Fluctuations and fundamentals

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The stock market goes up, and it goes down -- but throughout American history, it mostly goes up. And there are reasons why the market, and the U.S. economy, generally rises.

What are those reasons? What do we need to keep in mind on days when the stock market tumbles? Here's the four-part formula for a strong economy and a strong stock market:

(1) Low taxes: High marginal tax rates prevent business from reinvesting in and expanding their businesses. The capital gains tax and America's corporate taxes, both high by international standards, are particularly damaging in this regard. Cesar Conda, a board member of my organization, the Free Enterprise Fund, notes that 14 of 30 members of the Organization for Economic Cooperation and Development (a group of the wealthiest countries) do not tax capital gains. China (a former communist country) exempts both domestic and foreign investors from capital gains taxes. We have a corporate capital gains tax of 35 percent.

Businesses invest in states with low taxes; the same holds true for nations. For individuals, of course, high taxes mean less money to spend for themselves and their families. This in turn has a negative impact on corporate revenues, as money goes to government rather than to corporations.

(2) Lower government spending: The flip side of taxes, of course, is all the government spending -- and government budget deficits -- that those taxes finance. So lowering government spending, whether by eliminating wasteful "earmarks," better competition for the purchases by government itself (no more $500 Pentagon hammers), significant entitlement reform, or just leaving certain functions to the private sector -- will mean more money for the productive side of the economy.

In recent years, the size of government's growth has been somewhat masked as the economy has grown, but at about 20.3 percent of gross domestic product, it's still too high, even allowing for higher defense spending after the 2001 terrorist attacks.

(3) Open trade: This commerce between nations benefits both sides. Consumers save money by purchasing goods that can be made more cheaply abroad, and businesses save by importing lower-cost materials that they can then turn into higher-cost exports from the United States. Millions of American jobs depend on open trade. A retreat on trade would put those jobs at risk.

(4) Sensible regulation: Intrusive government regulation puts a "tax" on businesses just as much as monetary taxes do. The cost of compliance with federal and state regulations continues to soar; the Federal Register (in which proposed, new and amended regulations are published) grew to a whopping 78,000 pages in 2006. The threat of new regulations directly hurts the stock market; consider the declines in the stocks of some pharmaceutical companies once the Democrats started threatening new pricing rules. This is doubly bad, as the capital these companies raise finances new innovation that improves our health.

All true, you might think, but what happened earlier this week? One factor was clearly China, a powerful engine of Asian and global economic growth. Investors in Chinese stocks may simply have feared those stocks were getting too risky. Because international economies are so intertwined by globalization, it's not surprising that investors here stood up and took notice. But the solution isn't to wall ourselves off from the world. It's to get back to economic fundamentals and give investors the confidence that they need to invest in the market.

Every day, many factors affect stock prices. Emergence of new competitive products, possible mergers or earnings reports drive prices one way or the other. We can't guarantee the market will rise forever.

But pro-growth policies permit entrepreneurs and companies to do what they do best and leave more money for consumers to spend, driving up corporate earnings, which fuels the stock market and investor confidence.

Now government needs to do its part, to keep the focus on economic fundamentals so stock prices will rise or fall based on market forces rather than the effect of clumsy government actions that depress the market.

Mallory Factor is chairman of the Free Enterprise Fund.