State of the Economy Jude Wanniski May 8, 1996

The Commerce Department report last week that first quarter GDP rose at an annual rate of 2.8% does not persuade us that the economy is growing in any meaningful way. The only really significant economic impulse in the first quarter was enactment of the telecommunications bill, which has liberated the capital necessary to grow an entirely new telecosm industry. This positive surge has had enormous impact on Wall Street, which is busy now capitalizing the future of this industry, but it has little bearing on the GDP accounts. Far more significant to the current state of the real economy has been the sharp rise in long-term interest rates during the first quarter, which has continued into this second quarter -- from 5.97% on January 1 to today’s 7%. The first quarter also included a swing in the price of gold, from $393 to $415 and back again. The move was in part spurred by the unfortunate signal thrown off by the Fed’s cut in the funds rate in late January, to 5.25% from 5.5% -- a sign the usual political pressures of a presidential year would lead to a monetary expansion. These movements all worked to swell the GDP number. Individuals were encouraged to lock in housing purchases in expectation of higher rates. Consumer spending rose in anticipation of inflated prices -- the velocity of money rising almost to where it had been in 1990, when the inflation rate hit 5%. In one area where lower prices were expected because of an expected surge of Iraqi oil on the world market, domestic inventories declined as imports fell off. This also swells the GDP number, which rises with net exports and falls with net imports.

Those of you who have been following our work for a significant track of time know we have a low regard for the national income accounts that underpin these monthly GDP reports. The GDP numbers for the 1970s look marvelous, for example, even after being corrected by an official deflator. When corrected against gold, we can see why a period that looks so good on a GDP graph felt so bad on Wall Street. When the national income accounts were set up in 1933, they at least had the advantage of being set against a fixed dollar/gold unit of account. This limited the statistical distortions that arise with a floating dollar. My introduction to economics occurred in early 1971 when, as a reporter for the National Observer, I called the chief economist of the Office of Management and Budget, Art Laffer, to have him explain to me his GDP forecast, which at the time caused a political sensation. Laffer had forecast $1.065 trillion against a consensus of $1.045 trillion. His higher number was based on an assumption by Laffer’s boss at OMB, George Shultz, that the Nixon administration could persuade Fed Chairman Arthur F. Burns to inflate the money supply at a rate coincident with $1.065 trillion. The Nixon White House then whipped Burns into printing greenbacks with abandon, which was the process that led to the demolition of the Bretton Woods gold-exchange standard on August 15, 1971. In early 1972, when Commerce reported that GDP rose to a mere $1.038 trillion, Laffer left Washington practically in disgrace. The honor of the best forecast went to a Wall Street economist named Alan Greenspan. In 1975, when Commerce made its final assessment of fiscal 1971, Laffer’s forecast was the best, Greenspan’s among the worst.

When we forecast a “Bear Market Interlude” on March 28, as the first quarter closed, it was on the basis that the political uncertainties of the presidential year had temporarily increased risks, but that we were still in a secular bull market. At the time, the Dow was at 5631, climbing a few days thereafter before it peaked at 5691 on April 4. With the Dow today at around 5350, down 335 points from its high and 285 from our call, nothing has happened to persuade us that the interlude will soon come to an end. NASDAQ has continued to hit new highs in this period, but that is almost entirely explained by the telecosm surge. In the May 1 New York Times, Floyd Norris pointed out that 40 per cent of the rise of the NASDAQ composite index of 6000 stocks could be attributed to only the 100 largest -- and that 10% of the rise could be attributed to only eight of the 6000: Microsoft, Intel, Cisco Systems, Oracle, Sun Microsystems, Worldcom, U.S. Robotics, and American Online. The first fundamental reform of the 1934 Communications Act removed enough of the impediments to the growth of the new telecosm industry that a burst of unutilized capital -- time, energy or talent -- was enticed out of the domestic and world market. Almost all financial assets everywhere probably rose because of the telecosm promise -- some a great deal, some microscopically. The GDP numbers of course will include the efficiencies wrought by the telecosm industry as they unfold, and some will show up in the current quarters. Aside from this mountain building, though, the rest of the real economy remains on a great plain.

Risks continue to mount as a result of the Republican Party leadership’s stubborn refusal to admit it screwed up its management of the 104th Congress. It would help if House Speaker Newt Gingrich at least swept his mistakes under the rug without apology and struck off in a new direction. Instead, he is demanding that the nation first applaud him and his troops for their success in cutting federal spending. Yesterday, he lashed out at the news media for withholding this news from the voters and promised a tide of communications that would spread this austerity gospel. The Wall Street Journal does not help with its lead editorial this morning, “Boxed Score,” offering sympathy to Newt’s argument that the public is to blame for not applauding him -- instead of kicking him in the pants. 

The Journal should also give Bob Dole a kick in the pants, for offering to trade an increase in the minimum wage, which the Democrats want, for a 4.3-cent cut in the federal gas tax, which loses $30 billion over 7 years -- when he should be trading a cut in the tax on capital gains, which on static scoring also loses $30 billion in 7 years. Dole and Gingrich are both hiding from the Laffer Curve, the “fairness issue,” and supply-side economics, which they must address if they are to have any hope of halting the GOP slide. The hostility toward Jack Kemp in the GOP leadership is intense, precisely because his presence is a constant reminder that he warned them of each and every error they made since the voters gave them the Congress 18 months ago -- beginning with their decision to abandon the Laffer Curve and dynamic scoring in the week after the elections. Kemp, who remains the leader of the party’s growth wing in the absence of an alternative, can now watch the GOP leaders travel further down the trail blazed by Herbert Hoover. Little by little, Dole is even edging away from his advocacy of free trade, no doubt believing he is appealing to the Buchanan and Perot voters. He has recently bashed Japan on the Senate floor, backed the tightening of trade sanctions against Cuba, and hinted he might vote against China’s MFN status. Canada’s Trade Minister, Art Eggleton, yesterday decried Washington’s general drift toward protectionism as a result of presidential politicking. Withdrawal of China’s MFN status is almost as unthinkable as Hoover’s signing of Smoot-Hawley 66 years ago. There would be carnage in the world financial markets, given the financial house of cards built around Asian/China trade.

It is against this backdrop that we assess the rosy GDP report from the Commerce Department. When personal bankruptcies are running at a record high, as they have since January 1, according to MasterCard International, it cannot be all that rosy.  For an economy that should be growing at a true 5% or 6% a year until it recaptures the potential it lost in the last 30 years of inflation, even a true 2.8% rate would keep us barely even.