by Lawrence Kudlow
CNBC.com Chief Economist
Be careful what you wish for, Mr. Greenspan.
When it comes to fine-tuning the economy's growth rate, past history shows
that monetary policy is a blunt and clumsy tool, one that has produced at least
as many failures as successes. Changes in tax and tariff rates are the most
powerful regulators of economic incentives and growth, along with commercial
barriers such as wage and price controls.
Sure, a sustained interest rate rise and liquidity withdrawal campaign can slow
growth or induce recession. Interest rates are a tax on the marginal utility of
money.
Rapid rate rises reduce money demand and lower money purchasing powers.
As a result, falling money demand not only sinks economic growth, it also
raises the inflation rate -- too much money chasing too few goods.
Recessions and slowdowns are almost always periods of more rapid inflation.
This was true in 1969-70, 1973-75, 1978-82 and 1990. Conventional wisdom
misses this. But actually, inflation rises when growth is minimal. Or, inflation
falls when growth is maximized.
Think of it this way: more money chasing even more goods. This is why
technology booms induce disinflation, or mild deflation. Joseph Schumpeter
understood this. He argued that periods of rapid technological advance generate
more goods, with higher productivity, at lower prices. It's a metaphor for our
current long boom that dates back to 1983.
Mr. Greenspan's Humphrey-Hawkins testimony is his clearest statement to
date that the Fed will raise rates many more times to slow economic growth.
They are not targeting inflation, which is benign, but instead will impose a
speed limit on the economy.
Traditional monetary theory argues that inflation is a monetary phenomenon.
Nobelists Milton Friedman, Friedrich Hayek and Robert Mundell, among many
others, have convincingly made this case.
But Greenspan never once mentioned money, or excess money, in his
testimony. Instead, he talks of excess demand rising above the economy's
"potential" supply. But no one knows the economy's potential to grow.
A few years ago economists thought it was 2 percent. Lately, mainstream
analysts think it could be 3 percent. The Fed itself suggests that perhaps the
answer is now 3.5 percent.
But the evidence suggests that the Internet economy is capable of rising at 4
percent. Perhaps, if personal, business and capital gains tax rates were
lowered, then the new economy could grow by 5 percent per year.
In a strange new twist, Greenspan now argues that productivity advances are
actually inflationary. Talk about tortured logic! In this view, productivity is raising
stock market prices. So the wealth effect then leads people to consume more,
and this spending creates excess demand. Productivity and wealth gains are
therefore inflationary!
Never a mention about the pro-investment benefits of rising productivity and
stock market wealth. Only consumption. Though a recent Federal Reserve
Board study suggests that as share prices rise, long-term investors may
actually save more to reap high retirement returns. Hence the rising stock
market may actually induce less consumption by the new Investor Class.
The Fed's new logic that productivity is inflationary shows the ad hoc, Rube
Goldberg, incoherent nature of its thinking. Fed people choose and create
economic paradigms to suit their purpose du jour.
At the end of the day, all their confusing and illogical logic is designed to
somehow make people believe that they're really not trying to prevent growth
and prosperity. But that's what speed limits to growth are all about. Growth
prevention.
If unemployment drops too far, or growth increases too much, then inflation is
sure to follow according to the Fed view. It's the old Phillips-curve thinking
dressed up in new clothes. It's economic cross-dressing; the Phillips curve in
drag. Despite the absence of any core inflation, speed limits are back. Actually,
they never left. Old thinking dies hard.
Right now, the Internet economy still looks very strong. The Nasdaq index sits
on a lofty perch, up 8 percent so far this year. Computer production is rolling
out at a 48-percent pace (with prices falling nearly 20 percent). World demand
for computer chips, especially those customized for new Internet and telecom
use, is awesome.
Venture capital investment in last year's fourth quarter exceeded the year earlier
mark by 302 percent. Technology companies garnered 90 percent of these
investments. More than half the money flowed to Internet-related firms.
But the old economy doesn't look quite so promising. The DJIA and S&P
indexes, loaded with cyclicals and smokestacks, have lost an average 10
percent year-to-date. Might they be forecasting a growth slowdown from the
restraining effects of four Fed tightening moves over the past eight months, with
more to come?
Car sales still appear to be strong, but the S&P auto index is down 20 percent
since last April. Retailers like Wal-Mart, Kohl's and Abercrombie & Fitch are
being pounded. Financial service companies have been pummeled, down about
20 percent.
A widely followed consumer cyclical stock index has suffered a 20 percent
correction over the past several weeks. Despite strong housing starts and home
sales, groups such as building materials, hardware and tools, homebuilding and
household furnishings and appliances are getting whacked.
Stock markets, and their major sector categories, are leading indicators of the
future economy. A tough question for policymakers and investors is this: If the
old economy slows, will the new economy bail us out?
The economic zeitgeist is all with the new Internet economy. Faster growth,
more productivity and profits, lower prices. A fabulous story, the lifeline of the
long prosperity boom that began over seventeen years ago.
However, the new economy's contribution to economic growth, though rising, is
still less than one-third. That's a huge contribution, but it still leaves roughly
two-thirds to the traditional elements that comprise gross domestic product.
Even if the government data fails to accurately capture the real world
contributions of the new economy -- perhaps it's fifty percent -- that still leaves a
vulnerable half remaining. And, let's not forget, if it be true that technology
companies are less interest-sensitive, it does not always follow that their
customers are equally immune to rate hikes.
Mr. Greenspan's harsh testimony raises the age-old question of whether the
Fed can engineer a soft landing. He implied that the central bank prefers real
growth in a range of 3.5 percent, a substantial slowdown from the roughly
6-percent growth of the past two quarters. That's a 40-percent growth decline.
40 percent. Not mere fine-tuning, but a very sizable decline in growth.
Is this necessary? Does growth really cause inflation? Does the Fed have the
tools, or the information, to undertake such a precise and sensitively calibrated
surgical incision?
My answer is negative on all three counts. For generations central bankers have
claimed they are all-powerful. But the results speak for themselves, and they
speak poorly.
The Fed has always talked about "taking away the punchbowl." At least now, in
Mr. Greenspan's fourth term, the Fed may be willing to let the punchbowl fill us
a little higher.
My problem is that most individuals operating in the free economy know full well
when to stop drinking. They don't need the Daddy-state Fed to do it for them.
For those that do not know when to stop, they will suffer the consequences.
But the whole economy needn't be suppressed; our free-will, self-regulatory,
information technology discovery process is a more efficient economic
mechanism than government planning. This is why I disagree with Mr.
Greenspan's policy statement before Congress. It's an anti-market lurch back to
the past, while the whole thrust of our economic miracle is trying to fast-forward
into the future.
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