The Free Market 19, no. 1 (January 2001)
Earlier last year (February 17) in testimony before the House Banking Committee, Alan Greenspan argued that increases in productivity tend to create greater increases in aggregate demand than in potential aggregate supply. His reasoning was that productivity increases stimulate optimistic corporate earnings forecasts, which stimulate stock price increases, which lead consumers to assume increased personal wealth, which increases consumption (and thus aggregate) expenditure.
The Fed chairman's conclusion was that stock prices should rise no more yearly than the rise in nominal consumer incomes. One implication is that the six Fed increases in the federal-funds rate this past year were intended to hold increases in asset values to this rate.
Most economists and financial analysts find such an argument puzzling, schooled as they are in the virtues of aggregate spending and increased productivity for macroeconomic health. But what they may not be considering are the Fed chairman's possible theoretical roots. Whatever comments he makes concerning "aggregate demand" and "aggregate supply," Alan Greenspan's actual policy views may stem from his tryst with Austrian economics about forty years ago, when he was a successful, independent economic consultant and member of Ayn Rand's "inner collective" of Objectivist intellectuals. Austrian School writings were especially emphasized by various members of that group, which at one time included preeminent Mises scholar Murray Rothbard.
In fact, in his summer (July 20, 2000) testimony to that same Banking Committee, Greenspan alluded to his "having actually attended a seminar of Ludwig von Mises" in the 1960s and asserted that "I was aware of a great deal of what those teachings were and a lot of them still are all right." I think that Chairman Greenspan is far too modest.
While he was associated with Rand in the 1960s, Greenspan not only contributed economics articles to various Objectivist publications, but he also personally taught a private subscription course on "The Economics of the Free Society." If Mises's former student Alan Greenspan was influenced by Mises and other Austrian School economists, part of that course may shed some light on the current discussion of Fed policy, especially Greenspan's lectures on "time preference" and "the rate of future discount."
Not surprisingly, he argued in those lectures that human beings live and think in the present and exhibit time preference; that is, they discount future goods values, including money-- those goods only having value in the first place because, in time, they become present goods.
The rate of future discount (RFD) he defined as the present value of future money. The greater the RFD, the smaller the present value. And the RFD is directly determined by the degree of uncertainty of the future from the viewpoint of the individual decisionmaker. It is thus determined by psychological factors and becomes the basic parameter of the free economy. So far as the value of producer goods is concerned, Greenspan argued that their current value is based on their future production possibilities.
Confining our interest to the production side, Greenspan's RFD argument is similar to the Austrian argument that the interest factor that reduces the total expected value of future consumption or "first-order goods" (Greenspan's "present goods") provides a total present value for current intermediate or "higher-order goods" (Greenspan's "producer goods") that are intended to be used to produce those future first-order goods. A firm's profit rate would equal the RFD if the actual total current prices of the needed higher-order goods were equal to their total present value. Of course, the expected value productivity of higher-order goods and the expected length of the production period would differ from firm to firm. Competition among firms would set the prices of higher-order goods so that the profit rate would tend to be equal to the RFD.
For stock prices of a firm (I assume Greenspan meant the total paper asset value of the firm) to tend to be equal to the purchase price of newly manufactured production goods used by the firm (I assume he meant the value of all its material assets) those material assets would have to be purchased at present values set by the RFD applied to the expected future value of production. This would make stock prices of firms specializing in higher-order goods production rise more than those in lower-order goods production during an expansion period, since the longer production period of the former is only justified by the greater potential value of production as compared to shorter production periods of the latter.
According to the Austrian theory of the trade cycle, consumer preferences between spending and saving determine the relative proportions of all orders of goods produced, the fundamental two categories being first-order or present ("consumption") goods and all other higher-order or future ("producer") goods. They do so because the present supply of savings is rationed among real investment demands by "natural" rates of interest. The more present-goods oriented are consumers, the lower consumer savings, the higher natural interest rates, the lower the spending on higher-order goods, the shorter the production periods and the larger the proportion of first-order goods of all goods produced-- all in line with consumer preferences.
A period of bank credit expansion, such as the Fed has accommodated for most of the past decade, will drive nominal interest rates below natural ones. As a result, the structure of production will lengthen as investment in higher-order goods industries expands more rapidly than that in lower-order goods industries. Stock prices of the former rise more rapidly than those of the latter firms.
Consumer spending also increases as unemployment drops and wages and salaries rise, until inflation kicks in as higher_order goods producers bid resources away from lower-order goods producers and consumers suffer forced saving. Profits for lower-order goods producers then begin to lag. Unless the credit expansion can be accelerated, nominal interest rates will eventually rise to curb higher-order goods production and turn boom into bust.
It is notable that the Fed is focused on the federal-funds rate and consumer saving is at an all time low, while borrowing to finance consumption is now accelerating. Productivity in the last quarter of 1999 is estimated to have risen at the fastest clip since 1992, and has continued to rise the first half of 2000. Wage and salary increases have begun to accelerate this year and other nonpecuniary benefits are also increasing.
Prior to Fed actions to raise the federal-funds rate six times within the last year (and recent Greenspan comments on the stock market, productivity, consumer spending, and bank lending), stock markets were setting records for asset growth. Even after the rate increase began, the technology-heavy (read, very higher-order goods oriented) NASDAQ continued to set new records, until the plunge this spring.
Add to this the complication of cartel-led rising energy prices, as well as rising steel, construction materials, and other basic higher-order goods prices-- and it would seem that there is ample grist for an Austrian cycle theory mill.
Now, to speculation. In Austrian cycle theory, credit expansion is the underlying cause that always brings about a misalignment between consumer saving and investment in higher-order goods production. If Alan Greenspan is still "nurtured" by his early Austrian School roots, he has no desire to wait for any "natural correction," and believes it is possible to forestall it, he might push for the Fed to do the following: Aside from, or even in place of, controlling the rate of money supply growth, raise the federal-funds rate slowly to put a profit squeeze on higher-order goods producers, especially the high-technology, long-period of investment ones, thus shortening the structure of production and adjusting it more closely to apparent consumer preferences.
As uncertainty increases, this would also raise the RFD and decrease stock prices, productivity rates and wage increases. Unemployment would begin to rise and consumer spending to slow. What he might hope for is to finagle a soft landing, rather than experience the sort of 1930s "correction" for which the Fed is famous among Austrian School economists.
In this interpretation, it is not the "alignment" between aggregate demand and aggregate supply that Alan Greenspan's policies are specifically intended to address. It is the relation between consumer and producer demand in the context of the structure of production of lower-order versus higher-order goods. In today's economy, where money is not a commodity and controlling its supply and demand is uncertain at best, an Austrian School-influenced Fed Board of Governors chairman may believe that indirect Fed control of credit expansion by nominal interest rates is the best monetary policy alternative--and act on that belief.
Sam Bostaph, adjunct scholar of the Mises Institute, is chairman of the department of economics at the University of Dallas (bostaph@acad.udallas.edu).
