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Distributed by Copley News Service
February 26, 2001
Neither tax cuts nor interest rate cuts -- as desirable as both may be -- can stop the economy from shrinking, given current monetary policy by the Federal Reserve Board. We are up to our ears in a historically rare monetary deflation that will force prices and wages to fall just as monetary inflations require prices and wages to rise. It is the result of Alan Greenspan’s overzealousness during these last four years of economic growth the result of the Republican tax cuts of 1997 and the Internet-driven productivity surge.
Today’s conventional wisdom is that the economy has slowed and may be heading toward a recession because it had been expanding under the pressure of “irrational exuberance” and the bubble finally burst. I strongly disagree.
The economy will revive the minute the Fed ends the deflation and stops starving the economy of the liquidity it needs to grow. As much as I believe a tax rate cut is desirable and will increase long-run economic growth, a tax cut will not end the deflation, and the rather modest tax cut proposed by President George W. Bush will do little to offset the consequences of deflation. In fact, if the Fed does not meet the increased demand for liquidity that even a modest tax rate reduction will stimulate, the deflation will only get worse.
Now, I’m no economist, but I’ve been a student of economic policy and on the front lines of economic policymaking for more than 30 years. In my opinion the Fed is repeating the mistakes it made in the early 1980s, when the Reagan tax rate reductions caused an increase in the demand for dollar liquidity that the Fed, under the leadership of Paul Volcker, refused to supply, causing the price of gold to collapse from $600 to $300 and putting the economy into a deep recession.
When the Fed opens its doors for business every morning, it has basically only one lever that it can push and pull: It can buy bonds (which injects liquidity into the banking system) or sell bonds (which withdraws liquidity). The only question, then, is what criteria does the Fed use to tell it when to buy and sell bonds and how much of them to buy or sell?
Demand-side Keynesians would have the Fed calibrate the injection and withdrawal of liquidity into and out of the economy by targeting short-term interest rates. This is the model currently used by the Greenspan Fed, which has created the mess we are in.
Monetarists would have the Fed simply increase the money supply at the same constant rate they believe the economy is capable of growing over the long run. This was the model in use by the Volcker Fed when it put the economy into a deep recession at the beginning of the Reagan administration in 1981 and 1982.
“Supply-side” economists who hearken back to the pre-Keynesian classical school of economics contend that the Fed should seek to provide the economy with the amount of liquidity demanded by market participants under the specific circumstances at the time. The Fed can determine whether markets are demanding more or less liquidity, and thus whether it should buy or sell federal bonds, by watching inflation-sensitive commodity prices, especially the price of gold. If commodity prices are stable, the Fed is meeting the demand for money; if they are rising, the Fed is injecting too much liquidity into the economy and should sell bonds to mop up the excess; and if they are falling, the Fed is starving the economy of liquidity and should buy bonds to inject new money into the system.
We will know if and when the Fed decides to end the current deflation when the price of gold stops falling and begins to rise from $255 an ounce back toward $300 an ounce, its price just before the Fed undertook to slow the economy and “tame” the stock market back in June 1999. Lowering short-term interest rates a half-point at a time at six-week intervals will not succeed, and in fact there reason to fear that it may actually exacerbate the problem.
As David Gitlitz, president of D.G. Capital Advisers observes, “If borrowers, lenders and the banking system expect lower interest rates, then demand for bank reserves will drop, putting downward pressure on the Fed’s targeted interest rate, which perversely will require the Fed to withdraw liquidity to prevent the targeted interest rate from falling below its targeted value. That is what the Fed is doing today.”
The fact that expectations are ahead of the Fed means it is forced to react contrary to its stated policy goal. Eventually, markets will come to believe the Fed is done lowering interest rates and the delay in the economic recovery will end. Until then, however, we may be waiting on the Fed to cure a situation it is only making worse.
There is another, even more troubling problem with the Fed’s arbitrarily targeting interest rates in an effort to fine-tune the economy. Just like 1981, we are about ready to cut tax rates, which will unleash more productive activity and increase the demand for money. If the Fed does not adequately meet that demand for money, the deflation we are already suffering will only become worse, and what is now a mere slowdown could turn into a full-blown economic contraction.
Jack Kemp is co-director of Empower America and Distinguished Fellow of the Competitive Enterprise Institute.