The 160-point decline in the Dow Jones Industrial Average last Thursday was generally blamed on concerns about Federal Reserve policy and a potential interest-rate increase. If anything, news from the Fed front lately has been better, with the risks of a rate increase at the FOMC meeting next week actually declining. It was the news from the fiscal front and the specter of renewed partisan gridlock that surfaced Thursday that sent the DJIA, the broader market, and the bond market into decline. The continuing slide today reflects confirmation of budget problems discussed on the Sunday talk shows. The Russell 2000 index, which is where we have been looking for the clearest signals of broad-based economic growth, now is down for the year 1997. In other words, the further down the equity pyramid you travel, the worse things look. The negative Russell 2000, which excludes the top 1000 stocks, suggests the market no longer discounts the possibility of a budget deal that will include a capital gains tax cut. The decline of the lower-cap high-tech stocks is further evidence the market’s erosion is for the most part tied to the tax horizon.
This was the news that surfaced Wednesday when House Majority Whip Tom DeLay [R-TX] said Congress should forget about tax cuts and send the President an austerity budget. By Thursday it was clear Republicans felt they had no choice but to walk away from fruitless negotiations and attempt to blame the breakdown on the Democrats. The chairmen of the congressional budget committees, Rep. John Kasich [R-OH] and Sen. Pete Domenici [R-NM], are placing the blame on the President for his refusal to agree to a process that would “solve” the budget problem by adjusting the Consumer Price Index. The magic fix would automatically raise tax rates and cut spending every year ad infinitum by the amount of the adjustment, with all concerned agreeing that these were only technical corrections with no political ramifications. The magic fix would then permit Congress and the President to cut a deal that would lower tax rates and increase spending for the coming fiscal year.
The likelihood that Democrats would agree to a CPI deal that would bleed their primary constituents at the AFL-CIO and the AARP was never much higher than absolute zero -- about as high as the possibility that Democrats would ever permit a balanced budget amendment to the Constitution. President Clinton, now a literal as well as figurative lame duck, might agree to shoot Santa Claus if Democratic liberals said it would be okay with them. They won’t. Because Mr. Clinton faces the possibility of impeachment proceedings over corrupt campaign practices, his fate is in the hands of party liberals, led by House Minority Leader Richard Gephardt, who will protect him only as long as he does their bidding. So where do we go from here? On CNN’s Sunday "Late Edition," Senator Domenici appeared to be threatening to send an austerity budget to the President, sans tax cuts or any of the President’s initiatives on education. Domenici seems to think the threat will leverage the President into agreeing to a CPI deal, but Domenici always has been abysmal at legislative politics, and this is one of his worst moves. If Republicans send the White House a bare bones austerity budget, the President will sign it and Republicans will look even more hapless than they do at the moment.
Responding to Domenici on the same talk show, Budget Director Franklin Raines made happy talk about being willing to adjust the CPI, but only if the experts at the Bureau of Labor Statistics say so, which they do not. Raines is absolutely correct in saying the CPI should not be driven by the need to fill holes in the budget. He soothingly said the administration is prepared to come up with real Medicare savings ten years out, which takes the President past his tenure. Raines also slipped in the idea that any tax cuts be examined over a 10-year period, knowing the beancounters at the Congressional Budget Office and Joint Committee on Taxation will insist a cut in the capital gains tax will bankrupt us all in 10 years.
First the downside: Unless we get off this treadmill, the S&P 500 would follow the Russell 2000 south. With fiscal policy again in gridlock, the only tool left to combat economic weakness would be monetary policy. Now that the Fed has persuaded the bond market that it may have to tighten to pre-empt an inflation resulting from “excessive” economic growth, the logic follows that it will ease in order to pre-empt economic decline. The spot price of gold is still behaving itself, but that also would end with a big slide in the stock market and a decline in the demand for the dollar. Could the Fed offset a decline in the demand for dollar liquidity with monetary ease? It never has before. It would only send up the price of gold. Next Tuesday’s Fed meeting is a critical juncture for Greenspan. If he can talk the FOMC out of a pre-emptive strike, we at least might see a rally in bonds. If not, we will have every instrument of economic policy pointed in the wrong direction.
Upside? The budget breakdown might force the Republicans to take the initiative, which they should have done in the first place. The electorate last November gave the Republicans a clear mandate to take the lead, “clear” in the sense that Bill Clinton was re-elected without any agenda beyond protecting the country against excessive GOP austerity -- which he is doing. Reflecting a defensiveness that grew out of the humiliation of Republicans in the 104th Congress, Senate Majority Leader Trent Lott said he would give the President the first “at bat,” but if he struck out, the Republicans would step up to the plate. Putting Pete Dominici in the batter’s box as lead-off hitter is a guaranteed whiff. His CPI issue is dead, dead, dead.
If I were Trent Lott or Newt Gingrich, I would offer the President and the Democrats a supply-side growth budget, including the 50% exclusion on capital gains and prospective indexing, but without the enormously expensive kiddie tax credits that only build new entitlements into the tax codes. Gingrich, who caused his own difficulties by misreading the 1994 mandate as a public demand for austerity, is the perfect fellow now to rescue his party (and himself) by reading the 1996 mandate as one that puts growth before austerity. It was Gingrich who put the kiddie credits into the Contract With America, to buy off the religious right. The President is not going to get any grief from Gephardt if he agrees to a Republican growth budget, especially if it has room in it for some of the education initiatives the President would like to deliver. When the President accepted Trent Lott’s invitation to visit Capitol Hill last month, there were smiles and handshakes about task forces that would try to work this out, but all of that got sidetracked with the CPI nonsense.
Gingrich is fully capable of taking the lead here. However, unless he finds something to get him off his own treadmill, pressure is bound to build to force his retirement as Speaker. His position seems bleak, but in mid-March of 1995, Bill Clinton seemed to be a dead duck, making his comeback with a creative strategy designed by Dick Morris. If Clinton can survive the troubles he has seen and post an approval rating in the 60% range, Newt should be able to ride the growth horse up from the depths of his 20% ratings. There has been a budget breakdown, but the good news is that it is only mid-March, and there is plenty of time to do it right.