Recovery, phase two

Larry Kudlow
Posted: Dec 16, 2004 12:00 AM

The Federal Reserve began removing its post-9/11 emergency money-creation late last June. Since then, stock prices have gone up and bond rates have come down. Conventional wisdom was wrong.

 Alan Greenspan is clearly on the right track. He has gradually removed excess money in order to head off inflationary expectations. This begs a question, however: If a restrained monetary policy is so bad, why have markets responded so positively? The answer is that in the current economic environment, less is more. Less Fed money creation will generate more economic prosperity.

 After this week's Fed move to raise its target rate a quarter point to 2.25 percent, stocks again went up and bond yields again went down. Conventional wisdom that Fed restraint is bad for markets and the economy has again been proven wrong.

 All the chatter about the twin budget and trade deficits forcing the Fed's hand is just so much nonsense. Strong economic growth is reducing the budget deficit through higher tax collections, while rising import demands have widened the trade gap. However, both are signs of economic strength, not weakness.

 In fact, rising U.S. import demand is keeping the weak economies of Western Europe and Japan afloat. It's just about the only real source of economic stimulus for the countries that refuse to adopt the Reagan paradigm of lower tax rates and market-oriented deregulation. Critics of the American economic model call this "cowboy capitalism."

 But Europe and Japan need to put on their Stetsons and spurs if they are to start reigniting economic growth. Sanctimonious scolds, in Europe especially, should look to their own problems -- including a 10 percent unemployment rate.

 Meanwhile, U.S. economic policy is gradually shifting. In the 2000-02 period the problem was deflationary recession. The correct solution, implemented by President Bush and Fed chair Alan Greenspan, was lower tax rates and easy money. Over the past two years rising employment and investment have responded to new tax incentives while the Fed's stepped-up money creation provided the liquidity to fund recovery. Call this recovery phase one.

 Now we are entering phase two. A handsomely re-elected President Bush will move to make the tax cuts permanent, while the central bank will restrain money creation in order to stabilize the dollar and maintain domestic price stability. This phase might be characterized as tax cuts and stable money.

 Along with other pro-growth measures -- such as Social Security reform anchored by personal savings accounts, tax simplification that will likely flatten marginal rates and broaden the tax base, reform of litigation-settlement abuse and energy deregulation -- the policy mix of supply-side fiscal reform coupled with stable money should prolong a non-inflationary 4 percent growth path for years to come.

 The Fed's job is not yet complete. The recent spurt in gold prices, as well as a modest creeping up of inflation, suggests the need for more bond sales by the central bank in order to drain excess money. As a result, short-term interest rates will rise to more normal levels (think 3 percent to 4 percent) in the year ahead.

 Judging from the positive response of stocks and bonds to this year's Fed adjustment, another year of "measured" Fed actions will be well received by the markets and the economy. Let the worry warts worry. Let the pessimists whine away. The fact is, lower tax rates and sound money will deliver a long prosperity boom.