With gains in productivity and living standards now rivaling those of the Industrial Revolution, it’s clear that the so-called productivity paradox has decisively been overcome. I’d warn against complacency, though, because this extraordinary economic setting is not immune to upset by the sort of policy error that is now being committed by the Fed. 

No question, the widespread commercialization and adoption of  information technology innovations has been key to realizing the ongoing gains in productivity of the capital stock. But that in important respects has been the consequence of a major shift in the tax and inflation environment which boosted expected real, after-tax returns to capital, reduced the cost of capital, and spurred the enormous growth in productivity- and growth-enhancing  IT investment.      

Two related changes to the monetary/fiscal environment in the 1996-97 period were primarily responsible. First, the Republican Congress re-elected in November 1996 established from the outset that a significant capital gains tax cut was going to be among its highest priorities. Even months prior to passage, this had the effect of increasing investment demand for dollar liquidity, which showed up in a rising value for the dollar against foreign currencies and a steady decline in the price of gold, the commodity most sensitive to shifts in the currency’s purchasing power. At this point, a major alteration in the inflation expectations climate was being brought about primarily by expectations of a pro-growth fiscal event. 

It is also important to recognize the impact of inflation on the investment-tax climate. As an unindexed tax, the real, effective capital gains rate is compounded by inflation. During the inflationary era of the 1970s, real capital gains rates exceeded 100% on many long-held investments. This surge in real tax rates obviously posed a huge obstacle to capital formation and goes a long way toward explaining the break in the 3% trend rate of productivity growth in the early 1970s, which to this day continues to stump the mainstream economics industry.        

By the time the capital gains tax cut was enacted in summer 1997, retroactive to January, reported inflation rates were beginning to fall rapidly from the 3% levels that had generally prevailed in the previous few years. Thus, not only was the market embracing a 28% cut in the nominal tax rate from 28% to 20%, it was also discounting for a decline in the real, inflation-adjusted rate which exceeded 50% 

Obviously such a major boost to real expected after-tax rates of return opened the floodgates for an era of robust capital formation and risk-taking, of which the IT revolution is the most striking manifestation. Although it defies belief, one of the concerns of the Fed in setting out on its rate-hiking course a year ago was that the low cost of capital was contributing to an “excess” demand for labor and feeding into a potential outbreak of wage inflation. Thus, it has purposely set about attempting to undermine the roots of this enormously beneficial economic transformation. If it goes much further on this mindless path, it just might succeed.