Executive Summary: The congressional elections, while not significantly increasing Republican numerical strength, have advanced prospects for policies of economic growth. The 96th Congress promises to push the Carter administration toward further tax incentives while resisting the President's poorly conceived rebate program. The outlook for petroleum price deregulation has improved, without a crude-oil tax. Prospects for liberal reforms and national-health insurance have all but evaporated. Congress, though, . does not have a handle on domestic and international monetary policy, and while the President has taken a first, tentative step toward bolstering the dollar's value, the administration remains confused about the causes of inflation and continues to implement counterproductive anti-inflation policies.
Special Report: Aftermath of the November Elections
If there was anything for financial markets to fear about the November 7 elections, it was the possibility the results would be interpreted as a vote of confidence in the policies of President Jimmy Carter. Throughout his term thusfar, Carter has pursued an agenda we have described as Malthusian and Mercantilist. The Malthusian idea assumes permanent resource scarcity, and leads to policies designed to thwart rather than elicit domestic energy supplies. The Mercantilist idea, which is implied by resource scarcity, suggests that the economy is a zero-sum game, which calls for redistributive policies from those who have to those who do not. In his October 24 televised address to the nation, in which he outlined his plan for "voluntary" wage-and-price controls, the President went so far as to ask support for a period of "national austerity."
The elections not only failed to provide the President anything approaching a vote of confidence, they also appear to have gone a long way to undermining the liberal agenda. The elections were not commonly perceived as a referendum for or against economic growth (although this was The Wall Street Journal's perception). Taxes and spending were the issues highlighted by most candidates, and the conventional perception is that the electorate simply wants less of each. That's true enough, but it probably has been true for many years. The problem for the electorate, though, is that without economic growth the issue of government spending becomes a zero-sum game: Each segment of the electorate desires its taxes cut, its spending maintained.
The difference in 1978 is that the Republican Party, which had been for many years attempting to build a middle-class coalition in this zero-sum game — on a platform of "fiscal responsibility" — began the process of abandoning this winless strategy. General tax-rate reduction was advanced as an instrument for providing general economic growth. And while the national GOP lost its nerve in the last month of the campaign, diluting arguments for growth and reviving traditional zero-sum appeals, the initial push had positive effects. Republicans made their most pronounced gains since 1966, picking up three Senate seats, 12 House seats, six governorships, and more than 250 state legislators. In addition, the new GOP tack had a powerful effect on the Democratic Party, which, except for its committed liberal wing, adjusted its own course to reflect the appeal of the incipient GOP program. Instead of GOP tax-cutters confronting Democratic spenders, issues blurred as moderate Democrats crowded toward the Republican position. The net effect, though, was to shatter the liberal wing of the Democratic Party. To those commentators who demanded major GOP numerical gains as vindication of the Kemp-Roth bill, to which the party tied its fortunes, the results were unimpressive. On the other hand, the Republican National Committee and the Congressional Republican Campaign Committee gave no support to the Kemp-Roth platform in the homestretch of the campaign, reacting to Old Guard voices in the party that insist on spending cuts, not tax-rate reduction, as the theoretical priority. Individual candidates were left to their own devices, swimming against a tide of criticism in their own party.
To the degree Democrats "shadowed" Republicans on the issue, as Bill Bradley did in his New Jersey Senate race against Jeffrey Bell, they were successful, but emerged from their contests seeming far less committed to their original liberal agendas than when the campaigns began. Where they embraced this new GOP agenda, they did well too. California Governor Jerry Brown, a classic, unashamed turncoat, boasted that he "out-Kemped Kemp and out-Rothed Roth" in his embrace of Proposition 13 and its message for future state tax policy. New York Governor Hugh Carey developed his successful campaign against Republican Perry Duryea along similar lines, lambasting Duryea's Assembly record as a tax booster. Those liberals of both parties who were not prepared to make adjustments on the fundamental economic issue were decimated, however, with the most significant shocks resounding in the United States Senate.
The Senate Races
It was immediately clear to all political analysts that a lot more happened in the Senate races than merely a net gain of three Republican seats, bringing party strength to 41. For one thing, there is the ideological swing, which can be reckoned as a gain of between five and six seats for the forces of economic growth vis-a-vis the liberal agenda. The Republicans lost seats in Massachusetts, New Jersey, Nebraska, Michigan, and Oklahoma, but this was only a fractional ideological minus.
Paul Tsongas will be just as liberal as was Senator Brooke in Massachusetts. In New Jersey, Bill Bradley evidenced a flexibility during his campaign never observed in Clifford Case, which is a small plus. The displacement of moderate Republican Bob Griffin by moderate Democrat Carl Levin in Michigan is a wash, except that Levin promises to be more aggressive in defending the automobile industry from crushing federal regulations than was Griffin. Nebraska's J.J. Exon, who takes the GOP seat given up by retiring Carl Curtis, can be counted a plus in the sense that he will likely vote positively on economic growth issues while Curtis, an Old Guard conservative, was an intellectual drag on the new growth agenda. In Oklahoma, Democrat David Boren gets the GOP seat of retiring Dewey Bartlett, a plus in that Boren is not only as deeply committed to energy deregulation as was Bartlett, but emotionally committed to Kemp-Roth, on which he campaigned, which means a nucleus of support for Kemp-Roth can build on the Democratic side of the Senate aisle around Georgia's Sam Nunn - the lone Senate Democratic cosponsor of Kemp-Roth in the 95th Congress.
On the other hand, the eight Democratic losses in the Senate crippled the liberal wing of the party, the Senate being the chief repository of liberal theology in the party. The losses were in Colorado, Iowa, New Hampshire, two seats in Minnesota, South Dakota, Mississippi, and Maine. This was the first wholesale slaughtering of visceral liberals since they began to dominate the Senate in 1958. Except in Mississippi, where New Right Thad Cochran replaced Old Right Jim Eastland, every Republican gain represents the loss of a visceral liberal. Gone is the Hubert Humphrey seat, Wendell Anderson, Floyd Haskell, Jim Abourezk, William Hathaway, Thomas Mclntyre, and Dick Clark. And in no case were any of these replaced by GOP progressives of the Rockefeller mold. Just as importantly, they are replaced by young tyros who identify with the tax incentive approach to economic growth, not the Old Guard formula for balanced budgets that has resulted in increasingly imbalanced budgets.
The only shifts from Old Right toward the liberal agenda occurred in the Deep South. In Alabama, Donald Stewart won the seat that opened with the death of Senator James Alien. In Arkansas, David Pryor won the McCellan seat. The question mark over both is whether they will move toward Senator Nunn's growth agenda, or Senator Kennedy's liberal agenda.
Beyond these numerical calculations lies the intangible impact of this slaughtering of liberals, both on the legislative program for the 96th Congress and the 1980 elections. Consider that in 1980 there are 17 liberals up for re-election, including two in the GOP: Javits of New York and Mathias of Maryland. The Democrats are Bayh of Indiana, Bumpers of Arkansas, Church of Idaho, Cranston of California, Culver of Iowa, Durkin of New Hampshire, Eagleton of Missouri, Glenn of Ohio, Hart of Colorado, Rollings of South Carolina, Leahy of Vermont, McGovern of South Dakota, Nelson of Wisconsin, Ribicoff of Connecticut, and Stevenson of Illinois. As a class, they must all feel a new sense of vulnerability, like Jerry Brown and Hugh Carey a need to make adjustment.
It is not only that these 17 must now wonder about the need to adjust theology, it is also what this pondering does to the confidence of the class as a whole, a confidence necessary to hold the class together. Individual senators are willing to vote without thinking — taking cues from party theoreticians — when the political success of the theoreticians is demonstrably high. But this is no longer true. Senator Percy of Illinois was the perfect example of a visceral liberal who saved himself at the eleventh hour by begging forgiveness for his liberalism and throwing himself on the mercy of his constituents, something Brooke of Massachusetts was unwilling to do, although he knew it was the price he would have to pay to win re-election.
The impact on the Republican Party will have the opposite effect, a surge of confidence in the new theology of economic growth, along with the prospect that the issue can continue cutting deeply in 1980. Instead of the GOP having to plead with candidates to challenge heretofore invincible liberals, there will be a general stirring in the marketplace of candidates and the likelihood of high-quality candidates jockeying for position to challenge the 17, the overflow running into House contests. The effect will be felt in political finance as well. Businessmen who have given up hopes of defeating liberals, and have joined them with their bankrolls in vague hopes of limiting the damage through accessibility, will be attracted back to the possibility of winning elections rather than buying protection. We will not have to wait until 1980 before these effects are felt. Like the economic marketplace, the political marketplace is efficient. Discounting of the future is occurring already.
George Meany and the AFL-CIO, a major driving force behind much of the liberal agenda, despair already over prospects for labor-law reform in the 96th Congress. National health insurance can be scratched, as well as public financing of congressional campaigns. All of American business and industry is now able to cite the success of airline deregulation in argument for lessened controls on the economy, and the administration is on a path to deregulate the rest of the transportation industry. Just as Senator Stevenson donned a police badge in 1974 to show his appreciation of the crime issue, he will be looking for free-enterprise badges to wear in 1980. In just this fashion, Bill Bradley embraced deregulation in his New Jersey Senate campaign.
Early in the 96th Congress we should begin to see the palpable results of this alteration of the political landscape. Once again, key issues will be tax policy and energy pricing. In his "austerity" speech of Oct. 24, President Carter advised that there would be no reductions in income tax rates in 1979. On Nov. 14, House Ways and Means Chairman Al Ullman reiterated this view, that there would be no tax cut in 1979, unless there were a recession. But we can expect a serious drive to overwhelm these positions. Russell Long, chairman of Senate Finance, has already offered his view that there will be a 1979 tax cut. And the momentum built up on October in the last days of the 95th Congress, behind Senator Nunn's version of Kemp-Roth, will undoubtedly find expression in such a tax bill. The Nunn approach is to link future restraint in government spending to reductions in marginal tax rates, an approach opposed by liberals who want to use revenue increases for national health insurance and other social programs. Pressure behind such a tax cut will cut against the Carter vow to hold the fiscal 1980 budget to $30 billion, the administration refusing to concede that revenues will be higher with a tax reduction than without one. The paradox for Carter is that without the prospect of adjustment in inflation-bloated tax brackets, the economy will sink deeper into a 1979 recession that has already been forecast by the stock market, a recession that will both cut into federal revenues and expand government outlays in the entitlement programs — eliminating any chance of holding the 1980 deficit to anything close to $30 billion. The only way to achieve the $30 billion target is via a tax-rate reduction.
Al Ullman asserts that the idea behind Kemp-Roth was "totally discredited" in the November elections, but the opposite has occurred, the idea penetrating toward the center of national economic debate. In 1979, there will be greater establishment support for the idea that reductions in marginal income-tax rates will produce greater revenues as a result of real economic expansion and productivity. As a result of the political campaigns, the idea is at last being scrutinized carefully by economists in the financial community and important ground has been gained. In only the last few months, the idea has spread to economists at Citibank, Fidelity Bank of Philadelphia, Morgan Stanley, Paine Webber and Merrill Lynch. Through the banks and brokerage firms, supply-side theory is filtering down to corporate America, which in the last year was intellectually hesitate to support Kemp-Roth without drastic spending cuts. This opposition helped undermine national GOP support for Kemp-Roth in the last month of the campaigns.
In addition, both Democrats and Republicans are becoming more thoroughly schooled in supply-side economics. They also have a set of election results encouraging to those who won. No incumbent Democrat who supported Kemp-Roth in the 95th Congress was defeated. All but a handful of the incumbent Republicans campaigned in support of Kemp-Roth, with greater or lesser intensity and sophistication, and of the mere five GOP incumbents defeated, not one made any serious use of the issue. Of the three dozen new House Republicans, almost all employed Kemp-Roth as campaign material. The level of debate on these economic issues will be elevated in the 96th Congress as a result. The President's poorly conceived "wage insurance" rebate program may be the first casualty of this sharpened economic intelligence on Capitol Hill.
While Al Ullman said there would in his opinion be no tax cut in 1979, he alluded to the likelihood of a tax increase, on crude-oil production. This will be one of the fiercest legislative struggles of the year, with important implications for the economy and financial markets.
On May 31, 1979, the legal requirement that the President control major crude oil prices is ended, according to the Emergency Petroleum Allocation Act of 1973. The same act, though, gives the President discretionary authority to continue price controls on petroleum until September 30, 1981. On July 16-17, 1978, in Bonn, President Carter committed himself at a summit meeting of Western heads of state to permit domestic petroleum prices to rise to the world level by the end of 1980. If this were all that would be done the benefits to the economy would be significant, eliminating the burdensome regulation on the oil industry, the complex entitlements program that has the effect of subsidizing oil imports. In addition, incentives to explore and produce would leap, and the cash flow necessary to support such activity would be there. The President, though, still has his eye on that cash flow, and wants to divert a good part of it to the government as his price for phasing out controls. He was rebuffed by Congress last year with his plan for a crude-oil equalization tax, but as Al Ullman's remark suggests, there are plans afoot to push through an oil tax in different form or name, along with the belief that when Congress is confronted with a proposal for a "windfall profits tax" it will go along. The petroleum industry is gearing up to gain phased control by October 1981 without having to pay the price of heavy new taxes, which it suspects would become a permanent feature of government tax policy even after 1981. The prospects for the industry's success have improved significantly as a result of the November elections and there is genuine optimism that the 96th Congress will be markedly superior to the 95th on energy policy. The President could not possibly have gotten his energy bill through this Congress-elect. In addition, looking toward the 1980 elections, Carter cannot afford another bloody fight with the Oil Patch as he invited this year over natural gas. The election of a Republican governor in Texas, William Clements, not only detracts from Carter's re-election prospects (as George Meany has noted), but Clements will be a voluble goad to the administration on energy policy. Clements' dislike of Energy Secretary James Schlesinger, whom he worked under in the Ford administration, only promises to sharpen the coming clash over crude decontrol and taxation.
Until Congress adjourned on October 15, financial markets could still anticipate favorable news from Capitol Hill on tax and energy policy, news that turned sour in the closing days of the session, however. Thereafter, markets were forced to face squarely the policies of the President alone, especially his errant domestic and international monetary policies. Carter had been led to believe that passage of his energy bill would bolster the dollar in foreign-exchange markets, but the dollar did not pause in its decline with passage of the bill. Carter was also led to believe that his Oct. 24 austerity speech would stabilize the dollar, but it continued its fall as the price of gold reached up to a new high of $249.40. His decision to support the dollar directly, on Nov. 1, was the most promising economic decision the President has come to during the year.
Although neither Carter nor his economic team show any signs of understanding why the Nov. 1 action was correct (they accept the conventional Phillips-Curve notion that a stronger dollar is recessionary), the markets responded beautifully. The 35-point rise of the Dow on November 2, along with a collapse of gold, rise in bond prices and fall in long-term interest rates, was evidence of the correctness of the decision. The stock market does not rise 35 points on enhanced prospects for recession, although there was considerable commentary in the financial press to that effect. In fact, when the stock market resumed its slide on November 3, the same commentators suggested that the market belatedly realized the recessionary consequences of the Nov. 1 dollar-strengthening moves. The market slide more likely occurred once again because of general suspicion at home and abroad that Carter, the Treasury and Federal Reserve would not back the Nov. 1 policy prescriptions with policy action. Indeed, Treasure Undersecretary Anthony Solomon on Nov. 3 was already being quoted in The Wall Street Journal to the effect that dollar support would be only temporary.
The problem remains that Treasury officials like Solomon continue to compartmentalize domestic and international monetary policy, with the result that the $30 billion in foreign currency being assembled to mop up surplus dollars abroad must continue to swim against the tide of domestic money creation. After the once-and-for-all adjustment of dollar appreciation through the increase in bank reserve requirements, the process ceased having any significant effect on the dollar or the gold price.
What seems to be happening again, as in the past, is that the Fed's open-market desk in New York is selling bonds for dollars in the foreign-exchange offices and buying bonds with dollars in the domestic offices as it attempts to peg the federal funds rate. Neither the sale of 1.5 million ounces of gold by Treasury per month, nor the sale of $10 billion in foreign-denominated bonds by Treasury, can strengthen the dollar and reduce interest rates and inflation if the Fed offsets such actions by monetizing debt, injecting reserves into the banking system. Evidence that the Treasury does not know what it is doing is the fact that it has decided not to permit U.S. citizens to buy the foreign-denominated bonds it will issue, on the grounds that it fears Americans will buy foreign exchange with dollars in order to buy the bonds, thus weakening the dollar. The dollar, though, is not compartmentalized, but is arbitraged instantly around the world. The danger of continued economic ignorance in the administration is that the promise of the Nov. 1 decision will not materialize because of inept implementation, and the President will conclude that the Nov. 1 decision was in error. He would likely then return to magnified austerity and arguments for mandatory wage-and-price controls to combat the inflationary tide. At least, when Congress convenes on January 3, there will again be a political forum in which the pros and cons of administration economic policy can be aired. Fortunately, the new Congress holds more promise than the one it replaces.