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The Terminator’s Shooting Blanks
It's been a rough week for Alan Greenspan.


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Larry Kudlow

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.

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Actually, it’s been a rough week for the Terminator. Since he first started his recovery crusade, the Dow and S&P indexes have dropped 3%, while the Nasdaq has lost 5%. Though the Fed may not believe it, history shows that 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 (R., Utah) asked him Tuesday about my (and David Gitlitz’s) argument that slumping commodity indexes signal a deflationary shortage of liquidity, 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.

Part of the problem here is that tax rates on capital and business are too high. And so-called break-even hurdle rates of return following the stock-market crash have become an obstacle to investors. But Greenspan’s responsibility — whether or not he admits it — remains a scarcity of true Fed liquidity (i.e. currency and bank reserves, controlled only by the Fed). If the central bank were really stimulative, then commodity indexes would be rising, not falling. The dollar-exchange rate would be falling, not rising, and 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 three percentage points, but the economy’s growth rate has plummeted five percentage points. That’s why the federal-funds-rate-targeting approach is inferior to a market-price-rule approach. Market’s reveal more accurate and timely information about deflation or inflation than M2 or NAIRU or the Phillips Curve.

Not surprisingly, as 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 advisors 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 which has bi-partisan 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.

So the last great hope is indeed Terminator III Greenspan. Right now, the Fed is the only game in town. Arnold Schwarzeneger 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?



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