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Slow Economic Growth in 3rd Quarter

October 27, 2006

The U.S. economy grew more slowly in the third quarter than any time since 2003. The crashing housing market is the main factor for the slowdown.

A major question hanging over both the economy and the political campaign this fall has been just how severely the slump in housing would drag down growth. The Commerce Department’s report, which will be revised twice in coming months as more complete data becomes available, shows that the drag was indeed substantial.

Residential construction plunged by nearly one-fifth in the quarter, the steepest decline in 15 years. That trend alone knocked 1.1 percentage points off the overall figure for economic growth. As recently as the spring of 2005, that sector was a major motor of growth, adding more than one percentage point to the overall figure. With the economy shifting into a lower gear, analysts believe that the Federal Reserve will be unlikely to resume raising interest rates any time soon. The Fed paused in August after a two-year campaign of steady increases in its benchmark overnight lending rate, meant to combat inflation. It has kept the rate steady at 5.25 percent through three policy-setting meetings since then, even though the inflation rate has remained stubbornly high.

The majority view at the Fed is that the economy is already on a slowing trend that will bring inflation to heel, and the new report supports that view. A closely watched measure of inflation in today’s report, the G.D.P. price index, rose at a 1.8 percent annual rate in the third quarter, seasonally adjusted, compared with 3.3 percent in each of the first and second quarters. Falling fuel prices helped bring the rate down.

With midterm Congressional elections less than two weeks away, the new figures offer something for both Republicans and Democrats to cheer. The weak growth rate suggests that the economy is not as robust as it once was, bolstering Democrats’ criticism of the administration’s economic policies. But the report also finds consumer spending gaining strength, rising by 3.1 percent in the third quarter, compared with 2.6 percent in the second.

As the mid-terms approach, politicians are arguing about the state of the economy and the effect of the Bush tax cuts. Most of what is being argued is nonsensical, as if all "tax cuts" are the same. Tax cuts, in general, are a good thing: they do spur investment. Cutting the capital gains rate does spur investment. It also helps seniors who have their money in the stock market and other long-term investments. Allowing 100% of the health insurance premiums to be deducted by self-employed persons helps small businesses. These tax reforms all made sense.

The problems with the Bush tax cuts were threefold: 1) the tax incentives to multinational corporations for outsourcing hurt the U.S. middle class and the job market, and did not spur any investment or hiring by those companies; 2) Congress was unable to make the estate tax repeal permanent, which severely impacts small business owners and family business owners; and 3) the tax cuts were financed by massive borrowing from China while the U.S. was taking on an immensely expensive war in Iraq.

Borrowing to pay for tax cuts is just asking for fiscal disaster down the road. It's just delaying the pain. It also causes a diplomatic nightmare when you really need to lean on China and can't because you owe the country billions of dollars. That explains why we're tap dancing around in our response to Kim Jong-il's nuclear plans.

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