Fiscal/Monetary State of Play
Jude Wanniski
December 20, 1994


The big news yesterday morning was that the relevant Republican committee chairmen of the House and Senate have decided they will cut spending before they cut taxes. In the afternoon, the President countered with a list of spending cuts to pay for his tax cuts. The GOP message was delivered on "Meet the Press" Sunday, by Rep. Bill Archer of Texas, who will chair House Ways&Means, Rep. John Kasich of Ohio, the chair of House Budget, Sen. Bob Packwood of Oregon, chairing Senate Finance, and Sen. Pete Domenici of New Mexico, Senate Budget. Rep. Dick Armey of Texas, who will be House Majority Leader, took the same stance on "This Week with David Brinkley." The message equates with budget-balancing first, economic growth later. On its face, it is hardly encouraging, representing a tactical retreat from the emphasis associated with President Reagan toward that associated with President Bush -- the traditional GOP austerity approach.

The actual remarks of the Republican leaders were more encouraging than the press reports of what they said. What I heard from them was a clear, uniform agreement not only to cut the capital gains tax, but also to defend it as the one tax that probably will not have to pay for itself by spending cuts, once it has been reasonably scored. This was the term used by Bill Archer, who indicated that all of the tax cuts proposed will be scored on a dynamic basis, but capgains is the only one he singled out as a sure gainer. Which is to say that dynamic scoring does not mean that all tax cuts will gain revenue over the five-year scoring period. The Republican child credit of $500 will clearly be a money loser in any scoring system, as will the President's various tax handouts to the middle class. The GOP and White House middle-class cuts may even lose more money under a computer model that correctly adjusts for behavioral changes. That is, when the government gives away something for free, there is always more demand for it in reality than when the program is designed. This is why the Great Society programs and Medicaid dramatically outspent all initial forecasts. Inasmuch as a tax cut does little or nothing to lower the risk to capital formation, it will increase the deficit. This is why Sen. Phil Gramm's proposal to increase the individual exemption to $5,000 seems costlier on its face than a $500 child credit. Because his measure reduces the progressivity of the tax system on labor income, though, it also reduces the risk to capital formation. The $500 child credit subsidizes childbearing, as well as reduces the tax burden on families with children. These both may be worthy goals for the family-values people in the GOP, but they are very expensive ways to achieve those desirable ends.

On "Meet the Press," moderator Tim Russert also raised the question relevant to today's meeting of the Fed's Open Market Committee. He wondered why the GOP wants to cut tax rates now when the Fed is trying to slow down an economy that it believes is growing too fast. Kasich skirted the question by saying capital gains cuts won't have an economic effect for a year or so and thus will not pose a problem. Domenici knew Kasich didn't get it right, so he jumped in with a different answer, which is that because the tax cuts will be paid for, the effect on the economy is neutral, "a wash." Domenici, who has lived in a cash-flow Keynesian model since he came to the Senate in 1973, also missed the right answer -- which is that when a tax cut more than pays for itself in a correct scoring system, it not only causes the economy to grow faster, but also causes interest rates to fall. 

In a note to those four Republican leaders that I sent on Monday, I observed "there are TWO distinct reasons for rising prices, one of which Greenspan worries about and the other which doesn't bother him. The worrisome one is that which occurs because of inflation -- the permanent loss of the dollar's purchasing power (especially relative to gold). The one that doesn't bother him is the rise in prices that MUST occur in the business cycle, as rising prices of goods and services in short supply are the market's way of attracting new capital. This is why Greenspan would unequivocally support a capital gains cut right now, because it would mean that prices would not have to rise as far to attract new capital!!! A capgains cut would cause the economy to grow faster and prices to rise slower!!! Here, [the] answer that a capgains cut wouldn't have any effect for one year is almost, but not quite right. It instantly improves economic expectations, releasing new energies, surplus talent and time into the marketplace. It would be several months or a year before we began seeing it showing up in the statistics."

This drift of discussion toward budget balancing has been taking place against the backdrop of the Fed's deliberations over interest rates. The financial press is promoting the notion that the bond market is afraid of all this talk of tax cuts, either because the cuts will deepen the federal deficit, causing interest rates to rise, or lead to greater economic activity, forcing the Fed to raise interest rates to halt inflationary growth! The amount of money involved in either the GOP or White House plans is much too small to worry the bond market, which is lugging around almost $5 trillion in federal debt. GOP leaders would do well to pay attention to Senator Bob Bennett of Utah, who appreciates where the real money is. Bennett points out that for each 1% increase in interest rates, the bond market has to contemplate another $46 billion annually in debt service costs, which by simple arithmetic compounds to more than $300 billion over a five-year scoring period. 

With interest rates now 2% above their level of one year ago, this means the bond market is contemplating $600 billion more in debt service costs over the five-year scoring period as the national debt rolls over. In the "Meet the Press" discussion Sunday, Tim Russert demanded to know how the Republicans could possibly balance the budget in seven years, as that would require savings of $1 trillion, an impossible number. We have been pointing out that a drop of 4% in the long bond by itself saves $1 trillion in debt service costs over seven years, on a static analysis. If we take into account the economic growth that would occur with low interest rates, we could easily see a $1 trillion surplus. We expect some of this discussion will take place soon after the 104th Congress comes to town on January 4.

HOORAY FOR JIMMY CARTER: What's going on in Bosnia? Simply put, the Serbs are ready to cut a deal, having won the civil war, but need an independent actor who has not been contaminated by our feverish alliance with the Muslims, who have lost. By going to Bosnia and saying nice things about the demon Serbs, our former President accomplishes something neither White House nor GOP congressional leadership could. The Serbs now have an investment in Carter, their agent in the negotiations, which gives Carter enormous leverage: "Look, fellows, unless you want to see me disgraced after having gone to the trouble of sticking up for you, you better stick to any agreements I cut with Washington and NATO." The Clinton Administration can play it cool until Carter nails down a cease-fire. Carter's diplomatic skill comes from his ability to relate to heads of state, understanding that none of them are really demons, but in each instance subjected to political forces unleashed upon their regions and constituents with the end of the Cold War. Instead of complaining about Carter's intervention, GOP leaders should now be talking about a Swiss-style federation to knit the region together, with a common currency and federal tax system in the cantons of Serbia, Bosnia, Croatia and Slovenia. What next for Jimmy? He may have to do a second round in North Korea and Haiti, to offset the ineptness of Warren Christopher. After that, Saddam Hussein and Fidel Castro could both use some of Jimmy's particular skill at casting out demons.