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 he
stock market decline continues with painful vengeance and the unemployment
rate has notched up to a nine-year high. But if it's true that we
largely control our future through the proper choice of policy actions,
we may be able to correct the current situation.
A natural
starting point in determining what the “proper” choice would be
is to look at the policies that started the spectacular ride we’ve
had. To paraphrase Robert Bartley, the past two decades have been
the 20 fat years — our task should be how to replicate them.
The adoption
of a price rule combined with lower marginal tax rates during the
past two decades fueled an unprecedented prosperity in the U.S.
The decline in interest rates led to a lengthening of investor horizons.
Low inflation and tax rates increased incentives to produce and
as a result the economy expanded and the markets appreciated at
an incredible rate. Of course, we hit a few bumps during this period
of exceptional economic performance, yet we always recovered.
During the
late '80s, Papa Bush raised taxes and the economy went into a recession.
Also during that time, the Fed moved temporarily away form the price
rule and the inflation rate nearly doubled, to 4% from 2%. Bush
lost the election and Clinton moved in. The new president also raised
taxes.
But help was
on the way. The Fed returned to the price rule and the inflation
rate declined to the 2% range. The effective tax rate declined,
and with the Republicans capturing the House in 1994, the prospect
of future tax increases were greatly diminished. The economy responded
and so did the markets. Earnings grew at a fairly fast pace and
the valuations grew even faster.
The market
kept reaching new highs and a debate as to whether the market was
overvalued and irrationally exuberant ensued. That’s when the Fed
began tinkering with monetary policy to reign in the market —
and there's a direct connection between that tinkering and the depressed
market we are seeing today.
In 1999, Alan
Greenspan, a.k.a. the Maestro, was greatly concerned with the “century
date change.” He flooded the market with high-powered money while
simultaneously leaning on the banks not to lend money (i.e., not
to expand the credit system). Once the century date change occurred
— and nothing happened — the Maestro began to withdraw
the high-powered money, but he did not ease up on the banks. The
lending standard continued to increase, the bubble burst, and the
market went into a tailspin.
During that
time some other unfortunate events began to come into play. Energy
prices began to climb, with an effect analogous to a tax increase.
The combination of a slight increase in the inflation rate, higher
regulations, and the energy tax proved too much for the economy.
So, the economy rolled over.
The Maestro,
by then, had departed from the price rule and began "fine tuning"
the economy. Without the aid of complete foresight, this micromanagement
did more damage than good, and we have paid the price for it.
What
to Do
Obviously, this has not been such a great recent pattern of events.
But we should not despair. The economic fundamentals look good.
While it is true that Greenspan has temporarily moved away from
the price rule, there is no reason why we should not return to it.
Tax rates are low and there is no indication that a major reversal
in low-tax thinking will occur in the next few years. Given the
policies that are in place, and the players who are at the helm
in Washington, it doesn't seem likely that we'll fall into a dismal
cycle like that of the 1970s.
However, there
may be a mean reversal, and we have to realize that we control the
mean through economic policy. The critical indicators of where the
economy is headed are the policies enacted in Washington. Thinking
this way, the U.S. does not seem to be too far off the track. So,
how do we insure that we can continue the unprecedented, two-decade
expansion for many years to come? We need to guarantee that the
prosperity killers are destroyed. We must make sure that America
has price stability, as well as great incentives to work and produce.
This can be achieved by following a few simple steps.
On the monetary-policy
front the answer is a price rule. I favor targeting domestic prices
while other supply-side colleagues advocate using gold. But the
target is less relevant than the rule. The discipline imposed by
the price rule will make the actions of the monetary authorities
transparent and predictable. And Greenspan needs to be more transparent.
In the old
days he could get away with speaking in Greenspanese — because
the debate over his meaning confused the market, he could operate
without expecting a systematic reaction from the market. However,
over the years, people have decoded some of this Greenspanese and
his pronouncements have lost effectiveness. The Maestro has lost
much of his short-term impact on the economy. All that is left is
the regulatory effects of monetary policy on capital adequacy and
credit restraint. In short, Greenspan — or his replacement
— will have to move closer to a price rule if prosperity is
to continue.
On the fiscal
side, many of my supply-side colleagues advocate lower tax rates
— lower rates are better than higher rates. However, the current
tax-rate structure is fairly low by the standards of the past five
decades. This implies that further across-the-board reduction will
have less “bang for the buck” than previous rate cuts. However,
that is not to say that we can't make the system more efficient,
and one area to target is the elimination of double taxation embedded
in the tax code.
On the business
side, the laundry list includes the corporate tax, a depreciation
schedule that does not match economic depreciation, and the capital-gains
tax. On the individual side, double taxation includes the inheritance
tax and the taxation of savings. So far, President Bush has talked
a good game and made a little progress. But nothing permanent has
been done. The recent inheritance-tax legislation will expire in
10 years and the transition is a maze of new regulations. We need
clear rate reductions.
Looking into
the near future, there don't appear to be any major reversals to
the long-term, tax-reduction trend of U.S. economic policy. Nor
is there a clear repudiation of the price rule. With that in mind,
a long and sustained decline of the U.S. economy and the financial
markets doesn't seem likely. The inflation rate should continue
in the low, single-digit range, and real GDP growth should rise
to the 3% to 4% range in the not too distant future.
We shouldn't
expect a repeat of the 1970s. But we also shouldn't move away from
the sound economic policies that gave us the boom we're trying to
prolong.
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