When stocks began to slide in mid-May, the market was widely imagined to be "disconnected" from a real economy that was supposedly doing very well. That decidedly premature assumption led the chattering class to conclude the market's decline must have been purely psychosomatic -- a mere loss of "investor confidence."
We now know the alleged disconnection between stock prices and the economy was a myth. Aside from piling up some inventory, the economy shrank in the second quarter. Just as the stock market's collapse in late 2000 accurately anticipated the economy's downturn in the first three quarters of 2001, the market's slump from May 19 through July 23 accurately anticipated the recent bad news about second quarter GDP and earnings.
In late July, an upbeat Washington Post headline proclaimed, "Resurgent Profits Mostly Unnoticed." The reason that went unnoticed was that it never happened. After nearly all of the S&P 500 companies had reported their earnings, the average gain turned out to be merely 0.3 percent from a year ago, when the economy was in the tank. Investors have correctly feared that reported earnings would be too low, not that bad accounting would make them appear artificially high. The Washington spin on earnings was exactly backward.
Endless confusion about what drives the economy up or down often arises from the habitual carelessness of demand-side economics. Even Glenn Hubbard, the president's top economist, speaks only about adverse secondary effects of the stock market on consumer spending, neglecting the more fundamental effects of low profits and high political risks on the stock market.
Similarly, we are constantly told that consumers account for two-thirds of spending, never that business accounts for 85 percent of production. Consumers do not cause economic growth, they benefit from it.
Before consumers can spend more money, they must first earn it by working and investing. Increased income for workers and investors depends on more and better goods and services being produced by businesses. If it is not profitable for businesses to produce more -- if the cost of producing a thousand more widgets exceeds the revenue from selling that extra thousand -- then incomes originating in business will stagnate or decline. Weak business translates into weak consumers, not the other way around.
Fortunately, quarterly setbacks in GDP are common, and they tell us nothing about what happens next. With second quarter earnings now digested in stock prices, investors are turning a hopeful eye toward the third quarter
The Economist recently noted that "this administration has often placed politics above economics." As the elder President Bush discovered, putting politics ahead of economics is a sure way to lose on both fields. Bush's political advisers undoubtedly predicted that investors would feel comforted by the president's imitation of Al Gore's populism. Yet the Dow was comfortably above 9,000 until those neo-populist themes were tested on Wall Street. And the Dow will have to top 10,000 by November to prevent Democrats from making big gains in the House and Senate.
If White House political advisers continued to play along with their opponents' confidence game, and if anyone still listened to them, then Republicans would deserve to once again be effectively battered by "it's the economy stupid" in the November elections.
Economic understanding in Washington seems to be improving, however, and not just because Congress is on vacation. The president has switched from initiating trade warfare in steel and lumbered toward promising free trade agreements. The Democrats' bizarre suggestion that repealing future tax cuts would be helpful has fizzled. Instead, Washington is suddenly abuzz with seriously bold initiatives to help beleaguered investors.
Two of the best new ideas come from Cato Institute colleagues: Chris Edwards' idea of bringing the tax on dividends down to parity with the 20 percent tax on capital gains and Richard Rahn's idea of cutting the holding period for long-term gains from 12 months to six. It is just not possible to overestimate the lift that such proposals would give to the market and the economy. It's big, really big.
Good economics means economics that works, that delivers the goods. And that is why decisively excellent economic policy -- policy that maximizes individual liberty -- is always the most effective political strategy.