Positive and Negative Forces on Wall Street Jude Wanniski April 12, 2005

The papers today report wages of American workers declined last year. Steven Greenhouse of the NYTimes says of this fall in the national standard of living: "Even though the economy added 2.2 million jobs in 2004 and produced strong growth in corporate profits, wages for the average worker fell for the year, after adjusting for inflation - the first such drop in nearly a decade." Alan Meltzer of Carnegie Mellon thinks it is an aberration. Stephen Roach warns it will be a perpetual stagnation. The fact is, the economy continues to be mismanaged at several levels, and the costs of these inefficiencies can only translate into a lower standard of living even in the face of rising productivity. 

The most important is the Fed's mismanagement of the floating dollar by manipulation of the federal funds rate. There are, though, other inefficiencies in the system created by Congress and the administration in recent years that directly impact the national living standard. This report will discuss the negatives as well as the positives that are tending to move the value of real assets. Our last dozen reports have covered these in piecemeal fashion, but it seems a good time for a fresh overview.

First we note that even though the stock market has advanced from its 2001 lows, much of the increase since 2003 has been the result of a dollar inflation that followed the previous deflation. In the deflation, producers could not pass added costs in energy or health and pension benefits to consumers in order to show a return on investment. They are now able to do so because of the dollar inflation, with the gold price at $430 oz well above its equilibrium level of $350. We`ve described some of this increase in nominal asset values as "inflationary fluff." Meanwhile, wage earners are trapped because employers are now forced to share profits with other stakeholders -- who were stuck with capital losses and nominal dividends in the deflation. If they don`t, employers will downsize or outsource or relocate. 

Globalization is a real factor when the U.S. labor pool, once contained within a tariff wall, becomes part of a world labor pool. Even as wages fell or remained flat for 95% of the labor force at the bottom of the income pyramid, wage income for the top 5% grew by 1%. An increase in demand for lawyers, accountants and investment bankers was the reason given by the Economic Policy Group, which reported these numbers. 

In the<I>Times</I> account, while gas prices are mentioned by several economists as a reason for last year`s aggregate wage cut, nobody mentioned the deadly Sarbanes/Oxley legislation, which tore through the economy in 2004 with dollar costs undoubtedly exceeding the added energy costs. Democrats and organized labor cheered when the legislation aimed at punishing management passed Congress so easily, but we figure it knocked 800 points off the Dow Jones Industrials. In market cap, this is more than $1 trillion. Who paid for this giant new tax, which continues to erode equity values? At first blush, it was shareholders, but it has been a "trickle-down tax increase" that is now borne by wage earners. Of course, Sarbanes-Oxley sharply increased the demand for lawyers and accountants and probably for investment bankers helping public companies go private to get out from the crushing embrace of the SEC.

As for Congress being a positive or negative force for the balance of the year, we`re now into wishful thinking instead of confidence that a budget will be produced that makes the 2003 capital tax cuts permanent. Republican lawmakers are concerned that there are so many vacancies at Treasury that necessary work on Social Security, Medicare and Tax Reforms is going undone. Treasury Secretary John Snow, who is now on the mashed potato circuit trying to drum up interest in personal accounts, keeps his office essentially vacant as well. All the economic policy decisions are being made in the White House, with Karl Rove in control. This can be negative, but it could also be positive.

By that we mean the President`s strategy across the board has been to set up big reform objectives, but without the pre-cooked legislative plans that are usually developed in the Executive Branch. That is, Republican leadership in Congress is being challenged to work the nuts and bolts out on these reforms and then negotiate with Democratic members who are without serious leadership. They are able to maintain party discipline in the face of the GOP concepts, but once the reform pudding develops some theme, it may prove impossible for many Democrats to resist. My guess is that House Ways&Means chairman Bill Thomas is too smart to be spinning his wheels now when it will be another two months before the Tax Commission reports on proposed reforms. If he has more goodies on taxes and an easy-to-understand Social Security reform that contains an appealing approach to personal accounts, this could be pulled off. 

If it is, there would naturally be a surge in the demand for dollar liquidity, which would produce a decline in the dollar/gold price, perhaps below $400/oz. We're not going to get the full benefits from Fed policy until it abandons the funds target and targets gold, but we could see today how happy Wall Street was when the Fed minutes of its last meeting were released. They clearly state that long-term inflation expectations are under control and there is no need to raise rates faster, as Bear Stearns has been urging, with even an anonymous voice suggesting it may be time for a pause. The DJIA, down almost 100 points before the minutes came up, climbed 150 points on this teensy bit of good news. Imagine what would happen if it declared victory and took the summer off. 

Finally, there is the Middle East, with the potential to go either way. The Israeli/Palestinian situation remains a question mark, as it is still not clear how Ariel Sharon will deal with the settlement issue. The departing chief of Israeli intelligence sees little chance of success and predicts a third intifada. Iraq is also a question mark. Syria and Lebanon seem to have settled down, but Iran is still cooking. It would be nice if John Bolton is not confirmed as U.N. Ambassador, as he is only capable of causing trouble. But in the grand scheme of things, as long as he doesn`t provoke Iran into war over the Non-Proliferation Treaty, and oil shipping lines remain open, Wall Street should be able to live with him. Keep your fingers crossed.