Society of Pension Professionals, Dallas Chapter, July 15, 2003
The Economy:
"It's The Politics, Stupid!"
Speech by Donald L. Luskin
Perhaps you read in the newspapers this morning that President Bush
hosted a group of Washington reporters on a cruise on the Potomac in the
presidential yacht yesterday. A New York Times reporter was standing
at the rail when a gust of wind came up and blew her hat off into the river.
President Bush immediately ordered the yacht to be stopped. He jumped
overboard, landed with both feet on the surface of the river, and walked
across the water to get the reporter's hat.
The headline in this morning's New York Times? "President Bush
Can't Swim."
That story's really not so far from the truth about today's political
climate. It hasn't been this nasty, or this unstable, since the days of
Watergate. And press coverage has never been this biased and misleading.
This is the key to understanding the economy today -- it's been pretty nasty
and unstable, too. And it's the key to making smart decisions in the market
when a lot of economic research you read is as biased as that mythical
New York Times headline.
One of the most important things my firm does is help investors
understand how changes in politics and government economic policies affect
the economy and the markets. Remember that slogan that Bill Clinton had when
he won the presidency in 1992? His approach to politics then was, "It's the
economy, stupid." We turn that upside-down. Our approach to the economy is,
"It's the politics, stupid."
 That's not the only
thing we're turning upside-down. We think that the market right now is going
through a long and painful process of making a major bottom -- one that
looks very much like the long and painful process of making a top in 2000…
but perfectly upside down.
In fact, if you take a chart of the S&P 500 in 2000 and turn it
upside-down, and overlay it on a chart of the market today -- and you set
the March 24, 2000 top to line up with the October 10, 2002 bottom -- you'll
be amazed at how precise the correspondence is. If this pattern continues,
we'll be tacking on another 10% in the S&P 500 over the next three months or so.
But it hasn't been easy to get to this point. The political environment has
contributed to a pervasive sense of mistrust and risk aversion that has made
it even more difficult than usual to recover from recession.
That environment was determined by one great event -- and no, I'm not
talking about September 11. It was the "hanging chad" election of 2000, in
which Bush and Gore essentially tied, and in which control of the Senate was
perfectly divided between Democrats and Republicans.
That election set up an environment of great apparent stability -- hey,
we all agree on everything so much, let's call it a tie. One big happy
bipartisan family. Not! In the world of the hanging chad, the least
shock to the political system can have large chaotic effects. Think of the
power of a Jim Jeffords to change majority control of the Senate, or of an
Olympia Snowe to dictate terms of a tax bill. And the out-of-power party has
every incentive to make things as bad as possible, knowing that the least
dissatisfaction with the in-power party could flip the balance at the next
election.
 This environment
of instability has put the market through a series of three terrifying
bottoms over the last year, each one of them associated with a political
crisis. In each case the market recovered when the crisis passed.
The first crisis was one year ago -- triggered by the accounting scandal
at WorldCom. That was the opening for the Democrats to seize the political
initiative by insisting on a set of draconian new regulations on accounting
and corporate governance. It turned into a game of leap-frog, where the two
parties kept coming up with longer and longer jail sentences for CEOs. The
market turned around the day they stopped legislating.
The second bottom was last October, when President Bush finally got
congressional approval to invade Iraq. The market recovered when it became
clear that the Democrats didn't dare to force a constitutional crisis. The
third bottom was this March, when President Bush finally withdrew from a
downward-spiraling global diplomatic disaster, and gave up trying to enlist
European support for the invasion of Iraq. The market recovered when it
became clear that Bush would avoid a confrontation that could destroy the
post-war western commercial alliance.
 During this year of
crisis bottoms the stock market has become, according to our model,
extremely undervalued. At the worst of the ultimate bottom last October, the
S&P 500 was more undervalued than at any time over the last two decades. It
was precisely as undervalued then as it was overvalued in March 2000. Once
again -- it's 2000 upside-down.
But nobody can make themselves believe that -- even though it's there in
black and white. And it's exactly what you'd expect when investor confidence
has been hammered again and again by a succession of major political shocks.
In one sense the shocks are purely psychological -- they make us risk
averse. But more concretely, these shocks are themselves tangible economic
risks. They can lead to really bad anti-growth legislation -- like Sarbanes
Oxley. Or, just as dangerous, these shocks can make it impossible to pass
good legislation to help the economy get back on a growth footing -- as the
March diplomatic crisis almost made it impossible for President Bush to get
his tax cuts.
Let's look in detail at how those tax cuts came to be --
and how they almost didn’t.
Right after the terrorist attacks of September 11, President Bush's
approval ratings in the polls surged to record highs for any president. As
grim as it may be to put it this way, for George W. Bush, 9/11 was like
winning the lottery. And like many lottery winners, he just sat on his
winnings. After the invasion of Afghanistan, Bush did nothing in any major
policy domain -- and when the WorldCom crisis hit, he just went along for
the ride and signed the worst piece of regulatory legislation in recent
memory.
But then, somewhere last fall, before the November mid-term elections,
Bush woke up one morning and realized that he'd squandered his lottery
winnings. His net approval ratings -- his approval ratings minus his
disapproval ratings -- had fallen pretty much all the way back to where they
were before 9/11.
His response was three-fold. First, he set in motion the initiative to
invade Iraq and depose Saddam Hussein. Second, he threw himself into the
mid-term election fray with a vengeance -- and was able to slightly improve
the Republicans' hold on congressional control. Third, he proposed a radical
pro-growth fiscal initiative -- the elimination of the unfair double
taxation on dividend income.
This idea was more than a tax cut -- it was fundamental tax reform. And
it's very, very pro-growth. Nothing could be better for long term growth
than to withdraw government imposed barriers to capital formation. Simply
put, capital is where growth comes from.
But from the moment he proposed the dividend tax cut on January 7, the
media and the Wall Street economists declared it dead on arrival -- and they
spent the next five months trying to make sure it would be.
On Wall Street, the attack was led by Goldman Sachs' chief economist,
William Dudley. Now Eliot Spitzer has cleaned up Wall Street stock research
by severing the connection between stock analysts and investment banking
relationships. But how about the connection between Wall Street economics
and political relationships? Fact: Goldman Sachs' executives are the single
largest group of contributors to today's Democratic presidential candidates.
I report, you decide.
The most vicious media attack was by New York Times columnist Paul
Krugman, who is also an economics professor at Princeton. In his April 22
column, he wrote about Bush's claims that his tax-cuts will create 1.4
million new jobs.
"...let's pretend that the Bush administration really thinks that its
$726 billion tax-cut plan will create 1.4 million jobs. At what price
would those jobs be created? ...The average American worker earns only
about $40,000 per year; why does the administration, even on its own
estimates, need to offer $500,000 in tax cuts for each job created?"
Krugman's charge was a complete lie. The $726 billion in tax cuts was to
be spread over ten years. The $40,000 is a one year annual salary. The
Princeton economics professor forgot to divide by ten!
But it's even worse. The 1.4 million job estimate was just for the first
two years. If you assume further job growth, and include the fact that
salaries from the new jobs will be taxed to offset the $726 billion expense,
then the real cost per $40,000 job is only $17,000, not $500,000. Krugman
was off by a factor of 29.
I exposed this lie of Krugman's in an article on the website of
National Review magazine. But the Times never printed a
correction. And I can't tell you how many times Krugman's lie was repeated
by other columnists, and by senators and congressmen on the weekend talk
shows. That's how nasty things have gotten…
I had the opportunity to meet with President Bush on April 2, right in
the middle of the war in Iraq, and I was able learn from him first hand and
in depth what he intended to do to overcome criticism in the media and from
Wall Street, and even from so-called "moderates" in his own party.
He said, and I quote, "First I'm going to kick Saddam Hussein's ass."
Then he described how he'd reinvest the political capital he earned from
winning the war to get his tax cuts passed. He described his shock-and-awe
strategy of personal visits to the home states of swing senators. And he
described how he'd trim his original $726 billion proposal into a smaller,
do-able package -- by throwing out the parts that were basically hand-outs
(such as the so-called "kiddy credit") and hanging on for dear life to the
parts that would stimulate economic growth (such as the top-bracket
reduction and dividend relief).
Based on that meeting we told our clients to bet that this tax cut would
happen -- even though everyone had given up on it. We warned them not to
join that ever-growing graveyard of people who dared to underestimate this
president. And as it turned out, what Bush told me he would do is exactly
what he did. And as it turned out, the final version is even better than
what Bush originally proposed -- because House Ways and Means Committee
Chair Bill Thomas switched some of Bush's dividend relief into capital gains
relief -- and that's an even bigger stimulus to growth.
But when the tax bill was signed into law in late May, the media and Wall
Street still wouldn't let up. The New York Times complained that the
bill was really a much bigger tax cut than it seemed, thanks to legislative
"gimmicks" like sunset provisions -- and that it would lead to "deficits as
far as the eye can see." But the Washington Post complained that the
tax was really too small to provide any meaningful stimulus. Too big… too
small… you just can't please these people. And so the stock market just sat
there.
But we told our clients to buy stocks. We told clients that the market
was being blinded to how amazingly pro-growth these tax cuts were going to
be. So far, that's proven to be very right.
The effects of these tax cuts will be far reaching. Just yesterday Citibank
raised its dividend by 75%. And last week Microsoft announced it would no
longer award stock options to employees, but instead would award stock
itself. The media didn't report on this, but we told clients that
Microsoft's move was all about preparing to start dividending out its $46
billion cash hoard. They can't do that while so many employees hold so many
options, the value of which would be damaged by a large dividend payout.
So as the market has moved through its series of three political crisis
bottoms over the last year, we've become increasingly bullish. We've called
each bottom, and told clients to add to stock positions each time. We see a
president who is becoming increasingly skilled at using his political
capital -- and who is committed to using it for pro-growth policies.
In my meeting with him, Bush told me he planned on being a two-term
president. The first term would be all about tax cutting. The second term
would be all about saving Social Security by converting the system to
privately controlled accounts. Those are, essentially, Bush's only two
major, heartfelt economic priorities. For everything else, he's willing to
take the lead from congress, and go along to get along.
And that's a bit of a risk factor. A major new prescription drug Medicare
benefit will be a real long-term economic negative -- an unfulfillable
obligation to future generations on which we must eventually default. I
asked Bush about this, and he told me that he can only do so much in the six
years remaining -- to save Social Security, he's willing to make Medicare
worse. That will be a problem for the next guy.
But with his tax cuts and his Social Security reform, he plans to lay the
groundwork to -- as he puts it -- "forever change this country into
'entrepreneurial heaven.'"
That's what the financial markets are seeing right now, even as the
published economic statistics worshipped by Wall Street economists and the
media show only tentative signs of recovery. To them, I say those statistics
in the rear view mirror are smaller than they appear. Ignore them. It's the
politics, stupid. And now the politics are pointing to growth.
About the Author
Mr. Luskin is chief investment officer of Trend Macrolytics LLC, and former
vice chairman of Barclays Global Investors.
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