Another new-era prponent who blasts at Greenspam from a different angle.
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June 29, 1999
The Fed, Not the Economy,
Is Overheating
By Brian S. Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson in Chicago.
It now appears all but certain that the Federal Reserve will raise interest rates tomorrow. Keynesians and monetarists are saying that it is about time. Even some supply-siders favor the move, but argue weakly that it is "for the wrong reasons." Nonetheless, the Fed is making a costly mistake: Raising rates is the wrong move for the wrong reasons.
Why would the Fed raise rates? Because the economy has been growing at a 4% rate and the Fed believes that the sustainable level of economic growth is just 3% (1% labor-force growth and 2% productivity growth). The excess growth, according to Fed Chairman Alan Greenspan, has been "spurred by the rise in equity and home prices," a "wealth effect" that the Fed believes has added at least one percentage point to growth over the past three years. This, he fears, threatens to produce an increase in inflation by lowering the rate of unemployment to a point where upward wage pressures will become irresistible.
The Fed's reasoning, however, contains some questionable assumptions, the first of which is that productivity is growing at just 2%. This figure is at best a guess: Productivity is virtually impossible to measure in the service sector and new technologies have made measurement errors worse.
Thus, even as academic economists debate whether productivity is rising by 1.75% or 2% per year, "New Era" companies--that is, those using new technologies to raise productivity--are pushing productivity through the roof. For example, Amazon.com sold $375,000 worth of books per employee in 1998, while their closest competitor, Barnes & Noble, sold just $100,000. Amazon accomplished this 275% increase in productivity in three years--an average annual increase of 55%. More broadly, the explosion of online possibilities has radically increased the value of computers even as their price has fallen. When prices fall, but value rises, by definition productivity is increasing.
This overall increase in productivity is immeasurable. But where we can measure productivity, it is surging. For example, productivity in durable-goods manufacturing has increased at a 5.9% annual rate--the fastest it has grown in the postwar era and stronger even than the best estimates of productivity gains during the Industrial Revolution. Indeed, were it not for the serious policy implications, the current suggestion that productivity is growing at 2% would be a laughing matter. Productivity growth is not only much greater than 2% but will remain so for decades.
But what about the so-called wealth effect? The thinking at the Fed seems to be that raising interest rates will damp the stock-market boom and thus force consumers to spend more conservatively. Alas, there is a flaw in this reasoning: The "wealth effect" does not exist. As most accountants--but too few economists--know, it is impossible for the economy as a whole to spend the wealth created by the stock market.
Think about it. If I buy a stock for $50 a share and it appreciates to $100 a share, I definitely have more paper wealth. But in order to spend that wealth, I must sell the stock to someone else. Only then will I have $100 to spend, while the buyer will have the stock but not the money. For every credit, there must be a debit. Increases in asset prices cannot increase aggregate demand. [What a bunch of baloney. How can this guy can explain the fall in savings rate?]
The same logic applies to homeowners or stockholders who borrow against their assets in order to spend. It is impossible for aggregate spending to increase because for every borrower there must be a saver. Once again, credits in the economy must equal debits.
The stock market represents the value of future earnings. And when productivity is strong, stock prices go up. However, while a company or individual can spend those future earnings by issuing or selling stock, the economy as a whole cannot. We must wait for the actual earnings before aggregate demand increases.
A third point on which the Fed errs is his view that low unemployment presages inflation. This notion flatly ignores the laws of supply and demand. A rise in nominal wages will not create inflation as long as the Fed does not accommodate the higher wages with excess money creation.
But there is a still more important point. There are now roughly 800,000 new business starts in the U.S. per year. Many of these are highly efficient New-Era companies that will eventually replace less efficient Old Era ones. One mechanism for this transformation is higher real wages. Highly productive New-Era companies can afford higher real wages, while less productive Old-Era companies cannot.
Again, the book-delivery business offers a good case study. Crown Books filed Chapter 11 last year and Lauriat's, a 127-year-old, 72-store Boston bookseller, closed its doors just weeks ago. Many Old-Era industries are overstaffed; higher real wages will force them to fold or transform. But the fact that the unemployment rate continues to fall suggests how effective New-Era companies have been in picking up the pieces. It's a sign of a dynamic economy, not an overheating one.
The Fed's decision to raise rates will certainly make life harder for old-era firms. By mistaking low unemployment for a sign of overheating the Fed runs the risk of creating deflationary forces that could harm the economy, especially in the commodity sector. Already, low prices are forcing mines to shut down and commodity producers to seek trade protection or federal aid through emergency spending bills. These pressures are just as real as the strong growth in wages and consumption but far more damaging.
Because the Fed is convinced that the economy is growing too rapidly, the bond market has priced in a significant interest-rate hike. The run-up in bond yields during recent months is partly due to misplaced fears of inflation, but mostly due to fear of the Fed. For the Fed to use the rise in bond yields as evidence of higher inflationary expectations is just circular logic.
The Fed is ignoring the signals of commodity prices and New-Era technologies and seems intent on bursting what it thinks is an asset bubble and an overheating economy. No one knows how far the Fed must go to slow the economy to 3% real growth. But the data suggest that attempting to do so may cause the onset of severe deflation and spell the end of the New Era. The real problem today is not that the economy is overheating, but that the Fed is using the wrong models to justify the wrong move.
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