Rosy Scenario
Jude Wanniski
September 5, 1985


Executive Summary: The next few months will be among the most exciting of Reagan's presidency, as he "shoots the rapids," on Capitol Hill. South Africa sanctions, trade protection, spending vetoes, tax reform, the debt ceiling "chicken game," with preparations for Gorbachev in his spare time. But it's hard to be bearish with Stockman gone, Reagan giving the boot to the protectionists with his decision on shoes and veto threats. When the smoke clears later this year, the President should have a tax reform in hand that closely resembles his Treasury plan, as the bipartisan House coalition hangs together. Baker and Darman strategy looks good at Treasury, Donald Regan looks better all the time as chief of staff a terrific appointment coming at the Fed owing to him. With the monetarists exposed, it's time to be bullish.

Rosy Scenario

In the next few months President Reagan will be moving through one of the most interesting periods of his presidency, shooting the rapids on Capitol Hill. He'll clash with Congress over South Africa, tangle with the protectionists on trade bills, probably shut down the Government again in a duel over the debt ceiling, confront new demands for tax hikes, veto appropriation bills, and try to fire up support for his tax reform. In his spare time, he has to prepare for his November summit meeting in Geneva with Soviet leader Mikhail Gorbachev. It will take skillful maneuvering to avoid a crackup along the way, but if he manages as well as we expect him to, 1986 will be a good year for the economy and a fine one for his presidency.

This isn't what we're getting from the Washington press corps, which has spent the month of August insisting that the Reagan Administration has already run out of gas. "A sluggish start" for his second term, was the general conclusion of the Beltway illuminati in comparing 1985's record to date with 1981, as they do every year. U.S. News & World Report had reporters call around asking opinion leaders: "How would you advise President Reagan to get his Administration back on track?" The starting assumption is that it has been derailed. A good part of this attitude flows from Reagan's failure to break his campaign promises not to raise taxes and not to cut Social Security benefits. The President's "coaches" at the Washington Post were almost sure they could talk him into taking their advice again, at least going for an oil-import tax. They were as surprised as David Stockman that he didn't go along, and were among the leaders in pronouncing Administration derailment.

A second chorus in these Beltway Blues is the accepted wisdom that White House chief of staff Donald Regan just doesn't have it. His predecessor, Treasury Secretary James Baker III, "had it." But Don Regan is a bumbler, blamed for getting the President into the Bitburg mess (from which he was never supposed to recover) and of course responsible for the "sluggish start" of the second term. In the week before Labor Day, six major publications were working on "The Donald Regan Story."

It's important to understand the nature of this extraordinary Beltway game. The Washington establishment, being unable to control the President directly, attempts to persuade the President, through his staff, to cripple himself. This is the nature of bare-knuckled political competition, one supposes. As Treasury Secretary, Regan did not cause the establishment any real grief because he was not effective in countering Budget Director Stockman, the Beltway's favorite Cabinet member. After he switched jobs with Jim Baker six months ago, his favorable press ended soon after he brought Pat Buchanan into the White House as Communications Director. He could have saved his "Beltway reputation" by bringing the President along on Social Security and an oil-import fee. But he didn't.

Instead, Stockman is gone. The President's mandate is preserved. Taxes haven't gone up these last six months (but the stock market has) and interest rates have declined. The Beltway Boys weren't predicting any of this at the beginning of 1985. The President was supposed to have been defeated on aid to the Nicaraguan contras. The MX missile was going to be buried. And "Star Wars" was going to be turned into a bargaining chip. The only setback for the Reagan agenda came when he let himself be talked into a freeze on defense spending amidst a carefully orchestrated melodrama over $600 toilet seats the one "inning" he lost in this year's "game."

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SOUTH AFRICA. The President has been at his best in his handling of policy during the race crisis in South Africa, refusing to be swept along by the sanctions hysteria. Congress will soon send him a "wrist slap" sanctions bill, which he will veto, and Congress will override with the White House not putting up a big fight.

The aim of American liberals is to encourage race revolution by undermining the South African economy, but a "managed" disinvestment policy was always doomed to failure. Every profit opportunity that an American investor could be persuaded to forego would be snapped up by another investor, American or foreign. As long as the South African economy was expanding and profitable, apartheid was relatively "safe." The majority black population, for its part, was willing to forego political equality as long as it could share in the nation's economic prosperity; in the rest of Africa, with few exceptions, there are neither democratic institutions nor economic expansions.

The economic distress that has fostered racial turbulence and bloodshed in South Africa has come about accidentally, as the result of the deflationary monetary policies of the United States. For more than a year, Lewis Lehrman has been warning that the Federal Reserve policy initiated in October 1983 to "cool off" the U.S. economy by keeping bank reserves scarce and interest rates high was having a severe, unintended impact on the South African economy. Lehrman pointed out that the side effect of the Fed policy was to sink the dollar price of gold, putting intense pressure on South Africa's dollar debtors and collapsing the real wages of its labor force.

What we're seeing now is a culmination of those deflationary forces, which have been felt around the world, but with special intensity in a nation that earns half its foreign-exchange in gold exports. Its decision to suspend payments of principal on its $15 billion of foreign bank debt until December was unavoidable; it couldn't earn the foreign-exchange fast enough even if the price of gold hadn't declined, but in that situation the international banks would have rolled over the debt, not questioning South Africa's creditworthiness.

Disinvestment is occurring primarily because these financial stresses have shrunk profit opportunities and forced doubts about creditworthiness, not because of fears the government will soon collapse and give way to a black Marxist regime. The labor unrest is similar to the upheavals in the United States in the deflationary 1870s. And as in the 1870s, the unrest is likely to dissipate as the current deflation is absorbed by the system and real wages adjust. The recent upward drift of the gold price, which the financial press incorrectly attributes to fears of mine shutdowns in South Africa, will help relieve the deflationary pressures and enable the Government to resume its debt obligations. (The financial press also attributed any decline in the daily gold fix to fears that South Africa might sell its gold reserves to meet its short-term debt obligations!) When gold tumbled by $8 September 3rd, commodities and currencies also fell across the board.

In fact, it has been the recent moderate easing of monetary policy by the Fed that had gold finally inching up. Any retreat from this more relaxed posture will not only force South Africa to extend its debt moratorium into 1986, but invite emulation in Latin America, as Fidel Castro will surely recommend.

My guess is that this economic crisis will not be enough to bring down the government or end apartheid, but the unpleasant experience will hasten contingency plans for that eventuality. A number of supply-siders have argued for several years that fundamental reforms will not come to South Africa until Black Africa reforms politically and economically, forcing the South African whites to compete for black labor by matching civil liberties. It stands to reason that whites will be more comfortable with the idea of sharing political power with blacks if the general environment in Black Africa is democratic and capitalist rather than authoritarian and Marxist. A South Africa surrounded by thriving low-tax, free-market black democracies with a healthy respect for private property would find it much easier to shed apartheid. For supply-siders, there are only these two possible solutions: Violent, by undermining the South Africa economy, and peaceful, by elevating the economies of its neighbors. While President Reagan opposes the violent solution, his State Department has done nothing to promote the alternative.

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PROTECTIONISM. The President's hardline against trade protection for the shoe industry was among the boldest and most courageous of his presidency. Along with his subsequent pledge to veto any protectionist legislation ("We must not retreat into the failed policies of the past, whether they be protectionism or higher taxes"), the shoe decision practically guarantees that Reagan will shoot these rapids successfully. Of course, to hear the Beltway press corps tell it, the President could have defused the protectionist threat on Capitol Hill by giving in on shoes! The Beltway Game rarely gets this absurd: We're told the President's shoe decision "triggered" a flood of protectionist legislation that will make life difficult for COP re-election chances in 1986.

"G.O.P. Fearful Reagan Policies Will Hurt in '86," The New York Times proclaimed on its front page of September 1, "Many Say White House Ignores Political Needs." The report, by Timesman Phil Gailey, elevates the assertion of Kevin Phillips a commentator for Old Guard Republicanism that protectionism is the winning political issue of the season:

The political danger protectionism poses for Republicans, Mr. Phillips said in an interview, is the opening it gives Democrats not only to question the Administration's economic policies but to raise the jobs issue in a way that taps a growing nationalist sentiment that Mr. Reagan so skillfully used to his own political advantage in 1980 and 1984.

The trade issue, Mr. Phillips said, combines the issues of jobs, fairness and nationalism into a strong political force. Noting that many American companies are adding a patriotic "Made in America" flavor to their advertising, he said, "Democrats have a chance to join a little-guy economy to red-white-and-blue Americanism" by campaigning against the Administration's free-trade policy.

The Democratic victory last month in the first congressional district of Texas Jim Chapman, a protectionist, narrowly defeating Ed Hargett, a Republican is being used as evidence that protectionism is a political winner, even though a Republican hasn't won that seat in modern times. In fact, protectionism is almost always a loser as John Connally found in 1980 and as Walter Mondale found last year. A CBS/New York Times poll last month showed that while 65% of those surveyed favored restraints on imports, only 12% still favored such restraints even if they would invite retaliation, raise prices or reduce consumer choice. Yet the Times and The Washington Post, which editorially oppose protectionist legislation, insist the President is hurting himself and his party by not beating the Democrats to the punch! Reagan's latest Gallup Poll shows him with a 65% approval rating, a new Gallup record for this point in a President's tenure.

The latest absurdity, reported in the September 2 New York Times, is that protectionism is such a danger to the world economy that perhaps the only way to stop it is to raise tariffs!!! Writing from Aspen, Colorado, Timesman Peter T. Kilborn finds:

Protectionism in world trade has gathered so much momentum that American and foreign officials who met here in recent days say that only the United States has the power to reverse it, possibly by orchestrating a shock to the world economy...

Some of those in attendance here doubted that Congress would support the Administration policy in the face of ever-rising imports and job losses in American industry. So the Aspen delegates saw only one other solution a "shock" antidote to protectionist fever, such as the imposition of a high American tariff on all imports.

Then comes Professor Lester Thurow of M.I.T., heir apparent to John Kenneth Galbraith as the liberals' favorite economist, writing of the "Debt Abyss" in the September 3 New York Times, offering yet another protectionist rationale to several generations of Democrats who have been raised as free-traders:

Most of the pressure for adjustment should fall on countries with surpluses in their balances of payments. If surplus countries adjust by raising their imports, the volume of world trade expands and the world economy grows. If deficit countries must adjust, they can do so only by reducing their imports, and this leads to a contraction in world trade and a stagnant world economy.

So far, so good. This is what Professor Thurow learned when he went to school. But now comes a Great Leap in Logic:

Put all of these considerations together, and America needs something like the recent proposal, by Senator Lloyd Bentsen of Texas, Representative Dan Rostenkowski of Illinois and Representative Richard Gephardt of Missouri, for a 25 percent import surcharge on the exports of those countries where exports exceed imports by 55 percent. This proposal has been widely condemned as simple protectionism, but it is in fact a trade expansion act.

In order to avoid paying the surcharge, you see, Japan, Korea, Taiwan, etc., will import more and this will be a boon to world trade and nobody would actually have to pay the surcharge. The argument is so shamelessly clever that one suspects Thurow cooked up the plan to begin with and now surfaces in the Times the day Congress returns from vacation. Thurow certainly knows governments do not import. People import. Tokyo officialdom would love to have the citizenry buy more American goods just as Washington officialdom would love to have U.S. citizenry buy more American goods. Similar arguments were made by the proponents of Smoot-Hawley in 1929-30, and led to Trade Wars just as surely as Rostenkowski-Gephardt would, with Professor Thurow in the guise of Darth Vader ("Father of Scarcity.")

The strategy seems to be to attach this protectionist measure to the debt-limit bill that has to be enacted before the end of the month so the Government can continue borrowing to pay its bills. Had the President compromised on shoes, it's certain the Democrats would have gone this route, sensing Reagan would be the first to flinch in a "chicken game" that could see the Government shut down. As it is, Democratic strategists may choose to shelve this strategy knowing the President would not flinch, given the signal of resolve he gave with shoes. Rostenkowski-Gephardt will easily pass both House and Senate and be vetoed by the President, who will be sustained in the House where the Growth forces are stronger than in the Senate.

Democrats will make a big issue over trade protectionism in 1986, and it will have the opposite of the intended effect. The great political "realignment" of the Thirties flowed from Smoot-Hawley, which turned a nation of Republicans into a nation of Democrats. Now the Democrats are talking themselves over that precipice.

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TAX REFORM. While the Democrats are leading the way on protectionism, they remain genuinely supportive of the President's tax-reform plan. As long as this bipartisan alliance continues, chances remain excellent for enactment, possibly in time for an effective date of January 1. It is significant that Ways and Means Chairman Rostenkowski has invited the committee Republicans as well as Treasury Secretary Baker and Deputy Secretary Darman to a "retreat" at Aerlie House, Virginia, to discuss tax reform away from the pressures of Capitol Hill. The session was originally planned for Ways & Means Democrats only, which invited suspicions that a partisan strategy was going to be worked out. All this is to the good.

During the recess, though, several stories were floated about the alterations Rostenkowski wanted to make in the President's package, to increase benefits to the middle class and make it "fairer." There's persistent talk of a fourth personal income-tax bracket, at 40 percent, and insistence that the capital-gains rate be boosted to 23 percent from its current 20, instead of being cut to 17.5 percent as in the President's proposal. There's also talk of fiddling with the business rates, depreciation schedules and oil-industry tax preferences. Much of this is normal posturing of the kind that precedes all negotiations.

The main threat to reform was the campaign mounted by New York Governor Mario Cuomo over the issue of state-and-local tax deductibility. But Cuomo did not succeed in rousing meaningful support for retention of deductibility, which would have killed the whole reform idea, given the revenues involved. The only topic still under discussion is whether or not to permit some deductibility of property taxes. The most alarmed elements of the Cuomo coalition are the public-school teachers, who realize the end of property-tax deductibility will remove the inherent bias favoring public over private schools in the federal tax codes. For the same reason, social conservatives are eager to see deductibility ended.

For all the talk about Democratic reshaping of the President's proposal, there really is little room for maneuver. The time to alter tax reform was at its greatest between announcement of the first Treasury proposal last December and announcement of Treasury II in June. Treasury II contains all the obvious refinements that involve the revenue tradeoffs, satisfying most of the business community. Tinkering with any aspect of this "equilibria" threatens the whole, which is why I don't expect the final version to look much different than Treasury II. (There's still the likelihood that the provisions adversely effecting Puerto Rico and the Section 936 Corporations will be altered in committee, since no revenues are involved at this point and alteration will increase business support.)

There remains some concern that the Old Guard Republicans in the Senate will have to be dragged kicking and screaming to tax reform; Senator Dole seems to blow hot and cold from week to week.

My sense is that the Administration strategists, Baker and Darman, are correct in expecting a big bipartisan vote in the House to have a dynamic effect on the Senate, which will feel it has no choice but to go along. The most likely obstructionists, Dole and Domenici, aren't large problems because they really don't have fervent beliefs on these matters. Only fanatics make serious obstructionists.

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SPENDING POLICY. There was a lot of blustering out of the Western White House about an autumn veto strategy on appropriation bills. But there's not much percentage for the White House to follow through. These days, the Government doesn't run on appropriation bills anyway, but on continuing resolutions. To confront Congress on nickels-and-dimes would simply distract from the areas where the President needs congressional support. If the Old Guard Senate Republicans attempted to revive tax-increase maneuvers in connection with the budget, the President could respond with confrontation over spending. But with David Stockman gone, there's nobody around to engineer that kind of scenario. This doesn't mean that the tax-hike forces have retired for the duration, but that without a foothold inside the Administration they will spin their wheels. As with the Democrats on protectionism, the Old Guard GOPers believe higher taxes can be a winning political issue if carried by someone, unlike Mondale, who is "likeable," like Howard Baker. Thus, the former Senate Majority Leader who is running for President (under the guidance of former Commerce Secretary Pete Peterson) already promises a big tax boost as soon as he is inaugurated!

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MONETARY POLICY. The M-1 money supply continues its climb, but that is only forcing wholesale admissions that it is a wholly unreliable policy guide. The New York Fed report of mid-August, that the Emperor wears no clothes, left monetarists naked. The report by two Fed senior economists, Carl J. Palash and Lawrence J. Radecki, observes that M-1 failed to signal the 1973, 1980 and 1981 recessions, and that: "Financial innovation and deregulation have so distorted the relationship between money and economic activity that money is no longer a reliable guide to the economy's course." The unclad monetarists are squealing in embarrassment, but the word is finally out, and is now being identified with the New York Fed President, Gerald Corrigan, who everyone knows is Paul Volcker's protege and candidate to succeed him as Fed chairman.

The report was a necessary step leading to the abandonment of monetary aggregates as "targets" of Fed policy. The next step should be to amend the Humphrey-Hawkins Act in Congress, ending the requirement that the Fed annually report on its M-1 target objectives. With the monetarists cleared off the playing field in their birthday suits, the monetary debate will come down to commodity-price targets or rules versus no targets or rules that would inhibit the Fed's discretion.

Of extraordinary importance will be the President's appointments of the next two Fed governors, as that will bear mightily on the outcome of that debate. The best possible news is that the White House, via Don Regan, has already settled on Assistant Treasury Secretary for Economic Affairs Manley Johnson as one of the two new Fed governors. Best possible in that Johnson, who came to Treasury in 1981 from George Mason University, where he professed economics, is a recent convert from monetarism to a price rule, having watched firsthand the collapse of M-1 as a reliable guide. He will be a tower of strength at the Fed. (In July, I asked Alan Reynolds to draw up a list of potential Fed nominees that we could recommend. He drew up a list of 20. But when I asked which he was confident would vote correctly at every meeting of the Federal Open Market Committee, he said he could guarantee only one, Manley Johnson. Some would vote to ease when they should be tightening and some would vote to tighten when they should ease. Only Johnson, by his lights, would always get it right! This would be a gaudy feather in Donald Regan's cap.)

The second Fed appointment will not be nearly as significant. Whoever it is, for better or worse, it couldn't negate the Johnson appointment because it couldn't match the influence Johnson will have on the internal dynamics of the FOMC. We will have to wait until January for these benefits, but chances are the earlier Fed appointment will also add a vote to the growth wing at the FOMC, with Preston Martin and Martha Seger. These votes will be crucial next year to keep the FOMC from tightening to shut off a renewed economic expansion.

On the continuing question of "Whither Volcker?," my guess is that if he does leave before his term is up in 1987, it will be sometime next spring. If he stays on past the spring, I'd guess he'd start thinking about another re-appointment and what it would take to pull that off. Persistent rumors that former Citibank chairman Walter Wriston is a leading candidate for the job reflects the influence that Secretary of State George Shultz has on Donald Regan, Shultz being a close pal of Wriston and Milton Friedman. But I get just as persistent denials that this is in the works.

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This all adds up to a fairly rosy scenario, with the President shooting the rapids as niftily as the young man who just went over Niagara Falls in barrel, with hardly a scratch. But with Stockman gone, the monetarists exposed, and Reagan and Regan giving protectionists the boot, it's hard to be anything but bullish. We'll soon see.