Wall Street Journal, June 29, 1999

The Greenspan Rule

In a country with inflation so low it's almost gone, it is intriguing to see the Federal Reserve on red alert, with Chairman Greenspan madly signaling that the Fed in its meetings today and tomorrow may tighten money to ward off inflation. Leading inflation indicators have been mixed, with May's flat consumer price report canceling the April alarm. The best argument for a boost, maybe the only one, is that the Chairman wants it. In his 12 years as Chairman, Mr. Greenspan has logged a record solid enough that we're prone to bet he knows what he's doing. The question is, does the rest of the world know what Mr. Greenspan is doing? How, precisely, does he decide when and how much to ease or tighten money?

Having spent much time ourselves deciphering the speeches, acts and runic utterances of one of this nation's most successful Fed Chairmen, we figure Mr. Greenspan's technique goes roughly as follows: He fuels up on a few tons of data, checks such vital readings as the consumer price index, the price of gold, the stock and bond markets and the extent to which his countrymen are sounding irrational, exuberant, off on an unsustainable track, or whatever.

Then he flies by the seat of his pants.

This approach has worked for the economy, and is of course politically handy for Mr. Greenspan. It lets him make his own calculations, and the explanations of them let him throw bones to various constituencies. In particular, it spares him having to actually shut down such nonsense as the apparently endless discussion in some dusty quarters of the Fed over the Phillips Curve - which wrongly preaches that high growth brings inflation. Growth is good for an economy. It creates wealth, not inflation. The job of the Fed is not to decide how much wealth the country should be allowed to create, but to keep the price level steady enough so it's easy to create all we can.

Mr. Greenspan himself made clear in testimony to the Congressional Joint Economic Committee last week (excerpted nearby) that he doesn't think much of the Phillips Curve, or its sidekick notion, known as the non-accelerating inflation rate of unemployment, or NAIRU - which in the spirit of further nonsense argues that it's bad for everyone who wants a job to actually have one. The Phillips curve has "significant flaws," warned Mr. Greenspan, who also said that growth due to normal rises in employment and productivity should not be seen as "anything other than a plus." Yet the absence of a Phillips curve doesn't mean there are "no limits" to how fast employment can grow without raising a danger of inflation. The Phillips curve doesn't generally apply, that is, but does right now.

Well, OK, we guess. Our worry is that once the 73-year-old Mr. Greenspan moves on, whoever succeeds him may prove less skilled at off-the-cuff navigation. Word is that Mr. Greenspan might agree to stay, if offered reappointment when his term expires in June 2000, with a Presidential election campaign in progress. But there's no guarantee he won't at some point, say in a Gore or Bradley Presidency, be replaced by a Fed Chairman without such sure instincts. Someone trying to imitate his methods might either actually unleash inflation or, alternatively, crash the economy by picking the wrong time to follow the Phillips curve.

With Mr. Greenspan still in the Fed's top chair, this would be a good time for the Fed to try to codify his technique. Some form of some clear rule for Fed decisions might not be more reliable than Mr. Greenspan's pantseat, but would have the virtue of letting the rest of us understand what the Fed is doing, and giving us a standard against which to measure future action. Most immediately, such a rule could provide enough certainty to help the bond markets avoid the convulsions that come with trying endlessly to second-guess the Chairman.

We know it's a tall order. The Fed's job is to keep the price level stable, and the challenge there starts with simply figuring how to measure whatever it is we call the price level. Any rule amounts to a grab for certainty, which can never be completely achieved in a fast-changing world. There is even a danger that the best of Mr. Greenspan may become outdated by changes in technology and the economy that no one can predict right now. But these dangers pale next to the worry that Mr. Greenspan's departure, whenever it comes, might leave us adrift.

In the long run a Greenspan rule could transform the talents of one man into a useful legacy for the future. Mr. Greenspan has presided over an era of bounty, in which the Fed looked mainly to steadying the money, and left the economy free to grow. That's a great way to navigate, and unless Mr. Greenspan plans to remain Fed Chairman forever, it's time he tried to share his map.


NAIRU -The View From the Fed
Fed Chairman Alan Greenspan testifying before the Joint Economic Committee, June 17:

Rep. Maurice D. Hinchey (D., N.Y.): Over the last several years, in fact over the last six years, since I have been a member of the House of Representatives, we have had a number of discussions about the efficacy of such things as the Philips curve and NAIRU, the nonaccelerating inflation rate of unemployment. And we've argued that these indicators are outmoded and that, in fact, they are artifacts of an older economy and not valuable in ascertaining the level of inflation particularly or the likelihood of inflation in this particular economy.

I was startled on Tuesday to find that I'm in agreement with the editorial writer of The Wall Street Journal. So I'm wondering to what extent you agree with me and the editorial writer of The Wall Street Journal with regard to such things as the Philips curve and NAIRU as indicators of nascent or incipient inflation in the economy.

Mr. Greenpsan: Well, first of all, I certainly agree - I read that editorial, and I certainly agree that inhibiting growth as a goal which somehow is implicit in some of these particular structures makes no sense to me at all. I mean, growth that is coming from one increasing population and especially accelerating productivity is not something which I think we should look upon as anything other than a plus. There is no inherent instability that occurs as a consequence of growth that is strictly the combination of normal growth in the work force plus productivity.

There is a question, however, that you can at times create a situation in which you are running a rate of growth which exceeds the implicit underlying rate of growth of productivity. And as a consequence of that, you of necessity are bringing on additional people to work, which is all well and good if it is people who are normally entering the workforce.

But if on occasion, as we have been, we are reducing continuously the level of the number of people who are, one, technically unemployed, as defined by the Bureau of Labor Statistics and the unemployment statistics, plus those who are not in the labor force but say they would like a job, the combination of those two statistics, which represent about 10 million Americans, has been falling at a fairly significant rate.

And I think, as I indicated in my prepared remarks, leaving aside the Phillips Curve and aspects which I happen to agree has got some significant flaws in it, there is still a limits question; it is not as though there are no limits whatever. And I think that the issue which should be differentiated here is whether one should rely on a very questionable statistic about where the NAIRU is, if such a concept can exist for national economy, I think, frankly, it probably does exist for a metropolitan area where workers can move back and forth and interchange and there is relationships between wage rates and the degree of unemployment; I'm not sure that readily translates to an overall economy where people in Portland, Oregon can't move to Portland, Maine, as readily as they can move across the street.

But I think we have to distinguish between the question as to whether the NAIRU or the Phillips Curve, on which it - which employs that, is a functioning means for policy on the one hand, or whether there are no limits whatever to what expansion can be without creating a destabilization. It's the latter, I think, that is the crucial issue. But I certainly agree with you on the former.


The Fed, Not the Economy, Is Overheating
By Brian S. Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson in Chicago.
Wall Street Journal, June 29, 1999

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.

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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