Now, why is a relatively elastic cross elasticity important? Although U. S. unemployment is now down to 4.2%, wage rates are nevertheless stable with only modest acceleration. While there have been some recent significant productivity gains, one still wonders why labor costs are so stable in a climate of labor shortage? Is it that unions have become less demanding? I think the answer is that the unions recognize that if they attempt to push up wages, the employer could produce these goods in Europe or Asia. The unions do understand the relevance of an elastic cross elasticity of supply.

I would like to consider another important factor fueling an asset bubble. The Federal Reserve, and especially Chairman Greenspan, have been concerned about the danger of an asset bubble for more than 2 years. Greenspan knows that high money growth rates can fuel an explosive boom in equities. And in his December 1996 address he publicly expressed his concern about "irrational exuberance". Why has he allowed money growth to continue at these very high levels? 10/ And why is it he can't act to restrain this explosion of money? I am referring here to what I call the handcuffing of the Fed. 11/

I define handcuffing as a situation where, in the absence of inflation, the Federal Reserve will not restrain money growth. I believe the handcuffing of the Fed has been an important, indeed critical, facilitator of the boom since 1995. 12/

Suppose you are a Wall Street professional and you have learned that the Federal Reserve will not raise interest rates for the next two or three quarters. What would you do? The market professional has a green light to speculate and to leverage his investments. This is precisely the situation since 1995: (1) the growing idle capacity in Europe, Japan and southeast Asia keeps U. S. inflation benign; and (2) the absence of inflation prevents the Fed from restricting money growth by raising interest rates. 13/ More precisely, the idle resources in the global economy and the elastic cross elasticity of supply, absent U. S. inflation, provide a signal for professionals to leverage and speculate.

To recap: What the market professionals fear most is that the Fed will raise interest rates forcing them to liquidate a position. But if the Fed appears to be handcuffed--unable to raise rates--the stock market professionals are energized as though they are on an adrenaline high. Learning that the Fed will not raise rates is the best news they can hope for. They are free to borrow, to leverage and to speculate. The handcuffing of the Fed and the liberation of market professionals are, I suggest, critically important factors in fueling the post 1995 stock market boom.

As I have indicated in Section II, I doubt that the technological advances and productivity breakthroughs that the New Paradigm theorists attribute to the current economy are all that different from earlier boom periods such as the 1920's. 14/ If there is something uniquely different to the current boom, it is, I suggest, the extent and duration of the handcuffing of the Fed.

VII. GREENSPAN AND THE MONETARISTS

A second factor that handcuffed the Fed since 1995 is that Greenspan is in a bit of a trap--one that he himself set. He cannot easily, or readily,

raise interest rates even though money growth is excessively high so long as inflation is quiescent Let me explain. Greenspan is limited by his 1990-1991 victory over the monetarists. During the recession of 1990-1991, many observers, and especially monetarists, questioned Greenspan since key monetary aggregates, and especially M2, were not growing sufficiently: the M2 aggregate grew by only 1% whereas the midpoint of the Federal Open Market Committee (FOMC) recommendation for that period was approximately 2 1/2%. Using that FOMC midpoint, by 1992 "the M2 money stock would have been approximately $200 billion larger and the GDP perhaps $350 billion higher". 15/ Many economists questioned why Greenspan was so niggardly in expanding the money supply in 1991 and 1992. And the criticism that money growth in the 1990-1991 recession was much too low came not only from Milton Friedman and other monetarists but also from Paul Samuelson.

Greenspan's defense in the 1990-1991 period was that one cannot gauge the thrust of monetary policy by examining money growth rates, thus generating the problem he has faced since 1995. By propounding this view in 1991-1992, testifying in Congress, and arguing against money growth as the proper variable to gauge the thrust of monetary policy, he can not, in the post 1995 boom, cite rapid money growth as a basis for Fed restrictive action. So he is in a difficult position.

The markets and Wall Street can readily point to the lack of inflation, and argue that the Fed has no basis to tighten. They can cite Greenspan's 1990-1991 testimony concerning the inappropriateness of focusing on money growth to gauge the thrust of monetary policy, especially when prices are stable. They will also point out that we now have a 4.2% unemployment rate, that many former welfare clients have finally found jobs, and that if he tightens these former welfare recipients may lose their jobs. Greenspan will be charged with racism--they will not only call him a bad central banker, they will also charge him with other transgressions. So his basis for action has been taken away. Greenspan was too successful in fighting the monetarists in 1991. He downplayed the significance of high monetary growth--the one argument that he could have used in the 1995-1999 period.. I conclude that Greenspan's 1990-1991 victory over the monetarists is limiting his current policy options.

Greenspan's June 1999 testimony at the JEC suggests that he may now feel that he could raise interest rates and limit money growth even though current inflation is still relatively benign. 16/

In this paper we argue that the extraordinary boom in the U. S. equity market results from a number of special factors and we reject the New Paradigm and the notion of a New Economy. The special factors facilitating this extraordinary boom in which P/E ratios have reached an all time high in excess of 35 are summarized below.

First we note the large volume of idle resources in 65% of the Global Economy--in Europe, Japan, Asia and Latin America. Second, the global idle resources and unused capacity ensure that America faces an elastic aggregate supply that can be readily augmented by the global idle resources. Third, the resulting elastic augmented aggregate supply guarantees that inflation rates in the U. S. are fairly tame. Fourth, the absence of inflation in the U. S. tends to handcuff the Fed since Chairman Greenspan finds it difficult, in light of his prior public position, to restrict the accelerating growth of the money supply in the absence of inflation. Fifth, the perception that the Fed is handcuffed liberates the market professionals to borrow and leverage their portfolio positions, knowing that the Fed is handcuffed.

We suggest that this mechanism explains the relative absence of inflation in the U. S. in the face of a recovery in its ninth year, extremely high monetary growth rates, an extraordinary boom in equities and real estate, and the highest P/E ratios in recorded history.

The boom in America is directly related to high unemployment rates and low capacity utilization rates in Europe, Japan, Asia and Latin America. The post-1995 U. S. boom is dependent on the idle resources in post-Maastricht Europe, on the stagnant Japanese economy of the 1990s and on the considerable idle capacity in Asia and Latin America. In short, America's spectacular boom--its ability to grow for over nine years without inflation--is dependent on the very substantial volume of idle resources in the global economy--on the fact that we are currently living in a global economy that is Keynesian.

Greenspan's June 1999 and July 1999 testimony to Congress may indicate that he is now ready to raise interest rates and limit money growth--take the handcuffs off--even though inflation is still relatively benign.

We do not deny that there have been spectacular breakthroughs in computer technology and advances in telecommunications with corresponding increases in productivity in the 1990s. But as our citation from Schumpeter suggests, similar claims were made for the motor car in the 1920s. Indeed Schumpeter describes this period as the "industrial revolution of the twenties".

If the secret of our post-1995 boom is that we are living in a Keynesian global economy, then, like the Keynesian world of the 1930s, it is a temporary phenomenon and not a permanent feature. We therefore reject the New Paradigm; and we conclude that the extraordinary rise in equities since 1995 is a likely asset bubble. 17/

August , 1999

IX. FOOTNOTES

1/An exposition of the New Paradigm and the New Economy view is presented by Steven Weber "The End of the Business Cycle"; Foreign Affairs, July-August, 1997, volume 76 #4 pp. 65-82. For a critical analysis of the New Paradigm see Paul Krugman "Seeking the Rule of the Waves" Foreign Affairs, op cit, pp 136-141 and his "How Fast can the U. S. Economy Grow?" (Harvard Business Review, July-August 1997, pp. 123-129) Ugo Sacchetti "Whither the U. S. Economy?" (Banca Nazionale del Lavoro Quarterly Review #208, March 1999, pp 69-94) argues that the trends which have sustained the current boom cannot continue, and are bound to be reversed. He suggests that the U. S. economy may enter a period of significant recession.

Chairman Greenspan takes an intermediate position. He states: "The 1990's have witnessed one of the great bull stock markets in American history. Whether that means an unstable bubble has developed in its wake is difficult to assess. A large number of analysts have judged the level of equity prices to be excessive, even taking into account the rise in 'fair value' resulting from the acceleration of productivity and the associated long-term corporate earnings outlook.". . . . . "But bubbles are generally perceptible only after the fact. To spot a bubble in advance requires a judgement that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best." See Alan Greenspan: "Monetary Policy and the Economic Outlook." Joint Economic Committee, U. S. Congress, June 17, 1999.

In subsequent testimony he states:"Premptive policy making requires that the Federal Reserve continually monitor economic conditions, update forecasts, and appraise the setting of its policy instrument. Equity prices figure importantly in that forecasting process because they influence aggregate demand. As I testified last month, the central bank cannot effectively directly target stock or other asset prices. Should an asset bubble arise, or even if one is already in train, monetary policy properly calibrated can doubtless mitigate at least part of the impact on the economy. And, obviously, if we could find a way to prevent or delate emerging bubbles, we would be better off. But identifying a bubble in the process of inflating may be among the most formidable challenges confronting a central bank, pitting its own assessment of fundamentals against the combined judgement of millions of investors." Alan Greenspan: Statement before the Committe on Banking and Financial Services, U. S. House of Representatives July 22, 1999, p. 13.

For a novel interpretation of the New Economy, see J. Bradford DeLong "What 'New' Economy?", Wilson Quarterly, Autumn 1998, pp14-26.

2/Irving Fisher, The Nature of Capital and Income. (New York, Macmillan, 1906.)

ibid. The Theory of Interest. (New York, Sentry Press, 1930).

ibid. The Purchasing Power of Money. (New York, Macmillan, 1931).

ibid. Constructive Income Taxation (New York, Harper, 1942).)

ibid The Making of Index Numbers. (Boston, Houghton-Miflin, 1927).

ibid. Mathematical Investigations in the Theory of Value and Price. (New Haven, Yale University Press, 1925).

3/Irving Fisher The Stock Market Crash and After. (New York, Macmillan, 1930).

4/ The factors stressed in the New Paradigm are very similar to those stressed by Fisher. On technology, see Fisher's Chapter 8 on SCIENTIFIC RESEARCH AND INVENTION; on globalization and restructuring see Chapter 7 on THE AGE OF MERGER and Chapter 9 on INDUSTRIAL MANAGEMENT. On the non-confrontational labor relations, see Chapter 10 on LABOR'S COOPERATIVE POLICY; and on the central bank success with price stability see Chapter 12 RELIEF IN SEVEN YEARS OF STABLE MONEY.

5/ Fisher, in the fall of 1929, stated that "Stock prices have reached what looks like a permanently high plateau." See J. K. Galbraith The Great Crash (Boston, Houghton Miflin, 1961) , page 75.

6/ "Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?" See Alan Greenspan "The Challenge of Central Banking in a Democratic Society", December 5, 1996 (Washington, AEI), p. 14.

7/ See Kenneth R. Harney: "The Nation's Housing". The Washington Post, July 13, 1999, pp. G1, G2.

8/Alan Greenspan "Monetary Policy Report to the Congress Pursuant to the Full Employment and Balanced Growth Act of 1978", February 23, 1999, p. 25. This report by the Fed Chairman, which he delivers twice annually to both the House and the Senate Banking Committees is sometimes referred to as the Humphrey-Hawkins Report.

9/ Greenspan, in a sense, created this problem when he downplayed the significance of monetary growth rates in his testimony on the 1990-1991 recession. See Section VII, below, on GREENSPAN AND THE MONETARISTS.

Buchanan and Fand, in discussing Greenspan's testimony during this period, write "One argument offered by Greenspan himself is that the public did not want to hold more M2: thus there was a need to "work down the debt excess", "restructure the balance sheet", "work off the debt overhang" and "work off the excess of the 1980s". But these statements expressed an elementary fallacy. Any nominal target can be achieved by the Fed through central bank operations, especially a target as wide as the low end of the range from 2.5 to 6.5% that was set in 1992.....We may sum up this section by asking defenders of Federal Reserve monetary policy in 1990-1992 three questions: 1. Could the Fed have produced more M2 in the three years 1990-1992? 2. Would more M2 have increased output, employment and income? 3. Would such increases have been desirable?". James M. Buchanan and David I. Fand: "Monetary Malpractice: Intent, Impotence, or Incompetence?". Critical Review volume 6, number 4, pp 465-466.

See also David I. Fand: "Monetarism and the United States Economy: 1990-1995" in Avi Cohen, Harold Hagemann, and John Smithin (editors); Money, Financial Institutions and Macroeconomics, (Boston, Kluwer, 1997). Chapter 12, pp 175-190.

10/ It is interesting to note that after his comments on "irrational exuberance" in December 1996, money growth almost doubled from a 4.6% growth in 1996 to an 8.5% rate in 1998. See Table 3 and Chart 4.

11/ In response to a question from former Governor Lawrence Lindsey, Chairman Greenspan states:"We are constrained by an unwritten set of rules. From where I sit, one of the toughest jobs is to know exactly where we cross the line. We are a central bank in a democratic society that functions under an existing set of laws. We have technical independence in the sense that there is nobody that has the legal capability of rescinding an action we take in the monetary area. But we cannot do things that are totally alien to the conventional wisdom in the professional community. Of course, if we simply look to the conventional wisdom to tell us what to do, we might as well go out of business and have somebody run policy by just conducting a poll." Lawrence B. Lindsey: Economic Puppetmasters (Washington, AEI Press, 1999), page 34.

12/ In the interview with Former Governor Lindsey, Greenspan also states "There is a fundamental problem with market intervention to prick a bubble. It presumes that you know more than the market. There is also a problem of timing. You might prick it too soon, in which case it comes back, and you may just make it larger the next time. There is also the very interesting question as to whether the central bank is intervening appropriately in the market. This raises some fascinating questions about what our authority is and who makes the judgement that there actually is a bubble." Lindsey, op. cit, page 50.

13/ As indicated in the next section, Greenspan's 1990-1991 arguments downplaying the signficance of monetary growth rates further limits the Fed's ability to act. See also Fand and Buchanan, op cit.

14/ Schumpeter, describing this period as 'the industrial revolution of the twenties' states: "This is what we find. The electrical, chemical, and automobile industries, which together with their subsidiaries and all that directly and indirectly hinges upon them--the motorcar, for instance, is responsible for a great part of the total of postwar construction: roads, garages, gasoline stations, suburban residences--account for 90% of the postwar changes in the industrial organism and for most of the increase in real income." See Joseph A. Schumpeter Business Cycles (Abridged, with an introduction by Rendig Fels), (New York, McGraw Hill, 1939). page 305.

15/ "Alan Greenspan's monetary deceleration during and after the 1990-1991 recession was even more stringent and restrictive than the tight money policy that Paul Volcker introduced to reverse double digit inflation in early 1980. The M2 growth rate of 2.8% and 1.9% in 1991 and 1992 fell below even the midpoint of the Fed's target ranges, which were explicitly selected to slow inflation Had the Fed hit the midpoint of its own money targets in 1991-1992, by early 1993 M2 would have been approximately $200 billion larger and the GDP perhaps about $350 billion higher." See Buchanan and Fand, op cit, pages 461-462.

16/Greenspan in his testimony states: "While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy. . . . .The bursting of the Japanese bubble a decade ago did not lead immediately to sharp contractions in output or a significant rise in unemployment. Arguably, it was the subsequent failure to address the damage to the financial system in a timely manner that caused Japan's current economic problems. Likewise, while the stock market crash of 1929 was destabilizing, most analysts attribute the Great Depression to ensuing failures of policy. And certainly the crash of October 1987 left little lasting imprint on the American economy." Alan Greenspan: Joint Economic Committee testimony, June 17, 1999, op cit.

17/ Former Federal Reserve Governor Lawrence Lindsey, who discussed these issues in an interview with Chairman Greenspan, writes "We have one other very important consideration. The bigger the bubble in asset prices, the more dependent the economy is on the wealth-generated spending caused by the bubble. The economy will get a dose of "the higher they rise, the harder they fall".

Greenspan acknowledges as much "Of course there are dangers and to be sure, we don't want to get ourselves hung up on a very expensive bubble" Greenspan is well aware that this is the dilemma he faces: "If you had a gold standard there wouldn't be the choice. No matter what we do, we're creating potential trouble. Absent the gold standard, open market policy should endeavor to create monetary conditions in the least worst manner?" So Greenspan sits on the horns of a dilemma. On the one hand, if he tightens monetary policy he risks disturbing both the political concensus that supports the Fed's independence and the economic conditions that underpin having society making the most of a supply shock. On the other hand, if Greenspan does not act to tighten policy, the bubble simply gets bigger and bigger, until the Fed has no choice." Lindsey: op cit., p. 52.