No Inflation? Look Again

BARRON’S
MONDAY, NOVEMBER 15, 1999

No Inflation? Look Again

It’s confined to stocks today, but it will spread

By GEORGE REISMAN and ROBERT KLEIN
Think again. So far, it’s confined to stocks, but it will spread.

Alan Greenspan is correct to be concerned that rising asset prices will lead to more spending and higher prices elsewhere in the economy. He is also correct that the extraordinary increase in stock prices is being fueled by a wave of optimism. What he does not say is that neither the optimism nor rising asset prices would be possible without massive amounts of new money created by the Federal Reserve and the banking system.

While a roaring stock market is certainly not the Fed’s intent, it is the inevitable consequence of its easy-money policy. Since the end of 1994, the banking system, under the umbrella of Federal Reserve and related government intervention, has expanded by more than 60% of the money supply as measured by currency plus deposits upon which checks can be written. This explosive money-supply growth has led to a boom in stock prices. The accompanying chart below illustrates how an expanding money supply, or the expectation by investors of a future expansion, pushes stock prices higher. Money really does move the market — and it also breeds speculation.

Greenspan, in an article he wrote in the ‘Sixties, “Gold and Economic Freedom,” described how this process worked in the late ‘Twenties. He discussed the Fed’s attempt to lower interest rates by pumping excess reserves into the banking system: “The excess credit which the Fed pumped into the economy spilled over into the stock market — triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late… .” Though the environment in the ‘Twenties was different in some ways from that of today, the Fed stimulated the boom then, just as it is doing now. Greenspan realizes that monetary policy is a very blunt tool. In attempting to stimulate the economy with easy money, the Fed cannot control where the money will flow; it can only initiate and encourage the flow.

What confuses people about today is that the rise in prices thus far has been mainly limited to a rise in stock prices, and to a lesser extent, real-estate prices. In other words, the people have chosen to spend most of the excess money on Wall Street, rather than on Main Street. Therefore, price increases as measured by the consumer price index appear to show relatively little cause for concern.

By contrast, if the Fed’s inflation of the money supply were causing grocery prices to skyrocket as they did in the ‘Seventies, people would be alarmed. They would demand an end to the Fed’s policy of inflation, which is why, in 1979, Paul Volcker was brought in to run the central bank. What makes the soaring Dow Jones Industrial Average different from rising lumber and milk prices is that people see rising stock prices as simply reflecting a healthy economy. People say, “Relax, it’s a bull market.” Today’s strong economic growth and lack of economy-wide price pressures makes this view plausible. However, when the rise in the stock market far outstrips the growth in the economy for many years, one must look for another explanation.

Given its abstract nature and seemingly inexplicable gyrations, the stock market appears to many people to have a mystical quality, which makes it hard for them to view it as subject to inflation, like other markets. As equity claims to businesses, stocks are productive assets. They rise in value with a prosperous economy and the associated earning power of the underlying companies. However, given their limited supply, stock prices can also rise merely on the foundation of a growing money supply, especially when the additional money goes mainly to buy stocks.

The excess money has been going mainly into stocks over the past few years because the market has been rising, with a few brief exceptions, since the early ‘Eighties. People want to buy stocks simply because stocks have been going up. The ruinous inflationary policy of the Fed in the ‘Seventies pushed real rates of return into negative territory and drove the stock market down to a 15-year low in real terms. In the ‘Eighties, the Fed reduced the rate of money growth, restoring real rates of return and enabling the stock market to catch up from its dismal performance in the ‘Seventies. By the mid-1990s, the accepted wisdom had become that all one needed to do was buy blue-chip stocks no matter what the price, and hold them for the long pull. Any losses would be temporary. Thus, in late ’94, when the Fed reopened the monetary spigots, people bought stocks, and they have been buying them ever since.

Price pressure has not yet spread to the rest of the economy, for a few reasons. First, labor productivity has improved over the past decade, which has enabled wages to rise without pushing up product prices. The unemployment rate has dropped to 4.1% and is unlikely to go lower. Thus, without more unemployed workers to hire, companies will have to resort to bigger wage hikes to attract employees. Commodity prices have been held down by economic weakness in Asia and Latin America. However, Asia is beginning to recover, and industrial commodities have risen 15%20% from their lows.

The Inevitable Rise

Rising stock prices will inevitably lead to rising prices in the rest of the economy. First, thanks to their rising portfolio values, people feel they have enough savings and therefore can afford to consume more. This, of course, is known as the wealth effect. Less well understood by investors is the shift in prices relative to one another. Since much of the newly created money has gone into the stock market, stock prices have been bid up to astronomical levels relative to prices of other goods in the economy. Consequently, by selling some shares, stockholders have a great and growing ability to buy consumer goods, such as homes and automobiles. Here is a common example: In 1995, approximately 500 shares of Procter & Gamble were required to purchase a Honda Accord; today, one can purchase three Honda Accords with the same 500 shares. As investors sell shares to purchase other items, this will work to push stock prices down, while pushing up the prices on the items purchased.

Thus far, stockholders have been the beneficiaries of the inflation. As prices rise throughout the economy, stockholders will lose their advantage. This is an example of the principle illustrated by the economist of the Austrian School, Ludwig von Mises, that the effects of inflation are spread unevenly; some prices in the economy rise before others.

The Internet IPO Rush

Also, businesses are taking advantage of the high prices offered for their shares in the stock market by selling equity or borrowing against the rising market value of their existing equity. The frenzied rush by Internet companies to raise money through IPOs and secondary offerings is a salient example of this process. They use the money to buy computer gear, hire scarce technology workers, buy advertising, rent office space. Thus, they compete with established companies to bid up the resources they need to run their businesses. By this process, the money and spending move from the stock market to the rest of the economy. Furthermore, the lower cost of obtaining funds due to the rising stock market also makes it possible for businesses to use a lower hurdle rate of return when evaluating the feasibility of a new project. Businessmen undertake additional projects they could not justify if the cost of capital were higher, thereby drawing more money from the stock market into the economy. Aiding in this process are the many companies that find it cheaper to build capacity rather than to buy it through an acquisition in the stock market.

Therefore, the stock market is working like a transmission belt by which the newly created money will ultimately push up prices across the economic system. At that point, the Fed will be compelled to act forcefully, sharply tightening the money supply and raising interest rates substantially. Given today’s record valuations, these rate hikes, or merely the anticipation of more rate hikes, will cause the market to plunge. Novice day-traders and thousands of other investors, oblivious of the risks they have been taking, will suffer heavy losses.

Commentators will point to the predictable scapegoats: greedy Wall Streeters, short-sellers, daytraders, hedge funds, even tightening by the Fed. The real culprit, of course, will not be the Fed’s tightening, but its preceding easy-money policy, which created the need to tighten in the first place.

So instead of a new era, what we have is a repeat of past eras. While the inflation is manifested in the slightly different form of rising stock prices, it is doomed to end as all inflations do — in a bust.

GEORGE REISMAN is professor of economics at Pepperdine University’s Graziadio School of Business and Management and is the author of Capitalism: a Treatise on Economics. ROBERT KLEIN is a Los Angeles stockbroker.

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