The New Economy's Speed Limit
You don't have to believe in bubbles to think that the Federal Reserve should follow up its 50-basis-point tightening with more of the same (page 43). For the first time in years, corporations everywhere are raising prices. The modest rise in the April core index of the consumer price index should not blind anyone to what is happening. Rising prices are a sure "whites of their eyes" sign that inflation is beginning to accelerate. The economy is clearly racing too fast and the Fed should tighten until the economy slows to a sustainable pace. If the decade-long expansion is to continue, inflationary expectations must be stifled.
The argument for a stern Fed is not that it is needed to burst a financial bubble. Two new books, Irrational Exuberance by Robert J. Shiller and Valuing Wall Street by Andrew Smithers and Stephen Wright, argue that stocks are wildly overvalued and due for a decline followed by many years of poor returns. In essence, they say that the market has misvalued the New Economy by allocating way too much capital to high-tech companies, sending price-earnings ratios and share prices into the stratosphere (page 166).
The fallacy of the bubblists is that they place too much emphasis on swings in human emotion and not enough on the basic rationality of markets. Take the Internet. Because it has so little history, no one really knows in advance what business models will work on it. So vast sums of venture capital and investor money have financed a sequence of new businesses. Over the past three years, p-e's and prices have risen and fallen as each new model has been tested in the marketplace. Business-to-consumer dot-coms were hot. Then not. Pure content plays were hot. Then not. Business-to-business sizzled. Then cooled. Infrastructure is the latest play, but that too shows signs of wear and tear. When only the dot-coms appeared able to grasp the Internet, valuations soared even for profitless companies. Now that Old Economy corporations are proving they can adapt to the Net, valuations are changing again. Profit is back in fashion.
Sure, emotion plays a role, but the basic process is quite rational. The markets are allocating capital to different business models in rapid succession. Fast-moving capital is nurturing a sustained period of investment, productivity growth, and noninflationary economic expansion. For four years, the U.S. economy has been able to grow at 4% annually, generating jobs for just about everyone in the country, including millions who formerly were on welfare. The speed limit for noninflationary economic growth rate is now double what was possible in the '70s and '80s. That's a major achievement.
But the economy is not safe at any speed. There were few price increases when the economy was running at 4%. But at 6%, the rate at which it has been expanding in the past three quarters, prices are heading higher in beer, paper, tires, wages, insurance, Disneyland, airline tickets, houses, popcorn, movies, health care--you name it.
America has a speeding problem, not a tulip problem. Its economy is growing two percentage points too fast, and the Fed should aim at slowing it to about 3% to 4% per year. That would get the New Economy back on track in time for the markets to allocate capital to the Next Big Thing. Have you heard of the mobile Net?