JACK KEMP COLUMN

No reason to raise interest rates

By Jack Kemp

Copley News Service

Word is that the Fed is going to raise interest rates again this week, and that would be a huge mistake since there is no legitimate reason to do so. None of the price indices reveal so much as a whiff of inflation in the air. The more reliable market indicators of inflation - the price of gold, other price-sensitive commodities and the foreign-exchange value of the dollar - also indicate a substantial measure of stability.

Yet the Fed maintains that none of these indicators is reliable because excess demand in the economy is inflating an economic bubble: Producers are producing too much. Too many people are working. Stock prices have risen too high. Consumers are spending too much and saving too little. The economy is growing too fast and exceeding its capacity.

In other words, we are experiencing what might be called growth inflation, or "growflation," a belief that the economy spontaneously grows faster than it is really capable of. According to this notion, unless the Fed lets the air out of the bubble gradually by raising interest rates, the bubble will burst, causing businesses to fail, equity prices to crash and unemployment surges.

Sounds scary, doesn't it? While there's no truth to it, it sure creates a ripe environment in which to expand the Fed's discretionary authority over the economy. By inventing a natural source of inflation outside the Fed's domain, namely spontaneously generated excess demand, the theory of "growflation" not only exonerates the Fed from being the single source of inflation but also transforms the Fed into society's lone bulwark against inflation - quite the bureaucratic switcheroo.

If "growflation" is accepted as reality, monetary policy cannot be based on a simple market-based price rule, which relies on movements in the prices of sensitive commodities like gold to dictate how the amount of money in the economy should be adjusted to keep the supply and demand for liquidity in balance. Instead, the discretion of the Fed must be relied upon to thwart inflation by bringing to bear esoteric knowledge that only it possesses to fine-tune capital and labor markets in a quest to overcome the natural tendency of free markets to spontaneously run out of control.

The fact is, only the Fed can generate excess demand in the economy by creating too much money. In our fiat-money system, it is the Fed that calibrates the injection and withdrawal of money into and out of the economy. If there is excess demand in the economy leading producers to produce too much and hire too many workers and misleading investors as to the true value of companies' shares, it is only because the Fed has permitted too much money in the economy.

Too much money can be thought of as analogous to a surge of adrenaline in the human body in times of stress. It can spur the body temporarily to physical feats that cannot be sustained once the adrenaline rush recedes. Were the adrenaline rush to be artificially maintained for any length of time, physical damage would result to the body.

When there is too much economic adrenaline surging through the economy, people exchange their excess money for commodities and other goods and services. As everyone does so, prices of commodities, goods and services go up. For a time, producers are fooled by what appears to be a genuine increase in demand for their products. They respond exactly as the law of supply and demand dictates and step up production, which also entails higher demand for labor.

Workers respond to the increased demand for their services by demanding higher wages. But since the apparent increase in demand is merely the result of people attempting to get rid of unwanted money, the increase in production creates goods people really don't want at higher prices. The result: excess supply and excess workers at current wage and price levels.

Unless the Fed compounds its original mistake with an additional infusion of unwanted money - which will generate another round of artificially heightened demand, rising prices and rising wages - inventories will build up, workers will be laid off and a recession will follow. Eventually, if the Fed manages to match the supply of money with the public's demand for liquidity, the economy settles down to normal.

Think of "growflation" like a medical theory that hypothesizes some overachievement hormone other than adrenaline that is not only undetectable but also does not influence other bodily functions like heart rate and blood pressure. If left unregulated, the theory goes, this hormone would lead the athlete to perform relentlessly beyond his natural capacity and damage his body.

Since the hypothetical hormone cannot be detected or measured, an attending physician would have to be assigned to monitor athletic accomplishments per se, exercising discretion to tranquilize the athlete when his or her achievements began to exceed earlier marks by more than a predetermined statistical measure. Imagine the mediocre level of athletic performance that would result under this theory.

Recently Fed Chairman Alan Greenspan offered the so-called "wealth effect" as the economic overachievement hormone - a non-monetary source of excess demand. He hypothesizes that people are paying for consumption they can't afford by increased borrowing because they feel richer as the result of the appreciation of their stock portfolios. But it is unnecessary to appeal to some hypothetical and unverified "wealth effect" to explain increased borrowing and the actual dis-saving, or wealth consumption, that is occurring.

Since 1993, when budget deficits started turning into budget surpluses, the increase in government saving brought about by the substantial federal, state and local budget surpluses has been almost exactly offset by a dramatic decline in personal saving, which fell from slightly more than 4 percent of GDP to less than zero. In other words, with federal taxes at an all-time high (21 percent of GDP) to run budget surpluses, individuals are dis-saving to stay even, not to go on a spending binge.

If the Fed Chairman wants Americans to save more, he must forget about raising interest rates to slow down the economy. Instead, he should lobby hard for a reduction in tax rates and a reform of the provisions in the tax code that penalize saving by taxing it multiple times. Reducing tax rates, not increasing interest rates, is the right prescription for the U.S. economy.