October 31, 2003,
You can't buy, sell, or trade GDP, but this week's report of a barnburner 7.2 percent rise in gross domestic product is very significant. It informs us of the likelihood of a true recovery boom call it the Bush boom in the months and quarters ahead.
Within the third-quarter report, capital expenditures rose 11 percent overall and 15.5 percent for equipment and software. This beats the previous quarter, when equipment and software climbed more than 8 percent. The rally in tech stocks and new upwardly revised tech-industry estimates confirm that we're in the midst of a replacement cycle for computers and that fast-rising demands for broadband and Internet services are for real. Big DVD sales in electronic stores are more confirmation of the tech upswing.
What's extremely impressive is that 7.2 percent GDP occurred alongside a huge $36 billion drawdown of inventory (which followed an $18 billion destocking in the second quarter). So this was reflected in real final sales of businesses, a huge increase of nearly 8 percent in worldwide aggregate economic demand, and final sales at home (less trade), which increased 6.6 percent. In fact, private sector GDP the classic free-enterprise measure of consumption and investment which has averaged 6.1 percent at an annual rate over the past two quarters hit a 7.8 percent moon shot in the latest report.
Total spending in the economy also surged by 9 percent, combining 7.2 percent real growth with 1.7 percent inflation. This "money GDP" measure is a useful proxy for total business sales. According to economist John Ryding at Bear Stearns, non-farm business sales increased by 11.6 percent annually in the third quarter. With an implied productivity gain of 9 percent for the total non-farm economy, unit labor costs will come in way below business profits.
In simple language, when prices rise faster than costs, profits go up and business profits are the mother's milk for the stock market and future corporate production and hiring.
According to this week's data, economic profits from national income accounts (the very broadest measure of corporate profits) are roughly 50 percent higher than their bottom, which registered near the 9/11 terrorist attacks. Broad stock averages, meanwhile, have increased about 35 percent from their year-ago lows. On this basis alone, the stock market still looks to be 15 percent undervalued at the minimum.
As might be expected, the markets liked the news. Stock averages traded up about a half of a percentage point, the dollar firmed slightly, and Treasury bonds fell only a bit. As for this last indicator, at 4.35 percent, the 10-year government bellwether issue is still way below the 4.6 percent peak it registered early last summer.
Going forward, abnormally low inventories will be rebuilt, which will provide 1 to 2 percent higher GDP growth in each of the next several quarters. The third-quarter tally was no fluke. GDP will continue to grow rapidly as the step-up of inventory production creates a flood of new jobs in both manufacturing and services. The recent rally in raw industrial commodity prices providing both an incentive to produce and an economic reason to meet rising demands in the U.S. economy and overseas (especially China) only bolsters the inventory case.
Speaking of incentives, the Bush tax cuts have significantly lowered the after-tax cost to businesses of producing inventories and spending on new business equipment. Meanwhile, post-tax returns to investors have improved handsomely. A 50 percent cash bonus for the immediate tax write-off of new equipment will continue to figure into the impressive rebound in business-investment spending.
Yes, indeed the Bush boom has begun at last. This tax jolt has ended the prior capital bust which lasted a long and dreary three years and ignited a new capital boom.
But give due credit to House taxmeister Bill Thomas for crafting important pro-growth legislation to reduce tax burdens on all kinds of capital formation. Also give credit to Alan Greenspan & Co. The central bankers provided the necessary liquidity to finance these new investment tax incentives.
Of course, demand-side pessimists think these tax-cut effects will wear off in another quarter or two. But they'll be proven wrong because they do not understand the incentive model that rewards additional work, risk, and investment when all three get paid more after-tax. This inflation-free economic boom, bolstered by continued technology advances in broadband and Internet services, could last seven to ten years just like the prior two booms of the 1980s and 1990s. Just think of it.
Larry Kudlow, NRO's Economics Editor, is CEO of Kudlow & Co. and host with Jim Cramer of CNBC's Kudlow & Cramer.