Executive Summary: A forecast of a 2000 Dow by midsummer pales as assumptions of tax/monetary growth policies in Europe & Japan fall. Weakness in the U.S. economy can't be blamed on the Fed this time. Monetary deflation in the combined $3 trillion economies of Japan and Germany, plus stubbornness there and in the U.K. and France in cutting top income tax rates, smothers global expansion, cuts oil demand and price, cripples Mexico. Nakasone's electoral triumph should spur a breakthrough, but a misguided masochism spreads in hopes of producing "international harmony" through austerity. Wall Street also defends itself against the possibility that the tax bill will contain more than a few clinkers. But we remain optimistic a better bill will emerge, and Treasury's Baker and Darman will then shift attention and energies to the global economy. Canada may be the first to emulate the U.S. on reform as Ottawa feels pressures from the business community.
The World Economy Holds Us Back
In its haste At the Polyconomics conference in Puerto Rico, February 27-March 2, we asked that the participants guess the date the Dow Jones Industrial Average would hit 2000. Most of the guesses were clustered between Labor Day and Election Day, with the median at October 7. (The most bearish forecast of the institutional investors present was May 1, 1988.) My guess was July 30, 1986. The reasoning reflected the outlook expressed in my February 3 letter, "For Awhile, Clear Sailing" which saw all the main policy ingredients on track. The "Gang of Four" was ensconced at the Fed, guaranteeing an end to deflationary dollar policies and inviting lower interest rates. The G-5 accord of September 22 pointed toward stabilized exchange rates with the Japanese and Europeans. And the White House, Treasury and Federal Reserve were in harmony on the need to urge growth policies for Europe and Japan, that would match ours. Movement in that direction seemed plausible after the Tokyo economic summit in May.
These ingredients would be helpful to a continued advance of the Dow. Of equal importance, though, was my surmise that if the tax bill could be moved through Congress as fast as the Treasury people wanted — with a bill on the President's desk by August 15 — Wall Street would celebrate in advance with a 2000 Dow. The assumption, of course, was that the Senate would make improvements in the bill that passed the House in December, and that the Treasury team of Baker and Darman would keep it on a growth track in the conference committee. This realistically rosy scenario leading to a 2000 Dow by July 30 looked fairly good on July 2 when the DJIA hit 1909. Then the nosedive.
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As a rule, markets do not climb or tumble because market analysts pronounce themselves as bulls or bears. The value of the nation's capital stock did not plunge by $78 billion on July 7 because several technical analysts changed their tune over the holiday weekend. An analyst can move a single stock by bringing new information or insight to bear. A Henry Kaufman can at times get the bond market dancing with his pronouncements — because there's a surmise he has a pipeline to inside political information that hasn't reached the market. But nobody can move the New York Stock Exchange more than a whisker unless new information is provided about the basic superstructure of the economy.
Clearly the economy itself has not unfolded according to the February scenario, this being entirely due to the failure of Europe and Japan to follow through with growth policies. "Foreign Economies Curb U.S.," a New York Times headline pronounced July 14. "Experts Say Domestic Gains Flow Abroad." The story by Peter T. Kilborn tells us that most economists "were caught unawares by the rising power of foreign economies over the American economy. About half the strength expected of the economy this year has been drained away by Japan, Taiwan, and other countries, as American consumers and businesses keep buying foreign rather than American."
The idea is right, although the Keynesian analysis isn't. It isn't the excess of demand in the U.S. for foreign goods that is the problem. It is the failure of Europe and Japan to invite more production through lower tax rates and anti-deflationary monetary policies. Japan and West Germany, the two most important economies after the U.S., whose combined economic spheres are equal to 60-65% of the United States in GNP, stood stock still in the first half combined growth rate of zero or less.
But if they had expanded, wouldn't they have increased their exports to the U.S. even more? Perhaps. But they would have increased their imports from the U.S. and the rest of the world at a greater rate. The depression in oil and commodity prices continues to sap the strength of the U.S. banking community, with colossal losses finally bankrupting First National of Oklahoma City and setting embarrassing red ink records at BankAmerica. This commodity depression can no longer be entirely attributed to deflationary policies here. They stem from the stubborn, no-growth policies abroad that have flattened the industrial demand for commodities.
Commodity producing nations in the Third World could be servicing their debts at BankAmerica, et al, if industrial demand for their goods were lifting prices above the cost of production. Instead, they are forced to increase production of raw materials by an International Monetary Fund that forces export measures as the price of their cash injections. Only governments can mine copper and lift oil at above the cost of production, which in turn gluts the world market and keeps prices low in the U.S., driving out private commodity producers and their creditors. If U.S. trading partners would invite expansion, they would benefit most those segments of the U.S. economy that are most depressed.
Why are they not inviting growth? When Canadian Prime Minister Brian Mulroney came to power two years ago he visited Washington and asked then Treasury Secretary Donald Regan what three things he, Regan, would recommend to get the Canadian economy moving. According to sources present, Regan said he'd do the same three things that were done here: Cut marginal, progressive tax rates, keep monetary policy fairly tight, and deregulate! Mulroney supposedly expressed great enthusiasm for the suggestion and said these policies were exactly what he had in mind. But back in Canada, the new Prime Minister was persuaded that he couldn't do what he wanted to do, and instead levied new surtaxes on income. Interest rates then had to stay high to offset the capital flight that the higher tax rates invited, with the costs to debt service undoubtedly offsetting any imagined increase in tax revenues.
It's the same old story. Political leaders want to follow the Reagan lead but allow their finance ministers and the international banking establishment to talk them out of it. During the last 18 months, in Japan, France, Germany and the U.K., moves toward lower progressive income tax rates have been thwarted by the same argument: What works in the U.S. won't necessarily work elsewhere. Here's Prime Minister Thatcher, interviewed by Malcolm Forbes Jr., in Forbes July 28:
We are not like the U.S., which can finance its deficit by drawing money from all over the world. Would money come to this country as it comes to the U.S.? No. First, look at the U.S. geographical position. Marvelous. It is not surrounded by socialist countries, we have the Iron Curtain across our continent. We also have socialist parties in this country which have been very adverse to wealth creation. That limits the amount of money that will come here.
Unfortunately, this dismal reasoning is standard in Europe. Lowering tax rates for the express purpose of encouraging investment won't work because Europe is "different," and any investment that might be encouraged will be discouraged because the socialist parties that are out of power oppose wealth creation. Steve Forbes needles Maggie a bit, but she manages the last word in dismissing "the Laffer equation," announcing that "My husband is an accountant," so "we always look at both sides of the balance sheet."
In France, President Mitterrand wanted to emulate the Reagan tax cutting of 1981, but faced an inhibition that other socialist leaders run into: Europe's left has so thoroughly painted Reagan as a bogeyman that they must resist even those of his ideas they might admire. Prime Minister Chirac should have no such inhibitions, but after running as a supply-sider he used up his political chips by ending the "wealth tax" on old money instead of slashing the high marginal rates that obstruct the creation of new wealth.
In Germany, Chancellor Helmut Kohl is amenable to personal rate reductions, but seems timid in dealing with his Finance Minister in initiating reforms. When he met in Bonn with Rep. Jack Kemp in early July he only allowed as to how Germany will probably be forced to cut tax rates to compete with the new U.S. rates. (In the Forbes interview it doesn't bother Maggie Thatcher that a new top U.S. rate of 27% would compare with the lowest U.K. rate of 29%.)
Japanese Prime Minister Nakasone's stunning electoral triumph on July 7 should enable him to do just about anything he wants on tax or monetary policies, one would think. But the sparse reports we get out of Japan suggest serious pockets of resistance at both the Finance Ministry and Bank of Japan. The central bank stubbornly refuses to bring down the high real interest rates that have caused the current deflationary recession. It has practically become a matter of honor at the central bank to endure the suffering of supertight money, which has driven the dollar/yen ratio to below 160. Why? Because of the misguided idea that this rate will eventually reduce the trade surplus and thus placate U.S. protectionists. The Christian Science Monitor's Tokyo correspondent says this resolve has been spread to the country at large, the idea that a period of suffering, perhaps "four or five years," will produce positive political rewards for the nation.
This sounds particularly Japanese, but it is reminiscent of the COP Old Guard after Reagan's electoral triumph of 1980, with former Treasury Secretary William Simon proposing to have a quick recession in 1981 to get it over with. As it happened, the Old Guard prevailed, winning David Stockman over, postponing the Reagan tax cuts, and engineering the stifling monetary deflation of 1981-82.
Prime Minister Nakasone can avoid a similar fate if he acts to break this unusual austerity mentality in Japan during the next few months. It appears he will be allowed to remain as prime minister at least until year's end; the constitutional rule on tenure has been bent to that extent. What worries us most is that his election victory is being interpreted by some in his party as an austerity mandate. Nakasone last October commissioned a study group on "Economic Structural Adjustment for International Harmony," chaired by a Keynesian economist, Harua Maekawa. It reported April 7, stressing consumption over savings in tax reform and stabilizing of exchange rates at levels that will bring "harmony" with Japan's trading partners. Conservatives are hailing the Maekawa report as "courageous," but it instead seems to be a serious barrier to the kind of tax and monetary policies that would get Japan back on a growth track. At the very least, it looks like an internal debate over policy will prevent any swift action by Nakasone of the kind the election seemed to promise.
It would help if Nakasone would be getting more constructive economic advice from the U.S., particularly Treasury Secretary Baker. Baker played a positive role in May, signaling his concern that the dollar/yen ratio perhaps had fallen too far at 160. But Baker has since shied from taking on the protectionists in Washington who are the chief cause of the Bank of Japan's misguided masochism. At 155 yen to the dollar, it's hard to visualize any economic growth in Japan this year. Baker should be lancing this boil by publicly questioning the validity of the theory that currency devaluations really do encourage trade surpluses — eventually. This neo-mercantilist idea, which led President Nixon to blow up the Bretton Woods system in 1971, remains an article of faith at the Commerce Department, and among most Keynesians.
Leonard Silk of The New York Times, whose column is the most important Keynesian billboard, has grabbed onto the Wall Street nosedive to conjure up parallels with the '29 Crash, warning against protectionism and "beggar thy neighbor" policies in one column (July 16), and observing that "Somber Clouds Are Gathering" (July 18):
The American economy, though deep in debt, needs stronger domestic stimulus, but so do the European and Japanese economies. The chronic state everywhere is excess capacity in key industries, which not only is threatening to breed greater protectionism but also to curtail investment and bring on a domestic and international slump. And if the Europeans expect the United States to grow while shrinking its budget deficit, they will have to help engineer a lower dollar, lower interest rates, and an improving American trade balance.
Of course, the engineering of "a lower dollar" is precisely a "beggar thy neighbor" policy, aimed at Japan (which is why Silk mentions the "Europeans" as our allies in this endeavor). It is also wrong in its belief that such engineering will improve the U.S. trade balance. At the moment, the greatest boon to the U.S. trade account would occur if the Bank of Japan, Bank of France and Bundesbank "devalued" their currencies via domestic monetary ease — driving the yen to 180 or more to the dollar, with parallel moves in Europe. This is absolutely counter to conventional demand-management wisdom, which imagines only an impact on export-import transactions (We'll trade more of our goods for less of their goods!). Forgotten is the impact on the Japanese economy itself of an end to the yen deflation, and on real growth in Europe, all of which would swamp the imagined currency effects.
Most of the Federal Reserve governors, including the chairman, have an appreciation of these arguments, which is why they have been publicly urging easier monetary policy and tax cuts in Europe and Japan. This may be the biggest intellectual barrier Secretary Baker has to leap on the way to a global monetary reform — which the Japanese are clearly ready for. An agreement with the Japanese Government to stabilize the dollar/yen ratio at some reasonable, non-deflationary level — a G-2 pact, if you will — seems the most logical means of solving this problem. At the same time it would serve as an example and prod to the West Germans, who continue to shy from discussion of a new fixed-rate system.
My expectation is that as soon as the tax bill is wrapped up in the Senate-House conference, Baker and Darman will turn their full attention to this international agenda. The first breakthrough may come closest to home, with Baker already engaged in telephone consultations with Canadian Finance Minister Michael Wilson. According to The Wall Street Journal July 21, Wilson told a press conference that he'd had such talks following "warnings from businessmen that the cuts currently proposed in the U.S. individual tax rates could prompt many Canadian businessmen and head offices to move to the U.S." Said Wilson: "Canada must maintain a tax system that is competitive with that of the U.S."
Mexico has also suffered because of Treasury's understandable focus on domestic tax reform. To the bureaucrats attending to the Mexican debt crisis, the problem seems practically beyond solution because of the capital flight. The objective is to get the U.S. commercial banks lending to Mexico again, to get them some quick cash. The Treasury and Fed are restraining the IMF from adding another injection of austerity into the beleaguered country, but the IMF has been holding up approval of the rescue plan on the grounds that Mexico's deficit projections are not credible. The IMF goal is to make sure loans to Mexico aren't simply offset by further capital outflows, as if 90% interest rates on peso obligations will do the trick. As far as we can tell, not a soul is examining the tax structure — an incredibly high combination of income and value-added taxation that is crushing business and propelling assets north. But we have to assume that Baker is working this problem as he has Canada's. Growth outside Mexico would help Mexico. So would growth inside Mexico. But it is getting neither and is fast becoming a basket case.
These setbacks on the international economic front were putting a greater burden on Wall Street than it could bear when it was thrown another over the July 4 weekend. The straw that broke the camel's back, so to speak, was the new wrinkle in the tax reform process: An agreement between Senate Finance Chairman Packwood and Ways & Means Chairman Rostenkowski. On the surface the deal seemed harmless enough: Rosty would work toward the low marginal rates in the Senate bill; Packwood would work toward restoring benefits to the "middle class" that Rosty wants, with the extra costs to be paid for by assessing corporate America.
Because the agreement was conceptual, not specific, almost anything could be imagined. It's easier to say that the market was troubled by its overall assessment of the agreement than exactly why. But my guess is that it had to do with capital gains. Prior to the agreement, the market may have weighted a likelihood that some capital gains differential would emerge from conference as the House conferees pushed the 27% rate upward. The Rosty tilt toward the 27% rate on personal income dramatically increased chances that the differential would be eliminated, perhaps even closer to 30%.
In addition, rumors circulated that the conference might set the effective date of the higher capital gains rate sometime in July, catching those who had not cashed in their gains but who intended to benefit from the 20% rate before it expired January 1. The former chief of staff of the Joint Committee on Taxation, now a partner at Price Waterhouse, had alerted PW's clients to this possibility, which The Wall Street Journal reported July 9. A Ways & Means staffer was also said to be talking it up. Wall Street now has to defend itself against the possibility that this historic piece of legislation might have a few clunkers in it. It's also unhappy with a 1986 economy that has a tax increase — the loss of the investment-tax credit with no offset this year in the tax bill.
We continue to believe that the legislation that finally emerges will be better than the general expectations of the moment. Yet the parallels with the 1920s do have validity. Tax and monetary policies in the United States could be close to optimum, now as they were then. But if the rest of the world doesn't follow suit, the structural tensions will produce anything but international harmony. At the moment, all this is in doubt, which is why we'll have to wait awhile for the 2000 Dow.
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