Executive Summary: Where it seemed out of the question a month ago, it now becomes possible to imagine a Mondale victory November 6. Mondale's gamble, pledging an '85 tax boost, pays off as Reagan flounders on a defensive slippery slope that could see him specifying higher taxes as well. The Reagan-Bush campaign worries about the debates, how they can handle the deficit issue, and the "feel" of the economy in November. There's relief that Volcker won't tighten further, but no interest in pushing for ease. "Good news" about economic slowdown invites a spectacular Wall Street rally, expecting easier money from the Fed. Mondale's chances hang on how long the Fed hangs firm. Democrats keep their powder dry, but expect a blast at the Reagan/Volcker "tight money" timed right to rally the New Deal debtor class against the current deflation. A Reagan landslide, though, is still possible if Volcker feeds the bull market as the "good news" of slowdown continues. This month's GOP convention in Dallas can make a difference.
A Mondale Victory Scenario
Can Walter Mondale defeat President Reagan? We now have to consider the possibility. Earlier in the year, when Messrs. Mondale, Hart and Jackson were hacking at each other, we quoted political analyst John Sears to the effect that Mondale would have to run an error-free campaign in order to lose to Reagan by 53-to-47 percent. The President would have to make serious mistakes to lose, and could win by a landslide if he played his cards right against a floundering Fritz.
With three months to go to the November 6 elections there is still a chance for a Reagan landslide. But the probabilities of an easy win have greatly diminished. The political handicappers, who still don't believe Mondale-Ferraro can overtake the Gipper, at least now can imagine it happening. Mondale managed to handle his "impossible" problems at the Democratic convention, gambling and winning again and again, in the process unifying his party and enhancing his image as a political leader and serious contender for the Presidency. Meanwhile, the President has been floundering, thrown off balance by Mondale's unexpected success, making political and economic errors even as the economy heads south.
At the moment, the Reagan-Bush campaign is on a doubtful track. The President and his team are operating on a campaign strategy that begins with the assumption that the economy is in solid shape and will remain that way through the elections. The belief is that if they simply put their "record" against the records of Walter Mondale and Geraldine Ferraro, the voters will decide in the President's favor. After all, the President's policies have produced a stronger economy than he inherited from the Carter-Mondale administration, greater employment and much lower inflation. Right?
And Mondale and Ferraro are known liberals. Aren't they? The campaign technicians have all the evidence piled high, the voting records of yore, the speeches of yesteryear. Millions of dollars will be spent on campaign material and television spots to remind the electorate that the Democratic ticket is "to the left" of the GOP and a President Mondale would simply replay the dismal Carter years.
All of this will be a waste of time, energy and money. The voters already know where the Democrats came from. But in San Francisco Mondale threw off his New Deal clothes and donned the trappings of eastern establishment Republicanism. He's for a strong, but lean, military. He's opposed to wasteful social spending. He's for strong "family values." He's all for getting rid of the dreaded deficits by having the well-to-do sacrifice through higher taxes. And he will not repeat the mistakes of the past, whatever they were, including whatever mistakes were made in the Carter years. The press corps noticed that Mondale's acceptance speech did not electrify the convention. But Mondale wasn't speaking to the delegates, who were reconstructed liberals. He spoke to the voters at large, who are going to find it hard to believe that Fritz and Gerry are dangerous liberals. Instead of being defensive about his record, Mondale is being correctly shameless in acknowledging it, all the while speaking directly to the issues as a new man. He's coming across as a smart Gerald R. Ford, who could probably not think of any serious issue where he could disagree with Walter Mondale. Indeed, President Ford's 1976 running mate, Senator Dole, is running around extolling the virtues of the Democratic nominee.
The only political contest Ronald Reagan ever lost, remember, was to Jerry Ford in 1976, when Reagan ran as a Conservative. In 1980, he ran as a growth-oriented, supply-side radical, demolishing the establishment Republicans in the COP primaries and the establishment Democrats in November. Mondale-Ferraro should be duck soup for the President. But so far his advisers have him postured as an establishment candidate, slightly "to the right" of the Democrats. At best, this would produce a feeble victory, and it could easily lose.
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Mondale's pledge of a 1985 tax increase was greeted with hilarity at Reagan-Bush headquarters. The troops figured Fritz had sealed his doom with this extraordinary campaign promise. But Mondale was smarter than that, and his gamble paid off with the President's refusal to say that he would not raise taxes in 1985, indeed would not raise taxes in his second term. As it is, Mondale has set the terms of the debate within a fiscal framework and will remain on the offensive throughout the campaign, demanding to know the specifics of Reagan's "secret plan" to raise the taxes that "everyone knows" is an inevitability. The fact that there are so many Republicans — including former President Ford — who are among the "everyone knows" school strengthens Mondale's challenge.
The Democrats will now pound away at the idea that "the middle-class is standing on a trap door," which is how Mondale put it in his acceptance speech. The objective is to force the President to reveal which taxes he will raise, if, as he says, he may ultimately have to raise them. First, the President's advisors will have him announce which taxes he won't raise — marginal income tax rates. On this slippery slope, by election day the Democrats will have had a field day conjecturing on which remaining taxes the President will raise, forcing him to be specific. In a zero-sum tax competition, the Democrats can at least draw even with the voters. But far more important to the Democrats than winning or losing this debate on points is the neutralization of Ronald Reagan, the Growth Candidate, something Jimmy Carter could not do in 1980.
Why did the President fall into this trap? Because the high command at the White House, James Baker III in particular, would rather have the President say he may have to raise taxes as a last resort than to appear irresponsible when confronted with the deficit issue. This was the same reason Baker sold the President on Senator Dole's "down payment" tax increase last January, the $50 billion tax boost that was finally signed into law by the President the day after Mondale's acceptance speech in San Francisco.
There are two things that have Baker and the political strategists deeply worried about the re-election campaign. One is the debates with Mondale. Had the President been categorical in ruling out a tax increase, Mondale would then surely taunt him in the debates to explain how he would reduce these deficits that everyone knows have to be paid for by our grandchildren and drive up interest rates to boot. What could the President say? They gave him an answer, such as it is.
The other thing that has the high command worried is the "feel" of the economy at the approach of election day. This is something they should be worrying about, even though they assume the economy couldn't possibly unravel in only three months. Former President Nixon has impressed upon them the simple truth that the economy doesn't have to be officially in a recession for the President to be hurt; if it is pointed toward recession, the voters will feel it, and they will see it coming before the Department of Commerce compiles the numbers that tell the bad news.
The trouble is, nobody around the President seems to be worried enough. Chances are getting better every day that the economy won't feel very good at all in a few months as we harvest the bitter fruits of the Federal Reserve's deflation. The White House should have been squawking for months about the deflationary track of commodity prices, which began falling gently almost a year ago and have accelerated dramatically since the Fed's tightening in March. We may already be in the early stages of at least a brief recession, a possibility that doesn't occur to many people because the GNP numbers for the first two quarters look so handsome.
Similar sharp declines in commodity prices always seemed to lead into serious recessions or even depressions, with commodity producers forced to shut down as prices fell below costs of production — taking with them banks and the service sectors they support. For a while, producers can hang on and produce for their own inventories, hoping for an upturn in prices. But when it is the Federal Reserve that is purposely driving down prices to offset previously induced inflations an upturn in prices has to await a Fed decision to ease, a decision the Fed seems determined to avoid.
The President, Jim Baker, Secretary of Treasury Regan and other top officials of the administration are aware of these arguments. Our Alan Reynolds on July 10 was invited by the White House to make presentations to the Office of Policy Development and the Treasury staff, outlining our concerns about deflation. The President was also briefed and was receptive to the arguments, so much so that he raised them the following day with his "outside" economic advisors. But the arguments were uniformly dismissed by the group, including Alan Greenspan, Herbert Stein, Arthur Laffer and Milton Friedman (who continues to predict a serious inflation just around the corner). In the following week, Rep. Jack Kemp made similar arguments before the President at a Republican leadership meeting at the White House; Donald Regan and Secretary of State George Shultz pooh-poohed the idea that a Fed easing of interest rates is necessary to brake the commodity deflation. The idea, which could have led to a White House expression of concern about the deflation, died on the vine.
At the same time, White House worries that the Fed would tighten further were relieved by Paul Volcker's report July 25 to the Senate Banking Committee. Volcker indicated that the economy had begun to slow down, that capacity utilization was not turning out to be as great a problem as had been thought earlier in the year, that prices were lower than had been anticipated, and that the Fed had decided to maintain the status quo. In response to a question from Senator Proxmire relating to the good economic news in 1984 and if the Fed is "finished with its contribution to the 1984 elections," Volcker said "I think you are right."
The news that the markets would not have to fear further squeezing by the Fed in the months ahead was sufficient to produce a rally in bonds. But if the Fed is going to maintain its target range on federal funds at the 11 -to-11 1/2 percent range through the elections it is certainly not good enough. It was this level that tumbled the price of gold below $350 and sent the dollar soaring on foreign-exchange markets. If the Fed does not lower this range soon, further commodity liquidation will have to occur, sending commodity prices lower, lowering production and increasing unemployment, increasing strains on the banking system and weakening the economy in general. As inventories are liquidated the demands for credit decline, putting downward pressure on interest rates. But if the Fed continues to sell bonds into that weakness to maintain the fed funds range above 11 percent as it has been doing assiduously, interest rates can't really fall. Hopes of a "soft landing" of the economy onto a "sustainable" growth path of 3 or 4 percent or so would vanish into the unavoidable recession.
The spectacular bullishness in all the markets — stocks, bonds and commodities — in recent days is almost certainly due to expectations that the Fed will respond to the "good news" coming out of the Commerce and Labor Departments that the economy is slowing — unemployment rising, the leading indicators down sharply, factory orders down, new construction down, and business loans and money supply down. Surely this means the Fed will help fed funds dip below 11% or at least permit it to fall as credit demands fall in the inventory selloff.
At some point of course the "good news" will be bad enough to trigger this response at the Fed. But what if Volcker, in line with his remark to Proxmire, insists on waiting for the "good news" to get so bad that nobody could question a marginal easing by the Fed as being politically motivated? The damage to the economy would be serious, the "feel" of the economy in November will be lousy, and President Reagan will pay at the polls for having tacitly embraced the Volcker strategy.
Even now, the President should be publicly worrying about the deflation problem and questioning the level of interest rates that the Fed has engineered. This would go a long way to solving his debate problem with Walter Mondale, when he is asked how he possibly expects to get the deficit and interest rates down without raising taxes in 1985. As long as he has his arms wrapped around Volcker, the President can't complain that it is monetary policy that is keeping interest rates from falling, monetary policy keeping the costs of debt service extraordinarily high, monetary policy that is preventing the economy from growing at a pace that will continue to lower government spending and expand the revenue base.
Mondale and the Democrats have so far been keeping their powder dry. But we can bet that Fritz will be ready to blast Volcker and the Fed at such time as a Fed easing will be too late to help Reagan and the GOP, just in time to have him identified with a lower interest-rate policy to relieve the beleaguered economy. At the Democratic convention, Jesse Jackson was the only speaker to denounce the "tight-money policies" of Reagan and Volcker. When Mondale is ready to fire at the Fed, he will be gambling that the Old Guard around the President will persuade him to defend Volcker's "anti-inflation" policies and denounce the Democrats as "inflationists."
We can see the Democrats preparing the way. The New York Times has now begun to worry about deflation, in its news columns and on the editorial page. "Deflation Can Hurt Too," the Times editorialized on July 30. And on August 1, Leonard Silk of the Times, who is as plugged in to the Democratic economists as anyone in the financial press, developed the line that we can expect to issue sooner or later from the top of the ticket:
There is no guarantee that this will be the "soft landing," with economic growth of about 3 percent continuing, that the Federal Reserve chairman expects and in fact is hoping for. The turnabout after the current election-year boom could be far more severe, intensifying strains on both the developing countries and the banks that have lent to them so heavily.
Foresight, coupled with hindsight of what caused the current danger, would suggest the Administration and the monetary authorities take measures to shore up the threatened financial institutions and to insure that the needed economic slowdown not worsen into a boom-bust cycle that would have worldwide repercussions.
In February 1983, I met with Jim Baker in his office at the White House to talk about monetary policy. I talked about deflation and how the deflation of 1981-82 came close to wrecking the world economy and the Reagan Administration. And I argued that as long as the United States was not on a gold standard, we would tend to have one-term presidents. Democrats, whose New Deal coalition was built around representing the interests of the debtor class, tend to inflate the currency when they come to power, usually to excess. The electorate has little choice but to turn to the Republican Party, which represents the interests of the creditor class. The Republicans then offset the Democratic inflation with a deflation, and when they do so to excess, fostering recessions and bankruptcies, the voters have to swing again to the Democrats. Only a gold standard depoliticizes the money, making it very difficult for the political parties to use monetary warfare to extract gains from each other in this zero-sum game.
Minor and relatively brief inflations and deflations can still occur through fiscal errors, as the parties war over taxes, tariffs and regulatory policies — producing what seem to be business cycles. But the dramatic boom-bust cycles the U.S. and world economies have experienced in the last dozen years can only be traced to the political inflations and deflations invited by the floating dollar. The President, the only person elected to serve all debtors and all creditors, is the only person who can end these swings by leading the way on monetary reform.
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The scenario for a Mondale-Ferraro victory requires that the President continue to flounder on tax policy, which will tangle him up in the debates with Mondale. It requires that Volcker ignore as long as possible the signals from the weakening economy, keeping interest rates high and commodity prices below the cost of production. If the voters feel a recession in October/November and Mondale turns his fire on the Reagan/Volcker monetary policies that have crunched the farmers, the smokestack industries, the oil patch, there would be a real chance he could retire another one-term president.
What about the remaining chance of a Reagan landslide on November 6? A sustained bull market is all that it would take. If there is sufficient "good news" hitting the markets in the period ahead, it becomes obvious that the White House can publicly encourage the Fed to lower interest rates without seeming inflationist and political. Wall Street seems to be smelling this development already.
Even if the economy still has a sloppy feel come November, with unemployment on a rise, a bull market on Wall Street would put Reagan in a strong, confident position — and enable him to dismiss talk of a 1985 tax hike with credibility. Mondale's pledge of higher taxes, which looks heroic alongside the administration's flummery, would be an albatross around the collective Democratic neck if on November 6 the voters could feel the financial markets pointing toward a solid economy next year and beyond.
As we've suggested before, the Republican national convention in Dallas this month can also make a big difference to how the GOP handles the fall campaign and the chances of a decisive Reagan re-election. The convention delegates promise to be much more militant than the White House staff on taxes and money, eager to get Reagan back on track as the Growth Candidate. What happens there could make the difference between a Reagan landslide and a Reagan defeat.