The Dow Jones Average and other market indicators tend to fall these days on each new report of increased prosperity. Or so it seems. The unemployment rate drops another tenth of a percent; stock prices take a nose dive. The most recent GDP figures suggest higher-than-expected economic growth; bond holders take a beating. How do high employment and rising output levels translate into a dimming of profit expectations and low asset values?
On Friday, July 28, we learned that the economy’s growth for the second quarter was 5.2 percent, higher than the expected 3.5 percent and higher than the first quarter’s 4.8 percent–and, not incidentally, higher than most any economywide growth rate that has proved to be sustainable. Supposedly reacting to this news, the Dow Jones Average dropped nearly 75 points, the NASDAQ nearly 180.
The financial press has learned to make it clear, of course, that the market is not reacting directly to the good news. It is reacting instead to the Federal Reserve’s likely reaction to the good news. From the Fed’s point of view, the news can be too good to be true. Unemployment rates can be too low and growth rates too high to be sustainable.
In a Fed-centric financial market, it doesn’t even matter whether the “too good,” “too low,” and “too high” have a clear basis in economic reality. (Although, as argued below, there is such a basis.) What matters is the judgment in this regard of the Federal Reserve Chairman.
If Alan Greenspan judges economic growth to be “too strong,” he is inclined to raise interest rates–to set the discount rate up a notch and target a higher federal funds rate. And this, of course, is bad news on Wall Street.
In recent months the economy has been characterized variously as “surging,” “super charged,” “overheated,” “red hot” and “on fire.” “Over exuberant” is the term introduced and applied directly to financial markets by Greenspan himself.
A more analytical–-and less inflammatory-–reckoning of an economy so described would be one that makes reference to the economy’s production possibility frontier, a principles-level device for describing its capacity for producing (on a sustainable basis) different combinations of consumption goods and investment goods: The economy is “(temporarily) beyond its production possibility frontier.”
The game plan of the Federal Reserve is to bring the economy back to its frontier before it comes back on its own–and possibly with a vengeance. In the vernacular of central banking, the Fed wants to engineer a soft landing so as to avoid a crash. This game plan for cooling off a red hot economy is implied by much of Greenspan’s recent testimony before the House Banking Committee and in recent press releases by the Federal Reserve.
But what is the evidence that the economy is in need of a cooling off? Growth rates and unemployment rates, by themselves, don’t tell the whole story. Those numbers don’t distinguish between genuine growth and unsustainable booms: Has the production possibilities frontier itself been experiencing particularly dramatic outward shifts? Or is the economy somehow beyond its own frontier?
The story has to be one about growth rates and unemployment rates in the context of recent developments within the economy and past policy moves of the Federal Reserve.
Focusing on the unemployment rate, we can ask first, “Is there evidence that the performance of the economy is based on the fundamentals and is therefore sustainable?” If we find little or no such evidence, we can ask, “Is the Federal Reserve trying to deal with an unsustainable boom of its own making?”
“Full employment” has for some time been taken to mean 5.0 to 6.0 percent unemployment. This isn’t exactly a praxeological construction, and we have good reason to be uncomfortable with the notion of a fixed natural rate of unemployment. Can’t the full-employment level of unemployment change on the basis of changes in the underlying economic realities? Of course, it can. But what do we make of the current unemployment rate of 4.1 percent? Has the natural rate itself fallen by a percent or so? Or is the current unemployment rate almost a whole percentage point below the natural rate? We should be receptive to an affirmative answer (plus a good argument) to either of these last two questions.
So far, however, we have not heard a persuasive argument that, say, 3.5 to 4.5 percent is a new natural rate. Throughout 1989 and the first half of 1990 the unemployment rate was in the 5.0-5.5 range. No one at the time suggested that that rate was anything but a (relatively low) natural rate.
Since then, we have had the Bush recession and the Clinton expansion (actually the Bush-Clinton expansion, since the upswing was well underway before the 1992 election). Has the natural rate moved down that sharply in the course of a single cycle? We doubt it. And if it has, then there ought to be a pretty good argument for that point of view. What underlying economic realities have changed so dramatically as to produce such a dramatic result?
No one or two or handful of changes jump to mind. But both professional and popular writers have presented us with their laundry lists of possible causes: demographics, labor-union passivity, just-in-time inventory management, the digital revolution, increased participation of women in the work force.
Nothing in the list grabs us as a plausible explanation, and, more tellingly, none of these explanations are consistent with a sharp fall in the natural rate over the course of a single cycle. Also, we should remember that similar lists can be-–and have been–-produced for other such expansions, including the credit-driven boom of the 1920s.
The strongest argument for the alternative viewpoint-–that the economy is currently below its natural rate of unemployment-–is the past actions of the Federal Reserve itself. Cheap credit was a part of the Bush strategy to remain in office in 1992. This element of the campaign strategy, first thought unnecessary, was implemented belatedly and had its most visible effects a few months after the inauguration of Clinton.
Unemployment fell from about 7.8 percent in mid 1992 to 5.5 percent in 1996. Then, just months away from the 1996 election, a further cheapening of credit (a reduction of the discount rate in late January), triggered an expansion that eventually sent the unemployment rate below the 5 to 6 percent range. Significantly, even the mainstream commentators at the time saw the monetary stimulation accompanying Clinton’s re-election bid as unwarranted and as politically motivated.
Since that episode, the Federal Reserve’s has charted a course primarily on the basis of what we can aptly call a “dead reckoning.” That is, Greenspan’s best guide as to where the economy is and what the Federal Reserve should do is the Federal Reserve’s own log book. The Fed adopted a position of monetary ease when the economy was in the middle of the full-employment range. That action ignited a boom and requires a monetary tightening at some point in the future if a disastrous bust is to be avoided.
Money-supply figures have long ceased to be a workable guide to Federal Reserve policy formulation: In the early 1980s, the elimination of Regulation Q blurred the distinction between money and credit. (It is more-than-a-little ironic that the viability of the Monetarists’ Rule of a slow and constant growth rate of the money supply depended so critically on the government’s prohibition against paying interest on checking account money.)
Movements in interest rates are an increasingly ambiguous guide, since short-run movements are based, to a large extent, on predictions in the financial markets about what policy the Federal Reserve will adopt.
Signs of inflation still serve as some guide as to when an engineered downturn may be preferable to the downturn that a conflicted market might itself precipitate. Incidentally, the fact that Greenspan raises the discount rate even in the absence of clear and strong inflationary pressures suggests that his thinking is more Austrian than Keynesian-Monetarist.
Recent responses to questioning about the Austrian theory of the business cycle by Congressman Ron Paul and recent reporting on Greenspan’s NBI lectures on business cycle theory in the late 1960s by Sam Bostaph give us some reason to believe that Greenspan hasn’t totally lost his Austrian bearings.
The larger issue, of course, is not Greenspan’s Austrian bearings or Greenspan’s hopes of engineering a soft landing. The issue of overriding significance is the economy’s performance as affected by a dominating and pro-active central monetary authority. Greenspan is trying to second-guess financial markets at the same time that those financial market are trying to second-guess him.
This is not a formula for economic stability. Keynes was famous for condemning capitalism on the basis of the claim that speculators were too short-sighted. They ignored the fundamentals while trying to “beat the gun” in financial markets–by buying or selling before their fellow speculators do so.
While Keynes’s vision ill fits a decentralized market economy, it is wholly applicable to a mixed economy in which the central bank and financial markets are continually trying to outguess one another and hence in which speculators are continuously trying to “beat the gun” in registering their own separate guesses. It is this gun play in financial markets that translates the seemingly good news on Main Street into bad news on Wall Street.
