Baker versus Shultz Jude Wanniski May 9, 1985

Executive Summary: The Bonn summit meeting set back prospects for world economic growth President Reagan shied from proposing supply-side tax measures for Europe and the Third World. Talk of a monetary conference was scotched. Monetarists in the U.S. and the U.K. were winners. Secretary of State Shultz dominated; Treasury Secretary Baker was the big loser, although the Establishment press blamed failure on Frances' Mitterrand, Shultz emerges as the Old Guard's champion in the Administration, forging alliances with McFarlane, Stockman, Sprinkel on domestic and foreign policy. Pat Buchanan energizes the populist cause but is outmaneuvered by the Shultz team in the agenda battle. Will Baker fight or submit? First he'll bide his time and consider alliances of his won. Tax reform comes first and Baker faces a dilemma over the proposed 35 percent rate. Shultz defeats Baker, but it's only Round One. 

Baker versus Shultz

On the surface, at least, the economic summit meeting in Bonn was a terrible setback to the prospects for world economic growth. Instead of urging Europe and Japan to cut personal income-tax rates to spur economic growth, President Reagan was maneuvered into supporting the British position: budget austerity and "reform" of labor unions. Instead of advancing the prospects for international monetary reform, the summit meeting produced a retreat from the modest idea of a high-level conference on the subject. Instead of recommending supply-side growth policies to the Third World, the summiteers slumped into the same old austerity posture that has produced so much Third World poverty.

The monetarists dominated throughout. At a personal level, the U.K.'s Margaret Thatcher and Geoffrey Howe, devoted Friedmanites, were successful in outmaneuvering French President Mitterrand in his attempt to promote a new system of fixed exchange rates. The summit was also a stunning triumph for another Friedman protege, Secretary of State George Shultz. It was Shultz who, as Treasury Secretary in the Nixon Administration, ushered in the floating exchange-rate world that France seeks to reform.

The biggest loser at the summit was the fledgling Secretary of the Treasury, James Baker III, who lost control of the agenda to George Shultz. It was Baker who three weeks earlier in Paris delighted the French and infuriated the monetarist network in the U.S. and Britain with his offer to chair a conference on international monetary reform. Baker also went to the summit urging supply-side income-tax cuts in Europe as a non-inflationary stimulus to growth, a proposal scoffed at by Allan Wallis, Shultz's Undersecretary of State for Economic Affairs, and spurned by the British.

France also rejected the tax-cut idea, as well as President Reagan's proposal for a new round of trade talks and French involvement in "Star Wars" research. Both The Wall Street Journal and New York Times blamed Mitterrand for the summit "failure," attributing his stubbornness to domestic politics in France. But Mitterrand's intransigence clearly seemed to grow out of his disgust with the U.S. on the monetary issue. There were press reports that Mitterrand was distressed with the "cross signals" he was getting from Jim Baker and, finally, that he was upset with the lack of support Baker had mustered for a serious effort on monetary reform.

All this was true. France has been aggressively, almost desperately, seeking monetary reform for years. It's nonsense for The Wall Street Journal to argue that Mitterrand simply wants the U.S. to prop up the weak franc; France has urged stable exchange rate talks throughout the dollar's swings from weakness to strength. In the four summit meetings of Reagan's first term all discussion of an international approach to exchange rates was blocked by Beryl Sprinkel — Donald Regan's Undersecretary for Monetary Affairs and a devoted protege of Milton Friedman.

With Sprinkel gone from Treasury to chair the Council of Economic Advisors, it was widely assumed the Bonn summit would be more hospitable to an exchange-rate discussion. This belief seemed confirmed when Baker on April 12, at a regular OECD finance minister meeting in Paris, offered to chair the monetary conference France has been seeking.

The monetarists in the Administration were outraged, reacting immediately by calling financial reporters and "explaining" that the Baker move was manipulative, designed to "outflank the French." This sowed seeds of suspicion among the French, which Baker and Deputy Secretary Richard Darman could never quite neutralize. There was added confusion when the Times on April 13 reported on George Shultz's Princeton University speech on the future of the world economy, wherein he denounced the idea of a par-value fixed exchange rate system and defended floating rates. (The Princeton speech as a whole could have been written for Margaret Thatcher, and was praised by her Chancellor of the Exchequer, Nigel Lawson, especially for its emphasis on deficits.) Although Jim Baker is technically the sole economic spokesman for the Administration, under the new reorganization plan, he is discovering that the Secretary of State can say what he wants. And with Martin Feldstein gone and David Stockman isolated, Shultz has emerged as the champion of the Old Guard in domestic as well as foreign policy.

Although Sprinkel was not originally scheduled to go to the summit meeting, Shultz had him pulled into the delegation. Sprinkel was thus in position to further poison the waters with the French, who were no doubt horrified to see him show up to give briefings on the absolute opposition of the Reagan Administration to almost any kind of exchange-rate interventions. Mitterrand may still be wondering if Baker betrayed him, but it's easy to see why he was not in a mood to give Reagan anything at Bonn. It was Shultz who did the damage, but being the consummate international bureaucrat, he walked away from the disaster without leaving fingerprints.

Even when it came to the Third World, the State Department's position in support of International Monetary Fund austerity policies was clearly read into the summit communique. Richard Darman has made no secret of his desire to push growth-oriented tax policies in the developing world. Peter McPherson, director of the State Department's Agency for International Development, has been vigorously resisting any such moves — with the public backing of Secretary Shultz. (In a January meeting with me in his office, at his invitation, McPherson insisted that high marginal tax rates have little or no effect on the developing nations — because they are avoided anyway. His formula for "growth" is identical to the IMF's: balanced budgets, currency devaluations, and termination of government bread subsidies. A conservative coalition headed by Paul Weyrich, the key new-right strategist, is urging removal of McPherson and alteration of AID's policies.)

Why is it that supply-side growth policies fared so poorly in Bonn? The conventional answer is that President Reagan's standing with his peers was not what it was several weeks earlier, both because of the Bitburg controversy and the softening of the U.S. economy in recent months. In The New York Times of May 5, Peter Kilborn put it this way:

A month or two ago, the Reagan Administration looked to Bonn as a celebration of the economic policies that accounted for the extraordinary growth and falling unemployment of the last two years, all with little inflation. The record provided the President with an opportunity to preach his supply-side economics to the slower growing, unemployment-ridden economies of Western Europe.

As the conference approached, however, there came the report of a precipitous slowdown in the growth of the economy during the first three months of this year, with signs of rising inflation as well.

This is all true enough. But the more fundamental problem is that Jim Baker was simply outgunned by George Shultz, and unless something is done to remedy this imbalance the President's second term is going to go down the drain. Part of the problem is that Baker is still tentative, even ambivalent, in his commitment to the populist agenda. He isn't as schooled as he might be in the supply-side growth arguments that he carried to Bonn, thus less sure of himself. But his deputy, Darman, has gotten himself up to speed on the intellectual side of things and for a while was providing his boss with the right rhetorical moves. There is no doubt that Treasury could be strengthened by the addition of a heavyweight Undersecretary for Monetary Affairs, a Lew Lehrman for example. But Baker is notorious for wanting to concentrate power in few hands, so there's not much chance of a personnel fix.

The answer lies in another realm. What Baker must now suspect, as a result of his experience in Bonn, is that he is indeed in a basic power struggle. What he may not fully appreciate is that it may be the most basic of all struggles. George Shultz has, after all, emerged as the most powerful advocate of the elitist agenda in the Administration. The firepower he assembled in Bonn against Jim Baker was not intellectual but political. Shultz shows every sign of awareness that he is the focal point of opposition to the populist reform elements inside the Administration, by stitching together alliances that are far more powerful than the organizational charts that Baker helped design.

The alliances are not only regarding matters economic. In an odd sort of way, Shultz finds himself contesting with the conservative populists on almost every issue of public policy before the Administration. This is because his worldview is essentially the same as it was during the Nixon years, the view of the Eastern Establishment, the Council on Foreign Relations, the Trilateral Commission, the elitist wing of the COP identified with the Rockefellers, Wall Street and the Business Roundtable. So much so that in 1980, when these Shultz allies were campaigning to get him the job at State (which first went to General Haig), Richard Nixon warned that Shultz would be a pushover for the international bureaucrats.

Shultz's principal adversary in the Administration has been Cap Weinberger, the Defense Secretary, with Shultz taking the accommodative line with the Soviet Union and Weinberger the confrontational line. But it has only been since Baker went to Treasury that Shultz had to worry about competition with the Treasury Department on international economic policy. Sprinkel kept Donald Regan safely penned inside the Federal Reserve boundaries, so virtually all foreign economic policy was made at State. Baker and Darman, though, want to internationalize the Reagan economic revolution. Hence the collision with Shultz.

Part of the drubbing Baker took in Bonn came over the monetary issue. But Shultz's alliance with the President's National Security Adviser, Robert "Bud" McFarlane, worked to undermine Baker's initiative on European tax cuts. Originally, the White House had planned to underpin the Baker initiative with a Presidential speech to the European Parliament in Strasbourg, France, on May 8. Under the guidance of Pat Buchanan, the new Director of Communications, a speech had been prepared that extolled the merits of supply-side tax cuts, entrepreneurial incentives and democratic capitalism in general. Shultz and McFarlane raised hell, arguing that we should not seem to be lecturing our allies on economic policy, that it could put strains on the alliance. The speech was killed and another prepared to the specifications of Shultz and McFarlane, leaving out economics and stressing U.S. willingness to negotiate with the Russians. The leftists in the parliament booed the President and walked out anyway.

Conservatives, by the way, are becoming generally alarmed at the direction of foreign policy under the Shultz-McFarlane alliance. The team, for example, has been so soothing in reassuring Europeans that "Star Wars" is only a research project — with nothing serious likely to be done for years and years — that even the Russians are being soothed. Even Henry Kissinger, not usually admired by conservatives for his opinions on nuclear strategy, is wondering aloud why we seem to be giving away the store on "Star Wars" after it brought the Soviets to Geneva.

Pat Buchanan also figured in a parallel struggle with McFarlane and Shultz over the Nicaragua contras. The question was whether the President should address the nation asking support for $14 million in humanitarian aid to the contras, or whether he should ask public support via TV for Senator Dole's budget cuts. Buchanan pushed for the contras. Shultz, McFarlane and Stockman went for the budget-cut appeal, and they won. The budget-cut appeal did nothing. But the awareness on Capitol Hill that the President shied from a TV appeal for the contras no doubt hurt that effort. When Nicaragua's Marxist leader Daniel Ortega celebrated his victory in the U.S. Congress with a trip to Moscow, conservatives figured there was sufficient disillusionment with the Sandinistas to turn the aid vote around. It was surprising to see the President instead pushed into a trade embargo of Nicaragua, which neutralized the fresh hostility toward the Managua regime. Conservatives, who would rather have the aid to the contras, envisioned President Reagan making hay in Europe over the Ortega trip to Moscow. They were appalled by the trade embargo, blaming McFarlane and Shultz for incompetence and worse.

All of this bears on the character of President Reagan's second term. James Baker III must be aware that he was humiliated in Bonn by the wily Secretary of State, although the press corps isn't writing it that way. (Baker gets a free pass and Mitterrand is the bad guy.) But it's not clear how the contest will develop from here or if there will be a contest. Will Baker put up a fight or will he behave, submitting to Shultz's views on the world economy? Obviously he gave up in Bonn after counting noses and firepower. But how will he play it from here?

If he is going to take on Shultz he surely knows he can't do it alone, that he would have to stitch together a natural alliance with others in the Administration who are also contesting the Shultz agenda. In the process he would become the leader in the Cabinet of the forces of economic growth and global democracy, the agenda Shultz and his allies resist. Weinberger, of course, would be a natural ally. So would Pat Buchanan, who has the clearest intellectual commitment to the populist growth agenda and as a result is under constant attack by the Establishment forces inside the Capital Beltway. The new White House chief of staff, Donald Regan, seems to be enjoying himself above this particular fray, so far not taking sides.

Chances are that Baker will bide his time and pooh-pooh talk of competition with Shultz. But because the same fundamental battle of agendas is going to be going on under his nose, it's not likely the Treasury Secretary will be able to avoid committing himself on one side or the other. His alter ego, Darman, seems to have come over emotionally as well as intellectually to the reformers, and Baker knows from his years next to the Oval Office that the Boss also tends in that direction.

The period ahead will provide ample opportunities to observe the progress of Jim Baker in the cruel world he has just discovered. We will see if he attempts to make amends to Mitterrand, and if there is more rather than less activity in Treasury that could lead to a monetary conference. Even before he left for Bonn, Baker had the beginnings of an understanding with Paul Volcker regarding the unreliability of the monetary aggregates, effectively muzzling Beryl Sprinkel's complaints about alleged excesses at the Fed. Volcker's views on European tax cutting and fixed exchange rates also point in the direction of a potential working relationship with Baker. This simply wasn't possible as long as Sprinkel was at Treasury.

Most immediately, though, the tax reform proposal will consume Baker's energies. But this will also be revealing, as we observe how he reacts in the crunch that's coming. So far, it's been easy for him to take the Treasury I proposal that infuriated all the special-interest groups and, with a little pushing and shoving, get it looking fairly respectable. The problem is that the Treasury II proposal they are urging the President to embrace — and present to the nation next week — couldn't pass into law.

The simple reason is that two of the provisions of Treasury I it retains, a top personal income-tax rate of 35 percent and the non-deductibility of all state and local taxes, can't exist together. The high tax states would combine to oppose the reform on this ground alone, which is the reason why both the Kemp-Kasten and Bradley-Gephardt bills pitched their top tax rates at 30 percent and lower. The 5 points at the top makes an enormous difference in this context.

Kemp-Kasten gets the top rate to 30 percent by employing a wage credit that soaks up the $10 billion the 5 points would cost the Treasury (getting the money on a graduated scale from people with incomes above $40,000). Bradley-Gephardt gets the money by limiting home mortgage-interest deductibility for higher-income earners, a route rejected by the President. Baker, rejecting the Kemp-Kasten solution, is forced by simple arithmetic to a 35 percent rate that will keep the reform from flying. It's too heavy. The recommended solution — by The Wall Street Journal — is to simply accept the static revenue loss of $10 billion, on the grounds that everyone, all reputable economists from all schools, accepts the proposition that a 30 percent rate will increase the efficiency of the economy, pull revenues out of the underground economy, and yield more than $10 billion in revenues. (We're back to the Laffer Curve!)

At the beginning of the negotiations between the Administration and the congressional proponents of tax reform, Rep. Kemp told the Treasury team that whatever they did, he had to have a top rate no higher than 30 percent in order to be able to sell the package inside New York. New York Gov. Mario Cuomo will breathe fire even at 30, if state and local taxes are non-deductible. But 30 could be sold, says Kemp. Buchanan agrees. Does Baker? One possible way out: A maximum tax of 25 or 30 percent, where the marginal rate can go as high as 35 percent, but then falls to the lower rate when the total average tax reaches 25 or 30 percent. It's encouraging that Treasury is now straining to make things work.

On the surface, at least, the Bonn summit was a disturbing setback to world economic growth. But there was an interesting conflict behind the scenes that may have been more important in the long run to the prosperity of the planet than what we saw up front. The cagey old Secretary of State taught a lesson in international politics to the fledgling Secretary of Treasury. Round One to State.