Domestic explanations of the global market setback last Friday fail to explain why Japan's stock and bond markets tumbled earlier, or why new "worries over inflation" in the U.S. had so little effect on gold, the dollar or U.S. bonds. Campeau's troubles were old news by Friday, and cannot explain the breadth of the market's decline. Slow growth of nominal retail sales reflected pre-Christmas discounts at retail stores that held down inventories and consumer inflation. Producer prices were dominated by cold weather (fruit and fuel), by a one-time jump in tobacco prices (which have since fallen), and by meaningless list prices on cars (which have since been rebated).
What actually roiled world markets, we think, was mainly international tax competition between the U.S. and Germany, and by trade and exchange rate concerns that could be particularly dangerous to both Japan and the U.S. For some time now, Wall Street has found itself stuck between the pull of world investors toward West Germany, largely due to Germany's lower tax rates, and the push away from Japan, due to threats of renewed U.S.-Japanese trade tensions and a Japanese political backlash. Frankfurt thus emerged virtually unscathed from the Friday drop in U.S. and Asian shares. Wall Street, though, took an even greater hit than Tokyo, thanks to Senator Moynihan's new wrinkle on Social Security which is threatening the capgains proposal that, until last week, seemed to be well back on track. We chalk up Wall Street's relatively bad performance to White House Press Secretary Marlin Fitzwater, quoted in Friday morning's papers as denouncing Senator Moynihan's proposal to cut Social Security taxes.
As we advised last Monday, Moynihan's proposal to cut Social Security taxes, potentially adding up to $55 billion to the 1991 deficit, could blow capgains to smithereens if handled indelicately. Those of you who watched the Brinkley show Sunday know both George Will and Cokie Roberts ridiculed the notion that the President can cut capital gains after rejecting a payroll tax cut for the middle class. Several of our clients called Friday making the same connection, urging us to ring the alarm bells at 1600 Pennsylvania, which we did.
The fundamental issue here is the competitiveness of future U.S. tax policy in the global competition for capital. Unlike the U.S., where tax policy could still become either better or worse, West Germany is the only major country that has clearly moved toward greater supply-side incentives this January. The marginal tax rate on a German couple with an income of about $60,000 will drop to about 35% from last year's rate of 50%. Meanwhile, Japan's new 3% VAT which, together with the 1989 2% tax on securities transactions, has seriously damaged Japan's economy, financial markets and currency.
As an IMF study points out, "tax considerations create a significant incentive for short-term capital flows and. these flows may change the real rate of interest or the path of the real exchange rate." An Economist (Jan. 13) survey of eight big portfolio managers finds them recommending a huge 8.3% of equity investments in West Germany, on average, compared with a neutral rating (based on market capitalization) of only 3.7%. By January 9, the dollar value of the German stock market was already up 46.3% from the end of 1988, compared with 27.5% in the U.S., and only 8.3% in Japan. As the IMF study notes, such a short-term capital inflow could either reduce Germany's real interest rates or increase the real exchange rate. The Bundesbank, though, has been leaning toward the mistake the Volcker Fed made in 1982 -- keeping money very tight in the misguided belief that real growth (rather than nominal spending) is the source of inflation. With 3-month interest rates up to about 8.3% and 3-month inflation down to 1.9%, real interest rates of roughly 6.4% on German cash look unsustainably steep.
The recent fad of buying German equities is usually attributed to some euphoric expectations about instant capitalism in Eastern Europe, rather than to West Germany's supply-side reform. Yet the immediate effect of Eastern immigration has been to raise West Germany's unemployment to 7.8%, the Eastern Europeans could only "buy" Western machinery with bad loans or gifts, and the dream of integrating even the Western portion of Europe faces formidable obstacles. If the strength of German stocks and the D-mark was really dependent on the spread of perestroika, rather than on improved domestic tax policy, Gorbachev's troubles in Lithuania would have provoked a flight from West German securities.
Another danger is that Japan-U.S. trade negotiations have turned hostile lately, under the spectre of U.S. Section 301 retaliation. Such U.S. bullying may be another force pushing Japanese investors out of the U.S. and the Asian NICs and into the more neutral territory of Europe.
Inflation in Japan has recently slowed to about zero in both producer and consumer prices — even though the yen has fallen 13% against the dollar and 26% against the D-mark over the past year. If a country with such a weak currency can experience zero inflation, German and U.S. officials cannot prudently push the mark even higher against the dollar without risking deflation in Germany and/or inflation in the U.S. and Japan.
The market has been spooked, though, Undersecretary David Mulford and Asst. Secretary Charles Dallara, the same pair who goaded Jim Baker III into his fight with the Bundesbank on the eve of the '87 Crash. The "cowboys," as they are called at the Fed, once again think the dollar is too strong. There have even been rumors in the Japanese press that the G-3 countries will soon lower the Louvre floor to 1.5 D-mark to the dollar. The threat of such instant exchange losses would obviously drive investors out of both Japanese and U.S. securities. Yet it is hard to imagine Japan going along with a move that would leave the yen ridiculously weak, or other European countries going along with a move that could easily splinter the EMS.
With Secretary Nick Brady out of action with hip surgery, Mulford almost certainly helped engineer the startling Bundesbank assault on the dollar January 4. We're told that at the morning staff meeting the next day, OMB's Richard Darman asked if the Bundesbank assault on the dollar was coordinated within G-7. If not, he pointed out, the G-7 accords mean nothing and we're back in the wild and wooly everyman-for-himself floating world. If it was coordinated, he thus implied, the cowboys at Treasury had to be part of the play, reminiscent of the one that rattled the markets in October '87. The run-up in the gold price and bond yields, mild though it has been so far, testifies to these global fears of an engineered assault on the dollar. The sharp hike in Japanese bond yields last Friday shows the even greater threat to the weak yen, with possible spillover effects on Wall Street as frightened Japanese investors moved to build-up liquid yen assets.
The new danger to capgains is related, because another market disappointment here will generate new pressures for monetary ease. In case you haven't noticed, the modest easing of short-term rates since the October 13 mini-crash has pushed rates up a bit on the long end. A concerted Fed-Treasury-G7 commitment to support the dollar at this point is urgently needed.
If the Bush Administration could get the capital gains tax down to 15-20%, without capitulating to any soak-the-rich schemes in exchange, U.S. capital markets would be far more competitive relative to West Germany. World investors would then buy dollars in order to buy U.S. stocks and bonds, thus strengthening the dollar. The price of gold would drop even more than the stronger dollar would suggest, because capital gains on stocks and bonds would face a lower tax than capital gains on gold. With the shift from tangible to financial assets, as well as the firmer dollar, the Fed could safely let the fed funds rate decline. The increase in Americans' after-tax return on both domestic and foreign bonds would tend to lower world bond yields. Risks of an inflationary Fed policy or U.S. trade warfare would be diminished by the reinvigorated U.S. economy and increased value of U.S. assets that would quickly follow a lower capital gains tax.
Unless we see more imagination at the White House in handling the Moynihan Plan, though, and more aggressiveness in getting Treasury under control, we can only be bearish for the immediate future. But it would not take much to get things under control, and Darman & Co. are alert to the fires breaking out around them. It reminds us the forces of darkness never sleep, nor can we.