December 09, 2005,
The economic indicators are painting a very bullish picture of the U.S. economy. In fact, the ongoing flow of good-news data has led President Bush to proclaim that the U.S. economy continues to gain strength and momentum, “thanks to good old-fashioned American hard work and productivity innovation, and sound economic policies of cutting taxes and restraining spending.” Fifty percent sound economic policy (in particular lower tax rates) is better than nothing.
The U.S. economy grew faster during the third quarter of 2005 than initially thought. The seasonally adjusted annual growth rate of 4.3 percent was much stronger than the 3.8 percent estimated a month ago, and it marks the tenth consecutive quarter in which real GDP has grown faster than its 20-year average of 3.2 percent. At the same time, inflation gauges were revised slightly lower. The personal consumption expenditure (PCE) price gauge, the inflation yardstick favored by the Federal Reserve, rose only 1.2 percent, a figure lower than previous estimates.
Meanwhile, companies in the S&P 500 have reported double-digit increases in corporate profits for a record twelve consecutive quarters. As for the dollar, it has gained 31 percent against the euro and 17 percent against the yen.
If the president heeded his own advice of spending restraint, he would preempt the solution to the deficit that is favored by the deficit mongers tax increases. Unfortunately, the president has not done so and, as a result, the possible extension and permanency of the 15 percent tax rates on dividends and capital gains may be in danger.
The irony of all this is that if the lower tax rates set in 2003 are allowed to expire, there will be a pick-up in economic activity in anticipation of the expirations. On the other hand, if the tax-rate cuts are made permanent, the current positive economic environment will remain in place, and so will the robust growth.
Either way, the outcome is an above-average growth rate for the coming year. But I would still favor tax-cut extensions, and more of the current economic environment, over no extensions and a short-lived false prosperity.
Critics of the president’s low-tax-rate policies do not seem to understand the power of incentives. Some argue that rising home values and the cash taken out as homeowners refinance have been the driving forces behind U.S. consumer spending. They worry that if housing prices slow down, a spending slide will follow, the implication being that a housing decline will lead to a recession. I don’t disagree with the latter statement, but my reasoning is a bit different than most.
Housing in the U.S. is a leveraged, tax-advantaged activity. You can buy a house on margin, say with 20 percent down, while the cost of carry mortgage payments is tax deductible. Clearly, tax treatment has made home owning very attractive. But the sustained rise in asset prices has to do with the underlying economic environment. As long as the basic incentive structure remains in the economy, there is no reason to suspect that housing prices will not exhibit a positive long-term trend and continue to be a great investment. The argument for long-run home ownership is even stronger than the one Jeremy Siegel makes famous in his book, Stocks for the Long Run.
The inflation outlook is also quite bullish. The incoming Fed chairman, Ben Bernanke, has made clear that he supports explicit inflation targeting. Perhaps now the price rule will get the formal recognition it deserves. This is not a knock on retiring chairman Alan Greenspan, who has done an extraordinary job. During his tenure, the inflation rate steadily declined to the 2 percent target range. In spite of the rise in the price of gold, oil, and other commodities, and the large swings in the foreign exchange value of the dollar, the U.S. inflation rate has remained quite tame. But when the price rule is in effect, it will do the job of managing the inflation rate while the traditional inflation indicators will fluctuate for reasons other than inflation (i.e., real rate fluctuations, higher uncertainty, etc.).
The one major source of uncertainty in the economy is the low tax rates that are about to expire. If lawmakers in Washington fail to act, at least we’ll see one more year of solid growth. But what a shame it will be to see this economic run suffer because politicians couldn’t extend a tax-cut policy that has proven without question to be a winner.
Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.