CAN REAGAN ADD UP?

Ambrose Evans-Pritchard argues that

politics caused the crash and only politics can stop it now

Washington AT the top of the Wall Street Journal's editorial page was an article by Arthur Laffer, one of the architects of Reagano- mics, arguing that loose monetary policy caused the stock market crash. This, then, was the definitive verdict of the supply-side theorists. But no, at the bottom of the page was a second article by another leading supply-sider, Paul Craig Roberts, saying precisely the opposite: that tight monetary policy was to blame. Not that Keynesians have done any better. They have been unable to agree among themselves whether the American economy has been in an inflationary or deflationary climate of late. It shows how much insight economists can give us into the madness of the last two weeks. It is notable that the only market analyst to give a clear, unequivocal warn- ing of the October crash did so for political reasons. Francis Curzio, publisher of the FXC Investors Corp. newsletter, says it was the Bork fiasco that alerted him.

The Reagan presidency began to crum- ble a year ago with the Danilov hostage swap, the tipsy leadership at Reykjavik, the loss of the Senate, and then the awful news that America had cut a deal with Iran. Reagan limped through the scandal, losing half his staff and half his stature, and leaving a demoralised administration that has ceded the initiative to Congress. Reagan has sallied forth only twice since the summer: for the Contras and for Judge Bork. In both he displayed bad timing and a loss of touch. He waited too long after Oliver North's Nicaraguan lectures to re- quest fresh aid for the Contras, by which time the House Speaker, Jim Wright, had already snookered him with a Central American peace plan. The award of the Nobel Prize to the Costa Rican President, Oscar Arias, is the last straw. Unless the Sandinistas make a lunatic blunder always possible — Contra aid is a lost cause.

That was to be expected in the end. America has no stamina as an imperial power, and the establishment has never liked the Contras. But one expected better for Judge Robert Bork. In 1981 he was confirmed unanimously by the Senate as a Federal Appeals Court judge. His subse- quent opinions have been unremarkable. If anything, they have been slightly to the Left of the Supreme Court itself. Nobody could accuse him of being a Somocista, surely. Yet within three months the in- dignation industry had indeed turned him into a Somocista, an agent of fascist jurisprudence disguised as a moderate. His vilification was sickening, but instructive. So was the 58:42 Senate vote to reject him for the Supreme Court. It showed why it mattered that Reagan had lost five South- ern senators in the 1986 mid-term elec- tions.

At first it was not clear. The 'conserva- tive coalition' still seemed to be intact and 'bou-weevil' Democrats were expected to vote with the Republican minority much of the time. But the coalition collapsed as Southern blacks, wrongly seeing Bork as a racist, held the feet of their senators to the fire. When Senator Howell Heflin of Ala- bama, the key Southerner on the judiciary committee, announced on 6 October that he would vote against Bork, the Dow Jones plunged 90 points within an hour. What disturbed the market was the craven submission of the Senate to interest group pressures. In this instance the lobbies happened to be liberal activists and minor- ity organisations. Next time they may be protectionist.

There are currently two immensely laden trade bills being synthesised in the conference committee of the House and Senate. Even if the Gephardt amendment, which mandates sanctions against countries that run persistent trade imbalances with the United States, is cut from the final bill, it is still likely to be an atrocious piece of legislation. Until recently, however, it had little chance of becoming law. President Reagan had vowed to veto it. But lately. the White House has been hinting that it would find a compromise more constructive than a showdown, which is code for saying that Reagan is now so weak he cannot count on a third of the Senate to sustain his veto. This year the President has already seen his veto of the extravagant Highway Bill over- ridden by a chamber that dares not take on the construction industry. Now it looks possible that the combined forces of the American Federation of Labour and the declining industries of steel, automobiles, textiles and shoes — to name but four may succeed in intimidating a veto-proof majority of Congress to buckle on protec- tionism.

It would be a calamity. It is often forgotten that the 1929 crash did not lead to the great depression. The Dow Jones fell from 298 to 230 but was back up to 294 by the next year. It was the 1930 Smoot- Hawley Tariff Act, which President Hoov- er finally decided not to veto, that began the disastrous contraction of world trade and the collapse of the stock market. To- day's protectionist-in-chief, Congressman Richard Gephardt, is doing a little too well in his bid to win the Democratic presiden- tial nomination for 1988. Like all protec- tionists, he claims his policies are designed to expand trade by forcing open foreign markets. He also talks of shielding Amer- ican workers against slave-wage competi- tion from abroad, though in truth the bulk of the $170 billion trade deficit is with high wage economies.

Black Monday has not dampened enthu- siasm for a depression bill. Nor does it seem that Washington will remember another terrible lesson from the 1930s: that tax increases are recessionary. The Federal reserve is not compounding the crisis with tight monetary policy, which thankfully spares us the Hoover hat-trick. But tax increases alone can do damage enough and there is an almost unquestioned consensus here that they are now both necessary and inevitable. The Republican leadership is broadly resigned to this, with the exception of strict supply-siders like Representative Jack Kemp, whose stock is falling. Presi- dent Reagan himself has given up defend- ing every last inch. After a lugubrious session with the Treasury Secretary, Jim Baker, and the Chief of Staff, Howard Baker, the detente duet, he agreed to parley with the Congress, protesting only that he would never accept 'a tax that has a deleterious effect on the economy'.

This tax obsession comes from the no- tion that the budget deficit, presumed to be a function of the trade deficit, is the cause of the crash. It is an odd assumption. The budget deficit fell from $221 billion in fiscal 1986 to $148 billion this year, a huge drop.

At the same time the States and municipa- lities have built up a $64 billion surplus.

The combined public-sector borrowing re- quirement is therefore only $84 billion, which is under two per cent of GNP, one of the lowest in the industrial world. True, it should be lower. America does not save enough to finance both the deficit and its investment needs without drawing on fore- ign capital. It also exacerbates the trade deficit, as long as the rest of the world is crawling in second gear. Moreover, the budget deficit is likely to creep up to around $165 billion next year, once the .windfall effect of tax reform is over. President Reagan and the Congress are discussing a minimum $23 billion reduc- tion.

The political debate in Washington seems to have stopped at this point. Hardly anyone in the Congress is weighing up the relative effects of achieving the reduction through spending cuts instead of through taxes. Reagan's insistence that 'the deficit is due to too much spending', is being dismissed as a politician's distaste for unpopular taxes. But the President may be right to insist that if you 'go beyond a certain point with taxes, you don't get more revenue, you get less'. Adam Smith strenuously explained this two centuries ago.. Arthur Laffer updated it with a modern graphic version when he drew his famous curve on a napkin. The difficulty lies in quantifying the effect of the Laffer Curve. The Harvard economist, Lawrence Lindsey, calculates that a top federal in- come tax rate of about 35 per cent yields the highest possible tax revenue in the United States. If his figures are anywhere near right then new taxes need to be on consumption, petrol, for example, that do not tamper with the incentive structure. But here too there is a snag. Indirect taxes are invisible: you forget you are paying them. They are an invitation to creeping statism.

That goes to the heart of Reaganomics. David Stockman, Reagan's first budget director and now the reviled apostate, says he never really believed the 1981 tax cuts could pay for themselves by stimulating economic gromith. He soon realised that the $28 billion budget surplus projected from 1986 was nonsense. But that was not the point. The deficits were deliberate. They were intended to `disfund the Left, starve the bureaucratic complex and the welfare state, and force spending cuts that would be politically impossible without the discipline of deficits.'

It was a colossal failure. Social insurance and poverty programmes were 9.5 per cent of GNP in 1980 and they were 9.5 per cent of GNP in 1986. Vested interests thwarted Stockman at every turn. He watched agri- cultural subsidies rise to $26 billion as dairy farmers were paid $1,300 per head not to milk their cows. It was not only the Democrats: Republicans were just as bad. The whole institution of Congress was rotten, driven by pork barrel politics. Sur- prisingly, he concluded that the executive branch was little better. Faced with resist- ance from his departmental chiefs over spending cuts, Reagan would yield.

Even so, Reagan may yet win half the battle. When he raised taxes in 1982 the Congress promised spending cuts in ex- change, but never delivered. This time the Congress has been so shaken by the crash that it may actually keep its word. If so, Reagan will at last have broken the ratchet effect of big government whereby deficit spending is eventually and invariably fol- lowed by increased taxes. But he has much else to answer for. By raising the military budget excessively, to 6.7 per cent of GNP, and by failing to pay for it with taxes, he has more or less guaranteed that there will be a backlash against the Pentagon in the next administration.

The silver lining of the stock market crash is that it has tempted Gorbachev to over- play his hand. His last-minute volte-face on SDI is patently calculated to extract more from the beleaguered President. With luck, Gorbachev will continue to press his advantage; an increasingly irritated White House will resist, and we will be spared a bad treaty. Much too much has been made of Reagan's desperation for a Soviet sum- mit in order to save his presidency. SDI is one of his core beliefs. The second silver lining is that the crash happened now rather than in the middle of 1988. It gives the Republicans a year to recuperate. Since it is in large part a political crisis it can, perhaps, be calmed by political action.

The market wants evidence that there is leadership in Washington, that Congress and the White House are capable of putting together a bipartisan budget pack- age. The figures matter less than the gesture, so long as the cut is measured and a good chunk of it comes from the spend- ing side. If successful it would do most for the presidential candidacy of the Senate minority leader, Bob Dole. The last week has seen him in the limelight, and he has performed well. Tough, practical, and above all Middle American, he enjoys the reputation of never having believed in Reaganomics. His chief rival for the repub- lican nomination, Vice-President George Bush, has somewhat lost that advantage even though he invented the term 'voodoo economics' in the 1980 primaries — and is tied to the mast of Reagan's sinking ship.

Even if there is a recession it will not necessarily harm the Republicans at the presidential level. Both Dole and Bush have the stature to inspire confidence in a crisis. The same cannot be said of the Democratic B-team. Governor Michael Dukakis of Massachusetts, a frugal budget balancer, who has raised as much money as all the other Democratic candidates together, looks strongest. Believing in neither the free market nor New Deal spending, he has tried a dirigiste experi- ment, akin to the Japanese planning minis- try Miti, that has helped bring his state's unemployment from 12 per cent to the current amazing 2.5 per cent.

The Democratic field does not include a single candidate who has ever served a full term in the Senate. The six survivors are more or less competent, but watching them together on the rostrum giving stylised and mostly identical left-wing speechlets at their umpteenth televised debate, one be- gins to ask if this can really be the choice.

The Democrats have failed to capitalise on the misadventures of Ronald Reagan. In the Iran-Contra hearings they managed to belittle the President without gaining any stature themselves. The result was a general disgust with Washington that en- compassed both the White House and the Congress, a sense that government was breaking down. The stock market crash is following the same pattern. It is a crushing blow for Reagan, yet no Democrat has emerged with distinction. Nor can the party simply fall back onto its New Deal tradition. If the crisis subsides it may have the paradoxical effect, through the timely release of air from the debt balloon, of prolonging the economic expansion through the 1988 elections. If not, America will be going into a recession with an unprecedented fiscal deficit, for which the Democrats have no answer.