Cross Currents for a Lame Duck Jude Wanniski April 13, 1987

Executive Summary: The departure this month of the two brightest members of the Reagan administration certifies the President's lame duck status. Major initiatives are out – a formal international monetary pact, deployment of SDI. But the President needs to tread water in dangerous currents, getting past one more budget cycle with serious tax hikes, fending off a bad trade bill, and avoiding a bad arms deal. Positive currents of past policy moves, especially on tax reform, will continue to feed global expansion. But we must now worry about monetary errors threatening the economy, nasty bumps in the bond market. Treasury's Jim Baker continues to stumble, under a new influence that's making life hard on the Fed's monetary harmony. Volcker and Manuel Johnson must deal with the new inflation. We urge gold sales to protect bonds. We're still sanguine on protectionism, expecting a sustained veto down the line, the idea lacking any semblance of a popular mandate. But Howard Baker, the new chief of staff, worries us more and more as he bashes Japan, magnifying the parochial protectionist impulses of Capitol Hill. The political economy moves into the 1988 presidential orbit, a positive quest for new instructions from the electorate. Chances of a global recession soon remain unlikely. But the cross currents the President faces are dangerous.

Cross Currents for a Lame Duck

The recently announced early retirements of the two smartest members of the Reagan Administration certified the President's lame-duck status. Treasury Deputy Secretary Richard G. Darman departs for Shearson Lehman to try his hand on Wall Street. Assistant Secretary of Defense Richard Perle will leave as soon as a successor is confirmed, to write a novel and go into a consulting mode. The outside chance that Darman could have pulled off an international monetary reform in the next year goes with him; Treasury Secretary Baker can't even manage day-to-day policy on his own. And the outside chance that Perle could have maneuvered a decision from the Administration on early deployment of the Strategic Defense Initiative is also gone.

While these initiatives would have added to the lustre of the Reagan Presidency had they been achieved, they were always longshots anyway — given the fact that neither was part of the Reagan mandate of 1984. Both ideas will be part of the process in 1988, as the electorate chooses a new President with a new agenda.

The President, as certified lame duck, need only tread water for the rest of 1987, through some tricky cross currents. He has to maneuver through one more budget cycle without a damaging tax hike, win a veto fight on the protectionist trade legislation that is headed his way, and talk Nancy out of trading away SDI for an arms deal with Secretary Gorbachev. Most of the danger is in the next several months. As 1988 approaches, policy will get pulled further and further into the orbit of presidential politics and the President will become more a spectator, thinking retirement thoughts himself.

Ripple Effects Continue

These observations do not mean that nothing of consequence can happen in the months remaining to Reagan. First, the good news. There remain very positive, powerful currents that were put in motion during the active years of his administration.

As long as it remains undisturbed, the 1986 tax reform will continue to feed the bull market on Wall Street as it takes full effect. (Stanford's Alvin Rabushka, who wrote a February 13 op-ed article in The Wall Street Journal that connected the bull market to the tax reform, tells me he had projected a Dow Jones average of 2700 at the end of 1987 and 3250 by the end of 1988, all else being equal, because of the positive wedge effects.)

Tax reforms that were inspired last year by the Reagan initiatives will be ripening this year and next. The Canadian reform proposals are due any day and we still expect them to be surprisingly bold. In Japan, with Prime Nakasone suffering political setbacks as a result of his revenue neutral tax reform and spending program, pressures should build in a positive direction. Germany still resists moving up its tax cuts, but may soon relent.

The Eastern bloc (even Poland) continues to creep toward capitalist forms; Gorbachev is taking bolder steps in the Soviet Union, and China, despite some fiscal timidity, seems ready for another lurch forward. The biggest threat to these promising moves would be a recession in the west, which would set back the economies of the east and reassert the Old Guard redistributionist forces. Continued economic growth in the west encourages reforms in the east.

As long as the U.S. expansion continues, the revenue impact on other political subdivisions at home and abroad is inviting tax relief where it occurs — as the Laffer Curve always implied. The 69-point rally of the DJIA on Friday afternoon, April 3, coincided with New York Governor Mario Cuomo's dropping his resistance to the legislature's cutting of the state income tax rate to 7 percent as the budget surplus swells.

As the monetary deflation ends outside the United States, this phenomena of copycat tax reform will pick up in other industrial nations and Third World countries. We're seeing this entirely different reaction to the revenue ripples of the Reagan era compared to the growth that followed the Kennedy tax cuts, when the propensity was to increase government spending instead of rolling back tax rates (compare Nelson Rockefeller to Cuomo, for example). In the next few years, even states or nation states that are not yet brave enough to ignore revenue neutrality will find room in their budgets for straightforward tax relief — as unexpected revenues flow in from the worldwide expansion. The positive effects then rebound to the U.S. federal budget.

G-7 Monetary Confusion

All these desirable fiscal effects are dependent upon a resolution of the recent monetary turbulence and stabilizing of exchange rates. But with Richard Darman disengaged from economic policymaking, Secretary Baker has been faltering badly in this arena. The sharp slide in the bond market began precisely when Baker started wobbling on the terms of the Paris exchange-rate agreement of February 22, when the Japanese were of the opinion that a floor of 150 yen had been set vis-a-vis the dollar. It's bad enough that Baker seems not to understand how much damage he's done in talking the dollar down close to 140. Even worse, nobody is making any sense in all the babble coming from the Administration on monetary policy.

In a real sense, the breach of the 150 floor has only hurt the United States. It did not add to the Japanese deflation pressures because it occurred entirely through a U.S. inflationary impulse, which is why the U.S. bond market has taken the hit. For months, the dollar/yen ratio has been steady at about 153 with the gold price at $400. The yen price of gold, then, has been steady at Y61,200. As Baker and others in the Administration talked the dollar down to 141 these last several weeks, the gold price has climbed to roughly $433, which translates into roughly Y61,194. That is, by this proxy for commodity prices, Japan has remained in equilibrium. The U.S. has added 7 percent to the equilibrium price level and the price of the bellweather long bond is down by roughly that amount.

On this track, the dollar really is devaluing, and would in fact translate into a lower trade deficit. But it would do so by putting the United States onto a lower growth path! Long term interest rates up and the stock market down!

What Happened To Jim Baker?

What has happened to our Treasury Secretary? Our best guess is that since Darman began to disengage several weeks ago, Baker has leaned more heavily on Charles DeLara, the chief U.S. delegate to the International Monetary Fund. Delara, an economist who served a hitch at the Institute for International Economics in Washington, is more or less a protege of C. Fred Bergsten, the world's most maniacal advocate of dollar devaluation. It was Bergsten whose theories helped push President Nixon into closing the gold window in 1971, and it was Bergsten as Assistant Treasury Secretary in the Carter years who was behind the dizzy dollar devaluation and inflation of that era.

Secretary Baker is not a full-fledged devaluationist. He no doubt genuinely hoped the Paris accord of February 22 would hold the dollar/yen rate at 150. But at the first test of the rate, with billions of dollars and yen being flung into the defense through foreign-exchange intervention, Baker probably succumbed to those like DeLara who argue that the trade deficit itself is pushing the dollar down toward some distant equilibrium level, and that central banks are powerless to fight the tide. Of course, the billions being flung into the dollar defense were being sterilized at the key central banks. "Enough is enough," Chairman Paul Volcker testified before Congress on March 23, referring to the dollar's slide. But it was not enough for him to pull the Fed into an unsterilized defense of the dollar, which it could easily do by pushing up the fed funds rate or even by notching up the discount rate with a clear explanation why. The gold price would drop, the dollar would shoot back over 150 yen, and the speculative markets would have understood that the monetary authorities mean business.

The Fear Of Global Recession

It seems strange that policymakers would be wringing their hands over the possibility of imminent world recession at a time of record-breaking booms on the New York and Tokyo stock markets. But The Wall Street Journal's lead story of April 10, "Policy Makers Worry That Global Recession May Be on the Horizon," takes that line. Reporter Art Pine quotes Volcker's worries that "growth may be slowing further," and says that "Like Volcker, Treasury Secretary James Baker and IMF Managing Director Michel Camdessus are worried about the continued sluggishness." Then the key line: "With the dollar falling, the Fed can't ease monetary policy. In fact, Mr. Volcker warned this week that the Fed may have to tighten up if the dollar keeps sliding. Such tightening would raise U.S. interest rates, slow growth, and possibly derail the stock market."

This conclusion is so conventional that the reporter feels comfortable stating it as fact, but it is not fact at all. By explicitly pushing up fed funds — selling Treasury bills into the open market, the Fed would be snuffing out the inflationary expectations that it observes in the climbing price of gold and sliding dollar. The Fed would also be taking the risk of exchange losses out of dollar bonds, as well as the opportunity of exchange gains in Tokyo's stocks and bonds. As long as the markets understood the move was to knock $30 off the gold price and push the dollar back over 150 yen — and no more — bonds would rally decisively. Volcker may not be sure this would be the result because in 1980, as fed funds were rising, long rates rose too.

But the markets then had no idea where the Fed was going, except to track the monetary aggregates. In fact, the Fed kept squeezing until the gold price had fallen below $300, from the $650 when the tightening began. The Fed doesn't have to squeeze 60 percent out of the gold price today, only 5 or 6. It should have been willing to snug up on Fed funds at the end of March, with the first pop in the gold price to about $415. But by delaying, it has become more difficult to get inflationary expectations under control without rattling the bond markets. At the time, almost every one of Polyconomics' institutional investor clients we'd spoken to agreed that bonds would rally on a clear, purposeful tightening of short rates — particularly if it were combined with easing by Japan and Germany. (And the surge in demand for dollars that would follow would quickly permit the Fed to drop short rates too.) Now, with the bond markets battered, gold climbing toward $440 and the dollar slumping to 141 yen, we have been recommending to Fed and Treasury officials unsterilized gold sales, to draw liquidity from the system without in the first instance depressing bond sales.

How long will it be before the Fed confronts this dilemma? Volcker will not take the lead, it seems, until he has the support of a majority of the governors. Lately, I'm told only Wayne Angell has been worried about the run-up in gold to the point where he'd be willing to tighten. Martha Seger and Robert Heller are said to want confirmation of the gold rise in broader commodity indices. Vice Chairman Manuel Johnson, who has said he would consider both rising gold and rising bond yields as market signals to tighten, seems to be holding back. But it's hard to imagine him holding back much longer. At the very least the Fed should stop feeding money into open market by buying bills and bonds, which sterilizes the interventions. Treating monetary errors at the Fed is like catching the first algae in a swimming pool; if there is procrastination, the problem grows geometrically, and the treatment must then be massive.

For about a year now, the Fed has been unusually harmonious on monetary policy. The behind-the-scenes clashes have been over bank deregulation, with Johnson, Seger and Heller — in favor — aligned against Volcker and Angell. Now, monetary policymaking has been forced onto more difficult terrain by Treasury's global clashes over trade, protectionism and exchange rates. Volcker always knew there would come a time when the Reagan "Gang of Four," appointed to counter deflation with easier money, would have to confront an incipient inflation with tighter money.

It's not hard to see that if Volcker desires reappointment as chairman — a decision likely to be made in the next several weeks — he does not want to risk the wrath of Jim Baker or the White House by leading a move to tighten, unless he has the other Reagan appointees, especially Manley Johnson, at his side. How the Vice Chairman, the key player, handles himself in the next several days will tell us a lot about him. Now we'll see this drama unfold.

The Protectionist Threat

Lame duck or not, we must count upon President Reagan to ultimately be a positive force in keeping protectionist trade legislation off the books this year. The fact that the Congress cannot show an electoral mandate for protectionism of any sort is one of the biggest problems it must confront. Even the Smoot-Hawley Tariff Act of 1930 could point to the protectionist plank in the GOP platform of 1928 as evidence of a mandate. There was nothing similiar in the 1986 elections, and the vaguely protectionist industrial policy ideas put forth by the Democrats in 1984 were decisively rejected by the voters.

The mercantilist cause was set back temporarily when the stock market reacted violently to the Administration's March 27 decision to slap $300 million in penalties on the Japanese consumer electronic industry — to offset alleged violations of last summer's semiconductor pact. The White House had believed that the penalty was on the mild side compared to what the industry wanted, and thought it would be viewed as a wrist slap, a "shot across the bow," as Special Trade Representative Clayton Yeutter put it. The Dow plunge of 80 points in the early trading of March 30 seemed to knock some sense into the administration, and there was hope the penalties due to take effect April 17 could be avoided, but Howard Baker, the new chief of staff, is turning into more of a problem than we'd anticipated.

The markets understand that trade wars are as irrational as shooting wars, and can begin through simple miscalculations. There's always a straw that breaks a camel's back and after the pounding the Japanese have endured this past year, swallowing perverse and deflationary policies pushed on them by U.S. protectionists, patience has been wearing thin. Instead of deflecting this threat, Howard Baker has been feeding it, magnifying the parochial and regional protectionist impulses that are felt on Capitol Hill instead of helping the President represent the national interest. The chief of staff's macho man blusterings against the Japanese from the Western White House on April 13 were clearly the trigger for the 52 point tailspin of the Dow that afternoon.

Logic does not seem to have much influence on the protectionist impulse. It was instructive for me to spend a few hours on a recent airplane flight sitting next to a Republican congressman who is a shameless protectionist. It made me realize how stubborn the problem was when I persuaded him that there were only two ways for the U.S. trade deficit to be balanced: Either the United States1 economy goes into recession, or the rest of the world expands. He did not like either option. Even the idea of a rest-of-the-world providing a bigger market for U.S. producers made no impression on him. They probably would not buy the products of his constituents, and external growth only means more competition for domestic producers.

This kind of thinking will produce a bad trade bill in the House of Representatives, and it will get no better in the Senate, perhaps even worse. There will be Republicans in Congress who will urge the President to sign such a bill on the grounds that it is "relatively mild." But that's what they told him last month on the Japanese sanction on consumer electronics. We now have to worry that Howard Baker will urge him in that direction too. But he rejected Baker's advice on the highway bill, and we're confident the President will veto a bad trade bill if the free traders urge him to. And a Reagan veto of the trade legislation that will wind up on his desk will not have as much difficulty being sustained in the Senate. There was, after all, merit in the highway bill, and the Democrats had trouble with only one senator in getting a solid phalanx to overturn the veto. On the trade bill, there will be plenty of Democrats who will break ranks, and several of the GOP senators who opposed the President on the highway bill will be with him on trade. Perhaps Howard Baker thinks that bashing Japan is ultimately the way to dodge the protectionist bullet coming from Congress. But we now have to worry that he's helping feed the beast with red meat instead of containing it. It's unsettling to realize there's no genuine free trade advocate left in the Reagan administration with any influence, except the President himself.

It's been so many years since we experienced the last two years of a two-term President — Elsenhower's 1959-60 — that it's hard to recall what life was like with a lame duck in the White House. It shouldn't be surprising that no major initiatives will take hold in the months ahead; both the Republican White House and Democratic Congress have run out of instructions from the electorate. Any of the bright, new ideas being discussed — those we like and those we don't — will wind up getting batted down because they have no real footing in the democratic process. Richard Darman no doubt sensed that whether he'd be around or not in the period remaining to the President, there will not be an international monetary reform and protectionist legislation will not pass into law. Richard Perle probably senses as well that the President's position on the chessboard of arms control is in stalemate; SDI is not going to be deployed or destroyed, but will be a pivotal issue in 1988 (Rep. Jack Kemp has gone so far as to give SDI "referendum" status in his campaign for the GOP nomination).

The jostling on the issues that will increase as we move deeper into the orbit of the presidential elections should have a positive effect on the political economy. Free trade arguments will be heard from some of the important candidates, including Democratic front-runner Gary Hart as well as Kemp. As the Reagan era winds down, a new set of instructions from the electorate is in the process of being shaped. No time is really being lost. But the bumps in the financial markets in recent weeks reminds us how dangerous the cross currents are that the President faces in his lame duck years.

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