No Armageddon, But No Victory Yet Either

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The world economy has once again dodged Armageddon. The European Union finally forged a Greek bond deal, and a rescue fund big enough to ring-fence banks and sovereign debt, in order to avoid a catastrophic, Lehman-like contagion event. At the same time, the U.S. economy moved away from the threat of recession with a third-quarter real GDP report of 2.5 percent. In response, stocks are soaring. We'll live to see another day.

First the American economy. Led by surging business investment of highly profitable corporations and a modest gain in consumer spending, the new GDP report says "no" to a double-dip recession. As the economy stalled out in the first half of the year -- with 0.4 percent GDP growth in the winter quarter, 1.3 percent growth in the spring, and August data showing zero jobs and retail sales -- I warned nearly two months ago that we were on the front end of recession. Turns out I was too pessimistic.

Profits-rich business is the savior. It's really too bad that President Obama is out on the campaign trail beating up on millionaires, billionaires, oil and gas, and other companies. Because in the third-quarter report, it was business equipment and software investment, with 17.4 percent annual growth, that led the charge. Additionally, the building of plants, factories, office buildings, and private infrastructure helped save the faltering economy with 13.3 percent annual growth in Q3.

Incidentally, a large chunk of this is coming from the often-attacked energy sector. Think oil-and-gas shale revolution, which single-handedly may be propping up the economy outside of the high-tech sector.

And by the way, while profit is often a dirty word in Washington, the S&P 500 companies are reporting roughly 16 percent profit gains, which is better than expected. Profits are the mother's milk of stocks, business, and the economy, and they are sustaining even this subpar recovery. They are the only real form of stimulus. Profits are keeping us out of recession.

But just think of how much more stimulus would come with tax reform that permitted a penalty-free repatriation of roughly $1 trillion in foreign profits of U.S companies. And while left-wing politicians rail against corporations that allegedly don't pay their taxes, the fact is that full-scale business tax reform that lowers the marginal rate and broadens the base would end uncertainty and unlock a couple of trillion dollars of corporate cash. That money would invest so heavily we'd finally get some serious job creation.

Now, coming out of a deep recession, we should be recovering at a 5 percent growth rate or better. So far, since mid-2009, the so-called recovery growth rate is only 2.5 percent. That's why the jobs picture remains disappointing. Businesses won't move until they get clarity on all the regulatory and tax threats.

Of course, President Obama isn't helping any. His populist language is harsh and divisive. His tax-the-rich proposals would move entrepreneurs who represent 80 percent of business income to as much as a 50 percent tax rate at the margin. This is a demoralizer, not a job-creator.

So, with 9.1 percent unemployment and sluggish growth in personal incomes, it's way too soon to declare victory on the economy.

Even with the markets rallying, stocks are still below late-April levels, and way below the prior peak of October 2007. In rough terms, investors have suffered a near $4 trillion loss of wealth. And with home prices about 35 percent below early 2006 levels, homeowners have lost over $7 trillion of wealth.

This combined $11 trillion wealth-loss effect is a massive family shock that means consumption will continue at a snail's pace. On top of that, a 3.9 percent consumer price hike over the past year is a body blow to real consumer income.

If only Washington would quit tampering with our free-market economy, and if only the president would see that the American economic system is supposed to reward success, not punish it, the animal spirits would recover and we'd double the economic growth rate. Unemployment would come way down in the process.

As for Europe, a trillion-euro rescue package is the key, plus the deal to have the banks take a 50 percent haircut on the Greek debt. The EU will guarantee the funding requirements and other liabilities of the European banks while they absorb the Greek bond-price writedown. And in the event of sovereign defaults, the European Financial Stability Fund will partially guarantee buyers of Spanish, Italian, or Portuguese bonds.

Right now we can be thankful that Armageddon has been avoided. Even more, U.S. regime change is coming in November 2012. Think how 2.5 percent could grow to 5 percent, with flat-tax reform and a regulatory moratorium. A very bullish thought.



Larry Kudlow is a senior contributor at CNBC, and also co-author with Brian Domitrovic of the new book JFK and the Reagan Revolution: A Secret History of American Prosperity.  

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