Tuesday, December 04, 2007

Twenty-Five Years of Prosperity (and more to come)

A significant paradigm shift has taken place in the U.S. economy over the last quarter century. During that time, the U.S. economy has been in prosperity 95 percent of the time and in recession only 5 percent. That is, the United States has had a grand total of only five negative GDP quarters in the past 25 years. In the prior two decades, the U.S. economy was mired in recession about a third of the time. This earlier period was a time marked by high inflation, high taxes, and overregulation of the economy. This caused the U.S. to look weak, while the Soviet Union looked strong. Clearly, things have changed. Prosperity has become the rule, not the exception.

Three fundamental reasons point to the cause of this long-lived prosperity:

Global Spread of Capitalism

Across the globe, free market capitalism has been triumphant over the socialist-planning model. Karl Marx was wrong; Milton Friedman was right. Put another way, the central planning model did not work whereas the free market model did. Fortunately, two strong, visionary, broad-shouldered leaders were in power while historical forces were aligning to push markets in the free-market capitalist direction. One of them, of course, was Ronald Reagan. The other was Margaret Thatcher.

Over the past two and a half decades, the capitalist model has spread like wildfire around the world, and it shows no sign of pulling back. In China, India, Eastern Europe, and Russia, however imperfectly, the newfound principles of free-market capitalism, economic opportunity, and “liberalism” in the traditional sense of that word are being applied and working beautifully. In one country after another, hundreds of millions of people are climbing out from the pit of poverty. Middle classes are growing by leaps and bounds. This will continue for many years to come.

Our world has witnessed a total shift in the intellectual thought of economics. That shift has created more growth, prosperity, income, wealth, and business opportunity than anybody dreamed imaginable—including me.

As an indication of how remarkable these changes are, the Chinese congress recently did a couple of things worth thinking about. First, earlier this year, the congress took a further step away from its communist past by passing legislation that strengthened private property rights for individuals and businesses. Second, a serious, vocal, intense debate among Chinese intellectuals is taking place concerning the merits of instituting major democratizing reforms. At the federal level, this does not mean that pure democracy will be breaking out any time soon. But at the local level, voting is occurring for the first time. It is not possible to overstate the magnitude of the dramatic changes that have occurred in China over a comparatively brief time.

Low Income Tax Rate Regime

As a supply-sider, I believe that a low income tax rate regime possesses tremendous power to change economic behavior. Economic freedom dictates that people should keep more of what they earn after tax. Recent Nobel Prize winner Edward C. Prescott from the Federal Reserve Bank of Minneapolis and Arizona State University put it quite clearly and succinctly when he said that economic behavior responds significantly to changing tax rates. In addition, the economic power of lower marginal tax rates on capital gains and dividends is similarly huge. The low tax rate regime of George W. Bush’s administration has given a big boost to the overall economy and the investment sector.

Behavior of Central Bankers

Central bankers have come to hate inflation. This is a key point. The cruelest tax of all is inflation. It distorts everything. It reduces the value of everyone's money and buying power. It lowers rewards for risk-taking and returns on investment. It impedes investment and expansion. Moreover, most tax systems are not even indexed for inflation.

Thirty years ago, central bankers had developed an unfortunate tolerance for inflation. They believed it was the trade-off for lower unemployment (the Phillips curve). That tolerance led directly to the double-digit rates of inflation that the United States experienced in the late 1970s and early 1980s. But since the time of Paul Volcker, central bankers have developed an almost obsessive vigilance combating inflation. That vigilance has helped pave the path for more than 25 years of tremendous prosperity.

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These three points are key parts of what I refer to as the greatest story never told. It is a story of optimism. It is a story of wealth creation. It is a story of economic growth and prosperity. In the end, it is ultimately a story of great hope and great promise.