- The Washington Times - Sunday, October 7, 2001

From Robert Rubin to Alan Greenspan to Paul O'Neill to George Bush, just about everyone in Washington is talking about a small economic stimulus package that won't drive up long-term interest rates. But there's nothing wrong with driving up rates a bit. For recovery, higher rates are the real deal. Policymakers should think big, not small.
Last Wednesday in New York, President Bush presented the general outline of a $60 billion stimulus plan, including only modest tax relief for individuals and businesses, along with sizable government spending increases.
But no capital gains tax-cut, and probably no income tax relief for high-end earners who pay the most taxes, both of which are essential to reviving the stock market and re-igniting investment risk-taking. Responding to a question from the press, the president said, "But we're mindful of the effect on long-term interest rates, and we think that number is the right number."
Official Washington has the interest-rate story completely wrong. As a result, they risk getting the tax-cut story wrong too. A true growth-boosting tax-cut package should lead to higher rates.
Here's why.
In today's noninflationary environment, most interest-rate swings are driven by changes in the real interest-rate component of the market rate.
Think of real interest rates as the economic growth component of a Treasury bond. So real interest rates track closely with stock markets and the economy. So-called real interest rates reflect the economywide rate of return on capital investment. As real returns rise, and real economic growth advances, rising real interest rates drive Treasury market yields slightly higher. There's nothing wrong with this. Rising real interest rates merely reflect a healthy economy. Just what we need.
This is much different from the 1970s and other periods where inflationary fears were the biggest swing factor for interest rates, sometimes driving them 6 or 7 percentage points higher. In those cases skyrocketing market rates were a tall barrier to growth, as higher inflation closed down credit sources and acted like a huge tax increase on the economy, stifling investment, output, and job creation. Today, however, deflationary price falls are a much greater problem than inflationary price increases.
The difference between real interest rates and inflation expectations may seem like a technical matter, but it's hugely important. Between 1995 and 2000, for example, Treasury rates pushed slightly higher, but the economy was growing at better than 4 percent with tame inflation. The stock market roared. The average yield on the 10-year bellwether Treasury bond was 6.05 percent.
Today, however, that same 10-year Treasury is yielding only 4.5 percent. At first blush, this looks like a good thing. However, it's not so good as the low interest rate reflects a recessionary economy (and a reappearing budget deficit).
Over the past 18 months, as the economy has shifted from boom to bust, the 10-year note has dropped from 6.5 percent to 4.5 percent. What happened? Well, the economic slump has brought down investment returns and economic growth. So the real interest rate growth component of the 10-year Treasury has shrunk substantially.
Going back to Mr. Bush, a more aggressive tax-cut plan would foster higher investment returns, stronger economic growth and more jobs. It is these prosperity factors that should concern him, not small bond market swings.
Strong economic recovery will finance the war against terrorism and replenish budget surpluses over the next few years.
If next year's economy responds to tax-cut incentives and easier money with 3.5 percent growth, it is likely that the 10-year Treasury rate will move up to perhaps 5 percent or 5.5 percent, or nearly a percentage point above today's rate. This would be a good thing, not a bad thing.
In other words, a mild increase in both real and nominal Treasury yields is something to be desired, not shunned. That is why if Washington policymakers do their tax-cutting job properly, then higher after-tax investment returns and stronger real economic growth will generate a completely different interest rate result than the one now being prescribed by Robert Rubin.
Indeed, Mr. Rubin is selling us the wrong tonic. A point increase in real interest rates would probably be consistent with at least a 30 percent rise in the stock market and a return to 3.5 percent growth in the economy. Now that's a trade I'd love to make.
The best thing for America would be a real interest rate-raising economic growth policy that helps win the war against terrorism abroad by promoting economic recovery at home. However, if we pursue Mr. Rubin's deflationary interest rates, then we'll be faced with a Japanese-style economic strategy.
Long-term government bonds in Japan yield about 1.5 percent. Looks great, doesn't it? Trouble is, Japanese stock markets and economic growth have been sinking for more than 10 years. Now we wouldn't want that, would we?

Lawrence Kudlow is a nationally syndicated columnist.

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