Capgains Initiative, etc. Jude Wanniski and David Goldman July 24, 1992

CAPGAINS INITIATIVE: The growth forces in the GOP are galvanizing behind the idea that the President should unilaterally index capital gains simply by changing the present definition of capgains. The idea, first proposed by Paul Craig Roberts, was briefly considered at the White House in January, but was killed by Treasury Secretary Nick Brady on the argument from tax lawyers at Treasury that it was too complicated. We've urged that if Brady were replaced, the Acting Treasury Secretary could announce that he would redefine gains on November 4, the day after the President is re-elected. To do so prior to the elections would be denounced by Democrats as being political and "unfair." By requiring the President's re-election as a prerequisite for action the day after would cause a stampede of voters to the Bush-Quayle ticket. Washington Post columnist George Will yesterday advocated indexing capgains now. So did Paul Gigot in today's Wall Street Journal. Ted Forstmann has argued that this one act could liquify hundreds of billions of dollars of capital now frozen by threat of tax confiscation. By requiring the IRS to adjust any gains realized in 1992 for past inflation, according to, say, the GNP price deflator, would bring enormous relief to small businessmen and farmers. It would also make the nominal rate the actual rate on all future gains. This would cause a great boom on Wall Street, even prior to the actual event, pushing the Dow toward 4000 and dramatically shifting consumer confidence to an upward trajectory. What are the chances of this happening? Only if Brady is replaced. Brady and White House Chief of Staff Sam Skinner are now joined at the hip in opposing any growth initiatives. Brady actually told the Cabinet meeting Wednesday, as the WSJ reported today, that the economy would benefit if the U.S. basketball team won a gold medal in Barcelona! Skinner, who believes only deficit reduction will help, is paralyzing the White House with an almost maniacal determination to bring back Herbert Hoover. Jack Kemp is getting nowhere with arguments for a flat-tax campaign plank at the GOP convention, but hopes the return of Jim Baker to the White House will shake things up in his direction. Kemp, who is suggesting JBIII return as Treasury Secretary, is also arguing against Quayle's replacement on the ticket. Rep. Vin Weber, now a co-chairman of the Bush-Quayle campaign, is actively promoting Forstmann as Treasury Secretary, on the grounds that a fresh face and fresh thinking are needed in this obviously tired administration. (JW)

GREENSPAN RALLIES BOND MARKET: Fed Chairman Greenspan's Congressional testimony Tuesday and Wednesday left investors more convinced than ever that the Fed would avoid policy errors either in the direction of inflation or deflation. Greenspan didn't just hint that the Fed might lower its monetary growth targets, but questioned the usefulness of the monetary aggregates altogether in the context of rapidly-shifting velocity of money circulation. That is the strongest departure from official monetarism since the Volcker Fed embraced the "Ms" more than a decade ago. Greenspan didn't specify what other considerations should guide monetary policy, but the door is open to increased emphasis on commodity price level targeting. The early July reduction in the fed funds target showed the Fed's sensitivity to the deflation danger, and Greenspan's comments this week showed that the Fed will not overcorrect. Greenspan's actions, via the open market trading desk, confirm his statements. With the effective fed funds rate trading slightly above the 3.25% target, the gold price spike appears to be fading, as we expected. In addition, the Fed chairman's emphasis on a strong dollar reassured the markets that Treasury Secretary Brady's devaluationist obsession had been locked in the cellar for the time being. The long bond yield is now within striking distance of its mid-January low of 7.38%. The path downward is likely to be bumpy, both because of the uncertainties of election-year politics, and because a recovering dollar would tend to boost bond yields. As we expected, last week's Bundesbank rate increase appears to have marked the dollar's bottom. Nonetheless, Greenspan once again has affirmed our faith in his commitment to stable money. The bond market remains in a long-term rally. (DG)

PLUNGING EQUITY MARKETS SIGNAL WORLD RECESSION: This morning's slaughter on overseas equity markets brings the Nikkei Dow to a six-year low, and 34% below its year-end 1991 close. Germany's FAZ market index, meanwhile, has erased all of its 1992 gains, falling 12% from this year's peak. Tax increases and monetary strangulation are to blame, as we warned. Negative GDP during the next four quarters is possible in both Germany and Japan. Britain, now in its eighth quarter of recession, shows no sign of recovery. U.S. export prospects will continue to deteriorate, increasing the odds of negative GNP numbers during this year's fourth quarter or the first quarter of 1993. (DG)

BANK PROBLEMS ADD TO JAPAN'S ECONOMIC WOES: Japan worries us. High land prices discounted 7% growth over the next dozen years as well as low tax rates. After the 1989 increase in the capital gains tax on land to 52% from 20%, and the collapse of growth expectations, Japanese land prices could fall by as big a margin as the stock market itself, with devastating consequences for Japan's banking system. Michael Milken tells us (long distance) that Japan's banks will take a decade to work off their bad real estate loans. A July report by the Sumitomo Life Research Institute warns that Japanese banks' bad loans will triple if the land price collapse continues, forcing them to shut down lending. Japanese banks and regulators will face some tough decisions when the Bank for International Settlements capital adequacy standards take effect next year. Japan's banks can count capital gains in their stock portfolios as capital. A Nikkei average of 18,300 is the breakeven level for the 11 major commercial banks to meet the BIS standard, Sumitomo estimated, while the seven trust banks need a level of 17,200. With the Nikkei at 15,498, Japan's banking system may require a drawn-out reorganization, producing a prolonged credit crunch in the once capital-rich Japanese economy. Lending is already falling off at a 20-30% annual rate, according to the Bank of Japan's quarterly report released July 21, and the BoJ forecasts a money supply growth rate of only 1% during the July-September quarter in consequence. With manufacturing output down 8% between June 1991 and June 1992, it now seems likely that Japan's recession will be deeper than the 1-2% 1992 growth rate we projected on March 25, when the Nikkei Dow stood at 20,000. (DG)

RUSSIA'S ECONOMIC SITUATION WORSENS: We will publish Criton Zoakos' in-depth report next week on the continuing deterioration of the situation in Russia. Again and again our efforts to persuade the Yeltsin Government to deflate the ruble have been rejected in favor of the inflationary recommendations coming from the IMF, backed by our Treasury Department. New York Fed President Jerry Corrigan, the liaison between our central bank and Russia's, disavows any responsibility in advising on ruble stabilization. The ruble this week traded at 151 to the dollar, which implies complete economic collapse throughout Russia if the Government lifted all price controls as the IMF would like. The military-industrial complex has now wrested control over economic policy with a program as bad as the IMF's, but with more ominous security implications. Viktor Gerashchenko, whose monetarist policies as head of the old USSR Gosbank helped bring down the Gorbachev Government, and who was dismissed when Yeltsin came to power last December, is now back as head of the Russia central bank. It was Gerashchenko's idea to confiscate 100 ruble notes in January 1991 to "reduce the money supply" and fight inflation. Now, in another Friedmanite twist, he is arguing against any defense of the ruble. The increased economic distress is pulling political influence away from forces of democratic capitalism toward corporatist fascism, in which the strong devour the weak. (JW)