Executive Summary: The Presidential elections will dominate the financial markets and the U.S. and world economy in 1988, chiefly because all public policy decisions are being shaped with the outcome of this colossal power struggle in mind. This is all to the good, given the heightened ability of the electorate to pull the field of available candidates toward a positive policy track. With a universal belief that a strong economy helps the GOP, the Fed is at the center of the policy struggle. Monetarists push for ease, to help the GOP, but this would have perverse effects on interest rates and inflation. Better economic news helps the Fed resist such pleas and encourages support of the dollar, the issue that has the Fed's Manuel Johnson and Wayne Angell at opposite poles for the time being. The Brady Commission report is a nuisance, the chief cause of the hammering Wall Street has been taking in recent days (with the President lobbied on its behalf). But it should soon be stamped out, identified with the Veep. The campaign itself keys on the two most important issue candidates, Babbitt for the Democrats, Kemp for the Republicans. We still think Kemp will win, but he does not have to win for the markets to be upbeat through '88, he only has to stay close enough, long enough, to force the other candidates to adopt his ideas as theirs. The world continues to move toward incentive systems, including the USSR. With all the nuisances remaining, the outlook for the year is positive.
The Outlook for 1988
The gravitational pull of the Presidential elections will dominate all aspects of public policy during the year. As a result, the financial markets here and around the world will be indirectly churned by the colossal struggle for political power that is now unfolding. It isn't possible to exaggerate the importance of the elections on the markets. Practically every decision that has any possible bearing on the outcome of the economy and the elections is shaped by this political calculus. The contest for the White House is especially on the minds of every key advisor to the President, every member of Congress, every Fed governor, Supreme Court Justice, lobbyist and bureaucrat. With 13 candidates in the two parties going for the most powerful office in the world, the tensions are gathering to an incredible, almost palpable level.
All this is to the good. The mysterious workings of democracy demand the best of policymakers, at least in the net result. This year should be an especially good one as the electorate picks and chooses from the wide field and at the same time shapes the national agenda. We tend to forget that the process is as important as the outcome. The "higgledy piggledy" of the political marketplace (to use Adam Smith's term) will finally yield a President and a presidential mandate that are shaped by the demands of the electorate. On the assumption that the best man will win, given the choices the voters have, we should expect a reasonably good outcome whichever political party wins the White House.
The most important element in all this, as we finally get to the selection process, is the universal belief that a strong economy in 1988 benefits the Republicans and a weak economy the Democrats. This isn't as a reliable an idea as it would be if the incumbent were standing for re-election. The belief, though, sways policy and in the current state of affairs the implications for policy are rather good. The better the news about the economy over the next several months, the more likely that policy will improve. If signs of economic weakness appear, chances increase of perverse policy moves, especially by the Federal Reserve. This isn't the conventional view, which is reflected in the financial markets. The drop in the unemployment rate last week was taken as a sign of incipient inflation, which might lead the Fed to raise interest rates. It's more likely that a strong economy will encourage the Fed to defend the dollar, which will lower interest rates and produce other beneficial results.
The political assumption isn't to suggest that the Fed is a partisan institution. But all six members were appointed by President Ronald Reagan, and we can be sure all six are rooting for the GOP to keep control of the White House. As long as unemployment stays low and GNP stays on a positive upward slope, the Fed can resist pressures to "lower interest rates," which would mean monetary ease, a sinking dollar, higher commodity prices and, of course, higher interest rates. Treasury Secretary James Baker III is in the same boat. At the moment he is genuinely happy that the dollar's "free fall" has ended and the reported G-7 accord that would keep the dollar/yen rate between 120 and 140 is credible. If economic weakness turns up, we can be sure Baker's resolve will fade as speculators dump dollars to test the floor. He can't defend the dollar without the support of the Fed, after all, and the cross currents of opinion at the Fed have not yet been resolved around a reliable policy course.
The monetarists inside and outside the Administration continue to warn of impending economic weakness implied by the low level of monetary aggregates. As a class, the monetarists are the most anxious to keep a Republican in the White House, knowing any Democrats would seal them off completely from the levers of power. They are exerting constant pressure for monetary ease. We continue to make the case to them that Ml has been low because the dollar has been falling against gold and foreign exchange. This causes a decline in demand for Ml (a rise in velocity, to use their term). Tightening the supply of dollars in this environment (by buying fewer T bills) is the only way to increase the demand for M1, which would show up statistically as an increase in the money supply. But the important monetarists, Beryl Sprinkel at the CEA, Jim Miller at OMB, and Michael Darby at Treasury, believe that only by increasing liquidity can the aggregates be jacked up, which is why they oppose support of the dollar.
Their influence is felt at the Fed. Governor Robert Heller talks about being guided by commodity prices, but votes according to the monetarist Ml signals. Vice Chairman Manuel Johnson embodies the conventional view that the dollar can only be defended by higher interest rates, which he doesn't want to do because of a belief that the economy is in a precarious condition. The net result of this view, which prevailed at the Fed in 1987, was a weaker dollar, Black Monday, and higher interest rates at the end of the year than at the beginning! Johnson at times drifts into a quasi-monetarist mode, splitting the difference between commodity and quantity signals. His hand becomes ambivalent and uncertain. The bond market rallied January 7 when Johnson was quoted as warning speculators against the idea that the Fed wanted a lower dollar. Yet he still resists the idea that interest rates would fall with a clear defense of the dollar by the Fed, hoping he can "talk up the dollar" without risking anything real to make it move up.
The fact is that the entire upward move of the dollar came through monetary ease abroad, with the Fed contributing nothing but words. When the Fed last week had an opportunity to show support for the dollar at the domestic Open Market Desk in New York, it instead injected reserves on the lame excuse of seasonal requirements, thereby sterilizing its showy international support. Fed funds were at 6 3/4% at the start of the maneuver and the gold price at $483. That's roughly where they are now. In Japan, the price of gold has gone from Y59,000 to Y63,000.
At the other end of the debate at the Fed is Governor Wayne Angell, who dismisses talk of a recession, believing the economy is robust, and who thinks a firmer policy on dollar liquidity would both strengthen the dollar and lower interest rates. Angell has been a factor in tempting the other governors in this direction, including Chairman Alan Greenspan. On his departure from the Fed, Paul Volcker had advised Greenspan to pay special attention to Angell, and by all accounts this has happened. Still, there is irresolution in the wide spread of opinion on the board of governors as long as Manuel Johnson remains ambivalent and is something to worry about if the dollar approaches its "floor" of 120 yen.
Most of the hammering the market has taken in recent days we attribute to the Brady Commission. Nicholas Brady, Vice President Bush's closest friend, seems determined to vindicate the work he and his elite group of Old Guard austerians did in proving that Black Monday resulted from the federal deficit and speculative excess. The market dropped 140 points January 8 when it took a horrified look at what the Brady Bunch proposed. It's a mechanism that would not only have prevented the market from falling as much as it did October 19, but also would have prevented it from rising as much as it had before the Crash, Brady told The New York Times! The market rebound Monday, January 11, followed widespread reports that the Brady report was dead on arrival at the White House. The second nosedive Tuesday, the 12th, followed direct evidence that President Reagan had been lobbied into thinking that Wall Street's mechanisms, not the sinking dollar, had caused the Crash. This is compatible with the Veep's outlook, Bush being counseled not only by Nick Brady, but also by Martin Feldstein. Feldstein is the embodiment of those who hate the Bull Market because it should never have happened, given the doom he predicted unless taxes were raised to eliminate the deficit! It is bad enough to contemplate President Reagan being snookered into backing "reforms" of Wall Street that would "smooth out" the ups and downs of the markets. Imagine President Bush, with Nick Brady at his side, getting down to serious work with their monkey wrenches. The threat is too obvious to be terribly dangerous, we think. It should be stamped out fairly quickly. But again, it's something to worry about.
It's important to bear these elements in mind as we imagine the economic path in the next three or four months. We believe Wayne Angell will be proven correct. The economy will be strong, unemployment will not increase and remaining fears of recession will recede. Monetarists will feel better about the elections and they'll have to concede that somehow their goal of low monetary growth was achieved without the predicted recession. This pattern reduces pressure on the Fed to inflate and clears the way for a firmer dollar policy and a strategy to go with it. We can be fairly sure, though, that there is no pressure to raise the discount rate in a dollar defense. A decline in the dollar to the G-7 floor of 120 yen would bring such a call from foreign central banks, however.
As The Wall Street Journal has argued (which is also the case Governor Angell makes to his colleagues), the dollar can be defended by buying fewer T-bills and letting the markets know this "snugging" on the short end is a defense of the dollar. Angell has also let it be known that he'd prefer this policy to chip away at the gold price, until it moved at least to $450 from its current level in the $480s. This would knock a point or two off the Consumer Price Index over the next few years, to the 2 percent range. Last year's $80 rise in the price of gold, of course, predicted the later uptick in commodity prices, and unless it is soon knocked back a bit, the "inflation" will next be felt in wages and consumer prices. My guess is that we will more likely see gold drop below $450 than rise above $500, and this would be accompanied by a dollar rise to the 140 yen/1.80 DM level, and stronger stocks and bonds. We begin to hear reports that the dollar "overshot" on the downside, that its Purchasing Power Parity with other currencies is out of line and undervalued. If and when this takes hold broadly, the markets will move in that direction in order to feed on capital gains from a strengthening dollar.
There are side benefits to an upswing of the dollar that policymakers are well aware of. The trade deficit has remained stubbornly high because of the dollar's steady decline to the end of 1987. The deficit for November, to be reported this week, may decline as predicted, but the nominal improvement would be lessened because the dollar was weaker that month than in October. If the dollar's relative advance in January can be sustained, on the other hand, it will produce the first dramatic decline in the trade deficit when it is reported in March. It couldn't happen at a better time. The conference report on the trade bill will be emerging about then. A sharply lower trade deficit would strengthen the administration's hand against the protectionist forces in Congress. It would also reduce fears the Fed would inflate, and thus invite a stronger dollar.
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In addition to the broad divisions of the two political parties that are now engaged in this contest for power, there are of course the differences within the parties. Insofar as the future of the U.S. economy is at stake in this outcome, the financial markets have to juggle a great many variables in the discounting process. Obviously some candidates will be better for Wall Street than others, just as some will be better for Main Street than others. For the purpose of understanding the campaign as it unfolds, it helps to key in on the candidates who are most active in advancing ideas. The non-issue candidates are doing exactly that themselves, foraging for "safe" ideas among those the issue candidates have been developing.
On the Democratic side, the most important candidate in this regard is former Arizona Governor Bruce Babbitt, the only one of the seven contenders who is staking his campaign on the need to raise big, big taxes in 1989. The establishment press is suddenly elevating Babbitt for his willingness to put higher across-the-board taxes into play. If Babbitt is crushed in the early events, it will confirm the conventional belief in the party that the idea is no more attractive now than it was in 1984. The longer Babbitt hangs in, with the press corps awarding him honesty badges along the way, the more the Democrats will be able to talk themselves into thinking the 1984 problem was Walter Mondale, not his platform.
In the same way, Illinois Senator Paul Simon, the self-styled knee-jerk liberal in the crowd, will be watched as a sub-set of the Babbitt agenda. Instead of big honest taxes on everybody, Simon is playing the Robin Hood role, promising big taxes on everyone who makes more than $100,000. Jesse Jackson is for higher taxes, but is not quite as specific as to which of the rich he will steal from to give to the poor. Gary Hart is for higher energy taxes. Senator Albert Gore of Tennessee is holding his fire until Super Tuesday, hoping to emerge as the Southern conservative candidate, which implies a softer line on taxes. Governor Michael Dukakis, the front-runner in New Hampshire, where higher taxes are not wildly popular even among Democrats, is treading lightly on this issue. Prudence in spending, and so forth.
The other important issue the Democrats are watching is trade protectionism, with Rep. Richard Gephardt of Missouri the point man. Gephardt's stock sold off sharply with the October Crash, but he's been making a small comeback in the Iowa polls. If he surpasses expectations, Democrats will get more ardent on trade. This might be a positive step, persuading the party it would be better off with the trade issue this fall than with a compromise trade bill in the spring. If Gephardt is crushed, the Reagan Administration will more likely be able to get a watered-down trade bill out of Congress, which would still be worse than no bill at all. Because Iowa Democrats are especially liberal, the competition there is forcing the contenders into more strident anti-business, "anti-rich" stances than we're likely to see develop in the final Democratic product. Even Dukakis would probably be drawn into harsher stances than he's taken if he didn't have his New Hampshire lead to fall back on.
This may help move Dukakis into a clear position as front-runner after New Hampshire, without the baggage associated with the Iowa business-bashing liberals as he approaches Super Tuesday, March 8. The more Dukakis resists playing for the establishment liberals, the less ground he leaves Gary Hart, whose best chance for the nomination is if all the other Democrats play dwarf roles.
The most important of the GOP contenders for the presidency is Representative Jack Kemp, New York Republican. This is because he has the clearest identification with the underpinnings of the Reagan economic revolution and supply-side economics. Just as Babbitt is being rewarded by the establishment press for his honesty in supporting higher taxes, Kemp is being ignored and written off for his commitment to low tax rates. Kemp is also the most specific of all the candidates, Democratic or Republican, in laying out a blueprint of economic proposals as a means of extending the expansion without inflation.
If Kemp gets knocked out early, the rest of the political field will naturally discount the political value of his economic ideas. This would happen if he remained a distant third to Vice President Bush and Senator Dole after the Iowa caucuses, February 8 and New Hampshire primary, February 16. The longer Kemp remains a viable candidate, the more his specific economic ideas will seem attractive to the other candidates, even among the Democrats. He doesn't have to win the nomination or the Presidency for the ideas to survive and translate into policy in 1989 and beyond. But he has to hang in long enough to force his program onto the GOP platform and have the November elections interpreted in that light. His candidacy itself was enough to bring both Bush and Dole to support a cut in the capital-gains tax, which would thus be a sure bet in any GOP administration.
Bush and Dole have also pledged no tax increases. But William Safire's January 10 column in The New York Times, "The Case for Kemp," in predicting a Kemp presidency, suggests the likely political dynamic: "On economics, the Bush-Dole policy is traditionalist, pragmatist; it will defend the lower tax rates at first, then cave in to cut the deficit without slowing spending by raising sin taxes, then rates. The Kemp supply-side commitment to cut taxes to stimulate growth is sincere; he's done it before with Kemp-Roth, he'd do it again as President." On monetary policy, says Safire: "Dole says he doesn't know much about the dollar; Mr. Bush says he's against pegging it, but I think he would go with the advice of Treasury Secretary Baker, who is now feeling his way toward a modification of Jack Kemp's plan to attach currency prices to a basket of commodities. The goal is lower long-term interest rates, and the one who understands this best is Mr. Kemp."
The main point is that there are varying levels of commitment to the Kemp ideas that would carry forward as policy whether or not Kemp wins. Unlike the stock and bonds markets, the electorate has to weigh ingredients other than economic in choosing a leader. But the voters give economics a very heavy weight. The other candidates can't get very far from the Kemp catalog and hope to win. We agree with Safire that the best outcome for the markets and the economy would be a Kemp presidency, and we still believe this will happen. Nevertheless, the whole world continues to move toward higher levels of incentive economics and currency stability, including the Soviet Union and the Eastern bloc. There are constant threats from the forces of darkness, including the Brady Bunch. But the superior ideas will prevail in any event, in greater or lesser degree, which is why our optimism for 1988 need not be hedged.
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