Washington: Out of Tune With Growth

David Malpass

As the U.S. economy slows in coming months the focus of markets and voters will likely shift to recovery--how to get back to a strong growth trend. Unfortunately, Washington seems increasingly out of tune with growth. We're poised to deepen what could be a sharp 2008 slowdown with a weak dollar, tax increases and protectionism, the opposite of the growth policies that are working abroad and have worked here in the past.

The time-tested path to recovery is through sounder money, lower tax rates, freer trade and tighter restraints on government expansion. As Britain's economy slouched through the 1960s, an investing watchword emerged: "It's never too late to short the pound." Some fear this now applies to the dollar. Margaret Thatcher reversed Britain's devastating decline with tax cuts, deregulation and a policy of sound money, which was exactly how Ronald Reagan fought off the weak-dollar malaise of the 1970s.

In mid-1993 China's Vice Premier, Zhu Rongji, chose sound money to break China out of the inflationary economic depression surrounding the Tiananmen Square debacle. He replaced the black market currency with a stable yuan to stop high inflation and food hoarding. Sound money in conjunction with price decontrols and tax cuts in rural areas have brought 15 years of very fast growth, policies that could work almost as well in Latin America and parts of Africa if the U.S. and the IMF stopped discouraging them.

When Vladimir Putin replaced Boris Yeltsin as Russia's autocrat, amid economic chaos on the last day of 1999, one of his first economic steps was to stabilize the ruble. His government then adopted a flat-rate income tax, ending Russia's days as an economic basket case.

The path to economic recovery is staring the U.S. in the face: Put a high priority on a strong and stable dollar, cut high tax rates and restrain Washington's economic expansionism.

Supersonic Capabilities but Engine Rattles

If the economy slows, we should be looking for problems in the engines of growth--labor, capital formation and innovation. We know we're riding in a championship flying machine that's capable of going supersonic when allowed. But we don't have to look far for engine rattles: a mountainous tax code, dollar weakness and constant lawsuits.

Nowhere else do so many middle-income people have to hire so many tax preparers. Our corporate tax rates are second highest in the developed world, penalizing job creation and investment. Washington levies heavy income taxes on Americans working abroad, discouraging precisely the skill mix we need most.

The capital gains tax, a critical determinant of asset values, was lowered to 15% in 2003, causing the predictable stock and housing market booms. But it's not indexed for inflation. And it's already scheduled to go up by a third in 2011, with Democratic presidential candidates proposing even bigger and earlier rate hikes. As the housing crisis deepens, we should be lowering or inflation-indexing capital gains taxation to increase asset values.

The uncertainty in U.S. tax rates and the scheduled tax rate increases have been reason enough for investors to prefer foreign investments. While many other countries are making clear their plans and techniques to cut rates, the 2007 Washington tax debate was solely about which taxes should be increased in order to get Congress to stop other taxes, such as the AMT, from going up.

Shrinking Dollar Means Less Investing in U.S.

As the weak-dollar trend embedded itself during the Fed's ultralow interest rate days in 2003--05, corporate investment plans shifted abroad. While the economic establishment still seems to think that investors like weak currencies so they can buy on the cheap, experience shows clearly that global investors are heavily growth- and momentum-oriented. They know that "cheap" often gets "cheaper." Instead, they bought Japan in the 1980s, when the yen was strengthening, and the U.S. in the strong-dollar 1990s. Now they're buying and investing in Europe, China and other emerging markets more than in the U.S. Investors want to buy and use strong and stable currencies, not weakening ones.

Dollar weakness has the added risk of building foreign wealth faster than U.S. wealth. The hot topic at international finance gatherings these days is how to keep the trillions of weak dollars amassed in Asia and the oil exporters (Russia, Saudi Arabia, Venezuela, etc.) from shifting the world's economic direction away from market-oriented private-sector growth.

Much of the world has used the opportunity provided by the 2003--05 flood of Greenspan dollars to increase the soundness of their monetary systems, create permanently lower tax rates and, for some, fund their social security systems. Think how much more Americans would be worth if beginning in 2005 they had been allowed to invest some of their Social Security payments in personal retirement accounts instead of having Washington spend it.

The waning days of the global boom find the U.S. with a weak dollar pumping up prices and discouraging investment here, an unworkable tax system studded with rate increases, and government processes bent on expanding federal power rather than limiting it. The 2008 election offers a chance for Washington to get back in tune with growth, but for now Washington's processes are stacked against a quick economic recovery.