The economic malcontents scored a one-round victory after the release of the GDP report for the fourth quarter of 2005, which showed the economy only expanding by 1.1 percent at an annual rate. But January’s non-farm payrolls report, which showed three-month job growth snapping back to nearly 230,000, has promptly put the pessimists back on the ropes.
At the time the sloppy GDP report was released, I argued that one-off factors — such as a drop in auto production and sales and a contraction in government spending — were the proximate cause for the weak reading and were not a harbinger of the future. Other high-frequency data such as business-equipment and high-tech output, as well as non-defense capital-goods shipments and orders, all boomed during the fourth quarter.
The January jobs report further buttressed the pro-growth case. It showed that the unemployment rate dropped to 4.7 percent while weekly earnings rose at the fastest pace since the year 2000. Moreover, non-supervisory production worker wages (i.e., “low-end wages”) rose 0.4 percent month-over-month in January and have risen at faster than a 4 percent annualized rate during the last four months. That’s faster than inflation any way it’s measured.
If we multiply hours worked by wages, we can get a proxy for income, which is up 6 percent year-over-year, the fastest since April 2000. Not surprisingly, there is a very tight relationship between hours worked and real GDP growth. The annual increase in hours worked in January is consistent with 3.9 percent real GDP growth while the three-month annualized increase in hours is consistent with real GDP growth of 4.2 percent.
Some have tried to rain on the pro-growth parade by pointing out that labor-force participation has not recovered to the highs reached during the bubble years of the late 1990s. But with wages and earnings on the rise and unemployment on the decline, this argument doesn’t really hold water.
The unemployment rate for high school graduates with no college education dropped to 4.4 percent in January, down from 5.7 percent in June 2003 (when tax rates on capital dropped dramatically). The black unemployment rate fell to 8.9 percent in January, the lowest in more than four years. And the unemployment rate for those with less than a high school diploma fell to 7 percent in January, well below the 9.4 percent levels that prevailed in June 2003.
Importantly, the real capital-to-labor ratio has risen 17 percent since the 2003 tax cuts went into effect while the economy has created more than 4.7 million new jobs. Initial jobless claims have fallen to their lowest level since June 2000 when the unemployment rate was just 4 percent. These are signs that the labor-market recovery is deepening and broadening.
While real wages have risen for the past three months in a row, the Federal Reserve’s excess liquidity does present a headwind in this respect. The good news is that a rising capital-to-labor ratio, record corporate profits, and booming productivity have set the stage for a strong labor market even if inflation moves higher. In fact, the late 1960s witnessed a significant increase in core inflation while real wages moved higher as productivity and profits slowed from record levels.
I expect much the same thing from the 2006 economy. Productivity and profits should slow from the torrid growth rates of the last few years as hours worked and wages paid rise. Think of it as Marxian distribution courtesy of Adam Smith’s invisible hand.
The worst thing that could happen now is for Congress to snatch defeat from the jaws of victory by failing to extend the crucial 2003 tax cuts. Shrinking after-tax returns to capital would be a blow to investor confidence which would negatively impact the capital-to-labor ratio and damage labor. With total tax receipts nearly $400 billion higher, capital-gains receipts rising much more than expected, and non-housing asset values up more than 5 trillion since the 2003 tax cuts passed, it simply makes no sense not to extend them.
In fact, with inflation pushing higher and excess liquidity still in the system, a higher effective tax wedge on capital actually could stop the current labor-market recovery in its tracks. And with more Fed tightening likely to occur during 2006 than most of the conventional economists expect, the lower tax rates now in place are needed to stimulate the supply side of the economy as the Fed moves to reduce excess liquidity and temper aggregate demand.
And we shouldn’t forget the last time excess Fed liquidity collided with an ill-conceived increase in effective tax rates on capital. That happened in 1987, and we all know what followed. Congress shouldn’t make the same mistake again.
— 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.