We have withheld judgment these last few weeks while contemplating the surprising weakness in financial assets. None of the conventional explanations were satisfying, and as hard as we tried to make the collapse in Tokyo relate to the sluggishness in stocks and bonds in New York, it did not fit, at least in our analytical framework. The only thing that works is capital gains, and the fact that over the last two weeks the prospects have steadily declined for a Bush victory this year on capgains. As the month began, there was still confident talk coming out of the White House about capgains being in the bag. Now, the shrewdest tax lobbyists we know are telling us the odds against capgains have climbed to 10-to-1. The Democratic leadership has hardened in its opposition, insisting that the only way it will give the President what he has asked for on capgains — a rather feeble package at that ~ is if he gives in on the income-tax "bubble," which is to say, push the top marginal rate to 33% from 28%. Because the White House will not give on that point, it seems more and more like a repeat of the gridlock we saw last year.
The notion that the bond market is spooked by fears of inflation even as gold and oil prices weaken is unacceptable. The only way we can explain the current sell-off in bonds is on this score. Remember, we've been among the very few analysts who relate bond prices to the prospects for a capgains differential. Alan Reynolds has made the undeniable point again and again that the only reason to hold a bond yielding 8 1/2% when money market yields are at the same rate is if the price of the bond can appreciate, adding a capital gain. As prospects for a capgains differential rise and fall, bond prices must follow.
Without capgains, the economy is not going to do much more than meander along at the current low growth levels. Demands for new liquidity will grow at a glacial pace, which means the Fed will have to wait considerably longer before it can ease without putting gold and commodity prices onto an inflationary incline that will only sink bonds further.
The Administration remains hobbled by its decision to keep the capgains issue isolated from its management of the economy. It simply is not willing to tell the American people forthrightly that capgains is an essential ingredient for the health of the economy and for U.S. competitiveness in the world economy. The President and his basic economic team have been citing the proposal again and again in their speeches and interviews, but in a disconnected, sterile fashion. At no time have the Democrats been threatened, even obliquely, with the blame for any economic weakness if they block capgains once again. Instead, the White House has set up the Fed to take the fall for sluggish growth. Richard Darman, the capgains strategist, designed this strategy to permit him to deal more easily with the Democrats — who are thrilled to pieces that the White House and Treasury have been zapping the Fed instead of fingering them as the real barriers to robust economic expansion.
If capgains does not succeed this year, a great many problems will compound. Economic growth and federal revenues will sag, increasing pressure for deeper spending cuts and new excise taxes. State and local revenues will continue to suffer along with real estate prices, especially in the northeast, forcing tax increases at these levels. We can expect no help out of Treasury, which by all accounts is a net negative force on capgains. Unless President Bush himself gets engaged, we expect continued drift.