The U.S. stock market fell sharply last Friday as worries that a confrontation over Iran’s nuclear program could cut off exports from that key oil supplier. Crude oil prices, meanwhile, have climbed to more than $68 per barrel. No doubt, a continued escalation of oil prices such as we’ve seen in recent weeks — the price is up more than $10 in the past month — would at some point pose a real threat to this economy’s extraordinary vitality. Certainly, the possibility of such an exogenous shock can’t be entirely ruled out, but that may be the only way the mainstream media’s relentless prophecies of economic gloom will come to fruition.
For the past couple of years it’s been a rough ride for the economic pessimists and their handmaidens in the media, people who have utterly failed to comprehend the fundamental shift in the economic landscape set off by George W. Bush’s slashing of the tax burden on capital formation. In the nine quarters since Bush enacted the cuts in capital gains and dividend taxes in mid-2003, which with the stroke of a pen boosted the after-tax returns on risk-taking, real quarterly economic growth has averaged 3.7 percent. In the previous nine quarters it averaged only 1.6 percent. Nevertheless, for hide-bound stalwarts of the dismal science, it’s been a never-ending campaign to spy the seeds of economic decline around every corner.
The latest spate of pessimism surfaced last week when the Wall Street Journal — which has been a ready outlet for the doomsayers in recent months — devoted a front-page piece to a group of economic forecasters who see a “marked slowdown in the works.” According to these naysayers, a cooling of growth late last year represented a trend shift that will pull the economy down to a growth rate of less than 3 percent this year.
It’s doubtful, however, that the economy slowed in any real sense in the fourth quarter last year. Yes, there was a drop in non-auto retail sales, which rose at an annual rate of just 1.9 percent in the final three months of 2005. This reputed softness in consumer spending has compelled the Wall Street economic fraternity to reduce their estimates of fourth-quarter GDP growth, which will be announced this Friday, to a rate approaching 3 percent, down from 4.1 percent in the third quarter.
It’s quite possible, however, that the reported sluggishness of “the consumer” reflects nothing more than short-run data volatility arising from the hurricane-related dislocations of late last summer. Friday’s GDP release might garner headlines for showing a significant decline in the growth rate, but there is scant evidence available to confirm that the overall pace of economic expansion fell back significantly in the final three months of last year.
A slowing economy, for example, would not likely be throwing off the kind of revenue growth now being reported by the Treasury. Tax receipts in the fourth quarter were up nearly 9 percent from a year earlier, with the Treasury recording an $11 billion surplus in December. In addition, the labor market is now showing hallmarks of the robust health considered so exceptional in the late 1990s, including weekly initial jobless claims falling below 300,000.
Industrial sectors of the economy are also showing renewed vibrancy, in particular gaining from a revival of capital investment activity. While industrial production grew overall by 3.8 percent in the fourth quarter, up from 1.5 percent in the third, a gain of more than 9 percent in business equipment manufacturing was even more encouraging. It appears that production in this critical area has ramped up to meet the capital-goods needs of American enterprise in expansion mode. This is consistent with more sensitive, market-based indicators that are capturing an investment setting where strong expected returns are fostering greater risk tolerance, which is so crucial to the growth-sustaining capital-formation process. This bolsters confidence that the distortions which might have contributed to an apparent slowing in fourth-quarter growth are very likely to prove short-lived.
The current climate of dynamic risk-taking, capital formation, and wealth creation points to a long-run era of vigorous economic expansion. But that’s not to say the risks are completely absent. An exogenous event such as a sustained surge in energy prices could conceivably take down this economy. But almost invariably, economic downturns result from government policy error, whether monetary, fiscal, or trade related. At this point, with the price of gold above $550 — up about $175 in a little more than two years — the most pressing risk is the potential of policy error from the Federal Reserve. If recent speculation that the central bank is prepared to call an end to its rate-hiking cycle is proven correct, the pause could end up being short-lived. If the lagged effects of the Fed’s long hyper-easy posture show up in the core inflation data, policymakers may have no choice but to re-start the rate-raising process, potentially overshooting the economy’s tolerance for higher rates.
There is also the question of whether or not Congress will extend the dividend and capital-gains tax cuts that have been so vital to the accelerated pace of expansion over the past two and a half years. While the current tax rates don’t expire until 2008, the prospect of higher levies ahead would have to be priced into the present value of financial assets, reducing expected investment returns, raising the cost of capital, and quite likely significantly slowing the rate of growth.
– David Gitlitz is chief economist of Trend Macrolytics LLC, an independent economics and investment-research firm.