Executive Summary: President Reagan's re-election year will be as good for the economy and financial markets as 1983, with another 6.5 percent GNP boost probable and another 15 percent climb in the DOW possible. The power struggle for the White House, though, allies Democrats and Old Guard Republicans who need a weakening of the economy in 1984 to reestablish their influence over national policy. But Reagan resists the "Big Con," refusing to be trapped with a budget-balancing platform while the Democrats gear up a supply-side flat tax. AS a rule, presidential election years are bullish because voter influence over economic policy is maintained. A parallel with the 1924 Coolidge election is drawn, pointing to an even better year in 1985. Volcker is still a concern, but much less so now that he's moved the Fed to a price rule and the explicit goal of price stability.
A Rosy Nineteen Eighty Four
Nineteen eighty-four should be a very good year for the American economy and the financial markets. We should see another 6-7 percent rise in real Gross National Product, inflation rates holding below 5 percent and interest rates declining as the Federal Reserve avoids inflationary or deflationary swings in sensitive commodity prices. Unemployment will continue its decline and the Dow Jones Industrial Average will continue its rise, perhaps by another 15 percent. What can prevent this rosy scenario from unfolding is if President Reagan is bamboozled into thinking the current raging debate over future federal budget deficits has to do with economics and that he must "do something" about them. The debate has only to do with politics, power politics, since in 1984 the greatest power center of all is at stake. Those who don't have the White House want it, and when they want it badly enough they're willing to say and do almost anything to get it. The outsiders know that if the economy continues to strengthen, their chances of topping Reagan diminish even further than they have in 1983. In the great game of presidential politics, it is in their interests to bring about a weakening of the economy and they need Reagan's cooperation.
In this big con game, the Democrats insist the economy will weaken unless the President raises taxes to cover the monstrous deficits they predict. Their economic viziers, the Keynesians, who also seek power, are forced to develop arguments about the evils of deficits even though their careers were built on the opposite proposition. In this hue and cry, they hope Reagan will lose confidence in Reaganomics, identified as supply-side economics, the ideas used to capture the White House in 1980.
The Democrats have strange bedfellows in those Republicans who themselves sought the White House in 1980 and lost. These COP factions don't necessarily wish the defeat of Reagan in 1984, but they certainly wish the defeat of Reaganomics, insofar as these are ideas that could keep them away from the power center in the future. This means they too must hope for a weakening of the economy in 1984. Their economic viziers, the commercial Keynesians (the Feldsteins, Greenspans, Stockmans, Steins and Penners), are forced to lie in the political beds they've made. They join Democrats in arguing that for the economic recovery to be sustained, a big tax boost is needed now.
It's not that these people are not good Americans. Democrats can always rationalize that any temporary economic decline would be offset by their recapturing of the White House in order to pursue other noble goals on behalf of their constituents. The austerity Republicans, whose ideas have not only been spurned by the President but have been made to look ridiculous by the 1983 expansion, can also justify their trimming of the public interest by seeing an intrinsic morality in a balanced budget, at whatever cost.
It's important to understand that this is not a cynical view but the reality of politics, always and everywhere. Alexander Hamilton, one of the architects of the Constitution and its system of checks and balances, early in his career hit upon David Hume's ".... maxim, that, in contriving any system of government, and fixing the several checks and controls of the constitution, every man ought to be supposed a knave; and to have no other end in his actions, but private interest. By this interest, we must govern him, and by means of it, make him co-operate to public good, notwithstanding his insatiable avarice and ambition.... It is therefore a just political maxim, that every man must be supposed a knave. Though, at the same time, it appears somewhat strange, that a maxim should be true in politics, which is false in fact." By this, Hume meant that "honour is a great check upon mankind. But where a considerable body of men act together, this check is in a great measure removed." In a court or legislative body, Hume wrote, this principle is so potent that the whole body "acts as if it contained not one member, who had any regard to public interest and liberty."
There are, of course, innocents who genuinely believe a honest intellectual debate is raging about the deficits. John Glenn seems to be one, bamboozled into proposing income-tax surcharges on individuals and corporations as the centerpiece of his collapsing campaign for the Democratic presidential nomination. But the main players in the struggle for power know exactly what's going on. Herbert Stein, who was President Nixon's chief economic adviser and is now an ardent foe of supply-siders and a champion of major tax increases, is disarmingly honest in delineating the power play. In the December AEI Economist, he writes:
The long history of groundless claims about the deficit produces skepticism about anything that may now be said on the subject. For many people, realistic discussion of the deficit is unacceptable, or beside the point, because the deficit is only a convenient symbol for something else they care more about. That is, people say they are against deficits because they are really against the entitlement programs or against the defense program or against the Reagan tax cuts. In general, most of these people would oppose these programs without regard to the presence of the deficit, and they will not change their mind about the deficits if that requires them to change their mind about the other things. Oddly, supporting or opposing deficits is now also a way of supporting or opposing Reagan, and people are more attached to their views of Reagan than they are to their views of the deficit.
In the same vein, Stein also observes:
Since 1981 the concern about the deficit has taken another turn. Then it began to be argued that the deficit would deepen the recession or at least abort the recovery, in the common cliche. This kind of reasoning had hardly been heard since the time of Herbert Hoover. Surprisingly, this claim about deficits was made by — among others — Keynesians who had once taken the lead in demonstrating that deficits stimulated the economy....Concern that the deficit would abort the recovery has faded as the recovery has actually begun and seems to be following a fairly typical path.
Despite these considerations, Stein simply asserts that because defense and social expenditures will continue to rise faster than any realistic projection of economic growth can produce revenues, taxes must be raised. This is the "structural deficit" argument so popular in 1983. But this structural deficit argument no longer suits the needs of the Democrats as the political season opens. They cannot argue that taxes must be raised to cover rapidly growing defense and social outlays because President Reagan simply counters with the argument that if such a problem indeed exists, it could be solved as well by reducing outlays. Where, Reagan asks, will the Democratic Party cut?
The Democrats are trapped by the question, unable to produce specific cuts of any meaningful nature. Except for George McGovern, who would cut the Pentagon budget by 25 percent (still only a saving of $65 billion), the Democrats are fearful of running as superdoves against the President and except for nitpicking are willing to concede defense spending as a political issue. That leaves them with social spending, and, of course, here they confront the main body of their constituents. As a result, in late December, a new argument was developed by their strategists. Taxes need not be raised in order to cover rising defense and social outlays, we now hear. They must be raised to cover the rising costs of financing the national debt. Leonard Silk of the New York Times, who is practically the official Keynesian spokesman for the Democratic Establishment, developed this theme in his column of December 30:
The prospect of huge budget deficits of $200 billion a year or more for the rest of this decade came under virtually unanimous condemnation this week at the annual meeting of the American Economic Association. One major danger is that the deficits are beginning to feed on themselves as the rising burden of financing the debt drives interest rates higher, which in turn causes deficits to grow faster.
Silk goes on to quote economists who assert that if interest rates remain where they are, federal interest payments will rise by a total of $142 billion in the 1984-89 period. And if they rise as they have in other postwar recoveries, net costs would climb by $208 billion. There is no discussion of what happens if interest rates decline. The economists quoted are almost uniformly associated with the Brookings Institution, the center of the Democratic Party's shadow government. Charles Shultze, for example, the new president of the AEA and onetime chief adviser to Jimmy Carter, tells Silk: "Eighty percent of the economists think there should be a tax increase," compared with "50 percent of the Congress and zero percent of Ronald Reagan." Silk concludes triumphantly: "It is commonly said that economists never agree about anything. In that case the saying is wrong." Case closed.
* * *
Our optimism about 1984 rests on the assumption that President Reagan and the key people around him are supremely aware that the deficit game is a political game. Reagan is currently king of the mountain, a handsome 1-to-4 favorite for re-election in London's betting parlors, and he has not gotten to this position by being an "amiable dunce," as Clark Clifford once characterized him at a Georgetown cocktail party.
There was a time when James Baker III, White House chief of staff, could have fallen for the big con, siding with 80 percent of the economists instead of his boss. But not any more. Baker and Presidential Assistant Richard Darman came in 1982 to doubt the boss's judgment on fiscal policy. And a year ago, as 1983 began, they were still tempted to think the President knew less about the economy than, say, Marty Feldstein or Alan Greenspan. But 1983's robust, non-inflationary expansion — which they enjoyed immensely — has made supply-side allies out of them.
For the President to step into the New Year with the confidence of his high command is no small thing. This is the first year in which this has been true, as evidenced by the fact that we no longer hear of power struggles within the high command. Finally, everyone's a Reaganaut. Given the President's proclivities, this means there is not only much less chance of Reagan being talked into a balance-the-budget platform, it also means there will be less resistance, more allegiance and enthusiasm, from these quarters if Reagan decides on a dynamic re-election campaign. This in turn increases chances the President will do just that, setting the terms of the campaign as he did as challenger in 1980. But now as incumbent he can set forth another bold platform of domestic and international reforms that will keep the Democrats on the defensive, pleading for the status quo. We could not expect a good year on Wall Street if we did not see this likelihood.
With some notable exceptions, presidential election years are usually good for Wall Street. The conventional wisdom is that this occurs because the party in power can pander to the masses by pumping up the economy artificially, leaving the bills to be paid after election day. This explanation asks us to believe that financial markets and the masses are easily fooled by short-term political maneuvers and are basically unable to discount the future. The more plausible explanation is that both the voters and the financial markets know that good economics is good politics. Voters-have their greatest influence over economic policy in presidential election years, when the candidate who listens to the 80 percent of the economists loses to the candidate who listens to 80 percent of the people.
This doesn't mean candidates should be slaves to the public-opinion pollsters who are rarely able to divine the interests of the electorate with their imperfect questioning. In 1980, all the pollsters, including Reagan's, told their candidates the voters didn't care for Reagan's tax-cutting ideas. Yet as Reagan stuck to his guns, he firmed his grip first on the COP nomination, then on the Presidency, and the stock market applauded all along the way.
In 1976, both the Ford and Carter teams were guided by pollsters and economists counseling austerity, which produced the classic remark during one autumn dip in the Dow that the financial markets worried that either Ford or Carter would win. The markets actually did much better in 1976 than they did in 1977. Jimmy Carter came out of obscurity to win the Democratic nomination, which he did by ignoring the findings of the Democratic pollsters who were telling Birch Bayh, Mo Udall, Fred Harris, and Sargent Shriver that the American people wanted to break up the oil companies and tax them to death. Carter instead favored deregulation of the oil industry, inveighed against the "disgraceful" tax system and double taxing of dividends, and voiced populist alarms about big government. The DJIA peaked in 1976 at the time of Carter's nomination, but it didn't really collapse until he was inaugurated in 1977, announcing energy and tax policies exactly opposite those that he seemed to be promising during his campaign.
This was atypical of the postwar pattern, which usually has seen Democratic Presidents inviting rising stock markets in the first year of their presidencies, while GOP Presidents invite declines. On the other hand, when Republican candidates win, they do so with much stronger stock markets in the year of election than do the Democrats, an average 12 percent rise of the S&P 500 compared to an average 5 percent for the Democrats.
The reason is that Republicans will often espouse more growth-oriented policies than will the redistributionist Democrats during the campaign period. But once elected, they chisel on their promises out of regard for "fiscal integrity." In 1952, Elsenhower gave every sign of espousing lower income-tax rates, but once elected said that would have to await a balanced budget. In 1968, Nixon promised an end to LBJ's 10 percent income surtax. In 1969, he said he would have to defer that and besides would have to double the tax rate on capital gains. In 1980, Reagan pledged a 30 percent tax rate cut over three years, beginning with January 1, 1981. Soon after the election, Senator Dole, David Stockman and the GOP establishment were busily hacking away at that mandate. In each case, election-year bull markets were followed by bear moves.
We need not assume that this will be the pattern of 1984-85. If it were left to the Republican elites, it would be: Reagan would make vague, low-tax, growth-oriented noises during the campaign, but spring a "budget-balancing" consumption tax on the unsuspecting populace after re-election was safely in hand. The one Republican campaign that broke this pattern in this century was the 1924 re-election of Calvin Coolidge, Ronald Reagan's favorite Republican President of the 20th century. The Coolidge bull market of 1924 turned into the red-hot Coolidge bull market of 1925, the New York Times share index rising 13 percent in 1924, 28 percent in 1925.
It seems reasonable to suggest that the centerpiece of the Coolidge campaign of 1924 — a plan to cut the top personal income-tax rate to 25 percent at $100,000 from 56 percent at $500,000 — had much to do with the bull market as well as his re-election. Treasury Secretary Andrew Mellon had persuaded the Congress in the Harding-Coolidge term of 1921-1924 to lower the income surtax to the 56 percent level from 73 percent at $1 million. But it wasn't until the 1924 election that a presidential campaign was dominated by the "growth versus fairness" issue in tax policy. Coolidge and the Republicans argued that lower rates would produce more economic growth and yield more net revenue from the wealthy than high tax rates; John W. Davis and the Democrats put forward a more egalitarian tax plank. The election outcome made it so clear that the low-tax, high-growth idea was the more politically powerful that the surviving Democrats were ready to cut deeper into the rates than the promised 25 percent. There was no thought of chiseling on the mandate in order to extract greater revenues.
The 1984 parallel with 1924 isn't exact. But it's close enough to give us a rough guide to the politics of the new year. The Democrats clearly recognize the political power of the tax-cutting idea, having learned from Reagan in 1980. While they would now like to persuade the President that a tax boost would do wonders for the economy and for his re-election prospects, they have already warmed up to the idea of a drastic cut in the top marginal income tax rate. As 1984 opens, all we hear are plans for "contingency taxes" and "tax plugs." But as the conventions draw near, San Francisco and the Democrats in July, Dallas and the GOP in August, the heavy artillery could easily involve a tax-cut competition.
If there was any chance Fritz Mondale would go the John W. Davis route, it ended when Senator Glenn "courageously" embraced the surtax ideas as a means of balancing the budget. The Glenn campaign, barely afloat, quickly sank to murkier depths. Mondale, who had pushed Glenn into this "fiscally responsible" decision by criticizing his 1981 vote for the Reagan tax cuts, shrewdly lashed out at Glenn's surtax, arguing that its increased progressivity would damage incentives and threaten the economic recovery. John Glenn is a pushover.
Even George McGovern, the most egalitarian presidential contender ever put up by the Democrats, is now singing the supply-side tunes. In a December 29 interview with the New York Times, McGovern praises Martin Feldstein and says interest rates would come down if the deficits are reduced, and this can be done by cutting $68 billion from the $275 billion defense budget and "Secondly, I think the '81 tax law should be repealed and replaced by something like the Bradley-Gephardt fair tax bill."
What's that? McGovern explains: "Well, it would cancel out most of the tax write-offs. It would leave the home mortgage interest write-off and philanthropic giving, but virtually everything else would be canceled out. Then it would lower the overall tax maximum but not more than 30 percent. No individual and no corporation would pay more than 30 percent. That would eliminate a lot of the incentive now to avoid paying taxes. I think if corporations and individuals knew that nobody would pay more than 30 percent, they wouldn't spend billions of dollars on tax lawyers and tax accountants and tax shelters to devise all these elaborate shelters. We'd probably recover at least $80 billion that's now going through tax loopholes in the way of write-offs of one kind or another."
Remarkable! And this from the same fellow who a dozen years ago proposed a "demogrant" of $1,000 to every American with an income of less than $16,000 as a vehicle for boosting consumer demand. By the same token Fritz Mondale has already embraced Bradley-Gephardt's 30 percent flat tax, and surely we will be hearing more about it in the fall campaign; at the moment, he no doubt hopes the President can be lured into following John Glenn down the contingency surtax road. But every little noise out of the White House indicates the President will not be bamboozled into asking for a fiscal 1985 tax. Instead, there are indications the President will also be endorsing a steep cut in marginal tax rates, a la 1924's Coolidge, with the 1984 campaign turning into an economic debate among supply-siders.
There are always Paul Volcker and the Fed to worry about in 1984. But after its latest squeeze, the Fed has left itself such little room for maneuver that it can't do much damage anymore. It would have been preferable for the Fed to ease sufficiently to keep gold from deflating below $400. The bond market would not have soured in the last quarter of 1983 and we'd be much more confident of another 6.5 percent rise in GNP this year. But even more important is the progress Volcker has made in putting the Fed on a price rule. In his address to the American Economic Association in San Francisco on December 28, as reported by The Wall Street Journal: "The Fed chairman offered a more elaborate presentation than in the past on what he views the central bank's primary goal—price stability. A 'working definition' of price stability, he said, would be 'a situation in which expectations of generally rising (or falling) prices over a considerable period aren't a pervasive influence on economic and financial behavior.'"
This was a startling piece of information, tucked away on the back page of the December 29 Journal. He tells the world that price stability is the Fed's primary goal and that he considers falling prices as unwelcome as rising prices. Although he did not specifically mention gold's price, there is now a much greater probability that gold will remain in a stable trading range around $400 through 1984 than there was at the outset of 1983 that it would hover above $450. At least we surmise that Volcker would not like the inflationary or deflationary implications of a sharp rise or fall in the gold price.
Based on these various political calculations and surmises, 1984 should be a splendid year, as good as 1983, and if Ronald Reagan follows in Coolidge's footsteps, 1985 will be better yet.