No one seems to have hit on it yet, but there are many reasons why the current economic recovery could easily develop into an eight- or ten-year boom, much like the prosperity cycles of 1982-1990 and 1992-2000. Back at the beginning of each of those recovery waves, few saw the prosperity coming either. The naysayers, in particular, were completely blind to the potential of a capitalist, market-based U.S. economy driven by science and technology gains.
Today, however, pessimists have little excuse not to see the potential for a multi-year, inflationless, low-tax-rate, low-interest-rate growth cycle — the key to which is in the amazing productivity story.
In the two decades prior to the technology boom, the ravages of high inflation, skyrocketing interest rates, over-regulation, and high marginal tax rates contributed to a measly 1.5 percent average annual increase in productivity, or output-per-hour. But over the past eight years, the application of innovative technologies — spurred by a wave of capital investment — has generated a 3.2 percent yearly gain in productivity through boom and bust. This productivity miracle has made the U.S. economy incredibly efficient. It has also enabled businesses of all sizes to slash costs and raise profits. The workforce has never been better equipped, and real wages keep rising.
Economists calculate the nation’s potential to grow by adding productivity gains to average population growth rates. In the U.S., population tends to rise at a 1 percent rate, so the new-era Internet economy is capable of growing in a sustained long-term fashion at roughly 4.2 percent a year (3.2 percent productivity plus 1 percent population growth). In the old-economy era, America’s capacity to grow was only 2.5 percent a year.
Over the next twenty years the difference between 4.2 percent and 2.5 percent amounts to $6.4 trillion in higher national income. In budget terms, at an average 20 percent tax rate, roughly $1.3 trillion in new revenues will turn deficits into surpluses. At the same time, more growth, investment, and work will operate to hold back inflation and interest rates.
While inflation is primarily a monetary phenomenon — a lower dollar value caused by too much money chasing too few goods — higher productivity and faster economic growth raise the supply of available goods and services that can be purchased with the same quantity of money. Hence, the existing money supply becomes less inflationary in a growth-producing, productivity-enhanced economy.
Other contributors to economic growth have the same counter-inflationary effect. Bringing down high marginal tax rates on individual incomes and capital formation (including dividends, capital gains, and faster business-depreciation write-offs for equipment purchases) also contributes to a more rapid expansion of the economic pie.
When it pays more to take the extra investment risk or work the extra hour, economic behavior rises to the occasion. Though demand-side economists seem not to recognize it, the recent Bush tax cuts are not one-time stimulants. The tax cuts on capital gains and dividends won’t expire until 2008; personal rate cuts extend until 2010.
That means pro-growth incentive rewards for risk and work will be in place for many years, nurturing greater investment and encouraging breakthroughs in the next biotech, Internet telephony, or broadband advance. This is the stuff of which powerful prosperity booms are made.
Over the next decade, the tax-cut consequences of proliferating capital formation and goods-producing business expansion virtually eliminate any threat of inflation.
Actually, the strong-dollar combination of lower tax rates, higher investment returns, more rapid technological breakthroughs, and even greater productivity gains — all promoting faster economic growth — will maintain the pressure for lower, not higher, prices. Hence, the Fed must keep the money spigots wide open.
To a great extent President Bush has made a supply-side bet on the next election. His Keynesian critics argue that the so-called temporary tax cuts are already wearing off. Consequently, they say, 7 percent GDP in this year’s third quarter will be a one-time event — followed by a tepid jobless economy and Bush’s defeat.
But there’s another doctor’s opinion. Reduced marginal tax rates will sustain the new economic-incentive structure for years to come. Lower taxes will keep on spurring new wealth and higher employment levels far longer than almost anyone dreams possible.
Meanwhile, year two of President Bush’s supply-side tax-cut experiment could generate 4 to 5 percent growth, as many as 2 million new jobs, and a handsome re-election victory. But the really interesting part of this calculus is the potential of another six-to-eight prosperity years (at the least) following 2004.
Left-wing economic pundit Paul Krugman will be floored. The high-tax Democratic presidential field betting on continued recession will be stunned. And George W. Bush’s supply-side re-election will have long coattails for federal, state, and local legislatures throughout the land.
— Larry Kudlow, NRO’s Economics Editor, is CEO of Kudlow & Co. and host with Jim Cramer of CNBC’s Kudlow & Cramer.