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Oedipus Greenspan

Guest Column
Dan Tortorice

As Sophocles’ Oedipus Rex opens, Oedipus is ruler of Thebes. But, with a quick reversal, at the end of the drama he is the most scorned man in the land. Similarly it seems to be with Federal Reserve Chairman Alan Greenspan. In January, one year ago, the wizard behind the prosperous New Economy was ushered into his fourth term with almost universal acclaim. Yet, just fifteen months later, with the ugly word recession rearing its head, the praise has turned to reproof, the acclimation to invective.

What happened? It’s simple really -- the miracle economy began to slow, and the critics have begun to emerge. But what do they blame him for? They accuse him simply of one sin: raising interest rates for no good reason. Well okay, they admit, to fight inflation, but because of the New Economy we don’t need to worry about that inflation bug.

These New Economy pundits put forward many arguments based around the amazing technological progress of the last decade to claim that inflation is dead. While a plethora of these perversions of economic reason abound, there are two particularly insidious ones that tend to pop up with more frequency as Greenspan-bashing becomes in vogue.

The first, proposed by Bill O’Reilly among others, runs like this: The technological progress of the ’90s has made our industries more competitive, and this competition puts pressure on businesses to keep their prices low. So we can’t have inflation even in the face of rising oil prices. If businesses raise their prices no one will buy their stuff. What makes this argument so vicious is on face it seems right. Yet like most amateur economic analyses it is flawed and misleading. Competition does keep down prices, but there is a limit to how low these prices can go. Specifically, the price in the market must be high enough that firms desire to be in the market given profit opportunities for their capital elsewhere. What competition does is to ensure that profit margins are as low as possible, while maintaining the desire for firms to remain in the market.

So when you raise the firms’ costs, say through higher oil prices, you cut into their profits. If the New Economy has really made the market so competitive, then given the new, lower profit margins of these firms, capital will flow out of the industry, seeking new opportunities elsewhere. The result: fewer firms in the market, less supply, higher prices, i.e.: inflation.

The second New Economy argument, proposed by Dr. Amitai Etzioni (a professor of sociology at George Washington University), can be paraphrased: the New Economy has revolutionized the way we do business, firms respond more quickly to government policy, so the Federal Reserve need not be so forward-looking when worrying about inflation. If inflation starts, the flexible New Economy will respond quickly to Fed policy and inflation will be nipped in the bud. I’m sure Alan Greenspan has not missed the technological progress of the last decade. But fortunately he has not been sufficiently wowed by e-mail to forget that the New Economy should have no impact on the Fed’s forward-looking inflation policy.

When we have a year of high inflation people see the purchasing power of their income decrease, so the next year, naturally expecting the same rate of inflation as the previous year, they ask for a pay raise. Unions across America do the same. And businesses, faced with rising labor costs, start to raise their prices, so there’s more inflation in the economy. And people, expecting prices to rise again next year, ask for more money. You get the picture. That’s how inflation got built into the system in the 1970s and only a painful bout with sustained high unemployment eventually ended it. But the important thing to remember about this mechanism is that the Internet economy has no effect on it. What fuels the inflation fire are peoples’ expectations. The Federal Reserve, by failing to put the monetary breaks on the economy, lets demand outstrip supply one year, resulting in higher prices. And the inflation is persistent in the economy. All the e-mails in the world will not make it easier to change these people’s perceptions.

Everyone knows that once you lose someone’s trust it is difficult to gain it back. Well, once the Fed loses America’s trust by allowing inflation to occur, it’s hard to gain the trust of 135 million working Americans again.

Alan Greenspan performs a dangerous balancing act, trying to manage economic growth with the inflationary pressures it brings. He’s usually good, but sometimes he misses. Yes, there is room for intelligent criticism of the Board’s policies, but the “New Economy,” “inflation is dead” route is not the way to go.

Dan Tortorice is a member of the Class of 2002.