Commentary: Greenspan Smells Something Burning

He has a radical argument about how the promise of productivity hikes can overheat the economy

The grand experiment in monetary policy seems to be coming to an end. For the past four years, the Federal Reserve has let the economy grow far faster and the unemployment rate fall far lower than almost anyone thought possible. But now, Chairman Alan Greenspan is saying enough is enough. He has signaled that the Fed is ready to raise interest rates repeatedly to cool the economy before it boils over like an unwatched pot on a high flame. And he's using a radical new argument about the perils of productivity and the stock market's relationship with the economy to justify the Fed's actions.

Has the widely admired Greenspan lost his nerve? That's what some New Era proponents and formerly fawning U.S. lawmakers are wondering. At a Senate Banking Committee hearing on Feb. 23, Greenspan was peppered with occasionally hostile questions from the senators.

SPEED KILLS? Confusion and skepticism over Greenspan's new thinking are understandable. But the chairman is on solid ground in trying to throttle back demand. According to the latest estimates, the economy grew at an annual rate of over 6% in the fourth quarter of last year--a pace that even the most ardent New Era advocates concede is not sustainable over the long haul.

Here's the issue from Greenspan's perspective: If investors believe productivity will continue to surge, they'll bid up stock prices today in the expectation that more productive companies will earn higher profits in coming years. The higher stock prices make people feel richer, so they'll spend more on everything from cars to cruises.

The difficulty, Greenspan believes, is the timing. The wealth effect created by a rising stock market boosts consumption right away, before the projected rise in productivity has a chance to kick in and hike the economy's capacity for producing things people want to consume. The result: an economy growing too fast for its own good--and one that risks skidding out of control. "It's the dark lining in the silver cloud of productivity," says Chris Varvares, president of Macroeconomic Advisers in St. Louis.

Greenspan's stance is putting him at odds with Wall Streeters who have long supported him. "It's ludicrous to call good news bad news," says former Fed Governor Wayne Angell, who is now chief economist for broker Bear, Stearns & Co. Angell accuses Greenspan of being obsessed with the stock market.

To which the Fed chief might reply: guilty as charged. Greenspan says the Fed can't conduct policy without taking into account the wealth generated by the boom on Wall Street. In the 1990s, stock wealth became a far bigger factor in the economy than ever before, he argues. "It is a new world we are dealing with," he testified on Feb. 23.

NEW GAUGE. By his reckoning, the wealth effect from bigger stock portfolios has added one percentage point to annual economic growth over the past five years. A wealth effect shows up only if stock prices rise faster than household income. If stock prices merely keep pace with income, investors don't feel the temptation to dip into their wealth to increase spending. Without that extra kick to the economy, there's no need for the Fed to fear overheating. Hence the controversial use of household income as a gauge for stock prices.

Critics say the Fed chief has unjustifiably set a speed limit for the stock market--that he's trying to control share prices. Greenspan denies that's the case, but in essence, the critics are correct. The real question is not whether he's doing it--he is--but whether it's the right thing to do for the economy.

If the wealth effect is a real problem, why hasn't inflation risen? Greenspan argues that the U.S. has kept inflation in check by importing cheap goods from abroad and by drawing new workers into the labor force. But neither can go on indefinitely. Eventually, the trade deficit will grow so large that it will pose dangers for the dollar. And the unemployment rate will fall so far that it will spark wage-driven inflation. And that's why Greenspan has decided it's time to turn down the heat of the New Economy.

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