Executive Summary: Last July, I sketched out a hypothetical path that would take the Dow Jones Industrial average from its then level of 800 to 3000 or 4000 by the early 1980s. Although nine months later the DJI has advanced to 850-plus, there has been little movement along the path of the scenario. By contrast, stock market records are being broken in Great Britain, which is almost certainly headed down the scenario path. In the United States, pressures for a similar surge are building up. But with the Carter administration still under the influence of the Phillips Curve, combating inflation by seeking lower growth, there remains the possibility that the U.S. will have to go through another pain threshold before policymakers stumble onto the bull-market track.
Bull Market Scenario Reviewed
There is an arresting headline in the March 12, 1979 issue of Fortune: "The Stock Market Should Be Twice As High As It Is." The article describes a fresh insight by MIT economist Franco Modigliani, who has examined the impact of inflation on corporate profits. Yes, says Modigliani, as the general price level rises, corporate deductions for depreciation and inventory expenses continue to be calculated at original cost. This leads to an understatement of true production costs and an overstatement of profits. The stock market takes all this into account in knocking down the value of a company's shares. In the last decade, the general price level has doubled while the nominal level of the S&JP 500 or the Dow Jones Industrials has barely moved, which means the real value of the stocks has been halved.
But wait, says Modigliani, there is a second effect that inflation has on earnings, an effect that cuts in the opposite direction and by roughly the same magnitude. Companies have been able to pay down corporate debt with inflated dollars. That is, if a company borrows when the inflation rate is 8 percent and the long-term bond rate is 11 percent, its real interest rate is only 3 percent. The other 8 percent is return of capital to the lender. Yet accounting principles require the firm to deduct the full 11 percent nominal interest rate payment from its gross profits. Thus, net profits are understated.
The point is neat enough and reasonable, but Modigliani proceeds to leap from it to an extraordinary conclusion, that market values are half what they should be because institutional investors have been aware of the first inflation effect but unaware of the second. The notion explicitly denies the concept of market efficiency, indeed suggests that the market can be at least 50 percent inefficient. Fortune's Mr. Rose, who has swallowed the Modigliani idea whole, goes so far as to imply that (in the 1960s) investors went through a similar learning threshold by altering their valuation of stocks to a primary consideration of growth potential instead of dividend yield.
A better analysis flows from Arthur Laffer's "wedge" model, coupled with efficient markets theory: that inflation (an erosion of the monetary unit of account) in and of itself has no impact on the real value of shares. It is through collision of inflation with progressivity in tax systems that the level of market values is adversely affected. That is, if the only wedge in the exchange economy were a 20 percent tax on all transactions, and the DJI was at 1000, a doubling of the general price level through a monetary inflation would send the DJI to 2000. It is when inflation collides with tax progressions that marginal tax rates climb, eroding incentives to both capital and labor and thereby reducing the efficiency of the aggregate economy.
Even without inflation, steep tax progressions have this eroding effect in an economy that is growing in wealth. If, say, in 1945 the tax on earnings over $100,000 is 91 percent, but there are few people capable of earning $100,000, the disincentive effect of the 91 percent rate is small. By 1960, though, the level of wealth has increased and many people are capable of earning $100,000; the 91 percent rate looms as a more serious barrier to increased productivity. A sudden reduction to 70 percent frees that mass of underutilized capital and labor in a new surge of productive effort. This was the effect of the Kennedy tax rate cut of 1963-64, which sent the stock market soaring in a heightened valuation of the nation's capital stock. It was not, as Fortune implies, a sudden realization by institutional investors that growth potential was more important than dividend yields.
What the Modigliani notion now fails to consider at all, as it points to inflation-induced gains on corporate debt, is that corporations share in the nation's collective debt. And in the last decade the collective debt has soared.1 Fortune is correct to say that "The market price of any stock is supposed to be equal to the present value of the future stream of the company's earnings." It would be more precise, of course, to say "the future stream of the company's after-tax earnings."
Here's the clinker in Modigliani's idea. Public debt — federal, state and local (including the unfunded liabilities of the Social Security System) — is now measured in the trillions of dollars, and in the last decade has risen several times faster than the general price level. This debt represents the promise of federal, state and local governments to tax those trillions of dollars out of the future economy. As the efficient market contemplates the future earnings stream of a corporation, it must assume an increasing portion of that stream will have to flow into funding of public debt, with a dwindling amount remaining for the holder of corporate shares.
Having said this, it can still be argued that the stock market indices should be double their current levels. But in the Laffer "wedge" model, this could only occur as a result of corrections in government monetary, fiscal and regulatory policies. As a result of inflation's collision with tax progressions in the past decade, the entire aggregation of U.S. capital and labor is now massed against marginal tax rates that impede their most efficient, productive use.
This, essentially, was the framework for my report of July 26, 1978, "A Bull Market Scenario", which sketched an hypothetical path to a DJI of 3000 or 4000 by the early 1980s via a rapid, systematic dismantling of the fiscal, monetary and regulatory "wedges". At the time, the DJI was struggling to stay above 800. With the DJI floating above 850 in mid-March 1979, the real value of the nation's corporate capital stock has not risen at all, given the roughly 7 percent rise in the general price level during the 9-month period.
There has, unhappily, been little movement along the path of the scenario. Congress did follow through on the Steiger amendment, reducing the top marginal tax rate on capital gains from 49 percent to roughly 28 percent. On a guess, this measure alone is probably worth more than 100 points on the DJI, enough at least to keep the economy from tumbling into a palpable recession. But in October, under the threat of a presidential veto, Congress failed to press ahead with phased reductions in personal tax rates ("Son of Kemp-Roth"), and by the narrowest of margins approved the Natural Gas Policy Act of 1978. In another guess, the DJI might have gained 100 points if these two measures — both critical to the fiscal and regulatory "wedges" — had gone the other way. As it was, the DJI skidded 100 points in the week after Congress resolved them.
Until November 1, when the President returned to a strong dollar policy, the Federal Reserve was traveling backward on the path of the outlined scenario for a bull market by failing to maintain the value of the dollar as a unit of account for transaction purposes inside and outside the U.S. economy. Instead, the Fed repeatedly raised the discount rate in the belief that in so doing interest rates would rise, cooling off consumer demand, thereby relieving upward pressure on consumer prices, slowing the rate of inflation. It pushed interest rates up, though, primarily by eroding the value of the dollar as a unit of account. Interest rates rise, after all, as money markets anticipate a future decline in the purchasing power of money. This is the way the Fed pushed interest rates up, increasing the price of credit by expanding the supply of money, continuing to inject reserves into the banking system.
The net result was more, not less, inflation, and throughout the Fed's pursuit of higher interest rates, we have watched the dollar price of gold and other commodities climb, presaging the inevitable rise in the general price level when there is an erosion in the unit of account. There is no way the government can persuade management and labor to accept a devalued unit of account, a devalued dollar in terms of basic commodities, for the purpose of trading their skills and efforts in the marketplace.
Since November 1 a little progress along the bull market scenario path has been made. The Fed has intervened in the foreign exchange market, the dollar has stabilized, the discount rate has not been raised in 4 ½ months, and the rate of growth of bank reserves has moderated noticeably.
Meanwhile, the Carter administration's economists have been attempting to emulate the wage-price guidelines, combined with "wage insurance'' tax incentives, that Great Britain has employed with apparent success in recent years. But British controls were successful only insofar as the Bank of England pursued monetary policies that stabilized sterling as a unit of account. Sterling has devalued against basic commodities in recent months and the incomes policy has broken down under pressure. The British stock market is enthusiastically discounting a Conservative victory in the next election, the Financial Times Actuaries All-Share Index climbing 18 percent during a one-month stretch in February-early March to a record nominal high. A headline in the March 17 Economist read: "British Stock Market: Panting for the Polls."
The reason for this is that the Tory leader Margaret Thatcher is on the path of our bull market scenario. She has pledged, when the Conservatives control Parliament, to cut the top marginal tax rate on personal incomes to 60 percent, from the present 83 percent on wage and salary income, and 98 percent on investment income. If there are no slipups, the British economy should be on its way to a solid, noninflationary economic expansion in the 1980s, shedding itself of the "British disease."
Events in Britain should be watched closely, for success there will breed successful economic policies on this side of the Atlantic. A similar bullish surge in the U.S. stock market could occur at any time, over a brief period, as soon as the Laffer "wedge" theory makes a breakthrough into the Oval Office. This remains the basis for my continued long-term bullishness, as we see the pressures for such a breakthrough building up steadily.
Except for passage of modest personal income and capital gains tax cuts, the most positive news of 1978 came in the November Congressional elections, which brought the demise of several leading Senate liberals who were associated with redistribution economics. Unfortunately, the conventional analysis of the elections has led to the current belief that the nation is in a "conservative mood", with conservative bottom-line policy defined as austerity in fiscal and monetary matters. Thus, in absorbing this wisdom, President Carter has concentrated on frugality in spending and high interest rates. Still, if we assume the policymakers must pass through this threshold before they arrive at the radical ideas of supply-side economics, this too is a positive development. At the very least, Keynesian deficit spending nostrums are out the window, and there is now a broad consensus that the nation's energy industry is over-regulated, with adverse supply-side effects.
A milestone in this gradual drift to supply-side economics was passed on March 19, when for the first time in twenty years the Joint Economic Committee of Congress issued an annual report embraced by both Democrats and Republicans. The Committee chairman's introduction, by Sen. Lloyd Bentsen of Texas, signals a dramatic shift in the JEC's theoretical approach to the U.S. economy:
... this Report illustrates an emerging consensus in the Committee and in the country that the Federal government needs to put its financial house in order and that the major challenges today and for the foreseeable future are on the supply side of the economy. . . .
To post World War II economists, the basic economic problem was to ensure an adequate level of demand. Insufficient demand was the main economic problem of the depression era. Excessive demand was the main economic culprit during World War II. So it was not surprising that economists were preoccupied for almost 30 years with the problem of maintaining an adequate level of demand in the economy. The Arab oil embargo and the subsequent behavior of the OPEC cartel suddenly and dramatically began to force the attention of the country and its economic experts on the supply side of the economy...
The JEC recommendations, though, are nothing to shout about. There is a mild embrace of the President's voluntary wage-price guidelines as an inflation-fighting instrument, and the usual confusion of "tight money" with high interest rates. There is no recognition given to the debilitating effects of high personal income-tax rates on productivity. When the Committee does dwell on tax relief, it has corporate America in mind. It continues its belief that monetary policy should be insulated from global considerations. Its most positive section is on regulatory policy, particularly its affirmation of the consensus on energy decontrol.
Nevertheless, the report's conceptual emphasis on supply rather than demand will have an immediate and powerful impact on the economics profession, especially in the academic marketplace. Authors of introductory economic tests for college use are already shoehorning supply-side material into their new editions. And economists who regularly testify before the JEC are forewarned that their standard approach is now certifiably obsolete. There is no telling at what rate these wheels will grind, but they are grinding, and it is not unreasonable to expect that sometime in the 1980s the Laffer "wedge" will be conventional.
At the moment, though, the Carter administration moves from pillar to post, taking up one problem at a time as dates fall due on the calendar, without any apparent strategic view of the U.S. economy and its fit in the world economy. We will attempt to buy a Middle East peace, with roughly $25 billion pledged to Isreal and Egypt over the next five years out of the U.S. Treasury, to bolster their respective economies. The durability of a Middle East peace will have more to do, though, with domestic economic policies pursued by Israel and Egypt, and whether these can provide sustained economic growth that will support an era of good feeling, Palestinians included.
The Middle East "taken care of", the President now focuses on the June 1 deadline for crude-oil deregulation. His proposals, expected before the end of March, are expected to include phased deregulation of crude prices in conjunction with a "severance" tax at the wellhead, a replay of the crude-oil equalization tax proposed in 1977. Although consensus exists on phased deregulation, there is no taste in Congress for new taxes. It will be difficult for Carter to find a congressional coalition to support the kind of package he has in mind. On June 1, legislative authority to decontrol goes to the President. We can only hope he has the courage to announce phased decontrol absent a tax. It will take courage both because Carter believes such a move will be inflationary, which it will not be, and because he will invite the wrath of the liberals, Senator Kennedy being at the head of that weakened phalanx.
There is now no concentrated focus on tax policy, either by the Administration or by Congress. However persuaded policymakers may be that Keynesian doctrine has seen its day, they remain in its grip. The idea of a Phillips Curve tradeoff between inflation and unemployment remains embedded in Washington's consciousness, and inflation is the targeted enemy in March 1979, with interest rates the weapon. Only here and there on Capitol Hill, among the Kemp-Roth crowd, is there the latent force of the idea that productivity is an effective weapon for combating inflation. With the increasing likelihood that Representative Kemp will seek the GOP presidential nomination, as New York's "favorite son," we may at least be assured that supply-side policies will be part of the national debate through 1979, if not to November 1980.
The bull market scenario remains intact. We are not yet on its path, as Great Britain seems to be. It is my belief that we will get on it, but perhaps not before we pass through another pain threshold, a recession induced by ill-conceived policies to combat inflation. Maybe then, with the unemployment end of the Phillips Curve again in focus, will the Laffer "wedge" come to center stage.
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1 R. David Ranson, "An Analysis of the Budget Deficit", H.C. Wainwright &L Co., Economic Study, May 13, 1977.