A Lot Going On, In Circles
Jude Wanniski
June 18, 1998


Under normal circumstances, we would not be terribly impressed with yesterday’s Fed/Treasury intervention to weaken the yen against the dollar. This is because the dollars used by the Fed to buy yen have only temporarily added to the dollar liquidity that the world has been demanding. The Fed, which still fears inflation, still refuses to supply the liquidity on its own hook, but was required to do so under law by the explicit Treasury order to do so. That’s the relief the world felt, which we could see in the price of gold jumping off its deflationary floor of $285 to its current $292. To a world gasping for dollar liquidity, the relief was instantaneous. But now the Fed will see this liquidity washing back to our shores, putting downward pressure on the agreed-upon Fed target of 5.5% fed funds rate, and all or almost all the liquidity will be drained through the sale of bonds to the banks from the Fed’s portfolio. That’s what “sterilization” is all about. The Wall Street Journal editorial today, “No More Benign Neglect,” which celebrates the intervention on behalf of the yen, is way off the mark by comparing this to the 1985 Plaza Accord, which involved an explicit policy change. This does not and will not be an explicit policy change until the Fed agrees not to sterilize, which means a lower funds rate, and a permanent addition to dollar liquidity.

If there is a lasting benefit, it would have to be purely psychological, which is what people like David Malpass of Bear Stearns, who is cited in the Journal editorial, are talking about. When our Michael Kurtz told our Global 2000 clients June 10 that Hong Kong appeared to be hitting bottom, which meant a buying opportunity, he did so on his confidence that China and Hong Kong would once again frustrate speculation they would devalue. In this round, speculation against China and Hong Kong hinged on the argument that the weakening of the yen against the dollar was hurting their export markets. With the Fed intervention, these speculators were burned in all the Asian currency markets. The question now: As the Fed sterilizes and the gold price inches back down toward $285, will the yen crank back up to 145, reviving speculation in Hong Kong? We’re afraid it will, because the problem in Japan remains its internal deflation, where yen debtors are being crushed with commitments at ¥40,000 gold that they made at ¥45,000 gold -- with their creditors crushed because the debtors cannot pay. The economy will remain paralyzed until the price level rises because of sufficient yen liquidity being added to drive it up, or with a tax cut that will give the entire system indirect, fiscal relief. None of these problems have been addressed in this quickie intervention. The problem remains the Fed’s deflationary dollar policy.

There is a lot going on in Washington that we have to watch. We were happy to see the cigarette tax killed in the Senate yesterday, although we expected as much. The White House thought it could frighten Republicans into supporting this tax-and-spend monster by portraying it as a program to prevent little kids from getting lung cancer. Once the public thought about it, it cut the other way, and now it would be a better campaign issue for Republicans this fall than for Democrats who hoped to ride it to a recapture of the House. There are important movements on the tax-cutting side that will bear upon financial and political markets as they play out. A deal among House and Senate Republican leaders seems to be shaping up around a strategy that would not be too bad if it could result in legislation signed by the President, but will have a high risk of a presidential veto that will simply leave the electorate confused in November.

The package would have in it a 15% capital gains tax and 12-month holding period, which House Speaker Newt Gingrich waved around Tuesday night at a Washington GOP fundraiser, chaired by Ted Forstmann, that took in $11 million in one swoop. Capgains is the easy part, because the scorers now seem to acknowledge it would have dynamic revenue effects and will not have to be offset by spending cuts under the pay-as-you-go rules. It will do no good to have this as part of a package that is vetoed, however. The problem rests with the two other elements. There would be a target of $60 billion in tax cuts spread over five years, most of that to take care of the marriage penalty. This amount would have to be paid for with spending cuts, which are unspecified.

The President could not get away with a veto of this small of a tax bill, although there will be screams from liberals that the spending cuts will come out of school lunches, etc. It is in the Social Security realm where we find the serious veto bait. A good part of the expanding budget surpluses that are now on the horizon are due to the overfunding of Social Security. Chairman Bill Roth of Senate Finance is eager to apply these surpluses to a plan that would begin to privatize part of Social Security. Gingrich and Trent Lott have bought into the idea because the President could not say the Republicans are using prospective surpluses to benefit the rich. About 2% of the payroll tax would simply be shifted to private accounts, which would somehow wind up going into Roth IRAs at some point. The idea is not bad, but it is certainly not as good as using prospective surpluses to lower marginal income tax rates or eliminate the estate tax, which Gingrich also talks about, though not seriously. The real problem is that Senator Pat Moynihan [D-NY] is violently opposed to the idea, which he says will endanger Social Security by draining funds before we are sure people now entitled to benefits will be taken care of. This is the kind of argument the President would likely use as he vetoes the whole kit-and-caboodle.

Jack Kemp is warning of this outcome, guessing the politics will favor the Democrats in the fall. He continues to argue that the prospective surpluses are so much bigger than any official estimates that Republicans should first use them to cut tax rates where there are supply-side growth effects. Chairman Bill Archer of House Ways&Means seems to agree with Kemp that the Gingrich-Lott-Roth approach could get vetoed and the voters won’t care. He definitely agrees with Kemp that if the looming surpluses were applied to genuine tax cuts, not the 2% payroll accounting shift, a presidential veto would be met with anger by the electorate, and the GOP would pick up seats in November in the House and Senate. There seems to be no support for them among those who count, who are reading polls saying the public doesn’t want a broad-based tax cut. Meanwhile, the Herbert Hoover wing of the party, who call themselves the CATs (the Conservative Action Team that includes Rep. Mark Neumann of Wisconsin), are yelling at Newt to cut more spending if there are to be more tax cuts.

In other words, don’t count your chickens yet, either in Asia or at home. The noises may seem happier, but actual policy movement remains on a circular track.