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Jewish World Review Dec. 12, 2000/ 15 Kislev 5761

Lawrence Kudlow

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No recession yet -- THIS YEAR'S sinking stock market -- the worst since the bear market of 1990 -- has sent up economic red flags that recession may be just around the corner.

Surely there will be another recession -- defined as an outright decline in the overall level of economic activity for at least two quarters -- in my lifetime. But as yet I do not see one coming next year. That said, my relatively optimistic view would be bolstered if government tax, money and regulatory policies tilted away from austerity and back toward growth. More on that later.

Certainly, however, recent economic numbers show that prosperity is looking a bit long in the tooth. Car, computer and home sales have slowed markedly. Factory orders for electronic equipment (read information technology) are down. Industrial manufacturing activity has contracted slightly for three of the last four months. Early holiday sales look to be slower than last year. Consumer confidence is faltering. Jobless claims are on the rise. Estimates of future business profits have been halved. Third quarter GDP growth came in at 2.4% annualized, the slowest pace in four years.

The tech-heavy Nasdaq index has been clobbered since last summer, losing 33% of its value. Year-to-date the index is off 30%, after tripling between October 1998 (the last major downturn) and March of this year (it's peak). However, it should be noted that even at current levels the Nasdaq has grown 70% from two years ago.

Other major equity indexes have fared relatively better, but still down on the year. The more old-economy Dow Jones industrial average and the broader S&P 500 have lost 7% year-to-date. Bear markets are normally defined as a 20% loss for an extended time period, say six months or longer. So the Nasdaq would certainly qualify, but the Dow and the S&P would not, at least so far. Ditto for the all-encompassing Wilshire 5000, an index closely monitored by the Federal Reserve, where the loss this year has been nearly 10%.

Official bear market or not, the roughly one hundred million members of the new Investor Class who own shares have not fared well this year. By rough estimates shareholders have lost about $1.5 trillion in wealth this year, and it is this declining wealth effect that leads some economists to predict recession next year.

However, let's not forget that the vast majority of Investor Class shareholders are in for long-term retirement purposes, not short-run spending. What's more, as a result of low inflation and high investment returns, the consumption share of household wealth has been declining for twenty years. So day-to-day spending from stock market wealth is an over-rated economic point. Also, remember that as a proxy for stock market wealth the S&P index has increased three-fold since 1990, and overall household net worth has grown by a net of about $22 trillion since then.

Without dismissing the wealth effect entirely, there are better economic explanations that suggest we are heading for a temporary slowdown rather than a prolonged slump. One is the so-called Y2K-effect, where consumers and businesses spent heavily to purchase new computers, software and other information tech equipment ahead of the January 1, 2000 century date change. But massive expenditures made last year and earlier this year were borrowed from normal spending patterns for the rest of this year and 2001.

Similarly, sales revenue and profit growth of many technology companies were also temporarily boosted by the Y2K-effect, as were their share prices. However, as revenues and profits descend toward more normal trends, so have their stock prices.

In other words, the Y2K booster rocket on economic growth and stock prices was temporary. Between the end of 1998 and mid-2000, real GDP growth increased at a 5.1% annual rate, nearly a full percentage point above the economy's five-year trend growth rate of 4.4% per year. As the Y2K-effect wears off over the next six quarters stretching to the end of 2001, a 3% GDP growth rate -- including a couple of 2% quarters -- would actually be consistent with the economy's longer-term 4% potential to grow. Unfortunately, the temporary growth correction, which from peak to trough on a quarterly basis might be 6% to 1%, may at times feel like a recession when in fact the underlying long-run prosperity cycle is still intact.

The principal economic danger at this point is Federal Reserve monetary policy, which was overly accommodative to the Y2K-effect last year, but has turned excessively restrictive this year. The Fed supplied high-powered money at a 16% rate in 1999, but the yearly rate of liquidity provision has nose-dived to 1% recently. This money deflation has already had a big impact on the stock market and the economy. Both will be dragged lower unless the central bank shifts gears. Quickly. At the next FOMC meeting December 19th -- the day after the Electoral College is scheduled to meet.

Despite clear disinflationary signals from commodity and financial markets, where gold and bond market rates have been falling and the exchange value of the dollar has been rising, the Fed stubbornly keeps its fed funds policy rate at 6˝%. Serious credit strains are unfolding in the high-yield junk bond market and parts of the banking system as a result of the Fed-induced liquidity shortage, yet monetary policymakers persist in their mistaken belief that low unemployment causes rising inflation. If the Fed would discard its Phillips curve and embrace inflation-sensitive market prices as a policy guide, then the fed funds rate could drop a percentage point in the next few months without endangering the goal of domestic price stability.

As it is, third quarter inflation registered only 1.9% on the GDP price index. The virtual absence of inflation is a big plus for the future economy. Recessions are almost always preceded by large inflation spikes, such as the 12-to-13% inflation rates that came before the 1973-75 and 1979-82 downturns, and the 6% inflation rates that led to recessions in 1969-70 and 1990-91.

Big inflation increases create an economywide tax hike effect, reducing the usefulness and buying power of money. It's a tax hike on money. Big interest rate increases resulting from inflation turn off the credit spigots, raise financing costs, reduce investment demands, and compress stock market multiples. Inflation also penalizes investment risk and wealth-creation by raising the effective tax-rate on unindexed capital gains derived from the sale of stocks and other assets. Inflation is the most powerful recession-inducer.

But the absence of inflation today leaves the economy more resilient and flexible than in past cycles. It would probably take a 5% to 6% inflation rate to cause recession. The probability of this is exceedingly remote.

Remember also that while technology stocks have suffered of late, huge technology investment in the economy in recent years will continue to throw off significant productivity gains in the future. Right now output per hour is rising at nearly 5% among nonfarm businesses and nearly 8% in manufacturing.

Also, rapid innovation rates, including more powerful bandwidth, and numerous wireless appliances connected to the Internet, and rapid diffusion rates, i.e., the mass consumerization of information tech and its applications, will continue to thrust the economy fast-forward. Long waves of technological advance produce above-average growth, productivity, profits and stock market returns, with below-average inflation and interest rates.

Low inflation, King dollar and the technology-induced productivity rise act as shock absorbers to cushion the impact of things like temporary energy price hikes, Y2K transition, or even Fed tightening actions.

But there are, however, two other prosperity threats that must be addressed if we are to maximize our economic growth. After-tax economic incentives have been weakened by rising tax burdens, as successful earners have been pushed into higher marginal tax-rate brackets. As a result of record personal tax collections, whose share of personal income has moved up to 16%, a post WWII high, the ballooning federal budget surplus is acting as a fiscal drag on the economy. Add to this the tax-hike effect of higher energy prices, another economic depressant.

While personal tax collections increased $144 billion over the past year, personal savings fell $138 billion. So, in a massive resource transfer, overflowing government coffers are draining purchasing power from the private economy. Surpluses are up, but private saving is down from diminished take-home pay. And debt paydowns to wealthy bondholders and foreign governments provide no relief to the vast majority of the workforce, who do not own bonds.

Another prosperity threat comes from rising regulatory burdens. Overzealous regulation, particularly the Justice Department's anti-trust lawsuit to break up Microsoft earlier this year, blocks the supply of risk capital necessary to finance innovative technologies just as surely as big tax hikes or major inflation spikes.

It is no coincidence that the Nasdaq market peak last winter came nearly at the same time as the Microsoft break-up decision. Nor is it surprising that the reappearance of Microsoft-basher David Boise as Al Gore's chief election-contesting lawyer coincided with a vicious post-election Nasdaq sell-off (Boise as attorney general, trustbusting Oracle, Dell, Compaq, Sun Microsystems, et al?). Risk capital ran for the stock market exits.

It is axiomatic to economic forecasting that prosperity booms typically die from bad government policies rather than old age. Without the prosperity killers of high inflation, tax-rate spikes, massive over-regulation or protectionist trade barriers (a qualitative model created by eminent economist Arthur Laffer over two decades ago), the current long bull market wave of prosperity that stretches back to the early 1980s should continue for many years.

Come to think of it, with only a few modest policy turns in a business-friendly Bush administration toward incentive-refreshing cuts in marginal tax-rates, enhanced super-saver private investment accounts for retirement, greater substitution of market competition for government regulations and continued expansion of global free trade, then our noninflationary technology-backed and productivity-enhanced economic growth potential could be raised to 5%, and Nasdaq 10,000 will be well within range. Hold that thought, and keep the faith. Better times are coming.

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.


12/04/00:Slumbering spirits
09/19/00: Euroland Tax Revolt is Good for the Europe
08/24/00: Tax Cut Issue in Campaign
07/31/00: Mr.G., you’re gaining on it
07/26/00: Investor Class Rising
07/17/00: The rising tide of national prosperity is lifting all boats
07/11/00: On Soft landings
06/29/00: Is the sky falling?
06/21/00: Internet-more-important-than-Fed update
06/14/00: The judicial hacker
05/16/00: Front-View Windshield
05/09/00: Don't Overreact
05/05/00: Give it Back
05/01/00: Wealth and Capital
04/18/00: Growth, Freedom and the New Investor Class--Stay the course
04/13/00: Correct Value
03/28/00: Governments roil the Markets
03/28/00: Fed should keep its powder dry
03/14/00: Reduce Debt, Derail Economy
02/17/00: Unsettled
02/10/00: Bush's Footprints
01/25/00: To preserve its standing as the world's number one economic power
01/06/00: It's not the '70s
12/28/99: They missed it
12/23/99: Bonditos
12/20/99: Dracula's Curve
12/16/99: When Alan Greenspan sneezes, Wall Street economists catch cold
12/10/99: Y2K-Related Cash
11/23/99: Y2K Money: Inflationary or Not?
11/16/99: Investor Retaliation
11/05/99: Rosy Lives
10/29/99: Drain Reserves
10/22/99: Supply-Side Is Mainstream
10/14/99: Y2K will likely bring more prosperity
10/07/99: Clinton's tax-cut veto
10/01/99: What's really bugging the stock market?
09/23/99: Growth Trade
09/09/99: Bad Dollar Logic
09/09/99: Buttered bread
08/31/99: Bull Market Alive and Well
08/26/99: Let Prices Rule
08/19/99: Blame OPEC, Not Growth

©1999, Lawrence Kudlow