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Jewish World Review Oct. 22, 2001/ 5 Mar-Cheshvan, 5762

Lawrence Kudlow

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Getting the story wrong -- THE stock market fatality count following Alan Greenspan's latest testimony before Congress reached about 2% or 200 Dow points by the week's end.

While a chorus of commentators on the market continues to blame this week's slump on Anthrax and earnings, I don't think so. As of now only six people have contracted the disease, far less than the available supply of cipro. Meanwhile bad earnings were fully discounted in the market's first full week of operations following the 9/11 terrorist bombings.

Instead, this week's market setback is more about the future economy, stupid. One of the key influences in the outlook for business next year is the amount of high-powered liquidity supplied now by the Federal Reserve.

Greenspan's testimony hinted strongly that the Fed believes it has done enough in providing new liquidity. The stock market, however, disagrees. So does the gold market, which is now barely hanging around $280. Broad commodity indexes continue to deflate.

Mounting evidence of a slowdown in new money confirms Greenspan's report to Congress. "As repair of the financial markets and payment infrastructure proceeded apace, loans were repaid, open-market operations could be scaled back, the unusual swap lines were allowed to expire, and the temporarily bloated balance sheet of the Federal Reserve largely returned to normal."

This was probably the most important sentence in the chairman's testimony. And this is what was not well received by this week's stock market, which continues to believe more, not less, liquidity is necessary in this environment of deflationary recession.

A recent USA Today story entitled "Debt weighs more as firms gobble cash" paints the picture. During the second quarter S&P 500 companies saw their cash flows available to pay debt fall 35% relative to interest expense. Small upstart companies are facing a credit crunch as lenders are demanding rates that are nearly ten percentage points higher than on government bonds, the worst financing squeeze since 1990. So far this year 120 borrowers have defaulted on $74 billion of bonds. Last year 108 borrowers defaulted on $34 billion of bonds.

Federal Reserve banking statistics for the latest week show a continued decline in excess reserves from $38.2 billion in mid-September to $2.7 billion through the week of October 3, then to $1.1 billion for the October 17 banking week just ended. Excess reserves represent spare cash on hand above and beyond what banks are required to deposit at the Fed. It represents potentially loanable funds, or money that could be used to purchase Treasury securities. Think of excess reserves as potential bank credit, just what this ailing economy needs.

The reason excess reserves are dwindling is just as Mr. Greenspan described to Congress. Emergency cash injections into the economy through open market operations are in fact being scaled back. The latest data show that so-called emergency liquidity has declined from about $80 billion right after the 9/11 bombings, down to around $40 billion in late September, then slipping to around $30 billion for the first half of October and now down to $26 billion.

If ever there was a time for excess liquidity from the Fed that time is now. Recession-related risk premiums are very high. But war-related uncertainty premiums are even higher. Both of these have become tall barriers to investment and production. Certainly lower marginal tax-rates on capital investment, business and personal incomes would provide welcome relief for slumping cash flows and a re-energizing of economic growth incentives.

But while we wait for tax-cuts, the Fed should be doing its part by injecting new liquidity. This is the wrong time for the central bank to be restraining its new money creation.

Mr. Greenspan may be influenced by some monetarist thinking that money supply growth is already too rapid and hence will fuel higher inflation next year. But monetarists are ignoring the sharp decline in the velocity, or turnover rate, of money.

Money is changing hands very slowly right now, largely in response to heightened uncertainties, which have substantially increased precautionary cash balance demands everywhere in the economy. This surge in cash balances reduces the economic power of new money creation. Since the 9/11 outbreak of war, three month growth of institutional money market funds has ratcheted-up to 24% at an annual rate from 6%. Retail money funds have increased to 9% growth from 5%. Overall cash fund volume now stands at $2.1 trillion. That is significant money not being put to work in the economy, undoubtedly in response to greater than usual fears and uncertainties.

As for inflation, show me the price hikes. Even the recent consumer price report for September shows that inflation has come down to 2.6% from 3.6% earlier in the year. Most economists agree that the CPI overstates price pressures by as much as one percentage point.

Meanwhile, below the headline number, the stubborn CPI services component (58.2% of the index) has slipped to only 1.6% over the past three months, down from more than 6% earlier in the year. The CPI commodities sector (41.8% of the index) has been deflating at a 2.5% annual rate over the past three months. CPI prices for personal computers have dropped 31.4% over the past twelve months.

Of course it should be noted that the flawed CPI index is a backward-looking inflation measure. But forward-looking financial and commodity indicators are strongly pointing to even lower future inflation.

So it's hard to fathom Mr. Greenspan's logic. He's getting the story wrong. Prices are falling, the economy is sinking, and uncertainty-related risk premiums have seldom been greater. In this environment, why then is he reducing Fed cash injections into the economy? And why is he counseling Congress not to enact permanent broad-based tax-cuts on investments, businesses and individuals.

It seems reasonable to think that new money and lower tax-rates would be just the right mix to raise economic spirits at home and to support the war effort abroad.

JWR contributor Lawrence Kudlow is chief economist for 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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©2001, Lawrence Kudlow