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Time to Inflate?

December 8, 2000

Gene CallahanIn National Review Online, Lawrence Kudlow offers George Bush some advice on the economy. However, there are some difficulties with his recommendations.

The first of these is an undue faith in aggregate numbers, such as GDP. My recent mises.org article pointed out some of the problems with such aggregate numbers; in brief, what they sum up is arbitrarily defined and measured with a fluctuating standard -- the dollar.

Henry Hazlitt commented on economic aggregates:

It is impossible, in sum, to arrive at a precise, scientific, objective, or absolute measurement of the national income in terms of dollars. But the assumption that we can do so has led to dangerous policies, and threatens to lead to even more dangerous policies. (The Failure of the "New Economics")

Furthermore, even if such numbers did have a solid meaning, they should only concern the head of a socialist state, but not the president of a free economy. As economist Ludwig Lachmann pointed out, such numbers are not the target of any individual's choice -- no one leaves their house in the morning thinking, "Today, at work, I'll produce 4% GDP growth." In a free economy, it is the choices of individuals that are sovereign.

Kudlow says:

Team Bush should make the case right now, during the transition period, that 2 percent economic growth in the new information economy is unacceptable... During the campaign Bush agreed with Fed chairman Alan Greenspan that 4 percent growth is a suitable target.

Let's grant, for the sake of argument, that GDP does accurately measure economic growth. Further, we find that it has dropped from 4% to 2%. In a free market economy, our response should be a hearty "So what?" Future growth is determined foremost by personal choices to refrain from current consumption (including consumption of leisure) in order to increase production down the road. Perhaps, as the economy grows, at some point consumers decide they have enough "stuff," and would like to spend more time with their families. These are free people who should be left free to make such a decision, not cattle to be hit with the "Fed prod" in order to get the herd moving again!

Of course, we don't live under a regime of laissez-faire, but under a "managed" market economy. The Federal Reserve is not going away any time soon. Given that the Fed is going to attempt to manage interest rates, it must be realized that it cannot engage in endless credit expansion. As demonstrated by Mises, Hayek, Rothbard, and others, it is a previous credit expansion that causes the subsequent downturn.

When the Fed floods the economy with liquidity, as it did in preparation for the Y2K "crisis," it does not create a single new capital good or natural resource. There are simply more green pieces of paper sloshing around the country. These tend to move from the Fed to the banks and then out to businesses. This inflation usually hits asset prices first, and may not hit consumer prices at all. This is exactly what we saw occur in this last cycle, as the NASDAQ soared to dizzying heights and "dot coms" with no profits projected for a decade became capitalized beyond solid manufacturing companies with years of profits behind them.

But Greenspan, who spent some time in Mises' seminar, understands that he cannot keep up this flood of liquidity without creating a bigger and bigger bubble. Businesses use the new credit to expand, but there are not commensurate savings to support the expansion. The increase in pieces of paper has not been matched by an increase in the supply of capital goods. The dot coms all begin chasing the same Java programmers and Silicon Valley office space, driving the price for these resources through the roof, and pushing these costs beyond the companies' long-term ability to afford them.

The longer the artificial expansion goes on, the more painful the inevitable contraction becomes. The fact that the rapid rise in asset values was due to the credit expansion is illustrated by the fact that as soon as the Fed touched the breaks, the expansion collapsed. The value of the NASDAQ index has been halved, share prices for many of the dot coms have declined well over 90%, while others have shut down completely. Layoffs are rampant, and the market is now flooded with the resumes of dot com castoffs. Kudlow unwittingly describes the wake of a credit expansion to a tee: "Car, computer, and home sales are slumping, industrial manufacturing may already be in mild recession, early holiday sales are slower than last year, consumer confidence is faltering, and estimates of future business profits have been halved." A renewed credit expansion will simply start the cycle over again.

I can heartily agree with Kudlow's call for a tax cut in the current economic environment (or in any other economic environment, for that matter). If this increases GDP, grand. But Bush should not attempt to fine tune the economy to achieve some arbitrarily chosen growth figure. Furthermore, he should not pressure Greenspan to reinflate, although if he enters office with controversy swirling around him and a recession in progress, the temptation will most likely be too great to resist.

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Gene Callahan, who writes frequently for Mises.org, is working on a book called Economics for Real People. See his Archive or send him MAIL


Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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