With all attention focused on Iraq this week, important decisions on domestic policy are still on hold. If by some last-minute miracle, things work out in the Middle East, President Bush would be in a more comfortable position to deal with the unfolding recession and banking crisis. The economic uncertainties generated by impending war, especially regarding inflation, would of course lift if war is avoided. This would take some of the pressures off the economy, but it's clear from discussions I had in two days with administration people and at the Federal Reserve that concern about the economy extends well beyond what happens in the Middle East. The official line of a short, shallow recession is held with some confidence, but nobody believes recovery will be robust later this year without policy changes on taxes and regulation. Asked for my assessment, I agreed that if there were no further policy shocks, the recession would end with weak growth -- but we have to assume state and local governments will be raising taxes and slashing spending as they struggle with mounting deficits, and these cumulative jolts can only deepen the economy's problems.
The failure of the Bank of New England and the bank problems in Rhode Island have increased the administration's commitment to the Treasury's banking reform legislation — which Treasury and White House officials argue will break the negative regulatory climate and revive lending. This may be true to a small degree, but insofar as Treasury is embracing this as a substitute for a renewed drive on capital gains taxation, it can't possibly get the job done. The core of the problem is after all with equity, not debt. The idea has also surfaced in the White House of substituting as a stimulus a non-controversial investment-tax credit for capital gains, but the economists at the President's Council of Economic Advisors are well aware this gets very little bang for the buck. Alan Reynolds of the Hudson Institute points out that the five industrial countries that have now entered recession -- Canada, the United Kingdom, Australia, Sweden and the United States — have the five highest capital-gains taxes in the industrial world.
More for political reasons than anything else, though, the guessing is that the President will almost surely restate his support for capgains in his State of the Union message — to keep GOP conservatives from waxing wrath. MA bone to Jack Kemp," was a comment I heard twice, from supporters of the idea who don't think the President will get serious about it. The pessimism grows from the awareness that Treasury Secretary Nick Brady is arguing against it, on the grounds that under the terms of the budget agreement, it would have to be paid for with higher taxes elsewhere. But CEA Chairman Michael Boskin and the President himself are now talking openly about a recession that has already begun -- which they did not want to do before Christmas. This means the President is in a position to suspend the budget scoring provisions of the Gramm-Rudman law, which the budget agreement amended last October. A memo on this "Emergency Exception Procedure" is now circulating within the administration and among Republican staffers on Capitol Hill. House and Senate Reaganauts are working with the U.S. Chamber of Commerce on a growth package that includes a 15% capgains rate, a cut of 2.2% in the combined Social Security tax rate, capital cost-recovery provisions, and Senator Roth's IRA plan.
In addition, the long silence between White House Chief of Staff John Sununu and House Minority Whip Newt Gingrich has ended, with a peace-making telephone call last week from Sununu that lasted some 40 minutes. After the first of the year, with 1992 just around the corner, the White House seems to have shifted into a re-election mode. On the assumption that Chairman Les Aspin of the House Armed Services Committee is right, and the Iraq war will soon be behind us, the political calculus of 1992 will return to pocketbook issues. My discussions with the President's principle outside political advisors indicate they are profoundly aware of how much political damage the President did last year to himself and the GOP with the budget deal. They know that unless he does restore some of his lost credibility on growth and taxation, the GOP will divide so thoroughly that Bush will be vulnerable both to a primary challenge and the Democratic nominee.
The selection of Agriculture Secretary Clayton Yeutter as the new chairman of the Republican National Committee was a surprising choice, and on first glance a baffling one. Like William Bennett, who refused the job, Yeutter has no known partisan political skills, never having sought elected office. Unlike Bennett, a combative ideologue, Yeutter seems an irrepressibly cheerful, back-slapping negotiator in the kinder and gentler mold. The 60-year-old Cabinet member, though, is the most thoroughly Reaganaut holdover in the Bush Cabinet, a supply-side free-trader with a degree in agricultural economics. Deceptively shrewd and effective, with sharp personal political skills, he would never allow the GOP to be drawn into a zero-sum debate with the Democrats over race issues, as Bennett had. He may not be as passionate in selling the growth agenda as Kemp, but he is as intellectually committed to it as almost anyone in Washington. It's hard to imagine him not pushing aggressively for a growth package that the party could immediately get behind. Sununu gets high marks for spotting his potential.
Sununu also won Reaganaut hearts with his backing of Larry Lindsay as the new Fed governor, to fill the Richmond seat vacated last summer when Manuel Johnson resigned. Lindsay, a 36-year-old Harvard PhD economist who converted to supply side from Keynes, has been the most ardent advocate of capital gains tax reduction in the White House. His views on monetary policy have never been publicly aired, but he is definitely in the price-rule, commodity-standard camp. Lindsay's most important contribution to the Fed will be to reinforce the views of all the Fed governors on the singular connection between the capgains tax, inflation, real estate values and the banking crisis. Fed Chairman Alan Greenspan is ready to publicly support a capgains cut on these specific grounds if the President makes that decision.
The gyrations in the gold price since the Kuwait invasion, especially yesterday's swing when it first seemed a deal was in the works, makes it clear the inflation fears are war-driven. Our confidence in the Fed's monetary policy remains high. The decline in short-term interest rates has been led by economic weakness and loan demand, not direct pressure by the Fed to goose the economy into expansion. Alan Meltzer of Carnegie Mellon was quite right in his Los Angeles Times column, 1-6: "Fed policy remains restrictive. Market participants watch interest rates because the Fed watches interest rates. But interest rates are falling because the economy is weak and loan demand is falling. Despite lower interest rates and a recent reduction in the discount rate, year-to-year money growth remains well below the Fed's announced target for the year." Meltzer, a monetarist, incorrectly argues the Fed should pump up money growth to hit its target. That would send gold flying and the long bond diving. Monetarists like Meltzer seem not to have learned anything from the experience of the 1980s, when unpredictable swings in money velocity made the supply targets useless. But Meltzer at least realizes, as the financial press does not, that the Fed has not been easy.
Fed Governor Wayne Angell agrees the Fed could try to pull the economy out of recession by pumping up money growth, essentially inflating away debt. But he argues that the market perception of future inflation would also be seen as an increase in the real rate of capital gains taxation, further depressing the value of capital assets and adding to the burdens of the credit markets. Once on that slippery slope, a Brazilian scenario beckons. There are no solutions to the economy's weakness through monetary ease, and there is greater chance of recovery if the Fed refrains from "pushing on a string," as the monetarists would prescribe. If the Fed can maintain restraint through the Mideast crisis, there would be a major payoff in the bond market when the crisis passes.
Your guess is as good as ours on how the events in the Mideast will develop next week. That imponderable aside, we find some patches of light appearing on the domestic front -- which is more than we could say as the year began.