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Reacting to statements made by Federal Reserve Chairman Alan Greenspan, the Dow Jones Industrial Average soared up 381 points. Jim Lehrer and guests discuss the connection between interest rates and the stock market.

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JIM LEHRER: The Wall Street Greenspan interest rates connection. Last Friday, Federal Reserve Chairman Alan Greenspan spoke, and today the Dow Jones Industrial Average roared ahead some 381 points. Here's what Greenspan said that caused the commotion.

ALAN GREENSPAN: It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress. Developments overseas have contributed to holding down prices and aggregate demand in the United States in the face of strong domestic spending. As dislocations abroad mount, feeding back on our financial markets, the strength is likely to intensify. In the spring and early summer the Federal Open Market Committee of the Federal Reserve System was concerned that a rise in inflation was the primary threat of the continued expansion of the economy. By the time that committee's August meeting, by the time of the committee's August meeting, the risks had become balanced, and the committee will need to consider carefully the potential ramifications of ongoing developments since that meeting.

JIM LEHRER: Now some interpretation and debate from two economists, Allan Meltzer of Carnegie Mellon and the American Enterprise Institute; James Galbraith of the University of Texas, author of the new book, "Created Unequal: The Crisis in American Pay." Professor Galbraith, so what did Wall Street hear in those words by Alan Greenspan that made the market do what it did today?

JAMES GALBRAITH, University of Texas: They heard a plain acknowledgement of a reality, which has been clear to the world for weeks, even months now, and which I think actually has been clear to Alan Greenspan for a long time before he felt able on Friday to make the forthright declaration that he did make, and they are reacting with a degree of relief to what they take as a promise that the Federal Reserve will now act and come to the rescue of a world economy, which is in very grave danger, by making a substantial cut in interest rates.

JIM LEHRER: And that's what he was saying.

JAMES GALBRAITH: I think that's the message that they heard. It is a message which is not a new case of analysis – I have to tell you that –

JIM LEHRER: But coming from him, this is the first time he had said that.

JAMES GALBRAITH: Well, it's actually not. In January, he gave a speech – a very important speech – to the economists gathered in Chicago – in which he warned of these dangers, so I think Alan Greenspan has personally been aware of the trouble for a good time. He, however, has not been able to – or has not chosen to push that view to a decision at the Federal Open Market Committee. And what the markets are reacting to is not a new analysis but perhaps a new energy and a new commitment on Greenspan's part to take a timely and important action.

JIM LEHRER: Allan Meltzer, do you see it the same way, that Alan Greenspan was saying we're going to cut interest rates?

ALLAN MELTZER, Carnegie Mellon University: I think if the market heard that, they heard the wrong message. I think all that Alan Greenspan said was that I'm a central banker, I watched what's going on; right at the moment I see that there's a lot of cross currents in the economy. If things get much worse, I'm going to do something about it, but right now we're on hold.

JIM LEHRER: Do you agree with Professor Galbraith that maybe the markets read it his way, rather than your way?

JAMES GALBRAITH: Oh, I think the markets may have read it his way, but that's just an overreaction. In fact, if he made the statement that Professor Galbraith thinks he made, then he made the wrong statement, and he'll probably have a hard time fulfilling that commitment. The Federal Reserve is in no position to bail out the world. It can't help the world. We're on a floating exchange rate system in most countries, and simply to do that would be the wrong medicine at the present time. Later, the right medicine, but right now it would be the wrong medicine.

JIM LEHRER: Well, let's go to specifically to the question of cutting interest rates. And beginning with you, Professor Meltzer, what would be wrong in the Fed lowering interest rates right now?

ALLAN MELTZER: Well, the economy is very strong at the moment. The domestic economy is very strong. The latest numbers from housing, from the employment, from the banking system all show great strength. It was only a few weeks ago that the Fed warned the banks about the fact that they were being too accommodative in their real estate loans. So reducing interest rates is certainly the wrong message to send them if, in fact, they believe, what they said only a few weeks ago.

JIM LEHRER: And the end result of that would be – what would be the evil bad result?

ALLAN MELTZER: We would get faster money growth, faster expansion of credit, more money going into interest sensitive sectors, and we would produce an inflation again.

JIM LEHRER: Okay. Professor Galbraith, you think Chairman Greenspan should, in fact, cut interest rates. Why should he do it?

JAMES GALBRAITH: Well, my friend, Allan Meltzer has an advantage over me in that he has two close colleagues who actually vote on monetary policy. And they have been the strong voices over the last six months who have been arguing that the principal danger is inflation. Last March, they argued –

JIM LEHRER: Who are they?

JAMES GALBRAITH: The Shadow Open Market Committee – they were talking here about William Poole, the president of the Federal Reserve Bank in St. Louis, Jerry Jordan, the president of the Federal Reserve Bank in Cleveland, who are members, or have been members of Professor Meltzer's group. They were arguing – Professor Meltzer was arguing that interest rates should be raised. Never has there been a more grave misjudgment, a more grievous error. But the problem has been that those who felt that interest rates should be lowered had had to argue against this position that held that inflation was a grave threat, but inflation has never showed up on the battlefield. And in trying to focus policy of the Federal Reserve as a defense against inflation, the Federal Reserve has ended up facing entirely the wrong way in face of one of the most serious crises to involve world economies, certainly in my lifetime and perhaps in the last half century.

JIM LEHRER: Okay. So –

JAMES GALBRAITH: But we are now looking at a world where we are – whether we like it or not – a part of the global economy and the Federal Reserve is, in fact, a major force on what happens to economies in Asia, and, therefore, to our – to their ability to trade with us – to their ability to buy our exports, and in recognizing that fact, I think Alan Greenspan took a major step forward on the problem.

JIM LEHRER: Okay. But what would cutting interest rates – how would cutting interest rates solve all those problems you were just talking about?

JAMES GALBRAITH: Well, cutting interest rates would do a couple of things. First of all, it would send a stabilizing signal to the markets not only in the United States but also throughout the rest of the world that have been in turmoil. But the major benefit would be felt in the American domestic economy, where we have seen a substantial slowdown in our economic growth.

JIM LEHRER: In other words, if you cut interest rates, more money would be available to – for people to borrow and that would be good for the economy?

JAMES GALBRAITH: Precisely. For households and businesses, and you would be able to buy another year or so of strong economic expansion, which would be a very good thing.

JIM LEHRER: Professor Meltzer, you don't see it that way?

ALLAN MELTZER: That's simply the wrong medicine. The domestic economy – their demand side is growing very rapidly. Even if the economy were on most projections to slow to 1 ½ to 2 percent, that would mean on the output side. The domestic demand would be growing 3 percentage points higher than that because we're importing so much. A cut in interest rates would make it harder, not easier, for Japan to expand. Japan is the central point.

JIM LEHRER: Why? Why would it make it more difficult?

ALLAN MELTZER: Because the Japanese yen would then decline – would then appreciate, that is, we've seen already that just the hint that the dollar – the Fed would cut interest rates has made the dollar depreciate. A depreciation of the dollar makes it harder, not easier, for the Japanese to get out of their problem, and the Japanese currency, the Japanese economy are the key point for Asia, 30 percent of Asian exports go to Japan. So that would be a mistake. What – it would mean that there would be more deflation, more banking problems in Japan, greater problems in Asia. What we need to do is the opposite of what Professor Galbraith and others are suggesting right now. We need to think about what is the long-term benefit of the U.S. economy. It's to have stable growth and low inflation. We should have learned through the crises of the last 10 years when Europe was growing slowly, when Japan was growing slowly, when there was a Mexican problem, that the best solution for the world economy was to have the U.S. economy grow steadily, with low or falling inflation, and that's the recipe that has worked so well in this decade and will continue to work well if the Fed holds to the course that it's on.

JIM LEHRER: Prof. Galbraith, what about Prof. Meltzer's point about Japan and the effect lowering interest rates would have?

JAMES GALBRAITH: Well, I think if we help stabilize our economy, if we help sustain growth here, that will make the task of the Japanese government, which one cannot minimize – it's a very serious problem – easier, rather than more difficult.

ALLAN MELTZER: No, no, that's got to be wrong, Jim.

JAMES GALBRAITH: What we're looking at here – the question is very simple: Does the crisis in Asia and the increasing trouble that we've seen in the last few weeks in Latin America and the drop in the stock market that we've seen and in equity prices generally in the United States since July, do these things threaten the stability of our economy and the ability of the United States to continue to grow, to continue to provide jobs, to continue to maintain a low rate of unemployment, and to continue to reduce the inequality, the grotesque inequality in our structure of pay? And the answer to that question, I think, is clearly, yes, they do threaten – they do threaten the prospects for sustained growth and continued prospects –

JIM LEHRER: All right.

JAMES GALBRAITH: -- continued progress along the lines that we have experienced for the last several years. So then the question is: Should the Federal Reserve recognize this fact and react to it? And Allan Meltzer's position is that they should not. My position is that not only they should, they have to.

JIM LEHRER: All right. Professor Meltzer, your own position aside, what do you think the Fed will do, in fact? Do you –

ALLAN MELTZER: I believe that at the present time they will stay on hold until they see that there really is the kind of problem that people are talking about. The Fed cannot bail out the stock market. The same people who were telling Allan Greenspan when he talked about irrational exuberance to keep his hands off the stock market are now telling him there's been a slight decline and we really need some help. In fact, only a few weeks ago we were worried about the fact that the stock market was rising too rapidly. It's made an adjustment now. It's still relatively high compared to earnings. There is really no justification for the Federal Reserve worrying about the stock market. The stock market doesn't influence the economy nearly as much as the economy influences the stock market. So the Fed's job is to keep the economy growing in a stable way, avoiding both inflation and deflation.

JIM LEHRER: Gentlemen, one of you is going to be right and one of you is going to be wrong, and we'll see which one it is.

ALLAN MELTZER: Thank you.

JIM LEHRER: Thank you both very much.

JAMES GALBRAITH: Thank you.

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