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Press Release

5.8 Percent


Last Friday’s news that U.S. economic output surged by 5.8 percent in the first three months of 2002 was welcomed by President Bush with guarded optimism. Although the economic rebound was greater than anticipated by many in the administration, not all of the news was good. Business investment, the key to the historic growth of the late 1990s, fell for a fifth consecutive quarter and consumer spending, which accounts for two-thirds of Gross Domestic Product (GDP), actually fell by 2.6 percent from the previous quarter.

As Philadelphia Federal Reserve Bank President Anthony Santomero has noted, much of the growth was caused by the most dramatic increase in government spending in 40 years. Following the 9/11 terrorist attacks, Congress authorized $40 billion in spending for redevelopment and increased military spending by 19.6 percent. So in many ways, to describe Friday’s number as a 5.8 percent increase in “economic growth” is misleading. It would be more accurate, although more of a mouthful, to describe it as a 5.8 percent increase in the most common statistical measure of the economy’s size.

Increases in government spending will increase GDP in the short-term because government spending accounts for roughly one-fifth of GDP. But since government must confiscate resources from taxpayers and debt markets to finance its outlays, government spending increases impede long run economic growth by misallocating resources that would be better utilized in the private sector. Thus, Friday’s news that the GDP increase was fueled by government growth was ominous news.

Cognizant of this fact, the Bush administration used the weekend to continue its push for Trade Promotion Authority and the permanent implementation of the tax cut passed last June. Uncharacteristic for an incumbent politician, Bush actually emphasized some of Friday’s bad news to make his case: Beyond the prolonged lull in business investment and more modest consumer spending, the stock market also shows signs of weakness and corporate earnings continue to disappoint. Last week, the Dow Jones Industrial average fell by 350 points and finished under 10,000 for the first time since mid-February.

Although stock market performance is often a useful indicator of underlying economic activity, many macroeconomists argue that this was the shortest recession in history because of the money lost by stockholders and venture capitalists. While no one would suggest that the $4 trillion loss in paper wealth helped the economy, the fact that the loss was not concentrated among banks and other lending institutions softened the blow. Commercial banks remained well capitalized through the stock market plunge and subsequent recession; when coupled with the easing cycle of the Federal Reserve, this allowed for strong growth in commercial loans for new homes, cars, and home improvements and appliances.

While healthy bank balance sheets and consumer spending kept the recession short and mild, the incentives to borrow and buy are beginning to peter out. Mortgage rates and car loans are edging upward, and much data indicates that the growth was largely a one-time response to attractive financing terms. Moreover, the slowdown in inventory liquidation by businesses – another one-time event – contributed 3.1 percent to GDP growth. During the recession, businesses cut output and offered huge discounts to rid themselves of higher-than-expected inventories. This process slowed in 2002 as unsold goods declined in quantity and businesses no longer felt the need to slash prices to rid themselves of inventories.

Things have improved, but by how much is anyone’s guess. If policymakers could possess enough information to enact policies to guarantee economic growth, the Soviet Union would still be alive and well today. But, with that in mind, here is a list of five policies the Bush administration should pursue to ensure that Friday’s optimism is not fleeting:

  1. Make the Bush Tax Cut Permanent- The tax cut from last June helped to blunt the severity of the recession, but the economic effect of the rate reductions and death tax repeal will not be felt until the entire tax cut package is made permanent. Effective tax policy increases incentives for wealth creation. Temporary tax cuts fail to change incentives and do little to contribute to growth.
  2. Call off the Dogs at Congress, the Securities and Exchange Commission (SEC), and the New York Attorney General’s Office- The fallout from the Enron debacle has gripped Wall Street with panic. Unfortunately, most of that panic emanates from concerns about what regulators and over-zealous public officials will do to “restore trust.” With no sense of irony, Congress is considering the creation of a new public-private bureaucracy to monitor accounting practices to replace the current public-private bureaucracy already in place. New regulations will put inordinate burdens on accountants and their clients, increase costs for consumers, and do little to increase the quality of financial information available to investors. Worse, this action comes as the SEC launches almost daily investigations into corporate accounting. Most of these investigations have been fruitless, but have sent stock prices tumbling nonetheless. Worst of all, New York Attorney General Eliot Spitzer is looking to prosecute Merrill Lynch and other investment banking firms for using their research departments to help attract investors for their clients. While this practice has been commonplace since the beginning of modern finance, there is abundant evidence to indicate that those investors who listen to the recommendations of top analysts have done quite well.

    As long as these incursions on well-functioning private markets continue, so too will the current market dislocation, leaving market movements entirely unpredictable and unstable.

  3. Deregulate and Allow for Consolidation in the Telecom Sector- No part of the economy suffers from greater overcapacity, or worse conditions for growth, than telecommunications. The Bush administration and the Federal Communications Commission (FCC) should act to quickly approve the proposed mergers of Comcast-AT&T Broadband and Hughes Electronics-EchoStar to allow for more efficient administration of these existing resources. The FCC should also deregulate the high-speed Internet offerings of local telephone companies to provide incentives for much needed capital expenditures. These companies possess the cash flow and access to debt necessary to resurrect demand for network equipment.
  4. Treat Spending Cuts Like the Priority They Are- Spending cuts have not been in vogue since the Republicans took control of both Houses of Congress in 1995. Today, pork-barrel projects and new spending initiatives threaten to siphon much needed capital from private markets. Politicians need to realize that entrepreneurs, consumers, and corporations will make use of each dollar not appropriated for government spending. No one can seriously believe that government can allocate resources more efficiently than these private actors, but politicians have lost the stomach for the spending restraint that helped to produce the economic boom of the late 1990s.
  5. Call on Congress to Enact Legislation to grant Fifth Amendment protection for “Regulatory Takings”- Last week, the Supreme Court weakened the 5th Amendment’s “just and fair compensation” provision by ruling that property owners do not need to be compensated for government-imposed moratoriums on development. If property rights only exist until someone can manufacture an argument for why they should not, no one will be willing to invest in productive assets, property, or commercial development. In the majority opinion, Justice John Paul Stevens invited Congress to change this current deficiency in the law, and Congress should do so expeditiously. Nothing is more threatening to incentives for wealth creation and economic growth than the specter of government expropriation of private resources. Just as no oil company is willing to invest in countries that have nationalized their oil industry and robbed shareholders of their investments, regulatory restrictions on private uses of property will make investors reluctant to commit discretionary capital. As this capital dries up, so, too, will economic growth.

Friday’s growth figure may turn out to be an aberration caused by an inordinate increase in government spending and a slowdown in inventory liquidation, but if Congress and the administration pursue the above policies, a robust economic expansion could continue. By taking steps to relieve American entrepreneurs of unnecessary burdens and disincentives, policymakers could foster the very growth that they are so fond of taking credit for at election time.