Alan Greenspan's Deregulation and Inadequate Regulation Led To Another Bubble

The following is an excellent excerpt from the book “THE PRICE OF INEQUALITY: How Today's Divided Society Endangers Our Future” by Joseph E. Stiglitz from Chapter 4 on page 84 and I quote: “Instability and Output – It is perhaps no accident that this crisis, like the Great Depression, was preceded by large increases in inequality: when money is concentrated at the top of society, the average American's spending is limited, or at least that would be the case in the absence of some artificial prop, which in the years before the crisis, came in the form of a housing bubble fueled by Fed policies.  The housing bubble created a consumption boom that gave the appearance that everything was fine.  But as we soon learned, it was only a temporary palliative.

Moving money from the bottom to the top lowers consumption because higher-income individuals consume a smaller proportion of their income than do lower-income individuals (those at the top save 15 to 25 percent of their income, those at the bottom spend all of their income).  The result: until and unless something else happens, such as an increase in investment or exports, total demand in the economy will be less than what the economy is capable of supplying—and that means that there will be unemployment.  In the 1990s that “something else” was the tech bubble; in the first decade of the twentieth-first century, it was the housing bubble.  Now the only recourse is government spending.

Unemployment can be blamed on a deficiency in aggregate demand (the total demand for goods and services in the economy, from consumers, from firms, by government, and by exporters); in some sense, the entire shortfall in aggregate demand—hence in the U.S. economy—today can be blamed on the extremes of inequality.  As we've seen, the top 1 percent of the population earns some 20 percent of U.S. national income.  If that top 1 percent saves some 20 percent of its income, a shift of just 5 percentage points to the poor or middle who do not save—so the top 1 percent would still get 15 percent of the nation's income—would increase aggregate demand directly by 1 percentage point.  But as that money recirculates, output would actually increase by some 1 and one-half to 2 percentage points.  In an economic downturn such as the current one, that would imply a decrease in the unemployment rate of a comparable amount.  With unemployment in early 2012 standing at 8.3 percent, this kind of a shift in income could have brought the unemployment rate down close to 6.3 percent.  A broader redistribution, say, from the top 20 percent to the rest, would have brought down the unemployment further, to a more normal 5 to 6 percent.

There's another way of seeing the role of growing inequality in weakening macroeconomic performance.  In the last chapter, we observed  the enormous decline in the wage share in this recession, the decline amounted to more than a half trillion dollars a year.  That's an amount much greater than the value of the stimulus package passed by Congress.  That stimulus package was estimated to reduce unemployment by 2 to 2 and one-half percentage points.  Taking money away from workers has, of course, just the opposite effect.

Since the time of the great British economist John Maynard Keynes, governments have understood that when there is a shortfall of demand—when unemployment is high—they need to take action to increase either public or private spending.  The 1 percent has worked hard to restrain government spending.  Private consumption is encouraged through tax cuts, and that was the strategy undertaken by President Bush, with three large tax cuts in eight years.  It didn't work.  The burden of countering weak demand has thus been placed on the U.S. Federal Reserve, whose mandate is to maintain low inflation, high growth, and full employment.  The Fed does this by lowering interest rates and providing money to banks, which, in normal times, lend it to households and firms.  The greater availability of credit at lower interest rates often spurs investment.  But things can go wrong.  Rather than spurring real investments that lead to higher long-term growth, the greater availability of credit can lead to bubbles.  A bubble can lead households to consume in an unsustainable way, on the basis of debt.  And when a bubble breaks, it can bring on a recession.  While it is not inevitable that policy makers will respond to the deficiency in demand brought about by the growth in inequality in ways that lead to instability and a waste of resources, it happens often.

How the government's response to weak demand from inequality led to a bubble and even more inequality – For instance, the Federal Reserve responded to the 1991 recession with low interest rates and the ready availability of credit, helping to create the tech bubble, a phenomenal increase in the price of technology stocks accompanied by heavy investment in the sector.  There was, of course, something real underlying that bubble—technological change, brought about by the communications and computer revolution.  The Internet was rightly judged to be a transformative innovation.  But the irrational exuberance on the part of investors went well beyond anything that could be justified.

Inadequate regulation, bad accounting, and dishonest and incompetent banking also contributed to the tech bubble.  Banks famously had touted stocks that they knew were “dogs.”  “Incentive” pay provided CEOs with incentives to distort their accounting, to show profits that were far larger than they actually were.  The government could have reined this in by regulating the banks, by restricting incentive pay, by enforcing better accounting standards, and by requiring higher margins (the amount of cash that investors have to put down when they buy stock).  But the beneficiaries of the tech bubble—and especially the corporate CEOs and the banks—didn't want the government to intervene: there was a party going on, and it was a party that lasted for several years.  They also believed (correctly, as it turned out) that somebody else would clean up the mess.

But the politicians of the era were also beneficiaries of the bubble.  This irrational investment demand during the tech boom helped to offset the otherwise weak demand created by the high inequality, making the Bill Clinton era one of seeming prosperity.  Tax revenues from capital gains and other income generated by the bubble even gave the appearance of fiscal soundness.  And, to some extent, the administration could claim “credit” for what was going on: Clinton's policies of financial market deregulation and cuts to capital gains tax rates (increasing the returns to speculating on the tech stocks) added fuel to the fire.

When the tech bubble finally burst, the demand by firms (especially technology firms) for more capital diminished markedly.  The economy went into recession.  Something else would have to rekindle the economy.  George W. Bush succeeded in getting a tax cut targeted at the rich through Congress.  Much of the tax cut benefited the very rich: a cut in the rate on dividends, which was reduced from 35 percent to 15 percent, a further cut in capital gains tax rates, from 20 percent to 15 percent, and a gradual elimination of the estate tax.  But because, as we have noted, the rich save so much of their income, such a tax cut provided only a limited stimulus to the economy.  Indeed, as we discuss next, the tax cuts had even some perverse effects.

Corporations, realizing that the dividend tax rate was unlikely to remain so low, had every incentive to pay out as much as they felt that they could do safely—without jeopardizing too much the future viability of the firm.  But that meant smaller cash reserves left on hand for any investment opportunities that came along.  Investment, outside of real estate, actually fell, contrary to what some on the right had predicted.  (Part of the reason for the weak investment, of course, was that during the tech bubble many firms had overinvested.) By the same token, the cut in the state tax may have discouraged spending; the rich could now safely stow away more money for their children and grandchildren, and they had less incentive to give away money to charities that would have spent the money on good causes.

Strikingly, the Fed and its chairman at the time, Alan Greenspan, didn't learn the lessons of the tech bubble.  But this was in part because of the politics of “inequality,” which didn't allow alternative strategies that could have resuscitated the economy without creating another bubble, such as a tax cut to the poor or increased spending on badly needed infrastructure.  This alternative to the reckless path the country took was anathema to those who wanted to see a smaller government—one too weak to engage in progressive taxation or redistributive policies.  Franklin Delano Roosevelt had tried these policies in his New Deal, and the establishment pilloried him for it.  Instead, low interest rates, lax regulations, and a distorted and dysfunctional financial sector came to the rescue of the economy—for a moment.

The Fed engineered, unintentionally, another bubble, this one temporarily more effective than the last but in the long run more destructive.  The Fed's leaders didn't see it as a bubble, because their ideology, their belief that markets were always efficient, meant that there couldn't be a bubble.  The housing bubble was more effective because it induced spending not just by a few technology companies but by tens of millions of households that thought that they were richer than they were.  In one year alone, close to a trillion dollars were taken out in home equity loans and mortgages, much of it spent on consumption.  But the bubble was more destructive partly for the same reasons: it left in its wake tens of millions of families on the brink of financial ruin.  Before the debacle is over, millions of Americans will lose their homes, and millions more will face a lifetime of financial struggle.

Overleveraged households and excess real estate have already weighed down the economy for years and are likely to do so for more years, contributing to unemployment and a massive waste of resources.  At least the tech bubble left something useful in its wake—fiber optics networks and new technology that would provide sources of strength for the economy.  The housing bubble left shoddily built houses, located in the wrong places and inappropriate to the needs of a country where most people's economic position was in decline.  It's the culmination of a three-decade stretch spent careening from one crisis to another without learning some very obvious lessons along the way.

In a democracy where there are high levels of inequality, politics can be unbalanced, too, and the combination of an unbalanced politics managing an unbalanced economy can be lethal.”

(THIS IS WHAT'S BEEN TAKING PLACE FOR MANY YEARS NOW—MOVING MONEY FROM THE LOWER BRACKETS TO THE HIGHER, WEALTHIER GROUPS, CREATING A WIDER DISCREPANCY BETWEEN BOTH GROUPS IN INCOME.  WHILE THE POLITIICANS IN CONGRESS WERE IGNORING THE PROBLEM, ALONG WITH THE RATINGS AGENCIES, SUCH AS STANDARD & POOR'S, MOODY'S ETC.,  THREE-QUARTERS OF THE POLITICIANS DIDN'T DO ANYTHING TO CORRECT THE GROWING PROBLEM.  THAT EVEN INCLUDES FORMER FED CHM ALAN GREENSPAN, WHO HELPED CREATE A GROWING FINANCIAL BUBBLE THROUGH THE USE OF UNREGULATED TOXIC DERIVATIVES.  HEDGE FUND DEALERS, PRIVATE EQUITY,  AND VENTURE CAPITALISTS ARE PROMOTING THE SAME RECKLESS PRACTICES.  NOW, WHILE I NOTICED IN OUR LOCAL PAPER, FEBRUARY 5, 2013, AN ARTICLE WRITTEN BY MARCY GORDON, AN AP BUSINESS WRITER FROM WASHINGTON TITLED “S&P EXPECTING LAWSUIT” SAID THAT JUSTICE IS GOING TO BRING A CIVIL LAWSUIT AGAINST STANDARD & POOR'S, WHICH WILL HOPEFULLY CHANGE THEIR WAY OF DOING BUSINESS BUT UNLESS THEY'RE MONITORED, BY ELECTED OFFICIALS THAT ACTUALLY TALK TO THEIR VOTERS, I DOUBT MUCH WILL CHANGE BECAUSE MOST AGENCIES WERE NEVER FINED OR FIRED.  THE PLIGHT OF the POOR WILL EVEN CONTINUE TO GET WORSE.  CAN YOU IMAGINE, I SAW ON TV's “INSIDE EDITION,” THAT 1.000 PEOPLE WERE LIVING IN THE SEWERS UNDER THE STREETS OF LAS VEGAS, WHICH AIRED ON JANUARY 28, 2013.  WHEN I GET MAIL FROM MY ELECTED OFFICIALS,I'D LIKE TO KNOW HOW THEY ARE GOING TO CORRECT THESE PROBLEMS, BUT MANY TIMES, ALL THE LETTER SAYS IS THAT THEY NEED MORE MONEY TO RUN FOR THE NEXT ELECTION CYCLE AND NOTHING GETS DONE.  THE PROBLEMS KEEP GETTING WORSE AND THE RICH KEEP GETTING RICHER.

 

LaVern Isely, Overtaxed Independent Middle Class Taxpayer & Public Citizen & AARP Members

 

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