revising the projected cost of a tax cut downward on the basis of the supply-side theory that tax cuts would create enough additional growth to pay for themselves, partially or entirely.
In the 1996 campaign, Bob Dole argued for an across-the-board reduction in rates that would have cost $548 billion over six years; President Clinton responded with the position that any tax cut should be much more modest. In earlier decades, demands for balanced budgets tended to come from Republicans, while Democratic Keynesians argued that deficits should be disregarded. The Reagan administration began to change this traditional alignment, with its supply-side approach to tax cuts. And during the Clinton presidency these roles were reversed: it was Democrats who wanted to hew to the path of fiscal responsibility and many Republicans who seemed relatively indifferent to fiscal effects, so long as the money went to reducing taxes.
As the deficits diminished and a surplus emerged during Clinton’s second term, the debate evolved again. Conservatives now argued for “giving back” the large projected surpluses to taxpayers in the form of a tax cut. It seemed that other uses of the surplus better reflected the preferences of the American people and we felt that continued fiscal discipline—in this case, beginning to pay down the debt of the federal government—would best promote economic growth. What’s more, Social Security and Medicare were facing huge deficits once the baby-boom generation began to retire in significant numbers. We couldn’t literally prepay these future obligations out of general revenues, but if the government had paid off its debt and was in a sound fiscal condition when those enormous bills began coming due, the country would be much better positioned to deal with them.
All of this argued against massive tax cuts. But dealing with the surplus left the Democrats in a tricky situation politically. Most voters don’t even understand the difference between the government’s annual deficit and its accumulated debt. So it was almost impossible to explain, in a way that people would relate to, why entitlement obligations we faced decades down the road meant that a government that was running a surplus should use the money to pay down its long-term debt instead of refunding it to taxpayers. Preserving the surplus as savings and using that to pay down debt would contribute to lower interest rates, greater job creation, and higher standards of living. But the reasons this was true were complicated. To better bring home to people the advantages of saving the surplus, the administration in 1998 reframed the issue as “Saving Social Security First.” The idea was to offset the political appeal of giving back the surplus in the form of a tax cut and remind the public that if the surplus was their money, the debt was their debt as well, and to connect saving the surplus with a purpose that was easy to explain. That argument worked to hold the line against massive tax cuts for a couple of years more.
In January 2001, the nonpartisan Congressional Budget Office projected a ten-year federal government surplus of $5.6 trillion. Because of certain long-established methodological practices that are widely viewed as unrealistic—for example, assuming that expiring tax credits, such as the research and development tax credit, won’t be renewed—that number was probably overstated. By September 2003, after two rounds of tax cuts, Goldman Sachs, using more realistic assumptions, estimated a ten-year deficit of $5.5 trillion. That’s a swing of $11.1 trillion, but adjusting for certain methodological inconsistencies, the better number to use is a $9 trillion deterioration from surplus to deficit. (Obviously, ten-year projections are extremely unreliable, but the risk of actual results being worse than these projections seems, if anything, to be greater than the chance of them being better—these projections all assume healthy growth rates, which might be undermined by these very deficits.)
Though many factors contributed, the tax cuts of June 2001 and May 2003 were central to this reversal. The CBO estimated that the first tax cut would cost $1.7 trillion, including debt service (the interest that the federal government will have to pay on debt that would have been retired absent the tax cut), but those figures assumed that the tax cuts will actually “sunset,” or expire, when scheduled to do so. Independent analysts suggested the cost would be higher, exceeding $2 trillion with debt service, if the tax cuts were instead made permanent. The second tax cut was officially estimated to cost $550 billion with debt service, again assuming the tax cuts would expire. If, instead, the tax cuts are made permanent, as proponents argued they should be, the cost would exceed $1 trillion over a ten-year period, with debt service. The combined tax cuts, then, represented roughly a third of the total deterioration of $9 trillion, and roughly two thirds of the $5.5 trillion deficit estimated by Goldman Sachs.
The tax cuts also helped to undermine the fragile political consensus around fiscal discipline that came out of the 1990s. The natural inertial tendency in Washington is toward passing more immediately gratifying tax cuts or spending increases, rather than what is best for the long term. A large tax cut, especially one that benefited higher-income taxpayers so much, made it hard to argue for discipline in other areas and thereby worked to unravel the reluctant sense of obligation to maintain sound fiscal policy. The federal debt, which would have fallen from one third of GDP to zero well within ten years under earlier fiscal estimates, instead was estimated two years later in that Goldman Sachs study to increase to more than 50 percent of GDP by the end of the ten years. Moreover, the numbers of baby boomers retiring will increase rapidly in the years ahead, raising Medicare and Social Security costs and making prospects as the years go on even worse.
Do Deficits Matter? With this as a background, the Great Fiscal Debate now moved to the question of whether these projected deficits mattered. This is clearly the heart of the issue. The proponents of tax cuts had to argue that they didn’t matter—or at least didn’t matter much—because large tax cuts and a sound fiscal position could not be reconciled. And tax cut advocates, including President George W. Bush’s CEA chairman, Glenn Hubbard, pointed to me as the symbol of the position that deficits have a significant effect on interest rates and therefore on economic activity, job creation, and growth. The Wall Street Journal editorial page dismissed the theory that deficits affect interest rates as “Rubinomics.”
Flattered as I was, at first I didn’t think this position could possibly get traction. But it was loudly trumpeted, and the countervailing view wasn’t. As a result, what seemed to me arrant nonsense came to be treated as a serious point of view. One tax cut proponent testifying beside me at a congressional hearing went so far as to say that nothing in the literature supported the concern about fiscal conditions affecting interest rates.
Nothing in the literature? The first thing you learn in Introductory Economics is that supply and demand determine price. It’s curious to me that people whose basic credo is that markets explain everything don’t think that an important factor in the supply and demand for debt financing—the federal government’s fiscal position—has any effect on interest rates. Put another way, it’s an even more obvious point: when the government borrows, the pool of savings available for private purposes shrinks and the price of capital—expressed as the interest rate—rises. If the Treasury ceases borrowing and instead begins paying down some of its outstanding $3.8 trillion debt, the savings pool available to the private sector increases and interest rates go down. A study by Robert Cumby at Georgetown University and two of his colleagues, completed sometime after that hearing, found a strong correlation between bond market interest rates and expectations about future fiscal conditions. The Cumby paper overcame a serious problem with previous papers that had examined only the relationship between interest rates and current fiscal conditions. Focusing instead on the relationship between interest rates and expected future conditions makes sense: a buyer of a five- or ten-year bond should logically be influenced primarily by expectations about interest rates and bond prices over the life of the asset.
But Cumby’s paper didn’t get much public visibility. Then Bill Gale and Peter Orszag of the Brookings Institution prepared a fifty-five-page paper with analysis and conclusions similar to Cumby’s. It cited other well-established economists in support of the impact of projected fiscal conditions on interest rates—including Martin Feldstein of Harvard, who has also long been a major voice supporting a moderate version of supply-side tax theory. Gale and Orszag went one critical step further and actively briefed the media and members of Congress and their staffs. As a result, their work received widespread attention and contributed meaningfully to the growing concern about our fiscal mess. This exemplifies an important point often deeply frustrating to serious policy analysts outside government, whose work seldom has any significant effect on the policy process. Having a significant influence ordinarily requires not only an important piece of work but also a savvy sense of how to get attention in the media, Congress, and elsewhere in official Washington.
Interest rates are affected by many factors, which makes isolating the impact of fiscal conditions more difficult. Also, though fundamentals win out over time, at any given moment the psychology of the market may be at variance with the fundamentals. For example, when the economy and private demand for capital are sluggish, markets may focus very little on unsound long-term fiscal conditions and interest rates may remain low, as happened in 2002 and the first half of 2003. (Although even during this weak period the historically large spread between higher long-term interest rates and the lower short-term rates the Fed controls suggests that the deficits might have been having some effect.)
But whatever the effects may be when the economy is weak, once economic conditions are again healthy, the private demand for capital will increase. Then markets will at some point focus on long-term fiscal conditions, and that increase in private demand will then collide with the government demand for financing to fund its budget deficits. Virtually all mainstream economists agree that there is no fiscal free lunch. Though no one can predict when, interest rates will react strongly to expectations of substantial long-term deficits and the effect of those deficits on the demand to borrow.
Let me put numbers on these concepts, to show how powerfully adverse the effects on our economy could be. When used to look at the effects of tax cuts, the Federal Reserve Board model projects that for each increase in the deficit of 1 percent of GDP, long-term interest rates will increase by 0.5 percent to 0.7 percent. Some analysts use lower estimates of that relationship, so, for purposes of this calculation, I assume that if the deficit increases by 1 percent of GDP, long-term interest rates will increase by 0.4 percent.
The $9 trillion deterioration in the Federal government’s fiscal position over ten years that I mentioned previously is an average annual deterioration of 7 percent of GDP per year. That is, the swing from the previously projected surplus to the now projected deficit averages 7 percent of GDP per annum. Since each 1 percent of GDP will increase interest rates by 0.4 percent, a change of 7 percent of GDP per year will increase interest rates by 2.8 percent (0.4 percent x 7).
With ten-year long-term bonds at roughly 4½ percent, that is an increase in interest rates of more than 60 percent. However, the situation is actually substantially worse. A key interest rate for most economists is the market rate of the ten-year bond adjusted for inflation, which is called the “real” interest rate. With today’s ten-year rate of 4½ percent and an inflation rate of 1½ percent, that means real interest rates are 3 percent (that is to say, the interest rate is 3 percent over and above the inflation rate). Using that figure, the 2.8 percent increase in interest rates that I’ve just described amounts to over 90 percent of real interest rates.
The deterioration from a surplus to a deficit is the most accurate way to look at the effect of current fiscal policy. However, analysts often refer to just the projected deficit. So, let me apply the same analysis to the projected deficit of $5.5 trillion over ten years, which averages roughly 4 percent of GDP per annum. This translates into higher long-term interest rates of 1.6 percent (4 percent of GDP x 0.4 percent). With an inflation-adjusted interest rate on the ten-year bond of 3 percent, that’s an increase in real interest rates of over 50 percent.
These are serious numbers. But the effects could be far more severe.
If fiscal imprudence continues, at some point markets may become concerned, not just about the projected future demand of the federal government on the available savings pool, but also about the risk of even greater fiscal disarray—with the possibility that the government will rely on inflation rather than fiscal discipline to work out its long-term fiscal problems. Then, the markets may pile on top of the already higher interest rates an unpredictable additional “deficit premium” reflecting those risks. Economists describe this as the risk that deficits could have a “nonlinear” effect on rates. And that could be hugely consequential, and could be even further exacerbated by the impact that an unsound fiscal policy can have on the interest rates foreign creditors require to lend to the United States.
Moreover, interest rate effects are only part of the picture. An unsound long-term fiscal situation can also badly damage business and consumer confidence—as was evident in the few years before the 1992 election. Large structural deficits can also diminish confidence in our economy and currency abroad, impair the ability of the federal government to serve the purposes the American people wish it to serve (including Social Security and Medicare), and undermine our resilience in dealing with future recessions or emergencies. In fact, our ability in 2001 to increase national security spending, and to put into place a stimulus to fight recession without running a serious risk of producing a large increase in interest rates, was the product of a sound inherited fiscal position.
In addition to the proposition that deficits don’t affect interest rates, some tax cut proponents also assert that tax cuts will increase private savings, work, and investment activity. This, in a nutshell, was Reagan’s theory in the 1980 Republican primary—that is, that tax cuts would pay for themselves through supply-side effects. But the deficit grew instead of diminishing, and by 1992 the federal debt had quadrupled. By the very end of the 1980s, this fiscal morass led to higher interest rates and diminished confidence, which fed the economic difficulties of the late 1980s and early 1990s. Moreover, the evidence that tax rates have significant effects on private savings or work is very thin. Most of the mainstream academic literature suggests that private savings is affected very little, if at all, by interest rates. Thus, reducing taxes would seem unlikely to affect private savings much, despite increasing the after-tax rate of interest. The academic literature also predominantly holds that decisions about how much to work are not significantly affected by marginal tax rates, at least within the ranges of the tax rate debate of the last two decades, with the possible exception of some effect on secondary earners in a family—and that effect on the economy is relatively modest. In fact, the effect of tax cuts on the incentive to work can even be negative, since lower average tax rates enable someone to work less for the same after-tax income. Tax cuts may also affect choices between nontaxable perks (e.g., a larger corner office) and taxable income, but such choices don’t significantly affect economic growth. My own experience in setting corporate compensation is that the effect of tax rates on work effort is nonexistent—at least with top tax rates in their current range, as opposed to the rates of 70 percent or higher that we once had.
Tax cut proponents often argue that “dynamic scoring”—that is, budget rules that assume supply-side effects—show that tax cuts pay for themselves. In 2003, the Congressional Budget Office and the Joint Committee on Taxation—both with leadership appointed by the Republican majority—each produced dynamic estimates that refuted these claims. The JCT, examining a version of the 2003 tax cut, concluded that the supply-side effect of the cuts themselves on growth would be slight, and that the overall effect of the cuts plus the deficits they create on growth over the long run would, if anything, be negative. Similarly, the CBO examined the administration budget proposal as a whole and found little effect—and possibly a negative—effect on long-term growth.
Some tax cut proponents argue that the real market for capital is global and that increased demand for capital in the United States can be met by increased inflows from abroad, with relatively little impact on interest rates. It is true that global capital markets will satisfy demand for financing that is not met by U.S. savings, including the demand created by increased deficits. But it is not true that the capital flows into the United States at the same interest rates as would have existed in the United States if we didn’t need that capital. And, in fact, the effect long-term fiscal deficits can have on the cost of flows of capital from abroad is one of the great dangers of these deficits. Funding some or all of our large fiscal deficits from abroad means attracting a greater inflow of foreign capital, and that will require paying a higher rate of interest. Moreover, studies clearly show that capital has a substantial home-country bias, making the interest rate increase needed all the greater. Secondly, the United States is such a large factor in capital markets that our excess demand—unlike that of smaller countries—can affect global interest rates. And, most troubling, if foreign capital markets become concerned about our fiscal policy and the soundness of our currency, suppliers of capital are likely to greatly increase the price demanded for use of their capital. This is exactly what happened to many countries during the second half of the twentieth century. And this potential consequence of fiscal ill-discipline could be especially dangerous to the United States under current circumstances, when we are dependent on large inflows of foreign capital to sustain a trade deficit and substantial savings shortfall. Finally, the empirical studies showing that deficits affect interest rates are based on data that reflect all factors, including whatever impact foreign inflows might have.
Because public understanding of these issues is so limited, serious discussion about and proposals to deal with the problem of deficits can easily be misrepresented. For example, in January 2002, Tom Daschle gave a speech arguing that our long-term fiscal situation posed grave dangers and needed to be repaired, without making any specific proposals for doing so. He went on to agree that short-term deficits might make sense when dealing with the currently weak economic conditions. But he was sharply attacked the next day for advocating tax increases during a recession. Daschle had actually done nothing of the sort, but the attack—which was widely and pretty much uncritically reported—took hold. And that deterred others from advancing the arguments Daschle had made.
One major impediment to serious discussion of our fiscal morass in the political arena is that it immediately raises the question of whether the country now needs to raise taxes to deal with the deficit. My view is that dealing with the fiscal deterioration that current policy has led to will inevitably mean shared sacrifice, as it did in 1993, and will involve both spending and tax measures. But whatever the components of the eventual solution, the President and congressional leaders of both parties should get together—sooner rather than later—to deal with what has become a serious threat to our future well-being.
Despite the difficulties Daschle and others encountered in trying to raise the deficit issue, the prevailing tone of the debate began to shift in 2003. The media perspectives shifted, influenced in part by the Gale-Orszag paper as well as more frequent comments by other prominent economic analysts, by the ballooning current deficits, and by the sharply increased long-term deficit projections. In this changing climate, the administration moved to acknowledge that long-term deficits do, in fact, affect interest rates. Under new leadership, President Bush’s Council of Economic Advisers accepted this point in an on-line Wall Street Journal article. But the tax cut proponents then argued that even if deficits did matter, the projected amounts were “manageable.” In making this case, however, they used estimates much lower than those used by mainstream analysts, and they did not acknowledge the potential for severe nonlinear effects, the immense entitlement costs on the horizon, or the potentially powerful adverse non-interest-rate effects of deficits on growth.
Robert Reischauer, a former head of the CBO and one of the wisest and most practical budget experts I know, thinks that those who run our political system may well be unwilling to repair our long-term fiscal mess until we reach what he considers an inevitable day of reckoning. When that crisis arrives, we will either have to make the decision to increase revenues substantially—at what may well be an inopportune time—or face severe and prolonged economic tribulations. Then the American people will look back with dismay at what happened. Unfortunately, no one who is now concerned about deficits has yet found a way to explain these future costs in a way that has political resonance in the shorter term, while these most serious problems are being created and can still be prevented. Leaving aside debates about whether deficits matter and about whether the supply-side effects are real, tax cuts and spending increases often seem attractive in the short term to politicians—and voters—who either don’t focus on the long term or perhaps, in some cases, recognize the potential problems but feel that they will fall on somebody else’s watch.
AS THIS DEBATE WAS evolving, my role in it evolved as well. I was still in touch with a number of Democrat senators and House members and, just as important, their staffs. In Washington, businesspeople tend to congregate around the elected official. But very often, if you want to be effective—either in knowing what’s going on or in actually getting something done—you’re well advised to develop a relationship with the right staff people as well. A good example is Mark Patterson, at that time staff director for Tom Daschle’s Democratic Leadership Committee, whom I got to know when he worked for Pat Moynihan. Mark is the kind of staff member who understands substantive issues, can read the politics of the Senate, and has a lot of good-humored insight into what’s likely to happen on the floor and in the various committees. It was through Mark and other congressional staff members that I started to get a sense of how I might be useful again in the debate over Bush’s 2001 tax cut proposal. When the Democrats controlled the White House, the administration had a series of policy positions that were a regular part of the public debate. Democrats in Congress could decide where they wanted to be on economic issues in relation to where the administration was. Most often, the Democrats on Capitol Hill, whether accepting or critical of our positions, used us as a resource for both policy and politics.
Now, all of a sudden, the Democrats didn’t have any of the support structure of a Democratic administration—the fixed star from which to navigate, if they chose, along with the resources, data, and expertise of the cabinet departments and the White House. For example, on tax issues, legislators from the party that controls the White House have at their disposal both the substantive analysis of professional economists at Treasury and the talking points that communications people at Treasury and the White House tailor to different constituencies and different states. They have people they can call on who are deeply involved in economic issues and are thinking about them from the same general perspective. If you’re a U.S. senator, there are always plenty of professional economists at your disposal. What you may lack are people who not only understand economic issues but have also lived in your world and have faced the same kinds of policy choices and political realities you have to face every day.
Once the Republicans retook the White House, the Democrats on Capitol Hill began to realize that the Clinton people had been a useful resource, and they seemed to miss having us. Alan Greenspan was seen by most as supporting Republicans on the tax cut issue when he testified before the Senate Budget Committee on January 25, 2001—though in that same testimony, he stated his concerns about not encroaching upon the Social Security surpluses and warned that a tax cut should not be so large as to plunge the government back into deficit. The Democrats needed people with significant economic policy-making credentials and political experience to support them in developing their positions and to validate those positions.
I remember one Democratic congressman saying to me, “Our members are ready to go out and fight on the tax cut. But many of them don’t fully understand this substantively. They want to have a comfort level with the issues.” It’s an important point: if you’re a member, you’re constantly being asked what you think about a vast range of complicated subjects. Even legislators who are very diligent and dedicated can’t be experts on more than a few issues. The leadership and other members who are deeply involved may give you material to help you understand an issue or answer questions from the press. But legislators don’t want to take a position and realize six weeks or six months later that they were wrong. The bipartisan Concord Coalition played an important role in meeting these needs on fiscal matters, providing analysis of fiscal conditions and the dangers of large long-term deficits, as well as the reassurance that comes from the support of well-respected figures. Among those associated with the organization who opposed fiscally unsound tax cuts were former Senators Bob Kerrey, Sam Nunn, and Warren Rudman, former Federal Reserve chairman Paul Volcker, and former Commerce Secretary Pete Peterson. They held press conferences and their work was widely circulated on the Hill during hotly contested struggles over tax cuts.
In early February 2001, at Tom Daschle’s invitation, I went, along with Laura Tyson, to an issues conference at the Library of Congress that the Senate Democrats were holding to prepare for the budget process. The following day I joined Leon Panetta at the House Democratic Caucus retreat in Farmington, Pennsylvania. I went to the House caucus meeting thinking that I would say what I thought and the members would be pleased that I agreed with them in opposing the size and distribution of the Bush tax cut—more or less what had happened at the Senate discussion. Instead, I was actually attacked. Members responded to my comments by castigating me for not speaking out and providing more of a public voice on their side of the issue. I remember Barney Frank saying, “What you’re doing is terrible.” He was really angry about it.
“First of all, you’re the politicians—I’m not,” I responded. That was true. It seemed appropriate to comment about policy issues I cared about, but I didn’t think I should have to be a public spokesman. Nevertheless, the complaint bothered me, and in the days afterward I thought about what more I could do. Traveling to a Ford board meeting in Detroit, I sketched out a long op-ed article laying out my reasons for opposing the administration’s tax cut. I began by saying that I had not intended to get involved in the public debate on fiscal policy at that point, but I felt strongly that a tax cut of the magnitude Bush had proposed was a serious error in economic policy. The piece appeared in the Sunday New York Times on February 11, 2001. Afterward, there was about a two-week stretch during which eight or ten senators called me. I had never had a period at the Treasury Department when that many senators had called on their own initiative to discuss a policy issue.
Of course, the majority of Democrats who opposed the tax cut didn’t win their fight. The tax cut was highly inefficient as a short-term stimulus—too much went to high-income groups who would spend less of what they received, and most of the cut occurred in later years, which helps little if at all in the short term and damages our long-term fiscal position. The tax cut also undermined our cushion for the unexpected. Within a year, the tragedy of 9/11, the enormous drop in the stock market, and the generally deteriorating economic conditions showed how dramatically unexpected events can affect the country’s fiscal condition.
The debate about what policies would have most effectively dealt with the slowdown will persist for years. The remarkable economic conditions of the 1990s inevitably led to excesses and imbalances—including high levels of consumer and corporate debt, a large current account deficit, and a stock market that was high by any conventional standard—that pointed toward a more difficult period in both financial markets and the economy. However, great strengths—such as low unemployment, high productivity growth, low inflation, and, initially, a strong fiscal position—also persisted. During the slowdown, monetary policy as well as tax cuts and increased spending on both military and homeland security provided strong stimulus to the weak economy. (These tax cuts in 2001 and 2003 could have provided this stimulus in a much less expensive, more effective way—and without long-term damage—had they been better targeted and temporary.) All of that stimulus was likely to lead to a cyclical upsurge. But the overriding questions remain: How well suited were the policy choices made in that period to minimizing the severity and duration of the downturn? And how did those choices affect our economy’s position for the long term? My own view is that on both scores the policy decisions during this time were far from optimal, and that on the second question they have created a serious threat to our future.
I WAS IN my office at Citigroup on the morning of September 11, 2001, when Sandy Weill came into my office and told me a plane had hit the World Trade Center. My first thought was that it must have been a small propeller plane and some kind of freak accident. Then, twenty minutes later, Sandy came in again to say that another plane had hit—and that they were big planes. At that point, it became clear what had happened.
Our first thought was for the several thousand Citigroup employees who worked in the complex, though not in the twin towers themselves. We leased twenty-five floors in 7 World Trade Center, which fell about eight hours later, though thankfully without killing anyone. We also occupied two large buildings several blocks north of the World Trade Center on Greenwich Street, which housed the trading rooms of Salomon Smith Barney, and owned or leased three smaller buildings in the Wall Street area. All of them had to be evacuated. Tragically, we later learned that six Citigroup people who were in the towers on sales calls were killed, and that brought home to all of us in a more personal way the horror of what had occurred.
Sandy quickly organized what turned into a running meeting in one of the conference rooms to manage our crisis response. Our primary focus, after accounting for all of our people, was to continue functioning. As the nation’s largest financial institution, that mattered not just to us but to the entire financial system. We weren’t able to use our Salomon trading rooms on Greenwich Street or any of our other downtown offices. Moving to a backup facility in East Rutherford, New Jersey, kept us operational, but parts of our business still weren’t functioning on September 12. The New York Stock Exchange was closed, initially for an undefined period. The clearing systems at the Bank of New York, an important clearing bank, went down. We were able to make payments, but it wasn’t clear that other financial institutions would be able to make payments to us. We were concerned about the possibility of cascading defaults.
In this instance, the fundamental payment systems and financial systems on which our economy depends continued to function. The Federal Reserve Board acted promptly to make liquidity available to banks until payments could start to flow again. But the warning about how little it would take to create immense financial and economic disruption in this country was clear. Measures have since been taken to reduce this vulnerability, but a complex, modern society is inherently at risk.
IN THE IMMEDIATE aftermath of September 11, there was a great deal of fear about what the attacks might do to the national economy and a great deal of uncertainty on the part of most people about how they should respond. The stock market was closed for several days after the attacks, and no one had any idea how dramatically stocks might fall when it reopened. Many people I spoke to were worried that the shock might have major consequences for asset prices and liquidity.
My own initial reaction was that the attacks could have an immense impact on economic confidence. Consumers, investors, and businesses make their decisions in the context of some framework, whether conscious or unconscious. People go to excesses within that framework, then conditions revert to the mean, and so forth. But the attacks injected new variables that were far outside almost everybody’s previous experience. People needed to develop new parameters—and hadn’t yet. A fundamental change of that kind is very rare and can temporarily stifle economic activity by putting everybody on hold until they can figure out how to relate to the new realities. And given that I had thought the economy—both here and internationally—was in more difficulty before the attacks than most people had, my personal view was that conditions could be even worse than many feared.
In those initial days, I received many calls to go on television and discuss the economic implications. For a week, I declined all invitations. In the first place, I wasn’t sure how to think about this, and I didn’t want to say anything publicly until I was clearer about my views. I also didn’t think that articulating my initial impressions would be helpful. People were looking for some kind of reassurance about the economy. And I didn’t have much that was reassuring to say. However I phrased my views, they could have had the effect of unsettling people further.
But day by day, I kept working through the question of how to think and talk about the economic consequences of September 11, making notes on a legal pad as usual. Given my concerns, the basic problem was how to speak publicly in a way that was truthful but also calming and reassuring. This was an issue I’d faced before. After speaking several times with Gene Sperling, I arrived at the framework of “competing considerations.” On the one hand, the attacks were likely to harm confidence, as well as having a negative impact on various economic sectors, including airlines, hotels, and tourism. The ease and cost of trade would also suffer due to security requirements—and security costs throughout the economy would increase. On the other hand, government spending on the military and security would increase, providing an economic stimulus. The net effect of September 11 on an already troubled economy would be the balance of all such positives and negatives. My notion was to combine that approach for the short term with some kind of affirmative statement about the long-term economic potential of the country—but always noting that realizing this potential would require meeting many challenges. This enabled me to focus again on such issues as long-term fiscal conditions, trade liberalization, education, and the inner cities.
Ad-libbing at a speech I’d been scheduled to give at the Japan Society in New York, I suggested two scenarios. The positive scenario was that even if the United States continued to face a significant terrorist threat in the months and years ahead, any attacks would be of a magnitude that our society could adapt to. Over the course of the following year, the imbalances that had existed prior to 9/11 would work themselves out and the impact of the attack on economic confidence would abate. At the same time, we would have a powerful dose of economic stimulus coming through the system. The result of all this would be that by the third quarter of 2002, confidence would return and the country would be back to a healthy rate of growth. The negative scenario was that terrorist events might continue in some significant way, unsettling economic confidence for a lengthier period of time, and that, combined with the problems that had already existed prior to September 11, would bring about a much more extended period of difficulty.
I had no idea what probability to put on those scenarios. And despite the many predictions people were making about the prospects for the economy, no one else, no matter how well informed, had any real ability to judge the relative probabilities. What I avoided saying that evening was that my private instinct was to give more weight to the negative scenario than the positive one.
Toward the end of that first week, I got a call from Jack Welch, the former CEO of General Electric, who said that Lesley Stahl at CBS had asked him to be on 60 Minutes. The program wanted to have a discussion that would air on Sunday night, before the New York Stock Exchange and other financial markets reopened the next morning. Warren Buffett had agreed to go on, and Jack said he would, too, if I would appear on the program as well.
At first I was inclined not to, because what I had to say, even in the competing-considerations formulation, just didn’t seem constructive. But I did think that the three of us calmly discussing the economy on television might conceivably provide some reassurance, even with my mixed views of the outlook. So I told Jack I’d do it. Then I had a conference call with Ron Klain, Gene Sperling, and David Dreyer. The three of them tried to help me anticipate the kinds of questions I might be asked. Would you buy stock when the market opens, or would you sell? What do you think the market is going to do tomorrow? What do you think people should do with their investments?
My view, as always, was that investments should be made with a long-term view. But that didn’t get me out of answering the questions I was likely to face about my short-term view of economic conditions and of the stock market. I spent a fair bit of time thinking about how to talk about all this. By the time the interview was taped that weekend, I had decided to express my analysis in two conclusions. I thought the odds of a substantial period of difficulty had increased because of the attacks. But I also continued to believe that the long-term potential of the American economy was strong. This seemed both nonalarmist and true to my views.
We had a preparatory conference call before the taping, and Lesley Stahl said, “One question I might ask is, ‘What do you think the market’s going to do on Monday? Would you buy or sell?’ ” Warren gave his answer—he wouldn’t be selling anything when the market opened and might even buy some stocks if they got cheap enough. Then Jack answered, saying that he’d probably hold his stocks, because the United States remained the best place in the world to invest.
Then Lesley said, “What about you, Bob?”
“Well, I don’t want to talk about the market,” I said. I felt that a former Treasury Secretary, whose voice some people might listen to, should exercise care in what he said—especially about stock market levels and the Fed—even after leaving office.
“You’ve got to talk about the market,” she said.
“No, I’m not going to talk about the market.”
“Okay, then I’ll ask you about the Fed and whether they should lower rates,” she said.
“You can do that,” I said. “But I’m not going to talk about the Fed, either.”
“Aren’t you going to talk about anything?” she asked. She was getting very worried. “I want you to be part of the show.”
“Don’t worry, I’ll find things to say.”
So we did the taping, and I did find things to say, though most of what I said was lost in the editing.
THERE WAS BROAD-BASED support across the political spectrum for the President’s military response to terrorism, but the issue of how to deal with the economic impact was much more complicated both substantively and politically. A variety of issues arose. Should the government support the airline industry, the insurance industry, or others affected by September 11? Should the government act to stimulate the economy in some way? If so, with what kind of stimulus—emergency spending, tax cuts, or both? And if tax cuts, what kind of tax cuts? I quickly began getting calls from members of Congress who were grappling with all this.
On the issue of helping specific industries, I thought the general principle was that we shouldn’t have government support for any industry except in extraordinary circumstances. We have a market-based economy and ought to let the market adjust to the new conditions, except for considering intervention if some sector systemically important to our economy may be severely affected. The airlines are systemically important to the economy and were in danger of ceasing to operate because of their mounting losses stemming from a shutdown of several days and weak passenger demand thereafter on top of already weak industry conditions. So I was in favor of doing something that would enable the major air carriers to continue functioning. But the $15 billion package that Congress very quickly passed to help the airline industry seemed excessive and an attempt to make up for poor market conditions that the airlines had been experiencing well before September 11.
The insurance question was complicated. Though the insurers, including Citigroup’s Travelers subsidiary, faced significant losses, the biggest casualty companies were not facing bankruptcy or a major disruption in their business and in my view shouldn’t receive public money to compensate for losses resulting from the attacks. But the industry faced a problem going forward that government did need to address: because of the attacks, insurers were no longer willing to provide coverage for terrorism or war—the losses could simply be too great.
As businesses rethought the probabilities not only of terrorism but also of other geopolitical events, risks were recognized that should have been but hadn’t been before September 11. This is another illustration of the broader issue of dealing with extremely-low-probability events that can have catastrophic consequences if they occur. In this case, the belated recognition of such risks created a serious economic problem. Without the availability of insurance that would cover the risk of another September 11–type attack, construction of new office buildings, shopping centers, and other major structures could be severely impeded. So in one way or another, the government had to become the insurer of last resort for these risks going forward.
This problem—and the need for a public-sector solution to it—is part of a larger principle that I have already discussed. Even in a market-based economy, there are many needs that markets by their nature cannot fulfill. One set of such needs is the risks we socialize because the private sector can’t handle them effectively—whether because the potential losses are too large to be treated actuarially or because a voluntary insurance program won’t work. For example, the Social Security system is designed to provide a safety net both for people too poor to save enough for retirement and for people who might be able to save enough but don’t. Like certain kinds of natural disasters, retirement security for the elderly falls into the category of risks our society has decided to protect against through government. After September 11, the risk of terrorism, which had always been present, was added to that list.
On top of these industry-specific issues, there was also a lot of discussion of moving very quickly on some kind of economic stimulus. September 11 was an extraordinary event that demanded action targeted to the circumstances. But the economic debate that ensued was too often a return to familiar issues. What can happen in such a situation is that people who hold strong positions take any change in circumstances as a new argument for their preexisting point of view. In the first days after the attacks, some long-standing advocates of tax cuts quickly seized the initiative to argue for their usual proposals. The circumstances were changed, but their proposals remained the same. Three specific ideas came to the fore: accelerating the phase-in of the rate reductions included in the Bush tax cut, passing a new reduction in the capital gains rate, and cutting the corporate rate. All of these measures would further undermine the country’s rapidly deteriorating long-term fiscal position. This was precisely the type of situation in which bad policy can easily be made—a sense of emergency, a set of superficially appealing policy proposals, and an eagerness on the part of politicians to act quickly. My view was basically pragmatic: I thought that additional tax cuts intended for stimulus should be temporary and, for reasons not just of fairness but of efficiency, should go to lower- and middle-income people, who had the highest propensity to spend rather than save. I would also have included temporary unemployment benefits and medical coverage for the unemployed, as well as some assistance to cities and states to help with their increased cost—all funds that also would have been spent right away. All of this would provide a more effective stimulus without an adverse long-term fiscal effect.
On September 17, the day after the 60 Minutes broadcast, the New York Stock Exchange reopened and the Dow fell by 7 percent. After the close, I sat for an interview with Tom Brokaw on the NBC Nightly News. Brokaw asked me a series of very straightforward questions. He said something about the capital gains tax cut, and I offered my arguments against it. I didn’t think a capital gains tax cut would add to our economic well-being under ordinary circumstances. Mainstream academic work strongly suggests that the savings rate is relatively indifferent to the tax rate on the return on savings (whether interest, dividends, or capital gains) and thus that reducing the capital gains rate is not likely to increase savings. Similarly, there is little mainstream evidence to suggest that investment rises with lower capital gains tax rates—investment in the stock market increased enormously in the years prior to the reduction in capital gains rates in 1997. My own decades of experience with investors and markets support this. And on the other side of the ledger, a capital gains tax cut does cost the Treasury over time and can create tax-driven distortions in the allocation of investment capital. Perhaps all this analysis would be different if extremely high tax rates were involved, but that was not the case here.
And under the circumstances that existed after September 11, a capital gains cut could have been outright counterproductive, since it might have encouraged people to sell stocks into a falling market. After the program, Gene Sperling said, “Bob, after all the years we were in the White House, that was the first time we’ve ever been able to systematically take on the arguments in favor of a capital gains tax cut in prime time.”
The next day I got a call from Janice Mays, the chief staff person for the House Ways and Means Democrats. The Democrats were trying to figure out what response they should make to the Republican tax cut agenda. Janice said that they’d distributed the transcript of the Brokaw interview to all their members, to help in their arguments against the capital gains tax cut.
The Democrats on the Ways and Means Committee subsequently invited me to Washington to meet with them about these issues. Then House Speaker Dennis Hastert and the bipartisan congressional leadership held a very unusual, formal, closed-door meeting on September 19—inviting the President’s chief economic adviser, Larry Lindsey, Alan Greenspan, and me—to explore possible economic responses to the attacks. That meeting was followed by a closed-door session with the Senate Finance Committee and various other meetings. For a few weeks, I was going back and forth between New York and BWI airport outside Baltimore, since Reagan National Airport remained closed for security reasons.
Moving forward the personal tax rate reductions that were supposed to be phased in under the Bush plan and passing a new reduction in corporate rates were, in my view, like the capital gains cut, immensely flawed ideas. Both would cause further damage to the country’s long-term fiscal position and would be highly inefficient in terms of their short-term stimulative effect relative to their cost. But in the prevailing climate, such proposals clearly had the potential to pass—especially after the Business Roundtable, an influential organization of large corporations, supported the idea of a corporate rate reduction. Democrats in the House and Senate, by contrast, had developed a program that in my view was much better tailored to the problem at hand.
I WOULDN’T HAVE guessed that the stock market would bounce back so quickly in the fall of 2001. The decline in the immediate aftermath of September 11 was never worse than 14 percent. For the month, less than 1 percent of the assets of stock mutual funds flowed out—versus more than 3 percent during the month after the day in 1987 that the market fell 22 percent. On October 11, a month after the attacks, the S&P 500 passed its level of September 10. Soon assets were flowing back into the market again. There was a certain wariness, and later in 2002 and in the first quarter of 2003 the market declined sharply, only to recover strongly in the second quarter. Throughout these ups and downs—exacerbated on the downside by corporate scandals and Wall Street regulatory and governance issues—the market still seemed to me to inadequately reflect economic and geopolitical risks. The imbalances that had grown out of the 1990s also remained largely intact. A major terrorist act had brought to the fore a whole host of destructive possibilities. In this context, stock valuations seemed high by many historical measures.
Indeed, quite a number of advisers and investors, such as Warren Buffett, were saying that equities were likely to provide lower than historical returns for an extended period. Also, bullish forecasts were usually based on projections of strong earnings growth and relatively low interest rates. But the strong economic conditions necessary for strong sustained earnings growth would likely lead to substantially higher interest rates—especially given our long-term fiscal morass. Yet this dynamic seemed not to be on forecasters’ minds.
My interpretation of the market’s behavior was that the psychological forces that had developed over an eighteen-year period persisted despite the significant decline of the market and the substantial losses incurred. In some ways, there was a strange sense of unreality to financial markets in the post-9/11 world. On the one hand, there was a widespread recognition that the world had changed—or, more accurately, a widespread recognition that the world had not been quite what it had seemed to be before the twin towers fell. On the other hand, this newly recognized reality seemed to have less effect than I would have thought on how most people thought about valuation and risk in relation to financial markets—the post-1930s phenomenon in reverse. This may have reflected a tendency of markets both to manifest the expectations of an excessive period long after the conditions that gave rise to the excess were over and not to take into account broader factors that don’t fit within the framework that analysts use in evaluating stocks.
The people with national security backgrounds whom I spoke to were deeply concerned about what the country now faced. I shared a plane ride with Sandy Berger, President Clinton’s pragmatic and insightful national security advisor, who talked at length about the seriousness of the terrorist threat that people were only beginning to recognize. The fanaticism that was developing in segments of the Islamic world could affect our country and our economy very substantially for a long time to come. Terrorism could affect the economy in a whole host of ways—by raising security costs, by making trade more expensive, by increasing oil prices, and by creating political instability in key countries abroad. Beyond the obvious potential for catastrophic events and disruptions is the effect of increased fear and uncertainty on confidence—which is always central to business and consumer behavior, economic conditions, and risk premiums.
Why, after a couple of months, did professional economic forecasters continue to be nearly as positive about the near-term outlook as they had been since the economic slowdown had begun in early 2000? Throughout 2001, most had been predicting that strong action by the Federal Reserve Board to lower interest rates would work relatively quickly to restore healthy growth for the country. Before September 11, I had felt that forecasters were overstating the potential effectiveness of action by the Fed—it is powerful and did ameliorate the slowdown, but it is not omnipotent—and greatly underweighting the impact of continuing economic excesses and imbalances. In the aftermath of September 11, Wall Street economic forecasters acknowledged the potential for future terrorist acts and political conflict abroad. But all of this had relatively little impact on their analysis and predictions, perhaps because they had no way to quantify these risks and because of an inertial tendency to stick with a familiar framework.
Somewhat later, Citigroup hosted a dinner at a Manhattan restaurant for a group of very senior professional money managers. The long and interesting discussion of the outlook for the global economy focused mostly on terrorism and geopolitical matters. But at the end of the evening, when the participants offered their predictions, those predictions reflected frameworks that made no reference to most of what we’d been talking about throughout the dinner. Apparently, their models couldn’t accommodate such risks, so they weren’t included.
What struck me after September 11 was that not only did the forecasts from the leading Wall Street firms tend to be predominantly positive in the face of grave new uncertainties and continued imbalances, but they continued to be the same kind of single-point forecasts that gave a growth rate for the next year as a single number instead of a range. It has always seemed to me that such single-point forecasts imply an unrealistic degree of precision, since the outlook for the future is always a probabilistic array across a broad spectrum. Forecasters presumably recognize the limits on their forecasts, but consumers may be less sophisticated and, in any case, have no basis for judging the odds on a predicted outcome. Life is uncertain. Forecasters who try to predict how much the economy is going to grow next year often fail to take into account not only specific uncertainties, but uncertainty as a guide to life.