In August 1982, the great bull market began with a big tax increase (TEFRA), a point that House Ways & Means Chairman Dan Rostenkowski makes today in urging another big tax increase as part of the deficit-reduction package. He fails to mention that the Fed, almost simultaneously with passage of TEFRA, flooded the banking system with reserves to avert a Mexican default, and stock and bond markets boomed with the end to this first great deflation of the Volcker years. Indeed, rumors persisted all spring and summer of 1982 that the Fed would not ease unless the administration and Congress came through with the tax hike, and that perhaps a deal had even been struck between Volcker and Jim Baker, then White House Chief of Staff, to trade monetary ease for fiscal tightness, the traditional Keynesian policy mix.
What we hear now is even more public and explicit, a deal between Treasury Secretary Jim Baker and his counterparts in Europe and Japan that they will ease monetary policy — and maybe even fiscal policy -- if the U.S. raises taxes. As in 1982, the problem is not that taxes are too low in the U.S. Nor is it that U.S. monetary policy is too tight (gold was about $300 in 1982 before the Fed eased and is now $460). The problem is that both monetary and fiscal policies in Europe and Japan are too tight, which limits growth in both places, results in a capital inflow in the U.S. and, produces a mammoth trade deficit. The solution is for the rest of the industrial world to lower marginal tax rates and to end the deflationary monetary policies that have sent the DM, Yen and ecu climbing, with gold sinking in these numeraires.
Unfortunately, the policymakers of Europe and Japan say they will not expand their economies unless we contract ours, i.e., unless the Reagan Administration cuts big bucks off the federal deficit, which means tax increases to satisfy the Democratic Congress. From a purely economic standpoint, if Germany and our other trading partners would come through on such a deal, it would be, as in 1982, a worthwhile tradeoff. It would do a little damage to the U.S. economy in order to do a lot of good to the rest of the world, but then the second-order effects — external growth and a reduced trade deficit — would have very positive effects on both the U.S. economy and the protectionist threat. President Reagan doesn't want to do it, though, because he only sees the bad effects of "deleterious" tax increases, because he made a tax hike/spending cut deal in 1982 on TEFRA that Congress welched on, and because he promised in the 1984 campaign not to raise taxes.
If the President can be persuaded that the package being prepared by the Budget summiteers is not so terrible (and it would not be if it is limited to excise tax increases and spending cuts), the result would be positive for stocks and bonds, anticipating favorable action abroad, and perhaps a cut by the Fed in the discount rate — but not a new dose of liquidity. The dollar would seem to strengthen, although it would simply be the DM, Yen and ecu weakening in response to the easing by their central banks, through liquidity doses, not Lombard rate cuts.
Even if the President were to sign off on a new TEFRA, we don't know if it could be approved by Congress. Any new taxes will invite GOP opposition, which means a struggle of some kind to get approval. And it's not certain when or how the Europeans and Japanese will deliver on their current vague promises of expansion.
To expedite the process, we proposed to several of the participants in the budget summit to consider a cut in the U.S. capital gains tax as part of the deal. This would permit the President to say he is accepting a total package that amounts to no new net tax burden, thus fulfilling his campaign promise. But this would require that the budgeteers alter their "revenue scorecard" on capital gains and see a cut from 28% next year to, say, 18%. This would gain, not lose, revenues. The administration, we think, would accept this change if it came from the Congressional Budget Office, but Treasury will have no part of a dynamic analysis.
On November 6, I met with Democratic staff members of the Senate Budget Committee who work for Chairman Lawton Chiles, at their request. They seemed favorably disposed to reopening the capital gains issue, but that it could not be part of the summit package. They said respectable economic research has recently supported the idea that the optimum capital gains rate is between 16 and 18%. But Congressional hearings would be required to buttress that view before the CBO would be willing or able to revisit the issue with an eye to turning a rate cut into a revenue raiser. I suggested that Senator Chiles and the other key Democrats at the budget summit pledge an honest revisiting by the Congress on this issue, with Senate Budget Committee hearings in January, as a "good faith" gesture, to help win GOP support for a budget package that otherwise seems bitter (and to many, unnecessary) medicine. I advised them that many conservative leaders believe the Democratic Congress is purposefully trying to damage the U.S. economy so they can recapture the White House in 1988, and that such a good faith move would help remove these doubts. They agree the Democrats are looking for a growth issue and this may be it. It could be Senator Chiles will take this more seriously than we might otherwise imagine because he is up for reelection in 1988, and Rep. Connie Mack, a supply-sider, has already challenged him and has a 15% capital gains rate as part of his platform.
There are, then, some interesting possibilities afoot. If a reasonable budget deal can be arranged in a climate of good faith, and if this leads to relatively bold moves abroad on taxes and money, and if the central banks can patch together the Louvre accord, at least the process of stabilizing rates, we can see confidence coming back into the global markets.