On the Level: Tax Cuts Matter, Too!

On the day the Federal Open Market Committee is supposed to cut interest rates, it might pay for investors to focus more on fiscal policy and less on monetary policy.

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If this sounds a little crazy, that's great. It means that Wall Street may not yet have fully spotted this inflection point in economic policy. And that means opportunity for more forward-thinking folks.

Once upon a time -- i.e., before the 1980s -- both monetary and fiscal policy were considered effective tools to stimulate a weakening economy. Congress even held hearings on how to fine-tune monetary and fiscal policies to produce just the right amount of unemployment and inflation. The stagflation of the late 1970s blew away such notions and destroyed our faith in the effectiveness of fiscal policy as a macro weapon. That made sense at a time when the federal deficit was growing topsy-turvy, driven by defense and entitlement programs.

Monetary policy came to the economic rescue in the person of then-Fed Chairman Paul Volcker. Starting in 1979, he jacked up short-term interest rates, which peaked in June 1981 with the fed funds rate at 19.1%, and slew the inflation dragon that the elected politicians could not. His bold move signaled not just the beginning of the long period of disinflation that we continue to enjoy today but also the emergence of a new policy consensus in Washington that if you want to control the economy, use monetary policy.

Twenty years later, the election of President George W. Bush may signal the return of fiscal policy as a legitimate macro-economic tool. He clearly wants to cut taxes for ideological as well as economic reasons. He needs some quick successes after the controversy of last year's election process. He has received some kind of papal blessing from current Fed Chairman Alan Greenspan. And God knows, the economic and fiscal conditions are propitious for some kind of cut. We are running huge annual budget surpluses to meet competing policy objectives and inflation does not appear to be much of a problem for the moment.

This possible shift in awareness may not yet be priced into the financial markets. For example, we have yet to enjoy a day akin to Aug. 17, 1982, when the market realized that Volcker had strangled inflation. The bell on Wall Street that rang that day was Henry Kaufman, then the chief economist at Salomon Brothers.

Kaufman issued a report to his partners that day saying that inflation and interest rates, which peaked in this period around 20%, were coming down. That summer day the Dow Jones Industrial Average rose nearly 5% -- a startling move in those days -- from 792.44 to 831.23. That rally marked the beginning of today's 18-year bull market.

Now, a tax cut of $1.6 trillion, the number currently being bandied about, may not be on the historic scale of Volcker's monetary strike against inflation. But it deserves a lot more consideration than it has yet received. First, if Bush and Congress can move quickly on this, we could see money being put into the pockets of American consumers, investors and corporations by midyear. (That may be a better bet than Amazon.com's AMZN turning profitable this year!) Bush economic advisor Larry Lindsey has been quoted this week as saying that cuts in payroll withholding taxes could even take effect by July.

Whatever shape a tax cut takes, the size is drifting higher, according to Tom Gallagher, who runs the Washington outpost for the International Strategy & Investment Group. In a report released Wednesday, he writes:

At the start of the year, market expectations for a tax cut, using the Washington convention of 10-year totals, ran in the $700 billion-$800 billion range. That was the result of splitting the difference between Bush's campaign proposal of $1.3 trillion and a much lower figure for congressional Democrats. Several factors, some predictable and some not, are causing upward revisions:

1. Bush's proposal over the next 10 years is $1.6 trillion (the campaign figure was a nine-year number).

2. Surplus numbers are rising. CBO's figure today will represent a $1 trillion increase in the 10-year surplus forecast, compared to its summer projection, and $900 billion of this will be in the on-budget portion of the surplus, meaning it is available for tax cuts and spending increases.

3. Congressional Democrats, especially in the House, are moving more toward Bush on the tax cut. This reflects the economic weakness, the loss of the "bully pulpit" for Democrats, and the House Democrats falling short of expectations in the 2000 elections.

4. Greenspan's testimony is clearly affecting perceptions of the size of the tax cut. The new Senate Finance Committee chairman, Sen. Charles Grassley (R-Iowa), before the hearing said that $1 trillion sounded right to him, but after the hearing he said he is reconsidering.

We started at $1 trillion but have since moved to $1.25 trillion, and we think that may be too low. At a minimum, the Bush figure will be $1.6 trillion, and it will probably be higher.

Democrats are weighing in at around $850 billion. Simply splitting that difference would produce around $1.25 trillion, and chances are good that the political dynamics won't produce a "split the difference" outcome. That is, Bush may not try to reach an accord with Democrats more broadly. He may be able to pass his plan with minimal concessions by picking up just a few Democratic votes in the Senate and House.

Does the return of fiscal policy to stimulate "aggregate demand" -- now there's a phrase you may not have heard in a while -- ensure we avoid recession? Not necessarily. Much hangs in the balance here. Recall Tuesday's plunges in both consumer and business confidence. Business confidence has collapsed to a 20-year low and consumer confidence, which tends to follow business confidence, could fall a lot more. Even now, consumer confidence remains well above the lows set during the recessions of 1980-82 and 1990-91.

But the return of fiscal policy will create one more underpinning for the economy and the stock market. Monetary and fiscal policies will both soon be pushing hard to get the economy out of the ditch and back on the road. Tax cuts are good for corporate profit and revenue growth. They are good for consumer confidence. And it is hard to paint a tax-driven inflation scare that would spook the stock market. That may change in a year or two. But right now, low inflation remains the order of the day.

So, Washington is about to give the bulls new reason for hope. This could extend the rally for the next few months. The bears will soon be fighting not only the Fed, but also the White House and Congress. Longer term? Stay online.