· Joseph Stiglitz observed the hubris infecting the US economy in the 1990s, first as chairman of President Clinton's council of economic advisers and then as chief economist of the World Bank. In the first of two extracts from his new book, the Roaring Nineties, the Nobel Prize winning economist explains how the boom sowed the seeds of the US's present economic difficulties.

In the Roaring Nineties, growth soared to levels not seen in a generation. Newspaper articles and experts proclaimed that there was a new economy, that recessions were a thing of the past and that globalisation was going to bring prosperity to the whole world.

But toward the end of the decade, what seemed to be the dawn of a new era began to look more and more like one of those short bursts of economic activity, or hyperactivity, inevitably followed by a bust, which had marked capitalism for 200 years. Except that this time, the bubble - the boom in both the economy and the stock market - was greater, and so too were its consequences; the new era was a new era for the United States and the whole world. Thus the bust that followed was a downturn not only for the US but for much of the world.

This was not the way it was supposed to be. The end of the cold war left the US as the sole superpower, and it marked the victory of the market economy over socialism. The world was no longer divided on ideological grounds. It may not have been the end of history, but at least it was supposed to be the beginning of a new era - and for a few years that seemed to be the case.

Not only had capitalism triumphed over communism; the American version of capitalism, based on an image of rugged individualism, seemed to have triumphed over other, softer, fuzzier versions. At international meetings, we boasted of our success and preached to the sometimes envious economic leaders of other countries that if they would only imitate us, they too could enjoy prosperity like ours.

Everybody seemed to be benefiting from this new world order, this Economia Americana which brought unprecedented capital flows - sixfold increases to emerging markets in six years - unprecedented trade - an increase of over 90% over the decade - and unprecedented growth.

But Americans should face up to the fact that in the boom were planted some of the seeds of destruction, seeds which would not yield their noxious fruits for several years. We had not intended to plant these seeds - we had not even known that we were doing so. On the contrary, we believed we were planting the foundations of a prosperity that would continue into the future.

Echoes of tulip mania

What were these seeds of destruction? The first was the boom itself: it was a classic bubble, asset prices unrelated to underlying values, of a kind familiar to capitalism over the centuries. Bubbles are based on a certain irrational exuberance, and perhaps not since the days of tulip bulb mania had the irrationality of the market been more in evidence, as investors paid billions of dollars for companies that had never shown a profit - and likely never would.

No one - not the president, the secretary of the treasury, or the chairman of the Federal Reserve - can be blamed for this irrational exuberance; but they can be blamed for not dealing with the consequences, and in some cases, for feeding the frenzy. After a faint effort to let the air out of the bubble, the Fed simply added to the hype.

Bad accounting provided bad information, and part of the irrational exuberance was based on this bad information. We knew that the accounting systems had a major flaw, and that the system of chief executive officers' compensation provided incentives to take advantage of the limitations in our accounting systems.

We knew that those responsible for accounting, the accounting firms, faced conflicts of interest in providing good and reliable information. But short term and special interests prevailed over the long term and general interests. Not only did they stop efforts at improving matters; tax laws and securities legislation actually made matters worse.

Distorted incentives combined with irrational exuberance induced America's new financial behemoths to provide the finance that underwrote the bubble; they made billions from the initial public offerings and the deceptive boosting of their favoured stocks, even if gains had to come at the expense of someone - in most cases, ordinary shareholders.

To add froth to the frenzy, taxes on capital gains were cut. Those who earned their money by speculating and winning on the stock exchange were the heroes of the day, and were to be taxed more lightly than those who earned their bread by the sweat of their brow. With speculation thus especially blessed more money poured in, and the bubble was inflated even further.

Misguided deregulation and bad tax policies were at the core of the 1991 recession, and misguided deregulation, misguided tax policies and misguided accounting practices are at the core of the current downturn.

American investors had trusted the corporate auditors, and the auditors had betrayed that trust. Similarly, investors had trusted the Wall Street analysts about which stock to buy and those analysts too had betrayed that trust.

Our emerging understanding of the 1990s requires that we admit - to ourselves and the world - that we were engaged in a misguided attempt to achieve growth on the cheap.

Instead of curbing consumption to finance our boom, the US borrowed heavily, year after year from abroad, at a rate of more than a billion dollars a day. We did this to fill the widening gap between what we were saving and what we were investing - a gap that opened in earnest under Ronald Reagan but grew under George Bush Sr and Bill Clinton, and has reached new dimensions under the new President Bush.

We made some good long-run investments - both in the private sector and in the public, but too much of our investment went into wasteful private expenditures - the dotcoms that didn't pan out, the fibre-optic cables that were not needed. It is still not clear how much of the private so-called investment of the 1990s was sheer waste, but even if we consider only a fraction of the erosion in stock values is attributable to bad investments, the figure must be in the hundreds of billions of dollars.

By contrast, too little of our investment went to address vital public needs, in education, in infrastructure, in basic research. We provided tax credits and deductions for higher education, but most of the middle class kids who benefited were already going to college; the credits and deductions did make their parents' lives easier, but it was unlikely to have much effect on enrolments. The money could have been better spent targeting the very poor, for whom money is a real obstacle - whose parents do not pay taxes.

Most ironic in the age of the new economy, we also underinvested in research which underlay the new economy. We were, in part, living off past ideas - break throughs of an earlier day such as transistors and lasers. We were counting on foreign students to come up with scientific advances while our best students were putting together financial deals.

Of all the mistakes we made in the Roaring Nineties, the worst were caused by a lack of standing by our principles and a lack of vision.

Lessons to be re-learned

We had principles. As the administration came into office, most of us knew what we were against. We were against Reagan conservatism, we knew there needed to be a larger and different role for government, that we needed to be more concerned for the poor and for providing education and social protection for all, and we needed to protect the environment. The shortsighted focus on finance, on the deficit, made us push this agenda aside.

The central lesson that emerges from this story of boom and bust - that there needs to be a balance between the role of government and the markets - is one which evidently the world has had to learn over and over again. When countries got that balance right they grew strongly - America through much of its history, East Asia in the sixties, seventies and eighties. When countries got that balance wrong, veering either toward too much or too little government, disaster awaited. Although the failures of excessive government - evidenced by the collapse of the communist system - are the most dramatic, there are failures on the other side as well. If we in the Clinton administration sometimes lost that balance, matters have become even worse in the next administration - with the predictable consequences that our economy's performance has become worse.

The challenge today is to regain that balance, to learn the lessons of the tumultuous decade of the nineties and the years that have followed.

The warning came too soon

It was at a black-tie event in Washington in December 1996 that Alan Greenspan first uttered those attention-grabbing words, "irrational exuberance".

It was an impressive, wide-ranging speech, though Greenspan had so trained himself to speak enigmatically like the Delphic oracle - what came to be called "Fedspeak" - that it made the eyes of those untrained in deciphering what he meant, or might have meant, glaze over.

One of the topics on which he touched was the sudden plunge in real estate prices that had triggered Japan's descent into a broad state of economic paralysis. It was hard to put a precise value on something like real estate, Greenspan observed, and therefore hard to know when a speculative market might be due for a sudden contraction. It was also hard, he added, to know when such a contraction might prove to be a disaster for the economy at large.

Greenspan had no answers that night, only questions; but one of his questions made a memorable impression: "How do we know," he asked, "when irrational exuberance has unduly inflated asset values ..."

When I approached him after his speech to discuss several of the ideas that he had thrown out, it was clear that he was fixated on the "irrational exuberance" remark. He knew that the pundits would know it was the United States rather than Japan that he had in mind. He was worried about the stock market, which was having a blowout year. And if Greenspan was worried, the business and financial world had reason to worry. The following day, stock markets reeled in Tokyo, Sydney, Hong Kong, Amsterdam and London, as well as New York. Shares of General Motors, IBM and Dupont all fell by 2% or more as investors steeled themselves for a possible interest rate increase.

And then ... nothing happened. The labour department released statistics indicating slow job growth; signs of inflation failed to materialise, even later when unemployment continued its downward march; the Fed did not in fact raise interest rates; and the stock market continued to climb setting records with almost boring regularity for the next four years, until the bubble burst.

Many thought it was the responsibility of the Fed not only to prevent inflation but to stabilise the economy, and this meant doing something about the bubble. The failure is all the more puzzling because Greenspan had recognised that there was a bubble in 1996, and seemingly had tried to do something about it. But if there was a bubble in 1996, surely the run-up of the stock market in the final years of the century must have been truly disturbing?

·Extracted from The Roaring Nineties: Seeds of Destruction, Joseph Stiglitz; published October 2, Allen Lane; £18.99

Copyright Joseph Stiglitz 2003