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It’s Cash, Not Anthrax
Liquidity and the future economy are the real worries.


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Larry Kudlow

The stock market fatality count following Alan Greenspan’s testimony before Congress last week reached about 3%, or 300 Dow points. Market commentators blamed the week’s slump on Anthrax and earnings, but that’s just not the case. Only a handful of people have contracted the disease, far less than the available supply of Cipro. That rules out an Anthrax dip. And bad earnings were fully discounted by the market in its first full week of operations following the 9/11 terrorist bombings. So there goes the earnings argument.

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No, the week’s market setback is about the future economy, and Wall Street’s uneasiness with the direction Alan Greenspan is taking it.

One of the key influences on the outlook for 2002 is the volume of high-powered liquidity supplied now by the Federal Reserve. Greenspan’s testimony hinted strongly that the Fed believes it has done enough in providing new liquidity. The stock market, however, disagrees.

Here’s the sentence in the Fed chairman’s testimony that sent the markets downward: “As repair of the financial markets and payment infrastructure proceeded apace, loans were repaid, open-market operations could be scaled back, the unusual swap lines were allowed to expire, and the temporarily bloated balance sheet of the Federal Reserve largely returned to normal.”

This was not well received on the Street, which continues to believe that more — not less — liquidity is necessary in this environment of deflationary recession.

A recent story in USA Today entitled “Debt weighs more as firms gobble cash” paints the picture. During the second quarter, S&P 500 companies saw their available cash flows for debt payment fall 35% relative to interest expense. Small upstart companies are facing a credit crunch as lenders are demanding rates that are nearly 10 percentage points higher than on government bonds. This is the worst financing squeeze since 1990. So far this year, 120 borrowers have defaulted on $74 billion of bonds. Last year, a total 108 borrowers defaulted on $34 billion of bonds.

Federal Reserve banking statistics for the latest week show a continued decline in excess reserves, which have fallen from $38.2 billion in mid-September to $1.1 billion for the October 17 banking week just ended. Excess reserves represent spare cash on hand, above and beyond what banks are required to deposit at the Fed. They represent potentially loanable funds, or money that could be used to purchase Treasury securities. Think of excess reserves as potential bank credit — just what this ailing economy needs.

The reason excess reserves are dwindling is just as Mr. Greenspan described to Congress. Emergency cash injections into the economy through open-market operations are in fact being scaled back. The latest data show that so-called emergency liquidity declined from about $80 billion right after the 9/11 bombings to around $40 billion in late September. Liquidity then slipped near $30 billion for the first half of October and is now down to $26 billion.

If ever there was a time for excess liquidity from the Fed that time is now. Recession-related risk premiums are very high. But war-related uncertainty premiums are even higher. Both of these have become tall barriers to investment and production.

Certainly, lower marginal tax-rates on capital investment, business, and personal incomes would provide welcome relief for slumping cash flows and a re-energizing of economic growth incentives. But while we wait for tax-cuts and a hoped-for injection of new cash by the federal government into private sector hands, the Fed should be doing its part by injecting its own brand of high-powered liquidity. This is the wrong time for the central bank to be restraining its new money creation.

Mr. Greenspan may be influenced by the monetarist idea that money-supply growth is already too rapid and will fuel higher inflation next year. But monetarists are ignoring the sharp decline in the velocity, or turnover rate, of money.

Indeed, money is changing hands very slowly right now. Heightened uncertainties have substantially increased the demand for precautionary cash balances everywhere in the economy. As for inflation, show me the price hikes. Even the recent consumer price report for September shows that inflation has come down to 2.6% from 3.6% earlier in the year.

Prices are falling, the economy is falling, and uncertainty-related risk premiums have seldom been greater. In this environment, why is the Fed reducing cash injections into the economy? And why is Mr. Greenspan counseling Congress not to enact permanent broad-based tax cuts on investments, businesses, and individuals?

What we need now is a reasonable plan that incorporates both additional liquidity and lower tax-rates. That would be just the right mix to raise economic spirits at home and support the war effort abroad.



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