Thursday, January 04, 2007

Dow 14000 on Tap

January 4, 2007

You. In 1982, Time magazine's person of the year was a machine -- the personal computer. Twenty-four years later, after being empowered by the computer, the 2006 person of the year is -- "you." Time's cover sports a small mirror so we can contemplate ourselves -- the controller of the information age -- and think about all our blogs, pages on MySpace or Facebook and videos on YouTube.

The most interesting thing about this progression is that it did not result from consumer demand. Demand does not create wealth. Consumers were not marching in the streets 30 years ago complaining about the fact that there was no way to share their daily activities and innermost thoughts with thousands of their closest friends. People were not begging for personal computers, email, broadband, the Web or blogs. Entrepreneurs, futurists, scientists and the very early adopters birthed this technology: Today's average consumer was either clueless or still in diapers.


Even though some of this technology existed in the 1970s, the economic environment of those times was not conducive to its rapid development or deployment. Tax rates were high and regulation was stifling. This held back innovation, creativity and productivity. To offset this malaise, many macroeconomists counted on the Fed to hold interest rates low by printing more money, which only stoked inflation. The resulting stagflation created a lousy environment for new inventions.

In the early 1980s, tax rates were cut, government interference in the economy was reduced, and the Fed followed a tight money policy. As stagflation was cured, entrepreneurs got to work. In garages, basements and cinderblock buildings, today's technology promptly came to life even before its full usefulness was understood. It took more than a decade for the Internet and email to become real consumer products. It was the supply of this technology that fueled its growth, not the demand for it.

Despite evidence from the past 30 years, a majority of the analysis and press coverage of our economy still focuses on demand as the driver of wealth creation. As a result, we hear that rising oil prices are like a tax on the consumer that will slow the economy or possibly lead to recession. But this discounts productivity growth that allows higher costs to be absorbed. Moreover, one person's spending is another's revenue. So while Midwesterners pay more to heat their homes, energy producers in Louisiana, Wyoming, Texas or Oklahoma are shopping online with all that newfound income.

Money doesn't just evaporate. For every debit, there must be a credit. The world is a closed system as far as the dollar is concerned. Even if we send more dollars to OPEC, those dollars come back. Currency that leaves the country must return to purchase goods and services, or make an investment.

This explains why our trade deficit with China is not a significant problem. The dollars sent across the Pacific rebound as investment or spending on goods and services, such as the recent $3- to $4-billion contract with Westinghouse Electric Co. to build nuclear-power plants in China. While many fear that China might stop investing in the U.S., or sell its current investment holdings, this is misplaced worry. If China traded its dollars for euros, then whoever stood on the other side of that transaction would hold those dollars -- facing the same choices of buying from, or investing in, America. Foreign investment reflects the strength of the U.S. as a safe and sound economy.

Yes, the earth is flat, but American technology made it that way. The argument that the U.S. cannot compete, now that technology has leveled the playing field, sounds like a Michael Crichton novel. You know the story: We invent something and it turns on us -- Jurassic Park, the Andromeda Strain or even Frankenstein's monster. This makes great fiction, and who knows, it may happen some day, but the only way U.S. competitiveness will fall off the edge of the flat earth is if we place too many burdens on the entrepreneur.

Unfortunately, there are many who want to do just that. Based on a belief that the middle class is being squeezed, or too much of the profits of enterprise are going to the owners of capital, there is a push to raise taxes and redistribute more of our income.

But these beliefs are more political fodder than reality. In the first five years of the current recovery, inflation-adjusted average hourly earnings have climbed a total of 1.7% -- not great, yet still much better than in the first five years of the last recovery (starting in March 1991), when earnings declined by 0.5%.

Even so, average hourly earnings are a terrible measure of income because they do not include tips, bonuses, commissions or employer-paid benefits. Nonetheless, the data show that low- and middle-income workers' wages have performed better in the current cycle than they did in the same time period of the previous cycle. And to top it off, everyone who pays taxes faces a lower tax rate.

The process may be mysterious and magical at its core, but it is completely understandable. Lower tax rates encourage innovation and risk-taking. The impact of this raises productivity. And productivity raises living standards by boosting incomes or lowering prices.

It is true that corporate profits have climbed to a record share of GDP. And it is also true that income gaps have widened. But these can be positive signs, not negative ones. An economy without profits is a stagnant economy. And income gaps have widened in every period of rapid technological advancement going back to the invention of the wheel -- the first to use a new technology, and the entrepreneurs who push it to fruition, benefit the most, even as the new technology lifts living standards for all.

Fighting these trends diminishes technology's ability to raise living standards. If France had chosen to cut tax rates, regulation and the size of its government in the early 1980s while the U.S. continued on its path towards a social welfare state, it would be the French who would be complaining about excess corporate profits and the income gap. Americans, on the other hand, would fret about a 10% unemployment rate and march in the streets demanding job guarantees and shorter workweeks.

In an ironic twist, because the personal computer has decentralized business activity and altered the structure of many industries, the statistical machinery designed to measure economic activity has become increasingly inaccurate. The newspaper help-wanted advertising index has become useless. The Internet has spawned the growth of many companies with "no" employees. These microbusinesses, and an increase in self-employment, make it even harder to measure the total number of jobs or incomes. Legal documents and accounting programs are inexpensive and widely available on the Web, which means it's easier than ever to start a new business.

But measuring everything perfectly is not all that important. As long as policy is pointed in the right direction, technology and productivity will continue to advance just like they have over the past 25 years. Today, tax rates are still low enough to boost investment and entrepreneurial activity. At the same time, the Fed has not lifted rates to excess. As a result, both the demand-side and the supply-side of the economy in 2007 look solid. Another year of above-3% real growth and a 14000 Dow are on tap.

Other than some further increases in inflation, the only thing we should worry about is the "Magazine Cover Jinx." If the 1970 University of Texas football team can have its 30-game winning streak ruined immediately after making the cover of Sports Illustrated, then 2007 could be a tough year for "us."

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

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