Executive Summary: The failure of Establishment experts to see the link between the Smoot-Hawley tariff and the 1929 Crash denied Herbert Hoover guidance that could have avoided the Great Depression. GOP stubbornness on the issue led to a major political realignment, Democrats becoming the growth party. Now, Establishment failure to understand deficit/stock-market linkages misleads the Democratic Party into support of tax increases. A "smoking gun" is seen in the interplay of Washington and Wall Street, Feb. 27-28. The White House stands firm, supply-side influence at a new zenith, opening the first opportunity of a GOP landslide, control of Congress, a new political realignment. Mondale loses New Hampshire by an explicit Robin Hood media effort, Hart surges with a Carter-style "fuzzy" campaign. But the Democrats, including Hart, are still burdened by party elders who cling to the past. Democrats of '84 are the Republicans of '36.
Political Realignment: 1936 & 1984
The most surprising thing about the stock market crash of October 1929 is that neither the financial analysts nor the public policymakers of the time observed the perfect correlations in the collapse of the market and the progress of the Smoot-Hawley tariff legislation, then on the Senate floor. As the anti-tariff coalition in command began to fracture, stocks plunged. As the coalition revived, on test votes, Wall Street revived. When the coalition finally lost control to the protectionists, the market collapsed. Yet there is no record in The Wall Street Journal, The New York Times, or the Commercial & Financial Chronicle of any commentator who saw the connection. It was not until early May of 1976 that I stumbled on the correlations while browsing through New York Times microfilm. The only story I could find that linked the crash to the tariff bill was a Times report of October 29, 1929, that Senate Republican Majority Leader Watson accused the Democrats of delaying action on the tariff bill, thereby causing the market's collapse. Maryland's Democratic Senator Millard Tydings retorted that it was the Republicans who were causing the delay. The entire Establishment, with Wall Street's professional economists and bankers in the forefront, missed the boat entirely. The big political loser was Herbert Hoover, who might have vetoed the legislation had he even suspected it was the cause of the crash.
It is of course essential that portfolio managers understand the impact of political events on financial markets. It's even more important that presidents and policymakers understand and use market feedback as a guide in shaping policy. Hoover's blunder not only brought on the Great Depression; it also ended 70 years of Republican dominance. The GOP maintained a stubborn, protectionist posture throughout the 1930s while Roosevelt ran as a free-trader and gradually negotiated a series of reciprocal-trade agreements that softened the effects of the tariff act. Realignment occurred as the Democrats cemented their position as the party of growth.
The 1929 experience comes to mind as we observe the interplay between Washington and Wall Street in this presidential election year. In place of 1929's tariff bill, we have the federal budget deficits at center stage. The Establishment in 1929 had argued that the tariff would enhance American competitiveness and profits; instead it collapsed world trade. Now, the professional economists of the industrial and financial world have persuaded themselves that the deficits are not the result of the recent economic decline but will be the cause of future economic decline, and therefore must be reduced by major tax increases, along with spending cuts. Boiled down, the argument is that tax increases will sustain economic expansion by lowering interest rates (or keep interest rates from rising), by reducing federal borrowing requirements.
Putting aside the economic arguments on all sides of the issue, we ask: Do the financial markets like the idea of a tax increase?
Clearly the professional economists of the business and industrial world believe the markets would like a tax boost. In the market's deep slide from mid-January to February 23, market commentary in the financial press was transfixed with the idea that the decline reflected investor fears the deficits would not be dealt with. Even when steep declines were linked to reports or statements of the Fed or Paul Volcker that monetary policy would remain tight, the market commentary blamed the deficits for having incurred the wrath of the Fed and Volcker. When the DJIA climbed almost 15 points in the late afternoon of Feb. 23, analysts could base the rise on nothing of substance and instead suggested the market had been "oversold/' When the market rose 30 points on Feb. 24, at least a few analysts suggested it was because the U.S. budget deficit declined to $5.5 billion in January from $16.7 billion in December, a fact that did not make The Times at all.
The clearest evidence the market yearns for a tax increase, from this viewpoint, was provided on February 27 and 28. In the afternoon of Feb. 27, President Reagan met with a delegation of state governors and after the session Governor James Thompson of Illinois told the press that Reagan was willing to consider tax increases if Congress approved and implemented his requests for spending cuts. The report triggered a 10-point surge of the Dow in the last half-hour of trading, and the market ended up 15 points on the day. The financial press, followed by network television, was practically unanimous in reporting that the surge followed the President's new willingness to raise taxes. It was also reported that after market close the White House, through Press Secretary Larry Speakes, announced that there had been no change in the President's tax posture, that Thompson had been correct insofar as he went, but that he left out the important presidential proviso: there would be no future tax increase that could jeopardize the economic recovery. When the market opened down 10 points on the opening Feb. 28, the commentators had their "smoking gun." The Dow closed down 23 points on the day, helped down in the afternoon by the report that Paul Volcker, also speaking to the governors "in unusually direct, uncompromising terms" (according to the Times) said the financial markets wouldn't be impressed with the President's $100 billion down payment plan over three years because it was backloaded, $50 billion in the third year, and that the plan should be raised to $150 billion divided equally in the three years. "The country should not expect the Federal Reserve Board to support the economy's continued growth by averting a rise in interest rates, Paul A. Volcker, chairman of the Fed, told the nation's governors today," the Times reported. And within a story reporting the Senate Finance Committee voted $11 billion in new business taxes on Feb. 28, the Times pointed to the smoking gun: "In reaction to a White House denial of reports the President was relaxing his opposition to a tax increase, stock prices plummeted today." The prosecution rests its case.
To those who believe a tax increase would damage the economic expansion and, ipso facto, not be welcomed by the stock market, the prosecution's case has some serious problems. The most serious is the market's rise to its record high of 1287 on January 6. This was in the face of repeated defeats of Martin Feldstein, David Stockman, Paul Volcker, and Senator Robert Dole in their attempts to persuade the President that the economy would falter in 1985 unless a contingency tax were put in place in 1984. By January 5, the White House was so emphatic in its rejection of contingency taxes and tax "plugs" that the financial writers who had been assured by Feldstein and Stockman that they would win were writing embarrassed concession stories.
Dole and Feldstein, though, did not concede, shifting away from contingency taxes and tax plugs to Dole's "down payment" plan. The Dow came off its peak as this new maneuver was reported. The senior White House staff, supporting the President in his opposition to higher taxes on economic grounds, became intrigued with the idea of making this seemingly minor concession — which involved only $30 billion in "loophole" closings spread over three years in combination with $70 billion in spending cuts — as a means of defusing the Democrats on this hot political issue. As smiles broke out on the faces of Dole and Feldstein for the first time in months, the Dow tumbled, financial commentators somehow keeping a straight face in reporting that Wall Street had suddenly realized the threat of the deficit projections.
The markets tumbled further as Volcker put his shoulder to the wheel. There is by now almost nobody who does any serious business in the bond markets who does not believe that a marginal reduction in the Fed's federal funds target rate would rally the long-term bond market. Volcker probably included. But the Fed chairman, who will not acknowledge that monetary policy had anything to do with the '82 recession and the deficits it spawned, is as firmly wedded to his theory of deficits and interest rates as Smoot was to Hawley. For all practical purposes, he is now committed to a major tax increase as his price for even considering a marginal easing. He has also added to his arsenal the argument that such easing, even if it were to lower interest rates, would shut off the flow of foreign capital that is helping finance the deficit. His exclamations, which have the almost solid support of the Federal Open Market Committee (Vice Chairman Preston Martin excluded) have had the effect of terrorizing both the bond market and the stock market. By his persistent warnings of an international crisis, a flight from the dollar, the demand for dollars has declined marginally and the price of gold has risen marginally. But this has a wholly different effect than had he accommodated the demand for dollars by lowering interest rates, which would have had similar side effects on the gold and exchange markets.
In other words, the Fed should have arrested the decline in the price of gold at $400 by increasing bank reserves, which would have lowered interest rates and fueled a further expansion of domestic output and credit. Instead, it let the price fall to $365 and then, by "talking down the dollar," sent up the price of gold through fear, which means interest rates have to be higher than they would otherwise be in order to sustain the same inflow of capital.
The 45-point rise of the Dow from mid-afternoon, Thursday the 23rd to Friday's close the 24th was hardly a technical correction. The surge parallels the market's receipt of the news that the bipartisan "down payment" committee was getting nowhere, as the Republicans dug in their heels against defense cuts and tax hikes and the Democrats refused to budge on non-defense cuts. Such a political stalemate is exactly what the White House anticipated from the beginning. The stalemate reports were wrapped around the news of January's $5.5 billion budget deficit, a 43 percent decline from the deficit of last January. The news strengthens the President's hand and surely it would soften Volcker's heart, wouldn't it? No? Perhaps next month's deficit figures will, or the first quarter's. Deficits shrink in the second year of recovery as the income effects mushroom. But for now, the Fed chairman is committed to his course and the markets tremble as they bear with him.
Against this backdrop, perhaps there is an element of truth to the theory that the Dow surged on the afternoon of the 27th after Governor Thompson reported the hint that President Reagan would consider a tax increase after Congress implemented his spending cuts. Even before the White House "clarified" the report it was certainly clear to the markets that the Thompson message signified no change in Reagan's posture. If (a) a tax increase would be considered after (b) spending cuts were enacted, yet there is no chance of (b), then there is no chance of (a). The news was bullish for those who don't want a tax increase, but admittedly, there was a change of tone. Perhaps Volcker would be pacified, and end his exhortations about crises and higher interest rates unless taxes are raised as he awaited action on (b). Meanwhile, the tax measures in Congress would have to go into limbo, without Volcker's active help. And as the months rolled on, with the economy continuing to shrink the deficit projections, President Reagan marching toward re-election, all thoughts of "considering" a new tax boost would be forgotten. After Reagan's re-election, Volcker will resign as planned and the President will appoint Preston Martin, and that will be that. All the President really needs from Volcker between now and then is no turning of the screws at the Fed and silence on taxes and the "danger" of foreign investment.
Maybe Volcker would have been pacified with an unclarified report and maybe he wouldn't have. But the President would have seemed the more accommodating, without giving up a thing with his no (a) before (b). As it is, the tax crowd now has its smoking gun and a rampaging Volcker, reason enough for February 28's plummeting Dow.
Things could be better, but things could be worse. President Reagan and the senior White House staff, most especially Jim Baker and Richard Darman, know where they stand on tax and monetary policy. On the supply side. In a real sense, supply-side influence in the West Wing is greater now than it has been since Inauguration Day. The President clearly sees the Fed as a threat to the recovery. Stockman is in the dog house, Feldstein is buried under it. Monetarism is at a nadir and Beryl Sprinkel is not in favor. Senators Dole and Domenici are recognized as adversaries, threatening the economy, the President's re-election and the election of GOP candidates everywhere. Folks are fighting mad.
From this political standpoint, things are not bad at all. Given the firepower and enthusiasm at hand, supply-side strategists are now assuming the West Wing will find a way to deal with the Fed, with or without open conflict, which the White House and Volcker want to avoid. Chances are also increased that the President will accelerate exposition of his tax-reform proposals, in order to campaign on a new growth platform. Congress is moving ahead on its own to hike taxes, but this should soon bring murmurings about vetoes from the West Wing. With an energized, growth-oriented, forward-looking Reagan, backed by his senior staff, even bigger things become possible as the political season continues to unfold.
Given the disarray of the Democratic Party following Gary Hart's thumping defeat of Fritz Mondale in New Hampshire, it now becomes at least barely conceivable to supply-side political strategists that Reagan could win a landslide of 1936 proportions, carrying Republicans to control of the House as well as the Senate.
In 1936, the GOP remained committed to protectionism as a cure for the Depression, with a platform plank blasting Roosevelt for his trade agreements. The party also raged about the budget deficits that the Depression had produced. The Democratic sweep was among the most lopsided in U.S. history.
In 1984, the Democrats are in this same kind of fix, mesmerized by their own deficit arguments and pledging a host of tax proposals to undo the supply-side program that flowed from the 1980 elections. In this vein, Walter Mondale sealed his doom in New Hampshire, the most anti-tax of all states, by flooding the airwaves with Robin Hood tax commercials. Gary Hart's tax-the-rich, stop-the-deficit proposals are every bit as destructive as Mondale's. But Hart's media campaign was all imagery, a la Jimmy Carter's "fuzzy" campaign of 1976. When one candidate promises to tax you and the other promises to/change the Democratic Party's policies of the past (and looks like John F. Kennedy to boot), whom do you vote for?
For this reason, the White House would prefer that Mondale and Hart slug it out and that Mondale ekes out the nomination, carrying not only the Carter legacy of the past but his pro-tax baggage. But even if Hart should manage to assemble the money and organization needed to overtake Mondale, he's stuck with the fact that he has nothing to offer the electorate but deficit-reducing tax hikes. Unlike Carter, who managed to remain fuzzy throughout 1976, Hart has a record that makes him vulnerable, although not nearly as vulnerable as Mondale. Hart is not a protectionist, he favors decontrol of oil and gas for correct supply reasons — and nobody has ever won the presidency by opposing the interests of "little oil." But his hang-up with the deficits and his tax proposals will haunt him.
At bottom, that's the Democrats' problem. They know they must escape the New Deal, but the party elders have spent so much time and effort ridiculing the new ideas Ronald Reagan has brought to the Republican Party that the younger generation of Democrats is held back in confusion. The smoking-gun stock-market story no doubt has confused them even more, and their efforts will be re-doubled to tax us to prosperity. The 1984 Democrats are the Republicans of 1936. A Reagan landslide may end the confusion. A Republican landslide certainly would. The President, thank goodness, isn't confused.