In congressional testimony last week, Alan Greenspan opened the door for a change in Federal Reserve policy. Interest-rate increases will occur sooner than expected. I agree a few small restraining steps now will save the Fed, the stock market, and the economy a lot of high-interest-rate angst down the road.
But up to now the Fed has ignored strong price trends in gold and commodities, as well as rising bond yields — all traditional harbingers of mounting inflation — in favor of an “output gap” model of inflation, which argues against broad price increases so long as underutilized resources and idle capacity exist in the economy.
It is hard to fathom why monetary decisionmakers fight the overwhelming historical evidence inflation is always a monetary problem. No one has waged this fight more energetically than Fed Gov. Ben Bernanke, who continues to argue rising bond rates and a pronounced dollar decline relative to gold, commodities and foreign currencies don’t really matter. Ironically, the output gap he keeps trying to sell is really a fiscal indicator, not a monetary one.
The term output gap simply means the actual level of today’s inflation-adjusted gross domestic product (GDP) is below a theoretical level of GDP that would have been achieved if the economy were growing at full potential. In this sense, the former Princeton economics professor is right about the gap. Since the onset of the 2001 recession, the economy has fallen behind its long-run potential by $4.4 trillion.
This calculation assumes trend growth in GDP of 31/2 percent yearly, the historical record of the U.S. economy since 1947. For last year’s fourth quarter alone, potential GDP was about $11 trillion, while actual GDP came in at $10.6 trillion. Here, the output gap is roughly $400 billion.
Actual economic growth trends above or below a hypothetical level of full-employment GDP are the single biggest factor in swings between surplus and deficit. As economic resources have been underemployed for some time, the budgetary consequences have been severe.
Mr. Greenspan has suggested full employment would today equate to a 4 percent unemployment. The current rate is 5.7 percent. That “unemployment gap” of 1.6 percent represents underutilized labor. It’s a shorthand version of the overall GDP output-gap problem, which also includes underemployed business assets.
So, producing and employing below the long-run potential of the U.S. economy has resulted in a sizable shortfall of income and wealth. Consequently, tax receipts from wages, corporate profits, and capital gains also have fallen short. This above all has worsened the budget picture.
Assuming an average tax rate of 20 percent — the government rule-of-thumb — personal- and business-tax revenues fell about $80 billion short of potential in the last quarter. That’s $320 billion at an annual rate and about two-thirds of the estimated $480 billion budget deficit.
It’s clear then that the underemployment of the economy and the wide output gap between actual and potential GDP are today’s major deficit-causing factors. However, economic growth has rocketed since President Bush’s tax cuts were implemented retroactively last year.
And herein lies the solution.
If these new tax incentives are left in place permanently, as the president proposes, the gap between actual and potential U.S. economic growth will narrow rapidly. This is the most vital deficit-reducing action the government can take.
Importantly, a full-employment American economy, with 31/2 percent long-term growth and 4 percent unemployment, will produce a new cycle of budget surpluses beginning in 2011. As the economic baseline used by the Congressional Budget Office falls well below full employment — the CBO figures only 2.8 percent yearly growth and 5 percent unemployment — today’s long-range budget outlook appears much worse than it actually is.
Ben Bernanke has helped make this clear. Where he errs, however, is in linking the underemployed economy and the continued absence of inflation. Between 1965 and 1981, U.S. policymakers learned painfully that virulent inflation is quite capable during periods of rising unemployment and slowing economic growth. That’s because inflation is a monetary problem. At any given level of output, or output gap, the Federal Reserve can supply more money than the economy requires, driving up prices.
Economic history shows forward-looking inflation-sensitive indicators such as bond rates, gold and commodity prices and the exchange value of the dollar best reflect the inflationary risk of excess money. These indicators have recently warned of higher inflation, though the economy is still underemployed. Actual inflation has picked up in recent months.
Gov. Bernanke’s output gap is surely a budgetary problem. But it’s not an inflation solution. To maintain price stability the central bank must normalize its target rate and remove excess money from circulation. The sooner the Fed acts, the less action it will take.
Lawrence Kudlow is a nationally syndicated columnist and is chief executive officer of Kudlow & Co., LLC, and CNBC’s economics commentator.
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