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 The Presidential Election Cycle
Theory and the Fed
By Henry C K Liu
The Presidential Election Cycle
Theory (PECT) of stock prices suggests that stock-market
moves follow the four-year US presidential election
cycle, with stocks declining soon after a president is
elected when harsh and unpopular measures are necessary
to bring inflation, government spending and deficits
under control for the long-term health of the economy.
During the first half of the new term, taxes may be
raised and the economy may slow or even slip into
recession. At about midway into the four-year term,
stocks should start rising in anticipation of the
economic recovery that the incumbent president wants to
be roaring at full steam by election day. The cycle is
supposed to repeat itself every four years.
Of
course there is the supposedly independent central bank,
known in the United States as the Federal Reserve, which
sees its job as leaning against the wind of business
cycles through counterweight monetary measures, in
addition to setting long-term monetary policy against
inflation to preserve the value of money. Independent
central bankers have been blamed for losing the election
for incumbent presidents, as Paul Volcker did to Jimmy
Carter in 1980 and Alan Greenspan to George Bush Sr in
1992. They also have been accused of tilting monetary
policy to help an incumbent get re-elected, as Arthur
Burns did for Richard Nixon in 1972.
The late
Arthur Burns, a conservative Austrian-born economist at
Columbia University, was appointed Fed chairman by
president Nixon in 1969 and served until 1978. The Burns
era was the most opportunistically political in Fed
history, with Burns' ill-timed economic pump-priming
designed merely to ensure Nixon a second term, by
engineering money growth to a monthly average of 11
percent three months before the 1972 election, up from a
monthly average of 3.2 percent in the last quarter of
1971. Nevertheless, Nixon's second term was aborted by
political complications arising from the Watergate
scandal, leaving Gerald Ford in the wounded White House.
The economy was left to pay for the Burns-created
pre-election boom with runaway inflation that compelled
the Fed to tighten with a post-election vengeance, which
produced a long and painful post-election recession that
in turn contributed to Ford's defeat by Carter.
The Fed, as an independent institution above
politics, has yet to recover fully from the rotten
partisan smell of 1972. Burns' sordid catering to Carter
in hope of securing a reappointment for a third term was
a contributing factor to the inflation under Carter. And
Carter's defeat by Ronald Reagan was in no small measure
caused by the former's appointment of Paul Volcker as
Fed chairman. Some said it was the most politically
self-destructive move made by Carter.
Volcker,
having served four years as president of the New York
Federal Reserve Bank, replaced G William Miller, an
industry executive, as the Carter-appointed Federal
Reserve Board chairman on July 23, 1979. As assistant
secretary under Republican treasury secretary John
Connally in the Nixon administration, Volcker played a
key role in 1971 in the dismantling of the Bretton Woods
international monetary system, formulated by 44 nations
that met in Bretton Woods, New Hampshire, in July 1944
toward the end of World War II. Under that system - as
worked out by John Maynard Keynes, representing Britain,
and Harry Dexter White, an American who later in the
McCarthy era was persecuted unfairly by accusation of
having been a communist - each country agreed to set
with the International Monetary Fund (IMF) a value for
its currency and to maintain the exchange rate of its
currency within a specified range. The United States, as
the country with the leading economy, pegged its
currency to gold, promising to redeem foreign-held
dollars for gold on demand at an official price of $35
an ounce. (US citizens had been forbidden by law to own
gold at any price since the New Deal was created under
Franklin D Roosevelt.) All other currencies were tied to
the dollar and its gold-redemption value. While the
value of the dollar was tied strictly to gold at $35 an
ounce, other currencies, tied to the dollar, were
allowed to vary in a narrow band of 1 percent around
their official rates, which were expected to change only
gradually, if ever. Foreign-exchange control between
borders was strictly enforced, the mainstream economics
theory at the time being inclined to consider free
international flow of funds neither necessary nor
desirable for facilitating trade.
Nixon was
forced to abandon the Bretton Woods fixed-exchange-rate
system in 1971 because recurring lapses of fiscal
discipline on the part of the United States since the
end of World War II had made the dollar's peg to gold
unsustainable. By 1971, US gold stock had declined by
US$10 billion, a 50 percent drop. At the same time,
foreign banks held $80 billion, eight times the amount
of gold remaining in US possession. Ironically, the
problem was not so much US fiscal spending as the
unrealistic peg of the dollar to $35 gold. Fixed
gold-back currencies are simply not operational to
expanding economies, and fixed exchange rates are not
operational for economies that grow at different rates.
William G Miller, after only 17 months at the
Fed, had been named treasury secretary as part of
Carter's desperate wholesale cabinet shakeup in response
to popular discontent and declining presidential
authority. After isolating himself for 10 days of
introspective agonizing at Camp David, Carter emerged to
make his speech of "crisis of the soul and confidence"
to a restless nation. In response, the market dropped
like a rock in free fall. Miller was a fallback choice
for the Treasury, after numerous other potential
appointees, including David Rockefeller, declined
personal telephone offers by Carter to join a
demoralized administration.
Carter felt that he
needed someone like Volcker, an intelligent if not
intellectual Republican, a term many liberal Democrats
considered an oxymoron, who was highly respected on Wall
Street, if not in academe, to be at the Fed to
regenerate needed bipartisan support in his time of
presidential leadership crisis. Bert Lance, Carter's
chief of staff, was reported to have told Carter that by
appointing Volcker, the president was mortgaging his own
re-election to a less-than-sympathetic Fed chairman.
Volcker won a Pyrrhic victory against inflation
by letting financial blood run all over the country and
most of the world. It was a toss-up whether the cure was
worse than the disease. What was worse was that the
temporary deregulation that had made limited sense under
conditions of near hyper-inflation was kept permanent
under conditions of restored normal inflation.
Deregulation, particularly of interest-rate ceilings and
credit market segregation and restrictions, put an end
to market diversity by killing off small independent
firms in the financial sector since they could not
compete with the larger institutions without the
protection of regulated financial markets. Small
operations had to offer increasingly higher interest
rates to attract funds while their localized lending
could not compete with the big volume, narrow
rate-spreads of the big institutions. Big banks could
take advantage of their access to lower-cost funds to
assume higher risk and therefore play in
higher-interest-rate loan markets nationally and
internationally, quite the opposite of what Keynes
predicted, that the abundant supply of capital would
lower interest rates to bring about the "euthanasia of
the rentier". Securitization of unbundled risk
levels allowed high-yield, or junk, bonds with high
rates to dominate the credit market, giving birth to new
breeds of rentiers.
Ultimately, Keynes
may still turn out to be prescient, as the finance
sector, not unlike the transportation sectors such as
railroads, trucking and airlines in earlier waves, or
the communication sector such as telecom companies in
recent years, has been plagued by predatory mergers of
the big fish eating the smaller fish, after which the
big fish, having grown accustomed to an unsustainably
rich diet that damaged their financial livers, begin to
die from self-generated starvation from a collapse of
the food chain.
The Fed has traditionally never
been keen on changing interest rates too abruptly,
trying always to prevent inflation without stalling the
economy excessively - thus resulting in interest rates
often trailing rampant inflation - or stimulating the
economy without triggering inflation down the road, thus
resulting in interest rates trailing a stalling economy.
Market demand for new loans, or the pace of new lending,
obviously would not be moderated by raising the price of
money, as long as the inflation/interest gap remains
profitable. Deflation has a more direct effect in
moderating loan demands, causing what is known as a
liquidity trap or the Fed pushing on a credit string.
Yet bank deregulation has diluted the Fed's
control of the supply of credit, leaving the price of
short-term money as the only lever. Price is not always
an effective lever against runaway demand, as Fed
chairman Alan Greenspan was also to find out in the
1990s. Raising the price of money to fight inflation is
by definition self-neutralizing because high interest
cost is itself inflationary in a debt-driven economy.
Lowering the price of money to fight deflation is also
futile because low interest cost is deflationary for
creditors who would be hit by both loss of asset price,
deteriorating collateral value and falling interest
income. Abnormal gaps between short- and long-term
interest rates do violence to the health of many
financial sectors that depend on long-term financing,
such as insurance, energy and communication.
Deregulation also allows the price of money to allocate
credit within the economy, often directing credit to
where the economy needs it least, namely the high-risk
speculative arena, or desperate borrowers who need money
at any price.
The Fed might have had in its
employ a staff of very sophisticated economists who
understood the complex, multi-dimensional forces of the
market, but the tools available to the Fed for dealing
with market instability was by ideology and design
simplistic and single-dimensional. Interest-rate policy
has been the only weapon available to the Fed to tame an
aggressively unruly market that has increasingly viewed
the Fed as a paper tiger.
Monetarists, as
represented by Milton Friedman, advocated a steady
expansion of money supply as the optimum monetary
policy. To make the case that money supply, rather than
interest rates, moves the economy, one would have to
assert that the money supply affects the economy with
zero lag. Such a claim can only be validated from the
long-term perspective in which six months may appear as
near zero, just as macro-economists may consider the
bankruptcy of a few hundred companies mere creative
destruction, until they find out some of their own
relatives own now worthless shares in some of the
bankrupt companies. Targeting the money supply in a
volatile monetary regime produces large, sudden swings
in interest rates that produce unintended shifts in the
real economy that then feed back into demand for money.
The process has been described as the Fed acting as a
monetarist dog chasing its own tail.
By
September 1980, data on August money supply revealed
that it had grown by 23 percent. Monetarists, backed by
the banks, clamored for interest-rate hikes dictated by
money-supply data, to curb the growth. Having been
burned a few months earlier, the Volcker Fed was not
going to abandon its traditional interest-rate
gradualism focus and again let the money-supply dog
chase the interest-rate tail. Nevertheless, the Fed
raised the discount rate from 10 to 11 percent on
September 25, less than two months before the election,
but still way behind what was needed by the high
monetary aggregate and high inflation rate.
Carter, falling behind in the polls, attacked
the Fed for its high-interest-rate policy in the final
weeks of his re-election campaign in October. Reagan
opportunistically and disingenuously defended the Fed
being used as a scapegoat by Carter. After the election,
the Fed continued its high-interest-rate policy while
Reaganites were preoccupied with transition matters. By
Christmas, prime rate for some banks reached 21.5
percent.
The monetary disorder that elected
Reagan followed him into office. Carter blamed inflation
on prodigal popular demand and promised government
action to halt hyper-inflation. Reagan reversed the
blame for inflation and put it on the government. Yet
Reagan's economic agenda of tax cuts, defense spending
and supply-side economic growth was in conflict with the
Fed's anti-inflation tight-money policy. The monetarists
in the Reagan administration were all longtime
right-wing critics of the Fed, which they condemned as
being infected with a Keynesian virus. Yet the
self-contradicting fiscal policies of the Reagan
administration (a balanced budget in the face of massive
tax cuts and increased defense spending) overshadowed
its fundamental monetary-policy inconsistency. Economic
growth with shrinking money supply is simply not
internally consistent, monetarism or no monetarism.
The Reagan presidency marked the rehabilitation
of classical economic doctrines that had been in eclipse
for half a century. Economics students since World War
II had been taught classical economics as a historical
relic, like creationism in biology. They viewed its
theories as negative examples of intellectual
underdevelopment attendant with a lower stage of
civilization. Three strands of classical economics
theory were evident in the Reagan program: monetarism,
supply-side theory, and phobia against deficit financing
(but not deficit itself) coupled with a fixation on tax
cuts. Yet these three strands are mutually contradictory
if pursued equally with vigor, what Volcker gently
warned about in his esoteric speeches as a "collision of
purposes". Supply-side tax cuts and investment-led
economic growth conflict with monetarist money-supply
deceleration, while massive military spending with tax
cuts means inescapable budgetary deficits. Voodoo
economics was in full swing, with the politician who
coined the term during the primary, George H W Bush, now
serving as the administration's vice president. Reagan,
the shining white knight of small-government
conservatism, left the US economy with the biggest
national debt in history.
A tightening of money
supply alongside a budget deficit is a sure recipe for a
recession. Long-term high-grade corporate and government
bonds were seeing their market rates jump 100 basis
points in one month. New issues had difficulty selling
at any price. The possibility of a "double dip"
recession was bandied about by commentators. The Volcker
Fed was attacked from all sides, including the
commercial banks, which held substantial bond
portfolios, and Reagan White House supply-siders,
despite the fact that everyone knew the trouble
originated with Reagan's ideology-fixated economic
agenda. The Democrats were attacking the Fed for raising
interest rates in a slowing economy, which was at least
conceptually consistent.
The Reagan White House
accused the Volcker Fed of targeting interest rates
again instead of focusing on controlling monetary
aggregates, and Volcker himself was accused of
undermining the president's re-election chances in 1984.
Reagan publicly discussed "abolishing" the Fed,
notwithstanding his disingenuous defense of the Fed from
attacks by Carter during the 1980 election campaign.
Earlier, back in mid-April 1984, Volcker had publicly
committed himself to gradualism in reining in the money
supply and avoiding shock therapy, to give the economy
time to adjust. But he reneged on his promise by May,
and decided to tighten on an economy already weakened by
high rates imposed six months earlier, yielding to White
House pressure and bond-market signals. Gradualism in
interest-rate policy was permanently discarded.
Volcker's justification was amazing, in fact farcical.
He told a group of Wall Street finance experts in a
two-day invited seminar that since policy mistakes in
the past had been on the side of excessive ease, in the
future it made sense to err on the side of restraint.
Feast-and-famine was now not only a policy effect but a
policy rationale as well. Compound errors, like compound
interest, were selected as the magical cure for the
United States' sick economy.
Financial markets
are not the real economy. They are shadows of the real
economy. The shape and fidelity of the shadows are
affected by the position and intensity of the light
source that comes from market sentiments on the future
performance of the economy, and by the fluctuating
ideological surface on which the shadow is cast. The
institutional character of the Fed over the decades has
since developed more allegiance to the soundness of the
financial-market system than to the health of the real
economy, let alone the welfare of all the people.
Granted, conservative economists argue that a sound
financial-market system ultimately serves the interest
of all. But the economy is not homogenous throughout. In
reality, some sectors of the economy and segments of the
population, through no fault of their own, may not, and
often do not, survive the down cycles to enjoy the
long-term benefits, and even if they survive are
permanently put in the bottom heap of perpetual
depression. Periodically, the Fed has failed to
distinguish a healthy growth in the financial markets
from a speculative debt bubble. Under Greenspan, this
failure is accepted as a policy initiative, equivalent
to "when rape is inevitable, relax and enjoy it".
The Reagan administration by its second term
discovered an escape valve from Volcker's independent
domestic policy of stable-valued money. In an era of
growing international trade among Western allies, with
the mini-globalization to include the developing
countries before the final collapse of the Soviet bloc,
a booming market for foreign exchange had been
developing since Nixon's abandonment of the gold
standard and the Bretton Woods regime of fixed exchange
rates in 1971. The exchange value of the dollar thus
became a matter of national security and as such fell
within the authority of the president that required the
Fed's patriotic support.
Council of Economic
Advisers chairman Martin Feldstein, a highly respected
conservative economist from Harvard with a reputation
for intellectual honesty, had advocated a strong dollar
in Reagan's first term, arguing that the loss suffered
by US manufacturing was a fair cost for national
financial strength. But such views were not music to the
ears of the Reagan White House and the Treasury under
Donald Reagan, former head of Merrill Lynch, whose
roster of clients included all major manufacturing
giants. Feldstein, given the brush-off by the White
House, went back to Harvard to continue his quest for
truth in theoretical economics after serving two years
in the Reagan White House, where voodoo economics
reigned.
Feldstein went on to train many
influential economists who later would hold key
positions in government, including Lawrence Summers,
treasury secretary under president Bill Clinton and now
president of Harvard University, and Lawrence Lindsey,
dismissed chairman of the Bush White House Council of
Economic Advisers, and Gregory Mankiw, Lindsey's
replacement, who sparked an uproar last week by saying,
in the same intellectual tradition: "Outsourcing is a
growing phenomenon, but it's something that we should
realize is probably a plus for the economy in the long
run." Nearly 2.8 million factory jobs have been lost
since President George W Bush took office in 2000 and
the issue looms large ahead of the coming election in
November, where victory in rust-belt states such as
Ohio, Illinois, Pennsylvania, Indiana and Michigan could
be key, as well as high-tech states such as California,
Texas, Massachusetts and North Carolina. Democrats have
seized on Mankiw's comments as evidence that the Bush
White House is insensitive to the plight of unemployed
and underemployed voters, notwithstanding that the
Clinton economic team held in essence the same views.
By Reagan's second term, it became undeniable
that the United States' policy of a strong dollar was
doing much damage to the manufacturing sector of the US
economy and threatening the Republicans with the loss of
political support from key industrial states, not to
mention the unions, which the Republican Party was
trying to woo with a theme of Cold War patriotism.
Treasury secretary James Baker and his deputy Richard
Darman, with the support of manufacturing corporate
interest, then adopted an interventionist exchange-rate
policy to push the overvalued dollar down. A truce was
called between the Fed and the Treasury, though each
continued to work quietly toward opposite policy aims,
much like the situation in 2000 on interest rates, with
the Greenspan Fed raising the short-term Fed funds rate
while the Summers Treasury pushed down long-term rates
by buying back 30-year bonds with its budget surplus,
resulting in an inverted rate curve, a classical signal
for recession down the road, while talk of the end of
the business cycle was extravagantly entertained.
Thus, a deal was struck to allow Volcker to
continue his battle against domestic inflation with high
interest rates while the overvalued dollar would be
pushed down by the Treasury through the Plaza Accord of
1985 with a global backing-off of high interest rates.
notwithstanding the subsequent Louvre Accord of 1987 to
halt the continued decline of the dollar started by the
Plaza Accord only two years earlier, the cheap-dollar
trend did not reverse until 1997, when the Asian
financial crisis brought about a rise of the dollar by
default, through the panic devaluation of Asian
currencies. The paradox is that in order to have a
stable-valued dollar domestically, the Fed had to permit
a destabilizing appreciation of the foreign-exchange
value of the dollar internationally. For the first time
since end of World War II, foreign-exchange
consideration dominated the Fed's monetary-policy
deliberations, as the Fed did under Benjamin Strong
after World War I. The net result was the dilution of
the Fed's power to dictate to the globalized domestic
economy and a blurring of monetary and fiscal policy
distinctions. The high foreign-exchange value of the
dollar had to be maintained because too many
dollar-denominated assets were held by foreigners. A
fall in the dollar would trigger sell-offs as it did
after the Plaza/Louvre Accords of 1985 and 1987, which
contributed to the 1987 crash.
It was not until
Robert Rubin became special economic assistant to
president Clinton that the US would figure out its
strategy of dollar hegemony through the promotion of
unregulated globalization of financial markets. Rubin, a
consummate international bond trader at Goldman Sachs
who earned $60 million the year he left to join the
White House, figured out how the US was able to have its
cake and eat it too, by controlling domestic inflation
with cheap imports bought with a strong dollar, and
having its trade deficit financed by a capital account
surplus made possible by the same strong dollar. Thus
dollar hegemony was born.
The US economy grew at
an unprecedented rate with the wholesale and permanent
export of US manufacturing jobs from the rust belt to
low-wage economies, with the added bonus of reining in
the unruly domestic labor unions. The Japanese and the
German manufacturers, later joined by their counterparts
in the Asian tigers and Mexico, were delirious about US
willingness to open its domestic market for invasion by
foreign products, not realizing until too late that
their national wealth was in fact being steadily
transferred to the dollar economy through their exports,
for which they got only dollars that the United States
could print at will but that foreigners could not spend
in their own respective non-dollar economies. By then,
the entire structure of their economies, and in fact the
entire non-dollar global economy, was enslaved to
export, condemning them to permanent economic servitude
to the US dollar. The central banks of these countries
with non-dollar economies competed to keep the exchange
values of their currencies low in relation to the dollar
and to one another so that they can transfer more wealth
to the dollar economy while the dollars they earned from
export had no choice but to go back to the US to finance
the restructuring of the dollar economy toward new modes
of finance capitalism and new generations of high-tech
research and development through US defense spending.
Reagan replaced Volcker with Alan Greenspan as
Fed chairman in the summer of 1987, over the objection
of supply-side partisans, most vocally represented by
Wall Street Journal assistant editor Jude Wanniski, a
close associate of former football star and presidential
potential Jack Kemp of New York. Wanniski derived many
of his economics ideas from Robert Mundell, who was to
be the recipient of the Nobel Prize for economics in
1999 on his theory on exchange rates, not without help
from the consistent promotion of the Wall Street
Journal. Wanniski accused Greenspan of having caused the
1987 crash, with Greenspan, in his new role as Fed
chairman, telling Fortune magazine in the summer of 1987
that the dollar was overvalued. Wanniski also maintained
that there was no liquidity problem in the banking
system in the 1987 crash, and "all the liquidity
Greenspan provided after the crash simply piled up on
the bank ledgers and sat there for a few days until the
Fed called it back". Wanniski blamed the 1986 Tax Act,
which, while sharply lowering marginal tax rates,
nevertheless raised the capital gains tax to 28 percent
from 20 percent and left capital gains without the
protection against inflated gains that indexing would
have provided. This caused investors to sell equities to
avoid negative net after-tax returns, according to
Wanniski.
On Monday, October 19, 1987, the value
of stocks plummeted on markets around the world, with
the Dow Jones Industrial Average (DJIA, the main index
measuring market activity in the United States) falling
508.32 points to close at 1,738.42, a 22.6 percent fall,
the largest one-day decline since 1914. The magnitude of
the 1987 stock-market crash was much more severe than
the 1929 crash of 12.8 percent. The loss to investors
amounted to $500 billion, about 10 percent of 1987 gross
domestic product (GDP). Over the four-day period leading
up to the October 19 crash the market fell by more than
30 percent. By peak value in January 2000, this would
translate into the equivalent of an almost 4,000-point
drop in the Dow. However, while the 1929 crash is
commonly believed to have led to the Great Depression,
the 1987 crash only caused pain to the real economy and
not its collapse. It is widely accepted that Greenspan's
timely and massive injection of liquidity into the
banking system saved the day. The events launched the
super-central-banker cult of Greenspan, notwithstanding
Winniski's criticism.
By January 1989, 15 months
after the crash, the market had fully recovered, but not
the US economy, which remained in recession for several
more years. When a recession finally hit in full force,
three years after the crash, it was blamed on excessive
financial borrowing, not the stock market,
notwithstanding the fact that excessive financial
borrowing itself was made possible by the stock-market
bubble. The Tuesday after the crash on Black Monday,
Alan Greenspan issued a one-sentence assurance that the
Federal Reserve would provide the system with necessary
credit. John D Rockefeller had made a somewhat similar
declaration in 1929 - but failed to buoy the market.
Rockefeller was rich, but his funds were finite.
Greenspan succeeded because he controlled unlimited
funds with the full faith and credit of the nation. The
1987 crash marked the hour of his arrival as central
banker par excellence, the beginning of his
status as a near-deity on Wall Street. The whole world
now hums the mantra: In Alan We Trust (an update of the
slogan "In God We Trust" printed on every Federal
Reserve note, known as the dollar bill). It was the main
reason for his third-term reappointment by president
Clinton. He is the man who will show up with more liquor
when the partying hits a low point, rather than the
traditional central-banker role of taking the punch bowl
away when the party gets going. Greenspan can be relied
upon to keep the financial system liquid until after the
2004 election.
Reportedly, George H W Bush was
miffed by Greenspan's handling of interest rates, which
led to a brief economic downturn shortly before the 1992
election, when Bush lost to Clinton despite victory in a
foreign war. By 1994, Greenspan was already riding on
the back of the debt tiger from which he could not
dismount without being devoured. The DJIA was below
4,000 in 1994 and rose steadily to a bubble of near
12,000 while Greenspan raised the Fed funds rate (FFR)
seven times from 3 percent to 6 percent between February
4, 1994, and February 1, 1995, to try to curb
"irrational exuberance", and kept it above 5 percent
until October 15, 1998. When the DJIA started its
current slide downward after peaking in January 2001,
the Fed lowered the FFR from 6.5 percent on January 3,
2001, to the current rate of 1.25 percent set on
November 6, 2002.
In testimony before the Joint
Economic Committee of the US Congress on October 29,
1997, on Turbulence in World Financial Markets, chairman
Greenspan stated: "Yet provided the decline in financial
markets does not cumulate, it is quite conceivable that
a few years hence we will look back at this episode, as
we now look back at the 1987 crash, as a salutary event
in terms of its implications for the macro-economy."
From the market peak to the October lows, the Standard
& Poor's 500 lost 35.9 percent of its value. The
S&P 500 regained the lost value about two years
later.
The Fed chief angered the current Bush
White House and many Republicans on Capitol Hill when he
testified recently that George W Bush's tax cuts were
premature and that they should be offset by tax
increases or spending reductions to keep the deficit
under control. Few people can cross a president and the
party running Congress and still survive. To many
veteran observers of the central bank, Greenspan's blunt
assessment meant he either will retire as Fed chief in
2005 or will be replaced by Bush, though perhaps not
until after the 2004 election. The chairman, who turns
77 this year, keeps his plans private. The White House
is keeping mum about Bush's intentions, and any
speculation about replacements of Fed chairmen easily
can be off target. Still, many who read Fed tea leaves
think the signs point to a change in the chairmanship in
a year or two.
Whatever happens, most analysts
agree that any move by Bush to take Greenspan off the
public stage would have to be deft and respectful of his
stewardship of the economy during some turbulent years.
Though Greenspan has lost some luster in recent years,
he has still "got an enormous amount of credibility",
according to former Federal Reserve member Lyle Gramley.
Greenspan's four-year term as chairman runs out June 20,
less than five months before the election on the second
Tuesday of November, and his 14-year term as a member of
the Federal Reserve Board expires in 2006. This timing
has led many analysts to speculate that Bush will ask
the Fed chief to stay on until after the election but
not another term. That assessment is based on the fact
that Greenspan has been a thorn in the side of two
presidents named Bush. In the 1992 election campaign, he
provoked White House ire when he withstood pressure to
pump more money into the economy and drive interest
rates lower. Bush the father lost the election and he
and many aides put much of the blame on the Fed
chairman.
The current president recognized
Greenspan's importance from the beginning. In his first
trip to Washington as president-elect in 2000, the first
person he visited was Greenspan. The central-bank
chairman, with a sensitive ear to the shifting pitches
of politics, later gave a qualified endorsement of
Bush's $1.35 trillion tax cut in 2001. But this February
11, the chairman told the Senate Banking Committee that
Bush's new tax-cut proposal was premature since the
economy might be in the midst of a recovery. He endorsed
Bush's dividend-tax proposals but said any revenue loss
would have to be offset with spending cuts and tax
increases. And, he said, the deficit raises long-term
interest rates, contrary to White House economic theory.
Greenspan was largely expressing long-held views, but he
did it without his usual equivocation and caution,
suggesting he is not playing for another term. After
cutting interest rates 12 times trying to lift up a
sluggish economy with another liquidity bubble,
Greenspan's stock, like the market, is down.
Wall Street also firmly believes that the Fed is
heavily influenced by the US political cycle and is
loath to tighten monetary policy amid the sound and fury
of a presidential race. The independent and carefully
apolitical central bank - so conventional wisdom goes -
does not want to be seen to be favoring challengers or
incumbents, Democrats or Republicans, whatever its
governors' private views might be on the plausibility of
the economic and fiscal plans being proposed by either
side. The problem is that this conventional wisdom is
not supported by evidence. The Fed has actually
increased official interest rates in six of the past 11
presidential-election years - most recently in 2000,
when it raised rates from 5.3 percent to 6.5 percent in
the 12-month lead-up to the closest presidential poll in
modern times. In the other five election years since
1960, official interest rates fell, but without any
discernible pattern of favoritism toward either side of
the political spectrum.
The largest fall in
rates through a modern election year occurred in 1960,
when a sagging economy and high unemployment caused the
Fed to cut rates from 4 percent to 2.4 percent, and
helped challenger John F Kennedy defeat Richard Nixon.
The second-largest easing of monetary policy happened in
1992, when Bill Clinton ousted George Bush Sr amid a
strong, rebounding economy and falling interest rates.
This runs counter to the perceived wisdom about the 1992
election among Democrats, who believe it was a lousy
economy that delivered them the White House when, in
fact, by the time of the poll, the economy was growing
strongly, and among Republicans, who still blame the
Greenspan-led Fed for bringing down the first Bush with
unaccommodating monetary policy through 1992. "It's the
economy, stupid" was a great slogan, but perhaps not
quite as relevant in hindsight as it seemed at the time.
When Greenspan was appointed by Ronald Reagan in
1987, the year before Bush Sr was first elected, the
economy was gliding along at a 2.9 percent clip, with
6.2 percent unemployment. This was good performance at
the time, though weak by recent standards. However,
inflation stood at a "horrific" 3.1 percent and
Greenspan did not want to be known as the man who threw
away Volcker's heroic "victory" against inflation. He
mercilessly cranked interest rates up from 6.7 percent
in 1987 to 9.2 percent in 1989. The economy continued to
grow for a while, but by 1991 unemployment began to
rise, and reached a peak of 7.5 percent of the labor
force in 1992 and cost Bush the father his 1992
re-election. Historical data suggest it takes about two
years for policy maneuvers to slow the economy.
Ironically, the second-largest increase in
interest rates through a modern presidential-election
year happened in 1988, when a booming economy saw the
Fed fund rate rise from 6.7 percent to 8.4 percent
through the year. Even so, the first Bush won a
resounding victory over the liberal Democrat Michael
Dukakis. There were no complaints from Republicans about
a biased Fed that year. The largest election-year
increase in Fed fund rates happened in 1980, when Ronald
Reagan resoundingly defeated Jimmy Carter amid soaring
inflation and high unemployment. But the Fed's
2-percentage-point increase in rates that year was
triggered by inflation reaching 13 percent.
Evidence in support of political pandering, or
any systematic election-year policy decisions, is scant,
except with Arthur Burns in 1972, when incumbent Nixon
won emphatically over Democrat George McGovern. Although
the Fed tightened monetary policy modestly through 1972
(0.9 percentage point), most economists believe that it
should have acted far more vigorously in the face of
very strong growth and emerging inflationary pressures
that would overshadow the US economy for the rest of the
decade.
For the 2004 election, while there is
clear evidence of an economic case for higher US
interest rates to restrain another debt bubble even if
inflation pressure may not surface, Wall Street is
betting that low interest rates will persist until after
the election.
Reagan left the nation with the
highest budget deficit as a percentage of GDP (6
percent) in history with tax cuts and increased military
spending. Clinton left the nation with massive trade
deficits by pushing deregulated financial globalization.
The current account deficit is financed by a capital
account surplus through dollar hegemony created by an
international finance architecture that requires foreign
central banks to hold dollar reserves to prevent attacks
on their own respective currencies, notwithstanding the
dollar being a fiat currency of an economy inflated with
debt.
George W Bush won the 2000 election along
with the bursting of the Clinton debt bubble. Nine
months into office, Bush faced spectacular terrorist
attacks in the heart of the financial sector. The Fed
poured billions of dollars into the US banking system to
keep it from seizure, and left unsterilized funds
created through a $90 billion special swap arranged that
week with the foreign central banks. True to supply-side
economics, Bush pushed through a tax cut to ward off the
Clinton recession, but could not throw the PECT off
track. Stock prices fell like rocks.
The stock
market recovery in 2003, with the DJIA rising by 25
percent from its low in March, and the Nasdaq rising a
phenomenal 50 percent, and the S&P 500 rising 26
percent and the Russell 2000 rising 45 percent, fits
into the PECT, even though it is a jobless recovery. The
rise in equity prices is tempered by the dollar falling
20 percent against the euro, 10 percent against the yen,
despite Bank of Japan intervention, and a whopping 34
percent against the Australian dollar. When a dollar
buys less stock, it is not viewed as inflation by the
Fed because higher equity prices can support more debt,
which in turn causes the dollar to buy even less stock,
which causes equity prices to rise even more. Yet no one
seems to be worried about this bubble. The market takes
comfort in Greenspan's recent claim that the Fed
correctly focuses policies on trying to mitigate
probable damage after the eventual bursting of a bubble
of stock-market speculation rather than taking measures
to prevent the bubble itself. Irrational exuberance is
now the name of the game and the rule of the game is
that markets can stay irrationally exuberant longer than
investors can afford to stay liquid on the sideline.
The Bush tax cut and the Iraq war have led to a
huge and rising fiscal deficit projected by the
Congressional Budget Office to be $477 billion in fiscal
2004, which ends in September, less than two months
before the election. The accumulative deficit for the
next decade may total $1.9 trillion, or 20 percent of
GDP. If the recovery stalls, the 2004 deficit may reach
$600 billion. Deficits are not necessarily harmful if
they finance productive investments. Alas, war,
speculative profits and debt-driven consumption can
hardly be categorized as such.
Whoever is
president after the coming election, the first two years
of his term will likely be consumed with the need for
harsh measures to deal with a falling dollar, a runaway
budget deficit, a reinflated debt bubble, a jobless
recovery and a fiscal black hole in the "war on
terrorism". The monkey will be on the back of the winner
of the White House in November in the Year of the
Monkey.
Henry C K Liu is chairman of
the New York-based Liu Investment Group.
(Copyright 2004 Asia Times Online Co, Ltd. All
rights reserved. Please contact content@atimes.com for
information on our sales and syndication policies.)
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