The Presidential Election Cycle Theory and the Fed

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.