I. The Gathering Storm. The momentum of short-run economic, financial, and budget forces is creating the conditions for an economic Dunkirk during the first 24 months of the Reagan Administration. These major factors threaten: 1. Credit Crunch . . .
President Reagan will inherit thoroughly disordered credit and capital markets, punishing high interest rates, and a hair-trigger market psychology . . . .
The pre-eminent danger is that an initial economic policy package that includes the tax cuts but does not contain decisive, credible elementsm on matters of outlay control . . . will generate pervasive expectations of a continuing "Reagan inflation."
Such a development would almost ensure that high interest rates would hang over the economy well into the first year, deadening housing and durables markets and thwarting the industrial capital spending boom required to propel sustained economic growth. 2. A Double-Dip Recession in Early 1981.
This is now at least a 50 percent possibility. . . . Stagnant or declining real GNP [gross national product] growth in the first two quarters would generate staggering political and policy challenges. These include a further worsening of an already dismal budget posture . . . and a profusion of "quick fix" remedies for various "wounded" sectors of the economy. The latter would include intense pressure for formal or informal auto import restraints. . . . Obviously, the intense political pressures for many of these quick fix aids will distract from the Reagan program on the economic fundamentals (supply-side tax cuts, regulatory reform, and firm longterm fiscal discipline). . . .
There is a further danger; the Federal budget has now become an automatic "coast-to-coast soup line" that dispenses remedial with almost reckless abandon. . . .
For these reasons, the first hard look at the [budget] by our own . . . people is likely to . . . produce an intense polarization between supply-side tax cutters and the more fiscally orthodox . . . . The result would be a severe demoralization and fractionalization of GOP ranks and an erosion of our capacity to govern successfully and revive the economy before November 1982. 3. Federal Budget and Credit Hemorrhage.
The latest estimates place fiscal year 1981 outlays at nearly $650 billion. That represents a $20 billionm outlay growth since the August estimates; a $36 billionm growth since the First Budget Resolution passed in June; and outlay level $73 billion above FY '80; and a $157 billionm growth since the books closed on FY '79 just 13 months ago. . . .
Achieving fiscal control over outlays and Treasury borrowing cannot be conducted as an accounting exercise or exclusively through legislated spending cuts in the orthodox sense.m
Only a comprehensive economic package that spurs output and employment growth and lowers inflation expectations and interest rates has any hope of stopping the present hemorrhage. . . .
The vigorous tax cut package required to spur the supply side of the economy could raise [this year's] deficit to the $60-80 billion rangem . . . . Unless the tax cut program is accompanied by a credible and severe program to curtail [ budget] outlays, future spending authority, and overall Federal credit absorption, financial market worries about a "Reagan inflation" will be solidly confirmed. . . . Commodity Shocks . . .
The US economy is likely to face two serious commodity price run-ups during the next 5-to-15 months.
First, if the Iran-Iraq war is not soon terminated, today's excess worldwide crude and product inventories will be largely depleted by February or March. [ Editor's note: Some of these concerns are now fading; see news stories today, page one.] Under those conditions, heavy spot market buying, inventory accumulation, and eventually panic bidding on world markets will once again emerge.
Similarly, the present rapid draw-down of worldwide feed grain and protein oil reserves could turn into a rout by the fall of 1981, if the Soviets have another "Communist" (i.e., poor) harvest and production is average-to-below-average elsewhere in the world.
The problem here is that demand for these basic commodities is highly inelastic in the very short run; and this generates strong credit demands . . . If the Federal Reserve chooses to accommodate these commodity price/credit demand shocks, as it has in the past, then . . . only one result is certain: The already tattered credibility of the post-October 1979 Volcker monetary policy will be destroyed. . . .m Conditions for full-scale financial panic and unprecedented global monetary turbulence will be present. 5. Ticking Regulatory Time Bomb.
Unless swift, comprehensive, and far- reaching regulatory policy corrections are undertaken immediately, an unprecedented, quantum scale-up of the much discussed "regulatory burden" will occur during the next 18-to-40 months.
Without going into exhaustive detail, the basic dynamic is this: During the early and mid 1970s, Congress approved more than a dozen sweeping environmental, energy, and safety enabling authorities, which for all practical purposes are devoid of policy standards and criteria for cost-benefit, cost- effectiveness, and comparative risk analysis. Subsequently, McGovernite no-growth activists assumed control of most of the relevant sub-Cabinet policy posts during the Carter Administration. They have spent the past four years "tooling up" for implementation through a mind-boggling outpouring of rule-makings, interpretative guidelines, and major litigation -- all heavily biased toward maximization of regulatory scope and burden. Thus, this decade-long process of regulatory evolution is just now reaching the stage at which it will sweep through the industrial economy with near gale force, preempting multi-billions in investment capital, driving up operating costs. . . . II. The Threat of Political Dissolution.
This review of the multiple challenges and threats lying in ambush contains an inescapable warning: Things could go very badly during the first year, resulting in incalculable erosion of GOP momentum, unity and public confidence. If bold policies are not swiftly, deftly, and courageously implemented in the first six months, Washington will quickly become engulfed in political disorder commensurate with the surrounding economic disarray. . . .
For example, unless the whole remaining system of crude oil price controls, refiner entitlements, gasoline allocations, and product price controls as administratively terminated "cold turkey" by February 1, there is a high probability of gasoline lines and general petroleum market disorder by early spring. These conditions would predictably elicit a desultory new round of Capitol Hill initiated energy policy tinkering reminiscent of the mindless exercises of Summer 1979. Intense political struggles would develop. . . . The Administration would lose the energy policy initiative and become engulfed in defensive battles. . . .
To prevent early dissolution of the incipient Republican majority, only one remedy is available: An initial Administration economic program that is so bold, sweeping, and sustained that it:
-- Totally dominates the Washington agenda during 1981.
-- Holds promise of propelling the economy into vigorous expansion and the financial markets into a bullish psychology.
-- Preempts the kind of debilitating distractions outlined above.
The major components and tenor of such an orchestrated policy offensive are described below. III. Emergency Economic Stabilization and Recovery Program.
In order dominate, shape, and control the Washington agenda, President Reagan should declare a national economic emergency soon after inauguration. [ President Reagan subsequently rejected the term "emergency" as too alarmist, sources say, but he does plan quick action.] He should tell the Congress and the nation that the economic, financial, budget, energy, and regulatory conditions he inherited are far worse than anyone had imagined. He should request that Congress organize quickly and clear the decks for exclusive actionm during the next 100 days on an Emergency Economic Stabilization and Recovery Programm he would soon announce. Five major principles should govern the formulation of the package:
1. A static "waste-cutting" approach . . . will hardly make a dent in the true fiscal problem. . . .
This means that the policy initiatives designed to spur output growth and to lower inflation expectations and interest rates must carry a large share of the fiscal stabilization burden. . . .m
2. Dilution of the tax cut program in order to limit short-run static revenue losses during the remainder of FY '81 and FY '82 would be counter-productive. Weak real GNP and employment growth over calendar 1981 and 1982 will generate soup line expenditures equal to or greater than any static revenue gains from trimming the tax program.
3. . . . A dramatic, substantial recisionm of the regulatory burden is needed. . . .
4. High, permanent inflation expectations have killed the long-term bond and equity markets that are required to fuel a capital spending boom and regeneration of robust economic growth. . . . The Reagan financial, stabilization plan must seek to restore credit and capital market order and equilibrium by supporting monetary policy reform and removing the primary cause of long-term inflation pessimism: the explosive growth of out-year Federal liabilities, spending authority, and credit absorption.
This points to the real leverage and locus for budget control: [holding down] entitlement and new obligational authority in the Federal spending pipeline, which creates [heavy spending in later years].
The fiscal stabilization package adopted during [the first 100 days], therefore, must be at minimum equally weighted between out-year spending and entitlement authority reductionsm and cash outlay savings for the remainder of FY '81. The latter possibilities are apparently being exaggerated. . . .
5. Certain preemptive steps must be taken early on to keep control of the agenda and to maintain Capital Hill focus on the Stabilization and Recovery Program. Foremost, all remaining petroleum product controls and allocations should be canceled on day one. This will prevent a "gasoline line crisis," but will permit retail prices to run up rapidly if the world market tightens sharply as expected. This prospective price run-up can be readily converted into an asset: It can provide the political motor force . . .to step up US energy. . .production.
The following includes a brief itemization of the major components of the Stabilization and Recovery Program:
a. [Ten percent] Kemp-Roth [tax cuts in 1981 and 1982], reduction of the top income tax rate unearned income to 50 percent, further reduction in capital gains, and a substantial reform along 10-5-3 lines of corporate depreciation.
b. [Hold] outlays to the $635 billion range [in FY '81. Mandate] a hiring freeze and a severe cutback in agency travel, equipment procurement, and outside contracting would be the major areas for savings. [Also,] entititlement revisions and budget authority reductions in FY '82 and beyond. . . .
c. [On regulation], first and most urgent is a well-planned and orchestrated series of unilateral administrative actions to defer, revise, or rescind existing and pending regulations. . . . The potential [is] staggering. . . . On a second front, there are literally dozens of rule-making and compliance deadlines on the statute books for the next 20 months that cannot be prudently met. An omnibus "suspense bill" might be necessary during the 100 day session to defer these deadlines. . . .
d. . . . The probable 1981 "oil shock" could entail serious political and economic disruption. Therefore, the preemptive step of dismantling controls before the crisis really hits is imperative. Incidentally, the combination of immediate decontrol and a $10 rise in the world price would increase windfall profits tax revenue by $20-25 billion during calendar 1981, thereby [improving our] budget posture. . . .
Beyond this, a planning team should be readying a package of emergency steps to increase short-run domestic energy production and utilization. This should be implemented if the world market pinch becomes severe. The primary areas for short-run gains would be: accelerated licensing of a half-dozen completed nuclear plants; removal of all end-use restrictions on natural gas; changes . . . to permit accelerated infill drilling and near-term production gains; elimination of stripper, marginal, and EOR oil properties from the windfall tax; emergency variances from SO standards for industrial and utility coal boilers; and power wheeling from coal-nuclear to oil-based utility systems. . . .
e. The markets have now almost completely lost confidence in Volcker and the new monetary policy. Only an extraordinary gesture can restore the credibility that will be required during the next two years. . . . Restoration of the [the Federal Reserve's] tattered credibility is the critical lynch-pin in the whole program.