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Jewish World Review May 1, 2000/ 26 Nissan, 5760

Lawrence Kudlow

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Wealth and Capital -- AS THE DUST CLEARS after the first quarter GDP report, and the zany demand-side Phillips curvers gnash their teeth over the need for many more Fed tightenings to prevent growth, this seems like a good time to reflect on the power of capital investment to expand the supply-side of the economy and reduce prices at the same time.

First, some numbers. Over the past four quarters the U.S. economy has grown 5% with only a 1.8% increase in the GDP deflator and the GDP chain-price index. Pretty spectacular. Historically strong growth with historically low inflation. Put in a 4% unemployment rate just for good measure.

Within the GDP accounts, real consumer spending has increased by 6%, while business equipment investment has risen more than twice as much at 13.4%. So, demand-side consumption is bulging, but supply-side investment is bulging even more.

Now let's put all this in the context of Alan Greenspan's obsession with stock market-driven wealth increases. He argues that people who feel wealthier spend more; hence, the Fed must curb demand lest it outstrip supply, in order to prevent higher prices.

But, in reality, the so-called wealth effect is boosting supply and demand. In fact, the data suggest that if there is a wealth effect, it is generating even greater investment gains than consumption increases. So inflation remains virtually non-existent.

Former Federal Reserve senior economist Kevin Hassett, now a resident scholar at the American Enterprise Institute, believes that the "academic literature says stock market wealth creation generates a very small consumption effect, but a very large investment effect." In a telephone interview he cited work done by Glen Hubbard of Columbia University, Dale Jorgenson of Harvard and Alan Auerbach of Cal-Berkeley.

In a recent Investors Business Daily interview, Hassett argued that when the stock market goes up there are two effects on the economy. "One is that people who own stocks feel wealthier, and they consume more. And the other is that firms have a cheaper source of equity finance, and they buy more machines."

So the net effect is a small shift in the demand curve, but a larger shift in the supply curve. And it is this outward supply-curve shift that reduces prices. Therefore, in total, the so-called wealth effect is actually deflationary.

Trouble is, Mr. Greenspan has been relying on the FRB-US economic model used at the Fed. This model, and its supporters, have learned nothing since the 1970s. The model is driven solely by consumption. It has no investment-side response variables. For this reason it should be completely discarded.

The huge surge in capital investment in recent years, most of which comes from the information technology sector, is mainly responsible for the concurrent rise of productivity. Massive capital infusions have made the U.S. workforce vastly better equipped and trained. They have earned their compensation increases and deserve higher real wages. Note the accompanying chart which shows the clear link between the rising contribution to GDP growth provided by technology investment and the steady rise of productivity.

Stanford University economist Paul Romer calls this the "New Growth" model. It stems in large measure from the information technology boom, and it has not only transformed the U.S. economy, it is also transforming economic analysis. If only economists would keep their eyes open.

Romer also emphasizes the "law of increasing returns", which states that rapid innovation and its myriad spillover and application effects throughout the economy keep the growth momentum going. This is in direct contrast to the law of diminishing returns, where Nobelist Robert Solow of MIT argues that technology imparts only a one-time effect on economic growth, then the economy settles back into a so-called steady state equilibrium (of roughly 2 1/2% yearly growth).

The moral of this story is simply this. The rising stock market is indeed creating wealth, and that wealth is propelling capital investment and productivity higher and higher. With the production of more goods, and greater worker efficiency, inflation remains mute even while growth soars. All, of course, in the context of a steady dollar.

For these reasons I believe the Fed should be leaving well enough alone. The level of the monetary base is crashing. All the excess money of the Y2K fourth quarter has already been removed from the economy. Enough is enough.

If it ain't broke, don't fix it.

JWR contributor Lawrence Kudlow is chief economist for Schroder & Co. Inc and CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


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04/13/00: Correct Value
03/28/00: Governments roil the Markets
03/28/00: Fed should keep its powder dry
03/14/00: Reduce Debt, Derail Economy
02/17/00: Unsettled
02/10/00: Bush's Footprints
01/25/00: To preserve its standing as the world's number one economic power
01/06/00: It's not the '70s
12/28/99: They missed it
12/23/99: Bonditos
12/20/99: Dracula's Curve
12/16/99: When Alan Greenspan sneezes, Wall Street economists catch cold
12/10/99: Y2K-Related Cash
11/23/99: Y2K Money: Inflationary or Not?
11/16/99: Investor Retaliation
11/05/99: Rosy Lives
10/29/99: Drain Reserves
10/22/99: Supply-Side Is Mainstream
10/14/99: Y2K will likely bring more prosperity
10/07/99: Clinton's tax-cut veto
10/01/99: What's really bugging the stock market?
09/23/99: Growth Trade
09/09/99: Bad Dollar Logic
09/09/99: Buttered bread
08/31/99: Bull Market Alive and Well
08/26/99: Let Prices Rule
08/19/99: Blame OPEC, Not Growth

©1999, Lawrence Kudlow