Clinton Gridlock, etc. Jude Wanniski and David Goldman January 7, 1993

CLINTON GRIDLOCK: Today's Little Rock meeting of economic advisors will concentrate on what President-elect Clinton cannot do. He cannot reduce the deficit by spending cuts, nor stimulate the economy by spending more, nor fund his pet infrastructure and education schemes, nor raise taxes (without losing revenue), nor prod the Federal Reserve to print more money. The post-Reagan Keynesians have abandoned money illusion, the notion that printing-press money can stimulate economic growth, as Sylvia Nasar reports in today's New York Times. They have also accepted the reality of the Laffer Curve, at least in part, as shown in MIT economist James Poterba's proof that the 1986 cut in top marginal rates induced the rich to pay a much larger share of total income tax receipts. Now that demand management is discredited among the present generation of mainstream economists, Clinton is left without policy levers to pull. As Nasar reports, the retreaded Keynesians who now defend the Fed's anti-inflationary stance insist that low inflation means low growth. Even the idea of productive government spending as an alternative to demand management, favored by Council of Economic Advisors designee Alan Blinder, is under fire in the newer academic literature, as the The Wall Street Journal reported January 4. Given the hand-wringing over the higher deficit projections for FY 1994 -- a non-event which the markets ignored -- the danger is that Clinton might be stampeded into increasing the gasoline tax, a measure he has heretofore opposed. If that's the direction of things to come, the present NASDAQ rally should evaporate. We are still betting that Lloyd Bentsen is savvy enough to realize that there is no downside to indexation of the capgains tax.  (DG)

BANKING INDUSTRY OFFICIALS are confident Clinton will move quickly to loosen regulations that have discouraged bank lending, the White House Bulletin reports. Clinton was impressed at his economic summit last month with arguments that this could add $100 billion in economic stimulus, mostly through an increase in small business loans. The principal change would once again permit banks to make "character" and "judgment" based loans without fear of going to prison if the loans sour, as these have never been the loans that have gotten the banks in trouble. Two years ago, Ted Forstmann of Forstmann Little pleaded with Treasury Secretary Nick Brady and White House chief- of-staff John Sununu to make this simple change. "Forstmann was ahead of his time," says Ken Gunther of the Independent Bankers Association. "They weren't ready to listen to him. If they had, it might have made a difference to Bush's re-election." Three Clinton advisors in banking urged the President-elect in this direction even before Little Rock, including attorney Gene Ludwig of the Washington firm, Covington and Burling; Orin Kramer, a former Carter White House official who runs a New Jersey mutual fund and is close to Bob Rubin and Roger Altman; and Christopher Edley, Jr., a Harvard law prof who was issues director in the Dukakis campaign. We can almost bank on this to keep the economy moving, as it is one economic stimulus that has no budget cost -- a "freebie." Gunther, an old friend, is quite impressed with what he's seeing from Clinton's team so far, although that could quickly change when the economic package is unveiled. (JW)

BOND GYRATIONS: Expectations that Germany's Bundesbank will finally ease monetary policy during the first half of 1993 prompted Tuesday's rally in the long bond, as global investors factored expectations of a stronger dollar into U.S. bond prices. Pressure on the French franc prompted a defensive increase in the French overnight rate, showing the market that Germany cannot pursue its monetary crunch for long without destroying the last remnants of the EC's Exchange Rate Mechanism, the link between the German mark and the French franc. Quite apart from the fact that the Bundesbank's ultra-tight policy is sinking the German economy, Germany cannot afford to let the French franc go down in the wake of the British pound and the Italian lira. For this reason, the long bond rose along with the dollar/DM rate. Evidently, the market believes that the dollar is likely to rise further sometime this year. Short-term indicators like the spread between one- and three-month Euromark rates also reflect expectations of Bundesbank easing; earlier this week, the 90-day Euromark deposit rate dipped below the 30-day rate, a sign that the market expects money to be cheaper three months hence. Contributing to the dollar's present strength, though, is the Fed's failure to supply adequate liquidity to the market. This week's plunge in the gold price below $330 makes clear that U.S. money markets are excessively tight. During the past two months, it appears, the Fed's attention to price targets faded in the post-election crosswinds. From what we can tell, the open market trading desk simply is clinging to the 3% fed funds target for lack of a clearer idea about what to do next. Expectations that the Fed might lean against economic growth by tightening have now dissipated, as reflected in the year-end surge and subsequent drop in short-term interest rates. Unclear signals from the Fed Governors make us cautious about the bond market's near-term prospects.  (DG)

CROWDING OUT, AGAIN: The faster evidence accumulates against it, the more the economics profession clings to the "crowding out" theory of money markets. Stanford's Ronald McKinnon gave it another go on the Wall Street Journal editorial page December 24, claiming that budget deficits would crowd out private investment unless Clinton "broaden(s) the tax base and sharply curb(s) spending." McKinnon's line of argument promotes the use of taxes on the poor, e.g. a gasoline tax hike, to reduce the deficit. Supposedly, high bond yields result from "the disarray in public finances." How does he explain the fact that long-term bond yields have fallen by 2% since 1988, while the deficit doubled? As we have demonstrated, most of the increase in the budget deficit during the past decade resulted from the reduction of the inflation tax on personal income. Falling bond yields and rising deficits both reflect lower inflation; deficits also reflect lower economic growth, of course ("Deficits: Spending Is Not the Problem," 10-13-92). The "crowding out" theory assumes that federal borrowing drains a fixed pool of "savings," reducing capital availability to the private sector. But savings have nothing to do with the private sector's capacity to invest. During the 1980s, the annual variation in the market value of private assets averaged about $2 trillion, an order of magnitude more than the budget deficit. Americans' net worth (private assets minus debt) is close to $15 trillion. The capital is out there; the incentives to put it at risk are not. McKinnon's argument is a bit more sophisticated. He believes that individuals chose to put their money into high-yielding long-term bonds rather than low-yielding deposits, reducing the lending base of the banking system. Instead, he should ask why individuals chose to risk their money on long bonds, the prices of which have fluctuated wildly during the past two decades with changing inflation expectations, rather than risk their money on potentially higher-yielding investments in growing companies. The answer, of course, is that we have good monetary policy (low inflation risk) and terrible fiscal policy (a high tax rate on nominal capital gains). (DG)

WORLD MONEY BASE, AGAIN: We have had several requests for an explanation of a January 4 editorial-page article by Lewis Lehrman and John Mueller in The Wall Street Journal, purporting to show a relationship between inflation and something called "world money base," a measure of U.S. dollar reserves in the hands of residents plus foreigners. To simplify the Lehrman-Mueller argument, they mean that if Argentines stuff their mattresses with $50 bills as an inflation hedge, the increased demand for dollars will increase prices in the United States (although Lehrman and Mueller often change their definition of what prices are). As a reminder, our unpublished critique of the Mueller model is available on request. (DG)