Kudlow Offers Upbeat Economic Outlook

Free-market economist Lawrence Kudlow no longer makes regular guest appearances on CNBC’s morning business show "Squawk Box," where, as the former Reagan administration adviser says, he used to like to challenge all the "lefties."

But Kudlow has plenty of other media places to spread his eco-optimism. He is host of "Kudlow & Company," which airs nightly on CNBC (5 p.m.) and a house economics commentator for CNBC. The CEO of Kudlow & Co., LLC, an economic and investment research firm in New York City, also host of his own blog, Kudlow Money Politic$. I talked to him Wednesday by telephone from his home in New York City.

Does the current stock market dip worry you at all?

No. This is a correction and it’s mostly based around inflated commodities, gold and raw materials and probably energy. The biggest factor is (new Federal Reserve Chairman Ben) Bernanke. He has regained his monetary manhood. For a couple months there, in February, March and April, he sounded like the Neville Chamberlain of monetary policy and inflation-fighting. He was people-pleasing all these Wall Street Keynesians who think the Fed should pause every time the numbers are soft. He’s stopped his thrust of his confirmation hearings — which is that price stability is the most important factor and that’s what creates a good economy. He lost that. He was off-message.

Then all of the sudden, in early May, the Fed started putting the word out. Governors of the Fed called me — I can’t tell you which ones, but they were very senior Fed governors — to tell me that Wall Street was misinterpreting them. Then, of course, it all capped this week with Bernanke’s talk to the IMF (International Monetary Fund), when he was very hawkish on inflation.

Is there anything to worry about this tightening?

No. Forward indicators — such as inflation-indexed bond spreads, gold and the cheap dollar — have been telling the Fed that they need to keep tightening and withdraw some excess cash from the economy. I would characterize it as a relatively minor problem, but it’s something they have to attend to. So now that you’ve seen the Fed go at it, the inflated stocks, particularly the commodity stocks, which were picking up this whiff of inflation, have sold off, by like 20 percent. Steel. Aluminum. … Your chemical companies, a little bit. Gold producers like Barrack and so forth all got slammed down because they were way overvalued based on the expectations of higher inflation.

What’s your advice to the average investor?

I’m an optimist. I think the American economy is very strong. I call it the "Greatest Story Never Told." I think that profits are strong. Productivity is strong. Job creation is strong. Tax rates are low. I think the outlook for the stock market and the economy is extremely positive. People should be in the market. Stocks are undervalued. And this expansion cycle will go on for I would say at least three or four more years.

How do you prove there is a boom?

Here’s something nobody talks about: Everybody obsesses about housing. Housing had to slow down because it had gone a little too far. But two things: No. 1, commercial corporate construction is surging and that is going to pick up a lot of the slack. No. 2, corporations are investing in capital goods and generally infrastructure expansion.

The point is, here’s what the Keynesians don’t understand: The economy is not driven by demand-side consumption. The economy is driven by supply-side business expansion. If business is healthy and profitable, as it is, then the economy is sound. … You can’t create a job without a business and you can’t expand your business without capital.

So look what’s happened. George W. Bush has slashed tax rates on capital, including dividends and capital gains. Profitability is at a post-World War II record high. That puts the business sector in a strong position for the next several years and that is where the job creation will come from and that’s where the incomes will come from and that’s where the consumption will come from.

You are a supply-sider — can you simply define what that means?

Supply-siders believe in the incentive model for growth. If it pays, after tax, to work and invest and take risks, then people will do so. After the economic and stock market plunge of the early part of the decade, Bush did exactly the right thing by slashing tax rates. So it now pays more at the margin to invest — and investment was the weakest link in the early part of the decade. … History proves that when you lower tax rates, asset prices go up. And that’s just what happened. The stock market has had a fine run — and it ain’t over yet. It can go up another 25 percent in the next few years.

Is the Bush administration doing anything to compromise this boom — is it still spending or borrowing too much?

No. The other part of this economic boom story is that at lower tax rates the expanding economy is throwing off higher tax revenue collections. So for all this whining and grousing and pessimism, the fact is, the budget deficit is coming down.

It’s going to be about 2 percent of GDP this year and it’ll probably be about 1.5 percent next year. Once again, it is a triumph of Reagan’s supply-side model. So, I don’t fret about any of that. Although I had been very critical of the president’s spending and his lack of veto, and the Republican Congress, which in some sense has lost its way — the last two Bush budgets have been lean.

You’re seeing now a slower growth rate of the non-entitlements. So that’s good. He finally figured it out.

I interviewed the president about a month ago. The fact is, I said to Bush, "A lot of conservatives think you’re the biggest spender since LBJ." He didn’t like that. But he said, "Look at what we’re doing now. Look at what we’re doing now." So better late than never.

We’ve seen booms before and they all fizzle out in some way.

Oh, I don’t know. Organically, in terms of the economy, you’re right: We’re not going to repeal the business cycle. We’re not going to repeal the credit cycle. But can I say, we’ve had essentially a 23-year boom that began in 1983.

In that whole period, we’ve only had six down quarters; two of the mildest recessions in American economic history. And this is going to continue and I’ll tell you why: Under Ronald Reagan, American market capitalism was rejuvenated by getting government out of the way with heavy doses of deregulation and lower tax rates. He unlocked entrepreneurial capitalism, so the results have been unbelievable.

What was the basic Reagan model? Low tax rates and a strong dollar. The Bush model has been low tax rates but a soft dollar. Now that dollar has to be corrected by Bernanke and Henry Paulson, the new Treasury man. I believe they are going to do that. That’s why you’re getting this market correction.

The Fed is going to drain some more cash from the economy. Which means short-term interest rates will go up a little more — probably about 50 basis points, that’s all. We’re getting close to the end. But that’s why commodities are selling off. And actually, even though it has shaken the market up, because commodities were the leader, it’s a good thing because it means inflation is going to stay low for the next five years.

What they do now will impact this story for five years.