FED'S MONEY TINKERING CREATED MARKET BOOM; CENTRAL BANK PUMPED EXCESS FUNDS, CREATING DANGEROUS SENSE OF WEALTH.

Byline: George Reisman and Robert Klein 

ALAN Greenspan is correct to be concerned that soaring stock prices will lead to higher spending and prices elsewhere in the economy.

He is also correct that the extraordinary increase in the stock prices is being fueled by a wave of optimism.

What he does not say, is that neither the wave of optimism nor the rising stock prices would be possible without the massive amounts of new money created by the Federal Reserve and the banking system.

Since early 1995, the banking system, under the umbrella of Federal Reserve System and related government intervention, has expanded the money supply measured by currency, checking deposits and money market funds by 60 percent. This is the biggest jump in the money supply since the 1984-1987 period, which caused the surge in the stock market, before the '87 plunge.

Greenspan, in an article he wrote in the '60s, ``Gold and Economic Freedom,'' described how this process worked in the late '20s. He discussed the Fed's attempt to lower interest rates by pumping excess reserves in 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 . . . ''

While the environment in the '20s was different in some ways from that of today, the Fed stimulated the boom then, just as it is doing now. 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's situation 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.

By contrast, if the Fed's inflation of the money supply were causing grocery prices to skyrocket, as they did in the '70s, people would be alarmed. They would demand an end to the inflation, which is why, in 1979, Paul Volcker was brought in.

However, when stock prices soar, people say, ``Relax, it's a bull market.'' Nevertheless, when the rise in the stock market far outstrips the growth in the economy for many years, one must look for another explanation.

Rising stock prices will inevitably lead to rising prices in the rest of the economy. First, due to their rising stock portfolios, people feel they have enough savings, and therefore, can afford to consume more.

This, of course, is known as the wealth effect. Here is a common example: In 1995, approximately 500 shares of Proctor & Gamble were required to purchase a Honda Accord. Today, one can purchase three Honda Accords with the same 500 shares.

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 very visible example of this process.

They use the money to buy computer gear, hire scarce technology workers, buy advertising, rent office space, etc. . . .

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, this will cause the market to plunge, making the recent decline appear mild. Novice day traders and thousands of other investors, oblivious to the risks they have been taking, will experience substantial losses.