What’s Going On With the Economy?

© 2002 Copley News Service, 5/8/2002

The statistics tell us that the U.S. economy is in a recovery. But all this happy talk out of Washington is way over the top.

National output of goods and services, as measured by gross domestic product, is growing rapidly – 5.8 percent annually in the first quarter after correcting for inflation. Most economists also assure us that rapid economic expansion is sustainable beyond this recovery burst. According to the March Blue Chip Consensus Economic Report, “The pace of U.S. economic growth appears to be rebounding at a remarkably rapid pace.” The consensus forecast is for real GDP to grow at 3.7 percent for the remainder of this year and to expand by 3.6 percent in 2003.

But we may be in for a much longer economic convalescence than conventional wisdom now holds. More than half the first-quarter growth is attributable to companies replenishing their inventories after the recession. Another quarter of the growth is attributable to a dramatic spike in government spending in the aftermath of Sept. 11, which is more than twice the government’s contribution to GDP growth during 1999 and 2000. Vibrant long-term economic expansions are not built on a foundation of inventory replenishment, and continued increases in government spending at current rates will actually undermine the economy’s health.

Last Friday, the Labor Department reported that the unemployment rate rose to 6 percent in April, the highest in seven and one-half years. We know unemployment is a lagging indicator of the economy’s health, but this report is troublesome considering that the quintessential leading economic indicator, the stock market, has been dead in the water for months.

Looking back over the past year, both the Dow and Nasdaq have basically moved sideways. The Nasdaq rose above 2,000 for the first time at the end of 1998, and the Dow followed suit, rising above 10,000 for the first time early in 1999. Today, the Dow stands below 10,000 and the Nasdaq appears headed for 1,500. Information technology spending is depressed, and telecom is heavily in debt.

The reason the stock market is not signaling a robust expansion is that the outlook for business profits is dismal. The Wall Street Journal reports, for example, that the 1,146 U.S. companies comprising the Dow Jones Global Market Index experienced a net loss of $3.2 billion during the first quarter. These companies haven’t been collectively in the red since the first quarter of 1992, when the economy was still running in place after the 1990-91 recession. With profits down, investors’ after-tax returns to capital, especially in the technology sector, remain depressed.

Add to this uncertainty the disquiet created by recent revelations about corporate accounting practices and you have the makings of a crisis of confidence by investors and lenders. With the outlook for after-tax profits this uncertain, banks will be reluctant to lend and companies are not likely to go on a hiring spree, nor are corporations and entrepreneurs likely to risk making the kinds of investments that would revive the technology sector and the rest of the economy.

Free-market economies are remarkably resilient, able to overcome enormous obstacles thrown in their paths by wrong-headed government policies when they are operating at peak performance. Adam Smith was correct when he observed that, “The uniform, constant and uninterrupted effort of every man to better his condition . . . is frequently powerful enough to maintain the natural progress of things toward improvement, in spite both of the extravagance of government and of the greatest errors of administration.”

But notice that Smith said “frequently” – not “always.” When the debilitating effects of burdensome tax and regulatory policies accumulate or when monetary policy goes bad, as it did with the deflation of the recent past, even the strongest economy will be brought to its knees, just as the American economy was in 2001.

When that happens, policies that formerly were merely annoying become debilitating. And policy reforms – such as the Bush tax rate reductions – that were sufficient at the time become inadequate in light of altered circumstance to revive economic growth to previous levels. Simply making the temporary tax cuts of last year permanent is woefully inadequate.

Before we see a real long-term recovery take hold again, after-tax returns to capital and labor must rise. Cost-cutting and productivity enhancements will help, but the biggest burden on saving, investing, working and entrepreneurial risk-taking continues to be the federal tax code, which is impossibly complex, outrageously expensive, overly intrusive, economically destructive and manifestly unfair.