'It's the Economy, Stupid' Jude Wanniski May 30, 2003

If you remember, this was the sign that Governor Bill Clinton's campaign manager hung above his desk during the 1992 presidential campaign. Jim Carville knew the American electorate might be concerned or entertained by dozens of side issues, foreign and domestic, but the election would be decided by the bread and butter issues. It was a winning idea against an incumbent President who triumphed over the evil Iraqis but broke his promise not to raise taxes. It is getting to be about time that Karl Rove, the incumbent Bush's chief political advisor, dusts off that sign and hangs it over his desk. Remember it was Rove who upset the Democrats early this year by giving a pep talk to Republicans on how they could ride the war-on-terrorism patriotism to victory this fall. At the time, Rove and the White House were being assured by blue-chip economists both inside and outside the administration that the economy would by now be in a sweet little upswing that would lift spirits this November and into a second term. 

The upswing, such as it is, is simply the result of tens of billions of dollars being spent on the war, and as our Christopher Ecclestone points out, the war spending does not have the same effect as it did in the good old days. "It used to be a war would produce contracts for a million pair of boots and everyone in New England would be stitching them together. Now, a dozen scientists in L.A. get together and knock out a missile for $10 million." The news of Treasury
Secretary Paul O'Neill and Irish rock star Bono on “safari” in Africa merely adds to the surreal political atmosphere blowing out of Washington. With the President seemingly determined to tap the bond market for whatever it takes to blow Saddam Hussein to kingdom come, it should not take long before the American voters begin to realize the price they are being asked to pay for a totally unnecessary war in the Middle East. 

It is becoming clear Saddam is in the Pentagon's crosshairs, just so the settlers on the West Bank who are occupying Palestinian land can sleep easier at night. Except for the U.S. and perhaps U.K., the United Nations seems unanimous in agreeing that Iraq is no threat to anyone now and would not be a potential threat if it agrees to an appropriate inspection regime. The best news in the last week was the Washington Post report that the Joint Chiefs are uniformly opposed to an
Iraq adventure. But what happens if Iraq shoots down a manned U.S. aircraft in a "no-fly zone?" There is widespread speculation the Pentagon will invite a provocation in order to persuade Iraq’s neighbors to support military action. A Bloomberg commentator suggested last night that 9-11 might be the target date for such action. These clouds will hang over the financial markets until there are clearer signs this will be defused. We can thank Russian President Vladimir Putin for keeping his cool, as he will be a positive influence on President Bush’s assessment of Middle East matters. 

Against this backdrop, the market continues to slide as the price of gold advances. It normally does not matter why the gold price rises or falls in our analytical model, because in either case it means a surplus or dearth of liquidity. The military's drain on the budget and the implicit cost of war taxes to pay down the bonds being issued now has the added risk of mayhem on the subcontinent, a new escalation of violence in Israel, and a war with Iraq. An Iraqi war will not be paid for this time by subscriptions, but by US taxpayers alone. The gold price increase is still easing the deflation pressures, but if peace breaks out it will slide back, increasing the deflation pressure, but decreasing the contraction pressure. We of course prefer peace and deflation, if that is the only choice we have. 

And how does the President deal with Tel Aviv if Ariel Sharon decides to level the West Bank and Gaza? It was at least encouraging to see one of his Cabinet ministers noting in the Times this week the destruction of West Bank infrastructure only seemed to have increased the extremism and the pool of available suicide bombers. Angry Palestinians who were living in shacks are now furious Palestinians living in tents. How will this play out? The American Jewish community really has to decide once and for all to give up on the idea of a Greater Israel covering the West Bank and Gaza. It really has to commit itself to a unified position with President Bush and its supporters in Congress, just as the Arab League in Beirut committed itself to the security of Israel, in perpetuity. All other options have been closed off, always excepting Armageddon. 

Such news would be good for the world economy and bullish for the financial markets, but even if that rosy scenario unfolds in fits and starts, the U.S. economy is not going to let the President and the Congress off that easily. The tax system and the monetary system were in bad enough shape before 9-11. Now the costs have become almost incalculable. The runaway costs of government health care were troubling a year ago and are now scaring the insiders who see no end in sight. Of course, it can all be fixed with fundamental reforms of the tax- and-monetary systems, but that would require the almost total focus of a President being overwhelmed by these foreign-policy crises – which until recently seemed to be the most enjoyable part of his job. At least it would require the total focus of Treasury Secretary Paul O’Neill, who is instead traipsing around Africa with an Irish rock star, arguing over the size and shape of our diminutive foreign-aid effort. The WSJournal lead editorial this morning praises O’Neill for bringing “attention” to Africa’s need for “free markets.” One wonders if it would have sent a music critic to comment on Nero’s fiddling while Rome burned. 

We wish we could offer better prospects for an end to the bear market, but still see none in this part of the world. The deflationary drag is now small enough to produce selective stock picks that can overcome the drag, so we are not discouraging clients who think they see these opportunities. But weighing all the macro factors, there seems little chance of a renewed bull market. At best, the DJIA will bounce around the 10,000 mark as we all wait to see what comes next. For a bull market to unfold, the political leader of the known world has to give some serious attention to matters economic and put aside any plans for war.