- The Washington Times - Friday, July 27, 2001

Terminator III Greenspan once again went up to Capitol Hill to convince Congress and the public that he will slay the recession dragon and deliver prosperity-recovery to all.

Unfortunately, stock markets weren't buying. In fact, they were selling hard.

Though the Fed may not believe it, history shows financial markets are very good barometers of economic policy. Stock markets, in particular, signal whether the policies are pro-growth or pro-recession. Right now the market message is clear it's a huge Bronx cheer.

Once again, the estimable Fed chairman mistakenly argued that econometric models are more important than market messages. In particular, when Sen. Bob. Bennett, Utah Republican, asked him Tuesday about our argument that slumping commodity indexes signal a deflationary shortage of liquidity, Mr. Greenspan demurred.

He acknowledged that falling raw-material prices signal weak industrial demand, but he was unwilling to concede any monetary content. Therefore, he argued, there is plenty of liquidity in the economy, as illustrated by the rapid growth of the M2 money measure (which includes currency, demand deposits, money-market funds, and savings accounts).

But M2 is rising because little old ladies in tennis shoes along with everyone else are stuffing their cash in money-market funds. That means no one is taking investment risks by putting their dough to work in productive businesses or new high-tech ventures the stuff that makes for true economic recovery.

The basic measure of liquidity is the monetary base, made up of bank reserves and currency, and controlled solely by the Fed through its net purchases of Treasury securities. Noteworthy is the fact that short-run base growth has been declining since mid-May. Not coincidentally, both stocks and commodity indexes have sagged.

Mr. Greenspan's responsibility whether or not he admits it is the problem shortage of liquidity. If the central bank were really stimulative, then commodity indexes would be rising, not falling. The dollar-exchange rate would be falling, not rising. Various treasury bond-rate spreads would be widening, not narrowing (e.g. federal funds vs. two-year Treasury notes).

Tech stocks would be rallying, not sinking. But none of what should be happening is happening.

The fact that the central bank has been reducing its key policy rate does not really signal easier money. Instead, the Fed has been following economic demands lower.

Think of it this way: The federal funds rate has dropped nearly 3 percentage points, but the economy's growth rate has plummeted 5 percentage points. That's why the federal-funds-rate-targeting approach is inferior to a market-price-rule approach. Markets reveal more accurate and timely information about deflation or inflation than M2 or NAIRU or the Phillips Curve.

Not surprisingly, as Mr. Greenspan stubbornly stuck to his old-economy models, stock markets tanked. Actually, stock markets are tanking globally. The G-7 summiteers in Genoa, Italy, tried to persuade us that all will soon be well internationally. But Japan hit a 16-year low on Monday, and new numbers from Germany are flagging a worse European downturn than the EU commissars have been willing to admit.

Back home, Bush economic advisers Glen Hubbard and Larry Lindsey began to make a much-needed case Monday for capital-gains tax cuts and faster business-depreciation allowances to spur corporate investment. But the political probabilities for another round of tax cuts are presently slim to none. As we know, leading Democrats like Tom Daschle and Richard Gephardt are calling for tax increases. Think of it, Herbert Hoover goes Democrat.

But the real obstacle to additional tax cuts is the congressional budget accounting mania, which has bipartisan support in favor of maintaining large budget surpluses during the recession. No self-respecting Keynesian would sign-on to this economic gobbledygook, much less a supply-side activist. All budget surpluses should be returned to the economy as personal and business tax cuts. But it won't happen any time soon.

Supply-siders on Wall Street and Capitol Hill are beginning to mutter about a marginal slow-growth recovery that is saucer-shaped not V-shaped. What should be a 5 percent growth recovery is now being marked down to a 3 percent or even less recovery, one that will not do President Bush or congressional Republicans any good in next year's midterm elections.

So the last great hope is indeed Terminator III Greenspan. Right now, the Fed is the only game in town. Arnold Schwarzenegger would be ready for some bold outside-the-box move (like a reverse-gainer flip into a two-armed UZI bullet storm). But will Alan Greenspan?

Lawrence Kudlow is CEO of Kudlow & Co. LLC, and CNEC's economics commentator.

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