Ups and Downs
Jude Wanniski and David Goldman
March 10, 1993


PROMISE IN TOKYO: The Nikkei index has been on a tear this past week, led by Nippon Tel & Tel which has climbed to $7,000 per share from $5,000 in the last month, most of that in the past seven trading days. The Nikkei is still bobbing around 18,000, half its peak of three years ago. If it is going to recover that lost ground, the most important element is already in place: Lloyd Bentsen, not Nick Brady, as U.S. Treasury Secretary. Brady practically drove the Nikkei down all by himself. By threatening trade protection with their Super 301 weapon, Brady's team browbeat the Japanese finance ministry into deflating the "bubble" of asset prices by raising the effective capital gains tax on real estate. It also hammered the Bank of Japan into deflating the yen, on the idiotic mercantilist theory that this would squeeze its trade surplus with the U.S. Naturally, the deficit grew as Japan slid toward recession. Except for his slip-of-the-tongue February 19 at the National Press Club, for which he apologized privately, Bentsen has so far been the antithesis of Brady. He thoroughly impressed and delighted the Japanese at the G-7 meeting February 27-28, I'm told by the Japanese, who agree that it is nice to be out from under the Brady cloud. There are tax cuts in the wind. We're watching to see if the capgains tax break on real estate will be part of the mix. As Nippon Tel & Tel owns more real estate than any other corporation in Japan, it would benefit most as the restored values are recapitalized into its share prices. (JW)
THE GREENSPAN STOCK MARKET: Not only bonds, but also equities, owe their present strength to the Greenspan Fed. Falling inflation expectations account for virtually all the change in stock prices during the present business cycle, i.e., from the beginning of the recession in August 1990 to the present. Since we first noted two years ago that stock prices moved inversely with inflation expectations (as measured by the gold price), the observed relationship has strengthened,
holding up through the ups and downs of market reactions to the Clinton economic proposals. Our results provide strong evidence that the expected capital gains tax rate is by far the most important determinant of equity prices, and hence of economic growth (higher inflation implies a higher effective tax rate on nominal gains). Our stock-price model, updated through March 5, shows that 92% of movements in the Wilshire 5000 Index is explained by inflation expectations (the gold price) and the market's degree of uncertainty about future changes in the inflation rate (gold price volatility over 300 trading days).1 Stocks are not responding to the bond rally; on the contrary, both stock and bond prices are determined by risk-adjusted inflation expectations. Neither Bush nor Clinton can take credit for the 3.0%-3.5/o real GDP growth rate for 1993 discounted into stock prices. Thank the Fed for whatever breathing room the economy has. (DG)

OMINOUS ADDITION TO THE CEA: Much as Alan Blinder's appointment to the Council of Economic Advisors reassured us, news that Stanford's Joseph E. Stiglitz will occupy the Council's third slot represents potential for real mischief. Stiglitz belongs to an economic subculture that studies "market failure" and rationalizes government intervention, without noting the misguided government policies at the root of the market failure. Of all the economists who lean toward fascist-style cartelization of the capital markets (the dark side of the supply model), Stiglitz has provided the most sophisticated rationale. Noting that equity markets provide insignificant amounts of new capital to entrepreneurs (because equity is taxed out of existence), Stiglitz argues that private capital markets are unable to bear risks. The only agency able to take risks, he concludes, is the state. Governments, therefore, must shoulder an increasing share of risk in order to compensate for the failings of the capital markets. For the moment, Stiglitz's influence at the CEA will be limited to regulatory issues, with macroeconomics (including fiscal policy) under Blinder's jurisdiction. With any luck, Stiglitz will disappear into the labyrinth at the Executive Office Building. His presence in Washington, though, puts a face on the worst-case scenario for the Clinton administration. (DG)

NAFTA PROBLEMS: Special Trade Representative Mickey Kantor's call yesterday for special judicial commissions to review labor and environmental law in Mexico suggests that the Clinton administration wants to export its social engineering agenda. Legal experts in Mexico City emphasize that Mexico might be able to live with Kantor's proposals as narrowly defined, but that they would open up a Pandora's Box. Top Mexican officials are now considering their fallback options in the event that the North American Free Trade Agreement (NAFTA) is not signed into law as scheduled by next January. Fixing the peso against the U.S. dollar to reduce currency risk is one possibility, especially if the U.S. side would cooperate by establishing swap lines for foreign exchange market intervention to add credibility to the measure. Growth-oriented tax reform, on hold for the past three years, is another. NAFTA's problems might prove a blessing in disguise for Mexico, prompting greater attention to Mexico's stagnating domestic economy. Traditionally, though, major policy initiatives rarely emerge in the lead-up to Mexican presidential elections, which take place in July 1994, as contending candidates attempt to block any initiative which might give prominence to a competitor. (DG)

"NEW JERSEY SCHOOL": You should by now have received in the mail the essay by David Goldman, "A New Branch of Supply-Side Economics: The New Jersey School." It's the most important paper we have published in the last two years, essentially pulling together all we have learned in our day-to-day struggles with the financial markets as they link to economic behavior. All serious work in economics today is in supply (production) models as opposed to demand (consumption) models and there are now many variations, including those driven by state "risk taking" and investment. David's paper represents a summary of the state of our art and we think it represents the theoretical frontier. It's worth a careful reading or two and we urge you to share it with your colleagues. You also have our permission to copy and circulate it outside your organization. We appreciate any comments, especially critical, before it moves on toward a book being co-authored by David and Reuven Brenner of McGill University of Montreal, whose insights on theory have been the glue to our hands-on experience. (JW)

CAPGAINS POLL: A Gallup Poll of Congress indicates 72% of the members favor a cut in the capital gains tax, including 55% of the Democrats and 94% of the Republicans. We have not seen a breakdown of Senate and House. (JW)

1. For the period Aug. 2, 1990 to March 5, 1993, we obtain the following results:
Dependent variable:                       Wilshire 5000 Index
Predictor                                         t-statistic
Constant                                          33.43
300 Day gold volatility (squared)      -7.84
London p.m. daily gold fixing          -4.38
MAC1)                                                2.83
ARC1)                                             123.59
r2                                                       0.9958
Standard Error                                 27.0
Durbin-Watson statistic