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Greenspan’s Tough Sell
It's not the Fed that the economy needs.


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Larry Kudlow

When Alan Greenspan journeys up to Capitol Hill to deliver his semi-annual policy testimony, his principal task will be to convince Congress and the public that multiple Fed actions so far this year have opened the door to economic recovery. It won’t be an easy sell.

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Dallas Federal Reserve president Robert McTeer recently opined that the U.S. is not in a recession, but he doesn’t see signs of a pick-up anytime soon. Official business-cycle arbiters at the National Bureau of Economic Research don’t rule out the possibility of recession.

Well, there’s certainly a recession going on in profits, business investment, industrial production and the stock market. In the tech sector, semiconductor makers now predict no recovery until the middle of next year. Meanwhile the household employment survey has fallen five straight months, for a total loss of 1.1 million jobs. Should this job decline continue, consumer spending could be the final nail in the recessionary coffin.

Earlier this year the Fed chairman predicted a second-half recovery, and that mantra was picked up by Treasury Secretary Paul O’Neill. Lately, however, both moneymen have recanted. Now they hope for economic recovery in 2002, with perhaps a few tax-rebate-related growth hints emerging in the fourth quarter.

But a new recovery obstacle is appearing: commodity deflation. Basic materials prices are plunging everywhere. The widely followed Journal of Commerce index of industrial metals is crashing at a 17.5% annual pace, year-to-date. Dow Jones spot commodities have dropped 20% over the past fifteen months. Gold retreated $20 this spring. Even excluding a welcome drop in energy costs, crude materials in the most recent producer price report registered an 8% annual rate of decline over the past three months.

The Fed doesn’t talk about commodity deflation, but this disturbing trend has become a major obstacle to economic revival. Mr. Greenspan will try to convince Congress that lower interest rates and more rapid money-supply growth will soon brighten the economic skies. But until the commodity-deflation problem is solved, recessionary clouds will loom over the horizon.

Just as persistent commodity inflation hints that money is too plentiful (too much money chasing too few goods), commodity deflation signals that money is too scarce. The Fed antidote to deflation: create more money.

Ironically, many inside the Fed and on Wall Street now believe that money is growing too rapidly. Hence they want an end to Fed easing moves and hope Greenspan says as much before Congress.

But this monetarist view is emasculated by the severe commodity slump, which is pulling down the velocity, or turnover rate, of money. Deflation, in other words, causes money to lose its sex drive. Money-holders retreat, preferring to let their cash gather dust in non-productive money-market funds, instead of using it to finance innovative business ideas that will drive prosperity to the next level.

Year-to-date money-market funds have surged extra-celestially to $296 billion, a sure sign of no business confidence. This cash build-up represents over 60% of the gain in broad money M3 (which includes M2). Overall, interest-bearing cash funds now stand at $2 trillion, a record interplanetary level. As long as this money is left gathering moss — instead of being put to work in the economy or the stock market — the economic power of Milton Friedman’s money supply is substantially weakened. Neutered, you might say.

Another point on money. The only money controlled by the Fed is the monetary base, the basic liquidity measure comprised of bank reserves and currency. Only the Fed creates base money through the purchase of Treasury securities.

So far this year, the public demand for money-market cash balances has exceeded base money by a ratio of fifteen to one. In other words, the Fed has not even remotely financed the public’s appetite for cash. But the deflation-prone economy needs more liquidity.

This is why real-time commodity and financial market-price signals are better guides to Fed policy than money-supply measures. Or, for that matter, discredited NAIRU models that trade-off growth versus inflation. In our Internet-driven information economy, markets provide the best clues about future growth and inflation. Markets are smarter than Phillips curves or university professors.

If allowed to persist, a deflationary money squeeze can take on a dangerously self-reinforcing dynamic, feeding on itself through greater losses in production and employment, and greater aversion to investment risk. Deflation causes real-debt burdens to become intolerable, and rising real returns on money-market cash become even more attractive.

Does the Fed truly want to ignore the perils of deflation and risk another Japan-style recession in the U.S.? I think not.

Therefore, Mr. Greenspan should stop gathering moss. He should assure Congress that the central bank will continue easing policy by injecting new cash into the economy until commodity indicators stabilize. This is called a “price rule” approach to monetary policy, and it puts markets, not government, in the driver’s seat.

At the margin, the Fed must make money-market fund rates less competitive. They can do this by dropping their official policy rate a full 75 basis points to 3%, and keep the new rate in place for at least a year. As deflationary pressures ease, cash will be put back to work in the stock market and the economy. Its sex drive will recover. So will the economy.



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