12

The 2000s: The Job-Loss Recovery and the Bubbles

And the cornerstone of my economic policies, when I first got elected, was cutting taxes on everybody … who paid taxes.

—GEORGE W. BUSH INTERVIEW WITH LARRY KUDLOW, 2010

The productivity surge discussed in the previous chapter, in concert with what became known as the dot.com bubble in the stock market, were major drivers of the fabulous macroeconomic performance of the late 1990s. The productivity part was solidly based and lasted well into the 2000s.¹ You can see it in the data today, although as mentioned, Alan Greenspan perceived it well before it appeared in the data. There is also little doubt that the commercialization of the internet played a major role in the productivity surge.²

The Dot.com Boom and Bust

The stock market’s infatuation with dot.coms in 1998–2000 took an underlying reality and ran wild with it. Even at the time, many observers believed that stock traders had lost touch with any semblance of fundamental values. Market valuations for companies with no current earnings, and in many cases poor prospects for ever having earnings, soared to incredible heights. Ordinary people who had no business doing so became day traders. That a bubble was inflating was obvious to almost everyone. The only questions were when it would burst and how hard. Brave (or foolish) investors decided to ride the bubble for as long as they could. As is common in such crazes, too many “investors” thought they could be among the first out the door.³

Figure 12.1 offers a highly subdued picture of the stock market bubble by comparing the performance of the Nasdaq index (where most of the new tech stocks were traded) with that of the Dow Jones Industrial Average (the bluest of the blue chips) over the decade 1995–2005. Though subdued, the picture is still dramatic. You can barely discern what was actually a sizable bubble in the Dow, which rose from just over 3,800 at the start of 1995 to a peak around 11,500 in January 2000 (thus tripling in five years) before tumbling to roughly 7,500 (approximately its November 1997 value) by October 2002, a decline of 34 percent.⁴

But this rise and fall was dwarfed by the wild ride of the Nasdaq, which skyrocketed from roughly 750 at the start of 1995 to over 1,900 in July 1998, up more than 150 percent in just three and a half years. The party was just getting started, however. The dot.com craze really took off late in 1998, driving the Nasdaq to a dizzying peak of over 5,000 on March 10, 2000, an additional gain of 157 percent in under two years. Do the math. It multiplies to a mind-boggling 567 percent rise in the Nasdaq in little more than five years. Of course, the truly insane valuations of March 2000 couldn’t and didn’t last. By September 2001 the Nasdaq was back down to about 1,600, right where it had been at the start of 1998. It continued to fall, however, bottoming out at 1,242 in October 2002, thus making the peak-to-trough decline about 75 percent! The index did not return to the 5,000 range until the summer of 2016.

FIGURE 12.1. Two stock market indexes, 1995–2005.

Source: S&P Dow Jones Indices and NASDAQ OMX Group.

The Nasdaq is an average of many stocks. The ascents and subsequent declines of some of the individual dot.coms were far more spectacular. Priceline, which turned out to be one of the survivors, went public in March 1999 and saw its share price double in a month to over $900. At the time, all the company did was sell discounted airline tickets. The New York Times reported at the time that “Priceline, which lost $114 million last year selling $35 million worth of airline tickets, is now worth more than the United Airlines, Continental Airlines and Northwest Airlines combined” (Hansell 1999). A bit richly priced, perhaps? By the end of December 2000, Priceline shares had plummeted to $6.75, a drop of more than 99 percent. The company survived, however, and remains in business today as Booking.com.

Many other dot.coms simply vanished from the face of the earth. One well-publicized example was Webvan, which was founded in 1996 on a not-very-original idea: delivering groceries to customers’ homes. That’s a good idea, of course, but home delivery of groceries had been going on for a century or so (Muller 2015). Could ordering over the internet really be so superior to ordering by telephone? Apparently not. Webvan began deliveries in the San Francisco Bay area in June 1999, investing heavily in warehouses, trucks, and advertising in an effort to “get big fast” (the celebrated Amazon model). At the time of its initial public offering in November 1999, Webvan had logged cumulative sales of $400,000 (yes, that’s thousand, not million). Yet the initial public offering valued the company at more than $4.8 billion. Webvan filed for bankruptcy in June 2001.

FIGURE 12.2. Annualized real GDP growth rates, quarterly, 1999–2003.

Source: Bureau of Economic Analysis.

When the stock market crashes as hard as it did in 2000–2001, it is not surprising if a recession follows—and it did. However, the 2001 recession was both short (only eight months long) and shallow, so shallow in fact that it disappears if you look only at annual data: real GDP was actually 1 percent higher in 2001 than in 2000. You have to peer closely at quarterly data to find two slightly negative quarters, 2001:1 (a −1.1% seasonally adjusted annual rate) and 2001:3 (−1.7%). Those two quarters are not even consecutive (figure 12.2). But the National Bureau of Economic Research (NBER) business cycle dating committee, which looks at a myriad of data series, not just GDP, decided to call it a recession anyway. I have long called it the recessionette.

The Election of 2000 and Tax Cuts

A soaring stock market, burgeoning federal budget surpluses, and a booming economy formed the economic backdrop of the 2000 presidential campaign. That election ended in a virtual tie between Vice President Al Gore and Governor George W. Bush of Texas.⁵ Booming economies help incumbents, and as Bill Clinton’s vice president, Gore was almost an incumbent, just as Bush’s father had been in 1988. Yet Gore chose to run away from Clinton rather than toward him, presumably due to the taint of the Monica Lewinsky scandal. It was a costly political error; Clinton was extraordinarily popular at the time.⁶

Gore did, however, embrace the Clinton administration’s signal achievement, which he called “balancing the budget.” Curiously, Clinton, Gore, and other politicians of the day preferred to speak of balanced budgets rather than budget surpluses. Perhaps they thought that negative numbers were too complex for political discourse, or perhaps they just thought that “balancing the budget” had a nicer rhetorical ring. Political messaging aside, official budget projections in 2000 showed surpluses “as far as the eye could see.” For example, the Congressional Budget Office’s (CBO) ten-year projection issued in July 2000 envisioned budget surpluses not just continuing but actually growing larger through fiscal 2010 (CBO 2000). What to do with these surpluses became a major issue in the campaign.

Gore’s platform included a plan to pay off the entire national debt by 2012. Given what happened thereafter, that sounds like a bad joke. But serious people at the time were ruminating about the problems that might arise if and when there was no longer any Treasury debt outstanding. One of those serious people was Alan Greenspan (Greenspan 2007, 217–18). Among the many novel questions was how the Federal Reserve would conduct monetary policy in a world with no Treasury debt. As an early down payment on the eventual elimination of the national debt, Gore pledged to set aside funds for Medicare, Medicaid, and Social Security in a figurative “lock-box,” a metaphor that apparently lent itself to political ridicule. Inelegant messaging aside, Gore clearly ran as the fiscal conservative in the race. True to Clinton’s observation, the Democrats had become the party of Eisenhower Republicans.

In stark contrast, Bush and the Republicans of 2000 were not heirs to the Eisenhower legacy. Like Ronald Reagan twenty years earlier, George W. Bush campaigned on enacting large tax cuts, arguing, among other things, that the government should not take more money from people than it needed to pay its bills. As he opined in his August 2000 acceptance speech at the Republican National Convention, “The surplus is not the government’s money. The surplus is the people’s money” (Bush 2000). And it should go back to them.

Candidate Bush sometimes seemed to suggest that his proposed tax cuts would (almost?) pay for themselves with faster economic growth, thereby echoing the false assertions of the supply-siders of a generation earlier (Krugman 2001). When Gore attacked the tax cut proposal as a “risky scheme,” Bush famously countered that Gore was using “fuzzy math.” In sum, George W. Bush, like Reagan before him, ran on a highly expansionary fiscal plan despite a strong economy that did not need stimulus. They were perhaps Lyndon Johnson Republicans.

This sharp partisan difference in fiscal policy between Bush and Gore played a prominent role in the campaign, which ended in a virtual dead heat on election day. Initially Bush was declared the victor by the media, a call that was quickly withdrawn due to disputes over the vote in Florida. It took a harrowing thirty-six days to resolve the mess, which the U.S. Supreme Court finally did on December 13, 2000, by ordering a halt to a recount that was then in progress in Florida. Bush was thereby awarded Florida by a margin of 537 votes out of over 5.8 million cast in the Sunshine State. That slim margin was enough to give him 271 electoral votes and victory in the electoral college even though Gore had won the national popular vote by about 540,000 votes.

The days between the election and the January 2001 inauguration were tumultuous and unsettling, filled with huge political uncertainties and marred by a feeling among many Democrats that Gore had been robbed of the White House. This tumult may have contributed to the small decline in real GDP that took place in the first quarter of 2001 (−1.1% at an annual rate).⁷ That’s impossible to know. But a short, shallow recession began in March, although the NBER did not declare the start of the recession until November 2001, which was the month the recession ended.

The weak macroeconomic performance of early 2001 presented President Bush and his team with an entirely new rationale for a major tax cut: it would provide a Keynesian stimulus (though they abjured the adjective) for a sluggish economy. Never mind that Keynesianism was the antithesis of supply-side economics. “With the economy in a slump, a senior White House adviser said, the administration simply believes that the Keynesian rationale for a tax cut has the best chance of winning public support” (Leonhardt 2001).

The tax bill that Bush signed into law in June 2001 was comprehensive. It reduced income tax bracket rates (for example, the top marginal tax rate dropped from Clinton’s 39.6% to 35%), doubled the child tax credit, phased in a repeal of the estate tax, reduced the so-called marriage penalty, and more. Bush’s original request was scored by the CBO as losing $1.6 trillion in revenue over ten years, or almost 1.5 percent of GDP.

However, that sum was soon whittled down to $1.35 trillion over nine years by some creative accounting. To avoid a filibuster in the Senate, Republicans incorporated the tax bill into the congressional budget resolution; but that required it to include a sunset clause. The budget window then (as now) was ten years, so legislating tax cuts that would sunset after nine years reduced the CBO score substantially and did not carry the revenue loss over into the following ten years. Of course, neither Bush nor congressional Republicans intended the tax cuts to disappear, and that set the stage for future budget battles. Nor did the administration offer any pay-fors; the entire revenue loss went straight into the budget deficit.

Among the more interesting sidelights of the tax debate in 2001 was the active participation of Federal Reserve Chair Alan Greenspan. Greenspan, as we have seen, had gotten along famously with Bill Clinton. But Greenspan was a Bush Republican at heart. In congressional testimony just days after George W. Bush’s inauguration, the Fed chair all but endorsed the new president’s tax cut proposals, partly on the grounds that once the government had paid off the entire national debt, continuing budget surpluses would force it to buy private assets, something Greenspan found abhorrent.

Was he really so naive as to believe that Congress in the twenty-first century would allow surpluses that large to persist for years, as it had in the nineteenth century? Students of Congress rolled their eyes in disbelief, and we know that Greenspan had a keen political sense (Woodward 2000). Democrats opposed to the tax cuts were enraged at what they saw as rank partisanship from the Fed chief. Economists who valued the separation of monetary policy from fiscal policy winced at the idea that Congress might return the favor by interfering in monetary policy. Greenspan himself later admitted that his congressional testimony in support of tax cuts “proved to be politically explosive” even though (he claimed) “politics had not been my intent.… I’d have given the same testimony if Al Gore had been president” (Greenspan 2007, 220, 222). Many of us on the Gore team wondered about that claim.

Regardless, this overt involvement in fiscal decision making was something new for a Fed chief. Prior to the Clinton presidency, Federal Reserve chairs had grown accustomed to fending off attempted encroachments on their territory from the fiscal authorities. They didn’t like White House interventions, though they expected them. Now Greenspan, taking full advantage of his exalted status as the nation’s economic guru, seemed to be poaching into the territory of fiscal policy and on a hotly partisan issue to boot. Many observers of monetary policy felt that this was unwise.⁸ President Bush, however, was delighted: “I was pleased to hear Mr. Greenspan’s words. I thought they were measured and just right” (Berry 2001).

Curiously, the Fed chair eschewed what could have been a plausible Keynesian rationale for the 2001 tax cuts, even though the U.S. economy was weakening at the time and the Fed was reducing interest rates to bolster demand. The Federal Open Market Committee (FOMC) began a series of rate cuts on January 3, 2001, by lowering the funds rate from 6.5 percent to 6 percent. It then continued to cut rates aggressively throughout the year and then once more in 2002 and a final time in 2003, eventually pushing the funds rate all the way down to 1 percent by June 2003.

Fiscal policy was not passive during this period either. Not content with the 2001 tax cuts, which turned out to be exquisitely timed from a countercyclical perspective, the president followed with more tax cuts in 2003. The reductions in bracket rates that were scheduled to be phased in by the 2001 act were accelerated, as were depreciation allowances. Tax rates on capital gains and “qualified” dividends (which covered most of them) were lowered. The revenue losses from the 2003 act were smaller than their 2001 counterparts. And just as in 2001, the Bush administration did not propose any pay-fors. Doing so was made easier by the fact that the PAYGO law had expired in 2002.

The 9/11 Attacks and the Job-Loss Recovery

George W. Bush had been president for less than eight months when terrorists struck the World Trade Center in New York City and the Pentagon. Nearly three thousand lives were lost on September 11, 2001, and the nation, it is fair to say, was thoroughly traumatized. It was, after all, an attack on the American mainland, something Americans had not witnessed since the War of 1812. While accustomed to sending soldiers to fight overseas, U.S. citizens were not accustomed to defending the homeland. It was widely claimed at the time and since that 9/11 changed everything. In many respects it did. America has not been the same nation since, and 9/11 remains a searing memory to this day.

But from the narrow perspective of macroeconomics, 9/11 didn’t change much. Figure 12.2 displays the growth rate of real GDP, quarter by quarter, from 1999 through 2003. The two negative quarters in 2001 stand out; the second of these (2001:3) is the 9/11 quarter. But remember that the terrorist attacks occurred late in the quarter, too late to have much of an effect on third-quarter data. By the fourth quarter, when you might have expected 9/11 to have its greatest impact, growth was positive again though barely so. And by 2002, the economy was clearly heading uphill. Taking a broader perspective, GDP growth over the ten quarters prior to 2001:3 averaged 3.25 percent. Over the ten quarters after 2001:3 it averaged 2.9 percent. That’s lower but hardly a sharp break in trend.

Nor did 9/11 change fiscal or monetary policy much. The Fed, as noted earlier, was reducing interest rates aggressively before 9/11 and continued to do so thereafter. The Bush administration continued to promote tax cuts, just as it had before 9/11, and succeeded in getting more of them enacted in 2003. Real spending on national defense rose by about 15 percent over the two years following 9/11. But most of that was attributable to the ensuing war in Afghanistan (a direct response to the terrorist attacks) and, even more so, to the subsequent war in Iraq (which was a response to what?). Overall, however, the biggest changes in fiscal policy under President George W. Bush came on the tax side. The CBO’s estimates of tax receipts without the effects of the automatic stabilizers (thus controlling for cyclical influences) fell from 19.7 percent of GDP in fiscal 2000 to just 15.8 percent of GDP in fiscal 2004. That huge swing dwarfed changes on the spending side, which were just 0.6 percent of GDP over those same four years.

In sum, neither monetary nor fiscal policy shows any major discontinuity around 9/11. What did change after 9/11, but probably not because of 9/11, was the behavior of the U.S. labor market. As we saw in the previous chapter, a “jobless recovery” plagued President George H. W. Bush in 1991–1992. It may well have cost him the election. Job performance was even worse for his son, President George W. Bush. After the 2001 recession, the economy embarked on what was at first a job-loss recovery. Output grew but employment fell. Output per hour grew instead.

FIGURE 12.3. Payroll employment, monthly, 1990–2005.

Source: Bureau of Labor Statistics.

Figure 12.3 displays monthly data on payroll employment from 1990 through 2005. From March 1991 (the NBER trough) through March 1992, net job growth was essentially zero. Then the job market snapped back to life, and the economy added about 1.6 million net new jobs over the following year. After the minirecession of 2001, by contrast, the economy continued to lose jobs, albeit at a slow rate, for most of the next two years. Not until January 2005 did employment finally regain its March 2001 level. Huge uncertainties owing to, first, 9/11 and then the 2003 war in Iraq may have contributed to firms’ reluctance to add to their payrolls.

Fiscal Indiscipline under Bush

George W. Bush’s fiscal policies turned out to be among the most profligate in U.S. history to that point. His precedent of not “paying for” tax cuts in 2001 and 2003 was quickly extended to not paying for the wars in Afghanistan and Iraq and even to his expansion of Medicare to include prescription drugs. Medicare Part D was originally proposed by Bill Clinton in 1999 but rejected by congressional Republicans at the time. With drug prices rising sharply, Bush revived the idea in 2002 and 2003, and it received a far warmer reception from the Republican-controlled Congress. Medicare Part D became law in November 2003 and went into effect on January 1, 2006.

From a fiscal policy perspective, the unique thing about Part D is that unlike the rest of Medicare and most other entitlement programs, the law provided no source of funding. The costs for the new drug benefit would just be tacked onto the budget deficit. The CBO’s original published cost estimate was about $400 billion over the ten fiscal years 2004–2013 (CBO 2004a), but that was a highly misleading figure because drug benefits did not start until the second quarter of fiscal 2006. Had the CBO started the count in fiscal 2007 instead, the projected ten-year cost would have topped $600 billion. (For reference, $60 billion a year in those days amounted to about 0.4 percent of GDP.) And, of course, the bill for Part D would keep growing over time (CBO 2014).⁹

When you put all the Bush fiscal policies together and remove the effects of the automatic stabilizers, the CBO estimates that the fiscal 2000 budget surplus of 1.1 percent of GDP was transformed into a budget deficit of 2.8 percent of GDP by fiscal 2008 (a fiscal year that ended just days after the Lehman Brothers bankruptcy). Of course, Bush and his advisers could not have known in 2001 or 2004 that huge fiscal stimulus would be necessary in 2008–2010 to fight the worst recession since the 1930s. Nonetheless, the burgeoning deficits of the 2000–2007 were ill-timed for reasons Al Gore had highlighted in his presidential campaign: the leading edge of the populous baby boom generation would start turning sixty-five late in 2010, making huge demands on both Medicare and Social Security. Nothing was more predictable than that: you just had to add 65 to 1945 to get 2010. Yet, this inexorable piece of demography was basically ignored by Bush and his administration’s fiscal policy makers.

Monetary Policy and the House-price Bubble

Turning to monetary policy, the failure of jobs to return after the recessionette was probably the main reason why the FOMC continued to cut the federal funds rate (albeit only slightly) in 2002 and 2003 and then maintained it at the superlow level of 1 percent until June 2004. With Consumer Price Index inflation averaging about 2.5 percent during this time, the real federal funds rate was sharply negative.

The Federal Reserve has been subjected to withering criticism for being slow on the interest rate trigger as the house-price bubble inflated in 2003 and 2004.¹⁰ However, the central bank had a good reason for being slow: the economy was not generating jobs. To cite just one example, at the January 2004 FOMC meeting when the committee held rates steady yet again, Vice Chair Roger Ferguson noted that the “good news [on aggregate demand] must be tempered by a clear understanding that firms are not yet creating jobs as quickly as we would like” (FOMC 2004, 158). Even later in 2004 when net new jobs finally started to appear, the (annualized) rate of job growth was a mediocre 1.6 percent.

Furthermore, the FOMC had used forward guidance to give market participants hints that rate hikes were on the way well before it started to raise rates on June 30, 2004. It was on March 19, 2003, that U.S. forces struck Iraq with their “shock and awe” campaign. On May 6, 2003, a concerned FOMC shifted its assessment of the balance of risks to “weighted toward weakness over the foreseeable future.” But by the December 9 meeting, the risk assessment was once again balanced. That was already a subtle hint that rate hikes were likely once the fog of war lifted, and similar hints persisted until the FOMC actually raised rates on June 30, 2004, stating that “the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.”

Finally, hindsight is far clearer than foresight. As we look at the data today or indeed as people looked at them in 2008 or 2009, it is evident that a house-price bubble—fueled by irresponsible mortgage lending—began sometime around the year 2000. But what would become a big bubble was minor at first, and bubbles are hard to recognize in real time—especially when the fundamentals are improving, thereby justifying higher prices.

In writing my book After the Music Stopped (Blinder 2013) on the financial crisis, I scoured both scholarly writings and media accounts for early alarms about a house-price bubble. I found only scant warnings in 2002 and virtually none before that. Even the celebrated bubble finder, Professor Robert Shiller of Yale, was not convinced in the fall of 2003 that the United States was experiencing a house-price bubble (Case and Shiller 2003). Bubble warnings became common only in 2004, the year the Fed started raising interest rates. As I wrote in my 2013 book,

It is not hard to understand why most of us—including me—missed the early stages of the house-price bubble. America had witnessed comparable price increases in its history. Mortgage interest rates had fallen, which should boost house prices for perfectly conventional fundamental reasons.

So, even with the magnificent wisdom of hindsight, it is not obvious that house prices were bubbly in 2002 or 2003. How much harder, then, must it have been to tell in real time?

As late as October 2005, as keen an observer as Ben Bernanke, who was then Chairman of President Bush’s Council of Economic Advisers, declared that while “house prices have risen by nearly 25 percent over the past two years … these price increases largely reflect strong economic fundamentals.” While Bernanke was wrong … he was not alone in this judgment. (Blinder 2013, 33–35)

So, I am not inclined to fault the Fed for failing to raise interest rates in 2002 and 2003. (Its inexcusable regulatory failures, which it shared with other agencies, are another matter entirely.) And once the central bank started raising rates, it kept at it for a full two years. The initial liftoff from the 1 percent funds rate came at the end of June 2004. By the end of that year the rate was up to 2.25 percent. By the end of 2005 it was 4.25 percent, and it topped out at 5.25 percent in June 2006. All told, the FOMC pushed interest rates up by 425 basis points in two years. Was that enough? Did it come too late? Indeed, was the Fed’s easy-money policy in 2001–2003 among the root causes of the bubble?

Those questions will be debated for years. John Taylor and others were highly critical of the Fed’s “loose money” policy in this period (Taylor 2009a). My own view exonerates the Fed on the monetary policy side, though decidedly not on the regulatory side. It is based on four indisputable facts plus one assertion.

The first and most important fact was mentioned earlier: The recovery from the 2001 recession was not creating jobs in 2002 and 2003, despite meaningful fiscal stimulus. So the Fed, with its dual mandate, had good reason to keep interest rates low. Second, the house-price bubble was inflating well before the Fed dropped interest rates to the floor. That makes you wonder how important superlow interest rates were to feeding the bubble, though they certainly played some role. Third, the bubble continued to inflate for at least two years after the Fed started raising rates. So, do we really think the bubble would have been stopped by raising rates, say, a year earlier? And fourth, other countries such as the United Kingdom had house-price bubbles as big as or bigger than ours despite higher central bank interest rates. Those facts cast serious doubt on the notion that tighter money in, say, 2002 or 2003 would have curbed the U.S. house-price bubble.

My assertion is this: With popular expectations of house-price inflation running at 10–20 percent per annum,¹¹ a monetary tightening that pushed mortgage rates up by, say, 1 or 2 percentage points would not have been nearly enough to stop the bubble in its tracks. To accomplish that, much higher rates would have been needed, and that much tightening might have killed the economy. Instead, real GDP continued to grow in 2005, 2006, and 2007. The data shown in figure 12.4 suggest that the Fed’s interest rate medicine in 2004–2006, which works with long lags, may well have slowed the economy moderately. But its effects on the bubble were more dubious. Should the Fed therefore have tightened by much more than it did and likely have precipitated a recession? I think not.

Regardless of where you stand on the Fed’s culpability for the house-price bubble or what it might have done better, the central bank’s reactions (or lack thereof) to the bubble reignited a debate that had raged during and after the tech stock bubble a few years earlier: Should a central bank fight asset-price bubbles by raising interest rates?

FIGURE 12.4. Real GDP growth rates, fourth quarter to fourth quarter, 2003–2007.

Source: Bureau of Economic Analysis.

On the “yes” side, there are two indisputable propositions. First, bubbles do eventually burst. History speaks with one voice on this point, although it also tells us that when any given bubble will burst is never predictable. Second, when bubbles burst, they do cause economic damage to families, investors, pension funds, homeowners (if they are housing bubbles) and, if they are big enough, to the entire economy. So, it follows that if the central bank can recognize bubbles in time and if it has weapons to deflate them without killing the economy, it should use them.

Those are two very big ifs, however. As we have just seen, the house-price bubble of 2000–2006 in the United States was not widely recognized until at least 2005. By then it was too late. Or think back to the dot.com bubble. When did stock prices become excessively bubbly? In 1998? Probably not. Sometime in 1999? If so, then when? In early 2000? By then it was far too late. And by the way, was there ever a serious bubble in nontech stocks anyway?

That last question shines a spotlight on the second big if. As a rule, the central bank does not possess well-targeted instruments that it can deploy against particularly bubbly assets even if it thinks it knows which ones to target. The rising stock market in 1999 provided a clear example. Suppose FOMC members had been convinced sometime in 1999 that there was a bubble in tech stock prices but not in nontech stock prices, something they may well have believed. What could policy makers have done? Answer: Nothing. Or take the house-price bubble of the 2000s. Raising the funds rate would no doubt have pushed up mortgage interest rates. But how soon and by how much? Might a sharp tightening of monetary policy have broken the economy’s back before it burst the house-price bubble?

If there is anything resembling a consensus on bubble bursting today, it runs something like this. When equity-financed bubbles burst, a great deal of wealth gets destroyed. But the damage may be contained within the stock market, where it is mostly limited to upper-income households who can weather the storm.¹² The legend of 1929 notwithstanding, even a severe crash of the stock market need not cause a deep recession.¹³ As we saw in chapter 9, the devastating (to equity prices) crash of 1987 did not even slow the economy’s forward momentum. The sharp stock market crash of 2000 may well have contributed to the 2001 recession, but, as noted, that recession was one of the gentlest on record.

The other, more dangerous, type of bubble is a debt-financed bubble involving lots of leverage, exactly the type that inflated alarmingly in 2005–2007. When debt-based bubbles burst, creditors of all types are hurt, and cascades of defaults and bankruptcies may follow. Such debt-based bubbles can in principle originate anywhere. But more often than not they come from the real estate sector, where high leverage is a way of life (Turner 2016). Falling real estate values lead to mortgage delinquencies and defaults and thereby to loan losses for banks that hold these mortgages and to capital losses for holders of mortgage-based securities.

Furthermore, when the debt bubble burst violently in 2007–2008 (see the next chapter), we all learned that a complex and highly leveraged mountain of derivatives had been constructed atop these mortgage-based securities, thereby greatly magnifying the losses. Those frightening events imperiled banks and other financial institutions in a way that the stock market crashes of 1987 and 2000–2001 never did. Thus, the case for leaning against debt-financed bubbles is much stronger than the case for leaning against equity-financed bubbles. That said, such “leaning” probably means doing so with regulatory or macroprudential tools more than by raising interest rates. Blunt instruments cause collateral damage.

Chapter Summary

The 2000s up until 2008 was a period in which the idea of using fiscal policy as a countercyclical measure was basically shunned, just as it had been in the 1990s. However, in stark contrast to the Clinton years, when the focus on reducing the deficit turned chronic budget deficits into surpluses, the Bush II years saw the surplus quickly disappear and large deficits reemerge. Part of this fiscal transformation came because economic growth slowed and capital gains plummeted; both cut into tax receipts. But much of the fiscal deterioration stemmed from a series of policy decisions made in George W. Bush’s first term, when tax receipts were slashed and budgetary outlays leaped upward. Here is one small indicator: As Bush took office in January 2001, the CBO’s projection for fiscal year 2008 was for a surplus of $635 billion (CBO 2001). Three years later in January 2004, the projection for fiscal year 2008 was for a deficit of $278 billion (CBO 2004b). The fiscal picture had indeed changed mightily.

On the monetary policy side, by contrast, the main story of the 2000s was continuity. Alan Greenspan remained chair of the Federal Reserve through January 2006 and continued his policy of fine-tuning in deed though not in word. For example, the FOMC raised the federal funds rate by exactly 25 basis points at each of Greenspan’s last fourteen meetings in the chair. Baby steps, you might call them. There was not a single 50 basis–point move or a single zero during that streak.

When Ben Bernanke assumed the chairmanship on February 1, 2006, he was an untested economics professor replacing a central banking legend. So, it was only natural for Bernanke to project continuity with the Greenspan era, which is precisely what he did. The Fed funds rate went up by 25 basis points at each of Bernanke’s first three FOMC meetings too. Things would start to change dramatically at the Fed in 2007, but that is a story for the next chapter.

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1. There is controversy to this day about the end point of the period of rapid productivity growth. I prefer 2010; others prefer a much earlier end date, such as 2004.

2. Among many sources that could be cited, see Oliner and Sichel (2002).

3. For many earlier historical examples, see Kindleberger (1978).

4. Stock market numbers in this and the next paragraph are monthly averages.

5. Full disclosure: I was principal economic adviser to Al Gore’s presidential campaign.

6. Clinton’s approval rating hovered near 60 percent throughout the campaign, according to the Gallup poll. See Gallup Organization (2001).

7. Growth rates in the quarters just before and just after were 2.5 percent and 2.4 percent, respectively.

8. See, for example, Sperling (2001).

9. That said, as projections turned into actual spending numbers in the ensuing years, Part D expenditures came in lower than expected. See CBO (2014).

10. For one example, see Taylor (2009a).

11. For some examples, see Blinder (2013, 36–37).

12. In fairness, another class of victims would be pension funds, which are heavily invested in equities.

13. The notion that the stock market crash of 1929 caused the Great Depression is a vast exaggeration. Were it not for other factors, the crash probably would have caused a recession at most.