Monday, December 8, 2008

Where to Draw the Bailout Line?

The bailout-nation saga continued this week as the little-three carmakers from Detroit drove to Washington to plead for a $34 billion federal package to save themselves from bankruptcy and insolvency. Hot on their heels was a devastating report of 533,000 lost jobs in November. Actually, it’s a loss of 732,000 jobs, including downward revisions from the
prior two months. Unemployment moved up to 6.7 percent from 6.5 percent, a number that’s going to get worse as the volume of discouraged workers continues to rise.

So here’s the painful choice for both Republicans and Democrats in Congress: Will the political class risk a Detroit-carmaker bankruptcy that might lead to catastrophic liquidation — including, realistically, a couple million car-related jobs — all while the recession deepens and job losses mount (1.2 million in just the past three months)?

It’s a tough choice — especially for Republicans, most of whom want to vote against bailout nation and stop big-government encroachment on our free-market economy. That’s the right theory. But are the economic risks simply too great to employ it?

Various polling surveys say bailout nation, and a federal rescue for autos in particular, is very unpopular. At least 60 percent are polling against a bailout. The TARP bailout of banks is increasingly unpopular.

Meanwhile, the pressure for more bailouts grows daily. The Avis rental-car company wants a bailout from TARP. A company called BlueFire Ethanol wants a bailout. The trade association for equipment-leasing companies wants a bailout. There’s no end to it. And if we keep going down this path we’ll make a mockery of free-market capitalism.

Where to draw the line? That’s the huge political question.

Coming back to Detroit, there may be a pragmatic solution, one that takes some of the apocalypse-now threat of major economic decline out of play. Senator Bob Corker and others have proposed a federal oversight board that would in effect become a bankruptcy court. Strict conditions would be imposed on the carmakers, especially regarding compensation — the single-biggest reason for Detroit’s decades-long decline.

Corker wants Detroit to have the exact same compensation levels as the Japanese transplants in the non-union Southern states. That means moving hourly labor costs down from roughly $70 to $48. It means reopening the UAW contracts that have created the huge pay-gap between Toyota and GM. It means putting an end to excessive pension and healthcare benefits.

According to Professor Mark Perry of the University of Michigan, GM healthcare benefits add $1,500 to the price of every vehicle, while pension costs add another $700 per car. That will have to end. The lucrative jobs bank that pays laid-off workers 95 percent of their compensation also will have to stop. And bondholders will have to be satisfied with a complete renegotiation of GM’s $62 billion in debt, including the union retiree healthcare fund that is under-funded by $30 billion.

There still will be considerable job losses for downsized Detroit carmakers. They’ll have to cut a huge chunk of their dealer networks. Domestic brands will have to be sharply reduced. But essentially, as would be the case under Chapter 11 bankruptcy, the federal government will
provide short-term financing while Detroit goes through its radical restructuring. It looks like bankruptcy lite, and it will completely change the direction of the former Big Three.

It’s probably too much to ask, but tough federal action under the aegis of oversight-board enforcement also should relieve the CAFE fuel standards that have plagued U.S. automakers. At the very least, worldwide standards should be substituted for domestic ones. Making expensive small green cars is an unprofitable business.

Ironically, with oil and retail gasoline prices plunging, it’s not unreasonable to expect something of an auto-sales recovery. Gas prices have dropped all the way to $1.75 from over $4. This tax cut will help revive the whole economy, along with auto sales.

But if Washington can put this car-bailout business behind it, perhaps Congress can move on to the ultimate solution: restoring economic growth. President-elect Obama has been cagey about the details of his massive $700 billion infrastructure spending plan and whether he’ll raise taxes on successful earners. But this new New Deal, including Obama’s middle-class
tax credits, will not create permanent economic growth incentives. What will? A genuine supply-side growth agenda to reduce tax rates across-the-board.

If the Republican party wants to put bailout nation to rest it should campaign for lower corporate, individual, and investment tax rates. It should make clear that the Democrats are the government-spending party while the Republicans are the tax-cutting party.

We will not bailout our way into prosperity. Nor will we spend our way into prosperity. Somebody has to stand up and yell: It’s time to cut tax rates on the supply-side. That will reinvigorate growth and infuse new spirit into a demoralized economy.

Wednesday, November 26, 2008

Robert Mundell’s New Wisdom

New economic stats on consumer spending and business durable goods investment show an economy that’s sinking fast across-the-board. Wall Street economist John Ryding expects a 4 percent drop in fourth quarter real GDP.

Of course, the Fed is pouring in new cash hand-over-fist. And plunging retail gas prices to about $1.85 per gallon nationally amounts to a huge consumer tax cut of perhaps $320 billion, according to Mark Perry of the University of Michigan. So we’ve moved from tight money and an energy tax hike a year ago, to easy money and an energy tax cut today. The former mix has generated a nasty credit crunch and a recession. But the new monetary/energy mix will generate recovery next year. I hope.

At a wonderful dinner last night I had a chance to talk to Nobel Prize winning economist Robert Mundell about all things economic. What is to be done? I asked him.

Mundell, you may remember, was a leading supply-sider in the Reagan revolution. He argued for low marginal tax rates to spur the economy and a stable dollar to eliminate inflation. Bob Mundell also is the father of the euro. He is plainly an incredibly brilliant and distinguished

The dinner was put together by the indefatigable hard-money analyst Judy Shelton, a pretty smart gal herself. Our spouses were there along with some friends.

So here’s Mundell’s latest take on a pro-recovery, fiscal-monetary, growth mix. First, he’d like to see a complete corporate tax holiday for one year. He then favors corporate tax reform that would drop the current top rate from 35 percent to 15 or 20 percent. He believes this would generate badly needed business investment and job-creation to fight recession.

Incidentally, in today’s durable-goods business-investment report for October, capital-goods shipments are falling at a 12 percent annual rate versus their third-quarter average. Orders are down 35 percent. (By the way, that third-quarter average was a negative number.)

So Mundell is clearly on to something. Business needs help. Without healthy business, there will be no significant new job creation or consumer spending power.

On money, Mundell had two interesting thoughts: First, the U.S. dollar and the Chinese yuan should basically be re-linked at roughly today’s exchange rate (about 6.8 yuan to the dollar). There should be no more Chinese currency appreciation. Incidentally, Mundell thinks the Chinese economy is actually in some trouble. And he’d know. Mundell travels to China about once every other month as a key advisor to the Bank of China.

Also on the currency front, Mundell would prefer a floor under the euro at roughly $1.25. That’s about where it is today. It’s also roughly the same as the original $1.18 euro initial public offering in 2000. So Mundell is pressing for dollar stability relative to Europe and China. And he believes
that would be consistent with domestic price stability here at home.

Unfortunately, Fed head Ben Bernanke simply doesn’t think in these global currency terms. Mundell has no real problem with the Fed’s huge balance-sheet expansion to push new cash into the credit-crunched recessionary economy. He believes there is a huge demand for dollars at
home and overseas, and that the Fed should be accommodating this.

But Mundell frets that Bernanke is too much of a Phillips-curve unemployment-rate targeter, and that he doesn’t understand the powerful influence of a sound currency policy.

Putting it all together, Mundell’s anti-recession program is a reduction of the high marginal tax rate on business to reignite growth along with a stable dollar to contain inflation.

We also got around to talking about Paul Volcker, who is a friend of Mundell’s. He’s also my former boss from 1975, back when I was a young staffer at the New York Fed and Paul Volcker was the bank’s new president. Volcker, of course, has been counseling Barack Obama during the financial crunch. And today, the president-elect appointed Volcker, the former Fed chair, to be the head of a new White House advisory board on the economy. This advisory board takes a page from Ronald Reagan, who set up PEPAB, the President’s Economic Policy Advisory Board, back in 1981. Members of that group included Milton Friedman, Art Laffer, Alan Greenspan, Arthur Burns, Herb Stein, and others. George Schultz was the first chairman. This group helped sustain Reagan’s supply-side policies during some difficult times in 1981-82.

Now, no one really knows what Paul Volcker really thinks about the myriad TARP financial-rescue packages being run by the Treasury, the Fed, and the FDIC. Nor do we know what Volcker thinks about the Fed’s ballooning balance sheet, or U.S. dollar policy for that matter. A lifelong Democrat, Volcker is properly credited with slaying inflation in the 1980s. But he is no supply-sider.

Presumably, however, the conservative-Keynesian Volcker, along with Tim Geithner, Larry Summers, and Christina Romer, will advise Obama not to hike taxes in the next two years.

But that’s a presumption. We don’t know who else will be on this Obama economic advisory board. Might they consider a stable dollar and a big corporate tax cut? Well, if Volcker listens to his friend Mundell, he’ll gain some important advice to be passed along to the new president-elect.

Thursday, November 13, 2008

Bush Shows Obama the Way

President George W. Bush came out fighting for free markets with a strong and stirring defense of American capitalism on the eve of the G-20 World Economic Conference. Stocks soared 550 points Thursday as Bush’s luncheon speech was played live on all the major cable networks. It was as though Mr. Bush was trying to leave an economic-primer to his successor-elect Barack Obama. Markets cheered because it’s the best thing they’ve heard in many weeks.

Here’s one of several great passages from Bush: “At its most basic level, capitalism offers people the freedom to choose where they work and what they do … the dignity that comes with profiting from their talent and hard work. … The free-market system also provides the incentives that lead to prosperity -- the incentive to work, to innovate, to save and invest wisely, and to create jobs for others.”

In other words, free-market capitalism is the best path to prosperity.

During a gloomy period of financial crisis, recession, big-government rescues, and ailing banks and industrial companies, Bush has provided a strong visionary dose of big-picture economic prosperity and optimism that can lead the U.S. and the rest of the world out of its economic doldrums.

Here’s another uplifting passage from Mr. Bush: “Free-market capitalism is far more than an economic theory. It is the engine of social mobility -- the highway to the American Dream. And it is what transformed America from a rugged frontier to the greatest economic power in history -- a nation that gave the world the steamboat and the airplane, the computer and the CAT scan, the Internet and the iPod.”

Capping all this off, Bush said, “The triumph of free-market capitalism has been proven across time, geography, culture, and faith. And it would be a terrible mistake to allow a few months of crisis to undermine 60 years of success.”

That reference to 60 years harkens back to the original post-WWII economic-rebuilding conference held in Bretton Woods, N.H., in July 1944. At that historic meeting, the U.S. and Britain led 170 delegates from around the world into a new era of free markets, free trade, and stable currencies. It was a conference of global coordination that broke down the isolationist and protectionist sentiments that upset the world order so badly during the prior 15 years.

Ultimately, the free-market system forged at Bretton Woods, which was in no small way predicated on economic prosperity, led to a triumph of Western values over Soviet state socialism. And it was President Reagan -- along with his friend, British Prime Minister Margaret Thatcher -- who applied the final blow to the now-defunct Soviet system with his rejuvenation of free-market capitalism.

So what George W. Bush seems to be saying is this: Do not discard that triumphal system just because we’ve had a rough year in the financial markets and the economy.

In a few weeks Barack Obama will inherit the mantle of the capitalist system. What will he do with this responsibility? That’s the question being asked everywhere.

Since the election, and up until President Bush’s important G-20 speech, stock markets sold off nearly 15 percent. Investors want to know if economic rewards will be encouraged or penalized. Will trade remain open and free? Will we maintain competitive businesses that can compete worldwide? Or will we resort to the protection of ailing or failed businesses?

Will the U.S. lurch toward the semi-socialism of Old Europe? Or will we stay with free-market capitalism? Will we expand the nanny-state economy? Or will we keep the door wide open to entrepreneurial spirit and gales of creative destruction?

Investors want to know which way President-elect Obama is going to go. Might he reach back to the Democratic pro-growth supply-side policies of John F. Kennedy’s tax cuts, free trade, and strong dollar? Will he opt for Bill Clinton’s free-trade and strong-dollar policies, or even his capital-gains tax cut? Or will he fall back to the hopeless government tinkering of Jimmy Carter or the welfare-statism of Lyndon Johnson?

I’m keeping an open mind on Mr. Obama during this post-election honeymoon period. After all, he stole the tax-cut issue from Sen. McCain during the election. And surely he knows the conservative red states that joined his campaign for change didn’t vote for a leftward lurch to socialism lite.

Mr. Obama has a huge opportunity and an outsized responsibility to mend and revive the economy. It may be too much to ask, but perhaps he will give President Bush’s marvelous speech a close read. There is much wisdom there. And there is no iron-clad reason why a Democrat can’t adopt the economic-growth model that has worked so well and so long for this country.

Paulson's Rescue Plan Adjustments

Remember that huge congressional swing-out two months ago over the Treasury's request for $700 billion to purchase at auction a bunch of toxic assets that no one wanted to buy? And remember John McCain's curious behavior, temporarily shutting down his campaign in order to fly to Washington and save the nation from financial collapse? (Some say that
episode sunk Big Mac's campaign.)

Well today, Treasury man Paulson announced that there probably won't be any toxic asset purchases after all. Instead, he intends to forge ahead with more capital purchases to strengthen bank balance sheets and also, by the way, non-banks, which lend roughly 40 percent of total consumer credit. Think AMEX, GE Capital, maybe GMAC, and others.

Actually, Paulson has a good idea for a private capital injection into banks (and maybe non-bank lenders) that would then be matched by taxpayer capital. This was a good idea proposed a while back by Harvard economist and former Bush advisor Greg Mankiw. The more private capital the less the government-takeover threat and the healthier the banks will be.

But there's more from Paulson today. He talked at some length about Treasury assistance for securitized credit-card student-loan and auto-loan assets, and he said the Fed is designing a lending facility to meet liquidity needs for asset-backed securities and their sponsors. This securitized-loan business is a whole new avenue of rescue operations. And it surely opens the
door to a lot of non-banks that are going to play in the Treasury's sandbox.

Mr. Paulson also said the Treasury is looking at FDIC chair Sheila Bair's multi-billion dollar loan-guarantee program for foreclosure mitigation. This really means Uncle Sam will wind up eating some significant losses while the interest and principal on shaky mortgage loans
are written down.

Stocks were off big today — before, during, and after Paulson — closing down over 400. Tough to pin it on the Treasury man, however, since the plunge started in the early-morning well before he spoke.

Some folks think the stock market is stalking Obama, whose defining moment may be a GM bailout. Plus, investors are waiting for a new Treasury appointee who will shed light on Obama's tax and trade threats for 2009 as well as his UAW rescue mission that is so strongly favored by Speaker Pelosi and Senate Majority Leader Harry Reid. Policies protecting
ailing industries would certainly set a France-like tone for the new administration.

Here's a stat from my friend, blogger Mark Perry: Total compensation per hour for the big-three carmakers is $73.20. That’s a 52 percent differential from Toyota's (Detroit South) $48 compensation (wages +health and retirement benefits). In fact, the oversized UAW-driven pay package for Detroit is 132 percent higher than that of the entire
manufacturing sector of the U.S., which comes in at $31.59.

I don’t care how much money Congress throws at GM. With that kind of oversized comp-package they are not going to be competitive. It’s throwing bad money after a bad cause. What a way to start the new Obama era.

I would still argue that rescuing banks and consumer credit companies removes systemic risk from our lending system. But the only thing systemic about the GM bailout is the hegemony of the UAW. Or maybe I should be more cynical: Republican socialism followed by more Democratic socialism.

Monday, November 3, 2008

Is Obama Swiping the Tax Cut Issue?

Voters seem to think he’s the Ronald Reagan tax-cutter of the 2008 election.

Wouldn’t it be the height of irony if Barack Obama wins this election as the Ronald Reagan tax-cutter? His tax plans are severely flawed and his campaign narrative to support them is all wrong. And yet a recent Rasmussen poll shows that 31 percent of voters believe Obama is the real tax cutter, while only 11 percent choose McCain.

Believe it or not, Obama seems to have swiped the tax-cut issue from the Republican party. How can this be?

Well, for almost two years Obama has talked about cutting taxes for 95 percent of the people. McCain has no such record. And even though McCain has launched a strong Joe the Plumber investor-class tax-cutting surge in the last days of the campaign, it may not be enough to significantly impact Tuesday’s voting results.

This is bad news since Obama has some pretty strange views on taxes. Just look at his recent explanation for the decline in third-quarter GDP. He calls it “a direct result of the Bush administration’s trickle-down, Wall Street first, Main Street last policies that John McCain has embraced for the last eight years and plans to continue for the next four.”

Is Obama really blaming the Bush tax cuts for this recession?

After the bursting of the tech bubble and the 9/11 attacks, George Bush lowered tax rates across-the-board for individuals and investors. For five years the stock market rallied without interruption -- the longest bull market without a correction in post-WWII history -- while the economy expanded for six years, a bit longer than the average post-war recovery cycle.

And Obama wants folks to believe that tax cuts caused this downturn? Not the credit shock? Not the Obama-supported government mandate to sell unaffordable homes to low-income people and the pressure on Fannie and Freddie to securitize these loans? Not the oil shock?

No self-respecting Keynesian would buy into this. Yet Obama was at it again in Monday’s Wall Street Journal, saying, “It’s not change to come up with a tax plan that doesn’t give a penny of relief to more than 100 million middle-class Americans.”

Regrettably, not even John McCain has contradicted this. But the facts speak otherwise.

For example, the nonpartisan Tax Foundation says the Bush tax cuts -- which McCain would maintain -- provided substantially more relief than middle-class Clinton-era tax rates: A single earner making $30,000 will pay $2,756 under 2008 Bush tax law compared with $3,157.50 under Clinton tax law (in 1999). That’s a larger Bush tax cut by 8.7 percent. A married couple earning $50,000 will pay $4,012 under Bush compared with $5,085 under Clinton. That’s a bigger Bush tax cut by 21 percent.

So the facts of a middle-class tax cut are far different from what Obama claims. Obama also says his tax rates will be below those of Ronald Reagan. Wrong. Obama will raise the top rate to 39.6 percent, whereas Reagan left taxpayers with only two brackets of 15 and 28 percent.

Incidentally, the income cap for Social Security and Medicare taxes was about $42,000 when Reagan left office, compared with $104,000 today and the threat that Obama will raise that cap significantly.

It’s also worth noting that the Reagan tax-reform bill of 1986 mistakenly allowed the capital-gains tax rate to move up to 28 percent from 20 percent. Many believe this was a significant factor in the stock market crash of 1987.

Similarly, Obama intends to raise the cap-gains tax rate from 15 to at least 20 percent. It’s a risky move. Of course, Obama says only rich people will pay the higher cap-gains rate. But the reality is that a cap-gains tax hike will raise the after-tax cost of all capital, which will depress the future value of all equity assets.

McCain has recently proposed a reduction in the capital-gains tax rate from 15 to 7.5 percent. With 100 million-plus investors out there, and nearly two of every three votes in national elections being made by shareholders, this is right on target. Last Friday, McCain told me in an interview that a “low capital-gains tax is probably the greatest incentive for investment that we have in America today.

In the frenetic final hours of the campaign McCain is also talking up his corporate tax cut, which would be a tremendous boost to plunging stock prices since corporate profits are the mother’s milk of stocks. Indeed, McCain’s overall tax-cut plan is far more powerful than Obama’s when it comes to creating jobs and stimulating economic growth. But his marketing effort appears to be too little, too late.

These things do, however, have a way of balancing out: If Obama and the Democrats go on a tax-hiking spree to penalize successful earners and investors, they will pay for it dearly in 2010 and beyond.

Friday, October 31, 2008

My Interview with Senator McCain

What follows below is a transcript of my interview earlier this morning with Senator John McCain on the investor class and the stock market. Big Mac is talking tax cuts on capital gains, businesses, and individuals. There is no question that he is energized. Politically, he is still running even with Obama among investors. That is not good. Is there time for Senator McCain to break through and run up his margin with this crucial voting block?

Larry Kudlow: Let me go back to the first question, which you were beginning to answer. We've had this terrible stock market slump. Some say $3 trillion dollars worth of wealth have been lost by investors in the investor class. And I was asking, and I think you were answering, what is your plan to create some recovery in the stock market?

Senator McCain: Keep taxes low, cut spending, create jobs with alternative energy, including nuclear power plants, including drilling offshore, wind, tide, solar. Free us from our sending $700 billion or whatever it is across to countries that don't like us very much.
Free up credit. Larry, I’ve been meeting with a lot of small businesspeople, and they're having great difficulty getting lines of credit. This is something we've got to free up. Now, we have given the banking, the banks and other institutions the kind of infusion they need. It's time they pass that on to small businesses who say they can hire. They've got business, but they just haven't got the line of credit.

But make sure that everybody knows that we're going to keep taxes low. We're not going to raise taxes. We're the creator of business and the engine of our economy and small business, Senator Obama's proposal would tax half of all small business income, some 16 million jobs in America would be at risk. And then you put on top of that, he will force his mandated health care plan on small businesses, their employees, and their children. It's not good for America.

Kudlow: Just on the credit piece that you mentioned a few moments ago, have you and your campaign been following the improvement in the Libor credit market in London and the commercial credit markets here in New York? It looks like the Treasury plan is beginning to work. That may be a positive sign. Do you follow those areas?

McCain: Yeah, I do, and I get updates all the time. One of the areas that I’m still very disappointed in, though, Larry, and you may not agree with me, we've got to go in and get these home mortgages bought and give people mortgages they can afford so they can stay in their home. Look, I’m in Ohio. Homes are being foreclosed everywhere. A lot of these people, it's their primary residence, could stay in their home if they had a new mortgage at the new value of their home, at payment levels they could afford. That is the slow -- one of the slowest parts. I think it's the slowest part right now. Keep people in their homes. If they can't realize the American dream and stay in their homes, then obviously, the rest of this equation is hard to complete.

Kudlow: Let me swing back to the investor side. There are about 100 million investors, according to the Federal Reserve survey. And interestingly, in recent national elections, they're a huge voting block, almost two of every three votes cast are cast by people that own stocks either directly or indirectly. And yet, sir, you very, very seldom mention investors on the campaign trail. Why is this?

McCain: Well, I try to talk about them more often. A lot of the people that come, frankly, are people that are having trouble staying in their homes, keeping their jobs, et cetera. But I think it goes back to all this business of Senator Obama's view of "fairness." When Charlie Gibson said, why would you want to raise capital gains taxes when you know it will decrease revenue? And he said in “fairness”. And he told Joe the Plumber -- Joe the Plumber got the message through better, what we've been trying to do this whole campaign. [Obama] wants to "spread the wealth around." That takes from the investor class. That takes money from one group of Americans and gives it to another. Now that signal has been very clear. And I think people ought to pay attention to it, because it's been tried before in other countries, and policies of other left, liberal administrations. It doesn't work, and it's bad for America. We want to encourage the investor class, and that means capital gains and dividend taxes are low.

Kudlow: You've just unveiled a new tax cut on capital gains. Can you tell us about that? Because in some sense, that's probably the most important investor class tax.

McCain: It's the most important in many respects, Larry, and we want it low and we want it lowered. Every time -- there's one tax that there's no argument about, that every time it's been lowered since Jack Kennedy, we have seen an increase in revenues. Now, why anybody would argue, as Senator Obama does, that we need to raise it, even if it's -- of course, the amount needed to raise it is varied with whatever poll he's taken, but the point is that we want to lower it and keep it low and encourage investment, especially now in America in these difficult times.

Kudlow: But Senator, what is -- the current law rate is 15%.

McCain: Yeah, yeah.

Kudlow: You're taking the cap gains rate down to what?

McCain: First down to 10%, I would like to see it, and gradually even make it lower. Look, why should we tax people's gains twice? Why should we tax them twice, okay? They make an investment, they should be able to get their returns on their investment. And capital gains is obviously -- low capital gains tax is probably the greatest incentive for investment that we have in America today. And so, look, I’ll be glad to listen to smart people like you, Larry, but the worst thing we can do is tell people we're going to raise it, and that, obviously, would chill investment in America, right?

Kudlow: Well, with your lower capital gains tax, which in a recent speech you said 7.5% for two years, are you surprised, though, that respected pollsters like Scott Rasmussen or Investors Business Daily are still showing you running neck and neck, even with Mr. Obama? Back in 2004, President Bush beat John Kerry by 11 percentage points among investors. Now, you've got a lower cap gains tax. Mr. Obama proposes to raise the cap gains tax from 15% to 20%. Except you're still running even in the polls. Can a Republican win running even among investors? And why don't you think your message on capital gains has resonated with a bigger margin among investors?

McCain: I'm not sure, except obviously, when he broke his word that he would take public financing if I also did, he signed a piece of paper, that obviously, he's had a huge money investment. Look, I’m a 7.5%, I’d like to keep it permanently at 7.5%. Right now, we need more investment in America and in the stock market and in businesses and investment than ever before in these difficult times. So, it's pretty clear that if we keep them low, we will provide another tool for encouraging investment. Look, we are -- I am so happy we are where we are. I see a level of enthusiasm out here in this campaign, Larry that is remarkable. I haven't seen this level of enthusiasm before. I'm very optimistic, and we're coming from behind. I'm the underdog. That's where we always like to be. But we are within margin, and I’m very happy where we are.

Kudlow: Another really important tax for the stock market investors, of course, is corporate profits. Profits are the mother's milk of stocks, as I have said from time to time. You've proposed to lower that from 35% to 25%. Senator Obama says the other day, that's merely another huge and permanent tax cut for corporations, including $4 billion dollars for the big oil companies, but it is no help for workers. Would you react to Mr. Obama's criticism of your corporate tax cut?

McCain: He doesn't get it. Corporate tax rates in America are the second highest in the world. Japan is only higher. Ireland has 11%. Business -- I like to call them business taxes, because that's what they really are, because they're businesses and they create jobs and they create employment. And when businesses can go anyplace in the world, where are they going to go? Look, I can name you Fred Smith of FedEx, Meg Whitman, other CEOs who will tell you, when they have a choice to go around the world and pay less in taxes where they can invest more and increase businesses and jobs, they're going to do that. Obviously, they want to stay in America. And they want to create jobs in America, and they will, but we want to give them the incentive to do so. And lowering the business tax, the corporate taxes, in my view, they should be lower than 25%. Why is it that we're the second highest in the world, when 20 or 30 years ago, we were amongst the lowest in the world? It's not an incentive to businesses and jobs in America. It shows, frankly, that Senator Obama just doesn't get it.

Kudlow: You said yesterday or the day before when you were in Miami, Florida, the Democratic Congress is going to remove tax incentives or tax preferences for 401(k) accounts. Of course, that is a huge investor issue. What did you mean by that? What is the plan that Democrats want to take away from 401(k)s?

McCain: Well, that's exactly what they're saying. And Barney Frank, who is powerful, chairman of a powerful committee in the House, said we're going to raise taxes and we're going to increase spending. That's exactly the wrong thing to do in the economic difficulties we have. How did we get into this ditch? We ran up a $10 trillion deficit on our kids and half a billion dollar debt to China. So, obviously, they want to take the 401(k)s and use that money to give that to the government to spend, rather than people, and I think that's very dangerous disincentives to savings, which is exactly the cause of one of our problems, as we all know.

Kudlow: Last one, Senator, and I appreciate your time very much. Americans have an innate sense of optimism and confidence about stocks and the economy. The Rasmussen poll shows 73% believe stocks will be much higher five years from now than they are today. Is there a way for you in the closing days of this campaign to appeal to the innate sense of optimism that Americans have? Is there a way for you to connect with the investor class?

McCain: Well, I hope we've connected with the investor class by them examining our plans as we come closer to the election. But I also have to tell you, Larry, the people who want to invest are Joe the Plumbers of this world who want to own their small business. They want to employ people, and they want to invest in their futures and in the stock market and make investments, 401(k)s, IRAs and others, so that they could ensure their retirement and their future. And Joe the Plumber was able to do something that we hadn't been able to do this whole campaign, and that is articulate the reason why he doesn't want to see his taxes raised so that he can use it to buy a business and create jobs and to take care of his and his family's future. That's what this campaign is boiling down to, and that's why we're getting closer and closer, my friend.

Kudlow: All right, Senator McCain, thank you ever so much for sharing your time. Good luck in the rest of the campaign, sir.

The Dumbest Story Ever Told

Today’s GDP report showed a small contraction of 0.3 percent. But stocks went up nearly 200 points anyway. Many observers believe the thirdquarter downturn was not a catastrophe, especially if you factor in hurricanes and the Boeing strike. On top of that the short-term tax rebates ran out in the third quarter, and that helped depress consumer spending, which did fall 3.1 percent.

However, inventories are quite low after three quarterly declines. And business capex shipments actually rose slightly in the three-month period ending in September. So there’s no collapse, at least yet, in business investment.

Most analysts expect a much worse drop in the fourth quarter, ranging between a 3 and 4 percent contraction. But they are not factoring in a roughly $200 billion annual drop in consumer energy expenses that will accrue from the collapse of oil and gasoline prices. This is going to be a big consumer booster.

Meanwhile, credit markets continue to defrost and commercial paper is now rising again, as is inter-bank lending. So the economic story may not be near as bad as the consensus thinks. Remember, of course, the Fed is pumping in cash at a huge rate. That’s going to help the whole story.

The dumbest thing I heard today on the economy was a statement from Sen. Obama. He says the decline in GDP is “a direct result of the Bush administration’s trickle down, Wall Street first, Main Street last policies that John McCain has embraced for the last eight years and plans to continue for the next four.”

Wait a minute. Did I miss something here? After the bursting of the tech bubble and the 9/11 attacks, George Bush lowered tax rates across-theboard for individuals and investors. The stock market rallied uninterruptedly for five years. The economy expanded from the end of 2001 to the end of 2007. Are we to really believe the Obama narrative that cutting tax rates is the cause of this downturn? Not the credit shock? Not the Obama-supported government mandate to sell unaffordable homes to low-income people and to pressure Fannie and Freddie to securitize these loans? And not the oil shock, as well?

It was really tax cuts that caused this recession?

That’s the dumbest story ever told.

Wednesday, October 29, 2008

Mac Must Make the Investor Case Now

John McCain is gaining traction on the tax issue as he aggressively makes the case that Obama the Redistributor will take your money and give it to someone else, while he, McCain, will create more economic opportunity by growing the pie for everyone.

Key polls — like Rasmussen, Gallup, Battleground, and IBD — show a narrowing of the race to 2 or 3 percentage points just in recent days. This is in part because Joe the Plumber has crystallized McCain’s campaign message to a pro-growth tax-cut recovery plan that reaches out to investors all across the country. Now the big question is whether McCain will stay on message and keep hammering these points home.

Two days ago in Ohio, McCain argued: “We will cut the capital-gains tax. And we will cut business taxes to help create jobs, and keep American businesses in America.” It’s the first time he referred explicitly to his capital-gains tax cut, which would take the investment rate to 7.5 percent from current law of 15 percent.

Against the backdrop of plunging stocks and deflating home prices, that means asset buyers would keep 92.5 cents of every additional dollar of profit from the purchase of underwater stocks, houses, or any other asset. Current law will let you keep 85 cents on the extra dollar. So McCain’s plan is a 9 percent incentive reward to invest and take risks.

Now contrast that with Obama’s capital-gains tax hike to a 20 percent marginal rate (at least). That means you keep 80 cents of the extra dollar of invested profit instead of today’s rate of 85 cents. In other words, that’s a 6 percent penalty compared with current law.

Adding up McCain’s 9 percent reward and Obama’s 6 percent penalty, we’re talking about a 15 percent swing in the after-tax cost of capital and reward for investment. Stocks have already fallen 40 percent from last October’s peak. So the 15 percent differential between the Obama and McCain plans makes a very big difference to the 100 million investors who comprise nearly two of every three votes in presidential elections.

Additionally, McCain would provide a $15,000 capital-loss tax deduction and would lower the tax rate on retired investors who redeem their 401(k)s or IRAs to a rock-bottom 10 percent. Plus, McCain would drop the corporate tax — a big boon to consumers who actually pay the tax — and would keep income-tax rates at present levels.

Obviously, there’s a very significant difference between the Democratic and Republican plans. If only Mac hammers this home in the final days of the election. Sure, folks have a strong dislike for redistribution. They prefer opportunity. They want to grow the pie larger. And they don’t want left-wing activist Supreme Court judges to take away even more of their economic rights. Hence McCain’s case grows even stronger — if he pounds away and makes it. But yesterday on CNBC John McCain never mentioned capital-gains or investors. That’s not the way to do it.

The latest IBD/TIPP poll shows a 46-46 toss-up among investors. That’s not good. What I’m saying here is that while the redistribution argument is working, it needs to be bolstered by a strong case to investors, who are usually the very base of the GOP.

The opportunity is there for Sen. McCain. But he must have a disciplined investor message in the remaining days.

Monday, October 27, 2008

Reagan + Friedman + Keynes

We need all the help we can get

Back in early 1981, when I went to Washington to work for President Reagan, one of the architects of supply-side economics, Columbia University’s Robert Mundell, visited my OMB budget-bureau office inside the White House complex. At the time we were suffering from double-digit inflation, sky-high interest rates, a long economic downturn, and a near 15-year bear market in stocks.

So I asked Prof. Mundell, who later won a Nobel Prize in economics, if President Reagan’s supply-side tax cuts would be sufficient to cure the economy. The professor answered that during periods of crisis, sometimes you have to be a supply-sider (tax rates), sometimes a monetarist (Fed money supply), and sometimes a Keynesian (federal deficits).

I’ve never forgotten that advice. Mundell was saying: Choose the best policies as put forth by the great economic philosophers without being too rigid.

Of course, John Maynard Keynes was a deficit spender during the Depression. Milton Friedman warned of printing too much or too little money. And Mundell, along with Art Laffer, Jack Kemp, and others, revived the importance of reducing high marginal tax rates to reward work, investment, and risk. The idea was to make each of these activities pay more after tax, and in the process boost asset values across-the-board. This incentive model of economic growth was used effectively by President John F. Kennedy and the great 1920s Treasury man, Andrew Mellon.

During the 1980s Reagan enacted Mundell’s three-legged approach. He slashed tax rates on the supply-side and was not afraid to run budget deficits in the Keynesian mold. At the same time, Reagan gave Paul Volcker carte blanche to practice the tough-minded monetarism that curbed excess money and vanquished inflation. This eclectic policy mix reignited economic growth, and it ushered in a three-decade prosperity boom that revived free-market capitalism.

Today, however, the economic naysayers are ignoring the advice of Prof. Mundell. Looking at our financial crisis, with its deflationary sweep from stock markets to home prices to energy, they want to lurch leftward to a big-government tax-and-spend regulatory approach. Instead, we need to put all three legs of the Mundell hypothesis in place. And we’re already two-thirds of the way there.

Treasury man Henry Paulson is using a $700 billion rescue package to prop up banks with new capital, purchase distressed assets, and backstop inter-bank lending. Keynesian deficits will finance it. But it’s working. While ankle biters on the left and right have dissed Paulson’s plan, important credit-market spreads have declined significantly in the last two weeks.

Fed head Ben Bernanke, meanwhile, is combating deflation with a Friedmanite monetarist approach -- the second leg of the Mundell mix. Over the past two months the Fed has doubled its balance sheet and spurred a major increase in the basic money supply in order to meet the enormous liquidity demands that always accompany deflation. The Fed should keep this up in the coming months until stocks, commodities, and credit show life-signs of recovery.

But what’s missing is Mundell’s third policy leg: supply-side tax cuts. And here we find the partisan debate of the closing days of the presidential and congressional elections.

Democrats want to tax the rich, redistribute the wealth, and spend our way out of the economic doldrums. It won’t work. Senators Barack Obama and Harry Reid, along with Speaker Nancy Pelosi, disdain supply-side tax incentives. But Sen. John McCain wants to reemploy them as a recovery tool. McCain is right, and now is the time for the Republican party to call for sweeping tax cuts that would reduce marginal rates by half for businesses, individuals, and investors. Yes, it would be bold. But no bolder than Reagan in the 1980s, Kennedy in the 1960s, or Mellon in the 1920s.

The corporate tax rate should be slashed from 35 percent to less than 25 percent, including capital-gains. (Corporations, let’s not forget, don’t pay taxes. Only individuals do, since business costs are passed along to consumers.) The top individual rate should similarly be lowered, with fewer income brackets to clutter up the tax code. And investment taxes on capital-gains and dividends should be cut from 15 percent to 7.5 percent to revive the dormant animal spirits of investors.

These tax cuts would mean all three legs of Robert Mundell’s pragmatic approach to policy are in place. Use the money supply to combat deflation (inflation is not the problem), employ deficits to rescue and stabilize the banking and credit system, and slash tax rates to reignite economic growth.

In effect, a successful rescue plan requires a drawdown of all the major economic schools of thought. Given the current economic emergency, we need all the help we can get. For a change, how about a little pragmatism in the policy mix? That just might do the trick.

Wednesday, October 22, 2008

Washington to Wall Street

Obama’s Treasury-Ready Men

There’s a huge multi-thousand word article in this mornings Wall Street Journal on Paul Volcker, the former Fed chairman who conquered inflation during the Reagan years and has become a key financial advisor to Sen. Obama. Articles like this fan the flames of speculation that Volcker could be Obama’s secretary of the Treasury, despite his 81-year-old senior citizen status. But Volcker is a vigorous 81 and I think he could handle the job.

Of course, Volcker has a great reputation as a deficit-cutter and a strong-dollar man. What’s more, as a long time financial advisor who was president of the New York Fed, undersecretary of the Treasury, and of course Fed chairman, Volcker’s money knowledge would gain bipartisan support to solve the financial crisis, which will surely spill over into next year. Volcker would attract bipartisan support because of his superb reputation. He is not a supply-sider, nor did he agree with the Reagan tax cuts in the 1980s while he was Fed chairman. But he did work well with the Gipper. Reagan’s supply-side tax cuts along with Volcker’s tight money to slay inflation produced a strong economic recovery and proved all naysayers wrong.

Volcker will unfortunately agree with Obama that the top tax rate can be raised. Not good. But he’s very good on tighter spending and King Dollar. And he does have vast knowledge of the intricacies of world credit markets.

I’m sure the Obama campaign is encouraging the Volcker speculation, since Mr. Volcker brings gravitas and experience to Obama.

The other likely candidate for Treasury under an Obama administration is Lawrence Summers, the proven protégé who was Treasury secretary during Clinton’s last year and before that undersecretary. Summers also would be a strong player, with wide knowledge of our financial problems. He’s also for a stable dollar. And noteworthy is his long-held criticism of Fannie and Freddie. Like Volcker, Summers would agree to lifting the top tax rate; he is no supply-sider. But also like Volcker, he is a moderate-to-conservative Democrat who would be well received by Wall Street and investors.

Are Stocks Ready to Blast Off?

For those like myself who believe the stock market is on the rebound, please go to “Calafia Beach Pundit”, a blog site run by the very smart freemarket supply-sider Scott Grannis. He has a blockbuster chart suggesting a huge rally in stocks.

It’s based on the fact that the two-year swaps spread in the bond market has fallen significantly and is closely related to stocks. His chart suggests the S&P 500 could rebound to 1,200. That would be roughly 20 percent above today’s level.

If Big Mac Wants to Distance Himself from Bush …

The Washington Post reports today that Sen. John McCain is out there on the campaign trail criticizing President Bush in order to deal with the Obama media attack linking Big Mac to W. Apparently McCain is criticizing Bush and Paulson as bailing out the banks rather than buying up underwater mortgages to help homeowners avoid foreclosure.

Okay, fine. I think Paulson’s three-cornered plan to recapitalize banks, buy up toxic assets, and guarantee short-term inter-bank loans in London and New York is the right policy. And since surfacing two weeks ago, the rescue plan is actually helping boost the stock market. But if McCain wants to go there on mortgages, then go there.

However, the senator could distance himself from President Bush in other ways that might resonate with the investor class — the important voting bloc that McCain needs to win by 10 points but is now running even. For example, until very recently the Bush dollar kept sinking. So why doesn’t McCain distance himself from Bush by supporting a King Dollar
that will attract global investment for job creation, hold down inflation, and improve America’s standing around the world? Sen. McCain also could tout across-the-board pro-growth tax reform, such as Paul Ryan’s idea of 10 percent and 25 percent marginal tax rates.

Economic emergencies require strong medicine, and tax reform along with currency reform is consistent with McCain’s message that he will be a real Washington reformer. There’s also McCain’s plan to reform the corporate tax. In this case, McCain’s rate-slashing idea can be sold as a jobs and wages booster and as a tax-cut for ordinary consumers who pay most of
the higher corporate tax that is passed along to them.

These would be very strong economic-recovery ideas that are separate and apart from the Bush policies and have a strong reform message.

Thursday, October 16, 2008

My Interview with Secretary Paulson

Last night, on CNBC's "Kudlow & Company", I had an exclusive interview with Treasury Secretary Hank Paulson. The entire transcript follows:

Kudlow: A very special evening here. The man in the eye of the financial storm. Treasury Secretary Henry Paulson joins me live here in our nation’s capitol. Thank you very much for coming back.

It's a tough day. You know all about that. The market is down over 700 points. Your announcement was yesterday, but we still have the bumpy markets. Fear seems to rule. Volatility seems to rule. A lack of confidence everywhere. Let me ask you, sir. Are markets missing something with respect to your new plan? How do you comment on this, because it just doesn’t seem like there is a wave of confidence.

Paulson: Well, Larry, there's a lot going on right now and a lot going on in the markets. We knew that the financial markets and all the turmoil in the financial markets were going to have a significant impact on the real economy.

Today there was some evidence of that. The retail sales numbers came in at a disappointing level, but not a surprising level. So, I think what the markets are saying today is that they understand that we are going to have a difficult few months ahead of us. But what I would say is let us remember that we have a very resilient economy. Last quarter we grew at 2.8 percent.

The steps we’ve taken are absolutely the right steps. They are bold steps. They are strong steps to stabilize the financial markets and inject confidence into the banking system along with capital. When banks start lending to each other, feel comfortable dealing with each other, they will start lending to businesses and we’ll see this make a big difference in the economy.

Kudlow: Do we have to take a recession? Are we in a recession right now, sir?

Paulson: Well, Larry, what I'm saying is, we're clearly in a difficult period, and it clearly -- the financial turmoil and the very, very difficult time we've had where the credit markets have frozen up, and when loans weren't being made, weren't being made to small businesses, people -- it was hurting jobs, it was hurting confidence, and this has to have an impact. And it's having an impact. But by far the most important thing we can do here is stabilize the markets, stabilize the banking system, and I'm very confident that the moves we've done, taken, will do just that.

Kudlow: All right. I want to get into all those things. They are very important points. Let me begin - front - page stories in all the major papers today. When you unveiled on Monday your rescue package to the nation’s top bankers, apparently it was a somewhat contentious meeting. I want to ask you, first of all, are the major bankers with you? Are they on your team for the rescue package? Second of all, what was the biggest bone of contention in that meeting? What was it you had to sell them on?

Paulson: Well, Larry, let me begin by saying I don’t believe it was a very contentious meeting. I think it was a candid meeting. I think it was pretty extraordinary to get nine bankers running key institutions – institutions with 54 percent of the assets, 50 percent of the deposits in the United States of America -- and to get them to sign up for this plan.

What I said to them was – this is about the United States of America – it's about our economy – it's about our banking system and this is a program for healthy banks. This is not about failure. We want healthy banks to participate in this, because healthy banks need to be well capitalized. They need to be dealing with other healthy banks and with businesses. They need to be deploying their capital. This will be good for the country, it will be good for the system, and good for all of you.

Kudlow: How did you persuade my friend Richard Kovacevich, who runs Wells Fargo? He seems to be the most prominently mentioned. I wasn’t at the meeting and he didn’t talk to me, but from the news accounts, how did you talk him into coming on board?

Paulson: Well, I’ve got to say this. We talked to everyone and there are institutions that could survive just fine without more capital - they have adequate capital - but they need to be well capitalized. What we want to do is to come up with a program. Remember something else about this program. There is nothing punitive about this program. This is a program that said to all the investors that want to come into the banking system, that when the government comes in it is not coming in to squash private investment.

Kudlow: Private shareholders.

Paulson: Private shareholders. No, it is encouraging private shareholders to invest in these banks. So, this is about increasing confidence in the banks and about increasing confidence of the banks and the banking system so that they can be proactive in deploying their capital.

Kudlow: Did some of these bankers worry about management control exercised by the Treasury Department? I mean clearly there are limits to executive compensation. There are limits with respect to dividend payments. And there are generic issues -- will you exercise your warrants and will you exercise voting strength. In other words, is this nationalization? I think that's on the minds of a lot of people.

Paulson: Well anything but. Anything but and this is about taking the preventative action so we don’t need to do any more radical things. Let me just take the issues you mentioned one at a time. These are relatively small positions in ownership terms. These are passive investments. Management -- this is not anything like what you suggested.

In terms of executive compensation, there was broad agreement in that room that this is an important topic. No one spent time debating executive compensation. I explained what the law required and that we were going even further and that there wouldn’t be golden parachutes. If there were profits based upon financial information that turned about to be materially misleading, that compensation would be given back.

Kudlow: Both of which the country seems violently opposed to -- the political nature of the country right now is so much against that kind of thing.

Paulson: And also that we couldn’t have incentives that made compensation based upon excessive risktaking. All of those CEOs in that room understood it. As a matter of fact, when I outlined it, one of the CEOs said "Hank, why are we even spending time talking about this? Of course, we get it."

Again, these are investments that are good for the country and good for the banks. These are temporary investments to bolster confidence and to bring capital to the system. It will be deployed and the economy will pick up and these investments will be refunded.

Kudlow: Do you think that with the preferred stock and all the other aspects you just described -- really, you say passive investments, not active management control -- will that attract private shareholders and private capital, not just the shareholders today, but the potential shareholders tomorrow?

Paulson: Absolutely. I think where people have gotten confused is there have been situations where we’ve had to come in where there is a failure. That is a totally different proposition.

Kudlow: AIG. Fannie and Freddie.

Paulson: Yes -- that's failure. That’s where you have to come in. This is about attracting private capital and it was clear to the whole world that these preferred share investments are going to come in right alongside other senior preferred and not senior to them. And again, preferred doesn't vote with common shares. The warrants are for 50 percent of the value of the preferred shares. And again, the warrants are for non-voting common shares. So, this is about capital and protecting the American people by getting our financial system working the way it's supposed to work. So, we’re going to be able to create jobs. This is about people’s 401k plan. This is about loans to send their children to college and keeping our economy going. That's what it’s about.

Kudlow: So many people want to know. People stop me on the street -- callers on my Saturday radio show -- how can you get the bankers to deploy the government capital that you are injecting? For example, the yield on the preferred is 5 percent. Their cost on the preferred is 5 percent. Some of them have preferred stock that is 11 percent in yield. They have bonds outstanding that are 7, 8, 9, and 10 percent. What is to stop them from getting new government money at 5 percent and retiring the outstanding paper that is much more expensive, rather than deploying this new capital in the economy for the purposes you just described?

Paulson: Well, that's a key question, and let me say, even before that, the reason we set the terms where they were set, we didn't think this term should be set at what the market would demand in a crisis situation. That's why the government's coming in to begin with. We wanted the terms to be like what you would have in a normal situation.

Now, the way you get bankers to deploy the capital -- because they know it's their job to deploy the capital, making the loans which are so vital to our economy -- the way you get them to do that is they've got to have, first of all, plenty of capital; they've got to be well-capitalized. Secondly, they've got to be confident in the system. They've got to be confident that as the money flows between and among banks that they're confident in that and confident in the strength of the system.

Kudlow: Rather than pay down their own debt.

Paulson: They're not going to be paying down their own debt. The regulators understand that and they understand that.

Kudlow: Will you jawbone from time to time -- that's a bad word, jawbone -- will you be talking to them in consultation as you did on Monday, for example?

Paulson: I will clearly be doing that, but I will also say to you that they understand this, and regardless of whether we had government investments there, we would be jawboning and encouraging them to do the right thing. And I will say it will be a lot more effective if people aren’t afraid. This is about confidence and confidence in the financial system.

Kudlow: Mr. Paulson, let me just ask you another question that I hear a lot. People are relieved that you are guaranteeing, the FDIC that is, is guaranteeing the interbank lending. The LIBOR markets are frozen up. Some say the New York markets are frozen up for the short-term loan. That's a huge drag on the whole system. But, let me ask you this – when does this guarantee actually go into place? There is a 75 basis point cost that the banks have to pay. I assume there is some registration. LIBOR rates have slipped a little bit, sir, but not very much. When does this guarantee for the interbank loans really kick in?

Paulson: Larry, I think when you do something as quickly as we rolled this out, there may be some confusion in the marketplace. But, everyone has a guarantee for 30 days. So, there’s a 30-day guarantee.

Kudlow: Immediately?

Paulson: Immediately.

Kudlow: Do people know this key point?

Paulson: They should, because the guarantee is there immediately. At the end of the 30 days they need to subscribe to this. There is a 75 basis point fee. Then, if they subscribe, the guarantee lasts through June of next year. The guarantee applies to the senior obligations coming due -- unsecured obligations -- and they can refund those with a maturity out to three years.

Kudlow: Talking about the freeze up in London and New York and elsewhere, with the benefit of hindsight, was it a mistake to let Lehman go under? Because a lot of people are saying it was precisely the drop off in Lehman, which was roughly in early to middle of September when suddenly LIBOR rates went up, the spread against U.S. Treasuries went up something like 300 basis points and the whole system seemed to go haywire. The whole system was like a computer that completely froze up and there was nothing anyone could do about it. Was the Lehman decision an error?

Paulson: Let me talk a little bit about the Lehman situation. Some of you could argue -- are we dealing with a symptom or are we dealing with a root cause? Because one thing I saw clearly this weekend when we met with central bankers and finance ministers from around the world. There was something very good that came out of that weekend, which was the way in which we all agreed to work together with a common set of policies and objectives. The thing that wasn’t as good was to understand the extent of the problem with financial companies and banks in country after country where they said they didn’t have a real problem, to suddenly then have a significant problem.

But let me get back to Lehman. First of all, Treasury didn't have any powers to do anything as it related to Lehman. We've been very clear. I’ve been very clear when I talked with Congress in July that we didn’t have the authorities to deal with a wind down of a non-bank financial institution. So we were very, very clear about that.

Kudlow: But in truth sir, weren’t you deeply involved in the wind down of Bear Stearns last winter?

Paulson: Yes, working with the Fed and the Fed could loan -- under 13-3 -- they could loan against securities. But there was a hole that needed to be filled in the case of Bear Stearns. There was a buyer, J.P. Morgan. and they could loan against securities.

We worked very hard on Lehman. We all knew about the problem with Lehman for a long time and Lehman tried to work through their problems. I think regulators knew that if there was not a solution before they announced their third quarter earnings, there was apt to be a problem. It turns out there wasn’t a buyer.

There was no hole to fill. There just was not a buyer for Lehman. And, the Federal Reserve didn't think they had the authorities to loan (under 13-3) against Lehman. And I certainly wasn’t urging that because, again, we had a system where we have authorities that were put in place a long time ago for a financial system that existed in a different world and there are broad authorities if a bank fails.

Kudlow: But in truth, when you go back and look at it, the stock market is down 25 percent since Lehman, which was really just a few weeks ago. It was an extraordinary event and, at the time, some people applauded you and said enough is enough we can't take out every bank. But in looking back on it, that seemed to be the trigger to all this recent mayhem.

Paulson: I would say, Larry, looking back there’s a lot that happened. What was going on with Lehman, there is no doubt that when you look at the over-the-counter derivative markets, when you look at the complexity of today's financial world, a failure of any big financial system creates a big issue.

I always look back, in addition to looking forward and deal with the facts presented to us. But I could not have been clearer in June and July, that we didn’t have the authorities. And, we certainly didn’t have them at the Treasury and I don’t believe the Fed had them. If there was a buyer for Lehman -- we had a foreign buyer that was interested -- but near the end their regulator wouldn't let them. So, there was no buyer. There was no hole to fill.

Kudlow: Let’s move on. When you made your statements yesterday regarding the unveiling of the new rescue program, here’s what you said and I will quote. "We regret having to take these actions. Today’s actions are not what we ever wanted to do." What did you mean by that?

Paulson: What I meant was, you know, we're from the United States of America. We believe in free markets. We expect our markets to work well. Government intervention is about failure of a regulatory regime, mistakes on a lot of people's parts, but to me this was much, much better than the alternative. And this was about preserving our free market system and preserving our banking system and stabilizing it for the American people. There’s going to be a good deal of work that needs to be done once we get through this period and a good deal of work to make sure we don’t get like this again.

Kudlow: Some people read your statement and they wondered out loud -- did you mean the changeover in policy from the Treasury purchases of toxic assets to the new capital injections?

Let me read you what you told the Senate Banking Committee -- this is just a couple of weeks old -- in a very difficult Congressional battle, which you eventually won. "There were some that said we should just go and stick capital in the banks. Put preferred stock -- stick capital in the banks. And what to do when you have failures, you know, that what happened in Japan and other spots. But we said the right way to do this is not going around and using guarantees and injecting capital. There have been various proposals to do that, but we want to use market mechanisms."

What was it that made you shift your emphasis away from the toxic asset purchase and towards the injections of capital?

Paulson: Larry, I'm glad you asked me that question. Let me begin by saying that what we were talking about was always capital. Going back over a year ago, I did everything I could to jawbone institutions to raise capital. No CEO ever got in trouble by having too much capital. The illiquid asset purchase is about capital and about price discovery and freeing up capital. We're going to do illiquid asset purchases and it’s going to be integrated very well with the program.

When we worked with Congress we knew we were going to have the ability to purchase preferred stocks if it was necessary. But that statement I made then was about putting in capital if we dealt with a situation like Fannie or Freddie or AIG or we had to move to prop up a failing institution.

Kudlow: But some people are saying that the movement of Europeans toward capital injection, the movement of the British toward capital injection, essentially forced you to play your hand. Is there any truth to that?

Paulson: I look at it differently here. You always need to look at the facts, then the facts before you determine what you do. What we’re doing is very different from what the British are doing. It was clear to me after spending time with the Europeans and what was happening there -- learning more about this situation, that the problem was bigger than we had hoped and that the right way to make a big impact quickly was by purchasing preferreds on the terms of which we did it. That would make the taxpayer money go the furthest. This was clearly an investment where we should get these funds back with a profit.

We moved quickly, but remember let's just talk about what we've done. In just twelve days after the legislation was passed, we had the nine institutions (voluntarily) with 50 percent of their deposits in the United States sign on for a program.

Kudlow: For $125 billion

Paulson: $125 billion

Kudlow: And you’re going to go for a second $125 billion

Paulson: And then we are going to go broadly to other financial institutions and we’ll be going to regional banks and smaller banks and community banks.

Kudlow: That leaves only $100 billion out of the authorization of $350 billion. Is that where the toxic asset purchase comes from?

Paulson: Remember, we have $700 billion.

Kudlow: But you have to go back to Congress for the remainder.

Paulson: For the next $100 billion, all the president has to do is notify. Then, to go beyond that, there is a notification process and Congress has the ability, obviously, to pass legislation to prevent it. In terms of the illiquid assets, this is a $250 billion purchase of preferred equities and it gets very different from what we were talking about when we were talking to Congress. This is a way in which to encourage shareholders to come in and not the way in which I answered the question where we were talking about injecting preferred on a punitive basis.

Kudlow: We talked earlier about the recession or the downturn and the difficult position with retail sales falling three straight months. We really have unprecedented commodity deflation, credit deflation, home deflation, and all the rest of it. When do you think realistically that new credit will flow to consumers, to businesses, to state and local governments? When do you think Americans can realistically expect that to happen?

Paulson: Larry, that is the important question and that, more than anything else, will make a difference in this economy. I've said we have a resilient country and a resilient economy and it can bounce back and this is about confidence. We're going to have a number of difficult months here. We’ve taken the actions that I believe are the right actions based upon the facts that we looked at this week. I think they are the right actions and I think they can make a difference and they can make a difference more quickly than many people recognize, but it’s going to be confidence.

Kudlow: Whoever wins in November -- we’re a few weeks away -- would you be willing to stay on for a few months to keep this process intact before you hand it over.

Paulson: Larry, I’m going to work day and night through January 22 and right after the election I’m available to work with the best transition you’ve ever seen -- with whoever the new Treasury Secretary is. We're out looking right now for permanent leaders of this TARP and we're looking to get someone that will be more than acceptable to the next president and his economic team. This is going to be a first-rate transition -- can guarantee you that.

Kudlow: Mr. Secretary Henry Paulson, we appreciate it ever so much

Wednesday, October 15, 2008

Good Little Stuff from Big Mac

It certainly wasn't the big-bang across-the-board tax-reform and taxcut plan that I and others lobbied for. But John McCain's "Pension and Family Security Plan" unveiled today on the campaign trail does have some solid pro-growth nuggets. I’m calling it some good little stuff.

The most important pro-growth measure is a reduction in the capitalgains tax rate to 7.5 percent in 2009 and 2010. Although I wish it were permanent, at least it will reward investors who scoop up undervalued assets, including bargain-basement stocks and underwater homes. Two years is not a very wide window. But this could promote a faster recovery in asset prices
and wealth creation.

Alongside the cap-gains cut, McCain is proposing to increase the amount of capital losses eligible for tax write-offs from $3,000 to $15,000 for tax years 2008 and 2009. It's an offset to ordinary income. And again, while it should be permanent, at least it will be helpful.

Also in his plan, withdrawals from tax-preferred retirement accounts will be taxed at the lowest rate (10 percent) for the first $50,000 withdrawn from these accounts. Tax rules forcing seniors to sell retirement-account stock holdings when they reach age 70.5 will be suspended. That’s good.

In effect, going into the final debate, McCain has a significant corporate tax cut and a modest capital-gains tax cut. He also wants to keep the Bush income-tax cuts in place. All of these measures are pro-growth.

I would have preferred a Paul Ryan modified flat tax with two brackets of 10 and 25 percent. In other words, a true across-the-board reduction in marginal tax rates as an economic recovery measure to connect with folks who are worried about recessionary losses for their jobs and home mortgages. Economic anxieties are big, and a big-bang tax-cut response would be optimal.

But cutting taxes for businesses, capital gains, and individuals does give McCain a lot of pro-growth meat on the bone for the big debate.

Now, if only McCain can succeed in selling these measures. Especially the corporate tax cut, which should be sold as a middle-class consumer tax cut inasmuch as corporations pass along their tax costs to consumers in the form of higher prices. This is the key to selling the corporate tax cut. McCain's senior advisors tell me he has been briefed on this language, but so far it hasn't materialized in the debates. Perhaps it will Wednesday night.

Really, the McCain tax contrast with Obama is not hard to make. In the last debate McCain referred to Obama's tax hikes as Herbert Hoover. I'd like to see Hoover reemerge tomorrow night.

Saturday, October 11, 2008

The Light at the End of the Crisis

Fear and panic have taken over the stock market, the banking system, and the economy. It is one of those moments in history when people feel helpless, frustrated, and bewildered about what’s going on and why it’s happening.

Stocks are being pummeled in ways we haven’t seen in nearly a century, both here and overseas. The Dow Jones is down nearly 20 percent this week, its second worst week since December 1914. The S&P 500 dropped over 20 percent in what looks to be the worst week in the history of that index (going back to 1928).

Behind all this, the credit system is completely frozen. Banks are now loathe even to lend to each other in the overnight markets that are so vital to the daily financing of American business. And the profits outlook is deteriorating badly, sparking fears that we may have a deep and prolonged recession.

And yet, much good may ultimately come of this terrifying correction.

I commend everyone to read the Wall Street Journal op-ed of Friday written by John Steele Gordon, an eminent financial historian. Gordon writes that there have been financial panics roughly every twenty years throughout American history. He goes all the way back to Hamilton, who orchestrated the first banking bailout in 1792. From this came a regular money-supply system, a credible U.S. government debt system, and something of a disciplined banking system.

Gordon hopes that out of the current crisis we get a better system of well-capitalized banks regulated by a more unified government supervisory apparatus. My view is that the panic will pass and long-run American prosperity will continue. This may seem Pollyannaish right now, but I have great confidence that our free-market economy will come out better, with a strong financial underpinning, when the storm finally ends.

Paradoxical as it may be, strong government actions to stabilize banking are necessary to preserve the free-market-economy system. No free-market economy can survive without stable banking and credit. Without readily available credit, entrepreneurs can’t put their new ideas into commercial practice. And without that vital innovation, economic growth suffers.

The trick now is to use government levers in smart and efficient ways. Banks need to be recapitalized without punishing current and future shareholders. Henry Paulson is working on this. More than likely, the Treasury man and the G-7 finance ministers are figuring out a plan that will temporarily guarantee all short-term interbank lending in the New York and London money markets.

Britain has done this for its High Street banks. But the American and European banks in London are not guaranteed. This is the message of the LIBOR market, which has seized up. As of Friday, the three-month LIBOR dollar rate and its spread against Treasury bills have again increased significantly. This, in turn, is dragging down stocks.

In New York, the market for commercial paper issued by banks also has faltered. In fact, financial commercial paper has dropped nearly $160 billion in recent weeks. That’s why the authorities have to step in with a short-term backstop. Other measures to relieve banks of their distressed assets, backstop money-market funds, and guarantee all banking deposits will have a positive effect over time, as Paul Volcker noted in the Journal this week.

Meanwhile, the Federal Reserve has essentially moved off its fed funds rate target and is instead focused on injecting huge quantities of new cash into the banking system. The most basic money supply controlled by the Fed is now growing at a 16 percent rate after being nearly flat for 18 months. In the last five weeks the Fed has injected nearly $700 billion through a variety of lending facilities. This is important. The demand for liquidity during this period of asset and credit deflation cries out for massive new cash supplies from the central bank.

Then there’s oil, which is almost forgotten in this panic. The $150 oil shock and elevated prices at the pump are what worsened the credit crunch and hastened the recession. But now oil is about $80 a barrel. When the dust finally clears, lower energy prices will be an important tax-cut, pro-recovery factor. Meanwhile, the exchange value of the U.S. dollar is up 16 percent in recent months. That’s an anti-inflationary sign of confidence.

And as John Steele Gordon writes, hopefully we have learned to stop forcing banks to give mortgages to un-creditworthy customers, and to stop encouraging Fannie and Freddie to package these bad loans.

I recall the despair that surrounded the S&L/junk-bond credit crunch twenty years ago. Nobody believed prosperity would return for a long time. Commentators on the left wrote about the decline of the U.S. economy and American power. Yet the 1990s witnessed a strong prosperity boom; the free-market model of capitalism triumphed and the socialist model in Russia and elsewhere collapsed.

Yes, the months ahead are going to be tough. But I remain optimistic that our free democracy and free-market economy will survive this crisis as well.

Wednesday, October 8, 2008

Will McCain Make the Investor Connection?

While the presidential candidates were debating in Nashville on Tuesday night the Asian stock markets were selling off by 10 percent. Earlier in the day the U.S. market plunged by 500 points. These were big-time drops, yet presidential debaters never talk about the stock market. Nashville was no exception.

Roughly $2 trillion in U.S. shareholder capital has been lost in the past 15 months. Stocks are down 20 percent over the last month alone. Those are nasty hits. Stock market people are very unhappy campers right now. And the bad-news financial statements for September are now either in the mail or on the kitchen table. But there were no references to investors either by McCain or Obama on Tuesday night. This is nuts.

The investor class is a huge voting bloc. Shareholders in recent national elections represented nearly two out of every three votes cast. And most surveys put the investor-class population at slightly over 100 million. This includes direct investment through brokerage accounts, although the vast majority of investor-class members own IRAs, 401(k)s, and defined-benefit plans, such as state and city pension funds.

So why aren’t the presidential contenders trying to connect to investors? More glaringly, why isn’t McCain?

After the debate I checked in with TechnoMetrica’s Raghavan Mayur, who puts out the respected IBD/TIPP poll. Mayur consistently ranks among the top pollsters in terms of accuracy, including his work on investor preferences. For September, Mayur’s data show McCain with a small 45-41 lead over Obama among investors. That’s roughly within the poll’s margin of error, and for McCain it isn’t enough.

Four years ago this September, George W. Bush had a 10-point lead over John Kerry among investors. In November Bush won investors by a 53-42 margin. By this measure, McCain is now way behind. And I suspect it may be a function of his reluctance to talk directly about investor taxes -- especially on capital gains and dividends.

The Bush tax cuts in this area were very popular among shareholders since they reduced the cost of capital and raised after-tax investment returns. Of course, McCain has pledged to maintain President Bush’s investor tax cuts at the current 15 percent rate, while Obama proposes to raise them to at least 20 percent. But McCain seldom talks specifically about cap-gains and dividends, and the polling numbers strongly suggest he’s not connecting with investors.

Obama constantly bashes businesses and successful high-end earners, and one would think investors would be totally turned off by this. But Mayer’s polls don’t confirm it. Why? Perhaps investors sense a lack of tax-cutting passion from Sen. McCain.

For example, during the debate, McCain did mention how he and Obama differ on tax policy. At one point McCain even compared Obama to Hoover. “My friends,” he said, “the last president to raise taxes during tough economic times was Herbert Hoover, and he practiced protectionism as well.” McCain later said, “I’ve got some news, Sen. Obama -- the news is bad. So let’s not raise anybody’s taxes.”

But McCain never got specific on capital-gains and dividends, and he failed to educate voters on just how important investment is to healthy job-creating businesses.

Ditto for McCain’s proposed corporate tax cut. The senator wants to slash the business tax rate from 35 to 25 percent. It’s an excellent plan. But McCain doesn’t explain how two-thirds of the benefits of a corporate tax cut go to the workforce through higher wages, with the rest then going to shareholders. He also doesn’t point out that ordinary folks actually pay the corporate tax, since firms pass this tax cost along in the form of higher prices. So McCain could, in fact, call a corporate tax cut a consumer tax cut. But he’s not doing this.

McCain also needs to put investors on red alert about Obama’s middle-class tax cut. The Illinois senator’s huge government-spending plans will overwhelm his ability to cut taxes for 95 percent of the people. In fact, McCain needs to remind voters that Bill Clinton made exactly the same promise as a candidate in 1992 before he broke it as president in 1993.

Time’s running out. The investor class vote -- which still looks up for grabs -- has simply got to be a McCain priority if he is to win in November. Rag Mayur doesn’t have his October polling results in yet, but he believes the race will be much tighter than mainstream pundits believe. Message to Sen. McCain: The investor vote could well tip the balance.

Three Silver Linings

Another bad day for stocks, which seems to be a habit lately.

Fear is the big factor. Fear over the latest credit-crunch freeze-up in short-term lending markets. Fear over deepening recession. Fear over profits. Fear that Treasury-Fed bailouts — which grow larger by the minute — somehow won’t be enough. And fear that John McCain is going down in a three-house, Reid-Pelosi-Obama sweep that will raise taxes, embrace trade protectionism, end union secret ballots, and spend us into oblivion.

Amidst all this pessimism, permit me three silver linings: First, the strong dollar. Second, plunging energy prices that will generate an economy-wide tax-cut effect. And third, rapid money-supply growth after 18 months of flat money. In fact, on this last point — which is so important — it looks like the Fed has un-pegged its fed funds target rate and is instead focused on pouring cash into the liquidity-starved global banking system. Meanwhile, the Treasury purchase plan for toxic assets will get off the ground sooner, not later. And the Fed is now backstopping the commercial paper market.

Against the rising tide of pessimism I would argue that these positives are planting the mustard seeds that will grow into the next bull-market prosperity. Believe it or not.
Now it is up to John McCain to make a pro-growth case in tonight’s debate. As one friend put it at lunch, the former Navy pilot must shoot to kill. This is his last dogfight. He must hunt, not be hunted.

Today’s Zogby and CBS polls have Big Mac down only three points — a bit of encouragement from a whole spate of much worse polling numbers.

Monday, October 6, 2008

McCain Must Talk Growth and Recovery

John McCain needs a knock-out performance at Tuesday night's presidential debate if he is to keep his hopes alive.

Right now polls paint a dismal picture for Sen. McCain. Rasmussen shows Obama leading 52-44, Obama's highest level ever. (Moving above 50 percent is a key indicator.) The RealClearPolitics average has Obama up 6 points. Intrade shows Obama up by 34 points. It also could be that key states like Ohio and Florida are now up for grabs, while Obama could win in swing states like Virginia and North Carolina. McCain, of course, is moving out of Michigan.

The financial crisis and economic downturn clearly have buried Sen. McCain in recent weeks. Some of McCain's supporters think he can turn the page on the economy Tuesday night and instead attack Obama on character and qualifications. That doesn’t seem realistic.

The recession economy and the financial crunch are front and center. Folks are asking: Can I get a loan? Will I have a job? Can I keep my house? Unfortunately, Sen. McCain's message overemphasizes government spending cuts, almost to the exclusion of stimulative and expansive tax cuts. This just doesn’t seem like the right time for a government spending freeze, at least to the exclusion of other pro-growth policy levers. Sounds like too much root canal. More like Bob Dole than Ronald Reagan.

That's why McCain needs to stress that tax hikes of any kind would be a total disaster during this economic emergency, and that letting folks keep more of what they earn is a recovery prescription. He needs to emphasize the need for across-the-board tax cuts for individuals and businesses. Lower marginal tax rates will reward work, investment, and risk-taking. They also will put money in people's pockets as they keep more of what they earn.

McCain can point to Paul Ryan's modified flat tax with two brackets of 15 and 25 percent. That would be a great message. This is an economic emergency and it calls for strong medicine. This is not the time to take away tax cuts. It's a time to add them. And reducing marginal tax rates would add substantially to taxpayer benefits on a permanent basis with new incentive rewards.

McCain should next talk about a corporate tax cut from 35 to 25 percent as a means of boosting jobs and wages. He should note that study after study shows that roughly two-thirds of the benefit of a corporate tax cut goes to the workforce. A corporate tax cut also is pro-investment and will make this country more competitive. But the key point is that a lower corporate tax rate is a job-creator. McCain must explain that you can't have jobs without healthy businesses that are funded by investment.

McCain also should state that the Federal Reserve needs to keep expanding the money supply. Milton Friedman taught us many years ago that the monetary contraction of 1929-32 was a key cause of the Great Depression. So Big Mac should tell Ben Bernanke to stop targeting the federal funds rate and pump up the money supply even more. Right now credit deflation and recession are the problems -- not inflation.

From the beginning of 2007 to the middle of 2008 the monetary base controlled by the Fed has grown only 1.6 percent at an annual rate. The basic M1 money supply has been flat. This amounts to a long-run liquidity squeeze. The credit-crunched economy desperately needs cash. But the Fed is not providing it.

Over the past three months the central bank has stepped up a bit to a 4 to 5 percent growth rate. But that is still way too little in today's confidence-lacking banking environment. Everyone is hoarding cash rather than putting it to work. McCain should highlight this point.

He also should address all the Americans who might be worried about their bank accounts. He should propose that all deposits be guaranteed by the FDIC, at least temporarily. He might also suggest that G-7 central banks guarantee all inter-bank loans for regulated banks. (Hat tip to Wall Street economist John Ryding.)

He also should put Obama's tax hikes and trade protectionism in historical context. Under Herbert Hoover, taxes were raised, trade protectionism increased, and the money supply contracted. Sound familiar? Obama’s tax hikes and trade protectionism are Hooveresque.

Right now, McCain sounds austere when he addresses the economy. Tomorrow night he must sound expansionary for economic recovery. Tax cuts, free trade, and money growth -- those are the pillars of recovery. An across-the-board tax cut for individuals and businesses will boost jobs at home and our competitiveness worldwide. Free trade benefits both consumers and businesses. The Fed's money supply must keep expanding.

That message gives McCain a fighting chance.