Riding the Right Curve

Larry Kudlow
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Posted: Mar 11, 2006 9:05 AM
Despite the grim picture the mainstream media continue to paint about just about everything -- the insurgent-ridden reconstruction effort in Iraq, the looming Iran threat, the failed Dubai ports deal, the twin deficits, the president’s sagging poll numbers, the Jack Abrahamoff scandal, and on and on -- there’s one thing they just can’t taint: This U.S. economy remains very healthy.

It’s always amazing to listen to conventional demand-side economic pundits and mainstream reporters who try as hard as they can to minimize the excellent performance of the American economy ever since lower marginal tax-rate incentives were put into place almost two-and-a-half years ago. The latest chant is that a warm winter has artificially stimulated consumer spending, and that a day of reckoning marked by a housing-price crash and an overwhelming debt burden is headed our way. This is utter nonsense.

Apart from the inherent resiliency of our free-market capitalist economy, the fact remains that tax-induced capital cost reduction and resulting higher investment returns have boosted investment, healed business woes, and created employment growth near 2 million new jobs a year (and nearly 5 million since the middle of 2003 when the Bush tax cuts were implemented).

Unemployment sits at a low 4.8 percent today. Wages are perking up, with average hourly earnings rising 3.5 percent over the past year and 4.8 percent at an annual rate over the past three months -- their best performances since 2001. Importantly, falling gas prices at the pump are boosting real incomes enough that consumer spending is rolling ahead despite a slowdown in the housing sector and somewhat higher mortgage rates.

Of course, you can’t please the worrywarts. Yesterday they complained that wages weren’t rising; today they’re bellyaching that wage growth is too fast and that the Fed is going to have to tighten monetary policy much more in order to ward off cost-push inflation. This is more bogus Phillips-curve argument. But growth does not cause inflation.

Fortunately, new Federal Reserve chairman Ben Bernanke rebutted the Phillips-curve view in a recent speech at Princeton. Bernanke correctly argued that low inflation promotes economic growth and that strong economic growth is something to be desired, not shunned. The Fed chair cited Milton Friedman’s argument of nearly fifty years ago that inflation is a monetary phenomenon and not a function of too many people working or prospering.

In Friedman terms, there is a wee bit of excess money in the system, as illustrated by bond market inflation spreads and rising gold prices during the first quarter of 2006. Monetary base growth, the raw material of bank deposits, is a bit too rapid. But some of this will be absorbed by strong business investment while the rest will be removed by the Fed as it raises its target rate a few more times. All of this is a normalization of interest rates in line with strong economic performance.

Reagan economic guru Art Laffer taught us thirty years ago that lower tax rates ignite economic growth. Now, the Laffer curve is tracking a business-led expansion that is throwing off record budget revenues while corporate profits are soaring. Profits are the mother’s milk of business, the economy, and stocks, and are laying the foundation for even more hefty job gains.

According to the Fed, after-tax profits for last year’s fourth quarter hit 8.1 percent of GDP, a post-WWII record. At a trillion dollars, profits are way ahead of their prior peak in 1999 and have nearly doubled since their recent trough in 2001. Family net wealth, the nation’s true savings rate, advanced 8 percent in 2005 to a record level of $52 trillion.

On Friday, appropriately taking on the mantle of Salesman-in-Chief, President Bush answered his critics by giving a strong speech arguing for first principles on lower tax rates, free trade, global economic connectivity, and the use of trade as a diplomatic tool as well as an economic growth measure. Bush is certainly on the right track. And while Congress may appear to have gone offline on the critical extension of the 2003 investor tax cuts, Ways and Means Chairman Bill Thomas tells me that prospects for extension remain good. If so, this economic expansion will continue for many years to come.

In the months ahead, Ben Bernanke will follow the anti-inflation thinking of Milton Friedman. President Bush will continue to embrace the pro-growth Laffer curve. And the anti-worker Phillips curve will be pushed into the dustbin of history. In other words, economic growth principles will keep American capitalism on the prosperity path.