In an Uncertain World (50 page)

Even with all those qualifications, most investors who are in a position to have a long-term perspective should probably have some portion—and in appropriate cases even a fairly substantial portion—of their savings in stocks. The threshold questions are: How much? And should decisions about asset allocation be subject to short-term market views? There are all kinds of models that recommend the proportion of investible assets to put into stocks, based on performance data in stocks over some long prior period of time and the circumstances of the individual investor. An alternative is for an investor to start with a full understanding of the risks and then to decide how much he could live with losing if his investments fell substantially. That would set the outer limit of the equity allocation. The amount to actually invest in equities within that limit would be affected by a whole host of factors, including the investor's time horizon and income needs, and a disciplined approach to calculating likely risks and rewards over whatever the time horizon may be. In my own case, I have also made the judgment that I should avoid what I thought were times of market excess, while recognizing the uncertainty of those judgments. I certainly would not put all of my money into stocks, or put too much into a single stock or small number of individual stocks, or into any one sector of the economy. And I would buy stocks based only on the long-term prospects of a company, with a view toward holding any investment for a very long time unless those prospects change or valuation rises to irrational levels.

Warren Buffett is famous for this “value investing” approach—buying companies only when their prices are low relative to their long-term earnings prospects, with a view to being a very-long-term holder of the stock. I think that approach, carefully and consistently executed, provides the best opportunity to outperform the market indexes over time. Those who aren't particularly well positioned to make judgments about individual stocks can choose a mutual fund that has executed this approach successfully for a long time or a financial advisor who seems well equipped to do so. Another approach is simply to invest in an index fund, whose performance will track the market's. For those with sufficient resources, a wider range of possibilities has become available: so-called alternative investments, such as a private equity fund or various kinds of hedge funds. Conceptually, these alternatives can make good sense, but they are now becoming popular and faddish and may quickly become a new set of excesses, with unhappy results for many investors. For example, one postboom fashion has been “long-short” funds that attempt to be at least somewhat market-neutral by having long and short portfolios that are close to equal in size. The idea is to get the benefit of your selections whether stocks as a whole go up or down. Most active managers have made money over the last twenty years not because of their active management but because the market as a whole went up so much. With a market-neutral approach, you take away the one factor that has allowed most active managers to reap gains over the last twenty years—namely, the rise in stock prices—and keep the factor that history has shown most don't succeed at—namely, active management. I do believe that some investors have the judgment, skills, and patience to outperform the market indexes over time and, consequently, some long-short funds will almost surely do well, but I would guess that the great majority probably will not.

Finally, there is the challenge of evaluating results. For stretches of time, a stock picker may outperform the market for reasons that have nothing to do with skill. He may simply be in sync with the biases of the market—favoring telecommunications stocks, for example, during a period when the market as a whole favors them. Or he may be lucky. The “random walk” theory posits that if a large number of monkeys pick stocks by throwing darts at stock tables, half will do better than the average stock picker and half will do worse. If the winning monkeys then repeat the exercise once each year for ten years in a row, one out of 1,024 will beat the average every year, merely on the basis of probabilities. A stock picker who beats the S&P 500 ten years running will almost surely be lionized as having a special genius—and some may—but others will do so merely as a matter of chance.

   

THINKING BACK ON my own financial behavior, I'm reminded how commonly markets fail to behave the way you expect, feel, and hope. I've always had a cautious view toward stocks and have never invested a lot, partly because for most of my career I had significant exposure to the behavior of markets through my stake in Goldman Sachs. But in 1973, when the market slumped badly, a few companies whose fundamentals I knew well had come way down and seemed very cheap relative to their long-term value. Yet from the time I bought them to the time the market bottomed out in 1974, my investments fell in price by 50 percent.

The point of that story is that even a careful and highly disciplined investor can't see a market bottom any more easily than he can see the top. The broader point is that no one is very good at predicting the direction of the market in the relatively near term, and investors should allocate their assets based on long-term judgments about risks, rewards, and personal risk tolerance. However, as I said, that's a bit of advice I've never taken myself, tending instead to inject my own shorter-term market views. If I remember only the times I was right, for example 1998 to 2000, I have a terrific track record. If I'm more honest and remember all my judgments, I'm probably not much better than fifty-fifty on shorter-term market judgments—and I don't think anyone else is either. My experience in 1973 is probably also a warning that one should never be an absolutist about anything—including being a contrarian. If you see a long trend in one direction, question its soundness. But if you decide to bet against the herd, as I did in 1973, recognize that the stampede may go on for a very long time—and the herd may even be right. As my Goldman partner Bob Mnuchin used to say, people who sell at the bottom aren't stupid. The problems are real and the outcome is uncertain. Only in retrospect can you tell when the worst is over.

CHAPTER THIRTEEN

They Called It Rubinomics

I HAD FELT FOR SOME TIME that Al Gore would be a good presidential candidate and a good president. During the height of the focus on the Vice President in connection with a controversy around fund-raising practices in 1997, I had said to Gore's chief of staff, Ron Klain—a former Supreme Court clerk who combines enormous intelligence with great political savvy—that if I were to leave Treasury before the end of the Clinton presidency, I would very much like to help the Vice President in his quest for the presidency. This was a period when Gore was under a lot of pressure, and I felt that perhaps even a small gesture of encouragement would be useful. Later that same day, we were all in the Oval Office in preparation for a meeting with a foreign leader, and the Vice President came over to where I was standing and elaborately helped me into my chair.

Gore can be awkward in interpersonal interactions—an unusual and unfortunate characteristic for someone in political life. But that awkwardness can be misleading. Gore is very bright, vigorous in his thinking, and possessed of a sharp and often self-deprecating wit that I very much enjoy. I remember when the Prime Minister of Poland was visiting Washington and had the usual meeting in the Oval Office with the President, the Vice President, and a few senior officials from each side. It was a busy time at the White House, with electoral politics very much on people's minds, and I thought the meeting was probably a less than optimal use of the President's time—though, in fairness, Poland was the poster child for economic reform in Eastern Europe. At the end of the meeting, the Prime Minister noted that there were many people of Polish extraction living in the United States. The Vice President looked at him with mock astonishment and said, “We had heard something about that.” I told the Vice President afterward that I had practically broken up, because in his own ironic way, Gore was making the point to the earnest Prime Minister that this was exactly why the meeting was taking place.

I tended to agree with Gore on most of his policy positions. He strongly opposed George W. Bush's campaign proposals for a massive tax cut and for the partial privatization of Social Security. Gore had been a strong force for deficit reduction from the beginning of the administration, had worked hard on the Hill to pass the Mexican support program, and had very publicly supported trade liberalization, especially during the struggle to pass NAFTA—even though that had been politically difficult at times within the Democratic Party. He also had a strong focus on inner-city problems.

Gore's greatest passion, of course, was the environment. I had entered the administration with great skepticism about what seemed to me absolutism on the part of at least some environmentalists. But Gore persuaded me that the threats to the environment were a serious danger and that environmental protection and economic growth were not necessarily a trade-off; that, indeed, long-term economic growth would depend on sensible environmental policy. I came to believe that measures of the gross domestic product would more accurately reflect economic output if environmental costs and benefits could be included—though that is not yet feasible, either politically or technically. I remember a long conversation we had in the Vice President's West Wing office about global warming. Gore said that even if science didn't provide certainty, the evidence was considerable that global warming was occurring, and measures to repair it would take a long time to have substantial effect. If we waited too long and the evidence turned out to be correct, the result could be an unpreventable catastrophe. And with risk of catastrophe, you cannot afford to be wrong. This was in a way analogous to the problem a trader faces when he has a position that is almost certain to produce a positive return but is so large that failure could put him out of business. That is a chance he can't afford to take. And of course, with global warming, most experts believe that the risk of a catastrophe is real. Any sensible analysis of global warming seems to me to lead to the conclusion that putting effective preventive measures in place is imperative—though that still leaves questions about which ones make the most sense.

Unfortunately, rather than running primarily on the economic record of the Clinton-Gore administration, the Gore campaign took something of a populist tone. Income distribution is a critically important economic issue for any society; the question is the language you choose and the sense you convey with your words. At any time, but especially at a moment when people were broadly benefiting economically, language tinged with class resentment seemed to me politically and substantively counterproductive. If Gore were to win, his populist rhetoric in the campaign could hurt business confidence and investment, which was not the way to start a new administration.

All of this, of course, is a long-standing debate within the Democratic Party, which has its philosophical schisms just as the Republican Party does. I am not a political analyst, but I've been around this debate for many years, listening to the vigorous policy and political arguments on both sides. My view remained what I remember Hillary Clinton telling Bob Reich after the 1994 midterm election debacle: that the key in the general election is the 20 percent of swing voters in the middle of the electorate, and that class conflict is not an effective approach with those people. In response to this kind of criticism, Gore's campaign strategists are quick to point out that Gore got more popular votes than Bush. But whatever one's view of the outcome, I think the Gore campaign should have done better, given that he was running as an incumbent Vice President amid the best economic conditions in many decades.

   

AFTER BEING SOMEWHAT involved in the 2000 election, I didn't give much thought to what role, if any, I would have in the policy debate going forward. But three events quickly got me reinvolved: the new administration's tax cut proposals in early 2001, which I considered fiscally unsound; the Democrats' need for economic policy advice from people they were comfortable working with; and the September 11 attacks. All of these factors pulled me back into the policy-making process. It's useful to separate the history of the Great Fiscal Debate from current arguments around the question of whether deficits matter. After analyzing the issue, I'll relate the story of how I reengaged with the debate.

The Great Fiscal Debate:
More than anything else, it was my deeply troubled reaction to the administration's tax cut proposals that led me to reengage. The tax bill, debated and passed in the first half of 2001, began a period in which tax cut advocates dismissed mainstream views about the direct and indirect effects of large tax cuts on the government's fiscal position, the value of sound fiscal policy, and the harm caused by large, long-term structural deficits.

Conservatives often framed the debate over Bush's proposals as a question of lower taxes versus more spending. (Here and throughout the chapter, my reference to conservatives is to those who, through the 1980s and 1990s, coalesced around fervent advocacy of the tax cuts as an overriding priority, rather than more traditional conservatives, who, whatever their social and other views, were strong advocates of sound fiscal policy.) The Concord Coalition, an organization dedicated to fiscal discipline, and led successively by two Republicans, former Commerce Secretary Pete Peterson and former Senator Warren Rudman, was advocating policies that once were at the core of the conservative movement and the Republican Party (and eschewed by most Democrats). One of the ironies of this period is that today those policies are opposed by many leading conservatives and supported by many Democrats.

If government didn't give back the surpluses to the public in the form of a tax cut, leading conservatives argued, “Washington” would find a way to spend the money. Another version was that the surpluses were the people's money and should be returned to them. These formulations are as politically shrewd as they are simplistic and in many ways misleading. Nobody likes what government does when it's described as “spending.” Yet the major programs that make up the vast preponderance of government spending—from Social Security and Medicare to defense, law enforcement, education, and environmental protection—command widespread public support. In practice, even conservative supporters of tax cuts are reluctant to scale back these popular programs, and they even vote for increases at the same time as they inveigh against “spending.” These programs are the people's programs, just as tax dollars are the people's money. If tax cuts are not matched by spending reductions, they increase the size of the federal debt—a debt that is the people's debt.

The Bush administration's approach to tax cuts framed a new stage in the Great Fiscal Debate, an ongoing clash about the effects of fiscal discipline and of tax cuts on economic growth. This argument first affected policy in a significant way during the 1980 presidential campaign, when a group of conservative “supply-siders” attained prominence. The core of the supply-side theory was that lower marginal tax rates would cause people to “supply” more labor, working more and harder, which would increase growth—and the positive effect on growth would be so large that government tax revenue would actually increase rather than decrease in response to the tax cut.

George H. W. Bush, Ronald Reagan's opponent for the Republican nomination in the 1980 election, referred to this as “voodoo economics.” And not all of Reagan's advisers believed this theory. Some committed conservatives understood that reducing the size of government is difficult because of the popularity of most spending programs of significant size. Tax cuts seemed to offer a way around this political problem. If government's revenues were squeezed, this line of reasoning went, spending could no longer grow and might even be forced to shrink. Despite that theory, spending throughout the 1980s, agreed to by both the Reagan administration and Congress, consistently and significantly exceeded levels necessary to offset the tax cuts. The result was the large deficits of the 1980s, deficits that kept increasing during the early 1990s and were projected by the outgoing administration in 1992 to grow even more in the years ahead.

For a government to run a cyclical deficit—a short-term and temporary deficit in conjunction with a recession or an economic slowdown—isn't necessarily bad and at times may be entirely sensible. Keynesian economics explicitly advocates cyclical deficits produced by temporarily higher spending or temporarily lower taxes as a way of dealing with recessions. In the 1960s and '70s, some liberal Democrats who accepted that theory also found in Keynesian economics a convenient argument for advocating permanent increases in programs. But the Reagan tax cuts, combined with the Reagan-era defense spending increases, created something different: large and intractable long-term structural deficits, which persisted even when economic conditions were good. The Walter Mondale campaign of 1984 and the Michael Dukakis campaign of 1988 both argued that the existence of this structural deficit was a significant, long-term threat to the American economy. Essentially, they didn't get any response, because so few people understood the problem. Mondale told me some years later about his frustration at not being able to talk about the deficit in a way people could relate to.

By 1989, the deficit had begun to seriously affect the economy. People began to understand that deficits were contributing in some way to the difficult economic conditions of the very late 1980s and early 1990s, which changed the political dynamics of the issue. By 1992, the deficit was 4.7 percent of GDP—nearly $300 billion. Dealing with the deficit was a centerpiece of Clinton's 1992 campaign. One of the reasons Clinton focused so intently on the deficit is that it not only was causing harm to the economy but was also undermining confidence in government, limiting its ability to deal with problems and issues that people cared about. Though he supported reductions in many areas, Clinton wanted government to be more active in others.

After Clinton took office, the Great Fiscal Debate mutated. In 1993, the debate was between supporters of Clinton's economic plan—which included revenue increases, principally an income tax increase on the top 1.2 percent of taxpayers and a small gas tax—and opponents who argued that tax increases of any kind would harm the economy. Loyal supply-siders such as Jack Kemp and Paul Gigot of
The Wall Street Journal
argued that our economic program would harm the economy and lead to higher unemployment. Some were even more specific in their predictions. “I believe this will lead to a recession next year,” Newt Gingrich said at the time. “This is the Democrat machine's recession and each one of them will be held personally accountable.”

The 1993 deficit reduction program was a test case for supply-side theory. Instead of the job losses, increased deficits, and recession the supply-siders predicted, the economy had a remarkable eight years—the longest period of continuous economic expansion yet recorded. Unemployment fell from more than 7 percent to 4 percent, accompanied by the creation of more than 20 million new private-sector jobs. Inflation remained low while GDP growth averaged 3.5 percent per annum. Productivity growth averaged 2.5 percent a year between 1995 and 2000, a level not seen since the early 1970s. Poverty rates went down significantly, including among Blacks and Hispanics, and incomes rose for both higher and lower earners. For the first time in nearly thirty years, the budget balanced in 1998.

President Clinton's economic plan contributed greatly to these conditions. That success created an immense anger on the part of some conservatives, who saw a policy they decried lead to conditions they said wouldn't occur. Ever since, they've been trying to find other ways to explain what happened to the economy and to denigrate Clinton's accomplishment. During the 1990s, some moved to the position that the economy was booming for reasons they said had nothing to do with declining deficits and balanced budgets, and pointed instead to technological progress and trade liberalization (both of which were, indeed, also important, and promoted strongly by President Clinton). A number of supply-siders advanced the theory that the boom of the 1990s was a delayed reaction to Reagan's 1981 tax cut.