LESTER C. THUROW

Just because asset prices are higher this year than last year does not mean they are inflationary.

Something unique happened in America in the 1990s: Prices exploded on the stock market, yet consumer price inflation essentially disappeared. Both items have happened before, but never together.

The unique combination of exploding asset prices and stable consumer prices has lead to an active debate as to whether central bankers should raise interest rates to curb asset inflation or whether they should concentrate solely on price increases for consumer goods and services and ignore stock market prices. The case for paying attention to asset prices revolves around the hope that higher interest rates will stop stock markets from rising to unsustainable levels and thus prevent stock market crashes.

Most firms have reasonable prices relative to earnings.

Periodically Federal Reserve Board Chairman Alan Greenspan talks as if he will raise interest rates to stop asset inflation. Each time he does, stock markets take a dive. But he has yet to deliver on his threats and openly announce an interest rate increase that is designed to lower the stock market.

One reason he doesn't act is the experience of another central banker. In the early 1990s the head of the central bank in Japan raised interest rates to stop what he saw as a bubble in asset prices. He ended up collapsing the Japanese stock market—it fell from 39,000 to 13,000—and has never fully recovered. Mr. Greenspan hesitates because he does not want to go down in history as the man who ruined the American economy.

But each time he talks about raising interest rates to stop asset inflation, there is also an intellectual counter-attack from the financial markets and many economists. They argue that knowledgeable real investors are the only ones who should determine the prices of financial assets. Only those who risk their money are in a position to judge whether financial asset prices are higher than future profits would warrant and whether the market is applying the “right” price-earnings multiples.

It is relatively easy to measure consumer inflation. Are prices higher this year than they were last year for the same goods and services? But it is hard to measure asset inflation. Asset prices higher this year than they were last year are not necessarily inflationary. If profits are expected to go up in the future, today's higher asset prices are justified. Asset inflation only exists if prices are going up faster than future profits would warrant. But no one knows for certain what future profits will be. Neither do they know what the “warranted” price-earnings ratio on those higher profits should be. That has to do with the risk placed on owning equities versus the risks in holding government bonds. All anyone has are expectations and judgments. Whatever Greenspan's abilities as an economist, his expectations about future profits and his judgements about the right price-earnings ratios are no better than those of anyone else. In fact, they are probably worse since he is not risking his own money. Thus he should focus on consumer prices and forget about asset prices.

The Current Market

If we look at the current stock market, we see that booming prices are limited to a few firms that dominate indexes such as the Dow Jones average. Most firms have reasonable prices relative to earnings. Yet interest rate increases, since they affect prices-earnings ratios and not future profit expectations, lower the market value for everyone—not just the high flyers. Raising interest rates in this situation would be like raising interest rates to control a consumer inflation that was occurring only in one sector of the economy. To do so would be to create deflation in the rest of the economy. EE

Lester Thurow is a Jerome and Dorothy Lemelson Professor of Management and Economics at MIT's Sloan School of Management. He is author of several best-sellers including Building Wealth. New York: Harper Business, 1999.

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