The presidential election is upon us. You’ve been asked this question before, but now’s your last chance to answer it in the context of Bush vs. Kerry: Are you better off today than you were four years ago?
For many years now, the “misery index,” the sum of the unemployment rate and the inflation rate, has been a handy way of answering this very simple question. The election of Ronald Reagan to the Oval Office signaled a secular decline in the misery index. That decline did not preclude cyclical upswings such as the one that began in 1986 and carried through the Bush 41 administration. The index peaked in 1991 just before Clinton took over. It then steadily improved during the first half of the Clinton administration. However, during the last two years of Clinton’s second term, it began a cyclical ascent. That gave Bush 43 an opening for the economic arguments that he inherited a slowdown and that 9/11 had a large negative impact on the economy.
In spite of all this, the misery index is just about where it was when President Clinton successfully ran for reelection. Still, the index is higher now than when Bush took office.
Given the simplicity and elegance of the misery index, one wonders why there has been so little mention of it during the campaign. Is the misery index losing its clout?
I believe the loss of popularity is related to the development of the capital markets over the last 30 years. In a world with perfect capital markets people are no longer constrained by current income, they are constrained by their net worth and liquidity. Therefore net worth determines consumption and current income mostly determines whether someone borrows or not.
In this way, rather than focusing on the misery index, individuals are looking more to their personal P/E ratios (net worth over income) as the key determinant of their economic well-being. Such a ratio can also be figured out for the economy by using the economy’s net worth and the measure of disposable personal income.
This economy’s P/E ratio peaked during the fourth quarter of 2000 and did not begin a steady rise until the second quarter of 2003. According to the National Bureau of Economic Research, the recession began in March 2001, so the economy’s P/E is in line with the economic slowdown. In short, this system works.
Looking at the economy’s P/E over recent decades, it’s clear that the early 1980s marked a major turning point. I attribute that to the election of Ronald Reagan combined with Paul Volker’s chairmanship of the Federal Reserve. A combination of the price rule, lower tax rates, and deregulation proved to be the elixir the economy needed — although implementation mistakes were clearly made.
The phase-in of the Reagan tax-rate cuts produced incentives for people to delay income recognition, which led to an abrupt economic slowdown. But thanks to President Reagan’s leadership, these policies were not aborted; once the tax rates were fully implemented the economic recovery began in earnest. The economy moved to a higher P/E plateau that extended from 1986 to 1994.
The economy’s P/E saw a steep acceleration around 1995, peaking in 1999. The conventional wisdom is that the surge in valuation was a bubble. I differ somewhat on this. Once the Republicans took over Congress in the mid-1990s, we had the famous gridlock. As the push towards higher taxes and regulations was arrested, the economy flourished, as did stock market valuations.
But that was not all that was going on. The Fed’s actions engineered a decline in the underlying inflation rate in the U.S., thereby lowering the effective capital-gains tax rate, lengthening investor horizons, and reducing uncertainty. In 1998 the capital-gains tax rate was reduced to 20 percent and the search for cap-gains became the order of the day. The market continued its ascent. Unfortunately, the search for gains led to a dramatic change in the behavior of some market participants. Smooth and rising earnings became the new Holy Grail. Corporate behavior changed to deliver what investors wanted. Some did it legally and honestly, while others did not.
What originated the vicious cycle that began in the second half of 1999 is hard to determine. The accounting problems caused an abrupt decline in the net worth of the private sector. In theory that would lead the private sector to curtail spending and the lending sector to curtail lending, however the rising housing market dampened that fall and the credit restriction. That is why the recession was so shallow.
In this story, the Federal Reserve is not free of blame. In his concern over Y2K, Alan Greenspan flooded the market with cash in 1999 and abruptly pulled all of it out early in 2000. Although correlation does not imply causality, the coincidence cannot be overlooked. The data points to the Fed as one of the triggers of the recession. A compounding factor was the phase-in of George W. Bush’s first tax-rate cuts, which delayed incentives to produce. The phased in rate cuts made the economy weaker in the early going. It was not until the tax-rate cuts were advanced and the dividend tax-rate cuts enacted that the economy, and net worth, took off.
The question now is will net worth plateau, keep rising, or decline? Which way we go depends on the outcome of the election and the policy options that are taken in the next few years.
On the fiscal side of the campaign, President Bush has pushed his tax agenda. A lower tax-rate environment geared towards the elimination of the double taxation of income will lead the economy’s P/E to a new and higher plateau. Eliminating the tax-rate cuts by returning the top tax rates to Clinton-administration levels, as Kerry proposes, would be a negative shock to the system. The same can be said for Kerry’s healthcare program, which is similar to the one attempted by Clinton. At worst, these actions could drop the economy to the net-worth levels seen between 1988 and 1994.
Economic conditions will always be a bit different. But there is a lesson regarding the implementation of tax-rate cuts that we learned during the Reagan years: Do not phase in tax-rate cuts, for doing so will temporarily slow down the economy. The corollary to this is that a pre-announced tax increase will produce a temporary surge in economic activity. This is relevant for the election outcome.
A divided government (Kerry as president with a Republican Congress) will not protect us from a tax increase. If we take no action, tax rates will automatically go up in the next few years. More important, a pre-announcement of a Kerry tax increase will generate a false prosperity; people will try to recognize as much income as possible in anticipation of the tax increase. However, once the increase happens, the economy will slow and quite possibly fall into a recession.
For all those who have seen their personal P/E ratios grow under Bush, and for all those want to see their personal P/Es rise in the coming years, the choice on Tuesday should be perfectly clear.
– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.