Bond Market, Push and Pull Jude Wanniski May 13, 1991

When the DJIA climbed 40 points last Thursday, The New York Times observed that it was the Treasury's successful auction of 30-year bonds. Soon after 2 p.m., when the third leg of the Treasury refunding was reported, $11.75 billion of new 30-year bonds going at an average 8.21%, the DJIA ran up 25 points ("Treasuries' Strong Sales Lifts Stocks," by Robert J. Cole). On Friday, the DJIA sank 51 points, whereupon the Times attributed the decline to the unsuccessful auction of 30-year bonds the previous day ("Stocks Wilt in Fallout From Treasury Sale" by Robert J. Cole). Mr. Cole did find an economist at Aubrey G. Langston & Company, Robert T. Falconer, willing to say it took the dealers 24 hours to realize what bad paper they'd bought.
Our own surmise on why the bond market took such a hit Friday was that Treasury Secretary Nick Brady must have given a speech somewhere. Alas, Brady was silent Friday. All we could find was his Undersecretary, Robert Glauber, telling the Senate Banking Committee that all the problems of the world would go away if only Alan Greenspan would wave his magic wand and lower interest rates. Mr. Glauber, the brains behind Secretary Brady on domestic finance, in real life is a professor of finance at Harvard. In this morning's Evans & Novak column in The Washington Post, we get confirmation of our suspicion that Brady was behind the Fed's surprise discount-rate cut of April 29: "According to Fed sources, he called at least two Federal Reserve governors in an extraordinary exhibition of jawboning."

We suggested May 1 ("The Fed Surprise") that Brady turned to the Fed for monetary ease after failing to persuade the Bundesbank's Karl Otto Poehl to bring down interest rates in Germany. Had Greenspan resisted, his chances for reappointment by President Bush would have been seriously reduced. As it is, we can be sure Nick Brady and Budget Director Dick Darman would love to pin this recession on Greenspan, thereby absolving them of culpability in both failing to get President Bush his capital gains tax cut and persuading him to break his no-new-taxes campaign pledge. If President Bush threw Greenspan to the wolves, we can be sure there would be no protests from Senate Democrats, who are also eager to blame Greenspan's supposedly tight monetary policy for the recession. He is a convenient scapegoat for these partners in crime.

Senate Banking Committee Chairman Don Riegle is now not sure he will vote for the confirmation of Larry Lindsay to the Fed, even though Lindsay swore up and down before Riegle last week that Greenspan was too tight and he would be easy. Do you imagine Senator Riegle, or Senate Majority Leader George Mitchell for that matter, would shed any tears if President Bush dumped Greenspan? More likely, the Democratic leadership would pop the champagne and celebrate, for this would cast in concrete the Greenspan Recession.

We warned Darman in August of 1989, when he first publicly criticized the Fed for being too tight, that he was giving away the capital gains issue; the Democrats would love to blame the Fed for economic weakness, deflecting blame from their intransigence on capgains. For his part, Greenspan has wisely developed a record of support for the idea that the high capital gains tax is a primary cause of the credit crunch, and by implication, the recession. He should realize, though, that if he pushes the Fed into another round of cuts to pacify Brady and Darman, it will do nothing to pacify Brady, Darman or the Senate Democrats. Their primary motivation is not an end to the recession, but a scapegoat for the recession they brewed. Easing would only alarm the bond markets.

Secretary Brady seems baffled that interest rates remain so high when inflation seems so under control. He's hopelessly ignorant of the fact that he and his team have done nothing for almost three years but threaten America's creditors with capital losses on their bond holdings. A cut in the capital gains tax would persuade the bond markets that the Forces of Darkness, which Brady unwittingly represents, won't succeed in their drive to inflate. Greenspan's reappointment would only help. The Captains of Industry are now beating the drums for easier money, as witness the Business Council's weekend meeting in Hot Springs, Va. "Top Executives Urge Fed to Trim Rates," reads the headline on p. A2 of this morning's Wall Street Journal. The big guys can't see the end of the recession they have been promised and want the Fed to drown their sorrows with liquidity. How can we be so sure they will not eventually succeed?

We're not sure, of course. We're simply more confident that history will not easily yield itself to repetition. There are more people around who know what they're doing than there were in 1969-70, the last time the U.S. was caught in a fiscal recession. As David Goldman pointed out, the recessions of 1974, '80 and '82 were all caused by the Fed deflating, too hard after inflating. In each case, a moderate easing brought the economy back to life. This recession most resembles the '69-70 recession, caused by the Keynesian advice President Nixon received from his chief economic advisors, Paul McCracken and Herbert Stein.

Even before he was inaugurated, Nixon was persuaded by McCracken and Stein to break his campaign promise to repeal the 10% income tax surcharge, on the grounds that it was still needed to balance the budget. In addition, Nixon was talked into doubling the capital gains tax to 48% by Peter Flanigan, coincidentally a good friend of Nick Brady's and now a partner at Dillon Read. Flanigan's recommendation followed a survey of the Captains of Industry, whose interest was in shutting off the flow of capital to potential competitors. Another friend of Flanigan and Brady was a young Republican on the House Ways & Means Committee, George Bush, who helped push through this austerity program.

When the economy nosedived into recession, President Nixon asked Messrs McCracken and Stein what went wrong. When the surtax was removed and the economy remained weak, they could only answer: "Monetary policy. The Fed is too tight." Nixon, in 1970, had named his old pal Arthur Burns to chair the Fed. In early 1971, the Nixon team persuaded Burns to flood the banking system with reserves. But because we were still on a gold standard, the Bretton Woods system, the reserves poured into Europe where they could be exchanged for special Treasury bonds in accordance with the rules of Bretton Woods. This offset Burns' attempts at inflation dollar-for-dollar. The frustrated Nixon economics team met at Camp David, August 14-15, and decided to blow up Bretton Woods. The dollar was devalued to boot, triggering the inflation and cheating America's creditors, one of the most important of which was the Bundesbank. Won't someone tell Nick Brady why the Bundesbank refuses to play his inflation game?

The correct solution to the problems of the economy in 1971 was a cut in the capital gains tax. How could McCracken and Stein tell the President they made a boo-boo? Only the incredible efforts of entrepreneurial America got the rate cut in 1978, with President Carter kicking and screaming all the way. The correct solution to the recession today is also a cut in the capital gains tax. But how can Brady and Darman tell the President they made a boo-boo? So they tell him the problem is: "Monetary policy. The Fed is too tight."

The price of gold remains steady, close to $350, as the Fed shows continued resolve in keeping a tight rein on the overnight fed funds rate. Bond yields remain high, though. Why not? Creditors remain fearful that the Forces of Darkness may win at some point in the near future and they will be cheated, suffering quick capital losses. If the capital gains tax is cut, the pressure is off, equilibrium returning with a dramatic rally in the bond market.

A straw in the wind: Sen. Bill Bradley, Democrat of New Jersey, one of the leading crusaders against a capital gains differential, this past week told a Wharton School business symposium that "I would consider putting it back in," but only if he sees "sufficient analysis" that it would be in the nation's long-term interest. This from a fellow who in 1989 said of it: "I view the President's proposal as a knife aimed at the heart of tax reform." All it takes is a few more people willing to admit they made a boo-boo, and history does not have to repeat itself.