SYNOPSIS: Paul Krugman debates Larry Kudlow on the state of the U.S. economy

GREGORY: Welcome back to HARDBALL. On the day that the Federal Reserve raised interest rates by a quarter point, President Bush touted his economic policy of allowing Americans to keep more of what they earn and said the strategy is paying off.

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GEORGE W. BUSH, PRESIDENT OF THE UNITED STATES: The economy is growing faster than any other major industrialized country. Job growth is strong. We added over 200,000 new jobs in July. This country added nearly four million new job since May of 2003. The unemployment rate is 5 percent, which is below the average of the 1970s, 1980s and 1990s. Americans have more money in their pockets. And that is good news.

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GREGORY: Paul Krugman is a Princeton economist and "New York Times" columnist. And Larry Kudlow is an economic analyst and host of CNBC`s "Kudlow & Company." Welcome to you both.

PAUL KRUGMAN, COLUMNIST, "THE NEW YORK TIMES": Hi there.

GREGORY: Paul Krugman, let me start with you. Do you see the same economic portrait that the president does?

KRUGMAN: No. I mean, look, some job growth is better than none. It is -- you want to put these in perspective. That -- last month was a pretty good month for this administration. It would have ranked 69 out of 96 in terms of job growth during the Clinton years. So, it is not -- it is not really terrific news. And it`s a recovery that is not really delivering. There`s not a whole lot trickling down to wages. It is -- it is a disappointing recovery, although it`s a lot better. Thing are certainly better than they were in the summer of 2003, when it was really depressing.

GREGORY: Larry, is this a strong recovery? Is it a surge? Or is it kind of anemic?

LAWRENCE KUDLOW, CO-HOST, "KUDLOW & CRAMER": I think it is a -- it is a solid recovery that is getting stronger as we go on. And I think President Bush is exactly right. His tax cuts on investment and capital were big precursors of the last two years, creating four million jobs and dropping the unemployment rate to 5 percent. You know, interestingly, David, we`ve been growing now, I guess, at a 4 percent annual rate for each of the last two years, since those tax cuts. But I don`t think the administration has been very good at communicating their success. I was quite surprised on Friday, given a big jobs increase, that the president didn`t hold a special news conference to talk about it, not to crow about it, just to put the facts on the table. He`s running low on the economic polls. He`s got a lot to take credit for, in my judgment, after inheriting a recession and a stock market plunge and, of course, the war. And he`s helped us get out of that. So has the private economy. So has the work force. But I, frankly, am sometimes baffled by their lack of communication.

GREGORY: Paul, why is that, if there`s a rash of good facts, good economic facts, the American people are still pretty gloomy about it?

KRUGMAN: Well, they aren`t...

GREGORY: Larry mentions last week, a CBS News poll found 50 -- found 52 percent disapprove of the president`s handling of the economy.

KRUGMAN: Well, remember, the facts aren`t that good. Even Larry, in his attempt to spin it, is saying, well, it`s pretty good when you consider recession, stock market crash, the war. The fact is that, you know, by normal standards, this is a subpar recovery, by any standard. The Congressional Budget Office had a study out just yesterday talking about how much below the typical this recovery is in terms of job growth. It is not just not -- it is not great. It`s not -- don`t want to make it doomsday, but it is not great, very little shared by -- recent study by Congressional -- sorry -- Center on Budget and Policy Priorities said, you know, you can look at seven indicators of strength of a recovery. On six of them, this is just way subpar. It`s the worst of the postwar period. The only one that is really above par is corporate profits. Well, that doesn`t mean anything to most people. People are not feeling good about their job prospects or their wages.

(CROSSTALK)

KUDLOW: It might be a little stronger than Paul is -- look it, income after taxes and inflation is rising very nicely. It`s growing at over 3, three-and-a-half percent. And total incomes are rising at about 6 percent, six-and-a-half percent. I agree with Paul. If you compare this to the late `90s, it not as strong. But there was a lot of overhiring in the late `90s, from the Y2K problem and the Internet bubble explosion.

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KUDLOW: The 5 percent unemployment rate is actually lower than the average of the `70s, `80s, and `90s. And that is a pretty good proxy for how things have improved. But the point I`m making is, in that -- as we move forward here, we have very low inflation. We have solid growth of about three-and-a-half percent. You`re creating jobs at about 175,000, 185,000 a month. All you need to break even is about 100,000. This thing has got legs. It can go on for four, five, six more years. And I think that is the point the White House should make, that people should be more confident about the future.

(CROSSTALK)

GREGORY: Paul, quickly, why did the Fed raise the interest rate? What does it mean?

KRUGMAN: The Fed is concerned about, you know, eventually, having some inflation, although there is no sign of that really in the numbers right now. And a lot of this is conditioned by the fact that they are trying to get the markets ready for the fact that interest rates will eventually go up. There was a -- there`s a long story about 1994, when -- when the bond market suddenly said, oh my God. the Fed is eventually going to raise rates. And things plunged. So, they have got this view. I think they are wrong. I think that they are fighting a risk that isn`t there. But it is mostly a matter of signalling to the markets that the really low interest rates of 2003 are not going to last.

GREGORY: Right.

KUDLOW: I`m just dying to say.

GREGORY: Go ahead, Larry. Before the break, go ahead.

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KUDLOW: At the risk of being read out of the conservative movement, that I agree with Paul Krugman.

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KRUGMAN: Once, in a while, it happens.

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KUDLOW: Regarding the Fed.

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KRUGMAN: It`s like a stopped clock twice a day.

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KUDLOW: ... tightening at all. I think Mr. Krugman has it exactly right. There ain`t no inflation. And the Fed should take the next six months off.

GREGORY: All right. We can with -- we can to go press with that headline.

(LAUGHTER)

GREGORY: But we are going to a break. We are going to be right back with Paul Krugman and Larry Kudlow. You`re watching HARDBALL, only on MSNBC.

GREGORY: We are back on HARDBALL with Paul Krugman of "The New York Times" and Larry Kudlow, host of "KUDLOW & COMPANY" on CNBC. All right, guys, one of the ways that Americans feel the economy and whether it is doing well or not is, they look at how their homes are doing, what the value of their homes are vs., say, their stock portfolio. And, certainly, in the past few years, it has been good news if you own a home, if you`re trying to sell a house, certainly good news. Paul, you`re worried that Americans may be kidding themselves, that there may be a bubble about to burst here. Why?

KRUGMAN: You just look at the -- first of all, you look at the numbers. The number are -- not the national averages, because there is a large part of the middle of the country where nothing is happening. But if you look at the coasts, the house price increases are way out of line with everything that might justify it. They are way out of line with the increase in rents.

GREGORY: Right.

KRUGMAN: They are way out of line with the economy -- economic growth. So, it looks -- the numbers look like they did before the Nasdaq bubble burst. And...

GREGORY: And what drives that, just people willing to pay a lot of money in coastal areas?

(CROSSTALK)

KRUGMAN: Well, and the fact that people see that other people have made lots of money on their houses.

GREGORY: Right.

KRUGMAN: Everyone who buys a house now in New York or Miami or in San Diego assumes that the price will just keep going up and up and up. And that is what you call a bubble, because it doesn`t happen.

(CROSSTALK)

KUDLOW: I just feel -- look it, I have a different take on this. Quick anecdote. Last weekend, I was with my congresswoman from the East Side of Manhattan, Carolyn Maloney. She`s a liberal Democrat. I`m a supply-side Republican. But she was telling me the story how she was touring in Harlem, New York, and the building boom, the real estate boom, folks buying homes. They had access to credit. That whole area is being rebuilt. There was a story on the front page of "The Wall Street Journal" a month ago., the inner city of Baltimore being rebuilt because of the housing. And it is true in Philadelphia as well. I think the housing boom is a tremendous plus for middle-income people, for low-income people. And, yes, people that already own homes in Naples, Florida, and Beverly Hills, maybe they are overpaying.

KRUGMAN: Well, bubbles are fun when they are happening.

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GREGORY: But isn`t the scary point...

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KUDLOW: This thing is one of the best things that could happen to this country.

GREGORY: All right.

KRUGMAN: Bubbles are fun when they are happening. We were all very happy when the Nasdaq was soaring. David, you should know there`s a little bit of history here. Back in 2000, Larry wrote a number of scathing articles about self-important college professors who thought that the tech stocks were overvalued and urged his readers to go ahead and -- and keep on buying tech stocks. I mean, Larry always thinks the market is right. I sometimes think there is a bubble. I think the numbers are really, really clear here, and the frenzy, the atmosphere as well.

GREGORY: All right, so, what -- what happens? Because if -- if -- if the concern is that people are not saving -- the personal savings rate is abysmally low -- and people are spending a lot of money. They are spending it to gas up their cars and on other things in life. But they are looking at stocks vs. real estate and saying, well, at least I am going to be able to hold my investment. It is going to hold my line if I invest it properly in real estate.

KUDLOW: Right. Very important. That`s a very important point.

KRUGMAN: Well, I`m really...

GREGORY: But -- but -- but, Paul, is that -- I mean, what -- what concerns you about that?

KRUGMAN: Well...

GREGORY: And what happens if that thinking is wrong?

KRUGMAN: A lot of people are going to find themselves with mortgages they can`t handle. They are going to find themselves -- you know, personal bankruptcy will go up, except, of course, the laws have been tightened on that now, quite brutally. But the main thing, I`m just -- we -- you know, this -- this economic recovery, I`ve been complaining about it, but at least it is a recovery. And it is driven, it is driven mostly by housing.

KUDLOW: No.

KRUGMAN: It`s the increase in housing construction. It is the increase in wealth, which leads people to spend more. I`ve done the numbers, say about that three-and-a-half to 4 percent of GDP is housing. The tax cuts are around 1 percent. This is much more a housing story than a tax-cut story.

KUDLOW: Well, I -- I...

KRUGMAN: And when the housing thing bursts, we are in big trouble.

KUDLOW: I`m prepared to agree with part of that. But I think capital investment is now picking up steam. But I want to just come back to two points. Number one, when the Federal Reserve got too tight in year 2000 and inverted interest rates on their head, then I said get out. So, Paul is being a little unfair. More to the point, regarding housing, the expansion of homeownership among the middle, lower-middle and lower-income classes is one of the great benefits and boons of this economic prosperity.

GREGORY: But -- but -- but...

KUDLOW: And I don`t think we should be so worried about the super rich in Naples, Florida, or Beverly Hills, California, nor do I think the Federal Reserve should direct policies at stopping...

(CROSSTALK)

GREGORY: Well, Larry, let me ask you this, just more of a real-world problem.

KUDLOW: This is a good thing. It is rebuilding inner cities.

GREGORY: Understood.

KUDLOW: And this ownership is a model for how the rest of the economy can expand.

GREGORY: Final -- final question on this. If people are too leveraged, if they are putting too much of their money into real estate and the values don`t hold up, aren`t they in for a rude awakening?

KRUGMAN: Yes. I mean, that -- this is exactly what we are worried about. We are worried that there will be a rude awakening, that people will find themselves in trouble. And it`s not just the people who are, you know, heavily leverage and bought real estate. But, again, the economy -- we`ve got a real-estate-driven economy right now. It is all -- you know, if you ask, where`s the growth coming from, the answer is, the bubble did it. And if the bubble bursts, it actually -- as I said in "The Times," it sort of deflates slowly. But then we are in a lot of trouble, all of us.

GREGORY: All right, Larry, Larry, you can have the final word here.

KUDLOW: Just real quick, I think it is an investment-led recovery, particularly capital investment. I agree that housing is very strong. I`m totally in favor of that; 97 out of 100 people who make these borrowings know exactly what they are doing. You know, it is as though journalists and other professors think that the rest of the people don`t get it. They do get it. They know precisely what they are doing. They know how to roll over loans. They know how to fund them 30 years. You can make it more affordable by allowing yourself the new mortgage options that thankfully are available. You`re not going to have a housing bubble go bust when the unemployment rate is low and the economy is growing at 3, 4 percent. The name of the game here keep taxes down and stop the fed from throwing a monkey wrench into this prosperity.

GREGORY: We are going to leave it there. My thanks to Paul Krugman and Larry Kudlow. Up next, the battle over evolution vs. intelligent design. Which one is a real science? And what should be taught in schools? That debate straight ahead. You`re watching HARDBALL, only on MSNBC.

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Originally broadcast, 8.9.05