Political and Economic Cross-Currents Jude Wanniski August 3, 1998

Wall Street went into free fall Friday afternoon immediately after Senate Majority Leader Trent Lott announced that there would be no big tax cut this year and maybe no cut in the capital gains tax either. The DJIA finished down 143.66 points or 1.59% and at its bottom was down 225 points or 2.5%. The NASDAQ stocks finished almost at the low of the day, down 2.46%. NASDAQ stocks of course are more sensitive to capital-gains taxation, as we repeatedly have noted, because they rely more on rewards to equity than the blue chips, which are more sensitive to debt, having the reserves to withstand economic weakness. We saw NASDAQ catch up with the DJIA earlier this year as legislation went forward to reduce the holding period to 12 months from 18 on the preferential capgains rate. The Russell 2000, the third tier of equities, is down by 4% for the year. It includes lower cap NASDAQ stocks that are more sensitive than the larger caps to the monetary deflation that is depressing the bottom of the economy, as evidenced by the soaring number of personal bankruptcies. The financial press is now finally writing about the laggard Russell 2000, but with no clue that the lag is due to the Federal Reserve’s choke hold on liquidity. Gold, which should be closer to its 10-year average of $350, is still inching lower, dropping to $288 Friday and below $285 today.

To the degree Wall Street has been building up its hopes for a tax cut, it will settle back if it becomes absolutely clear nothing can be signed into law this year. There are added risks to Wall Street because of President Bill Clinton’s legal problems, as nothing constructive is likely to occur without some degree of bipartisan comity of the kind that facilitated last year’s budget deal. Because the November elections are bearing down on us at the same time Mr. Clinton’s problems are coming to a head, there are any number of ugly scenarios that could affect the outcome of the elections in favor of the GOP or the Democrats. If the bundle that will soon be sent to the House Judiciary Committee from Special Prosecutor Ken Starr leads to an impeachment of the President and a Senate trial, we may have to forget serious business in 1999. Finally, the economy clearly is weakening in the statistics as well as on the ground and will become weaker as the monetary deflation plays out. It soon should be impossible for Fed Chairman Alan Greenspan to keep a straight face in saying inflation is a greater problem than recession. In the process, the long bond should make its way to 5.5%. 

It may be hard to believe, but a capgains tax cut is still possible when Congress returns from its August recess. The reason it seems so unlikely is that key GOP players in the House and the Senate are proposing different packages to deal with the $1.5 trillion budget surplus projected over the next decade. The Wall Street Journal has been beating up Chairman Pete Domenici of Senate Budget and two of his allies, Sen. Phil Gramm [R-TX] and Sen. Rick Santorum [R-PA], denouncing them as obstructionists. The three are backing a Social Security reform that is far too  complex to be dealt with this year. It would put the government in a position of investing a pool of funds in stocks and bonds. At the very least, it would invite a veto, and surely the President would take the opportunity to scare the voters into voting Democratic. Their grandiose plan is not that different from the incremental measure proposed by Chairman Bill Roth of Senate Finance, which has the support of the ranking Democrat on the committee, Pat Moynihan of New York. The Roth plan would have the over-funding of Social Security invested in government bonds, as at present, but give the workers personal ownership of those portfolios. In five years, when the portfolios would grow to a point where they had substance, the workers would get control of them and be able to direct them to the financial markets themselves. The big difference is that workers would be able to leave their children these amounts when they die instead of having the portfolio go back into the general fund. This would be attractive to minorities, who get less out of Social Security because of shorter life expectancies. 

If this kind of measure were wedded to a capgains cut that would pay for itself, as the Congressional Budget Office projects, it would be sufficiently attractive to Democrats as to prompt a presidential signature. Mr. Clinton’s approval rating would rise with the stock market just at the time he would need to survive attempts to bring him down. There are, of course, Republicans who would gladly give up tax cuts and economic expansion in order to drive Clinton from office or to permanent disgrace. These attempts would only backfire, just as the President could not manufacture a partisan fight in order to win public support. The idea that voters will somehow punish Democrats in November for Clinton’s problems is based on the continuing myth that Republicans lost 48 seats in the 1974 elections because of Richard Nixon’s disgrace over Watergate. The GOP lost because it was entering one of the worst recessions of modern times and Nixon’s successor, President Gerald Ford, was asking for a $5 billion tax increase to balance the budget! He did this four weeks before the election! The chairman of the Council of Economic Advisors at the time was Alan Greenspan, author of the current global monetary deflation. 

It would not take much to put together a GOP consensus on a tax bill. Senator Roth and House Ways&Means chairman Bill Archer, who rarely talk to each other, would find they almost are in total agreement on what legislation should look like in order to win White House approval. They both oppose the giant tax cut proposed by Chairman John Kasich of House Budget on the grounds that he has not laid a foundation for it with the voters or taken it through an election cycle. They are correct. House Speaker Newt Gingrich makes perfect sense in his proposals, but only on alternate days of the week, as he shifts with the winds. Jack Kemp, who is outside Congress, remains on good terms with all the players, and is trying to find a way to achieve consensus by the end of the August recess. There will be a tax bill, but with Lott only promising a fix in the marriage tax penalty, it will look bad for Republicans in November unless they can reach a consensus.

Most worrisome is Greenspan’s continued deflation, especially the refusal of anyone of importance in the political world or the financial press to identify the Fed as the primary culprit in the Asian crisis. Greenspan himself is telling the Washington cocktail crowd that the convulsions in Asia are the natural result of their evolution to a higher level of capitalism! Let them eat cake. The carnage in the south Asia equity markets last night feeds the increased demand for dollar liquidity which the Fed refuses to supply, thereby intensifying the deflation that is sending commodity-dependent nations into a tailspin. The Sunday talk shows are devoted exclusively to Monica Lewinsky. The New York Times ran two long articles about the Asian crisis this weekend by David Sanger, but only to give the Treasury Department and several Harvard economists a chance to explain why the Asians only have themselves to blame. The Wall Street Journal’s “Outlook” column this morning, by David Wessel of the paper’s Washington bureau, is worse than worthless. “The challenge for policy makers today isn’t how to respond to a stock-market crash if one occurs. They know what to do; the lessons of ‘29 and ‘87 have been well-studied. The Fed would flood the economy with money.” How nice.