Larry Kudlow
A year ago, most of the economic geniuses predicted a long and deep recession following the terrorist bombings in New York and Washington. They were dead wrong. Instead, last year's third quarter marked the end of a year-long recession that began in the last quarter of 2000. This recession was caused principally by a prolonged period of monetary deflation, which wiped out share prices, corporate balance sheets, profits and capital goods investments. Since the third quarter of 2001, the free market, resilient and productivity-enhanced U.S. economy has rebounded at a 3 percent annual rate. That's below par, to be sure, but still way better than Europe or Japan. In this post-9-11 recovery, lingering deflation and a stubborn corporate credit crunch borne of excess debt, high real corporate bond rates, and wide spreads between corporate and Treasury rates has held back economic growth that usually runs 6 percent to 7 percent of the first year of recovery. Housing has really saved the day. Roughly 70 million people own their own homes, and collateralized borrowing and refinancing against these price-appreciating assets has provided significant liquidity and spending resources. Capital gains from housing are essentially untaxed, adding more value. Stock market turnovers should be similarly untaxed. It would add value to the stock market. Over the past three quarters, key economic performance measures show solid, if unspectacular, recovery rates. Real GDP has increased over $200 billion for a 3 percent annualized growth rate. Real consumer spending has advanced by a $173 billion, or 3.6 percent. After-tax personal income adjusted for inflation has gained $163 billion, or 3.2 percent at an annual rate. Corporate profits for domestic industries have grown by $121 billion, a 31 percent AR rate. Industrial production has advanced by slightly less than 2 percent annually, and factory shipments by nearly 5 percent. Inflation is nil. Treasury rates have fallen across the board. Stocks have not recovered, though they look to be significantly undervalued. Live and learn. For the first time in interplanetary history, a recovery in stocks will lag the recovery in the economy. The biggest single concern at this stage is the absence of sufficient liquidity to finance business and stock-market recovery. Liquidity preferences and risk aversion are both quite high. The Fed should be pumping in high-powered cash at least at a 10 percent pace, if not more. However, the past six months monetary base growth has slipped to 6 percent AR from a 14 percent pace in the prior six months. This is why the Fed spread, or the liquidity spread between 2-year Treasury notes and the Fed funds rate, is a miniscule 25 basis points. It should be 200 basis points, as it was in the latter part of 2001 and the early months of 2002, a period of advancing stock prices. The central bank would be well advised to deregulate the Fed funds rate and buy tons more Treasury bills, paid with newly created high-powered cash. In other words, plenty more money-adding is appropriate. An investor tax-cut package would also be helpful. Terminating or at least reducing the double taxation of dividends would incentivize investor stock buying. It would also incentivize corporate dividend payments. Balance sheets would gradually be restructured away from debt and toward equity. Dividend cash payouts would signal improved cash balances and better creditworthiness. On the personal side, dividends could be taxed at the same 20 percent marginal rate as capital gains. Increasing the capital investment loss deduction would help, as would the tax-free turnover of reinvested stocks. Higher limits for supersaver 401ks and IRAs, including Coverdell education savings accounts and medical savings accounts, would also promote saving and investment. Indeed, unlimited and universal supersaver accounts would bend the tax system toward a consumption tax and relieve the present problem of double and triple taxation of work, saving and investment. If the Bush administration proposes such an approach, it could provide a very positive jolt to economic growth and stock-market recovery. Whether or not an investor tax-cut package passed both houses of Congress, a highly unlikely event in the few weeks remaining before recess, it would still tell investors where the Republican Party stands on stock-market growth. Politically, it would give Republican candidates something very solid to run on. The Contract With America helped successfully nationalize key midterm election issues in 1994, illustrating party differences on a wide range of issues. The GOP routed the Democrats. In similar fashion, a Republican-backed Contract With Investors might well provide Commander in Chief George W. Bush with sufficient legislative majorities in both Houses to promote economic growth-related domestic security at home and the strongest possible self-defense-based national security overseas. Economic strength at home leads directly to military strength abroad. Ronald Reagan understood this well, and George Bush should follow in the Gipper's path.

Larry Kudlow

Lawrence Kudlow is host of CNBC’s “The Kudlow Report,” which airs nightly from 7 p.m. to 8 p.m.