The magnitude of Arnold Schwarzenegger’s victory yesterday won’t be known for a few weeks, when the absentee ballots are counted. It was clearly big enough, though, to enable the media networks to declare Governor Gray Davis the loser and Schwarzenegger the winner just one minute after the polls closed. Wall Street yawned this morning, opening down a fraction, but I think the reason for the last several days of market advance reflected growing confidence that this is how California would turn out. There was concern outside of California yesterday morning that the race might have tightened to a degree Davis might defeat the recall, with the DJIA shedding 50 points in the first half hour of trading. I e-mailed our new West Coast marketing director Wayne Jett in Los Angeles at 9 am, 6 am PST. He responded crisply at 7:16 PST: “Davis will lose (probably by double digits). Arnold will win, probably by double digits.” By coincidence, the market turned up almost exactly at that time, 10:16 EST, closing up almost 110 points from the bottom.
Now I am not saying all of the market’s movements yesterday were California related, but the election’s outcome presents very promising possibilities for the state economy, the national economy, and the financial markets. With Rep. David Dreier [R-CA] named to head the transition team, as Arnold prepares to govern, supply-siders clearly are in the ascendance. As a reminder, Dreier is chairman of the House Rules Committee, chairman of the Zero Capital Gains Caucus in the House. He’s also a very close friend of Bill Mundell’s, Bob Mundell’s son, who is the CEO of Michael Milken’s Knowledge Universe enterprise, headquartered in Santa Monica. It was Dreier who got Schwarzenegger connected with Art Laffer for their two-hour meeting a few weeks back.
As a reminder, here is how I sized up “The California Factor” in my August 11 letter:
I am encouraged by the developments of recent days, especially with Arnold Schwarzenegger’s decision to run. His positions on social issues supposedly make him anathema to the state’s hard-right conservatives who lost badly last November when they tried to defeat Gray Davis with William Simon Jr. Of all the GOP entrants, though, Schwarzenegger is the one who could take the kinds of steps that Ronald Reagan would to pull the state out of its fiscal crisis -- and be able to get the Democratic legislature to go along with him. The other Democrats in the field would be just as stymied as Davis. The other Republicans in the field might make the right proposals, but would not likely have the charm to get them through the legislature.
The crisis is not all that critical, if you remember that the $38 billion deficit facing the state is really only $19 billion averaged over the two budget years. If we round out the numbers for a $2 trillion economy, the deficit is only 1% of the total. The state’s bond rating has slipped somewhat given all the dire predictions of where the crisis might lead. But the rating would bounce back if the Terminator recommended a Reaganesque approach, which I suggest would be the elimination of California’s capital gains tax. Most certainly there would be no need for any kind of tax increase, as the state’s economy is running a huge deficit because it is already burdened with excessive tax rates that are sending financial and human capital east. The top income-tax rate is 9% or higher in those jurisdictions that have local add-ons. California should have gotten rid of its capgains rate years ago, but it would be easy now that so little revenue from that source is dribbling into Sacramento. The state’s economy would suddenly become a magnet for capital formation, and the growth that would occur would bring higher revenues to every city, county and hamlet within its borders. At the margin, it would increase revenues in every state in the union. A Governor Schwarzenegger might have to settle for a 50% exclusion on capgains, but even at that rate Californians would be able to see the way out of the woods. That would be especially good as the national economy is now being helped with the second round of Bush tax cuts.
In my contacts with Dreier in recent weeks, this remains the one idea I think possible in the first days of new government. In his recent WSJournal op-ed, Laffer recommended a radical tax reform, coming down to a flat tax. That would be much too big a bite for the Democratic legislature to swallow in the first phase of the Schwarzenegger era. But it becomes a realistic idea for the second phase, perhaps in 2005. California is really the intellectual home of the “flat tax,” having been originally developed by Stanford’s Alvin Rabushka and Robert Hall, the former a Republican, the latter a Democrat. Former Governor Jerry Brown, now Oakland’s Mayor, describes himself as a “compassionate supply-sider,” and is receptive to the idea of radical tax reform for California. Brown would know that if Schwarzenegger presents a popular plan to the legislature in January, accepting reasonable compromise, Democrats would have to make a deal or have the Governor take his agenda to the people in another round of initiative/referenda.
Admittedly, this is a rosy scenario, but this is the first time in many years I’ve seen the chessboard open-up as widely as it now has for supply-siders -- with California’s populism leading the way just as it did with Howard Jarvis and Proposition 13 in 1978 and with the Reagan presidency in 1980. Democratic economists of the Krugman persuasion are already panicked that Schwarzenegger will go in that direction, predicting as they did in 1978 with Prop 13 that radical tax cuts would doom the state’s economy. Warren Buffett is still co-chairman of Arnold’s economic advisory team and almost all the others appointed to that team look like conservative budget-balancers. So there will be some knockdown drag-out internal squabbles over the action-agenda in the weeks ahead and major fights over key posts. Personnel, as always, is policy. If I’m right on the rosy scenario, we would have the expansion of the national economy feeding into the expansion of California’s, and California’s feeding the nation’s. We would have a most welcome supply-side virtuous circle.