September 30, 2003, 7:00 a.m.
Not Fragile
But currency stability and lower oil prices are the key variables for growth.

Uncertainty about currency exchange rates and oil prices caused a sharp decline in stock prices in late September. But the fundamental engines for a U.S. expansion remain in place. These include the small-business character of the U.S. economy, 130 million employed workers, low interest rates, low inventory-to-sales ratios, adequate consumer balance sheets, and growing corporate profits.

The latest Bush tax cut has a lot to do with the economic turnaround now taking place. The 2003 tax cut was bigger, more growth-oriented, and earlier than almost any expectations, contributing to the Nasdaq’s outperformance. Even now, the tax cut is being underestimated.

Congress’s $350 billion static scoring of the new law is unrelated to the tax cut's actual size and benefits. The law lowered the tax on capital, investment, and labor, almost by definition causing economic growth and gains in the stock market. The income-tax cut adds substantially to disposable personal income. Beyond the near-term effect, the cuts in income-tax rates, assuming they are made permanent, will cause a $3.3 trillion increase in the net present value of disposable personal income.

The key variables for growth are now the value of the dollar (which determines inflation, deflation, and price stability), oil prices, and any actions by the Federal Reserve to reduce the volatility in the value of the dollar and interest rates.

As for oil, if high oil prices persist, there will be an increasing constraint on the pace of the global economic acceleration. But in the short-term, the negatives from expensive oil — cash transfers to OPEC and investment diversion into new oil production — are being offset by the reflation process and the U.S. tax cut. More, oil prices are expected to fall sharply under the pressure of Iraqi oil shipments and growth in non-OPEC oil production. Monopolies, remember, tend to lose pricing power over time.

As for the dollar and interest rates, they have both been extremely volatile in recent years. So the Fed's ability to create and communicate a bridge from super-low interest rates to normal interest rates — best done through a stable dollar policy — is a key variable in the economic outlook. This will affect the strength of the reflation and the time from reflation to the ensuing period of growth-maximizing price stability.

A “strong and stable” dollar, roughly at current levels, would be growth-maximizing, and would avoid future bouts of inflation and deflation.

There are still a good many bears out there, but the U.S. economy is not fragile. We never came close to a double-dip recession, a 2003 deflation, a consumer rollover, a housing crash, a problem financing the current account deficit, or a dollar crisis. Economic growth reached 2.9 percent in 2002 and will be substantially faster in 2003 despite Iraq-related uncertainty and expensive oil.

A constructive, multi-year reflation is now underway — the mirror image of the disinflation of the 1980s.

— Mr. Malpass is the Chief Global Economist for Bear Stearns.

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