Economic Recovery Depends on Tax Cuts

Suddenly America’s consumers are running scared—scared of possible terror attacks, scared that their jobs might not be there when they turn up for work in the morning, scared that the pensions on which they were relying to convert their declining days into golden years won’t be there. Most consumers may not be experts in the arcane subject of analyzing national statistical data, but they are pretty good at figuring out that the soaring cost of fueling their cars and heating their homes leaves less for them to spend on other things, and that the relatively benign national unemployment figure of 5.7 percent somehow doesn’t capture everything that is going on in the jobs market.

Since consumer spending has kept the economy from slipping into recession, this new, creeping fear is causing the President to redouble his efforts to get Congress to act on his package of tax cuts.

That, according to Harvard professor Martin Feldstein, leading economic guru to many of the Bush team, is the right way to go. Writing in The Wall Street Journal, Feldstein points out that the shift from budget surplus to budget deficit last year added $225 billion to aggregate demand and contributed to the 2.7 percent growth rate achieved in 2002. Unless Congress gives the President what he is asking for, that boost will amount to only a measly $32 billion this year, less than 0.3 percent of GDP, and shopkeepers around the country will find their stores as empty as they were during the recent blizzards that paralyzed a good part of the country.

Larry Lindsey, the former White House economic adviser who has returned to the private sector, where candor is more of a virtue than in his previous incarnation, has a pretty good track record. Readers may recall that when the Dow was around 10,000, I reported that Lindsey shocked my dinner guests by predicting that it would hit 8,000 by November 2002, on its way south. Well, Lindsey last week ruined another of our dinner parties by predicting a further 20 percent drop in share prices before they level out—with no bounce from that level in sight.

In a privately circulated memorandum, Lindsey starts with the proposition that “Households are not seeing their incomes rise enough to maintain spending growth at an acceptable pace.” The arithmetic is compelling and worth following. Incomes are rising at a rate that will put $328 billion more in consumers’ pockets. At current personal tax rates, $40 billion of that increase will go to the government. Rising energy costs and modest inflation in the basket of other goods consumers buy will claim another $207 billion, leaving consumers with only $81 billion, not enough even to allow them to increase their savings by as much as they did in 2002. “Iraq is the beginning of the economy’s problems, not the end,” Lindsey concludes.

It is true, of course, that with the exception of auto sales, which were down 6.7 percent from year-earlier levels, consumer spending in January showed its biggest increase since September of 2000. So some analysts believe that consumers are not yet prepared to start the long process of rebuilding the wealth they have lost in the stock market melt-down that has seen the NASDAQ index of high-tech stocks fall by about 80 percent from its peak. (If you have a taste for macabre celebrations, you should know that today is the third anniversary of the NASDAQ peak.) According to those who feel there is life left in the consumer sector, the huge sums still flowing to consumers from the remortgaging of their houses will provide funds for more purchases of cars, houses, furnishings and other goods.

But home prices are not expected to keep rising at recent rates—33 percent in the past four years—and many consumers who could benefit by refinancing at lower interest rates have already done so. Federal Reserve Board chairman Alan Greenspan estimates that in 2002 homeowners “cashed out” almost $200 billion of the rising equity in their homes, and pocketed an additional $350 billion in capital gains on sales of their houses. That source of funds is unlikely to reach 2002 levels this year.

There is worse. Many of the refinancings were done on a short-term basis, with interest rates subject to annual adjustments. Should the swift and successful conclusion of the war with Iraq persuade businessmen to begin investing in plant and equipment, interest rates are likely to rise. And so will homeowners’ monthly mortgage payments. This has the pessimists saying that any economic recovery contains the seeds of its own destruction, since any rise in interest rates would make the current level of mortgage debt unsustainable, leading to defaults and strains on the nation’s banks and mortgage lenders.

Meanwhile, those waiting for a share-price rebound are likely to be disappointed. America’s economy is now one in which producers have little pricing power. From airline tickets to trainers, from hotel rooms to apparel, competition is keeping prices down and the Internet is helping consumers to find bargains. Profits will be hard to come by even during a period of renewed economic growth.

But don’t let all of this depress you. Consumer incomes continue to rise, and Congress will eventually agree to a tax cut that will provide spending power over and above that reflected in Lindsey’s arithmetic, which is why Lindsey crafted the tax-cut package when he was at the White House. With Saddam fallen and the thermometer rising, oil prices will fall. Productivity continues to rise, allowing businesses to keep costs in check. The falling dollar will make made-in-the-USA products more competitive in world markets. And businesses that have been sitting on the sidelines will begin to worry that failure to upgrade their equipment leaves them vulnerable to competition from more aggressive rivals. The euphoria of the 1990s is unlikely to return, but neither is the fear that dominates early 2003 likely to persist.

This article appeared in London’s Sunday Times on March 9, 2003, and is reprinted with permission.