A roadmap for recovery

Larry Kudlow
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Posted: Nov 02, 2001 12:00 AM
Make no mistake about it, the 0.4 percent decline in third-quarter gross domestic product had virtually nothing to do with the Sept. 11 terrorist bombings and virtually everything to do with massive monetary mistakes made by the Federal Reserve over the past two years. Blame for this downturn must be placed squarely at the doorstep of the central bank. President Bush is right to say that the terrorist attacks "affected our workforce and our business base," and the economic aftershock of 9-11 would by itself have caused a temporary fourth-quarter contraction of about 1 percent of GDP. But the third-quarter drop -- which probably will be backdated to a recession that began last winter -- could have been avoided were it not for massive monetary mistakes. In the first place, nobody told the Federal Reserve to ratchet up its basic money supply by 17 percent in 1999, and then deflate it by 3 percent in 2000. This was a pillar-to-post policy gyration, and it was sheer lunacy. A massive money excess followed by a huge money shortage caused national income to careen upward unsustainably and then spiral downward later. This was the root cause of the recession. The Fed chairman's reputation was supposedly that of a cautious incrementalist. Instead, Alan Greenspan gave us unprecedented monetary volatility. No wonder the economy spun out of control. If the central bank had merely paid attention to real-time market price signals -- such as our upside-down interest-rate structure and sinking commodity prices -- they would have seen economic disaster ahead. Instead, the bank kept its blinders on and mercilessly deflated stocks, business profits and now the rest of the economy. Is the Fed capable of learning from its mistakes? Well, the recession-creators have in fact pumped $40 billion in new cash into the economy since the 9-11 terrorist bombings. Year-to-date, the Fed's basic money supply has now grown by 8.5 percent, a considerable improvement from last year's 3 percent decline rate. These are moves in the right direction. And if tax policy falls in line, we may soon bury this private-sector recession. But that's (SET ITAL) if (END ITAL) it falls in line. It is important to understand that at the very heart of this slump is the downturn in business. While class warriors on Capitol Hill attempt to block greatly needed business- and personal-tax relief, the contracting corporate sector is now forcing job layoffs faster than politicians can increase unemployment compensation. Yes, consumer spending continues to rise, albeit at a slow 1.2 percent annual rate in the third quarter. But get this: While industrial production has fallen for 12 consecutive months, business capital spending has declined in six of the past seven quarters. From its peak in mid-2000, private domestic investment has dropped $182 billion, or 10 percent. Technology spending this year alone has declined $75 billion, or 15 percent at an annual rate. Sen. Tom Daschle's stimulus proposal, however, is nothing more than an ineffectual, government-entitlement spending bill -- not a tax cut -- that would merely redistribute income. The Democratic package has no incentive effect that would raise after-tax economic rewards for innovation, investment and work effort. Hence, it could actually block economic growth rather than spur it. This week, Bush exhorted the Senate to "get to work and get something passed." He's right. The president supports a 30 percent bonus for the cash expensing of new equipment purchases, an end to the corporate alternative minimum tax and an acceleration of the income tax-rate reduction plan from 2006 to 2002. In round numbers, these measures will expand business resources by about $100 billion over the next three years, with another $50 billion or so of relief for individuals. Importantly, about one-third of personal tax filers are actually small businesses, so it is essential that the 40 percent top marginal tax-rate come down immediately to 33 percent (aiding unincorporated small firms). A modest combination of tax cuts and central-bank money creation should provide sufficient new investment and work incentives -- and the liquidity to finance them -- to get economic growth back on a 3 percent recovery path next year. But again, these would be moves in the right direction, and not the solution. Remember, a normal recovery rate historically runs in the 5 percent range. This is why comprehensive tax reform and simplification should remain on the policy front-burner, and why the Federal Reserve must develop a monetary reform plan that will place real-time financial and commodity-price indicators at the center of its money-creating operations. Maximizing homeland economic growth is a vital weapon in the war against terrorism. This will not only raise the American spirit, but also provide a shining example to the totalitarian-oppressed economies in the Middle East and elsewhere of just how effective the prosperity forces of freedom and democracy can be.