Politics & Policy

Stagflation Nonsense

Inside the latest "lackluster" GDP report.

Three months ago the first government estimate of gross domestic product for the fourth quarter of 2004 came in at 3.1 percent at an annual rate. At the time, the market consensus expected 3.5 percent growth. Immediately, the mainstream media started talking about an economic slowdown. Turns out, that 3.1 percent was finally revised up to 3.8 percent.

This past week, the Commerce Department reported its initial estimate for first quarter GDP at 3.1 percent. The consensus forecast was 3.5 percent. Immediately, newspaper headlines screamed about a soft-patch and the likelihood of further economic decline. Sound familiar?

Well, history is repeating itself — even though, if you look under the GDP hood, you’ll find that the country’s economic engine is humming along.

Is the media simply interested in a putting out a declinist view of America? Is this just more Bush-hating? Why don’t the media pick on Western Europe or Japan, places where economic growth rates are hovering at less than 1 percent. Ours is a healthy, prospering economy.

Headline writers and media pundits notwithstanding, the culprit for the lower-than-consensus GDP was once again higher imports (net of exports), which are really a sign of economic strength. Imports subtracted about 1.5 percent from the first quarter’s apparently lackluster GDP number. But stick that back in, and GDP would be 4.6 percent — not 3.1 percent.

The trade gap subtracted $663 billion out of an $11.1 trillion GDP. But consumers and businesses are buying heavily because incomes are up and prosperity is growing. All the trade-deficit talk is Alice-in-Wonderland stuff. Don’t penalize the strong U.S. economy just because Western Europe and Japan still remain on the edge of recession.

The core U.S. economy — subtracting out trade and government spending and keeping in consumer spending and business capital-goods investment — actually expanded at a 4.3 percent annual rate in the first quarter compared to a 4.8 percent pace in the fourth quarter and a 5.2 percent rate for the last year.

There has in fact been a temporary slowdown in business capital-goods investment, according to Wall Street economist Michael Darda, owing mostly to the expiration of the corporate tax cash-expensing bonus that Congress has chosen not to extend. They should put this back in the budget, but even without it, business capex will pick up speed in the quarters ahead as companies are flush with cash and profits are at record highs.

Finally, consumer spending and the housing sector were both quite strong in the latest GDP report. Although the media fail to see it — or just won’t say it — America’s economic heart is beating strong.

One reason the media keep repeatedly looking for a double-dip recession is that they continue to underestimate the pro-growth impacts of supply-side tax cuts. In the seven quarters following the Bush tax cuts of June 2003, the core private economy increased at a 5.6 percent annual rate. In the seven quarters before the tax cuts, the economy increased at only a 2.7 percent annual rate.

Remember, the tax cuts of 2003 contained strong supply-side incentives to work and invest. The top marginal rate on individual income was lowered to 35 percent from 39.6 percent, meaning that individuals were able to keep 65 cents on every new dollar earned compared to only 60.4 cents under the prior law. That’s a 7.6 percent incentive-reward for the extra hour worked.

Even a more powerful incentive boost came from the cut on the tax rate for investor dividends, which plunged to 15 percent from 39.6 percent. That’s a 41 percent reward for saving and investing. And let’s not forget the capital-gains tax cut that lowered the top rate to 15 percent from 20 percent. That’s a 6.25 percent incentive reward for capital formation (i.e., you keep 85 cents instead of 80 cents out of each cap-gain dollar). In total, the incentive effect of these tax cuts was 55 percent. That was huge. For work and investment, Uncle Sam keeps a lot less nowadays, while individuals keep a lot more. Private capital goes up, while the government’s take goes down.

Consequently, the private economy has a much stronger growth engine today. Individual quarterly GDP performance may bounce up and down, but the trend line has improved markedly over the past few years.

Parenthetically, the first Bush-sponsored tax cut in 2001 was really a demand-side approach, one that was dominated by temporary tax rebates rather than lower marginal tax rates. It didn’t qualify as a supply-side measure and it didn’t produce more economic growth. But the Bushies learned their lesson and went supply-side, putting through a tax cut that benefited all — including the tax collectors as receipts have gone up.

So, GDP is not a problem. Neither is inflation. Alan Greenspan’s favorite inflation measure, the chain-weighted price index for personal consumption spending, increased only 2.2 percent in the first quarter. Excluding energy, it was only 2 percent for the quarter and 1.8 percent over the past year.

Meanwhile, commodity prices are weakening and the air is gradually coming out of the oil bubble. As former Federal Reserve governor Wayne Angell has noted, the recent commodity slump shows that the Fed has done its job well by slowing money supply and raising its target rate. Bond yields remain near 45-year lows, more evidence of quiescent inflation.

If you listen too hard to pessimistic pundits you can get all lathered up over the risks of stagflation — slower growth and higher prices. Don’t go there. This is most certainly not the 1970s. For young people, this is not your father’s economy.

Money is sounder, tax rates are lower, productivity and profits are much higher, and world trade is more open. Today’s technology-streamlined and deregulated economy is not inflation-prone. And the Federal Reserve will cease its policy-tightening moves sooner than most folks expect.

So long as the Bush administration and Congress control federal spending, keep tax rates low, and avoid the growth-slowing pitfalls of trade protectionism, non-inflationary prosperity can continue for years to come. Economic policies matter, and right now they are pro-growth.

And so long as the Bush Republicans nuke the filibuster-happy Democrats, the president’s pro-growth reform agenda — of more investor-class ownership and greater tax-freedom to save — will expand the economy’s potential to grow even more in the years ahead.

— Larry Kudlow, NRO’s Economics Editor, is host of CNBC’s Kudlow & Company and author of the daily web blog, Kudlow’s Money Politic$.


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