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The economy's biggest problem.


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Larry Kudlow

Between late-season snowstorms, unusually cold weather, energy spikes, red/orange alerts, and the Baghdad war itself, no one can say for sure what the true condition of the American economy is — and we may not get a decent handle on this question for another month or two.

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What we do know for certain is that oil prices are coming down and that a swift and sure victory in Iraq is on the way. These are positives for economic growth, and the rising stock market is pricing in these developments.

But what kind of growth? A 3 percent recovery rate, such as we’ve had over the past five quarters, falls below the increase in American productivity. At 3 percent, unemployment will not decline and job creation will not resume.

To be sure, the Federal Reserve has done its part to spur more robust growth. Though it took them several years too long to do it, the money shortage — or the deflationary barrier to growth — has been sufficiently removed. Increases in gold and commodity prices confirm this, and they point to the prospect of mild reflation and future price stability.

The Fed, however, could provide some better guidance. This week, the central bank was right to leave the federal funds interest rate alone at 1.25 percent. But they could have given some indication that the monetary printing presses will be tanned, rested, and ready to create more liquidity should a wartime emergency arise.

In any case, the wartime dollar should be stabilized now that deflation has been corrected. The exchange rate index for the dollar currently stands at 100. That’s down from a peak of 120 a year ago, but it’s still much higher than the index level of 80 registered back in early 1995. So the recent drop in the index does not indicate a “weak dollar,” as many claim. Instead, it reflects a sane dollar level (economist Don Luskin’s accurate term) that represents recovery from the insanely overvalued and deflationary dollar that prevailed in recent years. As a sensible price-rule target, the Fed should maintain the current dollar index level.

Still, reflation alone will not get this economy moving to its potential. A capital shortage is the economy’s biggest problem.

The collapse of business capital from a devastating three-year stock market plunge remains a huge barrier to the resumption of business spending and investment. The same holds true for the hemorrhaging of corporate retained earnings, which have sunk to only $16 billion today from $225 billion in the late 1990s.

This capital is the ultimate seed corn of business. Until a rising stock market restores business capital and retained earnings are replenished, businesses will not be able to make the necessary investments in technology and other capital goods that are so vital to economic expansion. They just won’t have the resources.

As Wall Street economist Wayne Angell points out, capital is labor’s best friend. Business capital spending for the newest technologies and other work tools make labor more productive. That productivity gain translates into higher real wages for labor, just as it leads to higher real profits for business.

Over a century ago, Karl Marx attempted to pit capital against labor, and he was dead wrong. Today, class warriors in Washington are making the same flawed case, though they probably don’t realize it. It’s time to turn Marx completely on his head.

To cure our present-day shortage of capital, Washington policymakers should reduce or eliminate all taxes that penalize capital formation. Legislating an end to the double taxation of dividend profits is a great place to start. Reducing tax rates on personal incomes would help too.

One of these days Washington might want to consider abolishing taxes on business profits altogether. Profits, of course, are capital. If lawmakers retire the unintelligible corporate tax code and substitute a simple tax on business sales revenues, and if they add to that an expansion of Roth IRA tax-free savings accounts, we will be headed toward a tax system based on consumption rather than capital.

Such a system would have growth written all over it. People would be free to choose how much they consume relative to how much they save and invest. And free-choice would encourage capital formation — the ultimate tonic for maximizing economic growth, job creation, and the wealth of the nation.

Mr. Kudlow is CEO of Kudlow & Co.



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