Econ 101: Has the Economy Been Good or Bad?

     Economist Brian Wesbury has called them Pouting Pundits of Pessimism. These are the members of the media who seem to be focused on the negatives and cant find the positives in the economic news. And the positives are really quite startling. Despite a series of hurricanes that did record-setting amounts of property damage, flooded a major city, wiped out many communities along the Gulf Coast, and damaged our oil-producing and refining infrastructure leading to spikes in oil and gas prices the economy continues to move ahead. The media, however, prefer to focus on pockets of trouble like Delphis bankruptcy and General Motors plant closings.

     If you were to listen to television and radio stories and read the daily newspaper, you would think we were in a recession. In fact, Wesbury wrote in the December 2 Wall Street Journal that the number of people who think we are in a recession has risen from 36 percent to 43 percent.

     Yet the facts prove otherwise. Payroll employment rose by 215,000 in November, and the economy has created nearly 2 million jobs over the past 12 months more than 4.4 million since May 2003. The unemployment rate is 5.0 percent. This is lower than the average of the 1970s, 1980, and 1990s. The economy grew at a 4.3 percent annual rate in the third quarter, the tenth straight quarter in which GDP grew at a rate above 3 percent. The composite index of leading indicators increased 0.9 percent in October and has risen 1.2 percent over the past six months, indicating continued economic expansion.

     Average incomes were up 0.4 percent in October. Excluding motor vehicles, retail sales increased 0.9 percent in October. According to the National Retail Federation, holiday sales increased nearly 22 percent over last year as shoppers spent $27.8 billion in the post-Thanksgiving weekend. Sales of new homes jumped 13 percent in October, the largest one-month percentage gain in more than 12 years. The Commerce Department reports that sales of new single-family homes climbed to a record annual rate of 1.42 million units last month.

     We are also told that U.S. manufacturing is in the doldrums. Yet the Institute for Supply Management (ISM), a private research group, reports manufacturing output grew for the 30th consecutive month in November. The ISM's manufacturing index reading of 58.1 demonstrates continued sector expansion. How is this possible when the number of manufacturing jobs has decreased? The simple answer is productivity, which jumped 4.1 percent in the third quarter. It takes fewer workers to make manufactured goods today than in previous years, just as it takes much fewer agricultural workers to produce our food supply than it did 100 years ago. But even so, there is a shortage of skilled workers developing in the manufacturing sector.

     We had heard that the Federal Reserves policy of raising the Federal Funds rate would cause a slowdown in the economy. Since the Federal Reserve began this policy 16 months ago, more than 3.5 million new jobs and $750 billion in additional personal income have been created. So what is driving the economy?

     The primary reason for the strength of the national economy is the tax cut of 2003. Among other things, for individuals the 2003 tax cut reduced the marginal tax rates, expanded the standard deduction, and increased child care credits. Perhaps more importantly, it lowered the top marginal tax rate on dividends from 38.6 percent to 15 percent and the highest tax rate on capital gains from 20 percent to 15 percent. It also increased the amount that small businesses can deduct when purchasing capital equipment and increased the definition of small business.

     So how is it possible that a cut in taxes that the media tout as benefiting the rich could be increasing everyone's incomes, expanding the number of jobs, and increasing total output? The old Keynesian theories would say that since the rich save a lot of their income, they wouldnt increase spending much, and therefore tax cuts aimed at the upper incomes and reducing taxes on investment income would not be effective in expanding the economy. The answer, of course, is that the old Keynesian notions are wrong. Reducing taxes increases the incentive to produce things and hire people to produce those things. Cutting taxes does not increase economic activity because it encourages people to spend more, but because it encourages people to produce more.

     Since a market economy is based upon voluntary exchange, I can get rich only by producing something that other people want. This might include my labor services, such as when I get hired as an accountant. Or it might include a good, such as a compact disc player. Thus market economies reward you for figuring out what other people are going to want and satisfying them. The more people you please, the wealthier you get. In fact, you can get richest by producing for the masses, since there are a lot more of them than there are rich people.

     But producing things for others entails both hard work and risk. To become an accountant I must go to school for years, and when I start the process I am not sure how many accounting positions there will be when I graduate with my accounting degree. To produce the compact disc player I would need to hire workers, pay for materials, and all the while I hope that people will give up their turntables and vinyl records for my new product. If the government is going to tax away a significant portion of the profits I make, that means I would be punished for making the correct decision. When high taxation punishes me, I am less likely to invest in my education and job skills or to start my own business and hire other people.

     Reducing taxes on the rich in the end benefits primarily the non-rich. It is the latter that gain from increased production and the job opportunities that are created as a result of the investment and risk taking of entrepreneurs. And that is why Europe (other than tax-cutting Ireland) is mired in economic doldrums while the U.S. economy continues to chug ahead despite terrorist attacks, natural disasters and energy costs.

Dr. Gary L. Wolfram is the George Munson Professor of political economy at Hillsdale College in Hillsdale, Mich. He also serves as an adviser to theBusiness & Media Institute.