Debunking Krugman's Recession

Paul Krugman is pessimistic about the economy — which is not necessarily breaking news. But it never hurts to check in with one of the more bleak economic prognosticators of our day. What’s Krugman worrying about now?

Krugman points to the fact that interest rates on long-term bonds have fallen below rates on short-term paper as evidence that we’re headed for economic trouble. This circumstance is otherwise known as an inverted Treasury yield curve, and I actually agree with Krugman that it’s more proof the Federal Reserve is too tight.

Indeed, the yield curve is predicting continued economic softness, as is the current decline in the exchange rate of the U.S. dollar. But the central bank’s benchmark interest rate of 5.25 percent is simply too high. Fed chair Ben Bernanke would be justified to lower it to 4.75 percent, or even 4.5 percent.

That said, I disagree with Krugman’s conclusions about the record-breaking stock market. The New York Times columnist believes stocks are "a notoriously bad indicator of the economy’s direction," and he cites Nobel laureate Paul Samuelson, who once quipped that the stock market had predicted nine out of the last five recessions.

As I’ve discussed on CNBC’s "Kudlow & Co.," the strong, across-the-board, five-month rally in stocks cannot possibly be predicting a recession. While the stock market can sometimes emit false positives on recessions, rarely does it give off false negatives. In fact, I think it is predicting a "Goldilocks" soft-landing for the economy.

A glaring omission from Krugman’s analysis is the staggering rise in corporate profits. These are the tax-return profits recorded for the IRS, and rest assured that no CFO overestimates them. Corporate pre-tax profits are up a remarkable 31 percent through the third quarter — 25 percent after tax. Profits are the mother’s milk of business and the economy, and these days we’re talking a serious amount of milk.

A question for Krugman: When in the history of humankind have we had a recession when business profits are rising by 30 percent?

Profitable U.S. businesses clearly have the resources to grow their operations and continue hiring new workers. This, in turn, is the biggest factor sustaining the historically low 4.4 percent unemployment rate, as well as the strong gains in jobs and consumer incomes.

Over the past three months, corporate payrolls have increased by an average of 157,000. The number of individuals employed as measured by the Labor Department’s household survey has grown by an average of 319,000 during this period. It’s no surprise that these job gains have significantly increased personal incomes, which in turn have pushed real consumer spending roughly 3 percent at an annual rate above the third-quarter average. All of this bodes well for the fourth quarter, which could deliver a decent GDP growth rate.

Meanwhile, inflation readings continue to ease. Following tighter Fed money and a plunge in energy prices, the overall consumer price index has dropped to 1.3 percent over the past year. This equates with even more purchasing power for consumers in the malls and on the Internet for the holiday shopping season. What’s more, the big rally in homebuilder stocks suggests that the economic drag from housing is starting to peter out.

Markets are better forecasters than economic pundits and the models they cite. Rising stocks — helped along by lower energy prices, spectacular profits and rock-bottom tax rates on capital — are telling us that a soft-landing growth scenario is in the works for next year. Lower bond rates are saying we can bank on lower inflation and an easier Fed in 2007.

I’m still betting on Goldilocks.


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