Executive Summary: Whether or not it is officially declared, a "national economic emergency" confronts President-elect Reagan. A crisis atmosphere is borne of doubts that he will be sufficiently bold and quick in pursuit of supply-side economic reforms. Chances are high that he will be aggressive in advancing fiscal and regulatory reforms, but he may be tempted to follow dangerous legislative strategies. Chances are low that the administration will move boldly toward a classical monetary reform. Bond markets will remain volatile unless Federal Reserve policy is altered; a Reagan "task force" to study dollar/gold convertibility would help. The Reagan Cabinet is more promising than expected, especially with David Stockman at OMB. But Donald Regan at Treasury will probably be a burden to supply-siders. President Reagan's personal, post-Inaugural style will be important in determining the 1981 fate of his legislative program.
Waiting for President Reagan
In the summer of 1980, former White House Chief of Staff Donald Rumsfeld made the observation that the next President of the United States faced the distinct possibility of going down as the worst President in history. Others have come to the Oval Office with a cushion, said Rumsfeld, a "margin of safety." The U.S. has always been economically and militarily strong enough to permit the new President several mistakes while he got up the learning curve. Not so in 1981, said Rumsfeld. If the new President doesn't get things right from the start, his objectives at home and abroad could be overwhelmed by domestic turmoil and global strife. There's no time for trial and error.
The Reagan campaign picked up on the Rumsfeld "margin of safety" notion and incorporated it into the candidate's rhetoric in the last weeks of the campaign. It also led to the metaphor adopted by the Reagan transition team, which quickly became a journalistic cliche': The Reagan administration would "hit the ground running." In which direction, nobody quite knew, but with an urgent sense of mission, do-or-die, time running out, Ronald Reagan a take-charge hero or an instant goat.
Prior to the election, in this general spirit, the Reagan Transition asked Lewis E. Lehrman of New York City to submit a memorandum on his assessment of the post-Inaugural economic picture. The 42-year-old president of the Lehrman Institute, a financial wizard, was among the candidates for Treasury Secretary, his name put forward by Representative Jack Kemp as the favorite of the "supply siders." Lehrman submitted his memo to the Transition on November 6. Some of his observations:
The previous administration sewed chaos, and, I regret to say, President-elect Reagan may very well reap the whirlwind. If he is not ready, if he does not understand what is happening, he could easily be swept away by its hurricane velocity. The extraordinary coincidence is that these were very much the same conditions which greeted Margaret Thatcher when she inherited the whirlwind from her predecessors the big spending socialists. I might add that these were the very same conditions that caused the collapse of the Fourth Republic in France in 1958. Except that President DeGaulle understood the causes of collapse. The Fifth Republic, his creation, was born amidst his program for currency stability, budgetary equilibrium, and economic renewal and growth . . .
The following policies must be presented to the President-elect. Only he should reject them, for only he, in the end, must bear the consequences or the fulfillment of failure and success.
1) His administration must move much more rapidly than originally planned to establish budgetary equilibrium in the federal government.
2) The budgetary policy must be concerted with Federal Reserve monetary policy in a planned and coherent way. This coherence has been lacking in every economic and monetary program with the goal of stabilization in the past 20 years. Such a program in no way would compromise the independence of the Federal Reserve System. On the contrary, new procedures of monetary control, combined with budgetary equilibrium, could lead to the rehabilitation of the Federal Reserve System now, fairly or unfairly discredited in the marketplace.
3) Simultaneously we must move on a tax reform bill to be introduced not in November, but after the inauguration. The bill will implement marginal tax rate reduction and further reduction in capital gains taxes, while abolishing the inane distinction between taxes on income from savings and taxes on income from wages and salaries.
There are six months in which to decide and to act.... We are now in the midst of an ongoing financial crisis which has characterized the Carter Administration and the markets since the November 1, 1978 foreign-exchange panic which occasioned the first unsuccessful Fed-Treasury financial plan .... President-elect Reagan's transition has now been overtaken by a financial market crisis and economic events which are moving rapidly beyond control. This financial tidal wave has been coming in for years. It is now upon us.
It is now necessary for the President-elect to act discreetly but immediately . As he waits upon January 20, he must become prepared to undertake an emergency plan for economic stabilization and renewal at the onset of his Presidency. At this very moment he should organize a task force with the specific purpose of designing a program for economic stabilization and economic recovery the plan to be completed by Inauguration Day.
Copies of the Lehrman memo went to Rep. Kemp of New York and Rep. David Stockman of Michigan, Lehrman's allies in Congress. In turn, Stockman and Kemp constructed a longer, detailed memorandum entitled "Avoiding a GOP Economic Dunkirk" that Kemp submitted to the economic advisory committee to the Transition, in Los Angeles, November 16.
This review of the multiple challenges and threats lying in ambush contains an inescapable warning: things could go very badly during the first year, resulting in incalculable erosion of GOP momentum, unity and public confidence. If bold policies are not swiftly, deftly and courageously implemented in the first six months, Washington will quickly become engulfed in political disorder commensurate with the surrounding economic disarray. A golden opportunity for permanent conservative policy revision and political realignment could be thoroughly dissipated before the Reagan Administration is even up to speed.
The specific danger is this: If President Reagan does not lead a creatively orchestrated high-profile policy offensive based on revision of the fundamentals supply-side tax cuts and regulatory relief, stern outlay control and Federal fiscal retrenchment, and monetary reform and dollar stabilization the thin Senate Republican majority and the de facto conservative majority in the House will fragment and succumb to parochial "fire-fighting as usual" in response to specific conditions of constituency distress ....
In order to dominate, shape and control the Washington agenda, President Reagan should declare a national economic emergency soon after inauguration ....
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The most nerve-wracking aspect of the transition has been the apparent absence of the President-elect from the transition process. Yes, he is there on the perimeter, looking on, but there has not been the sense that he has been intellectually engaged. He is seen chopping wood at the ranch, having his hair cut, posing for a commemorative medal, seeing his tailor. Meanwhile, a Cabinet has been selected for him, rather than by him, or so it seems to even the most careful Reagan followers. A great debate swirls around his entourage on whether or not a national economic emergency should be declared on or after January 20. But the President-elect seems so casually disengaged, so laid-back, that we can imagine him being advised to declare an emergency, doing so, and promptly adjourning for a quick nap. On the other hand, his demeanor projects an unflappable, reassuring self-confidence of precisely the kind needed to preside during a national economic emergency. What seems most appropriate is a President Reagan who observes the fact of economic crisis, sets forth a sufficiently dramatic agenda to deal with it, invites the electorate to galvanize the Congress to action, and with nothing left to do, adjourns for a nap. In a sense, there would be no "crisis" atmosphere if we knew with certainty, in advance, that President Reagan would put forward exactly the right program for dealing with the situation. It would sell itself, or be relatively irresistible to Congress, and the financial markets, discounting the good news in advance, would usher in the Reagan years with a soaring stock market, plummeting interest rates, and a historic rally in bonds.
In other words, a crisis atmosphere exists because we don't know in advance what will finally happen when Ronald Reagan stops chopping wood. All the markets can do is peruse the transition externalities for clues to future action, and because there are so few definite clues, the markets move in crabwise fashion. Bulls and bears see-saw, guessing at what will happen after January 20, but are forced to wait upon the calendar for hard news. President Reagan doesn't have to declare an emergency. He just has to act like there is one, acting boldly, but more importantly, acting on the supply side.
The greatest danger remains the Old Guard, which is still extremely well represented in the transition and which continues to argue on behalf of caution. The Stockman-Kemp"national emergency" idea seemed to be received cheerfully enough on Wall Street, which has most to fear from the status quo, most to gain from policy change. Still, Arthur F. Burns clucked disapprovingly on Christmas Eve, joining those in the Carter Administration who warned that announcement of an emergency would have the effect of creating one. Where Reagan Chief-of-Staff James Baker had previously semi-endorsed the idea, it was then submerged by Reagan policy adviser Ed Meese. The problem is not that President Reagan will withdraw his commitment, say, to the Kemp-Roth tax cut, in the absence of a crisis atmosphere. The danger is that wheels can easily begin spinning on Capitol Hill if the voices of caution around Reagan persuade him to compromise early in the game.
The Old Guard continues to assert vehemently that Kemp-Roth, independent of dollar-for-dollar spending cuts, will be inflationary. This has been the view of Bob Dole, the new GOP chairman of the Senate Finance Committee. It is also the view of Rep. Barber Conable, the ranking Republican on House Ways and Means. The Reagan administration will hit the ground running with an ambitious tax bill. But it will also present, on a separate track, deep budget cuts. There will be an inevitable tendency on the part of Dole, Conable, etc., to delay tax-cutting as a reward for budget cutting. This traditionally unsuccessful GOP strategy fails to appreciate the role that high tax rates have in causing Federal outlays and revenue declines, that in other words high tax rates cause deficits. Stalling on the tax legislation would only prolong the weakness in the economy, extending the deficits. The preferable strategy would be to push hard on both tracks and let the tax track finish fast and count on economic expansion making it politically more palatable to cut into the budget.
A reason for optimism is the probability that Reagan will follow the latter strategy. If he also follows the counsel of both the Lehrman and Stockman-Kemp memos, and proposes ending the distinction between earned and unearned income for purposes of calculating income tax, the economy would get quite a lift. Because liberal Democrats would scream throughout that the measure was a "rich man's tax bill," which they are saying about Kemp-Roth anyway, there will be those in the White House counseling against such a move. If Reagan acts like a President with a mandate to cut tax rates, though, he would have no trouble at all getting the whole thing through. Liberal Democrats in both houses would have to resist at their peril. (If successfully carried out, this tax rate reduction to 50 percent from 70 percent on investment income would encourage supply-side income tax cutting all over the world; only "progressive" rhetoric keeps these rates, which produce little revenue, as high as they are everywhere.)
The probability that Reagan will follow a dynamic strategy on fiscal and regulatory policies no longer rests on speculation about his personal commitment. He has in fact appointed Rep. Stockman his Director of Management and Budget, and the 34-year-old whiz kid immediately became the single most important individual in Washington to the shaping of the nation's economic strategy. The most intellectual of the supply-siders in Congress, and, with Kemp, the earliest to champion a revival of classical theory, Stockman a year ago began devising the elements of the plan that surfaced in the Economic Dunkirk paper. In fact, he broke with the other supply-siders at the time and joined the Presidential campaign of John Connally, arguing that Reagan would not be tough enough in pushing the fiscal and regulatory elements of the plan through the Congress. The fact that Reagan has put him in charge at OMB is the greatest guarantee that the program will succeed. The most jaded veterans of Washington's fiscal struggles, who have come to believe it impossible to regain control of the Federal budget without first suspending democratic government, are forced to have doubts after meeting Stockman. Not only does he have the ability to think in terms of Grand Strategy, with a concept as least as big as the problem, he also understands the internal workings of the Federal establishment, how it all fits together. As a result, it is difficult to imagine Stockman losing a substantive debate within the Administration, easy to imagine Jim Baker and Ed Meese relying on him as they will no other among the economic players. This aspect of Stockman's potential is the central reason for bullishness among the supply-siders. It is one thing to draw up a plan, another to see it through. The idea that Reagan would appoint a budget director who believes that ultimately deficits are caused by high tax rates and the regulatory wedge tells us quite a bit about the President-elect. Here is the pertinent paragraph in the Stockman-Kemp memo:
A static "waste-cutting" approach to the FY 81 outlay component of the fiscal hemorrhage will hardly make a dent in the true fiscal problem. Persisting high "misery index" conditions in the economy will drive the soup line mechanisms of the budget faster than short-run, line-item cuts can be made on Capitol Hill. Fiscal stabilization (i.e. elimination of deficits and excessive rates of spending growth) can only be achieved by sharp improvement in the economic indicators over the next 24 months. This means that the policy initiatives designed to spur output growth and to lower inflation expectations and interest rates must carry a large share of the fiscal stabilization burden. Improvement in the "outside" economic forces driving the budget is just as important as success in "inside" efforts to effect legislative and administrative accounting reductions ....
For this reason, dilution of the tax cut program in order to limit short-run static revenue losses during the remainder of FY 81 and FY 82 would be counterproductive.
The dramatic market sell-off of January 7 was an echo to this Warning. The dive followed reports of Donald Regan's confirmation hearings, in which he argued that it would be 15 months before the Reagan economic program would have beneficial effects. This dismal prognosis, reflecting Alan Greenspan's private forecasts to Regan, implies much greater deficits in the short run. This, in turn, implies the need to "save" revenues in the short run by deferring the effective date of Kemp-Roth. Indeed, this was the news the market was getting late on the 6th and early on the 7th, that Kemp-Roth would not be made retroactive to January 1, as Reagan had promised. Its effective date would be its date of signature, presumably, or perhaps January 1, 1982. The ominous implication was that the tax cut would be used as a carrot to effect the spending cuts a strategy doomed to failure as it has always failed in the past. The news was surely grounds for bearishness if you could not bank on its being a temporary set-back. Greenspan's influence, we trust, will diminish somewhat after the inauguration, and Stockman's will crystallize, as long as he doesn't lose his nerve. Tax cut retroactivity is critical to the entire economic program representing a political commitment to the classical strategy as opposed to Greenspan's static Keynesian approach.
Stockman is a classical economic proponent in every sense, supporting the idea of monetary reform that restores dollar convertibility at a fixed dollar/gold ratio. Indeed, he wrote the final draft of the "gold plank" in the Republican platform last year. And he is certainly aware that positive movement along the fiscal/regulatory track could be offset by ill-conceived, negative policies by the Federal Reserve. But it is doubtful that his position and influence at OMB will be sufficient to bring about the necessary monetary reforms. The impetus has to come from the Treasury, which is chiefly why Stockman, Kemp et al urged the appointment of Lehrman to the top post, or at least Undersecretary for Monetary Affairs. The appointment of Donald Regan was viewed as a marginal improvement over the early candidates, William Simon and Walter Wriston, only in the sense that Simon and Wriston were proponents of the current inconvertible "floating dollar" a decade ago, and have been defenders of it every since, which made it extremely unlikely that they would willingly participate in a hard-money reform.
The chance of a hard-money reform in 1981 diminished with the appointment of Regan to Treasury not because he is against the idea, but because he has no understanding of the issue. This suggests he would be guided by conventional wisdom, the status quo, unless direction to the contrary came from the White House itself. This could be achieved by installation of Lehrman at the Monetary post of the Treasury Department by the White House. (Such a move would thus be reason enough for a bond-market rally.) And while the supply-siders believed it would happen, the opponents of a convertible currency have thus far been able to prevent it. William Simon and Bill Casey, who were instrumental in swinging the Regan appointment, have argued within the Reagan inner circle that Lehrman is too inexperienced for the job. Regan reportedly has vetoed Lehrman for the opposite reason, that Lehrman would be viewed as qualified, at a moment's notice, to replace Regan as Secretary.
In any case, the prospect of a classical monetary reform to end the inflation is not in sight. Certainly the fiscal and regulatory reforms that will unfold after January 20 will be encouraging to the financial markets, and despite Paul Volcker's fears, will make life easier rather than harder for him. But insofar as the inflation and interest rate peaks are chiefly the result of monetary mismanagement by the Federal Reserve, we would have to expect continued volatility in interest rates, high rates of inflation, and a bond market that may be enormously interesting to speculators, but not to investors.
To Alan Greenspan and Arthur Burns, who will remain influential at the Reagan White House via their protege at the Domestic Council, Martin Anderson, dollar convertibility is not possible until inflation is ended. To the classical theorists, convertibility would be unnecessary if monetary authorities could end inflation without it. There is, though, a consensus developing among the supply-siders and monetarists in their criticism of Federal Reserve policy under Volcker. There may be an administration statement, then, directly urging the Fed to control its own liabilities, which it has the ability to do, instead of trying to manage the money supply, which it has demonstrably failed to do. In regard to convertibility, at the very least we might expect a Reagan "task force" to study the issue, a move that in itself would be bullish for bonds and stocks signaling the President's interest and openmindedness.
This is really what we expect most from a Reagan administration, a continued willingness by the new President to entertain ideas that have been forbidden around the White House for years. As long as debate continues, as long as there is intellectual ferment around the Oval Office, the "right ideas" will remain live possibilities for policy.
This is what has been missing during the transition, though unavoidable, given the President-elect's proper sensibilities about the transference of power. What we have tended to forget during this wood-chopping period is that Reagan is precisely this kind of a politician, and that he is no doubt going to be this kind of President. This is worth quite a few chips, because it is a popular style. All the pre-Inaugural tea-leaf reading, especially surrounding the Cabinet selection process, gives us important clues about the direction of a Reagan administration. And for the most part these have been promising clues. But in only a few weeks we will have a lot more to go on, with an inaugurated President Reagan hitting the ground running. We're betting with the bulls.
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