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Jewish World Review Nov. 13, 2001/ 27 Mar-Cheshvan, 5762

Lawrence Kudlow

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Paradox -- THERE are many paradoxes in today's economy, but the bottom line is that better times are coming.

First and foremost, the U.S. economy is sinking, but stock markets are rallying. How can this be? Well, markets are forward-looking; GDP looks backwards. It's only a matter of time before the National Bureau of Economic Research post-dates the 2001 recession back to last March, but stock markets, especially the growth-sensitive Nasdaq, are telling us that next year's economy will be much better than this year's.

Roughly eighteen months ago the situation in early 2000 was a mirror image of today's story. Then the economy was still strong, but stock markets were tanking. Especially the Nasdaq index, which led the way down starting in April 2000. It turned out that the stock market message then was accurate: in 2001, the economy tanked.

Most economists don't use real time market signals, whether equity markets as economic growth forecasters or financial and commodity markets as inflation forecasters. But markets are smarter than econometric models.

Also back in 2000 a lot of people argued that Federal Reserve tightening policies had lost their clout. But they were wrong. Even though stocks and commodities were slumping, a lot of pundits chose to focus on GDP, which hadn't yet started downward. But, in fact, as we have all painfully learned, Fed policies to raise the federal funds rate and shrink the money supply were all too successful.

In 2000 and 2001 the central bank managed to deflate everything: liquidity, stocks, business, investment, profits, production, prices, GDP, the global economy; you name it, they deflated it. Nice work. Very impressive.

Today there is a similar mantra, only this time it's that Fed easing policies won't work. Well, don't believe it. Over the past ten months the central bank has been cutting its target interest rate and adding money to the economy. Disagreements may exist over the timing and the magnitude of the Fed's policy shift, but there can be no doubt that the department of money has completely shifted gears towards stimulating the economy, a stark contrast from last year's performance. The shift in monetary policy is a crucial factor behind the recent stock market upturn. Indeed the stock market's rally confirms the Fed move.

Some market mossbacks even go so far as to argue that the Fed has been too easy, and inflation will rear its ugly head next year. But once again markets are providing a more accurate view.

Commodity indexes are still deflating, and the differential between 10-year Treasury rates and 10-year inflation-adjusted rates (TIPS) is very narrow. In fact, the commodity and Treasury bond signals have for more than a year been predicting the kind of deflationary producer price report just released for October, where finished goods prices have declined slightly over the past twelve months and crude material prices plunged by a whopping 25% over the year. There's no inflation out there. Prices are falling, not rising.

Now by itself the prospect of a continuous deflationary decline in prices is something to be concerned about. The deflationary threat argues that the central bank should continue its money-adding policies and reduce its fed funds target rate to perhaps 1.25% or 1.5% before yearend.

But even the deflationary story is somewhat paradoxical. Declining energy and raw material prices are generating positive profit margins for goods -producing businesses. Over the past five months, commodity input costs have fallen below final goods prices, thereby setting up a positive profits margin. Over the prior 22 months profit margins were relentlessly negative, and this was a key recessionary factor.

Peering ahead to next year's economy, easier money and declining commodity costs set the table for stronger sales growth and rising business earnings. That's exactly what the stock market rally is telling us. There may even be some favorable straws in the wind right now. Notice that unemployment claims are falling, while chain store sales appear to be recovering. Consumer confidence surveys are edging higher.

Though most Wall Street gurus and virtually all politicians don't know it, the link between stock market performance and business profitability is vital to economic expansion. Profitably businesses have the resources to expand operations and create jobs. The stock market barometer leads, then business follow. The best possible news for lower unemployment and new job creation is a strong stock market, which foreshadows improving business conditions.

If tax writers in Congress can see their way toward reducing personal and business tax-rates to create incentives for small and large firms, then the outlook for jobs would be that much brighter. Remember, it is business that creates jobs.

On this score it is no wonder that the stock market advance in recent days has stalled. Sen. Max Baucus has produced a so-called tax-cut bill that spends $220 million to buy bison meat, cauliflower, eggplant and pumpkins. Then there's more pork for tunnels and railroads. Then there's tax-exempt bond pork for Indian tribes, investment deduction pork for Hollywood filmmakers and income tax credits pork for poultry manure. Not to speak of the bill's entitlement expansion for health insurance, something that might make sense but surely should be looked at in the context of overall health reform, rather than a pork-laden spending giveaway bill that masquerades as a tax-cut stimulus package.

The Baucus bill will never pass the Senate floor. But it does illustrate once again just how illiterate some politicians can be when it comes to promoting business, jobs and economic growth. No paradox here, just stupidity.

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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