Thinking About the Bull
Jude Wanniski
July 6, 1998


THREE-TIER MARKET: The equity markets have spread out into three distinct tiers, the blue chips of the S&P 500/Dow Jones Industrial realm, the high-tech, mid-cap NASDAQ realm, and the smaller company, lower-cap Russell 2000 tier. Generally speaking, the top tier of older, mature enterprises are happy with the general state of the domestic economy, the bond market, and to a lesser extent, the world economy. They would be happier if Japan was in less trouble, but they are most grateful that the Federal Reserve is not raising interest rates and seems unlikely to do so. NASDAQ is happiest when it sees the possibility of more capital formation, upon which it feeds. It had been lagging the S&P 500 until the last two months, but now has caught up on the strength of the politics of surplus and even inched ahead. This is on continued good news about capital gains taxation. It is now almost certain that the holding period will be reduced to 12 months from 18, this provision safely tucked into popular IRS legislation that appears to have smooth sailing ahead. There also is the chance the top rate will be reduced to 15% with a June 24 effective date, if House Speaker Newt Gingrich and Senate Majority Leader Trent Lott are serious. The Russell 2000 continues to lag badly because it is feeling the greatest effects of the monetary deflation that began 18 months ago. It needs liquidity to take the price of gold back up from the current $295 level to $330-$350, which requires a lowering of the 5½% fed funds rate by the Greenspan gang. During the past year, the S&P 500 is up 25%, the NASDAQ 29%, the Russell 2000 15.7%. In 1998, S&P is up 18.9%, NASDAQ 20.6%, and the Russell 2000 a mere 4.9%. (The commodity deflation, of course, is what is weakening the domestic economy.) 

THE FED POSTURE: Minutes of the May 19 FOMC meeting indicate the Fed is still worried about inflation and voted to remain tilted toward higher interest rates. Two Friedmanite monetarists who now have votes on the 12-member FOMC actually voted to tighten.  It does not concern Jerry Jordan of the Cleveland Fed or Bill Poole of the St. Louis Fed that gold is down 23% in 18 months, dragging oil with it, plus farm prices and farmland. Nor do they connect this weakness in commodity prices with record high personal bankruptcies. They ignore the strength of the dollar in the forex markets and they ignore the inverted yield curve on 2- and 10-year government bonds. These are true zealots, who follow the Master’s teaching that only the money supply matters -- and no matter that its increase is more than justified by the increased demand for “money” spurred by the increased after-tax rewards to capital formation. These are true incompetents who should be waiting tables instead of occupying seats at the FOMC. Yet they are only marginally worse than those other FOMC members, such as Lawrence Meyer, who believes economic growth causes inflation. These factions will not vote to add liquidity until they are certain economic recession in these sectors are spreading into others, with rising unemployment and declining “Ms.” We have to hope the FOMC last week voted a neutral posture, which must precede an easy posture and an eventual actual easing. 

TAXES: It was nice of Gingrich to credit Jack Kemp with talking him into pushing for a 15% capgains tax this year and that Trent Lott concurs. Alas, three days in Washington last week left me with the sense that neither Gingrich nor Lott actually believes it will happen this year. Worse, they seem to be following a line of least resistance instead of doing the heavy lifting it would take to overcome the bureaucrats at the Congressional Budget Office and Joint Tax Committee who say a 15% rate will pay for itself over five years, but not ten. Can you imagine Senate Majority Leader Lyndon Johnson and House Speaker Sam Rayburn contemplating a trillion-dollar budget surplus and allowing June O’Neill of CBO to block them on a nickel-and-dime tax cut or spending bill? One problem is that the cultural conservatives want to end the so-called “marriage penalty,” which not only does not “pay for itself” on the CBO scoring system, but also will give IRS fits by adding new complexities to the tax code when it is struggling with the Y2K problem. Kemp is urging the two GOP leaders to package capgains with Senator Roth’s payroll-tax initiative, a combination the President would have a hard time vetoing before the November elections. To make it happen, the pay-as-you-go rule could be ducked in the House and finessed in the Senate, Kemp’s Reaganaut advisors insist, but it would mean the GOP leaders would have to make the political decisions to bend or even break the budget rules that are obsolete anyway. In seeking to hold and deepen control of the House, Gingrich should not put GOP candidates in the position of saying they would have cut tax rates this year, but June O’Neill would not let them. 

KEMP AND JAPAN: We noted Kemp had a meeting scheduled with Japanese officials to discuss a fix for their economy. He did meet June 24 with Ambassador Kunihiko Saito and the embassy’s economic minister, who told him they had not previously heard the advice he gave them. Kemp and Empower America’s chief economist, Larry Hunter, stressed the argument that the high capital gains tax on real property is a primary source of the distress and could be cut or eliminated with little or no loss of revenue. This is because people now cannot sell property without having much of the sales price chewed up by taxes. Saito acknowledged that the government did purposely increase taxation on real property for the purpose of driving down prices of Tokyo real estate, but did not equate it with the sharp “bursting of the bubble,” as we have. Saito promised Kemp he would relay his recommendation to Tokyo where the Finance Ministry is now pondering permanent tax cuts to get the economy out of its recession. Saito also invited Kemp to Japan to discuss these economic issues. Kemp, who met earlier in June with China’s Ambassador Li, who also extended an invitation, is now planning such a trip to both countries later this year. During my Washington visit last week, Larry Hunter and I met again with the economics minister, Toshinori Shigeie, to discuss the problems the Asian economy has inherited via the Fed’s major dollar deflation as well as the Bank of Japan’s yen deflation. After some explaining, he understood we were not advocating a yen inflation, only an adjustment to a gold price of roughly ¥44,000 per ounce -- the average for the past decade. 

CLINTON AND CHINA: Yes, the President’s trip was an enormous success. It’s greatest import was that it recognized the great advances China has already made in human rights and democratic reforms, which the China bashers here have refused to acknowledge. The one “success” recorded by Clinton which we worry about is Beijing’s solemn pledge not to “devalue the yuan.” The Beijing government seems totally oblivious to the problems it is creating for its 1.2 billion citizens by its continued appreciation of its unit of account against gold. Beijing attributes its economic slowdown to the weakness of the south Asian and Japanese economies, but most of the problem has been its own monetary deflation as it follows the lead of the Federal Reserve. The Clinton Treasury team has succeeded in persuading the Chinese government that if it “devalues” it will set off another series of competitive devaluations throughout Asia. At a lunch last Thursday in Washington with a senior Chinese embassy official, I suggested they think carefully about the no-devaluation policy, because it put their monetary policy hostage to ours. If the dollar gold price sinks much further and they follow suit, their economy will feel more financial distress than it does now. China’s reserves are now becoming ridiculously high, at $140 billion. They should, I suggested, use a piece of these reserves to cut domestic tax rates, which would help relieve some of the monetary deflation. They are reluctant to cut tariffs faster, thinking it would make their state enterprises even less competitive. I disagree, believing the economy would expand and generate more revenue that could be used to help phase out uncompetitive state enterprise. But I can see that this is not an argument I could win.