Thinking About the World of 2004 Jude Wanniski December 29, 2003

At the close of each of the last 25 years, I have tried to look forward into the new year by organizing my thoughts around the major trends and political variables that would influence the course of events and move the financial markets. This report is about my thoughts on the global economy, where I start the process. During the coming week, I will report on the domestic economy and financial markets, as a subset of the world markets. Most of these big-picture exercises have been worthwhile and broadly accurate in at least getting the direction right, if not the magnitudes. The older I get, the harder I work at this exercise.

I have been wrong at times. My worst call was in December 1999, when I expressed fears about Y2K that were exaggerated by the government’s final estimate of embedded computer chips that could go haywire. Even so, we put the chance that nothing at all would go wrong at 20%. That is what happened when the chips failed at a rate about 1% of the government’s estimate.

Now with 2003 ending on positive notes in practically all of the world’s financial markets – the Dow Jones Global Index up 36% at its best level of the year – it is hard not to be optimistic about the near future. In a client letter earlier this month, I noted that when I was put on the spot at this month’s dinner of the Los Angeles Financial Analysts Society, I spontaneously offered the prediction that the Dow Jones Industrial would wind up somewhere between 12,000 and 12,500 at the end of 2004, a handsome gain. Global indices also should continue to advance smartly for the second year in a row. That includes the small chance that there will be a repeat of 9/11 here at home, or a major terrorist blow to world commerce that I could hardly imagine. 

The chief reason for my bullishness is that the revolution in supply-side economics that began in 1978 with Howard Jarvis and Proposition 13 in California and exploded with the 1980 election of Ronald Reagan is getting a second wind. This is true not only here at home, but also through much of the world, where the classical economics of production also is enjoying a new popularity with national governments. It’s about time. The world has seen the success of these ideas in the U.S. and in the U.K. (which had a 96% top marginal income-tax rate until Margaret Thatcher came along in 1979). The world also has seen the drawbacks of counter-revolution, when the elder Bush went for higher tax rates and budget balance.

The most important converts to date have been Moscow and Beijing, the big losers in the Cold War. Russia’s President Vladimir Putin, bought the Laffer Curve big time, and Russia is now booming atop a 13% flat tax on income that is lower than that of Hong Kong and Singapore. With Russia’s successful implementation of the flat tax, the idea of a single, simple tax system already is spreading throughout eastern Europe. Putin does not seem to be stopping there, and now plans to use some of the increased revenue flow to chip away at the VAT tax. If he can establish that pattern for his successors, Russia could enjoy double-digit growth rates for years. China’s tax system, with a top rate of 45% at about $150,000 per year, was sensational when it was put in place several years ago, but the high annual growth rates now are pushing millions of Chinese each year into brackets that are unnecessarily high. There is a movement underway in the “communist” government to move to a flat-tax system along Russian lines. If China goes, so goes all of Asia. This includes Japan, which still clings to the core tax system designed during the MacArthur occupation years. 

The Russia-China saga does not stop at taxation. Just last week, China’s national legislature changed the constitution to protect such private property as now exists, and the Russian government announced plans for further privatization of real property. In my several visits to Moscow and Beijing during the 1980’s and early 1990’s at the invitation of their governments, I stressed heavily the point that the United States never would have developed as it did if it did not sell off much of the western lands to new settlers. Most real estate in Russia and China still is “owned” by the state. The political pressure to privatize now is coming from the entrepreneurial class. These were ordinary people who at one time were satisfied to simply lease state property, but who now need the state’s protection of a more liquid property right in order to expand. China is moving cautiously in this regard, wary of the corruption that inevitably will accompany some of the transfer, as it saw in the “shock-therapy” break-up of the Soviet Union when the “oligarchs” used their pull to peel off some choice state property.  

In other ways, China is taking big steps, as it did Thursday when it suddenly lifted its 23% tariff on imports of five different types of steel. With one-fifth of the world’s population, China now consumes one-quarter of the world’s steel production, a percentage that will increase in the years ahead. This is because China is a half-century behind the rest of the world in its development, with the biggest neglect in its infrastructure. It still has a long way to go to catch up. On the other side of that equation, think of China (and Russia) sitting on a giant inventory of undiscovered mineral resources, while the U.S. and western economies have been exploiting theirs. In a decade, if it can solve the infrastructure problem and private property issues in a way that produces wildcatting for oil and gas, China’s oil production could exceed that of Saudi Arabia. There remains a great deal for China to do on the political front (i.e., to democratize), but as long as we continue to see motion in that direction, it is difficult to second-guess the leadership on timing. They are nothing if not methodical. The New York Times reported yesterday that Chinese businessmen are beginning to buy wine, in the earliest stages of trying to tell the difference between a Cabernet Sauvignon and a Merlot. They should develop their own vineyards soon, or they will be sucking dry California’s wine output, as they are now with the Midwest’s steel output. Note that China’s broad equity index more than doubled during 2003.

India is another case in point in the second-wave of the supply-side revolution. It was not that long ago (1967) that I was writing about the “green revolution” in agriculture that came along in the nick of time to keep 500 million Indians from starving to death. There now are about one billion Indians, with population growth rates likely to slow appreciably. Now the emerging political class in New Delhi has opted to emphasize economic growth (rather than population growth) with supply-side tax policies, as evidenced by the near doubling (in US$ terms) of the Bombay Sensex index this year. The new chief economist at the IMF, Raghuram Rajan, is an Indian who is mostly excited that after 55 years of independence, his native country finally is devoting its political energies to economic growth, not to religion or culture. Without question, the Internet has been speeding up communications between people in the developing world, bringing about the intellectual ferment that generates political change. This kind of dynamic is almost impossible to stop now that it is rolling, and there is no reason why it should not produce multiple surprises in unexpected places in the year ahead, especially if the IMF turns a corner with Rajan.

When I say unexpected places, I think immediately of Brazil, which a year ago was supposed to default on its enormous debt of $400 billion with the ascension of left-wing populist Luis Inacio “Lula” da Silva to the presidency. Instead, the Sao Paolo stock market has been on fire, up more than 100% in U.S. dollar terms. The economy itself remains in miserable shape, as evidenced by the country’s 15% unemployment rate, but the monetary and fiscal reforms Lula bought into surely will expand the economy during 2004. He probably knows nothing about supply-side economics, but his tax reforms are dramatically simplifying the tax system, and the central bank’s shift from a quantity target to a price target early this year -- the real/dollar exchange rate -- have been well within the supply-side ballpark. Interest rates have plummeted as a result and will continue to do so. The real and dollar cannot be pegged with drastically different interest rates. It is as simple as that. 

Please also note that Lula has apologized for the extent of his tax reforms, suggesting they will become bolder when the economy demonstrates that he was right in the earlier stages. He does not have to do a thing with income tax RATES if that is a problem. The top rate is 27.5%. He could work on the thresholds (which are low) and simplify further. The main point of this enthusiasm is that Lula could build a fire under all of Latin America, which has not had a leader on economic policy since the presidency of Mexico changed hands in 1994. I also am pleased that Polyconomics went against the grain on Lula from the very beginning. He clearly was a populist, not a communist. Several days ago, the Associated Press called him a Wall Street hero! Rest assured that we will be watching Brazil’s progress in 2004 as will the rest of Latin America. A good part of this phenomenon is cultural, by the way. Latins think they are different than the rest of the world. Of course they are in many respects, but everyone, everywhere responds to incentives and rewards in the same way at the margin. Other Latin leaders, including Fidel Castro, will be more impressed with Lula’s policies than they might with those of the "Yanquis." At least it gives them reason to change in Brasilia’s direction rather than that of Washington.

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