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Alan Greenspan is looking the wrong way.


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Larry Kudlow

Last year, Federal Reserve policymakers blew up the stock market and deflated the economy based on a flawed economic model and a set of misleading data. None of this would be so bad if it were merely an intellectual mistake in some mad scientist’s laboratory. But in fact the consequences of slamming down the monetary brakes and ending the long technology boom are very real.

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Here’s the troubling story. In 2000, while the stock market and the economy were in a rapid meltdown, sensible people puzzled over why the Federal Reserve stubbornly refused to ease up on their overly harsh policies. After all, slumping raw material and precious-metal commodity prices were signaling deflationary recession — not an inflationary boom.

But Alan Greenspan obsessed over the threat of “excess demand” and an “overheated economy,” mistakenly clinging to a flawed economic model that too many people working and producing would cause an outbreak of inflation. To support their case, the Fed cited published government figures on gross domestic product. Their figures showed 5% to 6% growth rates, exceeding the central bank’s 3.5% to 4% real GDP policy target range.

However, among the many follies of GDP targeting, the data are backward looking and subject to frequent revisions. In fact, the most recent government GDP re-estimate published last week tells a much different story, one that pulls the rug out from under the Fed’s logic.

New data now show that last year’s GDP growth was only 2.8% (and only 2.3% inflation), hardly worthy of a scorched-earth Fed-tightening cycle. Importantly, during the first quarter of 2000, when Fed policy makers developed their ill-conceived tightening strategy, it turns out that quarterly GDP growth actually came in at the low annual rate of 2.3%, according to the Commerce Department, far less than the 4.8% number originally reported. So, with the benefit of hindsight, the 2.5% downward GDP revision turns out to be bigger than the newly-minted and actual 2.3% growth rate.

The Fed’s prosperity-ending policy gaffe set off a chain reaction that is still being felt through rising unemployment, sagging stocks, and slumping business investment. Roughly $4 trillion of stock-market wealth has been eviscerated, the technology sector has been decimated, venture capital has dried up, and industrial production has fallen ten consecutive months. The household employment survey reports that 620,000 people have been put out of work. Hard-earned Federal budget surpluses are evaporating.

Supply-siders have long argued that instead of looking through the rear-view mirror at significantly revised GDP reports, the Federal Reserve should use forward-looking, real-time financial- and commodity-market price indicators to guide its policy. Also, the central bank should stick to maintaining price stability rather than targeting economic growth.

Inflation is caused by a decline in currency value when too much money chases too few goods, and not when more people work and invest. If rising inflation were the case last year, especially in the second half when the Fed fiddled and the economy burned, a collapsing dollar, rising gold prices, and spiking market interest rates would have shouted inflation from the rooftops. But commodities and Treasury yields were falling, not rising. So was the economy.

Had the Fed used a market price-rule, they would not have fine-tuned the economy into recession. And as far as correcting economic imbalances and stock-market overvaluations if and when they occur, markets, not monetary planners, do a better job. History proves time and again that frequent Fed tinkering always detracts from economic stability.

A market price-rule approach to Fed policy is essential to nurturing long-run, non-inflationary prosperity. It is baffling that after nearly 14 years on the job, the allegedly free-market Alan Greenspan has not yet undertaken this important reform. Right now the market message from commodity deflation cries out for additional Fed easing moves to inject more liquidity and reduce the fed funds policy rate. If Mr. Greenspan cannot lead the central bank in this direction, then President Bush should find someone who can.



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