Thursday, January 17, 2008

Back to the ’70s?

Stocks are having a rough new year, and it doesn’t bode well for the future health of business, the economy, or the country for that matter.

Maybe it’s just a long-overdue correction. But it seems like something else is at work. And since I believe stocks are a key barometer of our nation’s health and wealth, it’s worth paying attention to.

The early primaries, either the day of or the day after, have been greeted with plunging stocks. Soft economic data are greeted by plunging stocks. Ben Bernanke’s testimony today was greeted by plunging stocks.

Year to date, the major averages are down 6 to 10 percent. It’s the same story overseas, where Europe, Asia, Latin America, and even the fast-growing emerging markets have sold off. The Dow Jones world index is down 7.5 percent.

There may be a hundred reasons for all this, including recession and the lack of any inspiring political leadership from Democrats or Republicans. Or maybe the investor class is simply in a bad mood.

But listening to the so-called stimulus plan being discussed in Washington, I must say it sounds like we’re back in the 1970s, when presidents Nixon, Carter, and Ford (you can throw in LBJ, too) conjured up economic policies that were inimical to growth and strongly biased toward inflation. In those days, unemployment and inflation moved up together, instead of moving in opposite directions. This was contrary to what the Keynesian economic fixers advised -- Keynesians like Republicans Herb Stein and Arthur Burns, and Democrats Walter Heller and Charles Schultz.

Here was the problem: In order to fight inflation, policy makers raised taxes. In order to fight unemployment, economists pressured the Fed to rapidly expand the money supply. It wasn’t until Milton Friedman weighed in that people realized the core of the problem: Too much money was chasing too few goods.

When Nixon unhinged the dollar from gold, there was no governor on the U.S. money supply. This monetary expansion substantially increased aggregate demand. And yes, the economy would periodically get a short-term spurt. The problem was that higher tax rates, either through legislation or inflation, stifled producers and investors. So the supply of goods and services was held down while the demand for them was increased. This stagflation raised unemployment and inflation at the same time.

Sound familiar?

What we’re hearing from Washington is cause for Ben Bernanke to gun the money supply and drop interest rates more. At the same time, Congress wants to spend more (either through temporary tax rebates or more spending, or both) and pay for it all with a tax hike at some later date. That tax hike could mean overturning the Bush tax cuts, or new surtaxes on high-end producers and successful earners.

It hasn’t happened yet, but it does have a ’70s feel to it: Tax the suppliers of new capital, goods, and jobs, and stimulate the demand of everybody else. With all manner of confusion on the campaign trail (especially with Hillary and Obama pledging to tax rich people), and considerable uncertainty about the Republican election outcome, the stock market may be signaling its fear that there is no Ronald Reagan to turn things around.

Reagan, of course, slashed tax rates on producers, thereby igniting aggregate supply, while Paul Volcker curbed the money supply to control aggregate demand. Even more goods were chasing modest expansion in overall money demand.

The Bush White House has some tough calls to make right now. If they press for an across-the-board tax-rate reduction (Bush investment tax cuts plus corporate tax cuts), it would generate the necessary output of goods and services in the years ahead and would permit Ben Bernanke to ease money growth without fears of inflation.

It remains to be seen just who will eventually win this political tug-of-war. But it’s clear that stock markets are not overjoyed at the potential outcome.