Beginning in 1996, a Great Bubble grew and then burst, stripping $8 trillion of apparent wealth from American markets. Corporate management, investment bankers, accountants, and investors have all been named suspects. But in the end, responsibility lands squarely on our federal government, which is uniquely positioned and ultimately accountable for preventing what happened.

Bubbles Before

An economic bubble is a time of unsustainable prosperity in which the rapid creation of money, credit, and debt fuels even more rapid rises of stock prices, asset values, and spending. Wealth appears to be created, leading the public to buy and to spend more, thus creating further rises in stock prices, asset values, and spending. Financial promoters leverage these rising values to create even more money, credit, and debt. And so on. The spiral escalates until investors are no longer willing to pay higher prices. The bubble then bursts, and the whole scheme collapses.

The first economic bubble so christened—the exotically named South Sea Bubble—occurred in early 18th century England after the South Sea Company gained a monopoly on Britain’s trade with South America. The London-based company had far more success with financial engineering than with trade. Think Enron. Essentially, the company was able to pawn off government debt as a good stock investment. Think Wall Street analysts. South Sea stock rocketed then crashed. It opened 1720 at £128, rose 800% by June, and then plummeted back by December. Think NASDAQ. The South Sea Company spawned 120 imitators in 1720 alone, offering dubious paper securities to the public. Think IPO craze. Parliament passed the Bubble Act of 1720 banning all new private companies not under the control of the government, retarding British economic development for fifty years. Think Congress.

The most infamous American bubble was the 1920s New Era bubble. Driven by a belief that new technology—the automobile, the electric motor, the radio—had created a “New Era” in which the old rules of investing no longer applied, Americans adjusted their spending to their new wealth, buying stocks and homes on credit with abandon. In 1923, the Dow stood at 99. By August 1929, it had risen 400% to close at 380, but by 1932, fell almost 90% to 41.

By 1933, the economy had contracted by one-third, and unemployment reached 25%. The Great Depression was on, and because of its severity, an almost universal consensus emerged among American elites: Future bubbles must be punctured by the Federal Reserve early in their development.

The Economics of Bubbles

A bubble does all of its significant damage toward its end, not at its beginning. Three factors are responsible: (1) investing too much money in one sector of the economy and not enough in others; (2) spending too much based on the illusion of wealth; and (3) destruction of financial institutions caused by too many bad loans. Early phases of a bubble are almost indistinguishable from normal market fluctuations, and the damage is limited. But once a bubble develops, all the incremental investment and spending is waste. The longer it continues, the greater the damage. Therefore, once a bubble has clearly formed, the only rational policy is to pop it immediately.

The Federal Reserve is the instrument the modern economy uses to burst emerging bubbles by halting or even reversing monetary expansion by slamming on the economic brakes. It can hike short-term credit rates. It can increase stock margin requirements. It can use the bully pulpit. In the words of former Federal Reserve Chairman William McChesney Martin: “The job of the Federal Reserve is to take away the punch bowl just when the party starts getting interesting.”

The purpose for establishing the Federal Reserve in 1913, with its monopoly on printing money, was to guard against turbulence perceived to arise from a system of private banking. Perhaps, as some libertarians argue, this monopoly is a bad idea, but it is the law.

In the post-war era, no one believed that America would ever suffer another bubble because of faith in the Federal Reserve’s sense of duty and integrity. Certain sectors of the American economy might go through mini-bubbles and subsequent meltdowns. But the idea that America as a whole might suffer a massive bubble was not something serious people worried about. Yet it happened, starting around December 1996.

The Early Bubble

December 5, 1996 marks the start of the modern bubble, for on that date, Alan Greenspan gave his famous speech warning of the “irrational exuberance” of the stock market. But a clear sign that a bubble was coming occurred the year before. On August 9, 1995, a year-old company with no profits and little revenue made its IPO. Netscape went public at $28 per share and shot upward all day to close at $58, worth over $2 billion. Netscape CEO Jim Clark’s secretary, who knew nothing about stock options before joining the company, ended the day worth over $1 million. She retired two years later.

By late 1996, the S&P 500 index, the broadest and most representative measure of big company stock values had topped 750. It was selling for 20 times earnings, a very high ratio in a strong economy. Stock prices had almost doubled in the five preceding years.

It was time for the Fed to take away the punchbowl. Instead, as Morgan Stanley chief economist Stephen Roach said, “the Fed squandered the opportunity to pop the equity bubble in late 1996 and early 1997.” Worse, “an ‘irrationally exuberant’ equity bubble was suddenly rationalized by a Fed that embraced the New Economy with open arms.”

By early summer 1998, the S&P 500 had risen by 60% to 1,200, and the bubble spread to Asian stock markets. In August, however, financial markets in Asia (excluding Japan) began to crack—falling 50% or more in a matter of months. The Asia crisis put a number of U.S.-based financial speculators at risk, most infamously Long Term Capital Management. U.S. markets retreated 15%, but the S&P 500 still hovered around 1000, one-third higher than the irrationally exuberant levels of two years before.

The Federal Reserve faced a choice: it could let the markets do what the Fed itself should have done in early 1997—deflate the U.S. bubble—or it could bail out global interests in Asia and Wall Street. It chose the latter.

In an unprecedented move, the Fed summoned major Wall Street investment banks to its New York offices to arrange a bailout of Long Term Capital Management, and on September 27, 1998 announced a bailout plan. The next day, it began the first of three rapid rates cuts. The markets got the message: “Don’t fight the Fed.” The early bubble was over, and the mania began.

The Mania

For two years after the Long Term bailout, speculation in stocks became an American obsession. The S&P index eventually topped 1,500, more than 50% higher than October 1998, double December 1996, and four times higher than the early 1990s. By every relevant measure, the stock market was wildly overvalued during the mania, more so than at any other peak in its history, including the 1929 peak before the Depression.

The Internet bubble became a great speculative craze. Fortune’s June 9, 1999 cover promoted: “Net Stock Rules. Those wild Internet valuations change the whole game. Managers and investors: Ignore them at your peril.” The Internet bubble peaked as early as December 1999 and burst the week of the great NASDAQ decline, April 10–14, 2000.

The much bigger telecommunications and technology bubble had not burst, however. Investors burned on Internet stocks poured money into seemingly solid stocks. On September 1, 2000, the NASDAQ reached 4220—triple the irrationally exuberant levels of December 1996. Many of the bigger tech stocks, like the “Four Horsemen” of Cisco, Oracle, Sun, and EMC, hit all-time highs. Stock valuations were absurd. The 100 largest NASDAQ companies were worth over $5 trillion, yet they made less than 1/200th of that in income.

The great market players of the late 20th century—Warren Buffet, Julian Robertson, George Soros, John Templeton—warned of a stock market bubble. At the April 2000 Berkshire Hathaway shareholders meeting, Buffett cautioned: “If you are very early in a chain letter, you can make money, but there’s no money created.” Templeton observed to the Miami Herald, “This is the most dangerous period in financial history.” But no one cared about history, and the warnings of veteran investors went unheeded. By late 2000, the bubble in telecommunications and technology stocks finally burst. The NASDAQ declined to 2500 as technology budgets contracted across corporate America. The mania was over.

The Late Bubble

The economy now needed a deep, painful recession to purge the excesses of the Great Bubble. Both consumers and government had overspent, and the normal purge of a boom’s excesses includes repayment of debt and curtailment in the growth of government spending.

Beginning on January 3, 2001, however, the Federal Reserve took the opposite course. That year witnessed an unprecedented 11 short-term rate cuts, reducing rates from 6.5% to 1.75%.

These rate cuts did nothing to help telecommunications and technology companies. Excluding the Bells, most telecommunications companies went bankrupt, shedding 300,000 jobs. Capital spending on technology declined precipitously, and recession hit the U.S.

Rate cuts shifted the Great Bubble from telecommunications and technology to the consumer. Despite a worsening job market and the damage to mania stocks, Americans kept spending and taking on more debt faster than their incomes grew, and government spending continued to outpace inflation. Employees at soon-to-be-bankrupt companies such as Enron and WorldCom remained optimistic.

In mid-2001, as recession hit, the stock market wobbled. From April to September, the S&P 500 fell 30%, but September 11th masked the downturn. Easy victory in Afghanistan and no further acts of mass terrorism reassured Americans. By March 2002, most believed that we had conquered the recession. Magazines and newspapers headlined the triumph, and the Dow reached almost 10,600, just 10% off its January 2000 peak. But the victory was an illusion based on foreign money. In April 2002, the dollar began to break, falling more than 15% in four months, and the stock market followed the dollar down. By July 2002, the market had lost almost 30%, and Americans began to turn pessimistic. The late bubble was over.

Aftermath

The Great Bubble has left the American economy saddled with at least three major burdens:

Consumer and corporate debt now totals $9.5 trillion and $4.3 trillion respectively, double the levels of a decade ago.

America’s trade deficit now exceeds $400 billion per year, triple the levels of a decade ago. Because American companies are so uncompetitive in selling abroad, Goldman Sachs estimates that a 43% decline in the dollar would merely cut the trade deficit in half.

In the 1990’s, government spending at all levels rose from less than $2 trillion in 1991 to over $3 trillion in 2001.

Turning Off the Alarms

As in any large-scale disaster, a critical question is, who turned off the alarms?

The simplest answer is Alan Greenspan and his cheerleaders in government, the media, and on Wall Street. Greenspan never believed that “the job of the Federal Reserve is to take away the punchbowl just when the party gets interesting.” Just the opposite. Greenspan thinks his job is to spike the punchbowl when the party dies down.

There are other answers as well. The accounting system should have sounded an alarm, but many companies simply lied about their profits. The culture of “everybody-does-it” dishonesty, endorsed by the Senate on the day it acquitted President Clinton, resulted in the worst outbreak of accounting fraud since at least the 1920s.

During the Great Bubble, wage inflation, another alarm, was suppressed by mass immigration, as importation of foreign workers to the United States doubled in the 1990s. In the long-term, wage inflation means raises for American workers, a good thing. In the short-term, excess wage inflation acts as a self-correcting mechanism to stop bubbles: as workers become too expensive, companies stop hiring.

Instead of worrying about how to puncture the bubble, Alan Greenspan focused on increasing immigration to keep wages down. In his January 2000 testimony to Congress, Greenspan said, “Aggregate demand is putting very significant pressures on an ever-decreasing available supply of unemployed labor. The one obvious means that one can use to offset that is expanding the number of people we allow in. Reviewing our immigration laws in the context of the type of economy which we will be enjoying in the decade ahead is clearly on the table…”

One alarm did go off: the trade deficit, which during the Great Bubble more than doubled, but this alarm was ignored.

The trade deficit rose throughout the early bubble and, starting during the mania, exploded off the charts. For the years 1999—2001, the cumulative trade deficit was $1 trillion. Adjusted for inflation, the trade deficit had tripled in 7 years and remains at record levels

Americans facilitated the Great Bubble because they enjoyed their apparent prosperity too much to consider the long-term consequences of their borrowing. The market did no better, because markets are no smarter than the people who run them, and the people who ran them were drunk on cash. The mechanism designed to incorporate these insights, the Fed’s traditional duty to pop bubbles, was abandoned owing to a cult-like faith in a “New Economy,” a belief intimately connected to globalist ideology. Both share a central myth: old-fashioned specifics like location, nation, politics, culture, and character no longer matter. With the bursting of the Great Bubble, they could return.

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Robertson Morrow is a financial analyst in New York.