Commentary: The Case Against Greenspan's Tougher Tactics

Inflation is low. Productivity is soaring. Business investment in equipment and software is still strong, with the latest figures showing a robust 12% increase in 1999--the seventh consecutive year of double-digit gains. Yet conventional wisdom among most economists and forecasters is that the economy needs to be slowed to avoid a future bout of inflation. And according to Federal Reserve Chairman Alan Greenspan, that means cooling the red-hot segments of the stock market. He holds Wall Street responsible for the enormous increase in wealth that is spurring sharp hikes in consumption and investment. In a Mar. 6 speech, Greenspan reiterated that he wants to see "market forces, assisted by a vigilant Federal Reserve" bring the growth of demand into line with more sluggish growth of supply. Translation: He will raise rates until the stock market slows its rapid rise.

But with the U.S. in the middle of an investment boom, raising rates may be precisely the wrong thing to do. No less an authority than John Maynard Keynes, still regarded as the most eminent economist of the 20th century, believed that the correct response to an investment boom was to keep it going as long as possible--if necessary, by lowering interest rates, not raising them. "An increase in the rate of interest, as a remedy for the state of affairs arising out of a prolonged period of abnormally heavy new investment, belongs to the species of remedy which cures the disease by killing the patient," wrote Keynes in 1936, as the U.S. and the rest of the world were still suffering through the Great Depression. "A rate of interest, high enough to overcome the speculative excitement, would have checked, at the same time, every kind of reasonable new investment."

That's exactly the situation facing the U.S. today. Greenspan would like to slow the economy and the market. Yet by Keynes's lights, Greenspan's main tool--higher rates--seems to be pointed in the wrong direction. Since the Fed started the current round of rate hikes in June, 1999, the stock prices of Old Economy and mainstream companies have slumped, the Dow Jones industrial average has fallen by 10%, and many companies have fallen further still. Meanwhile, the tech sector--which is clearly the more speculative part of the market--has soared unimpeded, with the tech-heavy Nasdaq up by 80%.

The danger is that raising rates high enough to blunt the optimism of investors and restrain technology stocks will send the rest of the economy and the stock market into a tailspin. Greenspan believes it's "his job to make the market go down," says Charles M. Cawley, president of credit-card company MBNA Corp. "I think he is risking doing great harm to the economy."

Moreover, even if Greenspan manages to bring the stock market and the economy in for a landing without a crash, it may turn out to be a pyrrhic victory. The sizzling market for initial public offerings has helped fuel the rapid creation of innovative high-tech startups. At the same time, the industries at the heart of the New Economy, such as software, e-commerce, and semiconductors, have relatively low costs of production and tend to get more efficient and profitable as they grow larger. A slowing economy and weaker stock market could make the IPO market dry up and lead to fewer innovative new companies. Smaller economies of scale for existing high-tech companies could lower their profits and lessen incentives for introducing risky new products and services. The eventual result: less technological innovation.

Of course, allowing the economy to keep growing at a rate much faster than 4% risks an inflationary surge. That's the scenario Greenspan is worried about. But the combination of rapid rates of technological innovation and high levels of capital investment are serving to boost productivity and hold down costs. Productivity in the fourth quarter of 1999 rose by a healthy 3.6% compared with a year earlier, while unit labor costs went up by a mere 0.7%. That's hardly a recipe for inflation. Indeed, the risk of inflation heating up seems far less than the risk that rate hikes will inflict serious damage on the economy.

JAPAN'S MISTAKE. It's worth remembering that the history of using higher rates to choke off investment booms is not promising. Consider Japan in the 1980s. While that country had a very different economy from the U.S.'s today, there are a number of uncomfortable parallels. Business investment in Japan soared in that period, inflation was low, and the country looked ready to dominate the global economy. Nevertheless, the Bank of Japan moved aggressively to raise rates in 1989 and 1990, citing reasons--tight labor markets and soaring asset prices--that are almost identical to Greenspan's concerns today. In particular, the Bank of Japan argued repeatedly that soaring land and stock prices were supposed to be a forerunner of broader wage and price inflation.

But in attempting to contain asset prices, the Bank of Japan pushed rates high enough to wipe out the banking system and squash the real economy as well. The stock market peaked at the end of 1989, while corporate capital spending peaked in early 1991. That's when the Bank of Japan realized its mistake and finally started cutting rates. But it was too little, too late. Almost a decade later, the Nikkei market index is about 50% below its peak, corporate capital spending is about 30% lower, and industrial production has been basically flat for the entire 1990s. It is nearly impossible to imagine that Japan would have been worse off if the investment boom had been allowed to run longer. Even a slight rise in inflation would have been preferable to the decade of stagnation Japan has endured.

Nobody expects the U.S. to mirror Japan's experience. Nevertheless, the lesson is clear: Rather than throttling back the economy, Greenspan should ride the current wave of technological innovation and let the investment boom run as long as possible. In today's economy, that's the right way to assure America's long-term prosperity.

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