My assumption that 2003 will be a year without war with Iraq or North Korea still holds, as the last remaining argument of the hawks on Iraq is that the trigger must be pulled in February because the troops are ready to go and can’t be demobilized and mobilized again. And nobody seems to want to mess with North Korea, preferring to have South Korea work things out with Pyongyang. This leaves the national economy, which will turn on the monetary policies of the Federal Reserve and the fiscal policies of the government.
We will have to return later this week to evaluate the “stimulus” plan that President Bush will unveil tomorrow, but with what we know from the public prints and private assurances from government sources, the package will be a better one than we had been led to believe. We have a number of times expressed dismay with the exclusive focus on the double-taxing of dividends instead of capital-gains tax reduction. Where the Bush administration in its first two years squandered the available surplus on Keynesian cash handouts which had no positive growth effects, the approach we have been led to expect tomorrow will involve $600 billion in tax cuts and “revenue sharing” over 10 years. The Democrats are already attacking the mystery plan on the grounds that the tax portion will have no stimulative effect because a) it does not put money into the pockets of people who will spend it, or b) it is a giveaway to the rich, or c) in a $10 trillion economy, another $30 billion in tax relief does not have enough kick.
The report today that the administration will propose to entirely eliminate the double-taxing of dividends in one swoop is certainly far bolder than anything we had expected. Gary and Aldona Robbins of Fiscal Associates, who I think are the premiere supply-side technicians on taxation from their days in the Reagan Treasury Department, believe the total elimination of the double-tax will dramatically lower the marginal cost of capital. In the first instance it benefits those who directly receive the $130 billion per year that is paid by corporations. The rest of the total $270 billion payout goes to pension funds and other institutions that pay no tax on dividends received, but these will benefit as corporations find they have more dividends to pay out when the tax wedge is sharply reduced. Gary Robbins says the marginal tax on labor is now roughly 40% and the marginal tax on capital is 60%, upwards of 70% for corporations. Increasing the return to capital benefits labor the most, he says, in that it increases the capital/labor ratio in almost the same manner as it does with a lower capital gains tax. Labor becomes scarce relative to capital and real wages rise.
In other words, corporations that now do not pay dividends because of the double-tax, either squirreling away their after-tax profits in Treasury bills and bonds, will either be forced by the market to pay them out to shareholders who will re-allocate the capital to higher and better uses, or they will find better uses for the funds themselves. It will re-focus American business on earnings rather than share price and the net effect will be better for both. Glenn Hubbard, chairman of the President’s Council of Economic Advisors and the architect of the plan, is quoted as saying the plan would lift share prices by 20%, but I suspect he means over time. Robbins, a great admirer of Hubbard’s economic thinking, reckons there is a good chance he will get the whole package through, including the expensing provisions that give another boost to capital formation and “cost” only $50 billion over 10 years. Of course, the way to look at this is as government investments in lowering tax rates that are holding back growth and revenues.
The little market rally today might reflect the reduced risks of war, but it may also be impressed with the boldness of the reported economic plan. If it does run the congressional gauntlet, it could easily add 1000 points to the DJIA, but those gains would come in dribbles over the next several months. We would also expect to see the gold price come under pressure with increased demands for liquidity. In late 1996, the gold price began its decline in November, but it was already clear to Wall Street that the Clinton White House and GOP Congress were in a mood to cut a deal that would include the cut in capgains to 20% from 28%. It is not yet clear how the Senate Democrats will respond when the pieces move into the Finance Committee.
The funds the administration has earmarked for state governments is actually a fairly good idea, which you may recall we recommended a number of times last year. The idea came from Jamie Galbraith, son of John Kenneth. Its supply effects would be in closing state budget deficits to enable governors to get by without tax increases. The chief reasons the price of gold has been climbing smartly in recent weeks has not only been the continued global concern that the US may not be a good place to do business with if Bush does Iraq sans UN support. It is also an awareness that state and local tax wedges will have to go up, further cutting into business enthusiasm and liquidity needs.
With the price of gold at $350, which has been our target optimum price, the economy is finally freed from the need for downward adjustment in wages and prices on deflationary grounds alone. But the deflation did a lot of damage during gold’s round trip to $250 and back, and it will be awhile before surplus inventories are dealt with and rebuilding takes place. It would be nice if the Fed could find a way to stabilize gold here and avoid more unnecessary swings – and recent speeches by Governors Greenspan, Bernanke and Gramlich at least indicate fresh thinking on a price rule. Our Michael Darda now thinks something is going to happen this year, but perhaps only a step. It is worth noting again that with a new economic team in place, Mr. Bush has clearly elevated Glenn Hubbard’s role, and that Hubbard and his CEA team do appreciate the information on liquidity needs that the dollar/gold price emits. I’ve also counted it a plus that Karl Rove, the President’s chief political advisor, as an amateur historian may understand gold’s utility as a monetary anchor better than most modern economists. Just don’t hold your breath.
My continued optimism on Iraq was fortified during the weekend talk shows when I noted Zbigniew Brzezinski telling CNN’s "LateEdition" that if Bush does Iraq without UN support, there would be a slide toward “global calamity.” As the Democratic Party’s elder statesman on matters of national security, Zbig praised President Bush for directing the issue into the United Nations, but could not have been more hair-raising in his prediction that if the President changes his mind and goes it alone, the global terrorism that would be engendered would be catastrophic. Earlier on "FoxNewsSunday," Carl Levin [D MI], ranking Democrat on Senate Armed Services, practically laughed at the idea that President Bush might pull the trigger without a smoking gun. He argued we should not be doing Iraq, now or ever without the UN behind us. He said we should be concentrating on AlQaeda first, North Korea second, Iraq third, and if we do Iraq without UNSC support, we will have short term gains and small casualties in a quick war, but will activate Al Qaeda in direct attacks against us. He says there is NO evidence Iraq has nukes and only inconclusive evidence it still has some chem/bio. .... and the inspections are now just beginning, not ending. The International Atomic Energy Agency, meeting today, will report to the UN Security Council tomorrow, with positive steps proposed for both Iraq and North Korea. We’ll see later this week how things go.