In last year’s wonderful tax bill, which slashed the marginal cost of capital and provided the punch that has kept the U.S. economy in a mild expansion, there was one provision that helped a lot, but which was designed to expire on December 31 of this year: the depreciation bonus. At the time the tax bill passed in June, 2003, it was generally assumed that the 30% bonus in expensing qualified capital equipment put in service before January 1, 2005 would have done its job by now and could be allowed to expire. With two months before the November 2 elections, the expiration already is having negative effects on the stock market. Companies that find they cannot order equipment that can be delivered and put in service by December 31 have no incentive to order and sales are slowing as a result. Semiconductor orders have softened noticeably as a result, which is what we are being told. In the macro world, Gary Robbins of Fiscal Policy Associates figures the bonus reduced the marginal cost of capital by 7% and is gonzo.
This would have been okay if the other tax bills in the pipeline last year had been passed (i.e., the tax extenders and the corporate tax bill). If you recall, last summer we had our hopes up with House Ways&Means Chairman Bill Thomas that the Foreign Sales Corporation substitute in the corporate tax bill would be passed by Thanksgiving of 2003. It would definitely have given a big supply-side boost to Wall Street, the economy and the demand for liquidity. Now we have our hopes up with Chairman Chuck Grassley of Senate Finance that he and Bill Thomas can whip through a conference committee when Congress returns for three weeks after the GOP convention next week and the break for the November elections. The other tax bill extending tax breaks that are due to expire at the end of the year already should have been enacted, but for White House insistence on longer extensions. Although both bills should become law eventually, I have little confidence that they can squeak through in that three-week window.
The GOP convention in New York City will be a positive influence on the financial markets if it manages to squeak through without a terrorist disruption, which I do not expect to happen. It will be even more positive if President Bush unveils a promising agenda in his acceptance speech for the kind of tax and/or monetary reforms that would help him get re-elected. Surely, there have been enough hints that he will commit to some sort of simplified tax system. If this turns out to be wishful thinking among conservatives who are otherwise unhappy with his free-spending record that has ballooned the federal deficit, it will be a lost opportunity to win a mandate for tax reform. Earlier this week on CNBC, "Squawk Box" posed a "Yes/No" question to its audience on whether they supported a “flat tax” and even I was astonished that it came in at 75% "yes."
It is even more astonishing that Senator Kerry has not picked up on this issue, which strikes me as being ripe fruit on a low-hanging branch. Instead he promises to tax the most productive members of society because they are richer than the least productive. Kerry should be taking the lead on tax reform. Why he does not can only be attributed to the closely held belief among Democratic intellectuals that budget balancing and Robin Hood class warfare came back into their own in the eight Clinton years. The pounding Kerry has been taking on his military record in recent weeks and polls showing he is losing the slight lead he had may force a change in his campaign, for better or worse.
For Wall Street, the January elections in Iraq will have great importance. The recent escalation of violence involving religious dissidents protecting the mosques and their holy cities constitute a threat to the elections; they would be postponed or cancelled by the interim government unless there is a relative peace. The election of a nationalist body of Iraqis in an assembly might spell doom to the neo-con plans for a permanent U.S. military presence in Iraq. Yet this might also bring an end to attacks on the oil pipelines and the prospect of a government able to further develop the bountiful Iraqi oilfields that have been neglected for more than a decade. Thursday’s reported agreement between Shia clerics Sistani and Al-Sadr to demilitarize the holiest Iraqi city of Najaf was a big plus. Elections in January could cool off the insurgents and put oil at least below $40.
It is this kind of atmosphere that has brought down the price of oil from a peak of $49 bbl to Thursday’s close at $43. The excess reserves in the world oil industry remain too slim to give us confidence that energy costs in themselves will not drag the world into a serious economic slowdown. It will, though, take time for the global energy industry to commit the necessary capital to develop known oil fields. Every piece of good geopolitical news helps knock off nickels and dimes and dollars from the world oil price.
Last but not least, we have another FOMC meeting just around the corner. Given the soft equity market and strong bond market, at least we can say that the Fed may react to the iffy statistics in the economy and job market by seriously considering a pass on its measured march to an unspecified “neutral rate.” This would give Grassley and Thomas a shot at passing the tax legislation, which should push down the dollar/gold price. China and Hong Kong already are feeling the tremors of a revived inflation impulse with gold at $409. The Brazilian central banker, who should be hacking away at the 16% target rate, also is worried about inflation signs and opening the possibility of taking the rate higher.
This reminds us how much damage can be done to the world economy by a floating dollar and the suboptimal economic theories on how to manage it. The St. Louis Fed, which is still operating on a Keynesian model designed by former Fed Vice Chairman Larry Meyer, thinks the funds rate has to go to 4% by the end of 2005. There are other models kicking around out there that posit a 5.5% funds rate as "neutral." To get there either means a 10-year note higher, reflecting inflation and a much higher gold price, or an inverted yield curve, which implies recession. We cannot imagine Greenspan taking us that far, but who knows how long Greenspan will be around?
The late Herb Stein told me in 1971 in trying to explain all the moving parts of Nixon’s August 15 economic package, which included closing the gold window and raising tariffs: "It’s all a big mosaic." Except we will not see how it fits together until we make it around these next few political corners.