- The Washington Times - Thursday, February 24, 2000

Be careful what you wish for, Mr. Greenspan.

When it comes to fine-tuning the economy's growth rate, history shows 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 power. 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.

Federal Reserve Chairman Alan 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 Mr. 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, Mr. 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 their 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 crossdressing, 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 increase (with prices falling nearly 20 percent). World demand for computer chips, especially those customized for new Internet and telecommunications 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. Over half the money flowed to Internet-related firms.

But the old economy does not look quite so promising. The Dow Jones and Standard & Poor 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 policy-makers 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 more than 17 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 50 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 increases.

Mr. Greenspan's harsh testimony raises the age-old question of whether the Fed can engineer a soft landing. He inferred 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 punch bowl." At least now, in Mr. Greenspan's fourth term, the Fed may be willing to let the punch bowl fill up 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-market, 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.

Lawrence Kudlow is chief economist of CNBC.com and Schroder & Co. Inc.



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