Tom Daschle tried to turn the election into a referendum on the economy, blasting the Bush administration for “the worst performance in terms of real economic growth that we have seen in the last 50 years.” However hyperbolic, he raised a paradox: If the economy was so terrible, why did the GOP win? In fact, the economy isn’t wretched, and voters know it. Over the year, GDP has grown 3.2% (roughly the post-World War II average) and inflation has averaged 2.1% (half the average). Unemployment is 6%, compared with 6.5% since 1970.
Yes, after a recession the economy usually grows better than average, but the 2001 recession was mild – in fact, for the entire year, the economy actually grew 0.3% – so it’s not surprising that the recovery has been mild, too. Also, the economy is stronger than it has ever been in relation to the rest of the world. U.S. output exceeds that of the five runners-up (Japan, U.K., Germany, France and China) combined. The Democrats failed to pin a lousy economy on the Republicans because the economy isn’t lousy.
“Lousy,” however, is a good description of the stock market. Since the summer of 2000, it’s fallen 40% and is headed for a third straight annual decline, the first since 1941. Why? One reason is that investors, not having seen a bear market in a decade, overreacted. Some analysts contend that stocks were overpriced to start with; others see prices signaling a double-dip recession or adjustment by investors to reflect risks of terrorism and management chicanery.
I think the answer lies elsewhere, in corporate profits, which have dropped 27% over the last year for the companies that comprise the S&P 500. Talk to business leaders and you’ll hear complaints about a lack of pricing power. We may have entered a period in which the economy continues to hum along – and, I suspect, improve – but the profit-making power of corporations will diminish. Why? First, increased competition from abroad, thanks to free trade. Second, the Internet, which has lowered barriers to entry in sectors like book and computer retailing and has removed the lucrative friction from transactions like obtaining mortgages or buying machinery. Third, deregulation; as government ends its protection of monopolies in areas like telecommunications, old profit margins are under pressure.
These developments are good for consumers and the economy, but not good for individual businesses – especially those stuck in their ways. Many are responding by trimming operating costs. That’s fine. But businesses have also cut back on capital expenditures – a mistake. Business has entered a more competitive era of hard-won profits, so more capital investment and R&D are a necessity. High profit margins haven’t been abolished. Businesses with innovative products can probably make more money today – but only during the short period before others catch up. Then, the innovators will have to find new products. It’s an exhausting, but productive, treadmill.
The two essentials are accessible pools of capital and what Keynes called “animal spirits” – the desire of entrepreneurs to take risks. The danger is that capital and animal spirits have been constrained by the hysterical political reaction to corporate scandals. Institutions and policies that promote the two essentials – such as Nasdaq, employee stock options and investment-oriented tax relief – deserve vigorous promotion, and, with last week’s resignations of Messrs. O’Neill and Lindsey, the administration needs to support capital investment and risk-taking in a serious way. The economy is not rotten, but lower stock prices send a message: Profits won’t be easy any more. CEOs who think they can succeed simply by cutting costs will soon learn differently in an era whose motto will be, “Invest, innovate, or die.”
A version of this article appeared in the Wall Street Journal.
