Politics & Policy

The Hazards to Good Fortune

Only policymakers can screw up this economy.

Recent high-frequency data show that the economic pessimists have missed the mark by a country mile. Manufacturing output and core retail sales are accelerating, not slowing, and the post-Katrina economy looks much stronger than even some of the more optimistic analysts thought it would be. Residential real estate may cool, but a freeze isn’t likely. Moreover, business sales remain brisk and the outlook for non-residential fixed investment remains sound, which should help offset any weakness on the residential side of the investment ledger.

Nonetheless, the good news on the current economy should not blur very real risks that could come to fruition if policymakers make the wrong choices. From a pro-growth perspective, these risks include a failure to extend the 2003 tax cuts, an anti-growth “excess profits tax,” anti-China trade legislation, and a Federal Reserve model of inflation which is backward-looking and flawed.

Beginning with tax cuts, successful tax-cut extension this year looks increasingly grim, largely because Republican leaders have decided to squeeze savings out of Medicaid instead of scaling back some of the bloat from the $286 billion highway bill or trimming some of the lard from the $12.3 billion energy bill. This has led some moderates to balk; they do not want to run head first into the verisimilitude of voting in favor of tax cuts “for the rich” that are paid for “on the backs of the poor.” This is a truly shameful situation.

As for the “excess profits tax,” so-called conservatives are being seduced by bad politics and even worse economics when they assume that energy profits are the cause of high energy prices. The truth is just the opposite. In addition, without price and profit signals, the massive investments necessary to bring more energy supply on line won’t take place and retail prices will stay higher than would otherwise be the case. In any event, the crude oil bubble, and it is a bubble, has begun to deflate, so policymakers should leave well enough alone. Apparently, none of this matters when sound bites, demagoguery, and “doing something” takes precedence over rationality, markets, and incentives.

Looking to trade legislation, a symbolic revaluation of the Chinese yuan and other U.S.-based legislative issues have temporarily taken the wind out of the sails of the extremely misguided Schumer-Graham China revaluation/tariff bill. However, the threat of protectionist trade legislation has not completely lifted and could reemerge during 2006. Apparently, both parties have learned nothing from the disastrous Smooth-Hawley Tariff Act of 1930, which triggered a stock market collapse and lit the fuse of an international tariff war. As a direct result, global growth was incinerated, which propelled the spread of fascism, leading to mass murder and world war. Sadly, those who don’t learn from history are bound to repeat it — with catastrophic consequences.

Finally, the Fed’s model of inflation may not change after Greenspan leaves in January. If Ben Bernanke’s Fed uses the Phillips-curve/output-gap as an oasis to a numerical goal of 1 to 2 percent core inflation, the Fed almost surely will be on a path to policy error. Conversely, if a Bernanke-led FOMC downplays the Phillips-curve indicators and uses sensitive market information as a policy guide, it will be much more likely to terminate the inflation process before killing the expansion. To be sure, we cannot celebrate today’s strong growth statistics without expressing dismay over the most recent surge in precious metals prices — a worrying symptom of excess liquidity and the potential for a core inflation breakout significantly above the top of the Fed’s 2 percent comfort zone.

The optimists have been right about this economy all along. But the stench of policy error is in the air, and the odor is coming from Washington.

— Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.

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