Misunderstanding the Thick Haze of Economics

It is now clear that the fog of war and a rise in energy prices threaten to block the economy from any significant upward movement this year. The current economy appears to be growing just short of 2% in real terms (or inflation-adjusted). That’s unacceptably low growth.

The U.S. government doesn’t update gross domestic product on a monthly basis, but these estimates-based on growth rates of industrial production and personal income-are reasonable proxies for GDP. And in a recovering economy, GDP should be running closer to 5%.

A relatively swift resolution of the ongoing invasion of Baghdad and the forcible removal of Saddam Hussein’s regime over the next few weeks would certainly be a plus for U.S. business and job conditions. A newly privatized free-market oil sector in Iraq-one that could end the Saudi/OPEC hegemony over oil prices and production-would translate to falling power prices and contribute a tax-cut effect to the U.S. economy (even though such a development would be several years off).

But the critical element to putting this economy back on the path of vibrant growth is domestic economic policy. Washington must shift toward easier tax rates and maintain a program of accommodative money in order to rebuild decimated stock market wealth and reinvigorate investment in job-creating capital goods.

Recent increases in commodity prices, including gold, suggest that the Federal Reserve is doing its job on the monetary side. Deflation has been halted. But Greenspan & Co. must keep pouring sufficient quantities of new cash into the pipeline to ensure that there’s enough liquidity to fund more rapid economic growth.

Need For Tax Cuts

That said, the determining factor in a growth revival for next year is likely to be President Bush’s proposal to reduce personal tax rates and eliminate investor dividend taxes. Senate Republicans now need to organize a working majority to match GOP approval of the president’s plan in the House.

To do this, they should employ the argument that the tax cuts now on the table will ameliorate the capital shortage that is holding back business expansion. In addition, they must make the case that war costs are best financed by revenues streaming into the government as a result of an economic growth-shift in the direction of full employment.

Two presidents in recent history understood this argument well.

John F. Kennedy reduced marginal tax rates during the buildup to the Vietnam War. His Republican treasury secretary, Douglas Dillon, successfully pushed Kennedy in the direction of lower taxation and a stable dollar-economic growth policies that would be critical to halting postwar Soviet aggression around the world. When Johnson and Nixon raised taxes and sunk the dollar, they provided the Soviets with a dangerous opening for global dominance.

Roughly 20 years after the Kennedy/Dillon tax cut, Ronald Reagan employed exactly the same low-tax/strong-dollar strategy to revive the American economy in the run-up to his successful campaign to overturn Soviet communism.

The linkage between domestic economic growth and foreign policy is still poorly understood. But it is a vital connection both symbolically and financially. Significant world influence accrues to the most powerful economic nations. And the most powerful economies become models worldwide.

It’s a very good bet that our free-market system of capitalism will have an exemplary impact on countries in the Middle East and elsewhere who are attempting to liberalize their political and economic systems.

Last week, short-sighted Republicans and moderate Democrats in the Senate voted to slash President Bush’s tax-cut plan by half. (Stock market averages plummeted on the news.)

These senators should reconsider their position. A continuation of 2% or less economic growth will widen the budget deficit, not reduce it. Even worse, if these senators get their way and shift war-cost receipts and Social Security revenues into phony lockboxes-an unenforceable sequestration-they will only contribute to higher spending, slower growth and wider deficits.

President Bush’s former economic chief Glenn Hubbard has said recently that America will not realize its full potential to grow unless Congress embraces the pro-growth tax-reform plan now under discussion. He is exactly right. But he might have added that a successful foreign policy begins right here at home with a strong economic growth strategy.

Right now, there is a thick haze of economic misunderstanding in Washington, and it’s just as demoralizing as the fog of war.