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Sunday, October 31, 2004


Will our economy notice any difference?

Does it matter to the economy who wins on Tuesday? Is control of Congress as important as who wins the White House?

To understand where we might go, we have to understand how we got to where we are. The Clinton years saw tremendous productivity gains as PC's and networks replaced mainframes, and outsourcing provided a much cheaper labor supply. Those productivity gains mitigated the impact of the Clinton tax increases, so we enjoyed a Goldilocks economy (not too hot, not too cold) with low interest rates and high employment. However, the end of the second term saw the culmination and bursting of a speculative bubble in corporate stocks, that curtailed the growth period. As business reigned in spending, a mild recession took hold, and was still in progress as Bush took office.

Naturally, Bush recognized that tax cuts were needed and Greenspan recognized that even lower interest rates could help. The recession caused an already low inflation rate to almost turn negative and the Fed had to worry briefly about warding off deflation. Meanwhile unemployment rose somewhat, but despite the Democrat rhetoric, this was always a very mild recession. However by phasing in tax cuts, the slowdown was extended (you can do nothing worse than phasing in tax cuts, which only causes business to delay investment decisions, and consumers to postpone income, until the cuts take place). To further make life difficult for Republicans, a major shift in employment from corporations to smaller businesses and sole proprietorships took place, delaying the reporting of significant job growth in the payroll survey, (though it did show up in the household survey.)

So, at this point, we have a very mild recovery, the Fed raising interest rates to bring the funds rate in line with other rates, and a mildly constructive tax policy. At the same time, the Bush administration has made a number of mistakes on foreign trade (steel, China, etc.) and has done a very poor job of controlling discretionary spending in Congress while money is flowing out the door because of the war. As a result, the economy is good but precarious, and with higher oil prices taxing the rest of the economy, it would not take many mistakes to cause another recession by or before 2006.

Income taxes - the Bush income tax cut was helpful, but I dispute the common wisdom that its main beneficiaries were upper income taxpayers. in reality, they got very little relief because of the AMT. That is why upper income payers continue to increase their share of total taxes paid. Actually, lower income taxpayers, taken off the rolls entirely, and middle income taxpayers did best. But no one did all that great. This issue has been demagogued to death, but it was really not a huge cut. If it had been, the economy would be raging by now.

The worst thing to do now would be to roll taxes back as Kerry wants to do. Any tax increase would be harmful psychologically. However, we need to recognize that until the AMT is changed, any rollback of the cut for the $200,000+ group is largely symbolic, since they are already paying at the AMT rate, and will continue to do so, after all of their tax planning is done. It's just that this is a bad time for an increase.

The tax cut that really helped wealthy America was reducing the tax on dividends. This had a very salutary effect, namely by putting dividends on an equal plane with capital gains and encouraging larger payouts. This would really be a bad one to reverse. I think the dividend tax cut helped the economy more than any of the others.

Health care - the Bush drug prescription plan has been labeled a budget buster, but I doubt it will be as expensive as scored. It's actually a meager benefit versus the cost to subscribers. The problem is that it is a stake in the ground for a new entitlement, and Kerry will want to make the plan much more expansive and expensive. That is a serious threat.

Social Security - Kerry's worst and most cowardly issue. Something will have to be done, and it's just irresponsible to say that we can take care of it in 2025 when the situation will be uncontrollable. You can't promise not to cut benefits or raise taxes. Something has to give, the demographics are too obvious. The Bush plan may help, but it is only a first step. Medicare may be even in worse shape.

The Congress - It's ridiculous to expect Congress to act responsibly, since the nature of politics is to bring back as much money as you can to your district. Bush misplaced his veto pen in the first term and that better not happen again. That having been said, control of Congress is not life or death since the Senate pretty much requires a super majority of 60 to get anything major accomplished. Neither party has any hope of achieving that. However, if the Dems control Congress and the White House, I would not be buying any long term bonds. Congress needs to reintroduce the discipline that Gramm - Rudman spending limits provided.

In sum, I look for a recession sometime during the first two years of a Kerry administration. If Bush is re-elected, there is a better chance that we can take a longer view on social security, income tax policy, and other spending. It will require a much more forceful White House to address spending priorities. Otherwise, the recession is coming regardless of who wins.

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