The
Presidential Election Cycle Theory and the Fed
By
Henry C K Liu
This article appeared in AToL
on February 24, 2004
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.