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Jewish World Review August 19, 2002/ 11 Elul, 5762

Lawrence Kudlow

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Credit crunch time | It's not the accounting fraud, the corporate corruption, Martha Stewart, left-wing demagoguery about tax cuts for the rich, the budget deficit or the war on terror.

It's balance-sheet deflation and the corporate credit crunch. These are two faces of the same ugly coin. And if they're not dealt with soon, we may be staring at the weakest economic recovery in 50 years. Unfortunately, our money men in Washington don't seem to understand this problem.

Major corporations throughout the land are trying desperately to rid themselves of excessive debt-burdens accumulated during the last economic boom. But risk-averse investors don't want to buy corporate bonds to cure that debt. And high real interest rates are putting the squeeze on profits and operations.

With real interest rates abnormally high, companies are having to spend virtually every new dime of income on interest expense to service their unwieldy debt. This leaves very little money to spend on new capital investment, additional production or new job hires.

This economy isn't double-dipping into another recession, but it is growing too slowly to solve the corporate credit-crunch barrier to a full-fledged business recovery. Inflation-adjusted domestic final sales, a good measure of how goods are moving in the marketplace, has grown only 3 percent annually over the past three quarters. This pace is way too slow to bail out debt-strapped companies.

There's nothing lawmakers on Capitol Hill can do to rid firms of their burdensome debt (although they can help out this economy in several ways). But there's plenty the Federal Reserve can do to lower the onerous burden of unusually high real interest rates.

The classic solution to a deflationary problem such as this is to pour new cash into the economy. Immediately following the terrorist attacks on Sept. 11, the Fed seemed to be appropriately stepping up its creation of new money. Not surprisingly, economic recovery took hold nicely in last year's fourth quarter and this year's first.

Lately, however, the Fed has lapsed into its historic obsession with short-term interest rates. Instead of lowering the fed funds rate this week -- a move that would have allowed it to buy Treasury bills and inject more cash into the financial system -- the Fed decided to hold the rate at 1.75 percent. The rate has been at this "low" level since November, but the Fed mistakenly believes that a low and steady fed funds rate infers an easy cash policy. Paradoxically, this rate-targeting led to a significant decline in the Fed's cash-creating operations right when businesses needed the money the most.

Cash demands are not only skyrocketing in the United States, but also in Latin America. The collapse of southern-cone economies such as Brazil, Argentina, Uruguay and Paraguay, along with the already ailing economies of Venezuela, Colombia and Bolivia, has created an even greater demand for dollars throughout the hemisphere. Yet a Fed that can't even provide a money pipeline to its businesses at home is apparently oblivious to growing dollar demands below the equator.

It is rumored that the White House is finally considering a much-needed reform of the tax treatment of dividends, a positive move that would lessen the incentive for company debt and improve the incentive for individual stock purchases. Stock broker Charles Schwab proposed this, and President Bush indicated enthusiastic support.

Undoubtedly the Tom Daschle Democrats will attack this as a tax cut for the rich. But surely the president and congressional Republicans up for re-election will see the benefits of reaching out to the investor class.

The president's men may also be looking at an increase in capital-loss deductions, a tax-free turnover of stocks and perhaps even a tax-free status for business start-ups. All of these measures would improve the outlook for the economy and the stock market. So would a thorough corporate-tax overhaul. U.S. businesses currently rank 24th worst among industrial countries in this department. We can do better.

But our central bank must get in on the corporate-stimulus act. The Fed must relinquish its interest-rate targeting, let the fed funds rate go where it goes, buy back Treasury bills and get a substantial amount of fresh money moving toward cash-strapped businesses in need of a boost. Higher prices for gold and industrial commodities will tell the government bank if they are succeeding.

This simple monetary reform will solve the corporate credit crunch and will soon end deflationary price pressures that still ripple through the economy. Along with pro-growth tax reforms, a new monetary approach will generate sufficiently rapid economic expansion to finance a strong business upturn at home, and pay for a victorious conduct of the war against terrorism abroad.

JWR contributor Lawrence Kudlow is chief economist for CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


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©2001, Lawrence Kudlow