More From Wanniski & Galbraith
Jude Wanniski
July 19, 2004


Memo To: Website fans, browsers, clients
From: Jude Wanniski
Re: The Foolish Fed

Three weeks ago, June 29, Professor Jamie Galbraith and I wrote an op-ed that was published in The Washington Times urging the Fed to NOT raise interest rates the following day. We knew the Fed would do so anyway, in the belief that inflation had become a problem that deserved a pre-emptive attack by weakening the economy. When everyone on Wall Street, including some of my erstwhile supply-side friends, now accepts the notion that interest rates have to be higher than they are just because it is "unnatural" for them to be so low does not mean they are correct. To Jamie and I, a weaker economy means more, not less, inflation, everything else being equal. Since the Fed did hike the funds rate to 1.25% on June 30 from 1% where it has been for the last year, the price of gold has gone up, the dollar as weakened on the foreign exchange markets, and Wall Street has been in the doldrums.

Last Thursday morning, Jamie and I happened to be in NYC at the same time and were invited to discuss our op-ed by Kathleen Hays, the CNNfn anchor of "The Flipside" show that airs from 10 am to 11 am EDT. Kathleen spotted the Memo on the Margin when it ran here June 29 and tracked us down. Here is the transcript of the show, which I have edited slightly to correct for errors made when the transcriber thought one word was used when another was.

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KATHLEEN HAYS, CNNfn ANCHOR, THE FLIPSIDE: Worries about inflation might have been tempered somewhat this morning by the latest economic numbers. The producer price index a key measure of inflation fell 0.3 percent in June. Reflecting a drop in food and energy prices. On Main Street, does it feel like the economy is growing really stronger especially when it comes to finding a job? Joining us here in the studio, Jude Wanniski, president of Polyconomics. Also here in New York, James Galbraith professor at the Lyndon Baines Johnson School of Public Affairs at the University of Texas.

Welcome you both to THE FLIPSIDE.

HAYS: I want to start by asking you, Jude -- Jamie, maybe you want to chime in. How did you guys get together on this issue? Out viewers may not realize, Jude, you are a well known supply side, more conservative Republican type economist. Jamie comes from the liberal Democrat side of things. You guys have this op-ed that got a lot of people talking because two very different viewpoints, one conclusion. How did you get together on this?

JUDE WANNISKI, PRESIDENT, POLYCONOMICS: We've been in e-mail communication for the last three or four years. I've always had great respect for Jamie's father, John Kenneth Galbraith, who I'd meet some years ago and who was always respectful of supply side economics, always open minded about it as compared to other professors of the Keynesian flavor who just laughed at us, calling us voodoo economic people.

There are about maybe 20 academic economists who I communicate with by e-mail. Jamie is one of them. Over the last two years or so, we find that we have a lot of common ground when various issues come up. There are a lot of things we disagree with. But the one issue we found we emphatically agree on, is there is no reason for the Fed to be raising the Fed funds rate at all, now or in the future.

If you were to fight inflation, it's the worst possibly way. Because all it does is slow the economy down. The only way to get prices down by raising interest rates is to cause enough pain in the economy that people have to go out of business, they have to throw their inventories on the market at distressed prices and briefly there are lower prices. But that's not the way you fight inflation.

VALERIE MORRIS, CNNfn ANCHOR, THE FLIPSIDE: Jamie, weigh in on this. Give us your opinion on how you feel about this, especially in light of the fact that [the producer price index indicates] there is no evidence of monetary inflation.

GALBRAITH: The Fed acted with really no evidence of strongly rising inflation in an environment where the overall recovery is not very impressive at all. And we believe that they tapped the brakes, or if you like, took the foot off the accelerator just at the moment when the economy was starting to go uphill. And the evidence that came out, really starting the next day, revision of the GDP statistics, fall in durable purchases and other indicators that have come out since, including that producer price index you just indicated, show that we were right.

It's very hard to imagine that the Fed would have taken the step that they did if they'd had another 10 days' worth of evidence to work with.

WANNISKI: And this is still - it's a cloud over all the economic actors. I'm talking about all the people who were doing business in the United States. I mean the tens - you know, the hundred million economic actors, producers and consumers [who are] being told constantly that interest rates have to go up, they have to go up to a natural rate, Fed governors - some Fed governors say they'll have to go up eventually to 3.5 percent. Jamie and I say that's nonsense. It doesn't have to.

Interest rates are fine where they are now. And if you want to have the economy improve, you have to take the threat of economic slowdown away from all of these economic actors.

J.J. RAMBERG, CNNfn ANCHOR: Well, be specific with us for a second, if you can, Jude. Why exactly are you worried about interest rate hikes? What's going to happen?

WANNISKI: Well, if you - first of all, if you raise interest rates, the theory is that it will reduce the supply of liquidity. The Fed will not have to supply as much liquidity.

HAYS: By liquidity, you basically mean money.

WANNISKI: Money, creating money, yes.

HAYS: Yes.

WANNISKI: So the Fed will have to add less money. But they don't take into account that, when you're slowing the economic down, you're also reducing the demand for money. So you're... like spinning your wheels, and you're not fighting inflation.

You have to really raise interest rates to such a high level, in order to cause enough bankruptcies and enough people enough pain, that, at the end of the day, you don't fight inflation anyway.

HAYS: OK. Let me - this is THE FLIPSIDE. Let me, Jamie - I've got to give you the argument for why the Fed is raising interest rates, and we have seen some upcreep in inflation. People were worried about the run-up in commodity prices. And basically, you guys, you know, as well as I do, what the Federal Reserve is saying, no, we're not trying to slow things down. We're just afraid, if we leave this interest rate so low, that we're going to fuel a housing bubble, that money is just too cheap, people are being speculative, and we just have to take some of this out.

That is their argument. And, viewers, by the way, if you want to call and get in on the conversation, please do.

But, Jamie, answer that, because you - I'm sure you have well-respected colleagues that are on the opposite side from you. How do you answer that? There is some more inflation (INAUDIBLE).

GALBRAITH: There may be a housing bubble in certain parts of the country, but that is probably playing out now. It's certainly accelerated in recent months, as people got the news that interest rates were going to go up and went out and refinanced those mortgages one final time in order to take advantage of the low rates before they rose.

So it's very much more likely that the housing bubble with deflate slowly over the next period, the next six months or so, than it will accelerate.

In any event, a housing bubble is not a generalized monetary inflation. We still have 5.6 percent unemployment in this country. If you take a count of people who dropped out, who stopped looking for work, we are - it's far higher than that. We're still 5 million jobs below what we should be, if you take, as a basis, the employment levels in the economy four years ago.

So there is absolutely no argument for the idea that the economy is working at full capacity, going full blast, that we're about to have the kind of wage inflation that, say, characterized the late 1960s. It just isn't going to happen.

WANNISKI: One of the things that Jamie and I said in that article was that if we were patient, the patient would cure itself. In other words - and I said before, if you can increase the demand for money, and the Fed, because we're not on a gold standard, the Fed doesn't supply money, then the price of gold will fall. And the price of gold falling means [there is a] diminution of the inflation impulse.

There is a little bit of embedded inflation in the system now because gold is at $402. It should be closer to $350. But as the economy grows, because of the tax cuts that we had last year, because maybe things are getting worked out in the Middle East, the oil prices are falling, people are feeling better about doing business, they have an increased demand for money, and the price - inflation comes under control.


WANNISKI: You do it in a pleasant way, without having to wreck businesses, throw people out of work.

GALBRAITH: You know, there is a Ogden Nash couplet that, "if there's one principle to Americans unknown, it is to leave well enough alone." That applies to the Federal Reserve in this case. They really got busy before they needed to and before they should have.

MORRIS: We have so many other topics we want to talk to you about, but we have a caller.

And first of all, our caller, Bill from California, thanks for your patience. What's your question or comment, please?

CALLER: I would like to know, how is the American worker going to compete against the Chinese and the Indians in order to be able to pay the salary to pay all these payments on these houses and other things? How can the American worker compete against somebody making $1 an hour in China...and maintain our standard of living?

GALBRAITH: The answer, I think, is by doing jobs that Indians and Chinese cannot do. We have wonderful high technology industries in this country. We provide a lot of advanced services. We do a great many things for each other that can't be outsourced to India and China. Our task is to create jobs at good wages that people can do in this country that raise the living standard of this country.

A particularly important task right now is to deal with our problem of energy insecurity, diversify our transportation networks, move away from our dependence on foreign oil. We're going to need a lot of investment if we're going to do that. We should get that under way. Raising interest rates to slow the economy doesn't contribute anything to that goal.

MORRIS: I'd like to ask you all about health care costs. They are a rising. How does that fit into this puzzle of the economy and well being of our country, Jude?

WANNISKI: Well, health care cost is the one big problem that every one knows is out there and no one wants to talk about. Greenspan, in his recent testimony for the banking committees, said, look, the deficits now can be handled, but the deficits ahead of us - and I just saw a study by the National Center for Policy Analysis that estimated that, in order to cover the projected increases in health care costs because the baby boomers are retiring, would mean that we'd have to have $75 trillion now in the bank earning interest.


WANNISKI: Now the Congressional Budget Office says that figure is a little too high. Maybe it's only half of that. But the answer to both questions about the outsourcing and health care is always to increase the amount of capital available to the American workers.

In other words, if a worker only has a hatchet that he could chop down a tree, he can only be paid so much. If you give him a power saw, he can really produce more - that's [the importance of] capital. So the way to get more capital is to fix the macro economic policies, monetary and fiscal.

GALBRAITH: And I would not assign the task of dealing with health care costs to the Federal Reserve, because they only have one instrument, which is to raise the interest rate. And that only works by basically contracting the economy, increasing unemployment, making it more difficult for working families to purchase things. And that's - that has no direct connection to the problem of rising costs in health care.

HAYS: In other words, you can't stop health care inflation by raising interest rates, and that's what you guys are trying to get at. I wish we could continue, one of my favorite topics.

Jamie Galbraith, thank you for joining us.

GALBRAITH: My pleasure.

HAYS: Great to have you here in New York with us. And Jude Wanniski, thank you for joining us on THE FLIPSIDE.

WANNISKI: Thank you. Thank you all.