Wall Street Bubble? Jude Wanniski May 4, 1998

The only threat on the near horizon to the advance on Wall Street is from the Federal Reserve, where Gov. Larry Meyer is trying to persuade his fellow governors that economic growth is inflationary. Just the threat of higher interest rates in order to slow down the financing of economic activity is in itself keeping the economy from growing faster than it could be. Meyer is promoting an increase in the federal funds rate internally and through leaks to The Wall Street Journal’s Washington bureau -- which has been fighting supply-side economic growth for 25 years. We’re fairly certain Fed Chairman Alan Greenspan has things under control and will continue to fight off these forces. Still, his own December 1996 comment about “irrational exuberance” in the stock market suggests there may be remaining doubts in his mind about a “bubble” on Wall Street. This is a good time to go over the “bubble” arguments.

First, remember that Meyer was trained at a time when empirical data seemed to support the idea that economic growth would cause prices to rise, and that there thus is available to the political managers of the national economy a trade-off between inflation and unemployment. If you want to lower the unemployment rate, you can get it by accepting an increase in the inflation rate. This is what economists of both political parties were telling me in the late 1960s when I was a young journalist on the staff of The National Observer in Washington, D.C. Of course I believed them, until I observed that as the inflation rate began to rise following the 1967 closing of the London gold pool, the unemployment rate inched up too. Bigshot economists like Charles Shultz and Herbert Stein and James Tobin opined that the unemployment rate was going up for other reasons, and that there was a permanent “structural” unemployment being built into the economy. On this line of reasoning, which Larry Meyer learned in school, the unemployment rate could not fall below 5% without triggering wage inflation. 

This is when I began to learn that inflation is a monetary phenomenon, that prices can’t rise unless the “money supply” rises. Milton Friedman discouraged Phillips Curve arguments about an inflation/unemployment tradeoff, but that still left us with the empirical data that led the British Dr. Phillips to draw his curve. It is what led me as a journalist in the direction of classical theory, which could explain rising and falling prices in two ways that were compatible. The general price level would rise permanently if the price of gold would rise in a country’s paper currency and stay at that new level. This is compatible with Friedman saying “inflation” is a monetary phenomenon. On the other hand, the general price level can rise temporarily if there is a sudden, unexpected “shock” in new aggregate demand. Dollar prices climbed sharply in 1914-17 when WWI turned out to be an enormous drain on resources instead of a brief conflict. Governments stepped into markets and bid wildly for goods even as they called the work force to soldier. The new central bank, the Federal Reserve, kept the price of gold at $20.67 per ounce. When the war ended and contracts were terminated and armed forces demobilized, prices tumbled sharply before settling at the pre-war level. 

The opposite kind of shock hit in 1929, when after the long expansion of the 1920s, U.S. producers had contracted to exchange goods and services with the rest of the world at a high level of commerce. The Smoot-Hawley Tariff Act “shocked” the markets, which had assumed that it would be killed in the U.S. Senate, where 60 of 96 Senators supposedly were in opposition after it had passed the House earlier in the year. The first market to be shocked was Wall Street’s market for paper assets. It saw that the real trade of U.S. widgets for European and Asian gadgets could not be FINANCED at the same volume given the higher tariff wall. As U.S. widgets piled up on our side of the wall, their prices fell, dragging with them the price of capital and labor purely associated with domestic trade. This, though, was not a “deflation,” because the Fed throughout maintained the price of gold at $20.67 an ounce. It was a “contraction.” The general price level fell, but would have soon returned to pre-Crash levels if President Hoover and then President Roosevelt had not added higher tax rates on domestic production again and again, trying to balance the budget.

What is going on in the economy today is all positive. The lower tax rates on labor and capital and the Fed’s stamping out of monetary inflation under Greenspan are reducing the risk of trading New York widgets for California gadgets. As the news gets better and better about the expanding budget surpluses in Washington and in the 50 states, the threat of higher tax walls between domestic producers is receding. The consequent rise in the demand for dollar liquidity is making it less and less likely that there will be a return to inflation. 

Meyer is worried that we are running out of workers, but he does not understand that it is only the workers’ bodies we are running out of, not their brains. Our workers are fully capable of producing twice as many widgets and gidgets at the same price as long as they have twice the capital. We want labor to be scarce and capital abundant, for that is the only way real incomes can rise. Prices of widgets remain the same, but workers now can buy more of them with an hour’s work. Not twice as many. Some have to be retained as a return on the capital goods. These increases in productivity are not showing up in the numbers as fast as Wall Street is climbing in value because Wall Street sees the future numbers way before Larry Meyer will. Just as the equity market crashed from 381 to 41 between September 1929 and July of 1932, it now is in the process of “crashing up,” if there were such a term. 

We don’t need more bodies, as our Ph.D. economists suggest. Open immigration does drain brainpower from abroad and add to the increased average efficiency of the economy. But it is much easier to add the capital to our existing labor force, if we want to cause wages to rise to a point where one breadwinner can support a family. Just as we ridiculed the idea of “structural unemployment” in the past, we continue to warn that as capital formation continues to expand, the labor force will shrink as women who are forced to work to make ends meet will choose to return to full-time homemaking. This will occur as the remaining unnecessary barriers to commerce are removed, through expansion of the Roth IRA, reduction of income-tax and capgains rates at all levels of government, and a peeling away of regulations that were originally meant as make-work interventions by government workers. If there is one new federal spending program I would gladly promote, it would be for education programs within the prison system -- the one place where there are domestic bodies and brains going to waste. 

Is there a correction looming on the Wall Street horizon? It’s always possible that bolts will appear from the blue, or that the Fed’s Gov. Meyer will be able to persuade the FOMC to beef up the unemployment rate. It there is a correction, it will be a real one, not any bursting of a bubble. The price of an individual asset might go up or down more than it would if there were more information available about it. But it’s not going to go up because people have more money to spend. It’s going up because our government has been doing more good than harm in recent years, and it looks like it may do more good than harm as it deals with the budget surplus in the months ahead.