Campaigning in Iowa yesterday, Senate Majority Leader Bob Dole said he thought there was only a 50-50 chance of a budget agreement by year’s end, meaning this weekend. The budget negotiators meet today to set the stage for a Clinton-Dole-Gingrich summit tomorrow. An agreement would enable a full budget accord by the second week in January, and the rosy scenario we outlined earlier this week (“Thinking About 1996,” 12-26) would kick in. If there is no agreement, the government will remain partially shut down into 1996, as the parties await signs from public opinion on which side should give way. “Not that things have been pretty now,” writes Robert Novak, “but the deadlock is apt to get really ugly.” As if anticipating stalemate, the Republicans are already setting up a new line of attack on the debt limit. Chairman Bill Archer of House Ways&Means is warning the Administration that its use of the trust funds to skirt the debt limit already reached may be unconstitutional. We continue to believe this GOP maneuvering on the national debt is a losing gambit.
If this test-of-wills continues, we would not expect the stock market to crash, but rather to show more of the nervousness we have seen this past month. The broader market would continue to suffer more than the DJIA, but both would steadily recede as the days and weeks go by, with periodic sharp declines. This is not only because of increased risk that eventual resolution will be disappointing to capital formation. It is also because every day without a deal in 1996 will cause wealth never to be created, lost forever to the bottom line of the U.S. economy. We can observe this anxiety showing up first in cyclical stocks, with pulp and paper most noticeably in the news. The stock market advance of 1995 points to a strong economy in 1996 if there is a budget deal which includes the 50% exclusion on capital gains taxation. Paper inventories can be built only so high in anticipation of this expansion. The decline in interest rates helps only marginally in holding stocks. Every day of lost expansion in 1996 translates into a softening of business in commodities, which are the primary inputs that feed through general economic consumption.
The risks we face in this budget showdown are amplified by the weakness of economic analysis available to President Clinton. As far as his team of Keynesian economists is concerned, the economy is in good shape and will proceed on a positive trajectory whatever happens to the budget. If there is a little weakness, the President probably assumes that Fed Chairman Alan Greenspan will simply cut interest rates again and that will be that. There is a similar nonchalance among some Republicans, who believe the economy is doing as well as it is because inflation and interest rates are down. In this view, the capital gains tax does not figure into 1996 because it only affects long-term investment. The long-term is now, however. If we assume that there is $7 trillion in unrealized capital gains in the system, almost all of it inflated gains, the tax liability at 28% is roughly $2 trillion and at 20% roughly $1.4 trillion. That’s $600 billion in new risk the economy can take on when the 50% exclusion takes effect. A significant piece of that already has been built into expectations, via the financial markets and a 1995 inventory build-up.
The promise of retroactivity for the lower capital gains tax also has been built into the economy, at least to a degree. The smart money on Wall Street has not factored retroactivity into the value of financial assets, covering gains by hedging. In the real world, though, you can’t hedge the sale of farms, businesses or inventories, and a great many asset sales that went forward on the promise of retroactivity will cause their owners distress if that feature is pulled in the budget negotiations. The Keynesian economists who advise the President simply dismiss the economic arguments of retroactivity by saying what’s done is done. In real life, people who sold assets and committed them to other venues would have to sell them a second time to meet tax liabilities. With retroactivity, investors who hold gains in fledgling companies will need to sell a smaller share of their assets in order to meet tax liabilities. This is why retroactivity will have such positive effects on the capital base of emerging enterprise, with relatively small impact on the capital base of mature enterprise.
The Republicans would be in a much stronger position if any of their leaders were making these arguments. Speaker Newt Gingrich and Chairman John Kasich of House Budget are the only two visible figures who occasionally make the connection between the budget and economic growth, but all too often they leave the impression that this is a secondary consideration -- one that has effects far into the future, not tomorrow. Instead of arguing the budget should be balanced in seven years through spending restraint and economic growth, the GOP leaders invariably leave the impression that spending restraint will cause economic growth, which it will not. This leaves them in the position of going toe-to-toe with President Clinton on the wrong issues. The electorate knows the economy will not appreciably improve by the insignificant differences between the Congress and the President on their 7-year spending schemes.
Newt Gingrich has been quiet for the last week, but we hope he comes back from his Christmas holiday with some fresh ideas on how to solve this problem. We really don’t think he can count on the President having much new to say tomorrow. And he’s in a better position to understand how easily his herculean efforts to date can vanish if he tries muscle over creative diplomacy. The press corps has the summit set up in a way to suggest that either Newt or Bill will have to blink first, and the blinker will be the political loser. In this case, the blinker may well be the winner, if the electorate perceives that the economic expansion it is banking on will indeed occur.
Fussing over the debt limit remains a central confusion. A month ago, Republicans were condemning the administration for its duplicity in scaring the markets about default -- all the while planning to handle the debt with the trust funds. Now they are practically threatening impeachment of the President for paying interest on the debt in this manner. They really should clear it away and then make some Solomon-like decisions about the budget. It’s Newt’s baby, after all, his mini-Revolution within the Reagan Revolution. It’s really up to him to find a way to keep it and the economy pointed in the right direction, to take some calculated risks, even if it means putting his Speakership on the line. Happy New Year, we hope.