Downdraft

National Review, Oct 12, 1998 by Lawrence A. Kudlow

Prices are falling, and so are other economic indicators. What to do?

The stock-market decline is sending a message. So are other crucial economic indicators. But both congressional Republicans and the Clinton Administration seem bent on ignoring the looming signs of an economic slowdown. It's as if Team Clinton, reminiscent of the Nixon Administration in so many other ways, now wants a recession to make the match complete.

Consider the economic landscape. Corporate earnings are now dropping because prices are falling faster than productivity is rising. Productivity-adjusted wages, measured as unit labor costs, are well in hand, rising only 1.3 per cent over the past year. But commodity price indexes have sunk 20 per cent over the past year; hence unit profits have dropped 5 per cent.

The August producer-price report shows that crude material prices have fallen 12 per cent during the past 12 months, with an annualized rate of decline of 28 per cent for August alone. These price declines wipe out profits and inhibit production. Over time, declining production leads to weaker consumption. It is precisely this slowdown that is being factored into the stock market in the form of lower share prices and contracting multiples.

Industrial production and durable-goods orders have flattened out, following hefty gains in 1996 and 1997. The Purchasing Managers Manufacturing Index has dropped below 50 per cent over the past three months, signaling no better than 2 per cent growth ahead.

One antidote to deflation is an easier monetary policy. Fortunately, Federal Reserve Board Chairman Alan Greenspan has recently opened the door to an easing strategy, primarily aimed at ameliorating an international scene beset by currency collapses, dollar liquidity shortages, and a widespread credit crunch. But the message of the U.S. stock market, down 20 to 25 per cent over the past two months, suggests that Fed policy must also be directed at domestic deflation, which is weakening our economy here at home.

The Fed should quickly increase high-powered dollar liquidity by lowering the Fed-funds rate by 50 basis points (from 5 1/2 per cent to 5 per cent) and dropping the discount rate by 100 basis points (from 5 per cent to 4 per cent). The discount-rate drop would set the stage for another Fed-funds decline to 4 1/2 per cent if the first move does not stop commodity prices from falling.

But Congress and the Administration must be willing to do their part: more plentiful money must go hand in hand with tax cuts. Lower tax rates would reinvigorate economic incentives; the last income-tax cut was way back in 1986. Higher economic returns will induce individuals and businesses to take more risks and produce more goods, balancing extra money supplied by the Fed with more output produced by the entrepreneurial private economy.

Personal tax payments as a share of wage and salary income have risen to an average of 26.5 per cent, a drag on work effort and consumer spending that has increased by nearly 20 per cent over the past three years. As a corollary, the federal revenue bite on GDP has moved above 20 per cent, a record. This could be another danger sign, as an unprecedented volume of resources is being drained from the private economy.

One key reason for this is tax-bracket creep. In our excessively progressive income-tax system, as real incomes rise because of hard work, middle-income people are being pushed up from the 15 per cent tax bracket to the 28 per cent bracket. Someone who gets a raise from $27,000 to $30,000 retains only 72 per cent of the added income, or $2,160, instead of the 85 per cent (or $2,550) that he would have retained if he had not crossed into a higher tax bracket.

Meanwhile, the combined federal, state, and local tax burden works out to $9,939 for every man, woman, and child. This, according to the Tax Foundation, is greater than per-person spending on food ($2,537), clothing ($1,360), and shelter ($5,623) combined. On the business side the story is similar. Over the past five years corporate taxes have increased 7.7 per cent per year, while nominal dollar GDP has expanded at a 5.2 per cent average pace. Hence business taxes have grown nearly 50 per cent faster than the economy.

And there's still another tax drag: the primary budget surplus over the past 12 months has exploded to $300 billion (this figure excludes interest payments on the federal debt, because they circulate and flow back through the economy). The $300-billion surplus is a huge drain on private resources, accounting for nearly 4 per cent of GDP. With a $300-billion surplus, even an honest Keynesian would cut taxes.

But President Clinton isn't interested. He jolted the stock market with his recent speech in Orlando, Florida, when he slammed the door on tax cuts and insisted that the Federal Government will permanently claim the $300-billion primary surplus. What's more, his mantra that budget surpluses must be used to fund Social Security, not tax cuts, is an extraordinary exercise in cognitive dissonance, even for someone so practiced in the art. There is, of course, no separate or sequestered Social Security fund, since the program is a transfer system, not a fully funded free-standing pension plan. Trust-fund surpluses are automatically turned over to the Treasury for general government spending.