Executive Summary: A major difference between the Watergate period and the current Iran/Contraversy is the Dow Jones Industrial Average, hitting record lows in 1974 and pushing record highs now. The threat to economic policy has lessened as White House chief of staff Donald T. Regan survives. He will leave when he can pick his successor, now probably Richard Darman. The economy will be stronger in 1987 as exports and inventories expand, reflecting an end to the monetary deflation here and abroad, the U.S. tax reform and similar measures that will advance the economies of Japan, Canada and Western Europe. The trade deficit will drop to the $100 billion level, the budget deficit to the $160 billion level. Long-term rates will continue down, mortgage rates to 8-9%, spurring refinancing and higher housing starts. Corporate profits, distorted downward by deflation, will advance smartly with more efficient capacity utilization. As the President survived the 1981 attempted assassination, he'll survive the current affair diminished, but better than expected, the system able to be repaired for the benefit of the next President.
The Outlook for 1987
One of the biggest differences between President Richard Nixon's Watergate crisis of 1974 and President Reagan's Iran/Contraversy is the economic backdrop of each. The Dow Jones Industrial Average was to sink below 600 in the fall of 1974, its low point of the decade. Inflation rates and interest rates were climbing, and would continue to climb past the Ford WIN (Whip Inflation Now) buttons. In the current controversy (no longer a crisis) the Dow is knocking at 2000 and the economy is heading toward another four quarters of noninflationary expansion amidst declining interest rates.
Years after Watergate, I asked former President Nixon if he ever considered that he might not have been impeached if his economic policies had been successful. "It's true," he replied. "It's very rare in history for a political leader to be touched by scandal and brought down during an expanding economy."
I made this comparison to President Reagan during a 15-minute telephone conversation December 22, and he promptly indicated he had been much comforted by the bullishness on Wall Street during these last months. I told him he should be gratified because it has been his economic policies that have produced the Wall Street boom.
Indeed, the threat to President Reagan in the Iran/Contra affair has been to his administration's economic underpinnings. It's no coincidence that as the crisis came to a boil early in December so did the traditional economists, those of the GOP Old Guard and the most political of the Democratic economists, like Walter Heller, who warned of an imminent collapse of everything in sight. The scenario usually begins with a collapse of "confidence in the dollar" in a world of excessive corporate leverage, excessive public and private debt, excessive trade deficits, and excessive fill-in-the-blanks. It always leads to renewed calls for reductions in the U.S. budget deficit via a combination of spending cuts and tax increases.
The President's Pet Rock
The outcry was part of the general din aimed at the removal of White House chief of staff Donald T. Regan. Regan may not look or sound pretty, and perhaps he can be faulted for not going by the public-relations book. But he has become the President's Pet Rock, a boulder that sits in the way of any attempts by the loyal opposition to let Reagan be Mondale. The key to 1987's continued expansion has been the President's steadfastness this past month in support of Regan, and Regan's strength of character in refusing to wilt under the onslaught. There were moments when his few remaining supporters worried he would cave, pack his bags, and head for the golf course.
This isn't to say we expect to see Donald Regan around for the next two years. His ability to function effectively as chief of staff has been impaired by the excesses of his opponents in the COP, those who, like Senator Richard Lugar, have so insistently called for his head on a platter that his presence would remain an embarrassment to them. If Regan were truly indispensable they'd have to put up with him. But he isn't, and was almost certainly planning on leaving anyway early in 1987. Of all the senior people in the Administration, Regan has aged the most in the last two years, which Mrs. Regan has noticed along with the rest of us. Golfdom awaits.
The Next Chief of Staff
Golfdom awaits, but not before Regan helps pick his successor. In fact, we can expect that Regan will know he can leave with dignity when he feels politically strong enough to choose his successor. It is now conventional wisdom in Washington political circles that Drew Lewis, the Transportation Secretary in Reagan's first term and now CEO of Union Pacific, is waiting in the wings to run the White House in the post-Regan years. Lewis insists he is in tune with the President's philosophy, and he may even believe he is, but he isn't. And as the candidate of the "Get Don Regan" forces, Regan must fully realize that if Drew Lewis does succeed him it will be universally interpreted as a Regan defeat.
The logical alternative is Deputy Treasury Secretary Richard Darman, who was director of the Office of the President in the first term and Jim Baker's deputy as chief of staff. Darman has the respect, if not the affection, of the entire Washington establishment for his political and intellectual skills. And having spent four years at the President's elbow on a daily basis (unlike Drew Lewis) he knows the routine. Most of Donald Regan's staff (excepting Al Kingon) does not like Darman, but Regan himself does. And if Darman were to succeed Regan, it would be interpreted in the news media as a Regan going-away victory. The Reagan Administration would take on a much different coloration in its last two years with a Dick Darman rather than a Drew Lewis next to the Oval Office. Personnel and policies would be active and innovative under Darman. Under Lewis, we would have a caretaker, lame-duck government, in constant compromise and in constant retreat. An excellent Secretary of Transportation, one of my favorite figures in the Reagan first-term Cabinet, Lewis is exactly the wrong man to be Reagan's chief of staff in 1987-88. We are betting it will be Darman, which makes the economic outlook for these years seem more secure.
A Stronger Economy in 1987
The economy is going to be better than the consensus suggests, at least 4 percent real GNP growth and, in a best case scenario, 5 percent (fourth quarter to fourth quarter). This is because the economy will not be held back quite so much as it has been in the last two years by (1) deflationary monetary policies in the United States and/or (2) austere monetary and fiscal policies in the other major industrial nations.
The U.S. deflation has run its course. There seems close to zero chance it will be resumed in the years ahead, given the composition of the Federal Reserve Board and the new sensitivity of policymakers, journalists and economists to commodity price signals. In fact, commodity prices should firm up during the year, a natural delayed lag to the 1986 recovery of gold to $400 and oil to $18. If gold remains steady at $400, which is the most likely 1987 scenario, the price of oil should also inch up during the year in response to global demand, perhaps above $20. Of course, Third World commodity producers, Mexico, the Texas oil patch and Midwestern farmers will all feel marginal relief.
The 4 percent real GNP increase we expect in 1987 should be readily attainable through a modest increase in exports and a rebuilding of domestic inventories. The growth rate should bring the federal deficit below $160 billion.
The Trade Deficit and Japan
The trade deficit should decline to about $100 billion, down from the $140 billion level of 1986. The devaluationists will of course claim that the improvement comes as a lagged effect of the weakened dollar — which came off its peak almost two years ago, in February 1985. But the change in trade flows will come as a net increase in U.S. exports to the rest of the world. This will result from the rate of change of U.S. growth, to 4 percent from 3 percent, being lower than the rate of change of growth in the rest of the world, to 2 or 3 percent from slightly negative. In 1988, if the U.S. growth rate were to remain at 4 percent and the rest of the world would increase its growth rate to 4 percent, the relative rates of change would knock another $50 billion from the U.S. trade deficit. It is these relative rates of change of growth that dominate trade and capital flows, not currency rates. The direction of the trade account should be enough to relieve the protectionist pressures on Capitol Hill, at least giving the President sufficient leverage to have a veto sustained.
There are complaints that Japan's tax reform will not be sufficient to stimulate domestic demand for imports, and we agree the Japanese could have had a more dynamic reform. But the Japanese measures are better than Keynesian analysis suggests — the Keynesians unhappy that Japan isn't spending more on public works (consumption) or increasing its budget deficit (aggregate demand). The reduction in the top marginal tax rate to 50 percent, replicating the Reagan tax cut of 1981 (which was also pooh-poohed by Keynesians), will invite a faster rate of growth in Japan and lift the Pacific economy in general.
Canadian Tax Reform
Equally important, given the fact that Canada is the biggest trading partner of the U.S., will be the Canadian tax reform that will be announced in mid-February. Finance Minister Michael Wilson and his deputy, Stanley Hartt, may have finally decided to try a supply-side initiative. We're watching carefully to see if they push into the realm of dynamic revenue estimates, a la Kennedy tax cuts of 1964 and the Reagan 1981 legislation. If they do, working the combined federal/provincial rates down to a competitive level with the U.S., we would see a strong shift in the Canadian growth rate. The Canadian dollar would tend to strengthen, unemployment and interest rates would tend to converge again with the U.S., and Canada would experience a capital inflow and trade deficit. Canada and Japan together could account for half of the $40 billion improvement in the U.S. trade account we foresee in 1987. Prospective tax cut stimulants in Germany, Austria, France and Italy are also behind the surge of leading indicators we're seeing for the major industrial nations.
Third World Debt, Volcker and the IMF
Growth in the industrial world along with an end to the monetary deflation will bring marginal relief to Mexico. But the outlook for new growth policies at the International Monetary Fund and World Bank seems as bleak as ever. The election of Michael Camdessus of France over Onno Ruding of Holland as new IMF chief was a small victory, with Camdessus's obscure views on growth and debt-finance strategies preferable to Ruding's known monetarist/austerity bias. But Mexico and most of Latin America need supply-side tax reforms to solve these problems and restore capital inflows. Camdessus seems neutral at best.
Here the importance of the Federal Reserve chairman becomes paramount. The New York Times of December 21 suggests that because of the Reagan administration's current weakness it is more likely that Paul Volcker will be reappointed Fed chairman this spring. As far as it goes, this is true. Having lost its footing, the Administration would be more likely to shy from a change at the Fed, listening to the usual arguments that "the markets" would become unstable if Volcker were replaced. If Drew Lewis were to replace Donald Regan as chief of staff, there is no question but that Volcker would be begged to stay.
If Darman were to replace Regan, though, Volcker's position is less secure. Darman is well aware that "the markets" have strengthened over the last six years as President Reagan has succeeded in placing more and more anti-Volcker governors on the Fed. Volcker has been the most adroit of all the rear-guard tacticians of the Old Guard. He gives ground grudgingly, never, ever taking an innovative lead except to advise his constituents that they did have to retreat — either on domestic monetary maneuvers or in reaction to the Mexican debt crises of 1982 and 1986. There is no hint Volcker has lifted a finger on behalf of Third World growth strategies. He will be just as agnostic in a third term at the Fed. This alone would tilt Darman toward Vice Chairman Manuel Johnson, a close ally of his who is also a protege of Donald T. Regan. Volcker supporters, aware of this threat, are hailing Manley Johnson as a "comer" at age 37, who needs a bit more grey hair before hell be ready for the helm. We will know Volcker wants a third term if in the next three months he begins sounding more like a supply-sider on Third World issues.
Inventories, Interest Rates and Profits
One of the reasons we see a stronger economy in 1987 than the consensus projects is that we expect inventories to build at a greater rate. Most economists we read seem to dismiss the impact that tax reform will have in this area, worrying about the loss of the investment tax credit and the tighter depreciation rules. But the lower marginal tax rates on personal and corporate income will mean a lower tax penalty for inventories on both counts, and as inventories tend to be treated like other investments, we can expect an upward shift in inventories held.
The end to deflation also bodes well for inventories. In an environment of falling prices, it makes sense to run down inventories. A natural symptom of deflation is lower inventories relative to sales. There is abundant underutilized capacity in the U.S. and worldwide to contain the demand effects of an inventory buildup.
A continuing decline in interest rates in 1987 will add not only to the economies of higher inventories, but also invite a better housing picture than most economists are anticipating. The decline in interest rates is encouraged by the effects of tax reform, which will make the economy more efficient and thereby add to the supply of credit. But it is still monetary policy, steadied by the keying on commodity prices, that has the biggest positive influence on long-term rates. There remains the big question of whether the G5 nations will proceed with monetary reform in 1987. The recent European trip by Treasury Secretary Baker and Richard Darman, December 11-13, wasn't promising. But this undoubtedly has to do with the European concern for the stability of the Reagan Administration in the Iran/Contraversy. Should Darman wind up in the White House by spring, monetary initiatives could be underway soon thereafter. But in any case, Fed policy in and of itself will invite lower long rates during 1987. As mortgage rates drop to 8-9% in 1987 from the current 10%, a new wave of refinancing will occur, accompanied by the usual trading up that occurs as part of the process. A 1.7-1.8 million unit year seems reasonable in housing.
Automobile sales will strengthen a bit as well, but the number of imported units will remain below 3 million. The trade balance is improved even with constant import units as the market shifts toward lower value added Korean cars and away from the higher value added Japanese cars. This process should continue into 1988 and the years just beyond as Americans spend more on domestic autos than on imports, a side effect of the falling cost of capital here.
Corporate profits will also improve in 1987 as deflationary distortions wane. Real corporate profits have been growing smartly, but there is the illusion they have been weak, because of the distorting effect of deflation (e.g., one-time inventory losses). As more efficient capacity utilization combines with this positive monetary influence, nominal profits will advance more than expected. At the same time, wage demands will remain modest as the tax reform contributes to worker after-tax income in 1987 and '88. The 1 percent rise in unit labor costs of 1986 could be matched in 1987 with a 3 percent advance in wages, productivity making up the difference.
We see no inflationary threat as long as gold remains in the $400 range. There is still some upward adjustment of prices to the dollar's decline against gold over the last 15 months. But this will occur so gradually that it will not alarm the Fed, which understands it is a one-time event. During 1987, the dollar should tend to stabilize or strengthen against European currencies and the Japanese yen, where monetary policies have been tighter than necessary, but will seem to weaken against Canada, where the tight fiscal policy and loose monetary policy will reverse into the correct Mundellian mix (as long as the Finance Ministry does not mess up the tax reform).
Just as President Reagan survived the assassin's bullet in 1981, he will survive this episode in rather better condition than most suspect. He will have been diminished himself, insofar as his handling of these events will be viewed historically. But he was beginning to look larger than life anyway, and this cutting down to size will still leave him one of the most successful Presidents in U.S. history. It took time for his wounds to heal in the spring of 1981 and it will take some months for this rupture with the body politic to repair itself. The country will eventually be stronger as a result, because the crisis did reveal a variety of weaknesses and fissures in the government that can now be strengthened and mended. As a result, it may be easier, not harder, for the next President to conduct foreign policy, to do so in regular channels, with a Congress, State Department, National Security Council, CIA and Pentagon that are more sensitive to the demands on and limitations of the President.
From our vantage point, the outlook for 1987 is just fine.
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