Who's Going Too Fast?

Economists ponder the wealth effect the way many of us ponder alien life. They're pretty sure it's out there--but they can't prove it, they don't know how big it is, and they haven't a clue if it's dangerous. All of which is creating a bit of a stir among the dismal-science lot as their famous and thought-to-be-flawless colleague, Alan Greenspan, relentlessly jacks up interest rates to wage an undeclared war on this vague creature.

The wealth effect, simply, is the penchant to spend more as net worth climbs. You probably don't lie awake at night fretting about the problems that increasing your wealth may bring, but it's an issue in Washington because spending is the root of inflation. And inflation is bad. One way to attack it, therefore, is to attack net worth.

These days that means going after the stock market, and there can be little doubt that that's what Chairman Greenspan is up to--even if he won't say so, which he won't. Last week the Fed boss pushed the benchmark federal funds target rate to 6%, the fifth increase in nine months. For emphasis, he raised the symbolic discount rate as well and all but promised more to come. Banks followed by boosting their prime rate to 9%, the highest in five years--meaning higher costs for credit cards and mortgages.

Never mind that the markets shrugged, then rallied. The Dow closed the week up 4.9%; the supercharged NASDAQ rose 3.4%. That may only strengthen Greenspan's resolve. To be sure, the economy has been dangerously robust the past couple of quarters. And the gross domestic product is expected to rise 4.1% this year, well ahead of the Fed's presumed "speed limit" of around 3.5%. The torrid growth rate is what Greenspan cites most often when justifying rate increases.

But GDP expansion is a bit of a paper tiger. The economy grew 4.1% last year and even faster in 1998, yet aside from oil prices there has been no inflation to speak of. Meanwhile, amid all the angst about overheating, there are signs of a slowdown, most noticeably in the crucial housing sector. The dollar is in fine shape. And while rising oil prices have skewed the Consumer Price Index to a three-year high, the core rate is up a very modest 2.1% for the past 12 months.

So, why continue to raise rates? The Fed plainly is paramountly concerned that rising stock prices are creating such a glow around the nation's dinner tables that a family spending barrage is about to render household goods scarce and send consumer prices spiraling through the roof. It's an interesting theory. It's also a leap that could shut down the expansion prematurely and tarnish Greenspan's sterling reputation--potentially derailing Al Gore's presidential train, much as a weak economy did George Bush's in 1992.

Certainly, the bull market has added greatly to Americans' wealth and stimulated extra spending. Greenspan cites long-term studies showing that of every $1 made in the market, 3[cents] to 4[cents] gets spent on restaurants, vacations, curtains and other things in the real economy. Multiplied over trillions of dollars of new market wealth, that translates into billions of dollars in additional consumer spending and a 1%-to-2% boost in the nation's output.