Economic reality check

Larry Kudlow
Posted: Dec 02, 2004 12:00 AM

 If the economy's so bad, why is it so good? Crashing dollar, twin deficits, rising gold, foreigners selling our assets -- the list goes on and on for members of the negative and pessimist mainstream media. But unfortunately for them, and fortunately for the rest of us, the economy is in excellent shape.
According to the latest report from the Commerce Department, real gross domestic product rose 3.9 percent in the third quarter of 2004. GDP is still the best overall measure of the economy -- that is, outside of the stock market, which is always smarter than the bean-counters. The S&P 500 and the Wilshire 5000 are both up about 50 percent since October 2002. That's two more votes for a healthy, non-inflationary prosperity, one that's chock full of rising profits and record productivity.

 As usual, the optimists' list is way longer than the pessimists'. Core inflation is coming in around 1.5 percent. Business equipment and software ("cap-ex" as it is known on Wall Street) grew by 17.2 percent last quarter, while consumers spent at a 5.1 percent pace. Meanwhile, U.S. trade is very healthy. Exports rose by 6.3 percent at an annual rate, while imports increased 6 percent. New jobs are running near a 200,000 monthly pace. Unemployment, at 5.5 percent, is historically low.

 The dollar? If certain officials at the Federal Reserve will stop bad-mouthing it, we'll wake up one of these days with a 15 percent dollar rally. Why? Because President Bush's pro-growth fiscal policies will restrain spending and reduce tax rates, especially on saving and investment. Higher after-tax investment returns will attract foreign capital from all over the world. If you haven't noticed, Japan's economy is slumping again. Europe's economy never recovered in the first place. And fast-growing China and India are becoming our best export customers. The dollar is way undervalued in this environment.

 However, if you truly want a balanced trade account in the United States, the most effective but demoralizing way to achieve it is to induce recession with rising tax rates and excessive Fed monetary restraint. The trade accounts were balanced in the early 1980s and the early 1990s because of recession -- but this was reflected by a total collapse of U.S. imports, jobs and just about everything else. Recessionary policies would be lunacy today. America's trade gap is itself a sign of prosperity. Our economy is rising, while other industrial economies are not.

 Under President Bush's revival of Reaganesque, low-tax, cowboy capitalism, world money is migrating to the highest investment-return nation. Right now, that's the United States, among major countries, and China and India among emerging countries. This inflow of foreign money is raising our national income and stimulating our economy, including import demands.

 Meanwhile, the conventional wisdom that twin budget and trade deficits cause the weak dollar -- a thought that has been wrong for 25 years -- misses a crucial point: Strong U.S. economic growth reduces the budget deficit (which has already dropped $100 billion) but increases the trade gap.

 Here's another way to look at it: As the U.S. economy rises, tax collections go up and the budget deficit goes down, but the trade gap widens unless our major trading partners take pro-growth policy steps to cut taxes, deregulate markets and end socialism. This is what China and India have done as they liberalize their policies, increase their growth rates, and become important buyers of U.S. goods and services. Not until our G-7 partners take pro-growth policy steps will the trade gap begin to narrow.

 Meanwhile, both domestic interest rates and the dollar exchange rate are primarily driven by the Fed's monetary policy -- i.e., whether the central bank creates more dollars than the rest of the world wants. It is this excess money that causes inflation at home and sinks the dollar abroad.

 Rising gold and higher Treasury bill rates are market-price signals that the Fed should remove some excess money. That is what the Maestro intends to do, as he takes monthly steps to normalize the Fed's target rate.

 But the Fed is already tighter than many recognize. Commodity markets tell that story. The Commodity Research Bureau's spot index of 22 commodities has slowed markedly from a 24 percent rate of yearly increase last spring to only 7 percent recently. This sensitive market-price indicator is suggesting that the central bank is already creating dollars at a much slower pace, another reason why the dollar is undervalued.

 In the end, the pessimists will be wrong again. Lower tax rates and inflation-restraint will be a powerful tonic for rising stocks and the economy. Provided, of course, that the maestro doesn't take restraint too far.