Econ 101: Has the
Economy Been Good or Bad?
Despite media reports, the U.S. economy
isnít on the naughty list this year Ė and hereís why.
By Gary Wolfram, Ph.D.
Free Market Project Adviser
Dec. 7, 2005
Economist Brian Wesbury has called them ďPouting Pundits of
Pessimism.Ē These are the members of the media who seem to be
focused on the negatives and canít 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 Ö the economy
continues to move ahead. The media, however, prefer to focus on
pockets of trouble like Delphiís bankruptcy and General Motorsí
¬†¬†¬†¬† 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 Ė 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
¬†¬†¬†¬† 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
¬†¬†¬†¬† We had heard that the Federal Reserveís 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 ďthe richĒ 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 wouldnít 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
¬†¬†¬†¬† 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 the Free Market