Whom to Blame for the Recession?

Now that the economy appears to be on the right track again, I’d like to revisit what I think was the cause of the 2001 recession. I run across too many people who take a partisan stance and blame it on Dubya or blame it on Clinton. Really, the President doesn’t have as much power over the economy as most people think. While I’m no expert, I think the real answer is pretty simple.

Basically, this recession was caused by overproduction. Companies built too much stuff and ended up with too much inventory. When they finally realized this, they cut down production tremendously, laying off people, and cutting down their capital expenditures (CapEx) to buy equipment and parts from other companies, which had a ripple effect to those companies who also had to cut production. This is why you’ll hear some people refer to this as a CapEx recession (and I’d guess that many of them don’t actually know what that means, but just heard it somewhere and want to sound smart). Lack of consumer spending wasn’t really the cause. Corporate spending was.

So how did we get there? We had a tech stock bubble. What’s a bubble? When people start buying something, not because they think it is worth more than they are willing to pay, but because the price is going up. Much of economics assumes buyers and investors act rationally, but in reality, there’s a lot of mob psychology going on. I’d recommend Paul Ormerod’s Butterfly Economics for more on that (and I’m sure I’ll write a post one of these days). But suffice to say, sometimes buyers make decisions more based on what other buyers are doing, and not really because they believe what they’re being is actually worth what they’re paying. There are other famous examples of bubbles, like the Tulip Bulb and South Seas bubbles.

But anyway, the thing about bubbles is that they inevitably burst. The sooner, the better! The later they burst, the worse the resulting recession. The one person who had the power to burst the bubble early? Alan Greenspan, chairman of the Federal Reserve. Greenspan had an opportunity to burst that bubble in 1996, when he recognized the problem (irrational exuberance) and threatened to raise interest rates. The markets screamed bloody hell (who does he think he is, trying to manipulate the stock market?). Instead of doing the right thing anyway, he caved into public pressure and allowed the markets to become even more overvalued than they were already.

When so many investors make such overly optimistic straight-line projections of demand and growth, it was only a matter of time before the companies themselves (many rich with plenty of VC and IPO capital) started making the same unrealistic projections and increased capital expenditures accordingly. Of course, when the demand did not materialize, everyone had way too much inventory, and thus the CapEx recession (9/11 didn’t help, but it wasn’t the primary cause).

This was most obvious in the optical sector, where companies like Nortel, Lucent, and Cisco were spending and building out like crazy, thinking it was going to eventually pay off, and then they suddenly realized it never would. At that point, they immediately stopped spending and building, and all their suppliers (JDSU, AMCC, Vitesse, Broadcom, etc.) suddenly lost the bulk of their revenues and had to start laying off people.

Thus, the recession. We still have a glut of unlit fiber, which I’m sure will come in handy someday, but is of little comfort to the companies and investors who spent all their money on it.

Anyway, had Greenspan popped the bubble back in ’96, inventories would not have been as high, and capital expenditures would not have had to decrease so much for so long. Of course, it would have been an unpopular move, as it would have likely plunged us into a recession (most likely milder and shorter than this one), and few would really have believed there was ever any danger of a bubble. But all minor in the grand scheme of things.

So basically, this recession was because Greenspan is a political beast too concerned about his image and popularity to do an unpopular but correct move. I’m not saying he’s not the best person for the job, but that he makes mistakes like all of us, and this was definitely his mistake.

The “jobless recovery” is also commonly misunderstood, but it’s a slightly different case.

Updated on 5/22/21 to add links for the Tulip and South Sea bubbles.

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