Down to the Wire: Budget Scenario
Jude Wanniski
September 7, 1990


Despite the optimistic statements coming out of the summiteers this morning, probabilities remain very high that the Budget Summit convened at Andrews Air Force Base will fail. The good news is that President Bush is likely to emerge from the failure back in his partisan pro-growth mode. He will be in a position Tuesday night, when he addresses the nation and a joint session of Congress, to lay the burden of failure on the Democrats. The only question remaining open is whether the President stresses budget austerity and sacrifice, or his proposal on capital gains as a means of reigniting economic growth. I spent Wednesday and Thursday in Washington and came away believing the growth forces being marshalled by House Minority Whip Newt Gingrich are moving into a commanding position.

There is still plenty of bad-mouthing of Gingrich at the White House for his insistence on supply-side tax cutting instead of tax hikes and budget squeezing to lift the economy. But White House chief of staff John Sununu has edged into the Gingrich camp, acknowledging the importance of the political role Gingrich is playing on the threshold of the congressional elections. Budget Director Richard Darman is also accepting the strength of Gingrich's position, and Gingrich is now acting as if he has won the skirmish over strategy with Darman and Treasury Secretary Brady. Earlier this week, I thought there would be a truncated agreement that would not include capital gains, but that Bush would shift the GOP into an active campaign for his capital gains proposal. Gingrich, though, insisted that he would agree to no deal, no matter how small and shorn of onerous tax increases, unless it included capital gains. The White House has apparently given him a commitment that they can all walk away from the summit, threatening an October sequester, if the Democrats will not budge on capital gains!

Gingrich believes there is a small chance the Democrats might do so now, especially as they contemplate the damage Bush might do to their election prospects in his Tuesday night speech upon his return from Helsinki. Gingrich Thursday told the Citizens for a Sound Economy that the President will be seen as a leader who can pull the whole world behind him in the Mideast crisis, including the Soviets, and is unable to deal only with Saddam Hussein and the Democratic Congress. Gingrich is pressing the Kasten-Mack plan, of a 15% rate in the top bracket, 7.5% in the lower bracket, a one-year holding period, and complete indexing. The White House proposal has a 19.6% rate, three-year prospective holding period, and indexing. The bare minimum that I think Gingrich could accept would be the White House proposal with a one-year holding period no matter when assets were acquired. The Democrats will only have trouble with the 19.6% rate, and I assume they will not accept it without direct political pressure from the President. The threat of a threat will not be enough to budge them this weekend. Gingrich is absolutely firm on not giving the Democrats an increase in the top marginal rate which I would accept, but only with the Kasten-Mack 15% rate.

Without a deal, the painful sequestration would take place, and the Democrats have to wonder if their leaders, particularly Senate Majority Leader George Mitchell, have made the correct political calculations. The growing perception of economic weakness has the liberal economists pulling away from any willingness to accept tax increases and spending cuts, although there are still those like Charles Schultze willing to argue that tax increases can be offset by Federal Reserve monetary ease. A number of Senate Democrats, like Richard Shelby of Alabama, are feeling growing pressure from their constituents to cut capgains, and he has advised Mitchell that he will not help block a vote on capgains as he did last year. The arguments developed here that the high capgains rate in an inflationary environment is depressing real estate values everywhere, putting growing burdens on S&L and bank portfolios, are also spreading and eating into Democrat resolve. If Senator Kasten can make a deal next week with Senator Moynihan, to combine capgains and a Social Security cut, the dam would break. Gingrich promised Darman he would keep Social Security out of his tax package, but has said he would vote for the combination if it came over from the Senate.

The most encouraging meetings I had this week were at the Fed. I'm now absolutely confident that the Board of Governors will resist pressures to ease. I've spoken at some length to four of the six governors, including Chairman Greenspan, and find general objection to the Keynesian argument that because the oil-price increase "taxes" the economy, the Fed has to print more money to equalize aggregate demand. This was the bonehead idea that sent oil prices spiraling in the 1970s. The sharp rise in the gold price and collapse of the dollar that followed Iraq's invasion of Kuwait reflected the market's expectation that the Fed would act like it did in the '70s. When the Fed remained firm at its August 22 FOMC meeting, gold plunged and the dollar climbed. Press speculation this week that the Fed is about to knock short rates down to 7 3/4% because of the weakening economy is also uninformed.

If the Budget Summit indeed breaks down this weekend, the financial press will conclude that this means the Fed will not be able to ease. I was astonished in my meetings at the Fed to find how thoroughly the governors understand the importance of the capital gains proposal how essential it is to lift the demand for dollar assets, including government securities, in order for the Fed to be able to lower short rates without causing an inflationary spiral. I was greatly impressed with the newest member of the Fed, David Mullins, who came from Treasury under the sponsorship of Nick Brady, but who seems much more in tune with Wayne Angell's analytical framework than I had imagined. Angell and Mullins, it occurred to me, are the only academics on the board now that Manley Johnson is gone. I'm feeling much more comfortable about bonds than I was prior to my Fed meetings.

Greenspan, I sense, does not want to volunteer his strong views on capital gains, because the Democrats have made such an ideological issue of it. He no doubt fears he would be immediately subject to attack for being partisan. The other governors feel the same (although it makes me wonder why we give Fed governors 14-year terms to preserve their independence, if they still are afraid to volunteer what they think, especially when the matter bears so directly on the value of capital assets and the solvency of the banking system). Greenspan, though, will be testifying before House and Senate banking committees next week, and he is sure to be asked about his views, whatever happens over the weekend at Andrews. As his views come across the tape, I would certainly expect a serious rally in the financial markets. If the Fed governors would begin saying publicly what they are saying privately, Senator Mitchell's game would go up in smoke. It's going to happen.

What happens in Helsinki is of some importance to the proceedings, and to the course of action in the Middle East. Bush is of course asking Gorbachev to pull the Soviet contract advisors out of Iraq. The rumor I heard was that Bush will advise Gorby that if it becomes necessary to strike Saddam's nuclear and chemical installations, he would prefer not to kill the Soviet technicians in the process. In the psychological wars being played on both sides, the administration wants Saddam to see a Soviet departure as being a part of this contingency.

One week it seems like negotiation, the next like war. On the next cycle of diplomacy, my preference remains for a shift in negotiating authority to Egypt's Mubarak. Watching the British Parliament on C-Span last night, I was pleased to see several MP's from different parties make this same point. Saddam is now being seen throughout the Arab world including Iraq as negotiating with Bush, which means Tel Aviv. It's much more likely that war would be avoided via diplomacy if Saddam were seen negotiating within the region, with Mubarak in the lead. My guess is that Secretary of State Jim Baker is inclined in this direction. The Washington hawks, who in fact favor Israel's position of dropping diplomacy altogether and blasting away, are keeping Bush in the center of the process so far. I'm guessing the ball will soon be tossed to Mubarak and the Arab League, however. Perhaps, in contravention of Murphy's Law, everything will work out right this time.