But that's not the way it happened!
On the very first page of the preface of his new book, The Roaring Nineties, Joseph Stiglitz writes:
...the idea for this book was hatched as I considered stories [about the Clinton administration] that were not so widely available, or so well understood. The recovery from the 1991 recession, for instance, seemed to defy what was universally taught in economics courses around the world. The popular version, trumpeted by some within the Clinton administration, claimed that deficit reduction... had brought about the recovery, yet standard theory said that deficit reductions worsened economic downturns...
Stiglitz is here setting the stage for his argument--which will reach its conclusion on page 44--that the Clinton administration's deficit-reduction program was a mistake. But the story that he tells is not the story that happened.
First of all, Stiglitz's last clause in the quote above is simply wrong. There was never any theoretical prediction that the Clinton deficit-reduction program would send the economy back into recession in 1993 and 1994. The deficit reduction program did not cut the current-year deficit but the deficit three and more years in the future. Standard theory says that cutting the current deficit worsens downturns, but it also says that cutting the expected future deficit three, five, ten years down the road boosts investment and improves the current situation. The standard theory that says that deficit reduction worsens downturns refers to the contemporary deficit. The claims that the Clinton deficit-reduction program boosted the economy refer to the expected future deficit.
It did, after all, take the Clinton deficit-reduction program five years to phase itself in. The reduced future deficits people expected did lead them to believe that the Federal Reserve would keep interest rates lower longer. Bond prices did rise, and long-term interest rates did fall. With bond prices higher, banks that owned bonds were in better financial condition and proved willing to lend more, while companies seeing low interest rates proved willing to borrow more to finance investment. The result? The deficit-reduction program did play a role in the investment boom and the high-investment, high productivity-growth recovery of the 1990s--as standard theory did predict.
The other clauses in the Stiglitz quote above clearly and strongly imply that this "popular version"--the version I have just told, the version that takes Clinton's deficit-reduction program to have been good policy--is wrong. It implies that this version was "trumpeted" by "some" for political reasons. And it implies that Joe Stiglitz is here to tell the real story.
What does Joe Stiglitz think is the real story? Skim ahead to page 44. Discussing the aftermath of the passage of Clinton's 1993 deficit-reduction program, Stiglitz writes:
...owing in part to Clinton's success in cutting [expectations of] the [future] deficit, long-term interest rates fell sharply.... The price of long-term bonds increased.... [T]he banks saw a sharp improvement in their balance sheets. And because long-term interest rates were now low, making long-term bonds... less... attractive... the banks... went back to their real business, which is lending. It was the banks' increased readiness to give credit that made the real difference, and it was the Clinton administration's deficit reduction plan, and its inadvertent effect of recapitalizing the S&Ls, that got the economy back on track. Deficit reduction might be described, then, as a lucky mistake--a right decision made for the wrong reasons.
And it is at this point I say, "Huh?"
First, Stiglitz seems to say that the popular story that he was dumping on on page ix is in fact correct: deficit reduction did bring about the recovery. Only it wasn't lower interest rates that encouraged borrowing, but higher bond prices that encouraged lending, that was responsible. That seems--to me at least--to be a small (and debatable) difference. Surely both were at work. So where's the beef?
Second, that word "inadvertent"... In the Clinton Treasury in which I worked, we regularly talked about how the lower interest rates (that we hoped the passage of the deficit-reduction program would induce) would boost the economy through three channels: the interest-rate channel (lower interest rates make firms more eager to borrow more and spend it expanding their capacity), the money channel (the open-market purchases of bonds the Federal Reserve engages in to keep interest rates low get more spendable cash into the hands of the public, and they up their pace of spending), and the credit channel (lower interest rates mean higher bond prices, which means that better-capitalized banks have a more tolerant attitude toward risk and are willing to lend at a smaller premium over Treasury rates).
At least from where I sat in the Treasury, the effect of lower interest rates on bank capitalization and thus in easing the worrisome early nineties "credit crunch" was a very advertent and much-discussed effect indeed. (Although note that I do not believe that that credit channel played as important a role in generating the high-investment recovery of the 1990s as Stiglitz does.) I'd go to the Fed for meetings about the credit crunch and the credit channel. I'd come back to the Treasury for meetings about the credit channel. There were entire weeks I remember spending my time swimming in the credit channel. Why, I recall a very nice lunch in the spring of 1993 with then-CEA Senior Staff Economist Mike Knetter--then one of Joe Stiglitz's worker bees, now Dean of Wisconsin's Business School--at which we talked about many topics including bank balance sheets, the credit channel, and its relationship to investment spending.
The importance of the credit channel in generating the high-investment recovery of the 1990s may have genuinely come as a surprise to Joe Stiglitz--but if so it was only because he didn't have time to attend the nonstop meetings and read the boatloads of memos that landed on his desk.
Now none of this should be taken imply that the Clinton deficit-reduction program was anything other than a high-stakes gamble. Would the Federal Reserve be willing to keep interest rates low both in the present and in the future if the Clinton administration delivered on Greenspan's dearly-sought goal of deficit reduction? Would bond traders believe that the Fed would keep interest rates low--or would they succumb to irrational pessimism? Even if long-term interest rates fell, would any of the channels by which lower long-term interest rates can boost the economy--the interest-rate channel, the money channel, or the credit channel--be strong enough to produce the hoped-for high-investment, high productivity-growth boom? It was a gamble, but it was a reasoned gamble taken at favorable odds. And the alternative looked, at the time and today, very unappetizing indeed.
Consulting my memory, at least, I think that Stiglitz is completely off-base when he calls Clinton's decision to spend his political capital reducing the deficit a mistake.
Posted by DeLong at October 21, 2003 12:42 AM | TrackBackJoseph Stiglitz (2003), The Roaring Nineties: A New History of the World's Most Prosperous Decade (New York: Norton: 0393058522).
I'm not sure about this characterisation of standard theory:
"Standard theory says that cutting the current deficit worsens downturns, but it also says that cutting the expected future deficit three, five, ten years down the road boosts investment and improves the current situation. "
Surely what worsens downturns is *raising taxes* or *cutting spending*, not "cutting the deficit" (for example, if you cut the deficit from privatisation proceeds, it is not clear to me that this is deflationary). When did the spending cuts of the Clinton deficit reduction plan come into effect?
I have to say that the evidence for the existence of a credit channel is actually pretty weak; that's not to say that bank credit isn't important, just that the link to interest rate policy isn't all that strong or predictable. This is one of the areas where the endogenous money bunch have a point if you ask me.
Posted by: dsquared on October 20, 2003 11:26 PMI think Stiglitz was making the point that deficit reduction worked unusually well for Clinton because of the fact that many banks were heavily invested in long-term bonds (due to an accounting standard that I don't fully understand). In other words, the strength of the "credit channel" was anomalous. Future deficit reduction might not achieve the same results, however much attention is paid to this channel. This seems to be a weaker case of what Krugman called "When Good Things Happen to Bad Ideas." ("When Great Things Happen to Moderately Good Ideas"?)
Posted by: James McDonnell on October 20, 2003 11:50 PMSo you can have a grown-up professional argument about the past or the future but not the present. Paul Krugman's latest piece does put the opposition on notice to carry out the Tom Clancy thought experiment: an improbable sequence of accidents puts YOU in charge of US economic policy, today. Where do you start?
Posted by: James on October 21, 2003 02:51 AMThe Clinton surplus does not have to work through
credit channels or the banking system to work as
your analysis implies. Simply, if you look at the savings - investment data in the late 1990s, foreign capital inflows plus the government surplus were equivalent to about 40% of private investment during the investment boom(bubble).
Historically, strong capital spending has always been a sure signal for bond managers to shorten their portfolio -- compare the ratio of real capital goods orders to real nondefense capitl goods orders to bond yields. One of the most unusual features of the late 1990s was that the US had a capital spending boom without rising long-term interest rates -- probably about the only time that ever happened. I believe strongly that the govt surplus in the late 1990s played a major role in this development. You do not need a complex theory or rational to reach this conclusion, all you have to do is look at supply and demand. The current deficit problem is not the short run deficit, it is the long run structural deficit that raises serious questions about the ability of the US to experience strong growth or capital spending without soaring rates.
Certainly the surplus had an effect on the need to raise interest rates. The money supply can be shrunk by monetary policy that raises interest rates, or the money supply can be shrunk by fiscal policy that collects more revenue as taxes. When that tax money is going to deficit reduction and not more government spending, the effect is to shrink the money supply.
AG made a mistake by increasing interest rates in the late 90s. Fiscal policy was collecting over 20% of GDP as revenue and that should have been enough of a brake on the economy. We need monetary and fiscal policy to work together for the rest of the decade to prepare for the boomer retirement. When fiscal and monetary policy were on the same page during the 90s we made progress. However, first the Fed went off script and now fiscal policy is in reverse.
BTW- I was under the impression that Clinton deficit reduction and Fed holding interest rates down was not serendipity, but based on an understanding between Clinton and Greenspan. Is this not correct as Stiglitz implies?
Posted by: bakho on October 21, 2003 08:55 AM"There were entire weeks I remember spending my time swimming in the credit channel."
Well, that answers your question right there. You did not show Mr. Stiglitz the good places to go swimming.
This should not require nonstop meetings or boatloads of memos. One meeting with some good slides and an excellent lunch, and a one or two page summary of the "boatloads of memos" and then off you go some good times!
But you were a new guy, and your party planning skills were probably somewhat deficient. I'm sure you've learned a lot since then.
Posted by: northernLights on October 21, 2003 08:58 AMOn balance it was an awful political mistake, costing both houses of Congress in 94, leading to the Republican jihad against Clinton and Gores defect in 2000. Virtue never goes unpunished, a lesson that Bush appears to have learned well.
Posted by: Joshua Halpern on October 21, 2003 10:35 AMJosh- The balanced budget led to GOP jihad?? I hate to clue you in, but the jihad against Clinton started in 1992. The backlash against the Democrats in 1994 was not about budget, but about bickering, congressional scandals and failure to deliver on health care and other promises. Gay bashing helped energize the Clinton opposition, when the GOP managed to put it on the agenda early in the Clinton presidency.
In good times when people are not so worried about the economy. They feel free to vote on social issues. They can vote for a moral GOP Congress or a moral president like Mr. Bush. But once these moral leaders mismanage the economy, the economic issues come to the fore and the public will vote in the fiscally responsible Democrats.
Posted by: bakho on October 21, 2003 11:22 AMIt's always funny when economists start talking about other economists. When pronouncements are made to the masses, there's normally this authoritative tone, but once two economists are present at the same time, you end up with the same mumbling around -- maybe this, maybe that, you're way wrong there, how could you say something like that? -- that ordinary unscientific people come up with in their amateur personal affairs. And it seems to go on forever, even between guys who basically respect and admire one another.
Posted by: Zizka on October 21, 2003 11:47 AMWell, judging Stiglitz by the standards regularly applied on this site to more conservative economists, such as Mankiw or Meltzer, you'd have to assume he is lying, wouldn't you? So there must be an ulterior motive. Case closed.
Insted of politely suggesting he needs an editor, could you not ask, "Oh why can't we have better Nobel Laureates?," or "Why Does Joseph Stiglitz still have a job?"
Posted by: maiden lane on October 21, 2003 12:12 PM"On balance it was an awful political mistake, costing both houses of Congress in 94, leading to the Republican jihad against Clinton and Gores defect in 2000. Virtue never goes unpunished, a lesson that Bush appears to have learned well."
This is an argument that has been nagging at me. I increasingly think the argument is correct. Imagine the lunacy of allowing the tax on vehicle registration to rise significantly when the Governor of California is under attack. Whether the tax increase was needed or not, the Governor was a fool in the extreme to allow the increase. Of course there should have been tax reductions for the poorer and tax increases for the richer in Alabama, but voters would not abide the changes.
Posted by: anne on October 21, 2003 12:44 PMhttp://www.nytimes.com/2003/10/16/business/16SCEN.html
Cloudy Thinking on Tax Cuts
By ALAN B. KRUEGER
CONSERVATIVE and liberal political commentators alike have wondered why most Americans have enthusiastically supported two of the largest tax cuts in history even though most benefits will flow to upper-income families. Adding to the conundrum, in public opinion surveys Americans routinely express support for spending more on government programs like education, opposition to government budget deficits, and disappointment that the gap in income between rich and poor has widened — all of which are in conflict with regressive tax cuts.
In the most extensive analysis yet available, Larry Bartels, a political scientist at Princeton University, gives a simple but persuasive explanation: "unenlightened self-interest." Middle- and lower-income Americans supported tax cuts they suspected went largely to the rich because they thought they, too, would benefit, if only by a small amount, and because they failed to connect the tax cuts to rising inequality, their future tax burden, or the availability of government services.
Professor Bartels analyzed a small battery of questions added to the National Election Survey, a poll of 1,500 people interviewed in the six weeks before the November 2002 election, and again in the month after the election. The survey turned up some remarkable results, which he reports in "Homer Gets a Tax Cut: Inequality and Public Policy in the American Mind." ...
Posted by: anne on October 21, 2003 12:46 PMI think it was Hillary who lost the Congress with the health care disaster. No matter what your feelings on the policy itself, the high-profile crash and burn killed Clinton.
Posted by: Josh on October 21, 2003 01:20 PMJosh-
I think it was Hillary who lost the Congress with the health care disaster. No matter what your feelings on the policy itself, the high-profile crash and burn killed Clinton.
Well, we have a fiscal problem and health care insurance problem that will turn to crises in time. So, we had better learn to address the issues in far more compelling public ways.
Posted by: anne on October 21, 2003 01:25 PMI don't think you can rule out the completion of the Southern realignment in1994. It was bad enough for the Southern rednecks that Carter and Andy Young were buddies. However, Clinton appointing numerous blacks to cabinet posts and high government offices , standing up for gays, having a wife with a career, etc. pushed away the southern rednecks in droves.
When the GOP won in 94, the southern rednecks were leading the way. They are still in power trying their best to make the US just like MIssissippi.
Posted by: bakho on October 21, 2003 05:20 PMBrad, excuse me, but *when* in the 1990s did long term interest rates fall? Here is the time path of a representative one, the ten-year Treasury:
1984 12.46
1985 10.62
1986 7.67
1987 8.39
1988 8.85
1989 8.49
1990 8.55
1991 7.86
1992 7.01
1993 5.87
1994 7.09
1995 6.57
1996 6.44
1997 6.35
1998 5.26
1999 5.65
2000 6.03
2001 5.02
2002 4.61
Answer: in 1998, this rate dipped a bit below the 1993 value. Other long-term rates behaved in similar fashion.
Whatever story you want to tell about the Clinton deficit reduction plan, a big drop in long-term interest rates isn't part of it.
So what did kick off the economic growth that began in 1994? Interestingly, bank C&I lending started to increase *immediately* -- literally within days -- following the Fed's action that increased interest rates in February, 1994. You can look this up, too.
Is there a story here? I certainly did not predict such a thing in advance, but I did try to explain it in my 1998 book, Created Unequal. The most plausible explanation in my view: raising short-term interest rates forced banks to seek clients who would pay higher interest rates than the federal government. And so they started buying fewer bonds and making more commercial loans. Interestingly, a Nexus search for the phrase "credit crunch" reveals that it disappeared from the media almost as soon as this happened.
The story is consistent with a cartel view of bank behavior, but certainly not with the standard tale told of the Clinton plan.
JG
Posted by: James Galbraith on October 21, 2003 06:50 PMIs that 1993 number correct? If so, a temporary drop in the ten year rates occurred.
Outside of the 93 blip, the ten year rates have trended downward for a decade.
Posted by: bakho on October 21, 2003 08:34 PMThe 1993 number is correct. That marked the last year of the Fed's accommodative policy, adopted to help banks rebuild their balance sheets following the end-1980s systemic crisis. Short-term rates went from 3% at the start of 1994 to 6% by the end, and bonds had their worst year in modern history. Consider that the starting point.
Posted by: Dave Larson on October 22, 2003 03:08 AM