Doomed to Repeat

It`s 1929 all over again-at least according to Mr. Wesbury! (Much Grass, er., Muchos Gracias to Wil Wirtanen):


A Portrait of the Economy
By BRIAN S. WESBURY
February 14, 2007; Page A21

It's the best of times. It's the scariest of times. Last year, U.S. exports, industrial production, real hourly compensation, corporate profits, federal tax revenues, retail sales, GDP, productivity, the number of people with jobs, the number of students in college, airline passenger traffic and the Dow Jones Industrial Average all hit record levels. For the third consecutive year, global growth was strong, continuing to lift (and hold) millions of people out of poverty. From 30,000 feet, heck from 1,000 feet, it sure looks like the best of times.

In relative terms, the first five years of the current recovery have been much better than the first five years of the 1990s recovery. But all this has not softened the pessimism of many pundits and politicians who are either unimpressed or expect the whole thing to come crashing down any minute. That is, unless the government firmly grabs the reins of the global economy and steers it clear of disaster.

Many believe that the debate is over on global warming, nationalized health care, tax hikes, rich-versus-poor, the trade deficit and "obscene" oil company profits. Forgotten in this rush to pass judgment on capitalism is the fact that the last two times government seriously tried to control the U.S. economy -- in the 1930s and in the 1970s -- they made a terrible mess of it.

In the 1930s, the Smoot-Hawley Tariff Act caused a collapse in global trade, while the Fed allowed the money supply to shrink by one-third. Government regulation in the 1920s prevented banks from branching, which caused more than 10,000 to fail in the 1930s, deepening and prolonging the Great Depression. Herbert Hoover's tax hikes were icing on the cake, capping off a perfect storm of D.C. policy mistakes.

It took another 35 years, and a nice run of prosperity, but Washington finally gathered the courage to try this again. Between 1965 and 1981, Great Society welfare and health-care programs, wage and price controls, inflationary Fed policy, 70% marginal tax rates, 50% capital-gains tax rates, and highly regulated energy, airline, banking and trucking industries created severe problems. The Misery Index (calculated by adding inflation and unemployment) rose to 21.9% in 1980 (today it is 7.2%).

One of the worst mistakes of the 1970s was a National Energy Plan. On April 18, 1977, in a nationally televised speech, President Carter said, "World oil production can probably keep going up for another six or eight years. But some time in the 1980s it can't go up much more. Demand will overtake production."

President Carter's White House economists worried about "environmental damage and the risks to national security and to future economic activity posed by energy imports." To fix these problems, the Department of Energy (DOE) was created while the Congress and president pushed forward windfall profits taxes, price caps, subsidies for solar energy, tax breaks for using coal, and direct spending on synthetic fuels.

Not only did all of this fail to stop imports or the use of fossil fuels, it was also the source of economic pain. Part of the problem was faulty forecasts. Rather than peaking in the mid-1980s, the latest DOE estimates predict peak oil production no earlier than 2021, but possibly as late as 2037, 2067 or 2112, depending on assumptions.

The cost of government intervention is always underestimated in the midst of political battles, while the benefits are always overestimated. Impeding the free market alters the course of economic activity in ways that cannot fully be understood in advance. For example, tax subsidies for using existing solar technology diminish incentives for research and development, just like welfare payments undermine the willingness of many recipients to work or go to school. Why give up a sure thing for a future that is uncertain?

The U.S. is subsidizing ethanol, which pulls billions of dollars of investment capital away from other areas of the economy. When government picks what it thinks should be the winner, it saps resources from other ideas and potential advancements. In the 1960s, the U.K. picked coal and steel, while Japan picked consumer electronics, motor vehicles and exports. The U.K. was wrong. The Japanese got it right. But the odds of any government picking the right strategy, industry or technology are no greater than that of a single company or individual.

The power of a free market is that the odds of success are increased. With tens, or hundreds, of thousands of different entities researching, inventing, producing and distributing, successes not only multiply, but their profits generate resources that allow the economy to absorb the cost of mistakes and failure. It's called diversification. When one company fails, those closely involved are hurt, but not the entire economy. When government is wrong, millions suffer.

Unfortunately, the government reacts to market failure by creating more regulation. Think Sarbanes-Oxley. But the costs of this regulation are almost always greater than the benefits; and Congress tends toward denial when it comes to government failure.

One would think that the unbelievably dramatic turnaround in the economy from the malaise of the 1970s to the boom of the past 24 years would prevent the return of big government. But it appears that a growing number of American politicians, journalists and their constituents have forgotten the awful reality of the 1970s economy. Part of the problem is that people younger than 45 don't have even the slightest idea of how bad it was, or what caused it. They also have no idea that when Margaret Thatcher and Ronald Reagan turned away from socialism in the late 1970s and early 1980s, continental Europe (Germany, France and Italy) kept going. Then while the U.S and U.K. boomed, continental Europe fell behind.

Moreover, many of the more acute economic problems supposedly facing the U.S. are evaporating quickly. My models of the federal budget forecast a $115 billion dollar deficit this year, just 0.8% of GDP, less than half the size expected by the White House, and $57 billion less than the Congressional Budget Office (CBO). Next year, I expect a deficit of $35 billion. A budget surplus in 2009 is likely.

With tax rates low, profits and incomes rising, and strong non-withheld income tax revenues (from IRA withdrawals and capital gains), forecasts of a significant slowdown in revenue growth appear too pessimistic. Many argue that the cost of fixing the Alternative Minimum Tax will reduce revenue growth, but the AMT has been "fixed" in each of the past three years and revenue growth has consistently exceeded expectations. The wild card is spending. My forecast expects $40 billion more in spending than CBO estimates this year, mostly for the Iraq war. But gridlock in Congress should help spending growth to remain in check for the next few years.

Surpluses will change the calculus on tax hikes in dramatic fashion. Any argument to repeal the Bush tax cuts will face a strong headwind. This is great news for investors and the economy. In addition, with unemployment down to 4.6%, and real GDP excluding housing up 4.3% in the past year, many industries face labor shortages. Wages are being bid higher and much like the second half of the 1990s recovery, wage growth should continue to accelerate sharply in the months and years ahead. Data show that this process has already begun.

The economy is still riding a wave of productivity growth, built on the winds of technological change. Computer chips are still getting faster, cheaper and more efficient. Software is becoming more powerful and telecommunication advances are moving at warp speed.

Free-market capitalism is not perfect. But it remains the single most efficient and powerful system for creating wealth, reducing poverty and developing less wasteful ways of organizing output and consuming resources.

With the U.S. seemingly at a political turning point, the next few years are very important. At a similar juncture in 1929, and again in 1965, the U.S. moved toward bigger government. After World War II, and again in the early 1980s, Washington chose less intrusive government. The results speak for themselves. Good times or scary times: It's our choice.

Mr. Wesbury is the chief economist at First Trust Advisors L.P. in Lisle, Ill.