Friday, December 05, 2003
The return of the golden 1990s?
Posted by David Smith at 10:21 PM
Category: David Smith' s magazine articles

For stock market investors, the 1990s now seems like a very distant golden age. Share prices trebled on average during that glorious decade, and by many times that for some sectors and shares. The end of the Cold War appeared to have given way to an impressive exercise of economic power by the capitalist system.

With the ideological conflict behind us in the 1990s, it seemed there was only unfettered economic growth ahead. Technology, unleashed to its full potential in both consumer and business applications, opened up limitless possibilities. The new economy was appropriately named.

Not everybody got caught up with it, of course. When the Wall Street economists came over to Britain with their stories of an American economy that could grow indefinitely at a 4.5% or 5% rate, we questioned it. No advanced economy, particularly a lumbering giant like America, can transform itself in that way. The United States, to listen to some of the stories, had been magically altered from an economy with a problem of low productivity growth to one where nothing could hold it back.

The same was true, of course, of the stock market. Many doubted the rise, pointing to its obvious bubble characteristics. Few got much credit for doing so. The smart fund managers were those who rode the market boom but turned defensive in time to avoid the full consequences of the bust.

It seems, as I say, like a different era. It is worth remembering, however, that there are plenty of similarities between then and now. The long boom of the 1990s started in 1991-2, immediately after the first Gulf war, helped by a drop in world oil prices. We have just had, of course, the second Gulf war, and while oil prices have not tumbled as hoped – partly because of supply problems in war-torn Iraq – most analysts expect that to happen after the winter.

There is a president in the White House who is worried about whether the economic recovery will be strong enough to get him re-elected. George W. Bush knows all about that. His father faced exactly the same problem in 1991-2 and lost to Bill “It’s the economy – stupid” Clinton.

Bush junior’s problem is the same as his father’s. All the statistics say the US economy is recovering but voters do not believe it. That is because it is a “jobless” recovery, one which is not impacting on unemployment. In the early 1990s, when the American news magazines ran cover features on corporate downsizing and the absence of new jobs, the problem was exactly the same.

In Britain there were parallels too. A government that had prided itself on tight control of the public finances suddenly found that it was forced to borrow massively. Then it was the Tories. Now it is Labour. The credibility problems are the same. Tony Blair has not yet reached the end of the road, as Margaret Thatcher did at the end of 1990, but he has started to look frayed around the edges.

The point is that nobody was very optimistic then. Inflation was still a problem, particularly in Britain. Unemployment came within a whisker of 3m. In Europe, German unification had provided a short-lived boom but a hangover was on the way.

How did gloom give way to boom? One was the fairly rapid realisation that the so-called jobless recovery was merely a manifestation of the normal lags between an economic upturn and a fall in unemployment. Another was the disappearance of low inflation as a problem for policymakers, enabling monetary policy (low interest rates) to be highly accommodative when it came to growth. Even in the 1980s there was a perception that inflation was merely dormant, and waiting to surprise you, as it in fact did.

Another notable element of policy was the deliberate decision by governments to cut back budget deficits. This was the most important element of Clintonomics, and brave for a Democrat president. In Britain the Conservative government set about slashing the budget deficit it had created, a task continued after the 1997 election by Gordon Brown. In Europe, countries cut their budget deficits to meet the Maastricht criteria for monetary union.

Significantly, the only major country that increased its budget deficits substantially during the 1990s, Japan, suffered economic stagnation.

So can history repeat itself? In many ways the prospects are brighter now than they were a decade ago. Inflation is not a worry. The main concern for central banks is steering clear of deflation, although the risks there appear to be diminishing.

The productivity gains of the 1990s, particularly in America, were not a mirage. While some of the claims made then were overdone it does seem that, partly as a result of new technology, the United States is leading the global economy into an era of stronger productivity growth, which will feed directly into rising living standards and increases in corporate profitability.

Britain is in an unusual position going into a global upturn having missed out on recession (with not a single quarter of negative growth since 1992). The contrast with the bruised and battered economy of the early 1990s could barely be greater.

To be optimistic about the global economy does not mean share prices will treble by 2010. The gains of the 1990s did owe quite a lot to special factors, including the then unexpected conquering of inflation. But the kind of economic environment I expect does not sit easily alongside the idea of stagnant stock markets. Share prices will be a lot higher at the end of the decade than they are now.

What could governments do to help this recovery process along? One thing is to learn the lesson of the 1990s. Aggressive cuts in budget deficits were, contrary to the advice of some economists, hugely beneficial for growth. The current concern, described here last month, is that governments seem content to allow deficits to grow. They should study the evidence of the golden 1990s and think again.

From Professional Investor, December 2003-January 2004


Please explain how exactly "aggressive cuts in budget deficits" stir economic growth? While implying some unnamed individuals opposed the policy and were wrong, you don't even supply a reason why the policy you favor should produce these results. The evidence of the 90's you site, reducing budget deficits fuel economic growth is merely evidence by association as opposed to explaination.

I'm not sure you even understand the undercurrents of the 1990's. Name a single year in the 1990's when government spending shrank? You might believe that aggressive cuts in budget deficits would be associated with spending cuts. It just didn't happen.

In the US, Bill Clinton nevered proposed budgets that aggressively reduced budget deficits. In the year the budget to eliminate deficits over seven years started with the Clinton proposal of deficits of $200 billion annually as far as the eye could see. It turned to surplus in a year or so not because of anything in the budget or anything Bill Clinton did. Spending growth (yes growth) slowed and revenues exploded in the late 1990's. The explaination for the growth is the Fed's aggressive increase in the money supply to protect the economy from the "Year 2000 problem" and the capital gains tax cut in 95/96 that increased rewards for risk taking and work.

David, what's the Rubin explaination of the benefits of the elimination of budget deficits? Reduced interest rates that lower the cost of capital, right. David, what are interest rates now compared to the late 1990's.

Posted by: Gary Bezowsky at December 9, 2003 02:44 AM

How does reducing budget deficits promote economic growth? Three ways:
1 It reduces "financial" crowding out and therefore, other things being equal, will cut interest rates relative to what they would have been.
2. It reduces expectations of future tax rises and therefore promotes spending. This is known as Ricardian equivalence - people respond to big budget deficits (which they see as implying higher taxes in the future) by reining back spending.
3. It implies greater pressure on controlling the government sector. Private sector productivity is higher than in the government sector - therefore restricting the government sector's share of the economy, as happened in the 1990s, is good for growth.

Posted by: David Smith at December 9, 2003 12:29 PM

Crowding out? Interest rates are at historic lows in the US and lower than at anytime in the 1990's. Just how do you square that circle? Take a look at actual economic history, the Robert Rubin position that a budget surplus or small deficits lead to lower interest rates isn't supported by history. The Wall Street Journal has made this point many times referring to studies of past history. Interest rates are more closely related to expectations of inflation and the debasement of the currency through excesive money supply growth. Given the size of the world capital markets, budget deficits in the 3% to 5% range likely do not have that much of an impact as long as the Federal Reserve is mindfull of the money supply growth. The laboratory of the real world is the best test of "crowding out theory".

I have never heard of Ricardain but will look at the information. I am a little skeptical. Consumer spending has continued to increase for as long as I can remember and investment spending seems more closely coorelated to expected returns and influenced by tax policy at the margins (ordinary and capital gains). If people can't be convinced to fund their own retirements (a known future obligation), I'm hard pressed to believe that large budget deficits would lead people to believe that tax increases are coming and favor saving over spending.

I would love to see government spending decline in absolute terms. We would be better off without that drag on economic growth. Politically, the only way to control the growth of government is to cut off the oxygen. Balance budgets don't have a sizable political constituency. The Republicians haved learned that lesson. The Democrats never cared about balanced budgets until they lost power.

What turns my crank and my strong resonses to your columns is tendency to recast the economic policies of the Clinton Administration, hold them up as shining examples and ignore contrary evidence. The best thing he did was get out of the way, support free trade, sign welform reform and cut capital gains taxes. And most of these were forced upon his administration by a Republcian Congress. Welfare reform was adopted because he wanted to be re-elected in 96 during a so-so economic climate. The cut in capital gains taxes were pushed upon the Clinton Adminsitration by the opposition party in the House. Even his own party abandoned Clinton over welfare reform and NAFTA. The Clinton rhetoric about balanced budgets was just that, rhetoric. The man was not an aggressive advocate of balanced budgets and small government. He just said those things. Have you forgotten the man wanted to nationalize the US healthcare system.

Posted by: Gary Bezowsky at December 9, 2003 07:06 PM