The New York Times reported from Tokyo this week that Japan's new vice minister of finance for international affairs, Makoto Utsumi, argues that the U.S. economy must be slowed in order for the U.S. trade deficit to be reduced. Fat chance. As I warned President Bush and his team at Camp David in April, the cut in the capgains tax he's seeking, now with apparent success, will increase the trade deficit precisely because of its dynamic effects on the U.S. economy. The only correct way to offset this effect on trade and capital flows and avoid protectionism (and its attendant contractionary effects), as Robert Mundell observed in 1974, is to replicate these growth-oriented tax policies elsewhere. This, by the way, is why we've been so ardent in our efforts to encourage such reforms in Mexico, which could then spread through Central and South America. In a way there is now a global race between the forces of growth and protectionism.
Although we'll probably be eating turkey before President Bush signs a capgains bill into law, the real economy is already turning up as the recession psychology has been punctured. The conventional wisdom is that Fed policy has been the primary driving force in the bull market. But we think it has been an important secondary force, arresting the commodity deflation above $350 gold via a shift toward monetary ease in July. Capgains, though, is an elephant next to this horse. The supply-side Fed governors know well enough that optimum fiscal policy makes monetary policymaking easy, and vice versa. If Bush were to cave in to the tax increasers, for example, the capital flight would require the Fed to tighten mightily as an offset. This is the mistake the Canadians have been making this year.
The combination of correct monetary and tax policy is now dominating the markets. And if we are not going to have a recession in 1990-92, the inventory hedges that have been widespread among industrialists and consumers are now risky! Commodity buyers that assumed recession and attendant price breaks, letting their own inventories run down, are now faced with a horizon of firming prices as the expansion that is being seen in advance by the financial markets takes hold. Consumers holding back on auto and housing purchases, both hedging against a recession and expecting further price declines before buying, are now rethinking their options.
The northern New Jersey real estate market, for example, which has been pitifully weak this last year, is suddenly showing signs of life just in the last two weeks, I'm told by a major insider. The real estate bear market in the Hamptons broke three weeks ago. A friend who works at the heart of one of the nation's biggest retail chains called last night and advised me of a dramatic change in shipping that has developed over the last thirty days. The wealth effects of the bull market alone are triggering behavioral changes among consumers. Retail sales figures illustrate this -- a 0.9% increase in July, leaving behind the 0.1% decline recorded in June. We're getting other reports of inventory turns in cyclicals occuring just since the first of the month. The airline stocks are flying because a recession-free period ahead dramatically increases the value of this capital stock. With a virtual freeze on new airports, gates, and related infrastructure, and the aircraft manufacturers incapable of meeting demand for new planes (without cutting corners on quality and safety), the rise in United's stock value is only a straw in the wind.
Richard Darman's capgains deal has yet to be detailed, but there's little question one is in hand. A White House staffer just advised me that "We've won on the heart of the issue, but still don't have the soul." Bonds as well as foreign securities are thus far excluded from the Rostenkowski proposal, and clouds hang over each as a result. The hammering bonds took last Friday and in this week's Treasury auction followed the press reports on the bond exclusion. We're assuming Darman and Senate Finance Chairman Lloyd Bentsen will reverse this detail. A major job of our government is to get creditors to buy its bonds at the best price. To exclude bonds from the capgains bill makes no sense. Nor does it make sense, with the hand wringing over the U.S. becoming a "debtor nation," for the U.S. to punish our creditor class from extending credit to the rest of the world. I've written the governments of Canada, Mexico and Israel alerting each to the penalties involved in these xenophobic proposals, which no doubt come from House Majority Leader Richard Gephardt and the liberal Democratic caucus. How is Mexico especially supposed to pay off U.S. creditor banks if we are going to penalize U.S. investors there by withholding favorable capgains treatment?
A larger problem is over the holding period, in the sense that Darman himself, and Treasury Secretary Nick Brady, have persuaded themselves that long holding periods are good. I'm trying to persuade Darman of the following: Inflation-adjusted capgains are realized on assets by people who made high-risk investments, and the investments have risen in value to where they are now low risk, and more attractive to low-risk investors. The high-roller would like to cash out the gains by selling to an investor who prefers proven enterprises, then find another high-risk venture. If capgains are locked in for years, the action in the capital markets is slowed accordingly. Capital constipation, I call it. Nothing beneficial flows from long holding periods. Japan's 5% capgains tax is available in six months, for example.
The longer holding period is terrible for the business of Wall Street as well, because of this slowing of the action. Treating capgains as ordinary income drives away the individual investor, the little guy in the broad middle class, forcing him to invest through pension funds and institutional investors with portfolios big enough to dilute the lock-in effect. The long holding period is another deterrent to individual liquidity, with adverse effects on revenue flows at all levels of government as well as brokerage firms. Every month that Darman can knock off the proposed holding periods will have magnified effects on the economy throughout the 1990s.
In the stock market, the cyclicals and airlines should enjoy the biggest short- and medium-term gains, as these sectors run into supply constraints. Conceptually, the biggest long-term beneficiaries of the capgains are those enterprises with the highest intellectual content relative to physical content. Bear in mind that physical capital is limited and intellectual capital is unlimited. Value-added occurs when intellectual capital shapes physical capital. Brainpower takes a teaspoon of sand and turns it into a computer chip.
With a decent capgains tax, the U.S. will easily take the lead in its ability to add this kind of value relative to the rest of the world. Entertainment enterprises that are almost pure uses of human talent, producing movies and video plays, are in this high category. Entertainment enterprises that rent videotapes are not in this category because they can be duplicated with little effort, unlike Harrison Ford or Jack Nicholson. In the high category are enterprises that use brainpower to produce computer designs, leaving it to others to turn the designs into computer chips. Pharmaceuticals are obviously in the highest categories of value added. Enterprises that produce commodities like steel, copper, aluminum, paper, chemicals, etc., can be in the higher categories only if they advance the technological processes of production or in some other way massively increase the application of intellectual ingenuity. Those who argue the U.S. loses competitiveness when a plant or mill moves abroad can't see that it's precisely because U.S. competitiveness has advanced at the higher end of the value-added scale.
This is simply a conceptual rule-of-thumb, but it may be useful to managers of portfolios or enterprises. Political resistance to the process comes from the lower value-added enterprises or those with uncreative managerial talent, who wish to slow the process down. The dominant, liberal wing of the Democratic Party represents these forces, which are not by any means illegitimate interests. In a democracy, all interests that bear on the electoral process are inherently legitimate and must be weighed in the process of lawmaking and policymaking. The ferment of the next several months, though, will almost certainly yield a tax bill of major, positive proportions. Since each of you who read this missive are part of the political process, any effort you expend in the weeks ahead in the fight for its soul will have a positive impact.