A Reagan Rebound Jude Wanniski August 3, 1987

Executive Summary: President Reagan has survived the political coup attempt of the Iran-Contra hearings and could potentially hit a winning streak to year's end with his revived agenda. The Bork nomination, aid to the Contras, a deal/summit with Gorbachev, all seem in better shape. The trade bill is the iggest hurdle he faces, with divided interests from the two Bakers, Howard and Jim. The Chief of Staff wants a compromise bill out of the House-Senate conference this fall that the President can sign; the Treasury Secretary expects the bill will have to be vetoed, destructive to commerce even in diluted form. The variables suggest a veto will be sustained and trade will be a focal point of the 1988 elections. Enactment of protectionist legislation would sock bonds as well as stocks; Fed Vice Chairman Johnson warns of credit tightening if it passes. As the threat passes, though, the Fed's dilemma will be a happy one. The economy is stronger than it seems, Americans shifting income forward to 1988's lower tax rates. Next spring, GNP, tax revenues, money supply and consumer prices should all be higher than now expected. The new Fed chairman will then have a dilemma of his own. Democrats demanding that he tighten to prevent an inflation that has already occurred. A sporty course for a rookie.

A Reagan Rebound

President Ronald Reagan is clearly a happier man these days, not only surviving the Iran-Contra congressional hearings, but even emerging with a cushion of moral authority that could nourish him for the remainder of his presidency. He remains a "lame duck," as we understand the term -- without mandate, resources or time to undertake major initiatives or reforms. But he isn't crippled. And there is a sense in which the Democratic Congress, having failed to destroy or even cripple Ronald Reagan as it had Richard Nixon, has been humbled. The snappishness among congressional liberals reflects a gnawing fear that Reagan will get back on top and somehow make them pay for their failure, mobilizing public opinion behind what had been a defunct agenda.

The climate in Washington is foul indeed, the partisanship intense. Horace Busby, once a close aide to President Lyndon Johnson and now one of the shrewdest of Washington observers, wrote in his July 17 political letter: "Hatred for FDR, while he lived and after, is political legend; no other President evoked so much. Mr. Reagan is not yet in the same class, but as his term approaches an end, there is a welling up of intense feeling against him. Among some elements, he is Beelzebub, a chief devil personifying all that is wrong in the society."

President Reagan's most passionate loyalists exaggerate only slightly in arguing that this hatred for Reagan and Reaganism is behind the Iran-contra hearings, as an attempt to destroy the Reagan presidency. "If you shoot at a king, be sure you kill him," Pat Buchanan observed in The Washington Post of July 19. The President's former director of communications asserted that "For the last six months, the left wing of the Democratic Party, and its auxiliaries in the press, have sought to use the Iran-contra affair to cripple and kill the presidency of Ronald Reagan as they used Watergate to kill the presidency of Richard Nixon. They failed, Mr. President; they are retreating in disarray; and now is the time to let the jackal pack know what it means to strike a king."

It isn't clear that President Reagan realizes what an opportunity has been handed him. But if he took the offensive at the ripe moment, he could rally the sheepish Republicans who had doubted him in his darkest hours. He could pull in conservative and moderate Democrats who now doubt their own leaders. He could get aid to the Contras, win confirmation of Judge Robert Bork to the Supreme Court, demolish the protectionist forces in Congress with a sustained veto of the trade bill, and command a respectful position on the arms talks, SDI and a Gorbachev summit.

What is working against a revived Presidency is a weak White House staff that seems almost disappointed in the turn of events, as if a stronger Ronald Reagan means a diminished Howard Baker Jr. In the weeks since Lt. Col. Oliver North began his testimony, the White House has been a study in political ineptness, with a daily "posture statement" that seems designed to undermine the President's credibility. The President is not watching Colonel North's testimony. The President is watching a little bit of Colonel North's testimony. The President feels vindicated by Colonel North and Admiral John M. Poindexter. The President is angry with North and Poindexter for keeping secrets from him! Chris Wallace of NEC reported July 21 that he was told the President was so angry with the Admiral and Ollie that he might not pardon them if they are indicted and convicted! There's scarcely a man, woman or child in the United States who believes the President is angry at Ollie North and Admiral Poindexter. But the Howard Baker regime at the White House can only think in terms of conciliation toward Congress — even failed, would-be assassins.

The President's stance toward Congress -- dominant or submissive -- will contribute to the success or failure of the Bork nomination, the Contras, an arms agreement and summit. But it will be absolutely critical on the trade bill. The Democrats would be sorely irked in losing on these other issues, but if they can maneuver Reagan into signing a protectionist trade bill the victory would be sweet enough to compensate for the other defeats.

The last thing the Democratic leaders want is a successful override of a Presidential veto on trade. The Smoot-Hawley Tariff Act, passed for the most part in 1929 by a Republican Congress and signed by a Republican President in June 1930, ended the GOP's long reign as the majority party. The measure brought the Wall Street crash of 1929, triggering the Depression, and leading toward world war. The Democratic leaders are now on that same thin ice. Unless they are very careful, the trade bill that emerges from a House-Senate conference committee sometime this autumn would have dire effects on the world economy and, if it passed over a Reagan veto, would set the stage for Republican dominance of Congress and the Presidency in the 1990s.

The best outcome for the Democrats would be a "bipartisan" bill that would have the support of Howard Baker and Republican leaders of the House and Senate, who would urge the President to sign and thereby put the issue behind both parties in advance of the 1988 elections. We can imagine a point at which the conference committee bill can be described to the President by Howard Baker, Special Trade Representative Clayton Yeutter, and a new Secretary of Commerce as: "Not a perfect bill, but certainly one that you should be able to live with, Mr. President." It is exactly that point the committee will be working toward.

Chances the committee will be able to reach such a point are made difficult by the fact that Treasury Secretary James Baker III, knowing it is unlikely that he will be happy with the conference committee product, must assume the process will play out with a presidential veto and a fight to have the veto sustained in the Senate. The House would override a Reagan veto, everyone assumes, partly out of belief that the Senate would sustain. In 1929, the House easily passed Smoot-Hawley in March, but with many members sure the Senate would kill the legislation in the autumn.

In a way then, the tension over the trade bill is between the two Bakers, Howard and Jim. The chief of staff, a creature of the Congress, is a master of compromise and conciliation, which in this case makes him dangerous. By its very nature, the trade bill is an aggregation of parochial interests; smoothing it out will not make it any less nationalistic. The Treasury Secretary, on the other hand, has developed an international perspective, imperfect as it has been in its policy implications. His counterparts in the finance ministries of the world are counting on him to prevent destructive legislation, and there is little in the House and Senate bills that isn't.

The legislative impulse, remember, is the U.S. trade deficit, which can be reduced by either increasing investment opportunities in the rest of the world or by decreasing investment opportunities in the U.S. Growth of U.S. investment opportunities has been triggered by the Reagan tax reforms -- transforming the U.S. in 1988 into "the world's largest tax haven," as The Wall Street Journal puts it. Unless Japan and Western Europe -- not to mention the Third World ~ begin hacking away at their high marginal income-tax rates, capital flows into the U.S. will continue at high levels in 1988. Which means a continued high trade deficit.

The Democratic trade bill aims at "opening markets" abroad as the means of cutting the U.S. trade deficit, threatening either export subsidies or import barriers vis-a-vis countries that run trade surpluses with the U.S. The House-passed Gephardt amendment is the most egregious of the protectionist elements that are layered in both the Senate and House bills. It would automatically raise tariff barriers by specified amounts against surplus countries. This provision will be rewritten in the conference so it could be presented as a "moderate compromise." But other measures that have received little press attention are just as horrendous. The House-passed exchange-rate equilization tariff was designed around the false and destructive notion that a currency devaluation can adjust a trade deficit. The measure would require the Treasury to adjust the dollar exchange rate in accordance with this bogus hypothesis.

Other measures would either strip the President of authority to overrule protectionist findings of the International Trade Commission, or would increase the burden on the White House to cave in to special interest pleadings on trade. None of these measures should be acceptable to the President, but almost certainly the compromisers on the President's staff are prepared to swallow them in some form.

As in 1929, the legislation will emerge with all kinds of special inducements to parochial interests and individual legislators to bribe them into support of a measure they would otherwise oppose. The Senate repeal of the "windfall profits tax" pulls in oil-patch Senators who might otherwise be in opposition. There is a multi-billion-dollar bag of job-retraining money that aims at winning the support of state and local governments, who little realize the job-destruction potential of the rest of the legislation.

In the several weeks before Congress returns from its August recess and a Senate-House conference gets underway on the trade bill, the individual legislators will be hearing from their constituencies at the grass roots. This was also the pattern in 1929. The Senate was not in session in August, and as far as anyone knew, it was just as opposed to Smoot-Hawley in early September as it had been in July. But while the masses of people who are hurt by trade protection tend to remain silent, the small number who believe they will benefit are assiduous in seeking out their representatives and softening them up. We have to assume the Congress will be more, not less, protectionist come September, and President Reagan will have to be more alert to having wool pulled over his eyes in the conference bill.

There is always the chance that the Democrats will find themselves swept up by enthusiasm for the bill and will shape one they know the President will veto. As it stands, both Senate Majority Leader Robert Byrd and House Speaker Jim Wright are said by the White House to expect a veto to be sustained, with the trade issue then becoming a live one in 1988. They obviously believe it to be a winning issue, as John Connally did in 1980 and as Walter Mondale did, to a degree, in 1984.

A bill the President could easily veto on protectionist grounds might be overridden, of course. The 71-to-27 Senate vote for the trade bill was a clear setback for the free traders and the White House, who had wanted at least 34 votes to signal the strength to override eventually. The vote is a bit hard to interpret, though, because 52 Democrats voted for it with none opposed, clearly a party unity vote. Democratic Senator Bradley of New Jersey almost certainly would vote to sustain a veto, and he made a speech blistering a dozen of the worst elements of the bill even though he voted for it to further the process. Others in the Senate are in the same boat.

Of the 19 Republican senators who voted for the Senate version, 16 signed a letter saying they too were voting to further the process and would not vote for it on final passage unless it were moderated. Free traders can't take too much comfort in this letter. There are also senators who voted against the trade bill who will be tempted to swing back toward it as it is moderated in conference. At a critical moment next fall, the nose-counting on whether or not the President could win a veto fight might determine whether or not he signs the bill. Our best guess is that a vetoed bill will be sustained and the Democrats will not attempt a repair in order to resubmit and win in a subsequent round. The trade issue would become central to the 1988 Presidential campaign.

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In 1929, with the U.S. on a gold standard, the Smoot-Hawley shock did not severely damage the bond market. Stocks absorbed almost all the punishment. Short-term interest rates soared during the market crash, overnight money climbing over 20% in the liquidity squeeze, eventually falling back.

In 1987, with the dollar floating, passage of the kind of trade bill likely to emerge from this Congress would put severe pressure on the dollar. We got a whiff of it this spring when the semiconductor sanctions were imposed against Japan, with the Federal Reserve adding liquidity to keep overnight rates steady, thus letting the dollar fall, the gold price rise and long bonds decline. With a severe shock from protectionist legislation, it's likely that bonds and stocks would share in the punishment. But Federal Reserve officials are well aware how difficult life would be for them if the trade bill is enacted. Vice Chairman Manuel Johnson stressed this point July 29 in remarks at the Cato Institute in Washington, as reported in The New York Times the following day. He warned "that passage of protectionist trade legislation or a higher minimum wage would unleash inflationary forces — actual and psychological -- that the Fed would have to counter by tightening credit, perhaps severely." Governor Wayne Angell is also said to be alarmed at the prospect of almost any trade bill emerging as law. The new Fed Chairman, Alan Greenspan, is opposed to protectionist legislation in theory, but because he owes his appointment to Howard Baker, who wants some compromise legislation, it's probable Greenspan will waffle at some critical moment.

The pressure on the federal funds rate would force the Fed to either add liquidity to steady it, depressing the dollar against foreign exchange, shooting up the gold price and bond yields -- or, drain liquidity to steady the dollar and gold and protect bonds. A nasty choice.

The bright side is that if, as we believe, the protectionist bullet will be dodged, the entire interest-rate schedule will feel relief. The Fed's dilemma would be a happy one, adding liquidity to keep the dollar from strengthening or just sitting back and watching bond yields fall.

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The economy, we think, is quite a bit stronger than it seems statistically, and the illusion of weakness (particularly in personal income and savings) will intensify as we approach the end of 1987. The reason, of course, is the tax reform, which, as we have observed many times before, produces behavioral effects that baffle the government statisticians and cloud the national income accounts. From Main Street to Wall Street, the great preoccupation of CPAs and tax advisors is how to shift income forward into 1988 to take advantage of the top marginal income tax rate of 28%, from the current 38.5%, and how to shift expenses backward from 1988 to 1987 for the same reason. There are very few dummies in the U.S. when it comes to economizing on taxes.

There is, we're sure, a sizeable cohort of higher incomes that are even being moved across two calendar years, individuals finding ways to shift 1986 income to 1988. Because it's easiest to move income and expenses in the last quarter of the year, we have expected the last quarter will show up as a relatively weak one when Gross National Product is reported. But it will also mean a big first quarter in 1988 as income is finally received, invested and spent.

A second effect we have been inviting Fed and Treasury officials to contemplate is that more than one American, and perhaps millions of them, will consider the possibility that 1988 will be the low watermark on the top personal income-tax rate for this century. It is, after all, an election year, and should any of several Democrats gain the White House, there will be talk of surtaxes. This should have a prudent hedging effect, whereby people who have shifted past income into an indefinite calendar year through tax deferment plans — IRAs for example — will pull that income forward into 1988 in order to get it through the low tax gate.

All of this suggests not only bigger GNP numbers in 1988, but a one-time bubble of tax revenues that will pour into Federal coffers, and into state and local treasuries too. The projections of a weaker economy and bigger deficits in 1988 that are now coming out of the Congressional Budget Office and the administration are simply unimaginative. The same bureaucrats are still baffled as to why revenues surged this spring. Alan Reynolds, of course, in December based his lonely prediction of a 4.3% first quarter partly on this phenomenon.

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If GNP surges in 1988 as we expect, will the Fed tighten to shut it down? In October of 1983, remember, the Fed began its second deflation under Paul Volcker's chairmanship out of fear of Man overheated economy." The same income and GNP shifts had been occuring as a result of the 1981 Reagan tax cuts, which did not take full effect until 1984. The simple-minded neo-Keynesian idea that economic growth has an inflationary bias led the Fed to deny the demand for dollars that had been invited by the lower tax rates. The theory, propounded by liberal and conservative Keynesians, was that growth in excess of 3% was unsustainable and inflationary and should be avoided by a tightening of credit. The price of gold reacted, sliding from $400 in September 1983 to $275 in February 1985, when the dollar was at its zenith.

So will this happen again? The danger is that come next spring the signals will all seem "inflationary.11 The Keynesians will see GNP rising above 3%, the monetarists will see the monetary aggregates climbing as demand for dollars climbs. And the various price indices will be ratcheting up faster than most economists now suspect -- because the Fed this spring failed to defend the dollar. By allowing the gold price to climb from $400 to over $450, as if the climb meant nothing, the Board of Governors brought higher consumer and producer prices in 1988. Oil prices and commodity price rises will be followed by higher wage demands. Workers are not dummies either. Up goes the CPI.

Chairman Greenspan may tend to speak on the side of monetary ease at his first Open Market Committee meeting — on the grounds that the economy seems weak and the dollar hasn't fallen far enough to correct the trade balance. By next spring, after the horse has long gone from the barn, he will be pointing to the GNP, M-l and CPI signals and urging his fellow governors to lock the door with a monetary squeeze. Democrats will be demanding that he squeeze in order to demonstrate his independence from the White House and Republican Party!!!

Will the other governors go along? We encounter now and then a tendency to believe that Gov. Martha Seger and Gov. Robert Heller will never vote to tighten. But that implies an intellectual shallowness or absence of integrity on their part. My sense is they would likely vote to tighten in these circumstances and with those signals. To what degree is another matter. In any event, the Fed will be playing a sporty course in the next several months, with a rookie as captain. Hmmmm.

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Our fairly high degree of optimism is bolstered by the President's recovery. As Congress vacates the Capital for a month at home, President Reagan will have the stage to himself, preparing for the contests of autumn. My hunch is he will do better than almost anyone imagined a few short weeks ago, a bit lame, but not crippled. And happier than he's been all year.