In an Uncertain World (28 page)

A fifth factor, also related to our cultural tendency to embrace change, was our relatively low trade barriers. My initial belief in open markets was based on the standard comparative-advantage argument that dates from the great nineteenth-century British economist David Ricardo—that all countries will benefit if each specializes in the areas where it is most efficient compared to the others and then trades with the others. But Alan once made another point that never had occurred to me until he said it. The biggest advantage of free trade, he said, is competitive pressure
within
the United States from foreign producers. Companies have to become more efficient in order to meet competitive threats from outside our borders. Trade drives companies to reorganize and invest in pursuit of increased productivity. Conversely, Japan's and Europe's relatively less open markets protected companies and reduced their incentive to become more efficient.

But did these seemingly real changes in America's productivity growth justify the tremendous rise in stock prices that was taking place? Again, Alan, Larry, and I reached a similar, tentative conclusion: something real was happening in the economy, but at the same time, the markets were probably overreacting to that real thing. That is what the great Austrian émigré economist Joseph Schumpeter said: almost every transformative, productivity-enhancing development also results in financial market overreaction. To me at least, that tendency seems grounded in human nature. Markets—which are expressions of collective behavior—tend to go to excess, in both directions, because human nature tends to go to excess.

Some of our continuing discussion was about what, if anything, people in our position could or should do to mitigate that inherent tendency to excess. As discussed earlier, none of us thought that economic policy makers should become market commentators, or that we could guide financial markets the way the Japanese and some previous administrations in this country had tried to do, by talking them up or down. I tended to believe, however, that regulatory measures might possibly have some effect in inducing investors to exercise discipline, and could certainly help protect the financial system itself. Disclosure requirements were obviously the place to start and were generally not controversial, at least in principle. But such mechanisms were like the old adage: you can lead a horse to water, but you can't force it to drink. All the disclosures in the world won't help if investors don't care about risks or valuation. The boom in Internet stock prices in the late 1990s occurred despite full disclosure by companies with no real earnings.

Given the limits on what could be accomplished through disclosure requirements, I thought limiting leverage was also necessary both to constrain market excesses and to mitigate the harm they can create. For many years, banks and registered broker dealers had lived with capital requirements, and all investors were subject to margin requirements when they borrowed against stocks. But other kinds of financial institutions, including hedge funds, had no regulatory leverage constraints other than the margin requirements, if any, associated with the instruments they bought or sold short. My own view was that it wasn't necessary to impose special leverage rules on hedge funds as a class of investor. I still think that is right, though as they become a larger and larger part of trading activity, policy makers may revisit that question, if some systemic risk is thought to be at stake. I do think, however, that derivatives, with leverage limits that vary from little to none at all, should be subject to comprehensive and higher margin requirements. But that will almost surely not happen, absent a crisis.

While economically useful under most circumstances for more precise risk management, derivatives can pose risks to the system when market conditions become very volatile. That occurs because of various technical factors that can cause derivatives users to suddenly need to buy or sell in the underlying markets to maintain appropriate hedge positions. With the truly vast increase in the amount of derivatives outstanding, it is at least conceivable that the effect on already disrupted markets could be vast. Some evidence of that potential appeared in the third quarter of 2003, when a rapid spike in interest rates changed the hedging requirements for mortgage-backed securities. The result was substantial exacerbation of that spike. Similarly, in 1987, some traders estimated that “portfolio insurance” selling of stock index futures added substantially to the October 19, 1987, stock market collapse. In a later speech at the Kennedy School at Harvard, Larry characterized my concerns about derivatives as a preference for playing tennis with wooden racquets—as opposed to the more powerful graphite and titanium ones used today. Perhaps, but I would still reduce the leverage allowed on derivatives substantially.

   

ANOTHER FOCUS OF MINE, which was less typical for a Treasury Secretary, was poverty and the distress of inner cities as critical economic issues. We set up, for the first time at Treasury, an office to focus specifically on these matters, headed by an extremely able and highly committed former Supreme Court clerk, Michael Barr. Such questions were often framed as debates about whether or not to help the poor. But, as important as moral and ethical issues are here, you don't need to rely on altruism to make the case for tackling poverty. It is in everyone's self-interest to reduce the societal consequences of deprivation. Poverty can foster crime and health care problems and in various other ways increase social costs and affect the lives of people who aren't poor.

I learned very quickly, however, that advancing programs to help the poor—especially for minorities living in inner cities—was very difficult. Many people object to the idea of government assistance for the poor on principle; even well-designed programs meant to encourage work instead of welfare faced strong opposition. And the poor are not easily mobilized to advance their own economic interests. All sorts of groups could bring great pressure to bear when their concerns were at stake: environmentalists, labor, the elderly, business, and many, many others—but not the poor. You couldn't count on a major letter-writing campaign in support of food stamps or inner-city job programs.

A significant accomplishment in this area by the Clinton administration was a large expansion of the Earned Income Tax Credit, a payment under the tax code to low-income working families to help lift them out of poverty. However, the EITC increase and other measures—though they had substantial impact—were not even remotely commensurate with the scale of the problem. But our ability to do more was limited. For our first two years, deficit reduction and health care reform were our highest priorities. For the next six years, control of Congress was in the hands of people who rejected most government involvement in these issues.

Nonetheless, real progress was made in combating poverty during Clinton's years in office, largely because of the strength of the American economy. As unemployment fell back to levels not seen since the 1960s, the number of Americans living below the poverty line dropped steadily and gains by minorities were very strong. Births to teen mothers, which had been rising for forty years, finally began to fall. Welfare rolls began to decline significantly, even before the passage of a welfare reform bill in 1996. In New York, as in other big cities, the homeless population declined visibly. Clinton used to say that the best social program is a strong economy, though he always added that that wasn't sufficient. He was right. Some people focus only on the economy and neglect the necessity of well-designed programs. Others focus on the programs and miss the central importance of a healthy economy.

Advancing new programs was not our only difficulty. Once we lost control of Congress, defending the effective programs already on the books, such as the EITC, became a major challenge. Without a large staff or a big bureaucracy, the EITC had made an enormous dent in the size of our poverty population by providing a subsidy to the working poor that was a powerful incentive for poor people to work full-time instead of getting by on public assistance. A group of conservatives in Congress, led by Senators Don Nickles (R-OK) and William Roth (R-DE), pointed to fraud in the program—people who weren't entitled to the credit were receiving refunds—and we had to threaten to veto the 1997 tax agreement with the Republicans to prevent damage to the program. Fraud was a serious issue, significant reforms had been made, and we were strongly supportive of further reform. But the EITC was an excellent concept—Ronald Reagan, not a leading advocate of social programs, had strongly endorsed it because of its focus on work. And we insisted that the program be fixed, not cut back or thrown out.

Another program under attack was the Community Reinvestment Act, passed in the 1970s to discourage banks from the practice of “redlining,” or refusing to make loans in minority neighborhoods. The CRA required lending institutions, when seeking regulatory approval, to demonstrate that they had invested in their communities. This measure had greatly increased the availability and flow of credit in inner cities. After the 1994 election, however, we faced constant efforts to roll the program back in one way or another. One argument was that the CRA was simply a way for community and political groups to extort money from lending institutions. CRA almost surely had been misused in some instances—and we were again fully supportive of reforms. But, as with the EITC, we had to fight the all-too-common Washington strategy of using one rotten apple to proclaim the barrel spoiled. Our opponents seized on real issues about misuse in an attempt to eviscerate what had been, on balance, effective and valuable antipoverty programs. Happily, we were able to protect the CRA as well as the EITC. However, I'm not sure what would have happened absent our veto threat, and that is a sobering thought.

Welfare reform was the highest-profile issue in this area. In 1994, the administration had proposed legislation intended to replace welfare with work. But once Republicans took control of Congress, they passed a bill that was much more stringent. Inside the administration, feelings ran high. Some of us thought the bill Congress passed in 1996 was too severe and could create serious humanitarian and social problems. Others argued that the GOP bill was close enough to what Clinton wanted. Some believed that Clinton's reelection prospects could hinge on his signing the bill.

The President convened a meeting of relevant members of the White House staff and cabinet. George Stephanopoulos, who was one of the first to speak, set the tone for the discussion. George was against signing the bill, but he said—as I think everyone in the room thought—that this was an agonizingly difficult decision. A veto could have a decisive impact on the 1996 presidential election, and if that happened, the consequences for people on welfare could also be far worse. I had not been much involved in welfare reform, but I shared George's view that the President should not sign the bill. I felt strongly that some people on welfare are unable to work for reasons that are beyond their control, whether psychological, physical, or simply through a lack of work skills and work habits. This legislation didn't seem to me to address any of that sufficiently. What's more, the notion of cutting food stamps and other benefits to legal immigrants just seemed wrong to me. We needed more of a balance—not only stronger incentives for work, but also a greater effort at preparing and training people to work, and continuing to provide a true social safety net for people who couldn't work.

I never knew if that was a real meeting or if the President had already decided to sign the welfare reform bill and was merely mollifying those likely to disagree by allowing them to be heard. In either case, airing the issue in this way was an example of shrewd governmental process. Getting everyone into the room and giving us all an opportunity to speak on an issue about which people felt so strongly minimized subsequent leaks and carping to the press. A couple of well-respected subcabinet officials did resign over Clinton's decision to sign the welfare reform legislation. But had the President made his decision in a different way, the internal fallout could have been much heavier.

I never saw welfare as central to Clinton's reelection, but I understood its larger symbolic significance and the political concern. To me, the central issue was the economy. The country's continuing economic strength was obviously a powerful argument for giving the President a second term. Bob Dole, by contrast, seemed to me not to have a strong vision for his candidacy. I remember watching an interview with Dole on
This Week with David Brinkley
one Sunday, when I happened to be a guest. John Cochran asked him why he was running and what he wanted to do for the American people. Dole's response focused on the politics and the polls, instead of where he wanted to lead the country.

   

AT THE BEGINNING of Clinton's second term, I had to decide whether to stay or leave—possibly to become chairman of the Carnegie Corporation, a foundation involved in an enormous range of issues from education and civic participation to international security and development concerns. The President wanted to get together to discuss the issue and called me at the Jefferson one night at about 10:30 and asked me to come over. I was getting ready to go to bed but was happy to oblige. Since my Secret Service detail had turned in for the night, I went downstairs and walked over to the White House.

I went to the nearest gate, and the uniformed Secret Service officer inside the gatehouse asked if he could help me. “I'm here to see the President,” I said, mentioning that I was Secretary of the Treasury.

The guard gave me a suspicious look and sent me to another gate, where they recognized me and let me in. Then I went upstairs to the second floor of the residence, where Clinton and I had a long talk about what I was going to do, interspersed with an open-ended discussion of politics, our views of other people, and the policy issues that animated both of us.