The Twisted Economy Jude Wanniski and David Gitlitz March 14, 2000

When you make up a fairy tale as you go along, there is no telling where it will lead as new characters, situations and ideas are introduced, especially if there are 12 men and women taking turns in the storytelling -- the members of the Federal Open Market Committee. The rants and ravings of Fed Chairman Alan Greenspan become more embarrassing week by week, as he is forced to come up with new rationales for slaying the non-existent ogres and trolls of inflation. First, too many people working cause inflation. Then, too much wealth causes inflation. Now, at Boston College last week, Greenspan announces that too much productivity causes inflation: "The pickup in productivity tends to create even greater increases in aggregate demand than in potential aggregate supply. This occurs because rising productivity "fosters higher expectations for long-term corporate earnings," increasing household net worth and lowering the cost of equity capital, which has "helped to spur the boom in capital spending." Until these forces are contained by a "vigilant Federal Reserve," Greenspan warned, "the full benefits of innovative productivity acceleration are at risk of being undermined by financial and economic instability."

Unless you have been following this fairy tale from the beginning, as we have all by ourselves since the monetary deflation began in December 1996, Greenspan’s gibberish may even sound plausible. How else does one explain a boom in the New Economy and stagnation in the Old? The textbooks tell us about the Creative Destruction that is a necessary and healthy part of a vibrant capitalist system -- as the buggywhip industry gave way to the Model T makers. Neither the textbooks nor the lessons of history inform us on how a dozen men and women can manage this process when all they have to work with is a teeny-weeny tool called the federal funds rate. The net result of the Fed’s vigilant efforts has been a bifurcated market, with young enterprises absent any earnings being valued at skyhigh prices while older enterprises with earnings coming out of the wazoo are marked down to the bargain basement.

If you could just imagine away the dot.coms, there would be nothing to wonder about in the performance of the brick-and-mortar established equities. Their valuations are tied to standard dividend discount models weighted toward nearer-term earnings expectations. Add back in the high-tech sector -- where extraordinary gains represent a bet on future growth prospects -- and it becomes evident that all Greenspan has been able to do is accelerate the process of creative destruction. The Fed’s phobia about the inflation ogre has led Greenspan to shut off the oxygen to the senior citizens and force-feed steroids the toddlers. This is not a cash-flow argument we are making, i.e., that dizzy speculators are selling shares in Proctor and Gamble so they can buy Broadvision or JDS Uniphase. It is that the economy itself is seeing the Fed smothering the old folks and is making room more quickly for the kids, directing capital accordingly.

If the Fed did not have undisputed authority to tighten this single lever, the funds rate, but had to supply the oxygen demanded by the seniors, we would not now be in this predicament -- out of which we can only escape by finding a way to smother the kids. The juvenile biotech stocks are being hammered with rumors reported in the LATimes that President Clinton and U.K. Prime Minister Tony Blair are going to come out with a joint policy for greatly expanded freedom of information concerning the human genome. As Donald Luskin of Metamarkets.com puts it: "Investors are afraid that means NO PATENTS, and that would mean NO PROFITS." The "no patents" idea has also nudged its way into the Internet, as a piece by James Gleick in last Sunday’s NYTimes Magazine informs. Both are sinister thoughts propounded by those who have already gotten into a lead position and feel threatened by ideas not yet conceived, dreams not yet dreamt. President Gore would be perfect in that mommy role. President George W. Bush, on the other hand, may prefer to tax the Internet in order to finance tax cuts for compassionate conservatives. The governors of the 50 states would not mind seeing this proposal kept alive. John McCain's flat-out opposition to an Internet tax was one of the only read-my-lips pledges we saluted.

Greenspan's dilemma can be seen in the accompanying graph, plotting total U.S. market capitalization against the S&P 500, indexed to year-ago levels. Even while a standard indicator of market performance such as the S&P has plateaued, the strength of New Economy equities that dominate the NASDAQ have continued to propel aggregate asset values, i.e., wealth, higher. As a result, Greenspan's increasingly twisted logical improvisations find him paying lip service to the wonders of new technology but falling back on archaic Phillips-curve arguments to suggest that such pervasive and successful innovation is ultimately its own worst enemy. How, without pain, do we get out of this predicament, with its grotesque arguments and hunchbacked yield curves? You fix the dollar to gold, which takes control of the oxygen away from the FOMC and gives it back to the market. Either that, or Greenspan wakes up from his bad dream and sees the error of his ways.