We can't get enthusiastic about prospects for a capgains cut this year as long as the Bush administration keeps the issue inside the Beltway. OMB's Dick Darman, the ultimate insider, undoubtedly has in mind a fiendishly clever strategy that he believes will produce a capgains cut at the end of the maze. He may even see a way to wring a small cutback in the Social Security tax as part of the package he will be negotiating on Capitol Hill. But there are simply too many opportunities for the best laid plans of mice and men to snafu, even at the last minute, which is what happened to Darman's intricate inside maneuvering last October.
The White House semi-embrace of Dan Rostenkowski's proposal to cut spending, raise taxes, and freeze Social Security outlays for a year, is too clever by half. The package itself could have been designed by any of the economists in the Nixon, Ford or Carter administrations, which explains why the Business Roundtable immediately swooned over it. In congressional testimony yesterday, Darman allowed as to how the Rosty Plan would be "marginally negative" to economic growth. It would have been better if he had simply said it would produce a recession before the year was out. But Darman has no stomach for that kind of direct assault on the dopey ideas of members of Congress he is negotiating with. The best shape of his current thinking is in the comments imagined by Paul Gigot in his column on today's Wall Street Journal editorial page:
Now, let's think. I'm a multiple contingency planner. On the one hand, we've got all the budget leverage with the Gramm-Rudman sequester. We can still use that if we have to in October.
On the other hand, the Beltway still yearns for the "grand compromise" — tax increases in return for Social Security cuts. That's passe. I want more — a permanent Gramm-Rudman, the capital-gains cut, reforms in Medicare, a multi-year deal. Got to worry about that extra $20 billion we'll need for failed S&Ls too. If it works, I'm a genius!
The right will grumble, but it will swallow excise or gas taxes as long as there's budget reform and capital gains. Better work Bob Novak and Newt Gingrich. Tell 'em you can't rule anything out in advance of budget talks. As for the Democrats, they were going to write phony budget resolutions, drop the taxes on Rosty's lap, and blame us for the sequester. Rosty's gambit will prod the budget committee and neutralize Moynihan. We could also use a deal with Rosty to help roll Mitchell in the Senate...
Because Darman must manipulate so many politicians to pull this kind of deal off is why the White House continues to take potshots at the Fed for being too tight. He cannot take an aggressive stance against the congressional Democrats as long as he's playing an inside game. Last summer, you may recall, Darman openly warned that if a recession occurs, it would be the Fed's fault for keeping monetary policy too tight. If he instead had warned that a cut in the capgains tax would avoid any chance of recession, I have little doubt that he would have won. The Senate Democrats could not have stood the heat of a Bush public campaign on this issue, especially when many in their own ranks are being pressed at home to support the lower capgains tax. Even now, the Democrats cannot be blamed for the economic weakening that has in fact occurred, because Darman insists on blaming the Fed for any economic ills — because he doesn't care what the Fed thinks of him.
It remains my belief that this strategy has kept interest rates higher than they would otherwise be, in that global investors demand a premium on dollar assets for this political confusion. The Fed has been performing extremely well in handling the mechanics of monetary policy, except for the misstep in December when it decided to ease a bit more than it should have. The mechanics of policy, though, can be swamped by market psychology. The markets have to wonder what the Fed will do next, as well as what it is doing now, and President Bush has not been helpful on this score. As the economy creeps out of its winter trough, I expect the bond markets will be pleased to find that the Fed will be more willing to ease at that point than is now being assumed. It will be a bit harder to ease precisely because the White House has been urging that course.
A clearer sign that the White House might take the capgains issue outside the Beltway, promoting it as an emblem of economic growth, would do wonders not only for the stock market, but also for the bond market. Money demand would increase more rapidly than otherwise, and the Fed would have to accommodate to prevent the dollar from soaring and gold from plunging below $350. My express recommendation to the administration is to use the President's unusually high popularity with black Americans to promote the capgains cut in that community. HUD Secretary Jack Kemp is able to get ovations from black audiences when he does just that. But I haven't yet talked to anyone in Washington who thinks the Bush White House will go that route itself. House Minority Whip Newt Gingrich loves the idea, but one gathers he does not wish to do anything that might complicate Darman's intricate inside game.
As for the capgains legislation itself, the plan the Treasury department has developed as the official one is certainly as weak as could be. Instead of the flat 15% George Bush campaigned for in 1988, we now get a bill in the 20% range, with phased-in holding periods that dilute its impact even further. It is my fervent hope that if Darman wheels and deals away excise tax increases and user fees, he will insist on streamlining this capgains proposal. As is, the proposal does little to release "locked-in" gains that would make life much easier for the Northeast states and California, where most of the nation's wealth is concentrated. Few people realize that the capital gains tax is a transaction tax, which can be avoided by not transacting. The severe budget problems of the wealthy states are the result of massive non-transacting. A flat 15% with no phase-in period would flood these states with revenues and allow the governors and legislatures to avoid tax increases. We continue to make this point at the White House, but have yet to hear a peep from anyone to help capgains along.
The trade talks with Japan remain extremely worrisome. I continue to believe the demands of the Bush administration are disgraceful, insisting the Japanese government turn the patterns and culture of the country inside out to satisfy the protectionist wolves in Congress. History will view this episode as a blot on the Bush presidency, direct evidence of his linkages to the Hoover wing of the GOP. It can still push the Japanese economy into its first real recession since 1950, with dire effects on the world economy and an increase in the Japanese trade surplus with the U.S. But we can at least see a glimmer of light as the Japanese negotiators are making sounds of flexibility. The Tokyo stock market slide, we note, recovered this week a bit as this new flexibility was publicized. Still, we continue to doubt that they can give much on substance without incurring the wrath of their people, which would bring on yet another crisis for the ruling party. But if they can give on style, permitting the Bush administration to seem as if it got something for its tough approach, we could get a break. If this kind of situation ripens, I'd hope to see Secretary of State Baker step in to clean things up. There's nobody else available in the administration with the clout and skills to play this end game.
One of the reasons James Baker III has been so successful, I like to think, is that as a natural outsider, he knows he needs an insider to make things click. In the Reagan years, that man was Darman. In the Bush administration, the man is Robert Zoellick, a Darman protege. The reason Darman's success in the Bush years so far has been limited is that he needs an outsider to complement him, but he's trying to do it all by himself. Last year we thought he might be able to. This year, we're more skeptical.