In an Uncertain World (54 page)

On the issue of helping specific industries, I thought the general principle was that we shouldn't have government support for any industry except in extraordinary circumstances. We have a market-based economy and ought to let the market adjust to the new conditions, except for considering intervention if some sector systemically important to our economy may be severely affected. The airlines are systemically important to the economy and were in danger of ceasing to operate because of their mounting losses stemming from a shutdown of several days and weak passenger demand thereafter on top of already weak industry conditions. So I was in favor of doing something that would enable the major air carriers to continue functioning. But the $15 billion package that Congress very quickly passed to help the airline industry seemed excessive and an attempt to make up for poor market conditions that the airlines had been experiencing well before September 11.

The insurance question was complicated. Though the insurers, including Citigroup's Travelers subsidiary, faced significant losses, the biggest casualty companies were not facing bankruptcy or a major disruption in their business and in my view shouldn't receive public money to compensate for losses resulting from the attacks. But the industry faced a problem going forward that government did need to address: because of the attacks, insurers were no longer willing to provide coverage for terrorism or war—the losses could simply be too great.

As businesses rethought the probabilities not only of terrorism but also of other geopolitical events, risks were recognized that should have been but hadn't been before September 11. This is another illustration of the broader issue of dealing with extremely-low-probability events that can have catastrophic consequences if they occur. In this case, the belated recognition of such risks created a serious economic problem. Without the availability of insurance that would cover the risk of another September 11–type attack, construction of new office buildings, shopping centers, and other major structures could be severely impeded. So in one way or another, the government had to become the insurer of last resort for these risks going forward.

This problem—and the need for a public-sector solution to it—is part of a larger principle that I have already discussed. Even in a market-based economy, there are many needs that markets by their nature cannot fulfill. One set of such needs is the risks we socialize because the private sector can't handle them effectively—whether because the potential losses are too large to be treated actuarially or because a voluntary insurance program won't work. For example, the Social Security system is designed to provide a safety net both for people too poor to save enough for retirement and for people who might be able to save enough but don't. Like certain kinds of natural disasters, retirement security for the elderly falls into the category of risks our society has decided to protect against through government. After September 11, the risk of terrorism, which had always been present, was added to that list.

On top of these industry-specific issues, there was also a lot of discussion of moving very quickly on some kind of economic stimulus. September 11 was an extraordinary event that demanded action targeted to the circumstances. But the economic debate that ensued was too often a return to familiar issues. What can happen in such a situation is that people who hold strong positions take any change in circumstances as a new argument for their preexisting point of view. In the first days after the attacks, some long-standing advocates of tax cuts quickly seized the initiative to argue for their usual proposals. The circumstances were changed, but their proposals remained the same. Three specific ideas came to the fore: accelerating the phase-in of the rate reductions included in the Bush tax cut, passing a new reduction in the capital gains rate, and cutting the corporate rate. All of these measures would further undermine the country's rapidly deteriorating long-term fiscal position. This was precisely the type of situation in which bad policy can easily be made—a sense of emergency, a set of superficially appealing policy proposals, and an eagerness on the part of politicians to act quickly. My view was basically pragmatic: I thought that additional tax cuts intended for stimulus should be temporary and, for reasons not just of fairness but of efficiency, should go to lower- and middle-income people, who had the highest propensity to spend rather than save. I would also have included temporary unemployment benefits and medical coverage for the unemployed, as well as some assistance to cities and states to help with their increased cost—all funds that also would have been spent right away. All of this would provide a more effective stimulus without an adverse long-term fiscal effect.

On September 17, the day after the
60 Minutes
broadcast, the New York Stock Exchange reopened and the Dow fell by 7 percent. After the close, I sat for an interview with Tom Brokaw on the
NBC Nightly News.
Brokaw asked me a series of very straightforward questions. He said something about the capital gains tax cut, and I offered my arguments against it. I didn't think a capital gains tax cut would add to our economic well-being under ordinary circumstances. Mainstream academic work strongly suggests that the savings rate is relatively indifferent to the tax rate on the return on savings (whether interest, dividends, or capital gains) and thus that reducing the capital gains rate is not likely to increase savings. Similarly, there is little mainstream evidence to suggest that investment rises with lower capital gains tax rates—investment in the stock market increased enormously in the years
prior
to the reduction in capital gains rates in 1997. My own decades of experience with investors and markets support this. And on the other side of the ledger, a capital gains tax cut does cost the Treasury over time and can create tax-driven distortions in the allocation of investment capital. Perhaps all this analysis would be different if extremely high tax rates were involved, but that was not the case here.

And under the circumstances that existed after September 11, a capital gains cut could have been outright counterproductive, since it might have encouraged people to sell stocks into a falling market. After the program, Gene Sperling said, “Bob, after all the years we were in the White House, that was the first time we've ever been able to systematically take on the arguments in favor of a capital gains tax cut in prime time.”

The next day I got a call from Janice Mays, the chief staff person for the House Ways and Means Democrats. The Democrats were trying to figure out what response they should make to the Republican tax cut agenda. Janice said that they'd distributed the transcript of the Brokaw interview to all their members, to help in their arguments against the capital gains tax cut.

The Democrats on the Ways and Means Committee subsequently invited me to Washington to meet with them about these issues. Then House Speaker Dennis Hastert and the bipartisan congressional leadership held a very unusual, formal, closed-door meeting on September 19—inviting the President's chief economic adviser, Larry Lindsey, Alan Greenspan, and me—to explore possible economic responses to the attacks. That meeting was followed by a closed-door session with the Senate Finance Committee and various other meetings. For a few weeks, I was going back and forth between New York and BWI airport outside Baltimore, since Reagan National Airport remained closed for security reasons.

Moving forward the personal tax rate reductions that were supposed to be phased in under the Bush plan and passing a new reduction in corporate rates were, in my view, like the capital gains cut, immensely flawed ideas. Both would cause further damage to the country's long-term fiscal position and would be highly inefficient in terms of their short-term stimulative effect relative to their cost. But in the prevailing climate, such proposals clearly had the potential to pass—especially after the Business Roundtable, an influential organization of large corporations, supported the idea of a corporate rate reduction. Democrats in the House and Senate, by contrast, had developed a program that in my view was much better tailored to the problem at hand.

   

I WOULDN'T HAVE guessed that the stock market would bounce back so quickly in the fall of 2001. The decline in the immediate aftermath of September 11 was never worse than 14 percent. For the month, less than 1 percent of the assets of stock mutual funds flowed out—versus more than 3 percent during the month after the day in 1987 that the market fell 22 percent. On October 11, a month after the attacks, the S&P 500 passed its level of September 10. Soon assets were flowing back into the market again. There was a certain wariness, and later in 2002 and in the first quarter of 2003 the market declined sharply, only to recover strongly in the second quarter. Throughout these ups and downs—exacerbated on the downside by corporate scandals and Wall Street regulatory and governance issues—the market still seemed to me to inadequately reflect economic and geopolitical risks. The imbalances that had grown out of the 1990s also remained largely intact. A major terrorist act had brought to the fore a whole host of destructive possibilities. In this context, stock valuations seemed high by many historical measures.

Indeed, quite a number of advisers and investors, such as Warren Buffett, were saying that equities were likely to provide lower than historical returns for an extended period. Also, bullish forecasts were usually based on projections of strong earnings growth and relatively low interest rates. But the strong economic conditions necessary for strong sustained earnings growth would likely lead to substantially higher interest rates—especially given our long-term fiscal morass. Yet this dynamic seemed not to be on forecasters' minds.

My interpretation of the market's behavior was that the psychological forces that had developed over an eighteen-year period persisted despite the significant decline of the market and the substantial losses incurred. In some ways, there was a strange sense of unreality to financial markets in the post-9/11 world. On the one hand, there was a widespread recognition that the world had changed—or, more accurately, a widespread recognition that the world had not been quite what it had seemed to be before the twin towers fell. On the other hand, this newly recognized reality seemed to have less effect than I would have thought on how most people thought about valuation and risk in relation to financial markets—the post-1930s phenomenon in reverse. This may have reflected a tendency of markets both to manifest the expectations of an excessive period long after the conditions that gave rise to the excess were over and not to take into account broader factors that don't fit within the framework that analysts use in evaluating stocks.

The people with national security backgrounds whom I spoke to were deeply concerned about what the country now faced. I shared a plane ride with Sandy Berger, President Clinton's pragmatic and insightful national security advisor, who talked at length about the seriousness of the terrorist threat that people were only beginning to recognize. The fanaticism that was developing in segments of the Islamic world could affect our country and our economy very substantially for a long time to come. Terrorism could affect the economy in a whole host of ways—by raising security costs, by making trade more expensive, by increasing oil prices, and by creating political instability in key countries abroad. Beyond the obvious potential for catastrophic events and disruptions is the effect of increased fear and uncertainty on confidence—which is always central to business and consumer behavior, economic conditions, and risk premiums.

Why, after a couple of months, did professional economic forecasters continue to be nearly as positive about the near-term outlook as they had been since the economic slowdown had begun in early 2000? Throughout 2001, most had been predicting that strong action by the Federal Reserve Board to lower interest rates would work relatively quickly to restore healthy growth for the country. Before September 11, I had felt that forecasters were overstating the potential effectiveness of action by the Fed—it is powerful and did ameliorate the slowdown, but it is not omnipotent—and greatly underweighting the impact of continuing economic excesses and imbalances. In the aftermath of September 11, Wall Street economic forecasters acknowledged the potential for future terrorist acts and political conflict abroad. But all of this had relatively little impact on their analysis and predictions, perhaps because they had no way to quantify these risks and because of an inertial tendency to stick with a familiar framework.

Somewhat later, Citigroup hosted a dinner at a Manhattan restaurant for a group of very senior professional money managers. The long and interesting discussion of the outlook for the global economy focused mostly on terrorism and geopolitical matters. But at the end of the evening, when the participants offered their predictions, those predictions reflected frameworks that made no reference to most of what we'd been talking about throughout the dinner. Apparently, their models couldn't accommodate such risks, so they weren't included.

What struck me after September 11 was that not only did the forecasts from the leading Wall Street firms tend to be predominantly positive in the face of grave new uncertainties and continued imbalances, but they continued to be the same kind of single-point forecasts that gave a growth rate for the next year as a single number instead of a range. It has always seemed to me that such single-point forecasts imply an unrealistic degree of precision, since the outlook for the future is always a probabilistic array across a broad spectrum. Forecasters presumably recognize the limits on their forecasts, but consumers may be less sophisticated and, in any case, have no basis for judging the odds on a predicted outcome. Life is uncertain. Forecasters who try to predict how much the economy is going to grow next year often fail to take into account not only specific uncertainties, but uncertainty as a guide to life.