The financial markets in the past two weeks have been delivering a strong message, a warning shot. The question is whether our political leaders have been listening and understand the message. Unfortunately, early indications are that our leaders are doing what comes to them most naturally -- playing the blame game. This is business as usual for Washington, but it could have a catastrophic effect on our economy and our well-being. We need to understand the message, deal with it honestly and avoid the finger-pointing and partisanship that is Washington's No. 1 sport.
The message delivered by the financial markets was loud and clear: the 5-year-old economic recovery is at a crossroads. There's an old Wall Street joke that the stock market has predicted six of the last three recessions. The key, of course, is that it did predict the three. The market indicated, by wiping out a net $500 billion in wealth in a single day, that prospects for continued growth are uncertain. Neither the naysayers among pundits and politicians nor the pollyannas in the administration serve us well (or are telling the truth) by announcing the arrival of a recession or attributing the market action to "profit-taking." Millions of investors here and around the world cast a financial vote, and we should heed the results.
What was it that set off the frenzy of the past two weeks? The "usual suspects" are the twin deficits: budget and trade, an inconsistent dollar policy, a punitive tax bill being considered on Capitol Hill, an unnecessarily tight monetary policy by the Federal Reserve, the Middle East shoot-out and the latest fad: program trading. All these elements undoubtedly played a role, but with the exception of the tax bill, none are really new factors. Some editorial writers and many politicians have been decrying the twin deficits, Fed policy and the dollar problem (by the way, it is easier to be on the outside).
The twin deficits have in fact been improving substantially in real or comparative terms. The Louvre agreement, for better or worse, did establish some rules of the game for currency relationships. Other elements may not have improved, but, to repeat, they aren't new factors. Most "expert" analysis proceeds along the lines sketched above: looking at factors and assessing responsibility. But this is a little different from the blame game indulged in by the politicians and pundits. Essentially both are looking at the present and the past and finding fault. As a political or historical exercise, this is to be expected. However, the message the market has been sending has less to do with the present and the past than with the future.
For example, the market is not reflecting concern over last year's budget deficit, which in fact fell by almost one-third -- thanks in large part to a Congress which exercised uncommon spending restraint and had the courage to pass a tax-reform bill that the "experts" said would lose revenue and stunt growth but hasn't.
Rather, the market is concerned about future budget deficits with a Congress that is increasing domestic spending by $40 billion or so and trying to pass it off as a budget cut. The markets are concerned that taxes on business are about to be increased in a punitive fashion, particularly on mergers and acquisitions. The markets are concerned that the trade deficit is going to be reduced, by a 1930-era protectionist bill. The markets are concerned and confused about an administration that at times appears to be backing away from an agreement with the other major currency countries. The market is very concerned about the future impact of a continued tight-money policy that leads to higher interest rates.
All these elements were like dry brush awaiting a spark. Program trading was available as gasoline to inflame the inevitable fire. Hopefully, measures already taken, or being contemplated, will reduce if not eliminate the perverse impact of stock index futures. However, there's still a lot of dry brush out there that will have to be cleared if the economy is going to continue to grow, and the stock market to avoid being overwhelmed in a conflagration.
The reflex in Congress, of course, is to pass a law (or at least hold a hearing). The instinct in the administration is to say: Calm down, everything will be fine, everything will be all right. They're both wrong!
The last thing the world economy needs is a trade bill anything like the one in the House-Senate conference. By its actions this week, the Fed seems to have remembered the lesson of the 1930s, when a perverse Fed policy deepened and extended a recession into the Great Depression. It remains to be seen whether Congress remembers that the Smoot-Hawley bill was also a key to the economic collapse. The answer to our trade deficit lies in growth and openness on the part of our trading partners, not in shutting down the markets.
Regarding the budget, continued deficit reduction is needed, probably to the $130 billion range this year, rather than the increase that seems in the cards now. The so-called $23 billion cut is a complete phony, since it is divorced from any deficit target. Neither sequestration nor reconciliation will do the trick.
Of the two alternatives, sequestration at least has the advantage of "reducing" some spending, although in a positively perverse fashion, since less than one-third of the budget will get all the cuts! No part of the budget should be exempt from scrutiny, and a real target should be set and met.
The question of taxes must also be addressed. Unfortunately, the present discussion is on taxes as an alternative to budget cuts. The $23 billion budget reconciliation package at present includes $12 billion in new taxes, $2 billion in increased tax collection, $1 billion in interest "savings" and $8 billion in unidentified cuts (which might well be as phony as the recent military pay delay).
What has to happen now is for the administration to sit down with congressional leaders from both houses and both parties. They should agree on the message from the world's financial markets, and from its participants. In a matter of days, agreement could be reached on a budget that reduces the 1988 deficit to $130 billion and a trade bill that deals with legitimate complaints, rather than pandering to protectionists. This budget must contain real spending cuts, of more than $23 billion and, yes, taxes -- but the major portion of deficit reduction must be on the spending side, with the tax portion designed not to throw the economy in the tank. In addition, both Congress and the administration should deliver a strong message to the Fed regarding keeping interest rates reasonable through an adequate supply of money. With these measures, the financial markets will calm down, indeed, might improve. But if it's business as usual when the world wants strong leadership, the blame for the next recession can be laid right here -- inside the Beltway.
The writer served as President Reagan's Treasury secretary and chief of staff.