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From the Forum “Undoing Bush”

Two economic calamities have occurred on George W. Bush’s watch. The first has been a radically overvalued dollar, which, it should be noted, is a legacy of the Clinton years: by the date of Bush’s inauguration in January 2001, the real value of the dollar was already 27 percent higher than its low in July of 1995, the surge due in part to the stock bubble, in part to the financial crises in East Asia and elsewhere, and in part to high-dollar cheerleading by the Clinton Administration’s treasury secretaries. And yet despite these unsustainable highs, Bush did almost nothing to reverse the run-up; the value of the dollar actually increased in 2002. It has fallen since then, but it is still 12 percent above its 1995 low. The problem that a high dollar poses for manufacturing is straightforward: if the dollar is expensive relative to other currencies, then it is very cheap for Americans to buy imported goods and very expensive for foreigners to buy U.S. exports. In effect, an overvalued dollar provides a subsidy to imports and imposes a tariff on exports. Not surprisingly, this high dollar has led to a rapidly rising trade deficit, which in 2006 grew to more than $760 billion, or nearly 6 percent of GDP. This, in turn, has been the major factor contributing to the loss since 2001 of 3 million manufacturing jobs, or more than a sixth of the entire sector.

The other major economic disaster under Bush has been the unchecked growth of the housing bubble, and although this, too, was inherited from his predecessor, Bush in this case deserves an even greater share of the blame. By the start of the Bush Administration, housing prices (which over the prior forty years had just kept even with the overall rate of inflation) had on average, and after adjusting for inflation, risen approximately 23 percent over their mid-nineties levels—a substantial but still containable surge. In 2001, however, when the stock bubble collapsed, Alan Greenspan, the Federal Reserve Board chairman, seized on the expanding housing bubble as the best tool for boosting the economy out of the recession. He pushed the short-term interest rate down to 1.0 percent—the lowest level in almost fifty years—and, more important, assured investors of the safety of the housing market, telling Congress in the summer of 2002 that “recent sizable increases in home prices . . . reflect the effects on demand of low mortgage rates, immigration, and shortages of buildable land in some areas.” By 2006, prices were 73 percent higher than their pre-bubble values, for a total of more than $8 trillion in unsustainable wealth.

What should Bush’s successor do to reverse the damage? Unfortunately, once financial bubbles are allowed to develop, there are no easy solutions available. Even if a “soft landing” is possible, the notion that such a thing is somehow desirable does not really make sense. In the case of the housing market, if the bubble is allowed to deflate slowly, then the more than 140,000 people who buy homes every week are still purchasing them at bubble-inflated prices. These are the people who will take the greatest hit when the prices eventually adjust to a sustainable level. A slow adjustment may well be more harmful for existing homeowners as well. Americans have been borrowing at a record pace against their home equity, pulling out close to $600 billion in the peak year of 2005. They have been willing to draw against their equity because they assumed that prices would stay high and likely move higher. If house prices only adjust slowly, then more homeowners will have drawn down equity based on incorrect expectations about the path of the housing market.

The argument for a quick adjustment is similar in the case of the high dollar. If investors perceive the dollar to be adjusting to a lower value through time, then they will demand an interest-rate premium in order to hold dollars rather than euros, yen, or other currencies. This means that we will have to keep interest rates in the United States higher than would otherwise be necessary, as long as the dollar is in this adjustment process. High interest rates can slow the economy and strangle economic growth, especially if the economy is already suffering from the collapse of a housing bubble. A slow adjustment for the dollar would also sustain the pressure on the manufacturing sector. More factories would move overseas and more jobs would be lost, because U.S. manufacturing simply cannot compete at the current value of the dollar.

There are several tools that a new administration could use to bring about a rapid deflation of these bubbles. The first is simple: talk. A new administration could try to take the air out of the housing bubble (which already may be starting to deflate) by publicly presenting the evidence that prices have departed substantially from historical values and pointing out that anyone buying a home in this environment would be taking a substantial risk. It can also use the regulatory powers of the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of Federal Housing Enterprise Oversight to crack down on the issuance of risky mortgages. If the housing market is not already well on its way to correcting by the time a new administration takes office, such steps will certainly push the process along considerably.

In the case of the dollar, if the new administration, with the cooperation of the Fed, makes a public commitment toward attaining a lower dollar by a specific date (e.g., January 20, 2009), it can be fairly certain that the markets will take its cue. If the Fed is serious in its commitment, and prepared to act in financial markets to support it (by selling dollars), then only the most foolish investor would continue to hold dollars at an overvalued price.

Even with both the dollar and the housing market defused, the next administration cannot let the Federal Reserve Board write its own job description. Preventing future financial bubbles has to be placed at the top of its list of responsibilities. The economic and social disruptions from the growth and collapse of a major financial bubble swamp the negative effects of modest increases in the rate of inflation. While the Fed chairman and his colleagues may want to focus only on inflation, they must be forced to deal with bigger problems. The Fed, along with the Treasury Department, should take the kinds of proactive measures detailed above to prevent the sort of asset bubbles that have afflicted the stock market, the dollar, and the housing market during the past decade.

One last point: although budget deficits are not as big a problem as is often claimed, it will be necessary to take back Bush’s tax cuts, which have reduced annual tax revenue by somewhere between $100 billion and $300 billion each year. Of course, the war, too, is a substantial drain, costing more than $100 billion a year at present, or nearly 1 percent of GDP. It should be noted that neither the tax cuts nor the war broke the bank: when President Bush leaves office, the country’s ratio of debt to GDP is projected to be 66 percent, still below the peak debt to GDP ratio of 67.3 percent that we hit in the mid-nineties. But restoring the pre-Bush tax rates (at least for the wealthy) and ending the war will free up sufficient funds to support universal health care and a major round of infrastructure modernization. These initiatives, along with correcting the financial imbalances left by both the Clinton and Bush administrations, will be the unenviable economic challenges facing our next president.

is codirector of the <a href="">Center for Economic and Policy Research</a>, in Washington, D.C.

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June 2007

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