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The New Economic Reality
When will the bears wake up and smell the coffee?


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Larry Kudlow

August was supposed to be a bad month, but stocks rose anyway. September is supposed to be the worst month of the year, but stocks are surging anyway. When will the bears wake up and smell the coffee? We’re in a bull market. It has legs. It also has rising profits and productivity, lower taxes, and historically low interest rates. Investors are pouring money into stock prices. Think of it as rational exuberance. Economic pessimists had better beware — and that includes Democrats on the presidential campaign trail. Broad, positive economic moves like this tend to last a long time.

The latest statistics show that production and new orders are way up for industrial firms. Retail sales are booming. Housing is at record highs. Companies are beating profit estimates.

Proprietors’ income — which is a proxy for small business — is up 16 percent annually over the past three months. This is further indication that the recovery cycle has arrived and that business has reawakened. It says that capital expenditure is on the way and that new jobs will soon follow.

Contrary to the demand-side, consumer-spending view that pervades our media, it is supply-side business investment that really drives the economy.

New inventory building by itself could add a percentage point to gross domestic product in each of the next several quarters. GDP growth in the 5 percent range would not be unusual in these improved circumstances, and some economists are predicting 7 percent growth in the third quarter alone.

Is there enough cash in the pipeline to accommodate the acceleration of economic activity? The monetary situation looks good. On the strength of a $300 billion jump since the ground war in Iraq ended, the basic money supply is exploding at a 15 percent annual rate. And the price of gold, a key reflation indicator, is at $375. This tells us the Fed is accommodating the recovery in private money demands, stocks, and the economy.

The economic story has quickly gone from blah to rosy, and the Bush tax cuts implemented this past summer provided the turning point. After three years of investment drag, stock market decline, profit downturn, and business recession, lower tax rates on high-income earners, dividends, and capital gains — along with faster business depreciation write-offs for the purchase of new equipment — sparked the growth that is now developing.

For businesses, the after-tax cost of investment in capital goods has fallen significantly with the new round of tax cuts. For investors, the after-tax returns to saving and investing have increased substantially.

Timing is everything in life. The first Bush tax cut passed in 2001 was not slated to become completely effective until 2006. As a result, investment decisions were delayed. Apart from a temporary consumer spending spurt from short-lived tax rebates, economic recovery was stalled.

But this year’s tax cut became effective almost immediately — beginning in May for investment and July for lower tax withholding rates on income. Immediate tax cuts produced an immediate change in economic behavior. Investment decisions on the back burner were quickly put on the front burner. And the economy immediately picked up.

The recent rise in long-term Treasury-bond yields was induced by the economic recovery, and signaled that Fed easing moves had come to an end. Americans acted on this information. Those who delayed investment plans on the hope that financing costs would sink further, suddenly shifted gears and started investing in order to beat still higher interest rates in the future.

Give credit to President Bush for his unrelenting pursuit of pro-growth tax incentives. Also tip your hat to House Ways and Means chair Bill Thomas, who crafted supply-side tax-cut legislation against all odds.

Just as last spring’s stock market began predicting a business recovery, unexpected business strength this summer turned the market forecast into the real thing. Job creation will now fall into place. Stock market multiples will continue to expand. Animal spirits will keep rising. Entrepreneurship will gather force.

The only people who don’t get this are the nine Democrats running for president. They have presented a relentless vision of pessimism that is at loggerheads with both the American spirit and the new economic reality. Their platform of tax-cut repeal is a platform of prosperity rollback. It won’t work. Pessimism never does.

Mr. Kudlow is CEO of Kudlow & Co.



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