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Jewish World Review May 7, 2001/ 14 Iyar 5761

Lawrence Kudlow

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Bogus GDP -- FOLLOWING the release of last week's 223,000 job loss report, a White House statement said that President Bush is "very concerned about data suggesting that growth may not have even been the early report of 2% in the first quarter . . . that it is entirely possible that 2% growth be revised downward."

Got that right.

Look for deeper inventory cuts and additional markdowns in business investment spending. Alleged 2% growth was a false dawn.

And here's the key point: Contrary to what most economists tell us, GDP figures from the national income and product accounts certainly do not drive the economy. Nor, in many cases, do they even describe the economy accurately.

In fact, with growing frequency, the failure to account for the high-tech new economy, which is still sagging badly, and the Alice-in-Wonderland trade deficit accounting, should render the GDP data less, not more, important to discerning investors and government policymakers. At best, gross domestic product provides a sketchy picture of the past. But it's a frazzled, ragged, error-laden and incomplete picture.

A case in point is the recently released "advance" report of first quarter GDP. According to the Commerce Department, the economy expanded at a 2% annual rate during the January-March period, higher than consensus expectations and stronger than the anemic 1% pace of the prior October-December quarter.

But it was a bogus report. Eighty percent of the first quarter expansion resulted from a huge $43 billion decline of imports, the largest quarterly drop in the purchase of foreign goods since the 1991 recession.

Now, here's the GDP rub. In the wacky world of Keynesian trade deficit accounting, an import-plunging trade deficit decline adds to economic growth. This despite the obvious fact that a $22 billion drop in capital goods imports and a $20 billion fall in consumer goods imports are sure signs of a business and consumer slump.

Keynesian demand-siders believe that rising demands for international goods cause a reduction in the demand for domestic goods. In this static analysis, anything bought from overseas replaces spending and production (and jobs and income) at home. So trade deficits are bad for growth and trade surpluses are good for prosperity.

Trouble is, the only time the U.S. runs a balance in trade is during recessions. We reached this ignominious position during the recessions of '90-'91 and '80-'82. During those periods Americans did not import because their impoverished financial position prevented them from doing so. The logical conclusion of Keynesian trade deficit thinking is that recessions are great.

On the other hand, since the U.S. has been growing faster than the rest of the world for the better part of the past two decades, then of course we import more than we export and the trade deficit widens. Though in fact, as a measure of domestic prosperity, the level of both imports and exports has continued to rise.

Then there's the classic economic principle of comparative advantage. Why shouldn't American consumers buy low valued-added VCRs if they are produced efficiently and cheaply by foreign makers? Meanwhile, it is the U.S. that produces high-value goods such as software design packages.

Also, the trade deficit is a mirror image of our capital account surplus. Foreign investment inflows to the U.S. continue to break records, more than financing our trade gap. Testifying to U.S. prosperity during a trade deficit period, world capital always seeks the highest rate of return. Since the high-growth U.S. is producing big investment returns, trade deficits notwithstanding, foreigners continue to invest their cash in our entrepreneurial-friendly economy.

Even in Keynesian terms, if rising imports cause a loss in aggregate demand for home-produced goods, then a steady stream of rising investment inflows replaces the so-called lost demand. So it's a wash. Investment inflows cancel out the trade deficit.

So in GDP terms, let's cancel out the whole foreign trade sector. What's left is the category "gross domestic purchases." In the first quarter economic report, inflation-adjusted gross domestic purchases increased by a tiny 0.6% annualized rate, perilously close to a recessionary negative number, and much less than the 2 % average growth of last year's second half. The six-tenths of a percent rise in domestic GDP is the lowest reading since the recessionary first quarter of 1991.

Stock market investors have already discounted this virtual recession reading, and they are now anticipating an economic growth pick-up later this year and next. So in this sense the stock market is in much better shape than the economy.

But government policymakers should not assume any diminished need for tax-cut stimulus or additional Fed liquidity-enhancing interest rate cuts. Particularly on the fiscal side, the need for easier tax-rates on investment-sensitive top bracket incomes and capital gains is immediate. Meanwhile, monetary base growth has actually been shrinking at a 1.3% annual rate over the past three months. The longer policymakers delay on both taxes and money, the more prolonged will be the economic slump.

Providing additional liquidity and raising after-tax rewards for capital formation are the most urgent policy priorities. The U.S. economy is driven by ideas, innovations and risk-taking. It takes capital, especially venture capital, to commercialize and bring new ideas to the market. Then people all over the globe will benefit.

There's no GDP category for human creativity, or the economic freedom necessary to spawn that creativity. But creativity and freedom are exactly the driving forces behind the dynamic American model of growth.

Milton Friedman bluntly described it as capitalism and freedom. Joseph Schumpeter's technology-entrepreneurial model of growth described it as "gales of creative destruction" that transform and propel the economy toward prosperity. Friedrich Hayek observed that the market is a discovery process. But you won't discover it in GDP, a concept better suited for central planning than free enterprise.

JWR contributor Lawrence Kudlow is chief economist for CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


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©2001, Lawrence Kudlow