By any objective measure, the U.S. economy continues to perform in a more-than-respectable manner. Growth since the Bush tax-rate cuts of mid-2003 has averaged more than 3.6 percent. Historically sound growth. Since 2003, the Fed’s favorite measure of inflation, the rate of change of the PCE price index, has increased at a 2 percent annual rate. Historically low inflation. On a trailing four-quarter basis, the U.S. economy has enjoyed 18 consecutive quarters of double-digit corporate-profit gains. Our companies are healthy and getting healthier. Since the beginning of 2003, the stock market, as measured by the S&P 500, has gained 78 percent on a total-return basis. American investors, some 100 million or so, are making serious hay.
In times past, people would label this an era of unprecedented economic prosperity. Yet as I read the financial pages, I’m hard pressed to find any credit being given to either the economy or the policies that have delivered it:
“Extend the President’s tax cuts beyond 2009 and 2010, and the fiscal hole is enormous. Let them expire and the tax increases could derail the economy.”
“The President’s budget and economic polices count on continued good luck.”
“If the U.S. economy keeps growing like it is, Rodney Dangerfield is going to rise from the dead and file a patent claim.”
That last one gets bonus points for insightful wit: This economy gets no respect. And neither do the programs set forth by the Bush administration that underpin these economic good times.
Is this fair? And why do so many critics continue to believe that a recession is around the corner?
Before I answer these questions, I’ll side with the critics on one point: The biggest threat to the continuance of this expansion is a policy mistake. But the biggest policy mistake that can be made would be to somehow reverse or weaken the policy mix that is now in place.
For years now, the critics have said that the economic good times won’t last. Not only have they been wrong, but it’s clear they have a different view of what caused the economic rebound in the first place.
This is an important issue: There is no doubt that a recovery has occurred, and one economic camp (the one where I have placed my tent) traces that recovery to the tax cuts of 2003. But the other economic camp argues that it is the existence of those tax cuts that threatens the continuance of the recovery. Thus, on the debating floor, two Ockham’s Razors have emerged: If the tax cuts are allowed to expire, the economy will suffer; make the tax cuts permanent, and the economy will tank.
I argue for the sharpness of the former over the dullness of the latter.
Critics of the current economy do not believe that the incentive effects of tax-rate adjustments are strong enough to lead to prosperity when rates are reduced, and to economic slowdown when rates are increased. Their argument is nuanced; they assume that tax-rate changes operate through income effects. The thinking goes something like this: Since a tax-cut increases the disposable income of taxpayers, it results in an increase in aggregate demand. Viewed this way, the current expansion is nothing more than an excess-demand deficit-financed expansion.
As for the idea that making the tax-rate cuts permanent will be bad for the economy, the critics rely on an additional piece of information: the budget deficit. Proponents of this doomsday view believe that lower tax rates lead to persistent deficits which in turn “crowd-out” private investment and in the long run result in higher interest rates and lower growth.
Ockham, to say the least, would have had a problem with such convoluted thinking. In fact, it’s pessimistic thinking, and there’s no data to back it up: Historically, rising budget deficits have been associated with declining short-term interest rates, the opposite of what the “crowding out” view predicts.
But a lack of data has never silenced the economic pessimists.
In the Keynesian mind (the terms “Keynesian” and “pessimist” are interchangeable), a tax cut is nothing more than a redistribution scheme. The people who benefit from the tax cut will see their disposable incomes increase along with their expenditures. But someone, or something, has to be worse off because of the tax cut, and the government’s budget is a usual victim. Cut taxes, and either current expenditures or future expenditures have to decline, or future taxes have to go up. Tax cuts in this scheme represent the perpetual lose-lose scenario.
And now for the win-win . . . at least in part.
Since President George W. Bush took office, defense spending has increased by 50 percent alongside a healthy increase in domestic spending. Whether or not this spending has any impact on the economy will depend on the private sector’s perception of the government services being provided. If the spending policy leads to income redistribution, one can argue that one group’s gain is another group’s loss, so there should be no net aggregate-demand effect. On the other hand, if the services provided by the government are truly for the “public good,” it is possible that the value of the benefits will exceed their cost. This is the argument that the president has made regarding the war on terror. If the war is won, as was the case with the Cold War, the effort will have been worth it. If we lose the war, clearly we will be worse off.
That said, the unambiguous conclusion so far is that President Bush is a big spender. But there’s a good deal more to this story: The Bush administration also has cut tax rates while the Federal Reserve has maintained a domestic price rule.
First to taxes: Tax-rate changes, either up or down, alter the prices paid by consumers as well as the net-of-tax prices received by suppliers. Higher prices paid by consumers lead to a substitution effect away from market goods and into the underground economy. Lower prices received by suppliers lead to a substitution effect away from the production of goods that currently deliver lower after-tax returns and into other activities. In short, both suppliers and consumers see and react to the same signals. Hence, when tax rates are lowered, the predictable result is higher output: the consumer substitutes toward market goods, with that demand matched by higher output on the supplier end. This is exactly what we have witnessed since the Bush tax-rate cuts were enacted in 2003, and it’s the very dynamic that has helped deliver today’s strong economy.
I say “helped” because our central bank deserves credit, too: Very simply, the Fed’s adherence to a domestic price rule explains why inflation has remained under control in spite of a huge rise in commodity prices.
Much of this might sound familiar.
About four decades ago, the John F. Kennedy tax cuts, inherited by Lyndon B. Johnson, went into action, and they were implemented while the country was still on the Bretton Woods system, or the international price rule. The economy roared. (Johnson would later raise taxes and begin to dismantle the international price rule.) Then, about two decades ago, Ronald Reagan cut taxes while his cohorts at the Fed shifted monetary policy to a domestic price rule. The economy roared again. Neither JFK nor Reagan, it must be noted, was a slouch on defense.
Now let’s see: It’s 2007, taxes have been cut and remain historically low, the Fed by most reasoned accounts is adhering to a price rule, and strength is the foreign-policy credo of the executive branch. Sound familiar? Indeed.
If Bush got lucky, so did Reagan and Kennedy. The truth is, all three of these presidents are due some respect for turning out robust and sustainable economies.