Every time some genius says the stock market bubble “had to burst,” the following comes to mind: Between 1996 and 2002 commodity prices dropped by an incredible 30 percent. This is powerful deflation. Once it took effect, businesses were robbed of any pricing power whatsoever, profits shrank, and the stock market walls came tumbling down.
All those who heard a “pop” might want to get their ears checked. If they listened more astutely, they would have heard the unmistakable sound of a multi-year deflationary leak.
Over the 1996 to 2002 period, the corporate profit share of gross domestic product declined from more than 10 percent to less than 7 percent, amounting roughly to a $200 billion loss in earnings. This earnings decline was magnified by plunging stock market forces that resulted in a $9.5 trillion contraction in the capitalized market value of American business.
As if this wasn’t disaster enough, the ultimate corporate seed corn called retained earnings — think of it as a corporate safety net — was virtually wiped out. From an early peak of $233 billion in 1997, retained earnings fell to a paltry $11 billion in 2002. After a year of recovery, retained earnings remain abnormally low at only $16 billion.
The bubble babblers, of course, don’t recognize that deflation brought business and the stock market down — and that’s why they don’t understand how to fix the problem. But our president does. George W. Bush’s proposal to eliminate the double taxation of dividends will directly provide American businesses with the new capital they so desperately need. Without this money, corporations will not be able to expand operations, modernize equipment, or hire new workers. Unless business rebuilds its capital, the economy will not grow to its potential.
By making dividends tax free for shareholders, Bush’s plan will provide a powerful incentive for investors to supply new capital to business. Simply, they’ll want to buy more shares of companies that are paying out big dividends. And companies will be incentivized to pay out a larger share of earnings in the form of cash dividends to attract new investor capital.
Taxes matter. Eliminating investor dividend taxes will change the behavior of both investors and corporations. Investors will flock to dividend-paying stocks. Pressured by the new incentive to pay out cash, businesses will abandon profit-draining empire building, reduce their over-reliance on debt, and curtail phony cook-the-books accounting schemes.
In this new era cash will be king. Rather than optimistic share-price forecasts, investors will want bankable dividend checks. Tax-free checks will be an even greater incentive. And then investors will be better able to judge the worth of a company by a firm’s dividend payout ratio and its dividend yield.
It’s a simple and clean metric. Investors get the cash, and companies get the capital. That’s a good trade, and it’s the exact way to get this economy rolling again. That is, if the monetary problem of business pricing power is also remedied.
Between 1997 and 2002 the Greenspan Fed provided far less cash to the economy than was necessary to conduct business. This shortage of money was the principal cause of the powerful commodity deflation of those years. As commodity prices fell, businesses lost their pricing power and had to cut prices of their finished goods. This decimated corporate profits, retained earnings, and the stock market.
Plummeting stock prices, meanwhile, inflicted major damage on corporate credit-worthiness. And it’s an ongoing problem. Borrowing rates in the corporate bond market are still abnormally higher for businesses than the U.S. government’s risk-free borrowing rate.
The good news is that the Federal Reserve has been easier with the money of late. Deflationary pressures appear to be over, and commodity prices have started rising again after a five-year decline. This reflation trend could mean we’re headed for an upturn in business profits and jobs (despite February’s dismal pre-war jobs decline).
Commodities, again, tell much of the story. Although not one person in a thousand understands it, the Federal Reserve’s money-creating or money-extinguishing policies play a key role in determining commodity prices. Even a radical reform like tax-free investor dividends will not solve the stock market slump, nor will it guarantee an adequate supply of new business capital, if the Fed fails to keep a sharp eye on business pricing power as a guide to their money-creating operations.
In an era of high productivity, made possible by rapid technological advances that have streamlined business efficiency, the Federal Reserve must recognize that its current and future policies should err on the side of ease. With the Fed providing the monetary fuel, the next sound the bubble babblers hear won’t be a pop. It will be the dividend revolution starting off with a bang.
— Mr. Kudlow is CEO of Kudlow & Co.