Executive Summary: The stock market has now discounted the legislative results of the 95th Congress and awaits the outcome of the November 7 elections for clues to 1979. The economic mechanisms set in place by the tax and energy bills are bearish, especially when coupled with a new determination by President Carter to employ political muscle in getting his way. In addition, the bears have inflation signals going their way, a potential of double-digit rates in 1979 amid rumblings of wage and price controls. The bulls have only political momentum going their way, evidenced by surprising, last-minute Democratic support for Republican-styled tax cuts, This momentum will not be sufficient to keep the economy and stock market buoyant if Nov. 7 results are viewed as a vote of confidence in the President.
Bulls and Bears on Elections' Eve
In its haste to depart Washington, D.C. on October 15, only three weeks remaining to Election Day, the 95th Congress threw in the towel in its struggle with President Carter and converted a potentially promising record into a disappointing one. As late as the afternoon of Friday the 13th, it could still have gutted President Carter's energy bill, which instead will become an increasing burden to the economy as it is implemented. As late as the afternoon of the 14th, it had a golden opportunity to extend its gains on capital taxation to personal rate reductions. Instead, the Congress withered under pressure of a Carter veto threat, a threat that could not have been carried out without at least keeping the issue alive. As it is, the mechanisms established by the tax and energy bills will be in place into the foreseeable future. Only the narrow prospect that the November 7 elections will deal Mr. Carter a major political embarrassment stands in the way of a bear market into 1979, when the 96th Congress will take its place in renewed struggle against the new, arm twisting, logrolling Jimmy Carter.
This new facet of the President, his surprising ability to transform himself into a hard-nosed wheeler-dealer, "Lyndon B. Carter" one might say, surfaced only in the last two months. Because this transformation is being interpreted by the White House as the key to Carter's legislative "success," we must assume it will remain a permanent feature of his presidential style. This will be yet another bearish factor bearing on financial markets.
In the first 15 months of the Carter administration, the President seemed content to send misguided legislation to Capitol Hill and attempt to advance it by "soft" lobbying. Cabinet members testified to the merits of the proposed legislation. Mr. Carter invited legislators of both parties to the White House and reasoned with them. And he attempted to build grass roots support for his measures, via barnstorming, televised speeches, statements and press conferences.
None of this worked, and during the process the nation's capital stock plummeted by 25 percent, as measured by the Dow Jones Industrial Average. The DJIA dropped from roughly 1000 to 750 in early April of this year as the President intensified his efforts to increase the progressivity of the tax system and lay heavy new taxes on domestic energy production and use.
The market's rebound, beginning in April, reflected congressional resistance to the Carter tax push. Congress went in the opposite direction by pressing for a sharp reduction in the capital-gains tax, via the Steiger amendment, and by making clear it would continue to resist Carter pleas for a crude-oil equalization tax. In August, the remainder of the energy bill was confidently being pronounced dead, especially the onerous provisions of the natural-gas section. This effective counter-force buoyed the market. On September 8, in mid-day trading, the DJI touched 915. This smart, five-month market advance of 165 points on the DJI was all the more remarkable in that it was accompanied by the President's continued collapse in the public-opinion ratings and the continued decline of the dollar.
The market advance ended with the President's determined effort to regain control of Congress on these crucial domestic issues. All year he had been counseled to "get tough" with Congress, explicitly as a means of arresting the steady decline in his public-approval ratings. In August, he had toppled to a 38 percent approval rating in the Gallup Poll and a mere 30 per cent in the Harris/ABC Poll. The theory that took hold around the White House was that the public perceived Carter as a weak, wishy-washy President, and that it desired a strong President who could master the rebellious 95th Congress. The summer arrival of Carter's campaign image-maker, Gerald Rafshoon, cemented these views. The President's August 17 veto of a defense authorization bill, which The Wall Street Journal dubbed "The Rafshoon Veto," signaled the Carter turn from "soft" lobbying to hardball politics.
On August 30, the process began in earnest when the President cut short by two days his California holiday to save what had become the keystone of his energy bill, the natural-gas compromise. The forces opposing the compromise were totally unprepared for the flagrant exercise of presidential power that followed. What appeared on the surface, in the press, were Carter's three chief arguments on behalf of the bill: 1) He needs it to bolster his image vis-a-vis the European political leaders; 2) the compromise is the best available; 3) it is needed to rescue the falling dollar, by restoring confidence in the nation's ability to cut energy imports.
These arguments, all equally fallacious, could not possibly have saved the bill because the national power structure did not believe them. Nor could the bill be saved on its "merits," for it was conventional wisdom inside and outside the administration that the 171-page natural-gas compromise constituted a "bureaucratic nightmare." Its superficial promise of deregulation in 1988 has to be weighed against its instant regulation of the intrastate gas market, an enormous increase in the regulatory wedge that will be pounded into place over the next 18 months as the legislative language is translated into concrete regulations.
The only way Carter could sell this obvious barrier to commerce, which will drag down the efficiency of the entire U.S. economy throughout its existence, is by dipping into the legislative and executive pork barrel. Upon return from his California holiday, the President began working on two fronts. Retiring U.S. Senators and Congressmen were wooed with promises of ambassadorships, judgeships and federal sinecures; non-retiring members of Congress, Democrats and Republicans, were offered pet projects out of the federal pork barrel in exchange for votes on the gas bill.
On the second front, the President wooed American industry through his allies on the Business Roundtable. The incremental-pricing provisions of the bill will impose enormous costs on American industry as the bureaucratic process unfolds, as will requirements to switch from gas and oil to coal. The Machinists Union could see this as clearly as the industrial giants and realized the implications for U.S. competitiveness in world markets, and they became almost fanatical in opposing the bill. The industrial giants, though, capitulated to the carrot-and-stick tradeoffs employed by Carter, Eizenstat, Strauss and Blumenthal. In the week of September 4, Carter began turning the bill around with these industrial groups. Straightforward offers of protectionist measures against the Japanese were made in exchange for corporate lobbying on Capitol Hill. And those industrial groups that most fear the regulatory power of the federal government were offered implicit promises of friendlier treatment in exchange for explicit lobbying assignments. The automobile companies, no doubt aware that non-compliance would mean even unfriendlier treatment than they have experienced in the past, did an about-face with General Motors leading the way.
It was my belief at the time, and remains so, that the 58-point market slide between September 8 and September 20 largely reflected the President's success in reversing the fortunes of the natural-gas compromise, particularly in the Senate. The forces opposing the compromise, led by the independent oil and gas producers who will be damaged worst by the regulatory burdens of the bill, threw their lobbying resources to the House side. Because of the sheer number of House membership and their geographic distribution, it was much more difficult for the White House to buy votes with the kind of pork-barreling practiced on the Senate. Nor could the industrial giants so easily lobby Republican votes in the House as with their power peers in the Senate.
As late as Saturday morning, October 14, the independent oil and gas producers believed they had beaten back the compromise in the House Rules Committee. On the previous afternoon, three Democrats had joined the five committee Republicans to provide a one-vote margin requiring a separate vote on the gas compromise, which would mean stripping it out of the energy bill. The following morning, one of the three Democrats, Rep. B.F. Sisk of California, who is retiring, switched his vote although he had said hours earlier that he would "in no circumstances" switch. The Wall Street Journal reported that Sisk desires to head the Immigration and Naturalization Commission, a presidential appointment, and that the Carter administration "did promise Rep. Sisk a speedup of some water contracts in his congressional district that had been stalled."
Even so, that afternoon opponents of the gas compromise tried to reverse the Rule by vote of the House, and when the vote tally had been completed had apparently won 205-to-202. Democratic leadership applied pressure to swing one vote, then Rep. Tom Evans, Delaware Republican, became the decisive vote, joining only seven other Republicans in support of the bill. As the Wall Street Journal noted parenthetically: (The bill is supported by DuPont Co., which wields tremendous power in the State of Delaware.)
The point of this review is to suggest that the stock market's 22-point decline on October 16 reflected in part the certainty of the legislation's enactment. Because the energy and tax bills were both up in the air over the October 14-15 weekend, it is impossible to do anything more than surmise which had the greater impact on market values on the first day of trading. But in our model, the energy legislation as passed is almost wholly negative in its burdens on the economy's efficiency while the tax bill is not as attractive as the market believed it would be before it closed October 13. Indeed, as the Federal Energy Regulatory Commission develops regulatory language in the next 18 months, the burden on the economy would likely become greater than lesser, but discounting would occur at so glacial a pace the effects would elude all but the most alert analysts.
The tax bill's odyssey this year, especially at its culmination, holds hidden promise for the stock market. The fact that President Carter was in a position to shape the final details of the tax package over the October 14-15 weekend obscures the really promising developments in Congress during the previous week. Congress, after all, had no choice but to accede to Carter's demands over that weekend if it wanted to adjourn with a tax bill in hand. The Democrats could not afford to campaign in these final weeks prior to November 7 without a tax cut, and thus had to take seriously Carter's veto threats. Faced with this calendar, Chairman Russell Long of Senate Finance played it as close to the wire as he could to avoid a veto.
But President Carter will not have the calendar working for him in 1979 when the 96th Congress convenes. And with any decent Republican showing on November 7, the Congress will resume its discovery and fascination of the incentive effects of tax-rate cuts.
What Senator Long wrested from the President was almost all to the good, but hardly sufficient to offset the continued impact of inflation on the progressive tax system. The cut in the marginal capital-gains tax rate from 49 per cent to 28 per cent, the measure by which Rep. Steiger saved the stock market and economy from the pits last April, is of course the centerpiece of the package. The President, remember, had wanted to increase the tax on capital gains and move toward eliminating preferential treatment entirely.
The President had also originally proposed to convert the personal tax deduction of $750 into tax credits, to shift benefits away from the upper brackets. Congress, fortunately, went the other way and threw out the existing credits, increasing the personal exemption to $1,000 per person. The small reductions in the corporate tax structure were also beneficial, especially the reductions in the corporate surtax below profits of $100,000.
In an environment of price stability, these measures alone would have been sufficient to propel the stock market well above the 900 level. But this bullish force has been swimming against an inflationary tide as well as the drag of the energy bill. When the 95th Congress adjourned, having left marginal rates on personal incomes intact, the stock market was left with nothing on the horizon to discount but the coming elections and the relentless inflationary tide.
In its almost two years of existence, after all, the 95th Congress had pondered the tax issue even as the general price level rose by more than 12 percent — which means both capital and labor were pushed into higher marginal tax brackets at an unusually high rate. The tax bill Congress produced perhaps compensated for part of this rise, perhaps even most of it, but the implied future rate of inflation seems even more forbidding. What is worse, prospects of relief in 1979 originating from the Carter administration seem nil.
There is, remember, another true, faithful forecasting tool in addition to the stock market, one that probably has more to do with the decline in consumer and business confidence this year than movements in the stock market: The value of the dollar in terms of other currencies and in terms of gold. The market's valuation of the dollar in these terms forecasts the future movement in price indices, i.e., inflation. At the end of August, the dollar stood 18 3/4 per cent below its September 1977 level, measured against the currencies of U.S. trading partners, weighted to their national economic size. This means the United States would have to experience 18 3/4 percent more inflation than the rest of the world before purchasing-power parities returned to equilibrium.
The reason the price of gold has to be taken into account is that international equilibrium could also be attained if the rest of the world deflates by 18 3/4 percent, the U.S. price level remaining constant. This possibility could only occur if the dollar price of gold were constant. The fact that it has not been constant, but has risen in one year from roughly $140 to about $225, tells us that only double-digit inflation can do the job of forcing a return to international price equilibrium. Of course, economic policies that would appreciate the dollar against other currencies and also drop the price of gold would reduce the mathematical necessity of domestic price rises. The markets, in late October, are calculating that such policies are not going to be followed.
The bears, then, have everything going for them except for political momentum. In the last two weeks before it adjourned, the 95th Congress did succumb to the seductive appeal of aversion of the Kemp-Roth bill to cut personal tax rates by 33 per cent across the board, a measure that would have effectively indexed the tax system against inflation's effect during the remainder of President Carter's term. After Kemp-Roth itself was defeated, Senator Sam Nunn of Georgia, the only Democratic co-sponsor of Kemp-Roth in the Senate, proposed an attenuated version that would cut personal rates by 25 percent over four years. The "Nunn-Kemp-Roth" measure swept the Senate by 65-to-20 and House Republicans quickly organized a rally to instruct the House conferees to accept the Senate language in the final tax bill.
The 2-to-l majority in the House for the Republican-styled tax cut suggested sufficient strength in both houses to override a Carter veto. But with time on his side, Carter could pocket-veto and Democratic incumbents would have to explain all this at the polls. As a result, the Democratic conferees had no choice but to scrap the Nunn amendment on the orders of Speaker O'Neill and the White House.
With now a high probability of double-digit inflation plus recession in 1979, the 96th Congress will have to be prepared to resume the struggle against the Carter administration's errant economic strategies. If it does not, we can expect the President to continue playing hardball politics in a push for wage-and-price controls to control an inflation caused by the errant policies of the Federal Reserve.
We should not expect this struggle for economic policy to be won by the 96th Congress unless the elections of November 7 materially alter the complexion of the national legislature. Skimpy gains by Republicans, a pickup of fewer than 12-to-15 seats in the House and a standoff in the Senate, would bolster the President's resolve and ability to dominate the 96th Congress. On elections' eve, we continue to expect the GOP to do better than that, which would give the bulls something to hold onto as they contemplate the coming year.