An Anxious Time in the Market
Jude Wanniski
February 5, 1996


The rise in the price of gold to $415 informs us that Federal Reserve Chairman Alan Greenspan and his colleagues will have no choice but to try to inflate the economy out of the recession it is now in if there is no break in the budget impasse. The stock market still believes there will be a deal that will include a 50% exclusion on capital gains, which would 1) abruptly end the national inventory liquidation now underway and 2) begin an inventory buildup in anticipation of economic expansion. When we say the economy is in “recession” we mean it is almost certain that when the final numbers are reported, economic growth will be negative in this quarter. It technically requires two successive quarters of negative GNP to constitute a formal recession, which means President Clinton and the 104th Republican Congress can avoid that blot on their historical escutcheon by doing a budget deal. An upturn now would probably produce enough statistical growth in the quarter beginning April 1 to offset this quarter’s red ink. Every day that passes without a deal is one day of economic production and wealth lost forever.

The threat to the financial markets comes from two directions. First, the National Governors’ Association is meeting with the President and congressional leaders in Washington to plead for a budget deal that will enable them to plan their state budgets, on which, in turn, county and local governments rely. If the government cannot respond to these appeals with a genuine break in the logjam that includes capgains, there must be a stock market correction that reflects the certainty of recession ahead. Second, the political pressure on the Fed will come, to pull the economy out of the ditch with easy money. Greenspan has taken one gamble with a quarter-point cut in the funds rate, in the face of declining demand for dollar liquidity. The silly story that the economic weakness can be attributed to snow and cold weather of course will not hold up when spring arrives and the slide continues. Conventional wisdom holds that Greenspan has it in his power to print greenbacks to save the economy. We are already hearing a rising crescendo attributing all our economic problems to Greenspan’s “failure” to slash rates left and right last year. We would like to think that Greenspan would resist the incredible pressures abuilding, but he has given us no reason to believe he will. If he is cutting rates by a quarter point with slight signs of economic weakness, how does he explain a refusal to cut rates by a half point when signs are clear?

Economic expansion, of course, will not occur when overnight rates are cut in the face of falling demand for liquidity. The gold price will rise and the entire interest-rate schedule will steepen. The only “good” thing that happens is that inventory liquidation temporarily slows in anticipation of inflation. Inventories can be carried longer if near-term price increases outpace carrying costs. Greenspan has not been at the helm of a genuine stagflation, so he doesn’t quite know how quickly it can get away from him. Former Fed Chairman Paul Volcker had the last big ride, when gold shot from $280 to $850 in the five months between September 1979 and February 1980. He was then trying to help President Carter get re-elected with easy money, if you recall. We are not suggesting that gold is about to take off in that direction, only that the Beltway Boys are playing with fire.

On "Meet the Press" Sunday, Gov. John Engler of Michigan was the only voice we heard all weekend talking up the need to cut the capital gains tax pronto. Tim Russert asked: “Would you urge your Republican colleagues in Congress to back down on the tax cut in order to have a balanced budget deal?” To which Engler responded, bless his supply-side heart: “No, in fact I think we could probably do the capital gains right now since the President has agreed to that piece, and I think that’s very important for America. And I think that fits well within the constraints that I think John Kennedy was right when we go back, you know, a few years ago, that bringing these capital gains taxes down helps create jobs and get this economy moving, and we’ve got to keep that in mind. We’re a growth party also, so -- and I think we take a unique burden as the Republican Party for being focused on growth as opposed to just being focused on government, so we have to balance. It’s not just government; it’s also growth.”

More typical among the governors was New Jersey Gov. Christie Todd Whitman, an ardent Dole supporter, who, when asked by Russert immediately after Engler spoke if she would be “willing to scale down on tax cuts considerably in order to arrive at a compromise with the President” replied: “I think a balanced budget is the most important thing within a doable time period.” It is rather scary that Christie Whitman, who owes her governorship to Steve Forbes tax-cutting counsel, thinks a balanced federal budget will help her economy more than a cut in capital gains. The New Jersey economy, poised for deep recession on the heels of the massive AT&T layoff, would get there quickly if capgains is stripped from a budget deal. There are no gold mines in the Garden State to benefit from $500 gold.

Michigan’s Engler is absolutely critical to a positive outcome, in that he has the confidence of Speaker Newt Gingrich and the most revolutionary of the House Republicans. He also indicated yesterday that the partisan warriors are very close to an agreement on Medicaid and welfare, chiefly because the Republicans now recognize that “with the President’s veto, we literally are forced to drop back and reassess the position.” He indicated a willingness to give the President the federal fail-safe guarantees that he has demanded.

Will there be a deal? The President clearly wants a deal, with news leaking out that his political advisor Dick Morris has even shared his campaign polling results with the Dole camp, showing that Dole benefits from having a budget deal. We can be sure the President knew about this move, believing his re-election will be a cakewalk if he can help Dole get the nomination. There is, though, always the danger that Dole will buckle as he has in the past, and be willing to take a deal that does not include capgains. How will the Iowa caucuses next Tuesday affect the outcome, if he winds up losing to Forbes and interprets the loss as a demand for a deal at any price? The last, real, final deadline shaping up is March 1, which means the issue will be settled in the 10 days after the New Hampshire primary.

Where will Gingrich’s political head be at that point? By all public and private accounts, he is now doing what he can to undermine the Forbes candidacy, on the grounds that he will lose to Clinton and lose the Congress to boot. As far as I can tell, there is hardly a soul in Washington who is not terrified of the prospect of Steve winning the GOP nomination. President Clinton has to know he has no defenses against Steve, unless he can prove that Steve was a silent partner in Whitewater and once partied on the Forbes yacht with Paula Jones and Gennifer Flowers. Perhaps the voters will take Governor George Voinovich seriously. The Ohio Republican, a big Dole backer, last week angrily insisted on CNBC that citizens who are not professional politicians should not be allowed to run for President!

We don’t mean to frighten you about the dangers just ahead. It could all work out just right, if the Beltway Boys behave themselves. If not, we are grateful to Floyd Norris of The New York Times for reminding us that when the Dow hits 5444.84 it will be exactly double where it was at its peak before the Crash of 1987.