At no time in the post-World War II period have the level and direction of the U.S. stock market had such a critical influence on the American economy and the rest of the world as now. Much of the prosperity that we have come to take for granted is directly or indirectly linked to the rousing performance of equity prices in recent years.
Rising stock values have boosted financial wealth, underpinned consumer and business confidence, supported brisk consumer expenditures, lifted housing markets and provided a good portion of the capital our entrepreneurs could access to launch new businesses. Consumption, business formation and capital spending would all be put in jeopardy if the stock market should drop back substantially.
Thus, anything that could cast a cloud over this favorable set of circumstances has to be scrutinized with great care. The legislation of large tax cuts is capable of contributing to that unfortunate result.
The prospect of huge tax cuts sizable enough to eliminate future budgetary surpluses is beginning to concern many participants in the financial markets. The origin of the strong stock market advance of the past five years traces back almost exactly to the time when the markets were convinced the United States had embarked on a bipartisan commitment to fiscal discipline. Measures taken to pare back years of outsized budget deficits almost immediately bolstered market confidence, while generating palpable economic benefits.
Moving from budget deficit to surplus was the best thing that could have happened from the perspective of the American private sector and hence for the stock market. The reason is simple. As the following table shows, when the U.S. government began to shift from being a heavy demander of credit to actually repaying outstanding debt in 1992, when the commitment to budgetary discipline began to jell, the private sector gained greater access to credit and on more favorable terms than would otherwise have been possible.
The mechanism for this win-win result is straightforward. When the U.S. Treasury repays debt, it pays out cash to individuals and institutional investors. They do not turn around and spend that cash. It mainly goes back into other investments. They buy private-sector obligations, both bonds and equities, bidding up the relative value of those financial assets and lowering the cost of new capital to businesses. Without the competition for funding from the U.S. Treasury, the private sector becomes a more dynamic and successful demander of credit.
Fiscal discipline is a blessing to the economy and the stock market for another important reason: It lowers the risk of wide swings in the business cycle. When the federal government runs a budgetary surplus, it gains the flexibility to use fiscal policy actively to offset an economic downturn. We didn't have that flexibility at the onset of the decade of the 1990s, when the U.S. economy was laboring and many of our important financial institutions were distressed by a surge of bad loans. Because we had a large budget deficit at the time, fiscal policy was essentially inoperative. Monetary policy had to carry the full burden of stimulating a business turnaround. The result was that the United States struggled for several years with a below-normal economic recovery. Now that we have the flexibility associated with a budget surplus, the private sector can plan its activities with more confidence that its consumption and investment plans won't be waylaid by a severe recession.
I am worried that instead of taking pride in the unaccustomed good fortune of having a budgetary surplus to look forward to, members of Congress are proposing making steep reductions in taxes on the basis of highly unreliable forecasts of what the U.S. fiscal position may look like over a 10-year horizon. Nobody has a computer -- or crystal ball, for that matter -- powerful enough to produce accurate estimates of events so far into the future and so sensitive to myriad intervening events.
Worse yet, those in favor of large-scale tax cuts seem to be taking for granted that the stock market would respond favorably to such a policy. That is highly questionable. The U.S. economy is near full employment. A large tax cut would immediately unleash expectations of possible overheating that would either push up the American rate of inflation or compel a tighter monetary policy on the part of the Federal Reserve, or both. That is hardly good for the economy, the stock market or the Federal Treasury. It could produce lower levels of economic activity, reduced corporate earnings and lower receipts from income and corporate taxes. Compounding the perverse effect, if the stock market stops registering impressive year-by-year advances, the $75 billion or so in additional capital gains tax collections that have swelled Treasury revenues will become inert, eliminating a central factor behind the improvement in the budgetary position of the U.S. government.
It is worth repeating that stock prices are not certain to advance indefinitely. To believe they will is fanciful. Indeed, concerns about the future of the stock market have been lurking for months. Equity prices are high both in absolute and in relative terms, especially when measured against traditional yardsticks, such as earnings performance or the value of corporate assets. Moreover, there is the risk that the Federal Reserve will need to raise short-term interest rates further because overall demand in the American economy is far outstripping domestic production, as evidenced by a large and growing trade deficit.
Recently, new concerns have surfaced about the value of the dollar. As the dollar becomes more volatile in the foreign currency markets, we can't count on foreign investors to readily pour the hundreds of billions of dollars into American financial assets, as they have in recent years. So no one can guarantee that stock markets will behave themselves, even under the best of circumstances. But it is irresponsible to jeopardize the most favorable set of influences on the stock market in American history by abandoning fiscal policy discipline, whether by unnecessary and undesirable tax cuts or by ill-grounded spending programs.
The writer is president of Henry Kaufman & Co. Inc., a financial management and consulting firm.
Percentage Growth of Debt
Private U.S. Government
1992 2.6% 10.9%
1993 3.8 8.3
1994 4.6 4.7
1995 5.8 4.1
1996 5.4 4.0
1997 6.6 0.6
1998 8.7 -1.4
1999* 9.1 -3.2
* First quarter, annual rate