Executive Summary: Stockman's promise that the Reagan Revolution would fail didn't anticipate the spectacular success of James Baker III as Treasury Secretary – the brainstorm of Stockman's adversary, Don Regan. It all came together in May as the tax reform was pulled from the fire to a done deal. Improvements should come in conference on the effective date, saving $85 billion in '87 GNP, and a wrinkle on capital gains, if accepted, could push the Dow over 2000. Baker's Tokyo economic summit wasn't perfect, courtesy of his nemesis, George Shultz. But his post-summit maneuvering, putting a floor under the dollar, relieved the deflated yen and probably saved Prime Minister Nakasone in his July elections. The bond market worries Volcker will tighten as the economy expands, but his current board of governors watches prices and won't stand still for a whiff of deflation. The trend is still down for interest rates. Monetary reform follows tax reform, and maybe JB III follows JFK.
May: A Great Month for JB III
When David Stockman negotiated a $2.3 million advance from Harper & Row in early 1985, promising to deliver a book on "The Failure of the Reagan Revolution" by year's end, the idea seemed foolproof. It was conventional wisdom at the time, especially inside the Washington Beltway, that Ronald Reagan's days were numbered as an effective President. Stockman, still budget director, was predicting that the deficits would finally catch up with the President and he would have no choice but to ask for a big tax increase. The tax reform bill was also widely thought to be a dead letter, Bitburg was going to be a fiasco, Mikhail Gorbachev was surely going to win the PR battle at the summit, the lame-duck President would start planning retirement, maybe even early retirement, and the Stockman book would appear on the crest of this wave.
Why did this plausible scenario not unfold? In large part because of the inspiration of Treasury Secretary Donaid Regan, who asked White House Chief of Staff James Baker III if he would like to swap jobs. In his book, Stockman's chief accusation against Donald Regan is that he served the President faithfully, doing his every bidding without any regard to a personal agenda. Guilty as charged, Regan could easily plead, for with this masterstroke he submerged his own persona to the President's objectives, elevating Jim Baker to the limelight and the levers of policy power at Treasury. Regan had initiated the radical tax reform — which Baker might have shied from — but he sensed that it would take Baker's political skills to maneuver it through Congress while he kept it on the front burner at the White House.
President Reagan might have muddled through in any event, but the spectacular success of his second term to date — especially the bull market in stocks and bonds — would not have been possible without this move. Baker, the Texas ranger of the Administration, with his faithful companion Richard Darman, has performed so brilliantly that he has a good shot at going down as the third great Treasury Secretary in the nation's history — with Hamilton and Mellon. The tax bill seems a done deal, a truly earthshaking reform. And if Baker doesn't achieve a global monetary reform in the remainder of the Reagan tenure, he at least has it well on its way — with another milestone passed last month at the Tokyo summit.
The purpose of this recitation is as a reminder that the good news on Wall Street isn't an accident. Stocks aren't up because business is good and bonds haven't climbed because interest rates are down. The bull market is the result of policy changes to suit the President's tastes, hammered out by people who know what they're doing. The markets, we think, haven't fully capitalized this brainpower, especially in bonds. The news will get even better.
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It has been our thought from the outset of the tax reform that the legislation would look its worst coming out of the House Ways & Means Committee, and would improve each step of the way thereafter, in the House, in the Senate Finance Committee, on the Senate floor, and in the House-Senate conference. The reasoning was that the President's electoral mandate for tax reform would be felt least in Ways and Means and would be at its height in the conference committee, where the Administration would work to balance the interests of the Democratic House and Republican Senate.
So far, this has been precisely the case. The bill voted to the Senate floor by a unanimous Finance Committee is superior to everything that's come along since Treasury I and is not far from the shape of the Kemp-Kasten proposal that never got serious consideration. It will almost certainly be improved from this point, either a little or a lot.
The biggest problem, as Alan Reynolds points out, is that of the effective date and the blended rates. With the tax shelters being phased out January 1, 1987, the investment tax credit suspended as of January 1, 1986, and the personal rate cuts not taking effect until July 1,1987, it's clear to just about every economist that there would be an adverse short-run economic impact. The official projection is that the bill is front loaded on tax revenues by about $22 billion.
Unhappily, most economists are Keynesians, and to them the amount is small when expressed as an aggregate in a $4 trillion economy. The economic effect is adverse, but to a trivial degree. To the supply-siders, whose analysis turns on marginal rates rather than aggregate demand, the adverse effect is fairly serious. In a May 27 internal memo, Alan Reynolds advises:
Assuming a reasonably accomodative monetary policy, in all G-5 countries, a full-year reduction of marginal tax rates to 27-32% could produce a growth rate near 5% for 1987. The half-year reduction of tax rates to 38.5% or more in the Senate Finance Committee bill, on the other hand, would slow growth to no more than 3%. The loss of deductions and exemptions for a full year, together with a half-year cut in tax rates, means that both average and marginal tax rates would rise for many upper-middle class families with children. More importantly, they would know that tax rates would fall in the following year, and therefore would postpone earnings — something that is not difficult with nigh-income professionals, investors and managers. With output down, but expected future net income up, imports would rise, further reducing real GNP. . .
A reduction of GNP growth from 5% to 3% amounts to $85 billion, which, assuming an overall marginal tax rate of 28%, implies $24 billion less federal revenue. State and local tax revenue would also be reduced, and federal outlays increased.
The whole point of the exercise in deferring the effective date on the new rates to July 1 is to gain revenue, not to lose $24 billion through suboptimal economic growth. The point has been accepted by Secretary Baker, who has been gently introducing the idea of moving toward a January 1 effective date to offset the $22 billion revenue bulge. As in the past, once it's clear Baker and Darman have something this critical as a goal, they manage to pull it off. Our expectation is the effective date will be settled along these lines in the conference committee.
An even neater trick would be to have the conference committee accept the Senate bill in its entirety on the rates, and accept the House bill in its entirety on the dates. This would put the whole rate structure of the Senate version into effect on July 1 of this year, excepting the ITC suspension at the outset of 1986. This solves the "revenue loss" problem that the Treasury has to solve in moving the effective date to January 1, 1987. In already suspending ITC, after all, Treasury garners a windfall of tax revenues in the last three quarters of this fiscal year ending September 30, about $24 billion. These are really phantom revenues, in that they don't seem to be counted officially anywhere, but they are perfectly suited to covering the illusory revenue loss that supposedly would occur by accepting the effective dates in the House bill.
Darman, whose genius at grand strategy practically guarantees him a Cabinet post in some future administration, now aims to get the legislation through the Senate with as little fuss as possible. The longer the interest groups have to coalesce, trying to slip preferences back into the bill, the more difficult the conference will be. An easy conference, one that enables the President to sign a bill by Darman's August 15 target, will also make it easier to accomodate an earlier effective date. If the conference drags into autumn, options fall away on the timing, with negative short-run consequences for the economy.
In a tax bill of this magnitude, elements can be written in conference that did not appear in either House or Senate version, as long as they seem non-controversial and are meant as repair to the legislation as a whole. In this light, supply-siders are hoping for a fix on capital gains in the conference that the liberals could accept: a modest indexing feature.
There's no chance of getting a capital gains differential, as the venture capitalists would like, unless the top rate in the Senate bill creeps above 27 percent on personal income. But this is why it won't creep up. Liberal Democrats have such antipathy for a capital gains differential that they might even accept a 20 percent top rate to keep it out. (Old Guard Republicans love the differential so much they might go back to a 70 percent top rate to keep it in.) This is the glue holding together Senator Robert Packwood's unanimous committee.
But indexing a capital asset to the GNP deflator is something the liberal intellectuals seem to find acceptable, even appealing, perhaps because it is only really of use to longer-term investors and the ordinary homeowner — not the short-term speculator. By indexing above, say, 3 percent a year, in order to avoid static revenue loss, the longer-term investor gets protection against inflated taxable assets worth at least as much as a 7 percent differential. If Senator Bill Bradley and Ways and Means Chairman Rep. Dan Rostenkowski would give a nod to such a measure (they have become as close as the Corsican brothers), it would find itself in the final version without a murmur of dissent, we think. Michael Kinsley, editor of The New Republic and an arch-foe of the capital gains differential, tells me "It's immoral for the government to tax inflated gains." If the conference agrees, we would be surprised if the Dow kept its head below 2000.
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While Deputy Treasury Secretary Darman stayed in Washington to cook the tax bill with Senator Packwood, Jim Baker was in Tokyo planning a menu of monetary reform.
The ultimate goal is a fixed exchange rate system anchored by the international gold reserves of the major central banks. In order to get there, the Group of Five (finance ministers of the U.S., Germany, France, the U.K., and Japan) first had to agree to abandon the floating exchange rate system. This really meant that the United States had to take international responsibility for its dollar policy, as it had prior to the 1973 float. Secretary Baker did so with the G-5 on September 22, 1985, in New York City. At the time, he was faced with unyielding protectionist forces at home who ascribed the U.S. trade deficit to the yen/dollar ratio, then at about 220. The dollar had been as strong as 263 yen in February 1985, dropping as Federal Reserve policy finally eased.
The New York agreement began an explicit management of the floating exchange rates, but without specific target zones. The bottom line was that the Volcker Standard for the conduct of domestic monetary policy became the Baker-Volcker Standard for the conduct on international monetary policy — that is, a purely subjective feel for things. The yen/dollar ratio became the center of attention, at least in Washington, because of the protectionist political forces centered there.
The first move to 200 yen was accompanied by some further easing of U.S. monetary policy, as evidenced by a small rise in the price of gold to about $340 from $320. But most of the move resulted from a relative tightening of monetary policy in Japan. A parallel shift occurred in Europe, although not by the same magnitude.
The Keynesian economists had argued this exchange rate shift would reduce the U.S. trade deficit with Japan; Chrysler's Lee lacocca, reflecting this view, had spoken of a 200 yen range as his objective for competitive purposes. But the maneuver had the opposite effect, as the slight U.S. monetary ease moved our economy into a higher gear and the tighter Japanese monetary policy shifted them into a lower, deflationary gear. As a nation, Japan would thus tend to import less, and their debtors, squeezed at the margin because of the yen deflation, would have to throw goods on the world markets at distress prices to meet their obligations. The U.S. trade deficit would get bigger, we advised the Reagan Administration in October.
Japanese businessmen felt the deflation keenly in the 190 to 200 range, but just as their government was feeling the political pressure from the deflation, Saudi Arabia turned on the oil spigots, bringing instant relief to Japan. But spurred by the Reagan Administration's warnings of trade wars if more wasn't done on the exchange rate, the yen strengthening resumed, the dollar buying 180, then 170, then only 160 yen in mid-May. But now, not only were the yen debtors in Japan being squeezed by the currency deflation, but the oil price had bottomed out and was creeping up to hammer them from the other side, i.e., input prices rising and output prices falling.
Concurrently, Paul Volcker had introduced himself into the yen/dollar discussion. With the two new Reaganites on the Fed Board of Governors, Volcker faced a gang of four who were determined to cut the discount rate — not because of exchange rate considerations, but because gold and other commodity prices were droopy enough to risk shooting some liquidity into the system. Almost daily, somewhere Volcker would be saying he thought the dollar had fallen too far — the rising yen his new excuse to keep from easing further. At the House Budget Committee February 26, even Rep. Jack Kemp supported Volcker over Jim Baker on the yen rate, although there were by now so many variables floating around that it wasn't made clear the Japanese should be easing, not the U.S. squeezing.
We go through this recitation in order to discuss the current state of the currency markets, interest rates and monetary policy.
On Saturday, May 10, Baker returned from the Orient to the following situation: The U.S. trade deficit with Japan was at a new record high; protectionist sentiment was rising beneath the House trade bill; the yen was at 160, a record high; the Japanese economy was headed to recession; Prime Minister Nakasone was beginning to smell defeat in the upcoming July national elections, the opposition ridiculing him for not getting relief from his friend Ron at the Tokyo summit; Commerce Secretary Malcolm Baldridge and Special Trade Representative Clayton Yeutter were calling for an ever higher yen rate!
On Tuesday, May 13, in congressional testimony, Baker gave the first opaque sign that he believed the yen had been over-cooked. The dollar rallied to 163 from 160 on the news, paused the following day in confusion as Baldridge spoke again of a cheaper dollar, and began its march back up. Baker's testimony was an open sign to the Japanese government that the Reagan Administration would not pull the rug from under it if the yen eased.
Our assumption is that as the yen/dollar ratio approaches 180 or more, Volcker will come under pressure to ease. With gold below $350 and the dollar rising against the yen and D-mark, two of the Fed chairman's favorite recent arguments against easing are fading. He might throw a scare into the markets by hoisting the M-1 numbers, or letting it be known the leading indicators have him worried about an overheated economy. The bond market scares itself just thinking about this possibility. But these are worn out bogeymen, and if Volcker trots them out, he will risk losing the affections of Vice Chairman Manuel Johnson and the other Reagan appointees. Johnson and Wayne Angell are diplomatic fellows, and will stand shoulder to shoulder with the chairman up to a point, as after the February 24 vote. But these are price-rule folks who will not stand still for even a whiff of deflation.
In other words, interest rates may climb on expectations that the Fed will try to manage the real economy to keep it from growing faster than 3 or 4 percent (which was the drill in early 1984), but this board of governors won't play that game. It will supply as many reserves as the expanding economy demands, as long as the price signals don't blink red. The trend of long-term interest rates is down.
Secretary Baker's decision to publicly signal a floor to the yen/dollar ratio, as he had signaled a ceiling last September, was a nervy one. The Democratic leadership remains tempted by protectionism as a political issue, and there are plenty of Republicans who are worried too. The combination of Baker on exchange rates and President Reagan on the trade bill (calling it not protectionism, but "destructionism") invites the joining of the issue in the November elections. "The President is beginning to sound like Japan's No.1 lobbyist," Tip O'Neill's press secretary told the Times.
Even in the worst of times, trade protectionism doesn't do well at the grass roots on election day. And these are hardly the worst of times. The White House and Treasury have been worried that the trade bill might pass over the President's loudly promised veto. Which is why they've been throwing some red meat off the sled to the wolves — on Canadian shakes and shingles. But just as we predicted a monetary deflation in Japan would increase the U.S. trade deficit, we believe the Baker move to help Japan with its yen problem will work to decrease the trade deficit and the political pressures that go along with it.
Baker's nemesis remains the Secretary of State, George Shultz, who will go down in history as one of the worst Treasury Secretaries (when supply-siders write the history). The White House, Treasury and Volcker have all been hoping Japan and West Germany would expand their economies through tax cuts, which would also boost U.S. exports. But as in 1985, at the Bonn economic summit, Shultz prevailed on the President not to bring up the issue, on the grounds that it might offend them and they would refuse to sign his anti-terrorism statement. The Germans and Japanese, who had expected to be lobbied, were reportedly baffled that the President passed this opportunity. Shultz seems determined to keep any supply-side growth ideas from leaking across the U.S. border.
Nevertheless, May was a remarkable month for the Secretary of the Treasury, possibly the best of his life. But they may get better yet. The last JFK had a Texan as his running mate. The next one may too.